FINANCIAL STRATEGY AND DECISION MAKING I

FINAL EXAM – SAMPLE PAPER 2 – Solutions

Number of Questions: 2, Total Marks: 100
Time Allowed: 2 hours and 10 minutes reading time

NOTE: ATTEMPT ALL THE FOLLOWING QUESTIONS.

QUESTION 1
(a) The "time value of money" is the fundamental concept in finance. Briefly explain it
with the help of an example. Based on the time value of money, what are the two
fundamental investment criteria? [10 marks]

(b) What are the main types of financial ratios? Briefly explain how these ratios can help
analyze the financial performance of a company. [10 marks]

(c) Consider the following information about ABC Plc taken from the company’s financial
statements for the years ended 31st December 2023 and 2024.

2024 ($) 2023 ($)

Net profit 400,000 220,000
Turnover 5,000,000 5,500,000
Fixed assets 1,540,000 1,920,000
Loan 300,000 600,000
R&D expenses 320,000 120,000
Share price 2.92 1.32
No. of shares 1,200,000 1,100,000
Net working capital 60 –20
Current ratio 1.3 0.7
Quick ratio 0.8 0.35
Creditors days 54 62
Debtors days 28 59
Gearing 40% 66%
REQUIRED:
i. Calculate six more financial ratios for the years 2023 and 2024 from the given
information. [18 marks]
ii. Evaluate the performance of ABC Plc based on the given information and the new six
calculated financial ratios in part (i). Please comment on the success or failure of the
management in improving the financial performance of the company. [12 marks]

SOLUTION
(a)
The "time value of money" is the fundamental concept in finance. It means that money today
is worth more than money tomorrow. For example, if you are offered the choice between
$100 today and $100 next year, you naturally take the money now to get a year’s interest.

Based on the time value of money, the two fundamental criteria for investment are based on
net present value and the internal rate of return.

Investment Rules
NPV: Accept an investment that has a positive net present value (NPV).
IRR: Accept an investment project if the opportunity cost of capital is less than the internal
rate of return (IRR).

(b)
Financial ratios are created with the use of numerical values taken from financial statements
to gain meaningful information about a company. The following are the main types of
financial ratios.
▪ Performance ratios. For example, gross profit percentage, net profit percentage.
▪ Efficiency ratios. Inventory turnover ratio, debtors days, creditors days.
▪ Liquidity ratios. For example, current ratio, quick ratio.
▪ Debts ratios. For example, gearing, assets to liabilities ratio.
▪ Investors ratios. For example, earnings per share, price-earning ratio.

These ratios can help analyze the financial performance of a company. For example,
▪ Performance ratios are used to assess the relative success or failure of business
performance.
▪ Efficiency ratios are used to analyze how efficiently a company is using its assets.
▪ Increasing debt ratios may indicate that a company is overburdened with debt and
may eventually be facing default risk.
(c) (i)
No. Financial ratios 2024 2023
1 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 400,000 220,000
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 % = × 100% × 100% = 8% × 100% = 4%
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 5,000,000 5,500,000
2 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 5,000,000
= 3.25
5,500,000
= 2.86
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 1,540,000 1,920,000
3 𝑅&𝐷 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 % =
𝑟𝑒𝑠𝑒𝑎𝑐ℎ 320,000
= 6.4%
120,000
= 2.18%
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 5,000,000 5,500,000
4 𝐸𝑃𝑆 =
𝑖𝑛𝑐𝑜𝑚𝑒 400,000
= $0.33
220,000
= $0.20
𝑛𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 1,200,000 1,100,000
5 𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝 = 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 × 𝑛𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 2.92 × 1,200,000 1.32 × 1,100,000
= $3,504,000 = $1,452,000
6 𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝑝𝑟𝑖𝑐𝑒 2.92
= 8.76
1.32
= 6.6
𝐸𝑃𝑆 0.33 0.2

(ii)
(1) Although the sales figure has fallen in 2024, the net profit has improved from 4%
to 8%. The strategy to sell higher-margin products has resulted in lower sales but
higher profits.
(2) Despite a fall in sales, fixed-assets turnover is improved from 2.86 in 2023 to 3.25
in 2024. The strategy to sell underutilized fixed assets seems successful.
(3) The company has successfully improved the R&D budget from a mere 2.18% to
6.4% of the total sales.
(4) Despite the issuance of new shares, the earnings per share is improved from 20p
($0.20) in 2023 to 33p ($0.33) in 2024.
(5) In 2023, the company had a gearing level of 66%. Actions taken include an issue
of shares and the sale of property and these have significantly reduced the level
of long-term debt to 40% in 2024.
(6) The company takes 59 days on average to receive payments from its debtors in
2023, and it is improved to 28 days in 2024. It improved the company’s liquidity.
(7) Similarly, the company takes 62 days on average to pay its creditors in 2023, and
it is improved to 54 days in 2024. However, the company is still taking longer than
expected time to pay its creditors, and further improvements are required to
manage the creditors.
(8) We can write more..

QUESTION 2
(a) The principal elements of working capital must be carefully controlled so that the vital
resource of cash is not misapplied. Problems can occur at any point in the cycle.

Briefly explain the interconnectedness of the elements of working capital and the
importance of the management of working capital. [10 marks]
(b) FiinGroup is a reputed company that provides credit rating reports of businesses in
Vietnam. Credit analysis is the method by which FiinGroup calculates the
creditworthiness of a business or corporate bond. In other words, credit analysis is
the evaluation of the ability of a company to honor its financial obligations.

Suppose you are a credit analyst for a company. Discuss briefly how you would
perform a credit analysis of a potential customer. [10 marks]

(c) ABC Plc is considering a revised credit policy. Presently, the company has annual
credit sales of $5 million. The company offers a 4% discount to customers who pay
within 20 days, with 30% of customers taking advantage of this discount. The
remaining 70% of customers pay, on average, in 60 days. Bad debts are currently at
3% of sales. Variable costs make up 70% of the selling price. The new plans are not
expected to change the fixed costs. In the new policy, the company is considering
introducing a 6% discount for payment within 15 days. This plan anticipates a 20%
increase in sales with 40% of customers expected to utilize the new discount facility.
However, the average payment period for the remaining customers is expected to
extend to 80 days, and bad debts are projected to rise to 5%. The company finances
working capital from an overdraft at a cost of 10%. Is the proposed change in policy
worth implementing? [30 marks]

SOLUTION
(a)
The components of working capital are the elements included under current assets and
current liabilities. The principal elements of working capital must be carefully controlled so
that the vital resource of cash is not misapplied.

Cash circulates around the business as a result of routine transactions, for example, cash
paid to suppliers and cash received from customers. Cash is the fundamental business
resource. A business must ensure that its sources of cash exceed the amounts of cash spent
and promised on the purchase of inventories, fixed assets, and other goods and services
involved in running the business. For this, a business must carefully manage its inventory
turnover, quick ratio, overdraft, and creditors & debtors turnover ratios.

(b)
(1) A credit analyst can calculate and evaluate the customer’s liquidity and debt ratios
to determine the customer's financial health to meet its financial obligations.
(2) The average number of days the customer takes to pay its creditors can be evaluated.
(3) References from other businesses can be consulted to assess the customer's
creditworthiness.
(4) The customer’s credit rating over the years can be reviewed.

(c)
Current Policy
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 0.3 × 20 + 0.7 × 60 = 48 𝑑𝑎𝑦𝑠
48
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 ($) = 5,000,000 × = $657,534
365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 657,534 × 0.1 = $65,753
𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 5,000,000 × 0.03 = $150,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 5,000,000 × 0.04 × 0.3 = $60,000

Proposed Policy
𝑁𝑒𝑤 𝑠𝑎𝑙𝑒𝑠 = 5,000,000 × 1.2 = $6,000,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 0.4 × 15 + 0.6 × 80 = 56 𝑑𝑎𝑦𝑠
56
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 ($) = 6,000,000 × = $920,548
365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 920,548 × 0.1 = $92,055
𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 6,000,000 × 0.05 = $300,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 6,000,000 × 0.06 × 0.4 = $144,000

𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 92,055 − 65,753 = $26,302

𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 300,000 − 150,000 = $150,000
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 144,000 − 60,000 = $84,000
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 5,000,000 × 0.2 × 0.3 = $300,000
𝑁𝑒𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 = 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 + 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠
+ 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑁𝑒𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 = 26,302 + 150,000 + 84,000 − 300,000 = $ − 39,698
The proposed policy reduces the cost by $39,698. Therefore, the new policy is financially
attractive. Or the incremental contribution of $300,000 is greater than the increment in the
cost of $260,302. Therefore, the new policy is financially attractive.