Financial Management 2 June 2015 Marking Scheme This marking scheme has been prepared as a guide only to markers. This is not a set of model answers, or the exclusive answers to the questions, and there will frequently be alternative responses which will provide a valid answer. Markers are advised that, unless a question specifies that an answer be provided in a particular form, then an answer that is correct (factually or in practical terms) must be given the available marks. If there is doubt as to the correctness of an answer, the relevant NCC Education materials should be the first authority. Throughout the marking, please credit any valid alternative point. Where markers award half marks in any part of a question, they should ensure that the total mark recorded for the question is rounded up to a whole mark.
Answer any FOUR (4) questions Question 1 Marks Below is summary financial information for company ABS. This information covers the last two years. The company s financial year runs from 1 April to 31 March. Income statement 2014/15 (000s) 2013/14 (000s) Sales (revenue) 28750 27744 Cost of sales 22435 21025 Gross profit 6315 6719 Operating expenses 4278 4080 Net operating profit 2037 2639 Statement of financial position Non-current assets Land and buildings 31456 31524 Plant and machinery 18365 19067 49821 50591 Current assets Inventory 7256 6235 Trade receivables 4562 3695 11818 9930 Current liabilities Trade payables 2611 1987 Bank overdraft 1846 1326 4457 3313 Net current assets 7361 6617 Total assets less current liabilities 57182 57208 Less debentures 3600 2800 53582 54408 Financed by Share capital 29000 29000 Reserves 24582 25408 53582 54408 Inventories held as at 31 March 2013 were 5,000,000, trade receivables were 3,005,000 and trade payables were 1,600,000. Assume cost of purchasing purchases equal cost of sales. All purchases and sales are on credit. Question 1 continues on next page Page 2 of 16
a) Calculate the following ratios for both years. Marks i) Current ratio 1 Current assets/current liabilities 2014: 11818/4457=2.65:1 2013: 9930/3313=3.00:1 ii) Average payables settlement period 1 Trade payables/cost of sales(purchases) x365 2014: (2611+1987/2)/22435 x365= 37.4 days 2013: (1987+1600/2)/21025 x365=31.1 days iii) Gross profit margin 1 Gross profit/revenue x 100 2014: 6315/28750 x100=22.0% 2013: 6719/27744 x100=24.2% iv) Net profit margin 1 Net profit/sales revenue X100 2014: 2037/28750x100=7.1% 2013: 2639/27744x100=9.5% v) Average inventories turnover period 1 Average stock/cost of sales x 365 2014: (7256+6235/2) /22435 x365=109.7 days 2013: (6235+5000)/2))/21025 x 365=97.5 days vi) Gearing ratio 1 Non-current liabilities/ (share capital+ reserves + non-current liabilities) 2014: 3600/57182 x100= 6.3% 2013: 2800/57208 x100=4.9% Page 3 of 16
Marks vii) ROCE 1 Operating profit/(share capital+ reserves + non-current liabilities)x 100 2014: 2037/(53582+3600) x100=3.6% 2013: 2639/54408+2800) x100=4.6% viii) Average receivables settlement period 1 Average Trade receivables/ credit sales x 365 2014: (4562+3695/2)/28750 x365=52.4 days 2013: (3695+3005/2)/27744 X365= 44.1 days ix) Acid test ratio 1 Current assets-stock/ current liabilities 2014: 4562/4457=1.02:1 2013: 3695/3313=1.12:1 Page 4 of 16
Marks b) Based on your answers to part (a), evaluate the company's financial performance 8 in relation to profitability, liquidity, efficiency and financial gearing. Profitability: There is a small but quite significant drop in profitability both gross (24.2 to 22%) and net (9.5 to 7.1%) expenses to sales ratio is largely unchanged indicating good cost control in procurement. The operating expenses have risen by 4.8% compared to a sales increase of 3.6% and this, with the reduction in gross profit, has reduced the operating profit. ROCE has fallen largely due to the increased capital due to the extra debentures issued (2800 to 3600) and in part by the reduction in profit. The overall conclusion is that there has been deterioration in all measures of profitability. Liquidity: Current ratio has fallen but remains well above what is perceived a suitable minimum (the theoretically ideal current ratio of 2:1). Likewise the acid test is down but is still above 1:1 preferred minimum. Both ratios indicate that there are no liquidity problems and that the company can meet its shortterm liabilities. Efficiency: Both debtor and creditor days have increased there has been a significant increase in trade receivable days, increasing from 44.1 to 52.4 days. This could be weak credit control or perhaps customers have negotiated longer payment terms. This impacts upon the operating cash cycle. Trade payables have increased from 31.1 to 37.4 days this in part should help offset the increased receivables time. However, if ABS is taking longer than agreed trade terms there could be a risk of suppliers putting them on stop and it could also damage working relationships with suppliers who rely on prompt payment. Of some concern may be the lack of control over inventory the stock turn days has increased from 97.5 to 109.7 days. This appears to be a long turnover period. Financial gearing: Gearing has increased from 4.9% to 6.3% and is still very low irrespective of slight increase in debenture loan taken out by company in 2014. Gearing is an indicator of the financial structure of an organisation high gearing above 50% is considered high risk. Up to 2 marks for discussion of each area, total of 8 marks. Total 25 Marks Page 5 of 16
Question 2 Marks a) Discuss the role of non-executive directors in public limited companies (plcs) in ensuring effective corporate governance. Non-executive director roles include protecting shareholder interests, overseeing executive directors and senior managers, adopting independent position in decision-making, aligning director interests with increasing shareholder value in areas such as remuneration, transparency, auditing, separation of senior positions such as Chairman and CEO. 6 Non-executive directors should constructively challenge and help develop proposals on strategy as part of their role on the board. The board should establish an audit committee of at least three independent non-executive directors. 2 points per valid point made up to 6 marks b) Define the term strategic management accounting. 3 A form of management accounting in which emphasis is placed on information which relates to factors external to the firm, as well as nonfinancial information and internally generated information Up to 3 marks for appropriate definition. c) Identify THREE (3) distinct differences between traditional management accounting (TMA) and strategic management accounting (SMA). SMA places greater emphasis on relating management accounting information to the strategies of the entity. It includes much more non-financial data about an entity s operational activities. It incorporates data about the entity s direct competitors. 1 mark for identifying difference and 1 mark for brief explanation, 2 marks maximum per point made. Up to three differences only. 6 Page 6 of 16
Marks d) Explain the use of value chain analysis as a strategic accounting technique. 10 Value chain analysis was developed by Porter in 1985. Porter distinguished between five primary activities (e.g. operations, marketing and sales) and the five support activities (eg procurement and human resources) If a business is to outperform its rivals it must ensure the value chain is configured in a way that either leads to a cost advantage or to differentiation. (2 mark) The value chain includes a profit margin because a mark-up over the cost of performing the firm s value-creating activities is customarily part of the price (or total cost) borne by buyers a fundamental objective of every enterprise is to create and deliver a value to buyers whose margin over cost yields an attractive profit. Value chain analysis is a method of describing and analysing a sequence of activities from production to customers. Each stage of the value chain is identified and costs or benefits are assigned to each step. Each stage of the value chain should add value to the business. An organisation should compare their own value chains with those of their competitors. To achieve a cost advantage the costs must be examined to see whether they can be reduced or eliminated. Value chain analysis focuses on product differentiation, such as by asking how products are different to those of their competitors. (Up to 4 marks for basic description of value chain and its key components up to 2 additional marks for suitably labelled diagram 1 mark per point made for detailing steps in use of techniques, up to 4 additional marks.) 10 marks maximum for question for full explanation with diagram. Total 25 Marks Page 7 of 16
Question 3 a) A group company may acquire full ownership of a new subsidiary at a price not equal to the value of its net assets. Explain why this difference may occur and how it is reported in the consolidated financial statements. Marks 7 The maximum number of marks awarded for this question is 7. Award 1 mark for each bullet point listed below: The book value often does not reflect their true market value. This is most common with property, plant and equipment. Property often appreciates in value, whereas in the financial statements of some companies it is stated at historic depreciated cost. Reputation of the business, brand and the experience of employees can influence price paid. Therefore the fair value of all assets and liabilities must be determined. Candidates should discuss the concept of goodwill. Award 1 mark for each bullet point listed below: Difference on consolidation is called goodwill. Goodwill is recognised in the balance sheet as an asset and is measured as the excess of the cost of the business combination over the fair value of the net assets acquired. It is shown in the group balance sheet with the intangible noncurrent (fixed) assets at the start of the balance sheet. Negative difference on consolidation is called negative goodwill. b) When the parent company does not own all of the shares in each subsidiary, how will this be calculated and reported in the group financial statements? 4 Where the parent company does not own all of the shares in each subsidiary, there will be a NIC (or minority interest) figure in both the statement of financial position and income statement (1 mark) representing the outside shareholders investment (1 mark) NIC (or minority interest) is the part of net assets of a subsidiary company that is financed by shareholders other than from the parent company. (1 mark) In the income statement, a proportion of the profits is shown attributable to the noncontrolling interests (1 mark) c) State FOUR (4) accounting rationales for producing Group Financial Statements. 4 Award 1 mark for each bullet point up to a maximum of 4 marks The group is the economic reporting entity Financial statements are produced for the group as a whole All members of the group produce their own individual financial statements The financial performance and position of the group as a whole and for individual members is clear for users of the financial statements. Page 8 of 16
Marks d) Define the terms subsidiary and associate company. Explain the difference between a subsidiary and associate company within a group of companies. Award up to 2 marks for each description up to a maximum of 4 marks 4 Subsidiary an entity that is controlled by another company (i.e. the parent). Associate a company significantly influenced by another company but not under their control (i.e. not a subsidiary). 2 marks for explanation of a difference. e) Give SIX (6) reasons why many businesses operate in groups. 6 Award 1 mark for each bullet point up to a maximum of 6 marks Each part of the business has its own limited liability. So each part of the business has a sense of independence and autonomy. To create a market image of a smaller independent business. Employee loyalty to smaller, independent business. Taxation legislation applies to individual companies, not the group as a whole. Different legal systems in different countries. Total 25 Marks Page 9 of 16
Question 4 Marks Delta Ltd, a medium sized manufacturing company had prepared its annual production budget using the process of standard costing. However half way through its trading period it realised that it had been struggling to control the costs of its base raw materials and also the associated production labour costs of the process. The following data had been produced in relation to the manufacture of one unit of its main item of production: Raw material standard costs 120 kilos @ 5.65 per kilo Labour standard costs 15.5 hours @ 25.50 per hour. Actual material costs 135 kilos @ 5.45 per kilo Actual labour costs 14.25 hours @ 26.75 per hour. a) Calculate the following: i) Material Price Variance (MPV) 1 Material Cost Variance= Standard cost Actual cost Material Price Variance (MPV) Actual quantity of material used = AQ Standard price per unit of material = SP Actual price per unit of material = AP MPV = (SP AP) x AQ = ( 5.65-5.45 ) x 135 kg = 27F (1 mark) ii) Material Usage Variance (MUV) 1 Material Usage Variance (MUV) Standard price per unit of material = SP Standard quantity of material for actual output = SQ Actual quantity of material used = AQ MUV = (SQ AQ) x SP = (120 kg 135 kg) x 5.65 = 84.75 A (1 mark) iii) Total material Variance (TMV) 1 TMV = (SP x SQ) (AP x AQ) = ( 5.65 x 120 kg) ( 5.45 x 135 kg) = 57.75 A (1 mark) iv) Labour Rate Variance (LRV) 1 Labour Variances SR= standard rate, AH= actual hours, SH=standard hours. Labour Rate Variance (LRV) LRV = (SR AR) x AH = ( 25.50-26.75) x 14.25 hrs = 7500 A (1 mark) v) Labour Efficiency Variance (LEV) 1 Labour Efficiency Variance (LEV) LEV = (SH AH) x SR = (15.5-14.25) x 25.50 = 4500 A (1 mark) Page 10 of 16
Marks vi) Total labour Variance (TLV) 1 TLV = (SR x SH) (AR x AH) = ( 15.5 x 25.50) ( 26.75x 14.25) = 14.06 F (1 mark) vii) Overall Total Variance 2 Total Variance= Total labour variance +Total Material variance = 14.06-57.75= 43.69 Material variance is 57.75 adverse, labour variance is 14.06 favourable, so total variance is 43.69 adverse. (2 marks) b) Suggest TWO (2) possible reasons for the material and price variances in (a). 4 Possible material reasons include lower material price could indicate lower quality and so more material scrappage has a new supplier been located or have procurement renegotiated a lower price. Labour- pay rate increase, use of higher skilled/higher paid workers, unexpected pay rise, learning curve re workforce leading to faster production. (Up to 2 marks per valid reason explained- 2 reasons only) c) Briefly explain how inventories should be valued on the balance sheet and outline the consequences of not valuing inventories in this way (from a transfer price and profit perspective). 5 Inventory (stock) should be valued at the lower cost (1 mark) and net realisable value (1 mark) If the transfer price is used to value inventory (stock) then current assets will be overvalued (1 mark ) for profit which has not yet been realised (1 mark) and cost of sales will be lower (1 mark) and so profit will overvalued too (1 mark) unrealised profit should be deducted from the inventory value in the balance sheet (1 mark). Page 11 of 16
d) Discuss the factors that will influence a choice of discount rate to be used in an investment appraisal. Marks 5 The total number of marks awarded to this question is 6. Award 1 mark for the following bullet point. A discount rate is used in NPV and/or IRR appraisal. Award up to 5 marks for the following discussion. One of the difficulties with the NPV method of investment appraisal is deciding upon a suitable rate of return (discount rate) for a project (1 mark) Atrill states that the appropriate discount factor to use is opportunity cost of the finance. (1 mark) This in effect is the cost of the finance needed to fund the investment. (1 mark) It will normally be the cost of a mixture of funds (shareholder funds and borrowings) employed by the business and is often referred to as the cost of capital (1 mark) The level of risk may also be an important factor. (1 mark) Note: It is not expected students will know these advanced techniques but should neither suggest that the discount rate is the same as or related to the inflation rate. There should be an understanding that each business will have its own factors that influence the choice of discount rate. There is no single rate of return that is appropriate for every project/investment. Total 25 Marks Page 12 of 16
Marks Question 5 The directors of XYZ Ltd plan to introduce a new product. In order to manufacture the product, a new machine will have to be purchased at a cost of 300 000. This machine is expected to be operational for 3 years, at the end of which there is no expected residual value. The machine will be depreciated using the straight-line method. The new product is expected to sell for 40 per unit. Direct costs are 18 per unit. Annual production is expected to be 6000 units in the first year. Thereafter, annual production will increase by 20% compared to the previous year. Maintenance costs are expected to be 2000 per annum, which will increase in year 3 to 3000. Annual fixed costs are expected to be 40,000.The cost of capital is 8%. a) Calculate the net present value of the new machine and make a recommendation on whether the investment should proceed. 10 Net cash flows: Year 1 (6 000 x 22) = 132 000 (2 000) = 130 000 40 000* = 90 000 Year 2 (7 200 x 22) = 158 400 (2 000) = 156 400 40 000* = 116 400 Year 3 (8 640 x 22) = 190 080 (3 000) = 187 080 40 000*= 147 080 Award 4 marks if all three correctly calculated or 2 marks for 2 correct or 1 mark for only 1 correct year Net cash flow Discount factor Present value 0 (300,000) 1 (300,000) 1 90,000 0.926 83340.00 1 mark* 2 116,400 0.857 99754.80 1 mark* 3 147,080 0.794 116781.52 1 mark* Net present value (123.68) 1 mark* Award 4 marks for complete correct calculation as shown in above table. Note: if errors from first part carried forward award half the marks for correct use of discounting factors to calculate the NPV. Award up to 2 marks for the recommendation As the NPV is negative the project should not go ahead (1 mark) as it does meet the desired rate of return (1 mark). Question 5 continues on next page Page 13 of 16
b) Briefly explain the comply or explain requirement of the UK Governance Code and outline which type of companies are applicable to the Code. Award 1 mark for each bullet point up to a maximum of 3 marks. Marks 4 Comply or explain is an approach that covers much of the content of the UK Governance Code. The Code contains over 50 'provisions'. And yet there is no requirement to comply with these provisions and companies can decide not to do so provided they give an explanation of any non-compliance. The reasons for it should be explained clearly and carefully to shareholders, who may wish to discuss the position with the company and whose voting intentions may be influenced as a result. Where deviation from a particular provision is intended to be limited in time, the explanation should indicate when the company expects to conform with the provision The Listing Rules- not the Code- also require companies to apply the Main Principles and report to shareholders on how they have done so. Award 1 mark for identifying the type of companies applicable to the code. Applies to companies with financial years beginning on or after 29 June 2010. c) Provide the formula for TWO (2) ratios that investors might be used to assess the returns on their investment. You must give the name of each ratio. 4 The maximum number of marks awarded for this question is 4. Award 1 mark for a valid name and 1 mark for a correct formula for each ratio. Dividend per share- Measures the dividend paid per share in issue. Earning per share (EPS)- Relates the earnings generated by the business, and available to shareholders, during a period, to the number of shares in issue. Price to earnings ratio (P/E)-Relates the market value of a share to the earnings per share. Page 14 of 16
Marks d) Identity the FOUR (4) financial statements required under IAS1. 4 Statement of financial position Income statement as part of larger statement of comprehensive income Statement of changes in equity Statement of cash flows Notes on accounting policies and other explanatory notes. 1 Mark per item- 4 marks. e) Provide ONE (1) formula to show how the cost of sales is calculated in the income statement and briefly explain how it works. 3 The total number of marks awarded for this question is 3. Award 1 mark for the calculation. Cost of sales is calculated as follows: Opening inventory + purchases - closing inventory = Equals cost of sales. Award 1 mark for each bullet point up to a maximum of 2 marks. The cost of sales does not include any general or administrative expenses. It also does not include any costs of the sales and marketing department. Total 25 Marks End of paper Page 15 of 16
Learning Outcomes matrix Marks Question Learning Outcomes assessed 1 2 Yes 2 1 Yes 3 3 Yes 4 1,2,3 Yes 5 1,2,3 Yes Grade descriptors Marker can differentiate between varying levels of achievement Learning Outcome Analyse and prepare financial statements using International Financial Reporting Standards (IFRS) Assess the financial performance of companies Assess the use of managerial accounting in business strategy Pass Merit Distinction Demonstrate ability to perform the task Demonstrate an adequate awareness of issues associated with the subject and make some appropriate judgements Demonstrate an adequate awareness of issues associated with the subject and make some appropriate judgements Demonstrate ability to perform the task consistently well Demonstrate a sound awareness of issues associated with the subject and make consistently appropriate judgements Demonstrate a sound awareness of issues associated with the subject and make consistently appropriate judgements Demonstrate ability to perform the task to the highest standard Demonstrate a detailed awareness of the complexity of issues associated with the subject and make highly appropriate judgements Demonstrate a detailed awareness of the complexity of issues associated with the subject and make highly appropriate judgements Page 16 of 16