Introduction to Finance: Financial Statement Ratios, Analysis, and Budgeting

This file provides an adequate discussion about financial statement ratios like gross profit ratio, assets usage ratio, current ratio, acid test ratio, inventories holding period, and debt-equity ratio. It also explains the importance of financial statement analysis and how to calculate ratios. Additionally, it covers cash budgeting and the calculation of payback period, accounting rate of return, and NPV analysis. The subject is Introduction to Finance, and the course code is FIN4001.

Introduction
to
Finance

INTRODUCTION
The dictionary meaning of the term finance has broad aspect which states that something
which deals in monetary terms. In relation to the business, the meaning of finance is the financial
structure of the company such as, debt employed, equity capital employed. In this file, there have
been shown an adequate discussion about the financial statement ratios like gross profit ratio,
assets usage ratio, current ratio, acid test ratio, inventories holding period and debt-equity ratio
and explanation of financial statement analysis (Alshater, Atayah and Hamdan, 2021). There has
also been shown an opening statement of financial position and and cash budget of the
companies and a brief glimpse of the break-even point and margin of safety (Beaumont, 2019).
And lastly there is also shown the calculation of payback period, accounting rate of return and
NPV analysis of the projects and the selection of the projects.
TASK
Question 1 :
(a) Calculations of ratios for the year 2019 and 2018 :
(I) Gross Profit Margin = Gross Profit / Sales * 100
= £1313 / £3495 * 100
= 37.57 %
Interpretation :
Gross profit margin is a profitability ratio based on sales, it represents the relationship
between the gross profit earned and sales made during the year (Ge, Cai and Song, 2022). A high
gross profit margin is a favourable sign of effective management, in the above scenario, Liverton
Co. is earning gross profit at the rate of 37.57 % of the sales, which is quite good.
(II) Assets Usage Ratio = Total Sales / Average Total Assets
= £3495 / £3157.5
= 1.10 times
Interpretation :
Assets usage ratio refers to the relationship between the total sales of the year and
average total assets. This ratio is categorized under efficiency ratio, it measures the efficiency

with which the firm uses its assets. High asset usage ratio depicts the efficient utilisation of the
assets in generating the sales, likewise a lower assets usage ratio indicates that the assets are not
efficiently utilised to generate sales. In the present case, Liverton Co. is making sales by 1.10
times through utilization of its assets .
(III) Current Ratio = Current Assets / Current Liabilities
For year 2019 = £1687 / £744
= 2.267 times
For year 2018 = £418 / £502
= 0.8327 times
Interpretation :
Current ratio is a measure of short term solvency, it shows the relationship between the
current assets and current liabilities. An ideal current ratio is 2:1, however, ratio's satisfactory
depends upon the nature of the business (Hattori and Ishida, 2021). In the year 2018, the current
ratio of liverton co. was 0.8327 times but it has increased to 2.267 times in the year 2019. The
increment is because of the drastic change in short term investment, trade receivables and cash at
bank. The company has made short term investment of £75,000 and trade receivables has also
increased by £695,000 and cash at bank has also been increased by £451,000.
(IV) Acid Test ratio = Current Assets - inventory / Current liabilities
For year 2019 = £1687 – £150 / £744
= 2.066 times
For year 2018 = £418 – £102 / £502
= 0.63 times
Interpretation :
Acid test ratio also known as liquid ratio, it shows the measurement of short term
liquidity of the company (Ji and et.al. 2019). It depicts the relationship between liquid assets and
liquid or current liabilities, an ideal acid-test ratio is 1:1. Liquid assets does not include the
inventory hence the value of inventory is deducted from the current assets. In the present
scenario, the company's acid test ratio was 0.63 times in the year 2018 but in the year 2019 it has

increased to 2.066 times. The base for the increment is major change in trade receivables and
cash at bank and introduction of short term investment.
(V) Inventories = Average Inventory / Cost of goods sold * 365
Holding Period
= (102 + 150 / 2) / 2182 * 365
= 21.08 days
Interpretation :
Inventories holding period presents the number of days for which the company holds the
finished goods stock for making sales, higher the ratio the better it will be. In the above case, the
company holds its inventories for approximately 21 days for making sales, it can be considered
as good period as will help the company to make or purchase the goods, in the lead time for
selling them to the customers.
(VI) Debt-Equity Ratio = Long term debt / Total equity
For year 2019 = 170 / 2898
= .059 times
For year 2018 = 50 / 1951
= .026 times
Interpretation :
Debt-Equity ratio is a measurement of the long term solvency of the organisations, the
higher debt- equity ratio depicts the less protection to the creditors and vice versa (Kong and
Gallagher, 2021). This ratio indicates the relationship of long term debt fund or outside liabilities
with the total equity of the company, it is also an indicator of the financial leverage of the
company. In the present case, the debt equity ratio for the year 2018 was .026 times and for the
year there has been noticed an increment in the ratio of .059 times. Although the company has
noticed the increment, yet it would not have any major impact on the liverton co.'s operations.

(b) Explanation of importance of financial statement analysis :
Financial statement analysis is an identification and analysis of the financial statements of
the company. Financial statement is a structured representation of the historical financial
information of the company, it includes balance sheet, profit and loss account and cash flow
statements. Financial statements analysis is mandatory for the sound decision making regarding
investment, it also helps in assessment of the future growth of the firm. Analysing the financial
statements shows presents the liquidity, efficiency, solvency and profitability of the business.
Financial statement analysis is useful in providing the meaningful information to the
shareholders for making decisions regarding holding the shares of the company (Liermann, Li and
Schaudinnus, 2019). In short, financial statement analysis is the process of evaluation of the
financial condition of the business.
Question 2 :
(a) Opening statement of financial position at the start of July 20X5 :
Particulars Amount in “£”
Equity And Liabilities
Equity Share Capital 200000
Total 200000
Assets :
Non-Current Assets :
Tangible Non Current Assets 150000
Current Assets :
Cash At Bank 50000
Total Assets 200000

(b) Preparation of monthly cash budget :
Cash Budget (Amount in “£”)
Particulars July August September October
Novembe
r December
Opening
Balance (A) 50000 7500 -95000 -127500 -100000 -22500
Cash receipts
Sales receipts 150000 120000 150000 210000 260000 285000
Share Capital 200000
Total (B) 350000 120000 150000 210000 260000 285000
Cash
Payments
Payments for
materials 120000 100000 60000 60000 60000 60000
Labour Cost 80000 80000 80000 80000 80000 80000
Other expenses 42500 42500 42500 42500 42500 42500
Purchase of
Non Tangible
Assets 150000
Tax Bill 20000
Total (C) 392500 222500 182500 182500 182500 202500
Closing
Balance 7500 -95000 -127500 -100000 -22500 60000
In the above scenario, the company is having negative cash balance at the end of each
month except for the month of July and December. So the management of the company need to
improve its capabilities for the effective and efficient utilisation of the ability to increase revenue

to maintain positive cash balances at the end of each month (Piccio and Van Biezen, 2018). It can be
maintained by increasing sales and lowering the expenses related to sales, such as reduction in
raw material purchasing cost, labour cost and other expenses as well.
(c) Explanation of additional expenses which should be taken into consideration :
The overdraft facility is provided to the companies over and above the amount
maintained in the bank account of the company and it allows the company to pay their pending
bills and other liabilities (Ross and Wright, 2022). To avail the facility of overdraft, the company
needs to pay the fee and have to incur other expenditures such as, bank charges, maintenance fee
etc. With the help of overdraft, the organisation is capable of paying the bills and other costs on
time.
Question 3 :
Income Statement (Amount in "£”)
Particulars 2019 2020
Sales 13500000 13905000
Less : Variable cost
Direct Material 5625000 5625000
Direct labour 675000 585000
Variable Manufacturing Expenses 900000 877500
Variable Selling Expenses 675000 675000
Variable Administrative expenses 450000 8325000 360000 8122500
Contribution 5175000 5782500
Less : Fixed cost
Fixed Manufacturing Overheads 1650000 1650000

Fixed Selling and Distribution
Overheads 2850000 2850000
Fixed Administrative Overheads 930000 5430000 930000
Other Fixed Cost 1450000 6880000
Profit -255000 -1097500
Profit-Volume Ratio 38.33 41.59
(a) Calculation of the break-even point in units and sales revenue :
(I) Break-Even Point = Fixed Cost / Contribution per unit
(In units)
Year 2019 = £5,430,000 / £115
= 47,217.39 fans
Year 2020 = £6880000 / £128.5
= 53,540.86 fans
(II)Break-Even Sales = Fixed Cost / Profit – Volume Ratio
(In “£”)
Year 2019 = £5,430,000 / 38.33 %
= £14,165,229.71
Year 2020 = £6880000 / 41.59 %
= £16,542,438.09
(b) Calculation of margin of safety in units and sales revenue :
(I) Margin Of Safety = Profit / Contribution Per Unit
(In Units)
Year 2019 = £-255000 / £115
= -2217.40 fans
Year 2020 = £-1097500 / £128.5
= -8540.86 fans
(II) Margin Of Safety = Profit / Profit-Volume Ratio

(In “£”)
Year 2019 = £-255000 / 38.33%
= £-665,223.17
Year 2020 = £-1097500 / 41.59%
= £-2,638,855.49
(c) Discussion about the new strategy :
Break-even point refers to the point where fixed cost equals to the contribution, that
means it is no profit and no loss situation for the company, whereas margin of safety represents
the sales over and above the break even sales (Sarker, Khatun and Alam, 2019). In the current case,
taking lessons from the past, Jessica decides to lower its cost, for this the company has
established a new manufacturing unit in Leicester that has burdened the company with
£1,450,000 as fixed cost. On the basis of above calculations, it has come to notice that
contribution per unit has increased to £128.5 but due to excess fixed cost, the loss has also
increased by £842,500. Thus it can be concluded that Jessica needs opt for reactive approach to
reformulate the strategy to attain the expected results. Apart from all these, the company has
noticed decline in the direct labour cost, variable manufacturing and administrative overheads.
Question 4 :
(a) Calculation of the payback period, accounting rate of return and NPV :
Calculation Of Cumulative Cash Inflows (Amount in “£”)
Year Project A = 175000 Project B = 195000 Project C = 190000
Cash
Inflows
Cumulative
CI
Cash
Inflows
Cumulative
CI
Cash
Inflows
Cumulative
CI
1 75000 75000 95000 95000 50000 50000
2 65000 140000 65000 160000 60000 110000
3 60000 200000 45000 205000 65000 175000

4 55000 255000 45000 250000 66000 241000
5 50000 305000 45000 295000 57000 298000
(I) Payback Period = Initial Investments / Cumulative Cash Inflows
Project A = 2 Years + (175000-140000/60000)
= 2 Years and 7 Months
Project B = 2 Years + (195,000-160000/45000)
= 2 Years and 9 Months (Approximately)
Project C = 3 Years + (190000-175000/66000)
= 3 Years and 3 Months (Approximately)
Calculation of Average Profit After Tax (£)= (Cash Inflows - Depreciation) /
No. of years
Year Project A Project B Project C
1 40000 56000 12000
2 30000 26000 22000
3 25000 6000 27000
4 20000 6000 28000
5 15000 6000 19000
Total 130000 100000 108000
Average 26000 20000 21600
Calculation of Average Investment (£) = ½ (Initial Investment – Salvage Value) +
Salvage Value
Particulars Project A Project B Project C

Initial Investment 175000 195000 190000
Salvage value 5000 8000 4000
Average Investment 90000 101500 97000
(II) Accounting Rate = Average Profit / Average * 100
Of Return After Tax Investment
Project A = £26,000 / £90,000 * 100
= 28.89 %
Project B = £20,000 / £101,500 * 100
= 19.70 %
Project C = £21,600 / £97,000 * 100
= 22.27 %
Calculation of Present Value of Cash Inflows (Amount in “£”)
Year
Present
Value
Factor
@18%
Project A Project B Project C
Cash
Inflows
Discounted
Cash
Inflows
Cash
Inflows
Discounted
Cash
Inflows
Cash
Inflows
Discounted
Cash
Inflows
1 0.8475 75000 63559.32 95000 80508.47 50000 42372.88
2 0.7182 65000 46681.99 65000 46681.99 60000 43091.07
3 0.6086 60000 36517.85 45000 27388.39 65000 39561.01
4 0.5158 55000 28368.39 45000 23210.50 66000 34042.07
5 0.4371 50000 21855.46 45000 19669.91 57000 24915.23
Scrap 0.4371 5000 2185.55 8000 3496.87 4000 1748.44
Total 199168.56 200956.14 185730.68
(III) Net Present Value = Present Value Of – Initial Investment
Cash Inflows

Project A = £199,168.56 – £175,000
= £24,168.56
Project B = £200,956.14 – £195,000
= £5,956.14
Project C = £185,730.68 – £190,000
= £-4,269.32
(b) Evaluation of the above three potential investment to be undertaken :
If the calculations in part (a) are considered, then it can be explained that Project A
should be selected among all three proposals as it would recover its initial cost in least time of all
(Tellier, 2019). If Scrappit plc chooses the project B and C over project A then it would be able
to recover its cost in 2 years and 9 months and 3 years and 3 months respectively. Although
company can think about the project B apart from project A but it should completely ignore the
project C.
If accounting rate of return is considered, then project A should be chosen over all as it
provides the return of 28.27% but if the company is willing to select the project between B and C
then the company should ignore the project B as it has the least rate of return.
On the basis of net present value analysis, the company should opt for the project A as it
gives the company, highest NPV among all the potential investments, and project C provides the
return in negative, so choosing the proposal C would not be beneficial for it.
Therefore, it can be summarised that selecting the project A should be advantageous to
Scrappit Plc as it has least payback period, higher rate of return over investment and the highest
net present value.
(c) Discussion of approaches of investment appraisals :
 Payback Period :
Payback period refers to the period of time, in which the company can recover its
project cost, the payback period is derived through dividing the total initial investment by the
annual cash flow after tax if cash inflow is equal throughout the period whereas if cash inflow is

unequal then cumulative cash inflow will be considered (Velchik and Zhang, 2019). The project
having earlier payback period should be selected among the given alternative projects.
Payback period has some advantages with itself such as; it is calculated easily and
it gives a quick estimate of the time required for the recovery of initial cost. Apart from the
advantages, it has some limitations as well like; this approach ignore the time value of money,
and it also ignores the cash flow after the payback period.
 Accounting Rate Of Return :
Accounting rate of return measures the average annual net income to be generated
from the investment as a percentage of the initial cost. It is computed by dividing the average
annual income throughout the period by the initial or average investment over the useful life of
the project (Wellum, 2020). The highest rate of return should be opted if there are multiple
projects, the benefits of ARR approach are mentioned below :
 It does not require any special and complex procedure to generate data, it uses
readily available data.
 It considers the net incomes to be generated over the life time of the project.
This approach also has its limitations too which are given below :
 Just like payback period approach it also ignores the time value of money.
 This method does not use cash inflow but it uses only net income because net
income measures only profitability whereas cash flows are used to evaluate the
performance of the investment.
 Net Present Value :
The net present value approach is a discounted cash flow method that is used to
evaluate the capital investments. To derive the present value of cash inflows an appropriate
discount rate is selected, on the basis of which the value is computed then the initial cost of
investment is deducted from the present value of cash inflow to derive the net present value. The
positive net present value is selected if only one project is given, whereas the project having
highest NPV is selected if the multiple projects are being analysed (Wong, 2020). Just like other
approaches, this method too possesses its pros and cons, which are mentioned following :
The pros of net present value approach are;
 Unlike the above two approaches this method takes into consideration the time
value of money.

 The net present value uses the discounted cash flows therefore the cash flows can
be compared.
On the other hand, the disadvantages of net present value approach are;
 Calculation of net present value is difficult and the accuracy of this method
depends on the accurate estimation of the forecasted cash flows and the discount
rates.
 Net present value approach ignores the difference in initial outflows, size of
several alternatives if multiple proposals are given.
CONCLUSION
On the basis of above explanation of this report, it can be concluded that the computation
of ratios and analysis of financial statements of the Liverton co. provides the clear picture about
the financial position of the company (Wu and Huang, 2022). In case of Sasssy clothing, the
opening statement of the financial position of the company and the cash flow forecast provides
the glimpse of expected future outcomes of the company. The calculation of break even point
and margin of safety with respect to FreeAir Ltd. and the strategies formed relating to them
shows that company needs to produce more number of fans to increase revenue and surpass the
break-even. If Scrappit Plc is considered, then the company should adopt the project 'A' among
all the alternatives as it is beneficial for company in every aspect whether be it payback period,
accounting rate of return and net present value.

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