Foundation Accounting.docx

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Foundation Accounting

Task 1

Using your text book, other books, journals and/or internet resources explain the key

advantages of one key source of finance for a company.

The source of finance to be discussed is equity finance, according to Needles et al. (2010),

equity financing is achieved through the issuance of shares to investors in exchange for assets

which is usually cash, and investors are then issued a share certificate which they can transfer

at any time by selling it for cash in the stock market. By issuing such shares in exchange for

cash, the company is selling part of its interests to the investors, and this makes them part

owners and partners in the business with full rights as shareholders as prescribed by the law

(Gowthorpe, 2005). There are several advantages of equity financing and these are discussed

accordingly:

According to Needles et al. (2010), equity financing is less risky than most of the other types

of financing sources because the company does not pay interest on it, and will only pay

dividends when the board of directors decide to pay them, whereas in other sources that the

company has to pay interest, if it does not pay, it can be forced to pay the interest or be forced

to close down, if it cannot pay. Shareholders are only interested in returns on their investment

in the form of dividends or increase in the market value of the shares they have been issued

by the company which they can sell for a profit (Porter and Norton, 2010). Also, the

company can decide to divert the unpaid dividends into the business’ operations to finance

projects that need cash in order to improve the company’s profit making capabilities (Needles

et al., 2010).

The payment of dividends is flexible because it can be increased during the period of

profitable performance, and then be reduced when the company is less profitable, and they

still always have access to raise more funds whenever there is need for it (Porter and Norton,



2010). The share certificates have no expiry dates except when the shareholder sells the

shares, and the funds provided to the company by the investors does not have to be returned,

so they are a good source of long term funding for the company (Fleming, 2004).

Task 2

a) Explain the long and short-term sources of finance utilised by each company in two

consecutive years.

Molins PLC and Povair Plc

Long term sources of finance:

Equity:

Issued share capital which shows that the company has collected cash from its shareholders,

in return for share certificates which they can sell in the stock market either at a profit or loss,

depending of the value of the company’s stock on the stock market (Needles et al., 2010).

Share premium is the amount of money received over and above the actual value of the

shares.

Reserves represents extra cash that has been set aside by the company to meet some

obligations in the future which may either be expected or unexpected, but which is currently

available for the company to finance its operations.

Retained Earnings represents the part of the company’s net income which is set aside, and

not paid as dividends, but to be re-invested into the company’s main business in future.

Interest-bearing loans and borrowings are funds that have been borrowed for specific

investment purposes at fixed interest rate, and which must be repaid at the agreed date.

Employee Benefits refer to the benefit pension scheme run on workers behalf and from

which pension payments are made when the employee retires, and the company is responsible

for its maintenance.



Cumulative translation reserves represent the gains that result from varying exchange rates

in the previous years.

Task 2

Companies

Mollins Plc Povair Plc

Year

Ratios

2012 2011 2012 2011

Gearing Ratio(See Appendix A)

16.21% 11.26% 19.44% 19.50%

Dividend Cover (See Appendix B)

7.60 times 7.1 times 4.23 times 3.18 times

Dividend Yield(See Appendix C)

0.02% 0.00008%

Interest Cover (See Appendix D)

0.343 times 0.310 times 7.95 times 6.58 times

b. From the above analysis, the gearing ratio for Mollins Plc was 11.26% in 2011, it increased

to 16.21% in 2012, this shows that the company’s debt increased in 2012 and is likely to

continue to rise, Povair Plc’s gearing ratio reduced from 19.50% in 2011 to 19.44%.

Although, the two companies borrow to finance their activities while they both have enough

stock of cash in their share premium account to pay back the debts.

c. Risks and Rewards

Risk is the uncertainty attached to a specific investment which makes it impossible to confirm

that the investment has a positive or negative reward or that the reward is high or low, the

reasonableness of risk is measured in terms of the relationship between risk and reward,

hence, the higher the risk, the higher the reward, also, the lower the risk the lower the reward

(McMenamin, 1999). From the reports of the activities of both companies, we can see that



both are exposed to different types of risks based on their line of business as well as the

global economic and market cycles, but they have both tried to reduce the effect of such risks

by engaging in several range of business operations such that if one fails, the other can make

up for the losses from other sections. But because both companies declare dividends

progressively on a yearly basis, and the yearly increase in the earnings per share, the risks are

worth taking and this will keep shareholders happy, since it will increase the value of the

companies’ shares on the stock market.

d. How would the return to both (shareholders and loan providers) vary if the ‘Profit

before Interest and Tax’ rises or falls? (A sensitivity analysis is required by simulatingdata within a reasonable range).

The returns to both shareholders and loan providers can be affected by the performance of the

organisations regarding the amount of sales declared, and within its cost of sales, the

efficiency in the company’s inventory turnover as well as the management of administrative

expenses. A sensitivity analysis is provided below to show this:

Povair Plc Adjusted Consolidated Income Statement as at 30 November 2012

2012 2012

Adjusted Actual

£ ‘000 £’000

Revenue 53,518 76,455

(Assuming a 30% reduction in stock value in 2012 from

fire outbreak in the stores which also leads to a 30% reduction in sales)

Less: Cost of sales (51,231) (51,231)

Gross Profit 2,287 25,224

Less:

Distribution costs 500 990

(Distribution costs would also reduce since sales has reduced)

Administrative expenses (17,029) (17,029)



(Administrative expenses are assumed to be fixed costs)

Operating Profit/(Loss) (15,242) 7,205

From this big loss, the company would not be able to declare dividends and it would have

been unable to pay the interest on its loans for the year, and this leads to a default in

payments.

Task 3

Based on the comparable results of the ratio analysis and from other reports in both

companies’ annual accounts, Povair Plc has a lower risk profile and hence lower returns

while Molins Plc has higher risk and higher returns. This is because of the amount of debt

that Molins Plc shows in its report which increase it gearing ratio by 5%, and although it is

owing more, its returns are higher and is shown in its earnings per share for 2012 which is

40.0p per while Povair Plc which is less risky reported earnings per share of 10.1p. The

dividend cover for the two companies also shows that Molins Plc in 2012 is 7.6 while Povair

Plc is 4.23, the dividend yield for Molins is also higher at 0.02% while Povair is 0.00008%.

Although the closing share price for Povair Plc was 270p on 24th of May while that of Molins

was 155.5, the higher value of Poviar’s shares can be explained that investors are more risk -

shy, therefore very few of Molins shares are traded on the market because its shares are not as

attractive because of its level of risk.



Appendix

Gearing ratio refers to the measure of a company’s debt compared to its equity, which means

the extent is a company financing its operations with borrowed funds compared with the

owners’ funds (McMenamin, 1999). The higher the gearing ratio, the more the company isconsidered risky, and it is calculated as

Appendix A

Gearing or Leverage Ratio =

...%100Fundsrs'ShareholdeEquityCapitalDebtTotal

CapitalDebtTotal

(McMenamin, 1999)

Molins Plc

Gearing Ratio:

Total debt capital = £5,900,000 million, and Shareholders’ funds = £30,500,000

Therefore, gearing ratio for 2012 = %21.16000,500,30000,900,5£

000,900,5£

Gearing ratio for 2011 = %26.11100000,000,41000,200,5

000,200,5

Povair Plc

Gearing ratio for 2012

Total debt capital = Bank overdrafts and loans of £1,000,000

Bank loans £10,145,000

Total debt £11,145,000

2012 = 19.44%100000,174,46000,145,11

000,145,11

Gearing ratio for 2011

Total debt capital = Bank overdrafts and loans of £865,000

Bank loans £9,331,000



£10,196,000

2011 = %50.19100000,091,42000,196,10£

000,196,10£

The gearing ratio for Molins Plc for 2012 is 16.21%, and that for 2011 is 11.26%,also, for Povair Plc, the gearing ratio for 2012 is 19.44%, and that for 2011 is 19.50%.

While Povair Plc has tried to stabilise its borrowings during the year, Molins Plc’s

borrowings have increased during the year by almost 5% while that of Povair Plc has

reduced by 0.06%, from this analysis, Molins Plc’s long term gearing is riskier than

Povair Plc.

Appendix B

d) Calculate the dividend cover, dividend yield and interest cover ratios for both

companies for two consecutive financial years. Based on your calculations and other

relevant information, explain the risks and reward for shareholders and loan providers

for both companies.

Dividend Cover = times... payableDividends

(PAIT)taxandinterestafter Profit (McMenamin,

1999)

For Molins Plc, 2012 Dividend cover is = times60.7000,000,1

000,600,7

2011 Dividend cover is = times1.7000,000,1

000,100,7

For Povair Plc, 2012 Dividend cover is = times23.4000,023,1

000,282,4

2011Dividend Cover is = times3.18000,976

000,099,3

Appendix C

Dividend Yield = ...%shareordinary per priceMarket

shareordinary per Dividend (McMenamin, 1999)

Molins Plc

Market price as at Friday 24 May 2013: 155.5 pence (See attached screen print below)



Molins Plc: Ordinary Share Price as at Friday 24 May 2013

Dividend yield as at 13 May 2013 = %02.0 pence5.155

pence0.3

Povair Plc

Market price as at Friday 24 May 2013: 270 pence (See attached screen print below)



Povair Plc: Ordinary Share Price as at Friday 24 May 2013

Therefore, dividend yield as at 24 May 2013 = %00008.0 pence270

pence024.0

Appendix D

Interest Cover = times... payableinterestTotal

(PBIT)taxandinterest beforeProfit (McMenamin, 1999)

Molins Plc, for 2012, Interest cover is = times0.343000,700,15

000,400,5

2011, Interest cover is = times0.310000,700,17

000,500,5

Povair Plc, for 2012, Interest cover is = times95.7000,906

000,205,7

2011, Interest cover is = times6.58000,806

000,307,5



REFERENCES

FLEMING, L. 2004. HSC Business Studies, Glebe, NSW, Pascal Press.

GOWTHORPE, C. 2005. Business Accounting and Finance: For Non-specialists, Bedford Row, London,

Thomson Learning.

MCMENAMIN, J. 1999. Financial Management: An Introduction, London, Routledge.

NEEDLES, B. E., POWERS, M. & CROSSON, S. V. 2010. Financial and Managerial Accounting, Mason,

OH, USA, South-Western Cengage Learning.

PORTER, G. A. & NORTON, C. L. 2010. Financial Accounting: The Impact on Decision Makers, Mason,

OH, South-Western Cengage Learning.



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Foundation Accounting.docx