Revision Accounting and Finance

Question ONE
A family-owned private limited company manufactures a particular brand of sportswear in its
four wholly owned factories. The company wants to expand into Eastern Europe.
(a) Identify the advantages and disadvantages of using the following sources of finance to raise
the 10 million required for the expansion:
(i) Sale and leaseback of its four factories
(ii) An issue of new shares
Answers
(a) (i) Sale and leaseback is a contract to raise cash by selling an asset, in this case the four
factories, and immediately renting the properties back on a long-term lease. The advantage of
this type of finance is that it allows the company to stay in the factories and continue trading as
though nothing has happened. The capital released can be used immediately to enable the
company to expand into Eastern Europe. The disadvantage is that the company has sold some of
its most valuable assets and it must pay a rental sum for the period of the lease. Overall the
company will only benefit if the expansion into Europe produced more profit than the cost of the
lease.
(ii) An issue of new shares is a reasonably cheap way of providing the company with more
permanent capital which can be used to finance the expansion.
Another advantage is that the company is not obliged to pay dividends to the shareholders. A
disadvantage, however, is that the ownership is diluted and each share is now worth slightly less.
The shareholder will only benefit if the expansion creates sufficient profits to raise the share
price and to deliver higher dividends.

Question TWO
(a) Using examples, explain the following financial terms:
(i) Fixed costs
(ii) Variable costs
(iii) Debtors (trade receivables) and creditors (trade payables)
(b) A public limited company is expanding its production. For each of the following activities,
identify two suitable sources of finance, stating the advantages and disadvantages of each source.
(i) The building of a new factory costing 80 million
(ii) The acquisition of five new machines costing 10,000 each

Answers
(a) (i) Fixed costs are costs that do not vary in the short-term when a firm alters its level of
output. Examples of fixed costs include rent, rates, insurance and depreciation and must be paid
irrespective of the level of output.
(ii) Variable costs are those expenses that change directly with the volume of output.
Examples might include fuel with miles driven or raw materials and components with production
output. These costs will depend on the level of production and sales.
(iii) A debtor is a firm or individual that owes money because they have bought goods or
services but have not yet paid for them e.g. a customer buying goods by installments. A creditor,
however, is a firm or individual to whom money is owed for goods or services already provided
e.g. raw material suppliers who only invoice firms on a monthly basis.
(b) Long-term projects such as a new factory and the purchase of machinery should be financed
through a long-term source of finance.
(i) A factory can be financed through a mortgage or a long-term bank loan. The advantages of
these forms of finance for the firm are:
The cost of the buildings is spread over many years
The interest charges can be off-set against tax
The loan is secured against the value of the buildings

The disadvantages are:

The rate of interest might increase over the period
Failure to pay the interest and capital repayments might result in the buildings being
repossessed and the business closing down
(ii) New machinery can be financed also through a bank loan with the same advantages and
disadvantages. Alternatively the machinery could be financed using leasing. A leasing company
will purchase the machinery for the firm and leases it at an agreed rental for an agreed time
period. The advantages of this form of finance for the firm are:
No need for a large capital outlay as payments are spread over the life of the lease
No need to provide security
Rental is paid for from income generated by the assets use
Rental is fixed and can therefore be budgeted for
At the end of the lease the firm has the option to buy the asset or to enter in to another
lease for more modern machinery
The disadvantages are:
The firm does not own the machinery
The rental charges will be higher than the interest on a bank loan

Question THREE
(a) Explain the difference between:
(i) A bank loan and a bank overdraft
(ii) Hire purchase and leasing
(iii) Current assets and current liabilities
(b) For each of the following situations, explain what the most suitable source of finance is:
(i) A company with a cash flow problem that is having difficulty collecting its debts
(ii) A successful sole trader wishing to expand quickly
(iii) A private limited company wishing to modernize its fleet of cars
Answers
(a) (i) A bank loan is a formalized agreement between the borrower and the lender, normally a
bank. The capital borrowed must be repaid over a stated period together with interest in regular
installments. A bank overdraft, however, is a flexible loan facility. A business is given
permission to withdraw money from its account up to an agreed limit.
Firms only pay for what they borrow.
(ii) Hire Purchase is a means of buying a capital asset by paying a deposit and regular
installments over a period of time. Finance Houses, which retain ownership of the equipment
until the last payment has been made, provide the funding. With leasing, however, the firm (the
lessee) pays an agreed rental for the leasing of equipment from the leasing company (the lessor).
This eliminates the need for the firm to commit large sums of money to the out-right purchase of
an asset. At the end of the lease the equipment is returned to the leasing company.
(iii) Current assets are anything owned by an organisation that is likely to be turned into cash
before the next balance sheet date, normally within one year. Typical current assets are stock,
debtors and cash. Current liabilities, however, are the short term debts of the business.
These include all payments that are due before the next balance sheet date usually within one
year. Typical current liabilities are creditors, overdraft, dividends due and unpaid tax. It is
essential for firms to have sufficient current assets to pay the current liabilities.
(b) (i) This is a common short-term problem that results in businesses being short of cash to fund
their current operations. Short-term sources are designed to last for less than one year and
include: Approaching a bank for an overdraft. Interest is only paid on the amount used and is a
useful source of extra cash.
Negotiating longer trade credit: This will allow a firm to receive goods and materials for an
agreed period without payment. The aim is to collect money from debtors before the creditors
require payment. Where the debtors are reliable it is possible to use factoring to solve the
problem. A factor is a specialist company that provides finance for up to 85% of a firms debts.
In return the factor collects the total debt when due, subtracts its charges and pays the balance to
the firm. This allows a business access to the majority of its cash immediately.
(ii) This can be viewed as a medium term problem that would require medium term sources of
finance. A loan from a bank would enable the owner to expand but only if the business can offer
sufficient security to guarantee repayment. Interest and capital have to be repaid according to the
agreed schedule or the business could face closure by the bank. Where expansion requires the
purchase of new assets such as machinery leasing and hire purchase can be considered. Both

methods can be expensive and regular payments are required. The sole trader could seek a
partner to provide the extra capital. This will involve some loss of ownership and control. A deed
of partnership must be drawn up detailing the decision-making roles and the division of profits
and losses. Although disagreements might occur a partnership is a useful way of gaining more
permanent capital and additional expertise.
(iii) The upgrading of vehicles can be viewed as a long-term project that requires a long-term
injection of capital. The principal sources include:
Bank loan: A loan for at least five years to enable the expansion to generate sufficient profits to
repay the interest and capital. Security would be required and capital repayments made over the
life of the loan together with interest payments at the current commercial rate.
Share issue: A further issue of shares could be made to either existing shareholders or new
investors. This will dilute the ownership of the business but it provides a permanent injection of
capital without the need for interest or capital repayments. Investors would, however, expect a
return on the investment in the form of dividends.

Question FOUR
Define the term working capital and state three reasons why cash is so important to a business.
Answer
Working capital is the day-to-day finance required to run a business. It is the finance required to
pay for raw materials, running costs, labor and to finance credit offered to customers.
Cash flow management is one of the most important functions of the finance department. One
reason why cash is so important is to meet daily bills as they become due. If a company delays
paying its suppliers they may be reluctant to continue supplying the firm or to offer cost saving
discounts. In a similar way employees would not like any delay in receiving their wages.
A second reason for good control of cash is to satisfy major creditors especially banks who might
have issued loans to the business or extended overdraft facilities. Difficulties in meeting regular
repayments could lead to the firms closure.
A third reason for having adequate cash is for unforeseen events. These could be such events as
special deals on raw materials that might be offered for cash-only settlement or to compensate
for debtors lengthening the period of repayment. In either case cash will be needed.

Question FIVE
(a) What do you understand by the following financial terms?
(i) Gearing
(ii) Fixed assets
(iii) Budget
(iv) Debenture

Answers
(a) (i) Gearing measures the proportion of capital employed that is provided by long term
lenders. The gearing ratio is given by the equation:
Gearing = Long term liabilities/Total Capital Employed *100
(ii) Fixed assets are items that have a long-term function in a business and can be used
repeatedly. Examples might include buildings, land, vehicles, equipment and machinery.
(iii) A budget is a financial plan for a specified future period of time. A master budget combines
the forecast income from sales together with forecast expenditure. This can be used to determine
a forecast cash flow statement as well as a forecast profit and loss account.
(iv) A debenture is a common form of long-term loan issued by a firm. It is usually secured
against the assets of the business. The debenture pays a fixed rate of return for the duration of the
loan.
Question SIX
(a) Explain each of the following financial terms:
(i) Sale and leaseback
(ii) Venture capital
(iii) Preference share
(iv) Trade credit
(b) Explain the services and benefits for a business provided by:
(i) A factoring company
(ii) A leasing company
Answers
a)
i) Sale and leaseback is a long-term source of finance where the business sells a fixed asset and
immediately leases the use of it back again. The lease is usually on a long term basis. For
example a business might sell its head office and arrange a 99 year lease.
ii) Venture capital is a specialist form of finance comprising of a package of a loan and share
capital. In return for providing medium to long term capital the venture capitalist will acquire a
share in the company. This is usually provided for firms in high risk sectors where conventional
finance is not available.
iii) Preference shareholders are entitled to a prior claim on any profits before payment to
ordinary shareholders. Preference shareholders are less risky and often have a fixed rate of
dividend.
iv) Trade credit is a short-term source of finance provided by suppliers. Businesses are allowed
to buy goods and services now and to pay at the end of the credit period.
The trade credit is interest free and is provided to encourage sales. Typical credit period offered
is 30 days.
b)
i) A factoring company provides finance to bridge the gap between the issue of invoices by a
company and the receipt of payment i.e. the period of credit. Usually the factoring company will
extend 80% of the invoice value as soon as the invoice is issued to the customer. At the end of

the credit period the factoring company will collect the total due from the customer. It will send
the balance of 20% minus its own charges. The business benefits by receiving the bulk of its
money at the time of sale which it can use to fund further trade. The customer still retains the
same credit period and the factoring company earns a percentage of the invoice total for
extending credit to the business. It is similar to offering a discount for cash. The business does
not have the trouble of chasing payments.
ii) A leasing company is one that provides a method of acquiring assets without the need for the
initial cash outlay implied by purchasing. The leasing company will hire out capital equipment
for an agreed period of time at an agreed rate, for example a fleet of cars for two years at 250
per month per car. After the lease has expired the ownership of the assets returns to the leasing
company. The benefits of leasing are that it has less impact on cash flow, allows the regular
updating of equipment, releases capital for other projects, and provides the possibility of buying
the equipment cheaply at the end of the lease.

Question SEVEN
a) With numerical examples, explain the following terms.
i. Total cost
ii. Total revenue
iii. Profit
iv.
Working capital
v. Break-even point
vi.
Contribution margin

a)
i.

ii.

iii.

iv.

Total cost: This is the total cost of production of the firm. Its the summation of both
fixed and variable cost. It can be calculates using the formula Total Cost = Fixed Cost +
Variable Cost. For example, if the fixed cost is $1,000 and variable cost per unit is $5.
The total cost of producing 100 units will be 1,000 + (5*100) = $1,500
Total revenue: This is the total receipts of a firm from the sale of any given quantity of a
product. This includes total sales and other forms of revenue such as rent received, and
interest received. Total revenue can be calculated using the formula Total Revenue =
(Average) Selling Price * Quantity sold. For example, if the selling price per unit is $10
and when we sell 100 units, the total revenue will be 100*10 = $1,000
Profit: This is the excess of income (total revenue) over expenditure (total cost). It is the
net profit that is taxed by government. This can be calculated by using the formula Profit
= Total Revenue Total Cost. If the total cost is $1,000 and total revenue is $1,500. The
profit will be 1,500 1,000 = $500
Working capital: This is the day-to-day finance required to run a business. It is the
finance required to pay for raw materials, running costs, labor and to finance credit
offered to customers. Working capital can be calculated by using the formula Working

v.

vi.

Capital = Current Assets Current Liabilities. If the current assets of the company are
$2,000 and current liabilities are $1,500, then the working capital will be $2,000 1,500
= $500
Break-even is the output level at which a firms revenue just matches its fixed and
variable costs, earning neither a profit nor a loss. For newly established firms this is one
of its first goals so that it can survive. This point can be calculated using the formula
Break Even Point = Fixed Cost / Contribution per Unit. If the fixed cost is $15,000 and
contribution margin is $5, then the BEP = 15,000/5 = 3,000 units.
Contribution: The amount of revenue remaining after deducting variable costs. This the
amount each item sold contributes toward paying the other costs of the business i.e. the
fixed costs. Contribution per unit can be calculated by using the formula Contribution per
unit = Selling Price variable Cost. If selling price is $12 per unit and variable cost is $7
units per unit, contribution per unit will be 12 7 = $5.

NOTE: PLEASE GIVE FURTHER ATTENTION TO

BUDGEDTING, CASH FLOW FORECASTING AND
BREAK EVEN. REVISE THOSE TOPICS FROM NOTES
THORUGHLY.