According to T-Shirts Ltd’s statement of profit or loss, the company’s revenue, or sales, decreased by £735,000 in financial 2019 as compared to 2018. The cost of sales, i.e., the cost of goods that the company purchased to sell them to its clients, also decreased by £89,000 between the financial year 2018 and 2019. The next line in the statement of profit or loss shows the company’s gross profit, which is sales, or revenue, less the cost of sales. Since T-Shirts Ltd experiences a large decrease in revenue and only a slight decrease in the cost of sales, it earned half as much gross profit in 2019 as it did in 2018.
The company’s revenue expenditure increased by £189,000 in 2019 as compared to 2018. If one subtracts day-to-day expenses from gross profit, one will get operating profit, which is included in T-Shirts Ltd’s statement of profit or loss as “profit before interest and tax.” Operating profit indicates how successfully a company generates profit directly from its operations. As T-Shirts Ltd’s statement shows, the operating profit decreased significantly in the financial year 2019 to the point of being negative. The negative operating profit implies that the cost of sales and other expenses are greater than sales, which results in the operating loss.
T-Shirts Ltd’s financial costs increased by £37,000 in 2019 compared to the previous year, which may imply that it did not generate enough cash to pay its instalments in time or took an additional loan. The last line in the income statement is profit for the year, which is the profit less all the expenses, taxes and interest, and it is the amount divided among shareholders (Carey, Knowles and Towers-Clark, 2020). While in 2018, T-Shirts Ltd was profitable, in 2019, the company came up with a £500,000 loss. T-Shirts Ltd’s financial performance worsened between 2018 and 2019 because the company’s operating expenses and finance costs increased. According to the case study, T-Shirts Ltd increased costs to stimulate sales using an aggressive advertising campaign. However, overall expenses appeared to be greater than sales, which led to the loss rather than profit.
Statement of Financial Position
According to the company’s statement, the value of its non-current assets, i.e., those intended for use for more than one year, decreased by £8,000. It can be caused by depreciation, which is a planned reduction in the value of a particular asset over time (Carey, Knowles and Towers-Clark, 2020). Current assets are those that a company holds for less than a year, including such assets as inventories and cash (Carey, Knowles and Towers-Clark, 2020). T-Shirts Ltd’s statement of financial position indicates that the company’s inventories increased by £32,000 between 2018 and 2019. Such an increase means that T-Shirts Ltd bought more goods than it managed to sell.
Trade and other receivables indicate the sums of money that customers owe to the company for the goods they have received but have not paid for (Carey, Knowles and Towers-Clark, 2020). T-Shirts Ltd’s trade and other receivables increased in 2019 compared to 2018, which may mean that more sales were made on credit in 2019 than in 2018. An increase in inventories and trade receivables leads to a decreased amount of cash available to the company (Carey, Knowles and Towers-Clark, 2020). This is what happened to T-Shirts Ltd, which is seen from the line “Cash and cash equivalents,” showing that the company had spent all its cash available in 2018 by the financial year 2019.
T-Shirts Ltd’s statement of financial position indicates a £66,000 increase in total assets. However, since total assets equal to the sum of the company’s equity and liabilities, it is necessary to find out which of these two components financed the increase in assets (Carey, Knowles and Towers-Clark, 2020). The company’s statement shows that equity comprises share capital and retained earnings. While share capital remained the same between 2018 and 2019, the firm had no retained earnings in 2019 compared to £500,000 of retained earnings in 2018. No change in share capital means that shareholders did not withdraw from or invest in the business, while decreased retained earnings indicate that no profit was re-invested into business (Carey, Knowles and Towers-Clark, 2020). As a result of reduced retained earnings, T-Shirts Ltd’s total equity decreased by £500,000 in 2019.
Since total equity decreased, it may be expected that the growth of total assets was caused by an increase in the company’s liabilities. Liabilities are sums of money that a company owns to such entities as banks or suppliers (Carey, Knowles and Towers-Clark, 2020). Depending on the due date, they can be current, i.e., those that should be paid within a year, and non-current, which should be paid after a year (Carey, Knowles and Towers-Clark, 2020). T-Shirts Ltd’s non-current liabilities increased by £233,000 due to long-term borrowings, which means that the company has taken on an additional long-term loan. Current liabilities also increased by £333,000, mainly because of the bank overdraft, which is a negative cash balance regarded as a short-term loan (Carey, Knowles and Towers-Clark, 2020). Trade payables, i.e., amounts owed by the company to its suppliers and due to be paid within a year, contributed to the growth of current liabilities as well. Overall, both non-current and current liabilities of T-Shirts Ltd grew by £566,000 over the given period. It means that an increase in T-Shirts Ltd’s total assets was financed through debt rather than equity.
T-Shirts Ltd’s overall profitability decreased, as indicated by the ROCE ratio, which fell from 29.43% in 2018 to -32% in 2019 (see Appendix A). As is seen from the calculated ratios, the main reason for the decline in profitability is a decrease in profit margins rather than an inefficient use of assets. A decrease in operating profit margin results from increased operating expenses and decreased gross profit, as indicated by expense-to-sales ratio and gross profit margin, respectively. Liquidity ratios show whether the company generates enough cash to pay its instalments on time (Carey, Knowles and Towers-Clark, 2020). T-Shirts Ltd’s current ratio indicates that the company was solvent in 2018, but in 2019, its current ratio was less than one, meaning that T-Shirts Ltd was likely to have cash-flow problems (see Appendix B). The acid test ratio decreased from 1.93:1 in 2018 to 0.65:1 in 2019, meaning that the company was unable to pay all its short-term liabilities (see Appendix B).
Working capital ratios show the company’s effectiveness in controlling its inventories, trade payables and trade receivables (Carey, Knowles and Towers-Clark, 2020). T-Shirts Ltd’s working capital ratios indicate that inventory days, trade receivable days, trade payable days, and the working capital cycle increased in 2019 (see Appendix C). It means that goods were longer held in inventories, and the company’s liquidity decreased (Carey, Knowles and Towers-Clark, 2020). Furthermore, an overall increase in the working capital cycle implies that the business managed its working capital less efficiently than before (Carey, Knowles and Towers-Clark, 2020). Trade receivable days are likely to have increased because the company extended the credit terms for customers from 30 to 60 days. Overall, in 2019, T-Shirts Ltd made a loss, resulted from increased revenue expenditure and decreased sales. The company’s liquidity was also reduced because of decreased sales and increased working capital cycle. In order to improve its financial performance, T-Shirts Ltd should consider restoring 30-days credit terms and keeping inventories as low as possible to reduce its working capital cycle and increase liquidity. It should also reduce its operating expenses and increase sales.
Understanding Financial Information & Management of Cash
Accruals vs. Cash Accounting
There are two main accounting methods: accrual accounting and cash accounting. The difference between them lies in the timing when revenues and expenses are accounted for. In cash accounting, revenues and expenses are accounted for only when the cash has already been received or paid out. However, sometimes, the company does not pay expenses right after they are incurred or does not receive payment right after the goods have been delivered to customers. In these cases, the company deals with accruals and prepayments. Accruals are incurred expenses or earned revenues, for which the company has not spent or received cash yet (Carey, Knowles and Towers-Clark, 2020). Prepayments are expenses that have been paid for in the current financial period, but the benefit from them will be received in the following financial period (Carey, Knowles and Towers-Clark, 2020). So, accrual accounting accounts for accruals and prepayments, as opposed to cash accounting, which disregards transactions for which cash has not been spent or received yet.
In the case study example, accrual accounting is used since the statements include the company’s trade receivables and trade payables. These are the amounts that the company has not yet received or paid, but they are nevertheless accounted for. The benefit of accrual accounting is that it provides a more accurate picture of the company’s long-term financial position because it considers all payables and receivables. However, it fails to provide a picture of the company’s current financial health, especially the state of its cash flows. If a company does not keep track of its cash flows, it risks being profitable but not able to pay its debts because of a lack of cash. Therefore, a company using an accrual accounting method should additionally track its cash flows. Furthermore, accrual accounting is more complicated than cash accounting because it deals with prepaid expenses and unearned revenue. For accrual accounting, it is not enough to watch a company’s bank accounts; there is also a need to keep track of invoices. Consequently, with accrual accounting, there is often a need to pay taxes on the income that has not been earned yet.
The main advantage of cash accounting is its simplicity since it accounts only for the cash flows in a company’s tills and bank accounts and does not consider payables and receivables. For this reason, cash accounting is often used by small businesses that make purchases and provide goods or services for cash. With cash counting, companies also have to pay taxes only for the money that is already received. Another advantage of cash accounting is that it shows the current financial situation and cash flows of a company. However, it is also a drawback of cash accounting because it can overestimate the company’s financial health. For example, a company may have a highly positive cash flow but also large amounts of payables, exceeding the amount of cash. In this case, a company would be at the risk of losses in the long run, but its financial statements would make it seem profitable. For this reason, cash accounting is not helpful in making financial decisions.
Profit vs. Cash Flows
Profit and cash flow are important financial parameters determining the success of a business. Profit is the amount left over after all expenses have been subtracted from sales (Carey, Knowles and Towers-Clark, 2020). There are two types of profit: gross profit and net profit. Gross profit is the money left after all expenses related to the provision of goods, i.e., cost of sales, are deducted from the revenue. Net profit refers to the amount that is left after other expenses, including financial costs and operating expenses, are subtracted from gross profit. Cash flows are amounts that go in and out of the business at a particular period. Cash flows may be generated by operating activities, investment activities, and financing activities. The first one results from business operations; the second is generated by the purchase or sale of long-term assets, and the third includes cash flows used for funding the company.
The difference between these concepts is that profit is the main indicator of the success of the adopted business model, while cash flows show the extent to which a company can maintain its day-to-day business operations. Profit cannot show the whole financial situation of a company because it does not indicate the time when a company will receive or pay money. In other words, profit demonstrates how successful a business is in the long run, whereas cash flows show whether a company can pay its debts on time and survive. A negative profit means that a company should either raise prices or reduce expenses, while negative cash flows mean that a business has no available money to meet its financial obligations.
Being profitable does not necessarily mean having adequate cash flows and vice versa. The reason for this is the possibility of buying and selling goods on credit (Carey, Knowles and Towers-Clark, 2020). Supposing a company offers its customers credit terms that are longer than credit terms provided by its suppliers and other creditors. In this case, it may be unable to pay its instalments when they are due because it will not have adequate cash flow. On the other hand, the company may take on a loan to pay its suppliers or purchase new equipment. Although it will lead to sufficient cash flow, it may also decrease the company’s profitability if the debt increases expenses over sales.
Budget and Company Finance
Meaning and Purposes of Budget
To survive and prosper, a company should manage its finances wisely, and budget is what helps it to do so. A budget is defined as a plan drawn up using financial terms (Carey, Knowles and Towers-Clark, 2020). A budget is usually prepared for a period of up to one year and is more detailed than the company’s other business plans. In a budget, planned financial indicators are shown month by month, and the data for a budget are usually retrieved from the previous business performance and predicted future business activity (Carey, Knowles and Towers-Clark, 2020). According to Carey, Knowles and Towers-Clark (2020), there are two types of budgets depending on the scope: a functional budget and a master budget. A functional budget is a budget of a particular department, while a master budget a budget for the whole business and is comprised of the company’s budgeted financial statements. Budgets are also classified according to the way they are prepared and can be incremental, zero-based and rolling (Carey, Knowles and Towers-Clark, 2020). Incremental budgets use the previous period’s budget as a basis; zero-based budgets are prepared from scratch; rolling budgets are continuously updated.
The preparation of a budget serves several purposes:
- Planning. A budget helps a company to make up a comprehensive plan of its spending for the oncoming period.
- Decision-making. A budget helps a company make decisions regarding the allocation of its expenses. It helps in setting priorities correctly and distinguishing between a company’s needs and wants.
- Control. A budget allows a business to compare its actual performance to planned performance. Based on these data, a company can adjust its processes and manage its operations more effectively in the future.
- Communication and coordination. With the help of a budget, management teams communicate and coordinate their plans, defines the scope of their activities, and evaluate performance.
- Employee motivation. A properly drawn up budget challenges employees to achieve the set targets. Employees are motivated to meet their KPIs, as outlined in a budget, if they will be rewarded afterwards.
Benefits of Forming a Limited Company and Getting It Registered on a Stock Exchange
Forming a limited company is a choice that sole traders should consider, especially they are willing to expand their business. In a limited company, the company and its owners are separate legal entities. In other words, owners of a limited company have limited liability. It means that, in the case of legal issues or debts, owners risk losing only the amounts they invested in the company, while their personal assets will remain intact (Carey, Knowles and Towers-Clark, 2020). A business person deciding on forming a limited company may choose between a private and public company. A private company cannot issue its shares to the general public, whereas a public company is allowed to be listed on the stock exchange and sell its shares to the general public (Carey, Knowles and Towers-Clark, 2020). Private limited companies are usually indicated by an abbreviation “Ltd.”
Establishing a limited company and getting it registered on a stock exchange has several advantages:
- The ability to raise extra money. A limited company can raise additional capital by offering its shares to investors (Carey, Knowles and Towers-Clark, 2020). Thus, it is easier to expand the business as a limited company rather than a sole trader.
- Limited liability. Owners of a limited company do not risk their personal assets in case of company debts and legal issues.
- Higher perceived status. Customers and other businesses perceive a limited company as more credible and trustworthy than a sole trader.
Carey, M., Knowles, C. and Towers-Clark, J. (2020) Accounting: a smart approach. 4th edn. Oxford: Oxford University Press.
Return on Capital Employed
Now that all the parameters of the formula can be retrieved from the case study data, it is possible to calculate the ROCE for 2018 and 2019.
For 2018, ROCE =
For 2019, ROCE =
Gross Profit Margin
Gross Profit Margin =
For 2018, Gross Profit Margin =
For 2019, Gross Profit Margin =
Operating Profit Margin
Operating Profit Margin =
For 2018, Operating Profit Margin =
For 2019, Operating Profit Margin =
Expenses: Sales =
For 2018, Expenses: Sales =
For 2019, Expenses: Sales =
Use of Assets
Use of Assets = =
For 2018, Use of Assets =
For 2019, Use of Assets =
Table A1 summarizes all profitability ratios for T-Shirt Ltd.
Table A1: Profitability ratios for T-Shirts Ltd.
|Return on capital employed||-32%||29.43%|
|Gross profit margin||45%||60%|
|Operating profit margin||-28.84%||20.99%|
|Use of assets||1.1 times||1.4 times|
Current Ratio =
For 2018, Current Ratio =
For 2019, Current Ratio =
Acid Test Ratio
Acid Test Ratio =
For 2018, Acid Test Ratio =
For 2019, Acid Test Ratio =
Table B1 summarizes liquidity ratios for T-Shirts Ltd.
Table B1: Liquidity ratios for T-Shirts Ltd.
|Acid test ratio||0.65:1||1.93:1|
Working Capital Ratios
Inventory Days =
For 2018, Inventory Days =
For 2019, Inventory Days =
Trade Receivable Days
Trade Receivable Days =
Since the data about credit sales are not available, it is assumed that all sales were made on credit. Therefore, credit sales are equal to sales, or revenue.
For 2018, Trade Receivable Days =
For 2019, Trade Receivable Days =
Trade Payable Days
Trade Payable Days =
Since the data about credit purchases are not available, it is assumed that all purchases were made on credit. Therefore, credit purchases are equal to cost of sales.
For 2018, Trade Payable Days =
For 2019, Trade Payable Days =
Table C1 summarizes working capital ratios for T-Shirts Ltd.
Table C1: Working capital ratios for T-Shirts Ltd.
|Trade receivable days||81.49||37.87|
|Trade payable days||73.38||59.09|
|Working capital cycle||58.8 + 81.49 – 73.38 = 66.91||38.67 + 37.87 – 59.09 = 17.45|