Explain why accruals accounting is preferred to cash accounting.

Accruals accounting helps a business to identify its actual profit and net worth. Company law and accounting standards require companies to use accruals accounting to reflect the substance, i.e. reality of what has happened. Cash accounting does not reflect the actual trading activity of a business.

Greggs plc’s financial statements are based on accruals accounting. The accounting policy note (immediately following the financial statements) confirms that Greggs plc follows international accounting standards in conformity with the requirements of the Companies Act 2006. The standards and the act both dictate the use of accruals accounting.

(Appendix p. 450)

How does profit correlate to cash received and paid?

Profit does not correlate to cash received and paid. The timing of cash receipts and payments is simply a settlement arrangement made between contracting parties that cannot alter the substance of the transaction. Instead profit correlates to actual trading activity of a business, under accruals accounting.

The supporting note to Greggs plc’s cash flow statement illustrates the difference between profit and cash. The note shows that although Greggs plc reported a £13.0m loss in 2020, the net cash generated from operating activities was positive £61.6m. The main differences for Greggs plc in 2020 were depreciation and the decrease in payables.

(Appendix p. 449)

Explain whether offering credit to customers and receiving credit from suppliers directly impacts a company’s profit.

Offering credit to customers and receiving credit from suppliers does not directly impact a company’s profit (although the resulting impact on cash balances may have an indirect impact on profit). The timing of cash receipts and payments is simply a settlement arrangement made between contracting parties that cannot alter the substance of the transaction.

The supporting note to Greggs plc’s cash flow statement illustrates the difference between profit and cash. This reconciliation includes the change in receivable (debtor) and payable (creditor) balances. Although this impacts cashflow, it does not impact profit.

(Appendix p. 449)

Why is accruals accounting critical at the end of the financial year?

Accruals accounting should capture all sales during a financial year, including those that take place immediately prior to the year end, i.e. irrespective of whether or not cash for that sale is received in that year. Auditors will always be attentive to transactions around the year end to make sure they are reflected in the correct period. Large credit sales and credit purchases either side of the year end can have a significant impact on each year’s profit and therefore must be allocated to the correct year.

These principles equally apply to Greggs plc.

What is the main role and responsibility of an FD/CFO?

The FD (finance director) or CFO (chief financial officer) ensures the financial strategy is aligned with the business strategy. They are usually a board member. The FD has overall responsibility for the financial health of a business and closely monitors KPIs (key performance indicators) such as:

• ■Profitability performance measures
• ■Working capital and liquidity
• ■Long-term solvency performance measures
• ■Investor ratios.

Greggs plc’s FD is a member of the board of directors.

In the ‘Governance Report’ (part of the annual report) it is noted that the FD (alongside the Chief Executive) leads engagement with shareholders in relation to business performance. The report also notes that the FD is primarily responsible for the relationship with providers of commercial lending.

The FD (alongside the Chief Executive) signs the responsibility statement in respect of the annual report and accounts.

The FD also prepares the ‘Financial Review’ (part of the annual report) which tells the story behind the company’s financial performance and position.

(Annual Report and Accounts 2020, pp. 41, 103)

List the main functions of a typical finance department.

The three key roles within a typical finance department are:

• 1Management accounting
• 2Treasury
• 3Financial accounting.

Within financial accounting there are a number of functions:

• ■Accounts payable
• ■Accounts receivable
• ■Payroll
• ■Bookkeeping
• ■Fixed asset management
• ■Tax accounting
• ■Financial reporting
• ■Group accounting
• ■Liaison with external auditors
• ■Company secretariat
• ■Investor relations.

Details of accounting functions are unlikely to feature in annual reports, including Greggs plc.

Greggs plc’s ‘investor relations’ team’s responsibility includes the annual report and disseminating information to shareholders.

The investor relations team will also be responsible for the online information provided under the investors section at corporate.greggs.co.uk

What is the difference between financial accounting and management accounting?

The financial accounting team (often referred to as ‘finance’) is responsible for processing transactions and maintaining core accounting records. The purpose of financial accounts is to report the historic financial results of a company to shareholders as well as other internal and external stakeholders (such as employees and creditors).

The management accounting (MA) team monitors budgets, produces forecasts and provides information to support financial decisions. The MA team uses the output from the finance system to prepare regular management accounting information.

The purpose of management accounts is to help internal stakeholders, such as company directors, run a business efficiently and effectively. Frequent and regular financial information is needed to make informed business decisions and to understand if the business is on track to meet its plans.

Management accounts use past and present information, both financial and non-financial, to help a company make informed decisions about its future.

Greggs plc will use both financial and management accounting information. However, information relating to the role and structure of the finance team is unlikely to be published.

Explain the purpose of the nominal ledger and how it relates to the trial balance.

The nominal ledger is a central repository for all accounting transactions. Each transaction is allocated to a different nominal ‘account’ (or ‘code’) depending on its nature. The nominal ledger will sometimes be very detailed. For example, ‘sales’ may have an individual nominal account for every single product or service sold in every single geographical location. The level of detail depends on the size of company, its complexity and business requirements.

The trial balance is a list of every account in the nominal ledger and its associated ‘balance’ (or total), categorised into profit and loss account and balance sheet items.

While applicable to Greggs plc, this information is not published.

What is the difference between gross profit and operating profit?

Gross profit is calculated by deducting ‘cost of sales’ from revenue.

Gross profit is used to assess gross margin (the profit on top of direct costs).

Operating profit is calculated by deducting both ‘cost of sales’ and ‘operating expenses’, i.e. all operating costs, from revenue.

Operating profit is the profit from running the business (after deducting both direct and indirect costs).

Greggs plc’s cost of sales represents the direct costs of product ingredients, for example the puff pastry and sausage meat of sausage rolls.

Greggs plc’s operating expenses include the cost of staff, shop occupancy costs and depreciation on the ovens required to heat sausage rolls.

Greggs plc’s gross and operating profit (or loss) can be found on the face of the income statement.

(Appendix p. 445)

Define the acronym EBITDA and explain its purpose.

Earnings before interest, tax, depreciation and amortisation. This is essentially operating profit before known accounting adjustments and approximates to the cash generated by the company from its operating activities.

It is a commonly used measure of core profits by external analysts and therefore often used as an internal performance measure for listed companies.

Despite its popularity, the exclusion of depreciation can be the cause of its criticism. It is a non-GAAP measure.

Greggs plc does not disclose EBITDA as an alternative performance measure. Some analysts, such as Edison Investment Research provide EBITDA as part of their analysis of Greggs plc.

See ‘analyst coverage’ under the investors section at corporate.greggs.co.uk.

Define the acronym PAT and explain what this profit metric means to shareholders.

Profit (earnings) after tax. Also known as net profit, net income, net earnings or simply the ‘bottom line’.

Shareholders pay attention to PAT as it is usually the same as distributable profits (the profit remaining in the business after all other expenses). It is the profit that is available for distribution to shareholders or reinvestment in the business.

In Greggs plc’s income statement PAT is referred to as ‘(Loss) / profit for the financial year attributable to equity holders of the Parent’.

(Appendix p. 445)

Where are finance costs shown on a P&L (before and after which headings)?

Finance costs can be found towards the bottom of the P&L between PBIT (profit before interest and tax) and PBT (profit before tax). The notes to the accounts may provide further detail behind the number shown on the face of the P&L if required.

Greggs plc uses the term ‘finance expense’ in its income statement. Note 6 shows that most of the finance expenses are ‘interest on lease liabilities’ (see Chapter 9 Tangible fixed assets and depreciation).

(Appendix p. 463)

Where can retained earnings be identified in a set of financial statements?

Retained earnings are disclosed together with distributable profits in the statement of changes in equity. They can also be seen on the balance sheet under capital and reserves. Alternatively, refer to the capital and reserves note.

Greggs plc’s statement of changes in equity reconciles the change in retained earnings from one balance sheet date to the next. This note also shows other movements such as dividends and share buybacks (see Chapter 15 Capital and reserves).

(Appendix p. 447)

Explain the difference between a P&L account and a balance sheet and how the two statements fit together.

The P&L shows the income earned and expenditure incurred to generate either profit or loss over time, typically a year. It measures financial performance.

The balance sheet shows a company’s financing structure and financial position (net assets) at a point in time.

The P&L helps to explain the growth (or decline) in net assets. When a company makes profits, the net assets of the business grow. When a company makes losses, its net assets are depleted. The P&L should be reviewed in conjunction with a balance sheet to understand how a business has performed over time. In this context, a helpful analogy is to think of the P&L as a ‘video’ that records the transactions of the business throughout the year.

The balance sheet is the ‘photograph’ of the company’s position at the end of the year.

By comparing photographs from one year to the next and reviewing the video of the year inbetween, it is possible to understand how the business has performed.

The link between the two is the retained earnings found in the equity section of the balance sheet.

The financial review within Greggs plc’s annual report tells the story behind both the P&L and balance sheet.

Greggs plc’s statement of changes in equity reconciles the change in retained earnings from one balance sheet date to another. This note shows other movements in retained earnings from transactions such as dividends and share buybacks (see Chapter 15 Capital and reserves).

(Appendix p. 447)

List the key elements within a balance sheet.

The key elements within a balance sheet are:

• ■Long-term assets
• ■Short-term assets
• ■Short-term liabilities
• ■Long-term liabilities
• ■Capital and reserves.

Greggs plc reports under IFRS and the equivalent terminology is:

• ■Non-current assets
• ■Current assets
• ■Current liabilities
• ■Non-current liabilities
• ■Capital and reserves.

What are the key timing differences from accruals accounting which can be found within a balance sheet?

The key timing differences to pay attention to are:

• ■Stock
• ■Debtors and creditors
• ■Prepayments and accruals
• ■Deferred income and accrued income.

Greggs plc has inventories (stock) in its balance sheet consisting of raw materials and consumables as well as work in progress (note 15).

Note 16 itemises trade receivables (debtors) and prepayments. This note also includes ‘other receivables’ which may include accrued income.

Note 18 itemises trade payables (creditors) and accruals. This note also itemises ‘advance payments from customers’ and ‘deferred government grants’ which are both examples of accrued income.

(Appendix pp. 471–472.)

Why should a balance sheet always balance?

A balance sheet always balances because any profit or loss a company generates is reflected as an increase/decrease in net assets as well as a corresponding increase/decrease in shareholders equity. For example, where a company makes a profit, its net assets will increase by the amount of profit. Because this increase in profit belongs to shareholders, the shareholders equity will increase by the same amount to ensure the balance sheet balances. In fact, any change in net assets is mirrored by an equivalent change in shareholders funds, thus ensuring the balance sheet always balances.

N/A

Is the format of a balance sheet fixed or can it be presented in different ways?

A balance sheet can be balanced in different ways. Whichever way the balance sheet is arranged, the two halves will remain equal (i.e. balance). For external financial reporting purposes a certain presentation may be required e.g. UK GAAP or IFRS. The two presentations permitted are: (a) assets and liabilities (plus shareholders’ equity) (b) Net assets and shareholders’ funds.

Greggs plc’s balance sheet balances its ‘net assets’ (£321.6m in 2020) against its ‘equity’ (£321.6m in 2020).

(Appendix p. 446)

What is the purpose of the cashflow statement (CFS)?

The CFS shows the inflows and outflows of cash during a reporting period. It explains how the cash balance shown in the balance sheet has increased or decreased from the previous reporting period.

The CFS reveals how a company has:

• ■managed its short-term liquidity
• ■managed its long-term solvency and adapted its financing to prepare for the future
• ■invested in assets for the future.

For an established business, the CFS can be used to give an indication of the amount, timing and certainty of future cash flows. It also enables comparability of a company’s year-to-year cash position, as cash flows are not affected by accounting policies.

Greggs plc’s statement of cashflows explains the £54.5m net decrease in the cash (and cash equivalents) balance between the balance sheet dates of 28 December 2019 and 2 January 2021.

Greggs plc’s financial review provides some commentary on the movements in its cash flow during 2020.

(Annual Report and Accounts 2020, p. 41) + (Appendix p. 449)

What are the three main headings within the cashflow statement?

Operating activities, Investing activities and Financing activities.

For 2020, Greggs plc’s statement of cashflows shows:

• ■£43.6m net cash inflow from operating activities
• ■£59.2m net cash outflow from investing activities
• ■£38.9m net cash outflow from financing activities.

(Appendix p. 449)

What is the difference between operating profit and operating cashflow?

The difference between operating profit and operating cashflow can be explained by:

• ■accounting adjustments (depreciation, amortisation and the profit or loss on disposal of assets)
• ■movements in working capital (stock, debtors, creditors)
• ■interest and taxes paid.

In 2020, Greggs plc made an operating loss of £7.0m, while its cash generated from operations was £61.6m. The key differences (shown at the foot of the cash flow statement) are accounting adjustments on property, plant and equipment including right of use assets, as well as movements in working capital.

Greggs plc’s statement of cashflows also shows a net cash inflow from operating activities of £43.6m after interest and taxes paid.

(Appendix p. 449)

Assuming no other changes, if there has been an increase in the debtors’ balance over a financial period, will operating profit be higher or lower than operating cashflow?

Operating profit will be higher than operating cashflow. The profit from the increase in debtors will have been recognised in operating profit. However, as this has not yet been received as cash, the profit will not yet appear in operating cash flow. Therefore, the increase should be deducted when reconciling operating profit and operating cashflow.

During 2020 there was a £12.3m increase in Greggs plc’s receivables balance. This increase was deducted in the reconciliation between ‘loss for the financial year’ and ‘cash from operating activities’.

(Appendix p. 449)

Is bank interest paid an operating or financing activity in the cash flow statement?

Bank interest paid is an operating activity in the cash flow statement. An increase (or decrease) in bank debt would appear as a financing activity. The associated interest is classified as an operating activity.

Interest paid is shown in the calculation of ‘net cash inflow from operating activities’ in Greggs plc’s statement of cashflows.

(Appendix p. 449)

Explain the difference, if any, between the following terms: revenue, sales, turnover.

There is no difference! These terms are used interchangeably by accountants and finance professionals. The language of accounting comprises a lexicon of terms which, sometimes unhelpfully, includes different words to explain identical concepts or terms. Stock and inventory is another example.

Greggs plc uses the term revenue in the income statement.

(Appendix p. 445)

Revenue is analysed as retail sales, franchise sales etc.

(Appendix p. 458)

Why is the revenue metric considered to be so important by investors, analysts etc.?

Revenue is typically the largest single number in the financial statements and is a key ‘headline’ figure as it indicates the success of a business in generating income from customers. Every company has to sell to make money and therefore every business will have a revenue (turnover or sales!) figure, so comparisons can be readily made between businesses.

Revenue is one of eight key performance indicators published by Greggs plc to monitor the performance of the business against strategy

(Annual Report and Accounts 2020, p. 18).

When should revenue be recognised (recorded) in the accounts of a business?

When goods or services have been delivered or transferred to the customer. For goods, this is relatively easy as there is typically a point in time when a physical transfer of the good has taken place. For services, revenue is typically recognised to reflect the period over which that service is delivered or provided.

Revenue from the sale of goods is recognised as income on receipt of cash or card payment.

(Appendix p. 458)

Explain why the revenue number (in the financial statements of a business) is unlikely ever to be entirely accurate.

Because there is inevitably judgement involved. For example, there will always be a level of goods returned that must be estimated to account for net revenue. Further, products may comprise both goods and services and this may complicate the revenue recognition as each component must be accounted for separately

In respect of gift cards:

Revenue is recognised when the Group has fulfilled its obligation to supply products under the terms of the programme or when it is no longer probable that these amounts will be redeemed.

(Appendix p. 458)

There is judgement involved in determining the probability of redemption.

What is the difference between opex and capex?

Although both are cash outflows, they are treated differently.

Opex is expenses incurred in running a business. Opex is part of the P&L expenses.

Capex is payments to purchase or improve long-term assets which are shown in the balance sheet.

Opex for Greggs plc includes product ingredients, cost of staff, shop occupancy costs and energy costs for example.

Capex includes new shops and relocations, shop fitting, shop equipment and vehicles to move products from distribution centres to shops.

What impact does opex have on the financial statements?

Expenses in the P&L account which reduce current year’s profit.

Opex will be included in cost of sales, distribution and selling costs and administration expenses within Greggs plc’s income statement.

(Appendix p. 445)

What impact does capex have on the financial statements?

An increase in fixed asset values recorded in the balance sheet.

There will also be a gradual impact on profit over time through depreciation, which is an expense in the P&L.

Investing cash outflow in the cash flow statement.

Note 12 (Property, plant and equipment) shows capex as additions of £55.9m during 2020, allocated to various headings such as ‘land and buildings’ and ‘plant and equipment’.

Note 12 shows depreciation of £56.8m. The same amount (with small rounding) also appears in both the statement of cashflows (to reconcile cash from operating activities) and note 3 Profit before tax (as depreciation must be itemised in the notes to the accounts).

The statement of cashflows shows a cash outflow of £61.6m on the acquisition of property, plant and equipment as well as intangible assets during 2020.

(Appendix pp. 449, 467)

What are the main activities which result in a business tax charge?

• aProfits on sales of goods or services and returns from investments.
• bCapital gains from the disposal of assets and investments.

Greggs plc made a loss during 2020. No tax was therefore payable in respect of 2020. There are a number of reliefs available for tax losses in the UK (outlined in Chapter 8). The tax relief is shown as an addition (versus the usual deduction), in the income statement, in the year of the loss.

This relief, however utilised, will effectively be deducted from future tax liabilities. There are no repayments in respect of corporation tax from HMRC.

In 2020, the income tax line in Greggs plc’s income statement shows positive £0.7m (2019: negative £21.3m).

Gregg’s current tax liability, shown on the face of the balance sheet, is therefore £0 for 2020 (2019: £11.8m).

(Appendix pp. 445, 446)

Which taxes is a business responsible for administering and collecting?

• aEmployment taxes. Employers act as tax collectors and deduct employee income tax and other contributions directly from pay. This is then paid across to tax authorities. This system is known as PAYE (Pay As You Earn).
• bValue added tax (VAT) or sales tax. VAT is not technically a cost to a business, as it can reclaim input VAT on its purchases. VAT is effectively levied on the final consumer of certain goods and services. The business acts as a collecting agent on behalf of the tax authorities.

The costs of administering both systems are borne by employers.

PAYE and VAT are not shown or itemised in Greggs plc’s accounts, as they are not part of the company’s income or expenditure. Greggs plc is a collecting agent acting on behalf of HMRC.

Note 18 Trade and other payables itemises ‘other taxes and social security’ of £6.8m as at 2 January 2021. This represents any PAYE and VAT collected and not yet paid to HMRC.

(Appendix p. 472)

Give examples of expenses which are not allowable deductions from taxable profit.

Examples of non-allowable deductions from taxable profit:

• ■Depreciation
• ■Formation and acquisition costs
• ■Donations to political parties
• ■Entertaining clients.

Greggs plc has disclosed that from 2021 the effective (tax) rate is expected to be around 1.5% above the headline corporation tax rate; this is principally because of disallowed expenditure such as depreciation on non-tax-deductible qualifying properties and costs of acquisition of new shops.

(Annual Report and Accounts, p. 43)

Define a ‘capital gain’.

A capital gain arises when an asset or investment is sold for more than its original cost. In the UK, a capital gain is calculated after allowing for initial purchase-related costs, improvements and enhancement costs (but not repairs and maintenance) and selling costs. An allowance is also made for inflation.

Greggs plc has not disclosed any capital gains.

What is the difference between output VAT and input VAT?

Output VAT is charged by businesses on sales of certain good and services, by adding a set percentage to the (net) sales price. Input VAT is paid on business purchases (which is charged as output VAT by suppliers). The difference between a company’s output VAT and input VAT is paid to tax authorities (such as HMRC) or reclaimed (if input VAT is greater than output VAT).

Neither output nor input VAT are included in Greggs plc’s accounts, as they are not part of the company’s income or expenditure.

For a company such as Greggs plc, revenue and costs are measured net of VAT.

What is the tax gap?

The tax gap is a measure of the difference between the amount of tax collected by a country’s tax authorities and the amount that should be collected.

Greggs plc makes the following statement in its annual report:

The Company has a simple corporate structure, carries out its business entirely in the UK and all taxes are paid there. We aim to act with integrity and transparency in respect of our taxation obligations

Ensuring tax compliance is a key responsibility of Greggs plc’s audit committee.

(Annual Report and Accounts 2020, p. 43)

All fixed assets are subject to an annual depreciation charge. True or false?

False. Land is the exception.

Freehold land is not depreciated. See Significant accounting policies note.

(Appendix p. 455)

Explain the difference, if any, between depreciation and amortisation.

There is no difference conceptually. However, depreciation is a term that applies to tangible fixed assets, whereas amortisation is the (equivalent) term applied to intangible fixed assets.

Amortisation is recognised in the income statement on a straight-line basis over the estimated useful lives of intangible assets from the date that they are available for use. The estimated useful lives are five to seven years.

(Appendix p. 454)

Depreciation is provided so as to write off the cost (less residual value) of each item of property, plant and equipment during its expected useful life using the straight-line method over the following periods.

(Appendix p. 455)

Identify the most common methods of depreciation and explain how the depreciation charge will differ between each from year to year.

The two most common methods are straight line and reducing balance. Straight line charges the same annual depreciation from year to year, while the reducing balance (as the name suggests) will charge a declining amount each year.

Taking the example of a 5-year useful life asset, the straight-line method will charge the same flat amount annually, while the reducing balance method will charge more (than straight line) in the early years with a declining charge in later years.

By the end of the 5-year period, both methods will depreciate the asset to the (same) residual value.

Depreciation is provided so as to write off the cost (less residual value) of each item of property, plant and equipment during its expected useful life using the straight-line method over the following periods: Freehold and long leasehold buildings 20 to 40 years.

Short leasehold properties 10 years or length of lease if shorter

Plant, machinery, equipment, vehicles, fixtures and fittings 3 to 10 years.

(Appendix p. 455)

Which method of depreciation should be applied to office fixtures and fittings, to best reflect their likely usage from one year to the next?

Fixtures and fittings, such as lighting or partitioning in an office, are likely to be used evenly from one year to the next. The straight-line method therefore more accurately reflects the reality of usage of the assets and is therefore the more appropriate method of depreciation.

Greggs plc depreciates its fixtures and fittings on a straight-line basis over a 3–10–year period.

(Appendix p. 455)

Only assets that are owned by a company can be recorded in a balance sheet. True or false?

False. International accounting standards (IFRS 16) require all leases (finance and operating) to be capitalised and the related liability recognised. This is the principle of economic substance over legal form. Therefore, company balance sheets will include assets and liabilities relating to leases, even though the underlying assets are not actually owned.

Greggs plc had shop leases and these had the following impact:

• ■£270.1m right-of-use assets (balance sheet asset)
• ■£291.7m lease liabilities (balance sheet liability)
• ■£51.9m of depreciation (profit and loss expense relating to asset)
• ■£7.5m of interest expense (profit and loss expense relating to liability).

(Appendix p. 465)

What is meant by indefinite life and what effect does it have on the carrying value of goodwill in the financial statements?

Indefinite life implies that the asset has the potential to retain its carrying value into the future without depletion. The effect is that the asset is not amortised.

Greggs plc has no goodwill in its financial statements. It has not made any acquisitions since adopting IFRS accounting policies. (Goodwill from historic acquisitions dating before the year 2000 was written off against reserves on acquisition.)

Explain what is meant by negative goodwill and why this situation might arise.

Negative goodwill is the situation where a business is worth less than the sum of its parts. It may arise because a business is in difficulty and therefore the price reflects the need to realise value at short notice. This is commonly referred to as a ‘fire sale’.

N/A

All intangible fixed assets are subject to an annual amortisation charge. True or false?

False. Goodwill is the exception.

Intangible assets relate to software and the cost of its development which are measured at cost less accumulated amortisation.

(Appendix p. 465)

What commercial risks arise from holding too much stock and how should this be reflected in the company’s accounts?

The risk of delays in recovering monies invested (holding cost) and the risk of being unable to sell stock, i.e. not recovering the monies invested (incurring a loss). Annually, a company will assess recoverability and write down the cost of stock to its net realisable value.

Greggs plc records its inventories at the lower of cost and net realisable value.

(Appendix p. 455)

Greggs plc’s write-down of inventories was recognised as an expense in 2020 was £34.9 million.

(Appendix p. 471)

What commercial risks arise from having a minimal stock holding policy?

The risks are that profit opportunities are missed and customers could be lost (loss of customer goodwill).

It is very difficult for any business to quantify potential sales lost as a result of stockouts. Management and shop staff should continuously monitor and adjust stock levels to react to local demand.

Why might supermarkets apply FIFO accounting for items with a limited shelf life?

Perishable goods such as milk, eggs and bread have a short shelf life. Supermarkets implement procedures to sell items in the order in which they were purchased to minimise the risk of holding stock past the ‘use by’ or’ best before’ dates. FIFO accounting reflects the cost of items that are sold on a first in first out basis.

Greggs plc does not state its costing policy.

Why are debtors classed as assets and creditors classed as liabilities?

Debtors are assets as they will be a future cash inflow or ‘benefit’.

Creditors are liabilities as they will be a future cash outflow or cost.

Greggs plc had £39.4m of ‘Trade and other receivables’ at 2 January 2021, of which £22.0m was ‘Trade receivables’.

Greggs plc had £91.1m of ‘Trade and other payables’ at 2 January 2021, of which £48.8m was ‘Trade payables’.

(Appendix pp. 471, 472)

What is the objective of credit control?

The objective of the credit control department is to manage and collect amounts owed by credit customers. Inevitably some debtors do not pay unless they are continually chased and therefore credit control is considered a necessary role within organisations.

In note 2 of Greggs plc’s 2020 Annual Report, it is noted that ‘The Group does offer credit terms on sales to its wholesale and franchise customers. In such cases the Group operates effective credit control procedures in order to minimise exposure to overdue debts.’

(Appendix p. 460)

Explain the terms debtor days and creditor days.

Debtor and creditors days represent the average number of days of outstanding debtors and creditors, for all customers and suppliers. They are calculated as follows:

$\begin{array}{l}\text{Debtor collection period}=\frac{\text{Debtors}}{\text{Sales}}\times 365\hfill \\ \text{Creditor payment period}=\frac{\text{Creditors}}{\text{Cost of sales}}\times 365\hfill \end{array}$

The result can be compared against the actual credit terms offered and received. When reviewing days for the whole debtor or creditor balance it should be remembered that it is an average. Therefore, it can be useful to calculate days for individual debtors and creditors and use an ‘aged report’ which lists outstanding balances by customer/supplier and by time outstanding.

Note 1 of Greggs plc’s 2020 Annual Report itemises B2B revenue (franchise and wholesale activities) which in 2020 was £96.0m. As this is the only segment which receives credit it should be used as the denominator, with the trade receivables balance of £22.0m as the numerator. This gives an average ‘receivable’ collection period of 84 days (2019: 61 days).

Greggs plc’s ‘cost of sales excluding exceptional items’ for 2020 was £299.6m. It is not known how much of this amount related to credit purchases and therefore the ratio may be understated. Using the trade payables balance of £48.8m as the numerator gives an average ‘payables’ payment period of 59 days (2019: 59 days).

Note that the above ratios are approximations and may not reflect actual terms. Both revenue and cost of sales are annual figures, whereas the receivables and payables balances are taken at the year end, which may not be reflective of the whole year.

In note 16, Greggs plc provides the aging of its trade receivables balance. This shows that most trade receivables were not past their due date.

(Appendix p. 472)

What is the difference between specific and general bad debt provisions?

A specific bad debt provision is for specific known debtors. For example, those which have become insolvent or where there is a potentially unresolvable dispute.

A general bad debt provision is typically a set percentage of the overall debtors’ balance (for example 2%), to account for unanticipated bad debts (based on experience of the business).

That is, specific is for known risky debtors and general is for unknown potentially defaulting debtors.

In note 16 of Greggs plc’s Annual Report 2020 it is noted that the allowance for bad debts was immaterial.

(Appendix p. 471)

What is the difference between a prepayment and an accrual?

Prepayments are goods or services which have been invoiced and paid, but not yet received.

Accruals are goods or services which have received, but not yet invoiced or paid.

Prepayments relate to expenses paid in the period, which relate to the following period.

Accruals relate to expense incurred in the period and not paid until the following period.

At 2 January 2021 Greggs plc had prepayments of £6.0m and accruals of £15.1m.

(Appendix pp. 471, 472)

Give some examples of prepayment and accruals in practice.

Given the size of the prepayment and accruals balances, they are likely to relate to typical timing differences in expenditure, not dissimilar to the examples given above.

What impact, if any, do prepayments and accruals have on the P&L, balance sheet and cashflow statements?

Prepayments:

• ■P&L: No impact (following period-end accounting adjustments).
• ■Balance sheet: A reduction in one current asset (cash) and an equivalent increase in another current asset (prepayments). The net effect is that there is no impact on net assets.
• ■Cashflow: A cash outflow for the amount of the prepayment.

Accruals:

• ■P&L: An expense. Therefore, a reduction in profit.
• ■Balance sheet: An increase in a current liability (accruals). Therefore, a reduction in net assets.
• ■Cashflow: No impact as the expense has not yet been paid.

Prepayments and accruals will have the same impact as described above.

Given the size of the prepayment and accruals balances, the impact will not be material to Greggs plc’s results.

What are the advantages and disadvantages of making prepayments in business?

There are times when it may be advantageous to prepay for goods or services. For example:

• ■Taking advantage of a volume purchase discount.
• ■Hedging against inflation by purchasing earlier rather than later.
• ■Building a relationship with a new supplier.

On the other hand, prepayments represent a cash outflow which has an associated finance cost. There is also the risk of becoming an unsecured creditor should the recipient business become insolvent.

Greggs plc’s prepayment balance is not material relative to the size of its overall expenditure. These factors will not necessarily be applicable to Greggs plc’s business.

What are the three conditions for recognition of a provision?

The three conditions for recognition of a provision:

• ■There is a present obligation (i.e. a duty to make a future payment) resulting from a past event.
• ■The amount of the obligation can be reliably estimated.
• ■It is probable that there will be a future cost (or outflow of resources).

The accounting policy note to Greggs plc’s 2020 accounts states that: ‘A provision is recognised if, as a result of a past event, the Group has a present legal or constructive obligation that can be estimated reliably and it is probable that an outflow of economic benefits will be required to settle the obligation.’

(Appendix p. 457)

Give some examples of provisions in a business.

Examples of typical provisions are:

• ■Legal cases against the business
• ■Dilapidations
• ■Onerous contracts
• ■Restructuring.

Greggs plc’s annual report refers to the following types of provisions:

• ■Dilapidations
• ■National insurance
• ■Restructuring/redundancy
• ■Onerous contracts/costs.

Note 22 in Greggs plc’s annual accounts analyses its provision between various categories.

(Appendix p. 479)

What impact does a provision have on the financial statements?

On creation a provision will be recognised as an expense, i.e. it will reduce profitability in the year it is created, or increased. In contrast reducing or releasing a previously made provision will increase profitability.

Provisions are also recognised as liabilities on the balance sheet and therefore will impact a company’s net assets.

Provisions are an accounting adjustment and do not impact on cash flow. To be clear, if the future event, which has been provided for, actually happens, there will be a cash outflow at that time.

Note 22 in Greggs plc’s annual accounts provides detail on the movement in its provision balance. Analysis of the note shows that:

• ■During 2020, £14.1m of new provisions were made and £3.2m of provisions were released. Therefore, the net impact on the P&L was expenditure of £10.9m.
• ■During 2020, £10.9m of previously made provisions were also utilised. This is the cash spent on these items during the year.
• ■There was therefore, zero net impact on the overall provisions balance which remained at £7.4m. The note shows that the split between current and non-current as well as ordinary and exceptional did change between years.

(Appendix p. 479)

What is the difference between a provision and a contingent liability?

A provision is a known yet imprecise liability, i.e. we know it exists but we may not know exactly when it will have to be paid or how much. A provision is made when each of the following occurs:

• ■There is a present obligation (i.e. a duty to make a future payment) resulting from a past event.
• ■It is probable that there will be a future cost (or outflow of resources).
• ■The amount of the obligation can be reliably estimated.

In contrast, a ‘contingent’ liability arises when there is uncertainty over one or more of the above (hence the use of the term ‘contingent’). Typically, the uncertainties are around:

• ■the likelihood of the obligation (where it is possible but not probable); and
• ■the reliability of the amount.

The other key difference is that provisions are accounted for, i.e. they become an expense in the P&L and a liability in the balance sheet. Contingent liabilities on the other hand are just disclosed in the notes to the accounts and have no financial impact. They only become actual liabilities if one or more uncertain events actually happen.

Greggs plc has provisions as detailed in note 22 of the 2020 annual accounts.

Greggs plc has not disclosed any contingent liabilities.

(Appendix p. 479)

What is the difference between a contingent asset and a contingent liability?

A contingent liability arises where there is an uncertain liability resulting from a past event. A contingent asset arises where there is an uncertain asset resulting from a past event, i.e. one is to do with liabilities and the other to do with assets.

Neither contingent liabilities nor contingent assets are recognised in the financial statements. Instead, they are disclosed in the notes to the accounts.

Contingent liabilities are possible (more than remote) but not probable outcomes. If they become probable, then they are likely to become provisions (if they can also be reliably estimated).

Contingent assets are only disclosed if they are probable, not if they are just possible. If they become certain (and their financial benefit reliably estimated), then they are likely to become an asset.

Both contingent liabilities and contingent assets will only be confirmed by the occurrence or non-occurrence of one or more uncertain future events.

Greggs plc has not disclosed either a contingent asset or contingent liability in its 2020 annual accounts.

What impact does a contingent liability or asset have on the financial statements?

Neither contingent liabilities nor contingent assets are recognised in the financial statements and therefore have no financial impact. Instead, they are disclosed in the notes to the accounts.

N/A

What is meant by revenue and capital reserves and why is the distinction important?

Revenue reserves are distributable whereas capital reserves are not. This distinction is important to shareholders and lenders/creditors alike, as it determines the limitations of what company directors can distribute as dividends to investors.

Greggs plc has non distributable reserves comprising:

• ■Share capital
• ■Share premium
• ■Capital redemption reserve.

Greggs plc has distributable reserves comprising:

• ■Retained earnings.

(Appendix p. 446)

How are capital reserves created?

They are created by law or because of accounting measurement changes. Share premium and capital redemption are examples of capital reserves required to be created by law. Revaluation reserves are created only where a company adopts a policy of revaluation. Whether required by law or convention, capital reserves cannot be legally distributed.

Greggs plc’s capital reserves are examples of statutory reserves.

Greggs plc has no revaluation reserve as it has a policy of historic cost accounting for fixed assets.

(Appendix p. 446)

Explain why, when a company’s shares are bought and sold on a stock exchange, there is no effect on the company’s share capital.

The (subsequent) buying and selling of shares is known as secondary dealing. These transactions are one step removed from the original transaction that created the shares, such as an initial public offering, so they do not affect the company because it is not involved in the transaction.

Shares can be bought and sold subsequently for a price determined and agreed between the buyer and seller. The company’s only involvement is to maintain an up-to-date record of the current holder of the shares.

For example, 187,970 of Greggs plc’s shares were traded through the London Stock Exchange on 17 May 2021. (By volume, this represents less than 0.2% of the total number of shares in issue.)

This transaction would have had no effect on Greggs plc’s capital reserves as it was a secondary trade in shares.

Information on the volume of shares traded daily for listed companies can be obtained from londonstockexchange.com

What are the two main types of shares?

Ordinary shares and preference shares. Ordinary shares carry the most risk and offer the greatest reward. Preference shares are a form of non-equity share.

On 31 December 2020, Greggs plc had 101,426,038 ordinary shares in issue.

(Appendix p. 480)

Greggs plc has no preference shares in issue.

Explain what is meant by consolidated accounts.

Consolidated accounts (group accounts) show the result of adding together the profit and loss account and balance sheet of all companies within a group.

Greggs plc has nine subsidiaries, all of which have been consolidated into the group accounts.

(Appendix p. 469)

What is the purpose of group accounts?

Group or consolidated accounts are prepared to reflect the trading performance of the group with the outside world, i.e. on an arm’s length basis. This helps investors to understand the financial position and performance of the business.

By consolidating all companies within the group, investors can view the performance and position of Greggs plc as a single consolidated set of financial statements.

In what circumstances might a majority-owned company still not be consolidated?

Where the company is not controlled by the parent. This might happen because the parent may not have a majority of voting rights despite owning a majority of shares.

Greggs plc has nine subsidiaries, all of which are 100% owned and consolidated.

(Appendix p. 469)

What is meant by significant influence?

Significant influence is where one company is able to influence, but not determine, the decisions of another company. A seat on the board is often an indicator of influence, but without a majority of voting rights that board director will only have limited influence over the decisions taken by the company.

Associates are those entities in which the Group has significant influence, but not control, over the financial and operating policies. Significant influence is presumed to exist when the Group holds between 20 and 50 per cent of the voting power of another entity, unless it can be clearly demonstrated that this is not the case. At the year end the Group has one associate which has not been consolidated on the grounds of materiality.

(Appendix p. 469)

Why are companies permitted a choice between historic cost accounting and revaluation accounting?

Revaluations incur cost and management administration time so many businesses prefer to adopt the simpler and easier policy of historic cost. However, permitting a choice provides those businesses that seek to do so with the ability to reflect current values in their balance sheet, which in turn offers commercial advantages, for example in terms of raising finance from lenders.

Greggs plc has adopted a policy of historic cost accounting for fixed assets.

(Appendix p. 450)

Where a company chooses a policy of revaluation, it must revalue all assets. True or false?

False. A company does not have to revalue all assets. Revaluation policy may be adopted by class of fixed asset.

N/A

What is the accounting treatment for revaluation?

For increases in value, the difference is recorded in the asset held in the balance sheet and reflected also in the company’s capital reserves (revaluation reserve).

N/A

What effect does upwards revaluation have on a company’s ability to pay dividends?

Reported profits will be lower because depreciation will be charged on higher (revalued) asset amounts. This would suggest a lower maximum dividend payable. However, legally, the dividend level can be maintained at the same level as for a company adopting historic cost accounting. This is because an equivalent transfer of reserves is permitted from the revaluation reserve (capital reserve) to the profit and loss reserve (distributable reserve) to mitigate for the effect of the higher depreciation charge.

N/A

Impairment testing must be carried out annually for all fixed assets, both tangible and intangible. True or false?

False. Finite-life assets only require an impairment test when there are indications that an impairment may exist. Only goodwill (or other indefinite life assets, if any) must be subject to an annual impairment test.

Property, plant and equipment and right-of-use assets are reviewed for impairment if events or changes in circumstances indicate that the carrying value may not be recoverable.

The Covid-19 crisis has meant that all shops have had periods of no, or reduced, sales and the rate of recovery of sales is inherently uncertain. This is considered to be an impairment trigger and as a result all assets in company-managed shops have been tested for impairment.

(Appendix p. 452)

Why must goodwill be subject to an impairment test annually?

Goodwill is an indefinite life asset. As such, it is not subject to annual impairment, so its value may never decline. To ensure the assumption of indefinite life remains valid however, an impairment test must be carried out annually to (re) validate the carrying value of goodwill

N/A

Explain how impairments are accounted for in the financial statements?

Impairments reduce the carrying value of assets to their lower (recoverable) amount in the balance sheet. The reduction in asset value (i.e. the impairment) is an expense (loss) charged in the profit and loss account.

Greggs plc incurred impairment charges of £5.2m in respect of owned property, plant and equipment and £8.8m in respect of leased (right of use) assets.

(Appendix p. 461)

Can a previously impaired asset that has recovered its original carrying value have that value reinstated?

Yes, for all finite-life fixed assets. Goodwill, in contrast, can never be reinstated if it was previously impaired.

An impairment loss is reversed only to the extent that the asset’s carrying amount does not exceed the carrying amount that would have been determined, net of depreciation, if no impairment loss had been recognised. Significant accounting policies.

(Appendix p. 452)

Can UK companies have the option over which accounting standards regime to follow?

Non-listed UK companies can choose which accounting regime (FRS or IFRS) to adopt. Listed UK companies are required to adopt IFRS.

Both the Parent Company accounts and the Group accounts have been prepared and approved by the directors in accordance with international accounting standards in conformity with the requirements of the Companies Act 2006, and, as regards the Group accounts, International Financial Reporting Standards adopted pursuant to Regulation (EC) No 1606/2002 as it applies in the European Union (‘IFRSs as adopted by the EU’).

(Appendix p. 450)

Why do accounting standards still permit some choice of accounting treatment despite their obvious purpose, which is to ‘standardise’ accounting treatments?

Accounting standards generally seek to limit choice. Where choice is permitted, it is to enable a company to reflect more closely business reality. Where an alternative treatment is permitted to that recommended by a standard, then disclosure of the effects of adopting an alternative treatment is required.

The Group chose not to restate business combinations prior to the IFRS transition date (1 January 2004), as no significant acquisitions had taken place during the previous ten years. The Group’s policy up to and including 1997 was to eliminate goodwill arising upon acquisitions against reserves. Under IFRS 1 and IFRS 3, such goodwill remains eliminated against reserves.

(Appendix p. 450)

How can two companies that choose to apply different permitted accounting policies still be compared?

See the question above. Full disclosure of the effect of an alternative accounting treatment is required. This ensures that comparisons between companies can still be made.

See above. Alternative accounting treatments have been disclosed and explained.

International harmonisation of accounting standards will be achieved by 2025. True or False?

False. There is no set timeline for convergence

N/A

What is the primary purpose of external financial audit?

To give an opinion on the truth and fairness of financial statements

See independent auditor’s report within Annual Report and Accounts 2020 (p. 105) available under the investors section at corporate.greggs.co.uk

Why can external financial audits not identify all frauds?

Audit is based on sampling rather than testing of entire populations of transactions. In addition, a fraud that is carefully perpetrated and concealed by directors is, by its very nature, difficult to detect.

A fuller description of the auditor’s responsibilities with regard to statutory audits is provided on the FRC’s website at frc.org.uk (search for ‘Auditor’s Responsibilities for the Audit’)

Which companies are exempt from the requirement for audit?

Small companies are exempt from audit.

Greggs plc does not meet the small company criteria. It is a ‘large’ company. As such, it is subject to an external financial audit.

How frequently must an external audit be conducted?

An audit is an annual requirement.

The 2020 audit report covered the 53-week period ended 2 January 2021. See the independent auditor’s report within Annual Report and Accounts 2020 (p. 105) available under the investors section at corporate.greggs.co.uk

In what ways do external and internal audits differ?

External audit is a statutory requirement and is carried out for shareholders (whereas internal auditors report to management). External auditors must be independent, i.e. external to the organisation (whereas internal auditors are typically employed by the business). External audit focuses only on the financial statements (whereas the scope of internal audit is determined by management).

The external auditor’s responsibilities are set out in the independent auditor’s report within the annual report 2020 (pp. 104–111).

Greggs plc has an internal audit function comprising the Head of Business Assurance, supported by 16 auditors, along with the Data Protection Analyst. The majority of the audit resource is dedicated to the retail estate, providing the Audit Committee with assurance that the required controls for safe operation in the Company’s shops are in place and operating effectively. See Annual Report and Accounts 2020 (Audit Committee Report, p. 78).

What is meant by a modified (qualified) audit opinion?

A modified audit report is issued when the auditor is unable to issue a clean, i.e. unqualified report. The nature of modification will determine the qualification.

Greggs plc has an unmodified audit opinion. See independent auditor’s report within the Annual Report and Accounts 2020 (pp. 104–111).

What is the purpose of the Confirmation Statement and how frequently must it be filed?

The Confirmation Statement is an annual filing requirement for every company, including dormant companies. It is required to confirm that information provided to Companies House and displayed in the public register is accurate and up to date.

Greggs plc’s Confirmation Statement for 2021 was received for filing at Companies House on 19 April 2021. The Confirmation Statement for the previous year was filed on 14 April 2020.

What are the time limits for filing private and public limited accounts?

9 months for a private company, 6 months for a plc (although check for temporary extensions to deadlines for exceptional circumstances).

Greggs plc Group accounts for 2020 were filed at Companies House on 22 July 2021.

In the UK, where can you obtain financial information about all companies? How much does it cost to access information?

Companies House (gov.uk and search for Companies House). Information is free to access and download.

The filing history for Greggs plc can be accessed at the Companies House website (gov.uk and search for Companies House).

What information must be included in the annual Confirmation Statement?

The information that must be confirmed in the Confirmation Statement includes registered address, principal activities, share capital, shareholder name(s) and shareholdings.

Greggs plc includes the following in respect of its principal activities:

Manufacture of bread; manufacture of pastry goods and cakes. Retail sale of bread, cakes, flour confectionary and sugar confectionary in specialised stores.

Which companies are exempt from filing a profit and loss account?

All but the largest companies may gain exemption from publicly filing the profit and loss account.

Greggs plc is not exempt. It is a large company and has publicly filed its profit and loss account.

What is the relevance of agency risk in corporate governance?

Directors have a duty to promote the long-term success of the company for the benefit of its members (shareholders) as a whole, and in doing so, have regard for other stakeholders. Agency risk arises whenever this does not happen.

Greggs plc identifies stakeholders as comprising customers, colleagues, suppliers, shareholders, lenders and communities.

Details of stakeholder engagement are included in the Annual Report and Accounts 2020 (pp. 51–52).

The UK Code provides best practice guidance for directors of which companies?

UK premium-listed companies.

Greggs plc is a UK premium-listed company.

What are the implications of non-compliance with one or more provisions of the UK Corporate Governance Code?

Compliance with the UK Code is not a legal requirement. Non-compliance with one or more provisions should be discussed with shareholders and explained in the annual report.

Greggs plc Governance report included in the Annual Report and Accounts 2020 (p. 62) notes that:

The Company will not be compliant with Provision 19 of the UK Corporate Governance Code which observes that the Chair should not remain in post beyond nine years from first appointment to the Board.

As is recorded in the Chair’s Statement (on p. 58) in due course we will commence the search for a new Chief Executive, as Roger approaches retirement age. In recognition of this, and taking into account the disruption to the business caused by the pandemic, Ian Durant has been asked by the Board to remain as Chair in order to oversee succession. Ian was first appointed to the Board in October 2011, and became Chair in May 2013. The Board recognises that by extending his tenure until that date, the Company will not be compliant with Provision 19 of the UK Corporate Governance Code which observes that the Chair should not remain in post beyond nine years from first appointment to the Board. The Board, led by the Senior Independent Director, is of the view that Ian remains fully committed, and it is right and proper that Ian remains in the Chair to oversee such a sensitive and critical recruitment. The potential for this scenario was discussed with several of our largest shareholders during 2020, whose response was supportive.

What is meant by whistleblowing and why is this considered important in corporate governance?

Whistleblowing is the reporting of wrongdoing. It is considered an important mechanism within the UK corporate governance framework because employees are typically closest to the business and therefore most likely to spot breaches. For example, a breach of health and safety law is more likely to be identified by a worker (than say a customer or auditor) and should be reported to the Health and Safety Executive.

Greggs plc’s governance report 2020 includes the following statement to explain its whistleblowing policy:

Our ‘whistle-blowing’ policy creates an environment where employees are able to raise concerns without fear of disciplinary action being taken against them as a result of any disclosure. Any matters raised are treated in confidence and an independent review will be undertaken where it is appropriate. The Chair of the Audit Committee is the designated first point of contact for any concerns which cannot be addressed through normal management processes.

Which profitability performance measure is considered to be the best?

ROI is considered to be the best profitability performance measure as it looks at profit in the context of the investment required to generate that profit. However, although ROI is a good starting point to measure financial performance, don’t use it as a single measure. Consider ROI together with its drivers: profit margin and asset turnover.

Greggs plc discloses ‘return on capital employed’ as a key performance metric. This features within its annual report and its calculation is detailed at the end of the notes to the financial statements.

(Annual Report and Accounts 2020, p. 168)

What drivers explain a change in gross profit margin?

The drivers of gross profit margin are price and direct costs (cost of sales).

Greggs plc’s gross profit margin (after exceptional items) for 2020 was 63% (2019: 65%). The fall was because the fall in revenue (30.5%) was greater than the fall in cost of sales (28.2%).

The gross margin is however, consistent with previous years (2018: 63%, 2017: 63%).

What drivers explain a change in operating profit margin?

The drivers of operating profit margin are price and all operating costs, both direct and indirect (overheads).

As Greggs plc made a loss during 2020 (due to Covid-19) it makes more sense to look at the previous financial years.

Historic operating profit margins for Greggs plc have been as follows:

• ■2019: 9.8%
• ■2018: 8.0%
• ■2017: 7.5%

Coupled with a consistent gross profit margin, this shows a trend of increasing profitability, as the revenue has grown faster than overheads.

Why does a change in gross or operating profit not always correlate with a change in gross or operating profit margin?

Gross and operating profit margins look at the relationship between revenue and gross profit/operating profit. They are expressed as a percentage.

Gross and operating profit are absolute numbers expressed in currency, e.g. £.

When gross and/or operating profit increase or decrease relative to revenue, this will cause a change in the respective margin. However, when gross and/or operating profit increase or decrease in direct proportion to revenue, the margins will remain the same.

For example, if a company were to double its sales of a product, this would naturally increase both (absolute) revenue and gross profit. However, only if the (unit) price and cost of the product or service remained the same, would the gross profit margin also remain the same. In practice, discounts may apply at higher volumes which may affect the margin.

Operating profit margin is less likely to move directly in line with revenue, as overheads tend to increase/decrease in steps. By their nature they are less likely to be variable. In practice, it is reasonable to assume some increase in overheads as volume increases.

Reviewing both changes in margin and absolute numbers is necessary to understand business performance.

Between 2017 and 2018, Greggs plc’s revenue grew by 7%, however, its gross profit margin remained stable at 63%. This demonstrates a consistent margin, despite increased revenue and cost of sales.

In the same period (2017 to 2018), Greggs plc’s operating profit grew by 14%, i.e. double the rate of growth of revenue. This explains the growth in operating profit margin from 7.5% to 8%. In other words, overheads did not increase in the same proportion as sales, which enabled Greggs plc to make a higher profit, both in terms of margin and absolute numbers.

What are the drivers of ROI?

The drivers of ROI are operating profit margin (OPM) and asset turnover (AT):

$\text{ROI = OPM }\times \text{ AT}\text{.}$

This book has illustrated this relationship using operating profit margin and return on capital employed. Note that the ratios can be calculated differently by different organisations (see Greggs plc’s definition below), so it is always important to check how ratios are defined.

Greggs plc uses ROCE as an alternative performance measure. Greggs plc calculates ROCE as profit before tax as a percentage of capital employed.

The drivers of this measure can be calculated as follows (using Greggs plc’s 2019 results):

$\begin{array}{r}\hfill \text{PBT margin = 9}\text{.3\% [108}\text{.3 (profit before tax) / 1,167}\text{.9 (revenue)]}\\ \hfill \text{Asset turnover = 2}\text{.05 times [1,167}\text{.9 (revenue) / 569}\text{.7 (average capital}\\ \hfill \text{employed)]}\\ \hfill \text{ROCE = 19\% [9}\text{.3\% (PBT margin) }\times \text{ 2}\text{.05 (asset turnover)]}\end{array}$

(Annual Reports and Accounts 2020, p. 168)

Cash-only businesses (those that buy and sell goods for cash) need not to be concerned about their working capital? True or false?

False. Every business needs to ensure that they not only have the cash available to pay suppliers when it is required, but also that any surplus cash is put to good use in the business. Cash-only businesses will purchase stock for cash in the expectation of selling that stock for cash. However, the period over which cash is tied up in stock should be monitored. Stock that is not sold ties up cash that might otherwise be deployed elsewhere. In addition, until the stock is sold, a company that has not managed its cash well may be unable to purchase further stock. This could delay or prevent the company from investing in new products etc.

Greggs plc makes sales to the general public on a cash basis and sells to wholesalers and franchise partners on a credit basis.

See the financial review section within the Annual Report and Accounts 2020 (p. 44).

The events of 2020 have demonstrated the importance of ensuring good liquidity. Greggs plc has consistently maintained a net cash position in order to be able to meet its obligations through a downturn or temporary interruption to its ability to trade. The negative working capital position that is generated by the Company’s operations crystallises quickly in the absence of cash receipts from trading.

What does a high liquidity ratio imply for a business?

On the face of it, a high liquidity ratio suggests that a company has the liquid resources to meet its liabilities. However, the liquidity ratio does not take into consideration the timing of when payments are due. Companies with high liquidity ratios may therefore still suffer from liquidity problems, which can be identified by calculating the stock, debtors and creditors days ratios. Cash-based businesses can typically successfully operate with a low ratio.

Greggs plc operates with net current liabilities.

Greggs plc’s liquidity ratio:

Greggs plc’s working capital days

(Credit sales – Appendix p. 459; COS – Appendix p. 445; Stock, Trade receivables – Appendix p. 471; Trade creditors – Appendix p. 472)

Why is the acid test ratio considered a more realistic measure of a company’s liquidity?

The acid test ratio excludes stock. Stock is a non-liquid asset that must typically be converted into debtors and then cash. This conversion takes time for a typical business. Debtors and creditors, which are ‘near-cash’ assets and liabilities, present a more realistic view of the likely short-term cash availability to meet cash needs.

Greggs plc’s acid test ratio:

(Appendix p. 445)

When should creditors be paid? Why?

Creditors should be paid when they are due. Paying creditors early is poor working capital management practice; paying creditors late can have commercial (relationship) consequences that may affect future supply arrangements.

Greggs plc’s Stakeholder Engagement report in the Annual Report and Accounts 2020 (p. 53) states:

We understand the significance of our custom to our suppliers, and the pressure they were also under during the early stages of the pandemic. With financial support behind us we were able to meet all of our financial obligations, including those to landlords. The Board took the view that the strong long-term relationships that we have with our suppliers and landlords are an asset to the business and it was right to protect this.

What is meant by a negative working capital cycle?

A negative working capital cycle exists when a business receives cash from its sales before payment is due to suppliers. This gives the business an opportunity to use suppliers to finance the working capital needs of the business. Creditors offer payment terms which enable a business to buy stock and sell it for cash before settlement of the liability. This typically means that the business does not need to hold cash balances or facilities in reserve (e.g. an overdraft), although it is important to remember that cash from sales is still dependent on the timely sale of stock.

Greggs plc operates with a negative working capital position because most of the company’s sales are in cash. Suppliers are paid on credit.

Who is legally responsible for ensuring the long-term survival and prosperity of the business?

The directors of a company are responsible.

Our Section 172 statement describes how the directors, individually and collectively, acting in good faith, have exercised their duties over the course of the year to promote the long-term success of the Company for the benefit of its members as a whole, and in doing so have had regard to the matters set out in section 172(1) (a) to (f) of the Companies Act 2006.

See Annual Report and Accounts 2020 (p. 51).

What is meant by the term technical insolvency and how does it differ from actual insolvency?

Technical insolvency is the situation where a company has insufficient assets to meet the liabilities, i.e. it has negative net assets. Actual insolvency can arise irrespective of the net asset position. It is the situation where a company has insufficient cash available to meet its liabilities as they fall due.

N/A

Identify at least five early warning indicators of insolvency.

See table in Chapter 25 Insolvency and going concern risk.

N/A

What level of assurance can be gained by shareholders from knowing that a business is considered to be a ‘going concern’ by its directors?

Going concern is based on directors’ assessment of the ability of the business to continue in operational existence for the foreseeable future. It is a judgement based on an assessment carried out by directors at the time the financial statements are approved. The unpredictable and often rapid change in the economic and competitive environments can mean that businesses may not survive. The going concern statement therefore does not provide any guarantee of survival.

After reviewing these cash flow forecasts and considering the continued uncertainties and mitigating actions that can be taken, the Directors believe that it is appropriate to prepare the accounts on a going concern basis. After making enquiries, the Directors are confident that the Company and the Group will have sufficient funds to continue to meet their liabilities as they fall due for at least 12 months from the date of approval of the financial statements. Accordingly, they continue to adopt the going concern basis in preparing the annual report and accounts.

(Appendix p. 451)

What is the purpose of the viability statement?

The viability statement requires directors to take a longer-term view of the continued operational existence of a business. It requires directors to explain how they have assessed the prospects of the company and to state whether in their view the company has a reasonable prospect of survival, drawing attention to any assumptions. It should be noted that while the viability statement may have more detailed explanation and disclosure (than the going concern statement), it also provides no guarantee that the business will survive due to the uncertainties and risks of running a business.

Greggs plc’s viability statement can be found in the Annual Report and Accounts 2020 (p. 46).

The Directors have assessed the Company’s prospects and viability taking into account the ongoing significant uncertainties around the pace at which activity levels will recover from the pandemic, particularly in respect of the relaxation of social distancing measures. The assessment has taken the Company’s current position and plans and tested its viability under various scenarios that reflect the occurrence of the principal risks with which it is faced. These include threats to its operations and to the supply of products, both of which have been experienced to some extent over the past year.

Based on the results of the analysis, the Directors have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their detailed assessment.

What is the difference between liquidity and solvency?

Liquidity is the ability to pay expenses and debts as and when they become due.

Solvency is the ability of a business to service its long-term debts.

Managing liquidity is a continual short-term and operational activity.

Managing solvency is a long-term and strategic activity.

Liquidity is one of the key performance indicators shown in Greggs plc’s annual report.

Greggs plc calculates liquidity as cash and cash equivalents plus undrawn committed facilities. In 2020 this was £106.8m.

During the Covid-19 outbreak, Greggs plc sought debt financing to support its short-term liquidity requirements. These loans were fully repaid by the end of 2020. At the end of 2020 Greggs plc had in place a £100 million revolving credit facility with a syndicate of commercial banks to ensure a strong financial position going into 2021. At the end of 2020, Greggs plc had £36.8m of cash on its balance sheet and no drawings on the facility.

Greggs plc is solvent and has no long-term debts. Greggs plc does, however, report lease liabilities (mainly from shop leases) which some analysts may include in calculations of net debt (see Chapter 9 Tangible fixed assets and depreciation).

(Annual Report and Accounts 2020, pp. 10, 19, 41.)

Define ‘gearing’.

Gearing (or ‘debt to equity’) measures a business’s long-term financing structure. Its purpose is to compare a business’s borrowings (debt) with its funding from shareholders (equity).

There are two common methods of calculating gearing: ‘debt to equity’ and ‘debt to debt + equity’. Both methods can be calculated as a traditional ratio or a percentage.

The higher the gearing, the riskier the business – in terms of both dilution of earnings to interest payments and sensitivity of earnings to changes in interest rates.

N/A

Is there a preferred measure of gearing and why?

Many people find ‘debt to debt + equity’ easier understand as it gives a clear picture of a business’s exposure to debt, in relation to its total funding. It has a maximum of 100%, which is easier to interpret.

However, there are those particularly in banking, who prefer ‘debt to equity’. It is down to personal preference. It is nevertheless important to be aware of the method used and that it is applied consistently in analysis.

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Define ‘interest cover’.

Interest cover is a measure of the affordability of debt to a business. The more interest cover a business has, the more affordable its debt and the more ‘headroom’ it has to allow for volatility in earnings.

Interest cover is calculated as profit before interest and tax (PBIT) divided by interest.

This result indicates how many ‘times’ a business could theoretically afford to pay its interest charges.

Greggs plc shows finance expenses in its income statement. These largely relate to notional interest on lease liabilities which is part of the accounting adjustment under IFRS 16 (see Chapter 9 Tangible fixed assets and depreciation).

For 2019, Greggs plc’s interest cover was 18 times calculated as operating profit (£114.8m) divided by finance expenses (£6.5m). Greggs plc made an operating loss in 2020.

What is the relationship between gearing and interest cover and does this always hold true?

For most businesses there is an inverse relationship between gearing and interest cover. Management will try and strike an appropriate balance between the two.

Low interest rates will make it easier for businesses to achieve a comfortable level of interest cover and hence lead to higher levels of gearing.

However, the relationship between interest cover and gearing is not always simple, a highly profitable company may have a relatively high and comfortable interest cover, while maintaining a high level of gearing.

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Why is EPS not considered a good metric for comparing performance between companies?

EPS does not take into account different capital structures that may exist in each business. When issuing shares, companies choose the nominal value of shares (e.g. 1p, 10p, £1). The capital raised is therefore a function of both the number of shares and the nominal value of the shares. Two businesses may therefore have an identical number of shares in issue but raised different sums of capital from their shareholders.

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Dividend cover is a measure of the security or likelihood of a company being able to maintain the level of dividend payment to shareholders. True or false?

True. It is a measure of how many times the dividend could be paid. In this context, it gives a measure of the security (or likelihood) of a company still being able to maintain its dividend should it suffer a fall in profits.

2020: N/A

2019: 1.2 times (£87m/£72.1m). This information can be identified from the statement of changes in equity 2019.

(Appendix p. 447).

Dividend per share over the previous 10 years is detailed in the Annual Report and Accounts 2020 (p. 167).

(Appendix p. 447)

What are the limitations of dividend yield as a basis for comparison between companies?

Dividend yield compares the dividend (per share) to the price of a share. Share prices can be volatile (e.g. consider the effect of the pandemic on price of stock market shares). The dividend yield will increase when price falls. Looking at the trend of dividend yield over time (rather than a particular point in time) or against competitors may enable a more meaningful interpretation of dividend yield.

In response to the Covid-19 pandemic, the final declared dividend of 33.0p in respect of 2019 was cancelled as a cash preservation measure in response to the Covid-19 crisis. No dividends were declared by Greggs plc in respect of 2020.

Dividend yield = N/A (because no dividends were declared by Greggs plc for 2020).

What does a P/E of 20 mean, in literal terms?

A P/E of 20 means that it would take 20 years of earnings to recover the price invested in buying a share today (based on the latest reported earnings).

Greggs plc P/E ratio = N/A (Greggs plc reported negative earnings in 2020).

What are the main methods of valuing a business?

There are two main methods of valuing a business: (1) asset–based and (2) income–based. For income-based methods there are two main approaches (a) multiples and (b) discounted cash flows.

N/A

Which method/s will most likely result in the higher value?

Income-based valuations often produce higher valuations and give an indication of the maximum price an acquirer would wish to pay.

Asset–based valuations typically produce lower valuations as they do not include self-generated goodwill. They are likely to represent the minimum price a seller will accept.

N/A

Revenue or profit multiples: which is better in what circumstances and why?

Revenue multiples can be used for start-ups which may not yet be profitable or for businesses with volatile profits.

Profit multiples are better than revenue multiples, as they account for costs as well as revenue. There is a high correlation between profit and value across an industry sector.

In either case the revenue or profit figure used should be sustainable and not contain exceptional (one-off) items.

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Give some examples of factors which impact business valuations.

For publicly listed company the following factors may impact their valuation (share price):

• ■Competitors’ actions or reactions
• ■Analysts’ opinions
• ■Media stories and rumours
• ■Speculative behaviour
• ■Market sentiment and the economy
• ■Stock market bubbles and crashes.

For a buyer or seller, the following factors may impact their valuation:

• ■Percentage of equity being valued (acquirers will pay a premium for the ability to influence/control strategic decisions).
• ■Strategic reasons for buying or selling and the willingness of the owners to sell.
• ■Quality, experience and credibility of management and their employees, including organisational culture.
• ■Commercial potential of the target’s products and services.
• ■Competitiveness of the target’s marketplace.
• ■Number of competing buyers and sellers and their negotiation skills.
• ■If the transaction will be settled in cash or in shares.
• ■Macroeconomic and geopolitical factors.

Greggs plc is a publicly listed company. Latest share price information can be found at corporate.greggs.co.uk under the investors section

Greggs plc is covered by several analysts. See ‘analyst coverage’ under the investors section at corporate.greggs.co.uk

Give some examples of synergies that determine valuation premium.

Examples of synergies are:

• ■Marketing – opportunities to cross-sell and build a bigger brand.
• ■Operations – economies of scale, purchasing power and elimination of duplicate costs.
• ■Financial – access to cheaper finance, lower cost of capital (see Chapter 35 Investment appraisal) and tax benefits.
• ■Assets – access to unique resources, such as patents.
• ■Management – access to individuals, their reputation, experience and shared learnings.
• ■Risk-spreading – diversification into new markets and products/services.
• ■Competitive – to stop a rival obtaining the target.

N/A

Why is equity finance generally considered both a higher risk and higher reward form of finance than debt finance?

Equity shareholders have no right of repayment of their invested capital. As such, they are the last to be repaid in any liquidation or winding up of a business and may lose part or all of their sums invested. In return for this higher risk, they have the prospect of a higher return. All profits (i.e. surplus remaining after all expenses have been deducted from revenue) belong to the owners of the business.

Greggs plc reported a loss of £13.0m for the financial year 2020. This loss is suffered by equity holders (2019: £87.0m profit).

When, if ever, does a company have to repay equity finance?

Technically, never. To realise an investment, an owner must find a buyer for the shares and come to an agreement about price. This does not affect the company, however, as the initial capital invested remains invested in the business.

Greggs plc’s shareholders may sell or buy shares in the company through the Stock Exchange. This has no effect on the share capital of the company.

Can equity shareholders legally expect a dividend? How could they nevertheless force a company to pay dividends?

No, shareholders have no legal right to demand a dividend. The only way in which they can ‘force’ a company to pay a dividend is by using their voting rights to replace existing directors with directors who are willing to pay a dividend.

Shareholders do not have a legal right to a dividend.

No dividends were declared by Greggs plc in respect of 2020. In response to the Covid-19 pandemic, the final declared dividend of 33.0p in respect of 2019 was cancelled as a cash preservation measure in response to the Covid-19 crisis.

Debt is tax deductible which typically makes it a cheaper form of finance than equity. True or false?

True.

Greggs plc incurred interest expense on borrowings in 2020 of £0.8m (2019: Nil).

What sources of long-term debt finance are available to larger businesses?

Fixed–terms loans obtained from banks or other financial institutions.

Bonds issued to investors.

During the year the Group accessed liquidity under the Bank of England’s Covid Corporate Financing Facility (‘CCFF’) at a favourable rate of interest. The borrowings were repaid in December 2020 and the related costs have been charged to finance costs. The Group also arranged a £100 million syndicated revolving credit facility, which matures in December 2023 with options to extend for up to two years.

(Appendix p. 460)

Why do small companies typically find it more difficult to obtain debt finance?

Small businesses typically may have no track record and little or no assets which can be provided as security against lending.

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What is the purpose of MAPs (management accounts packs)?

Management accounts are produced for operational purposes. They provide timely and detailed information to company directors and managers, to help them run a business efficiently and effectively.

Management accounts analyse past and present information, both financial and non-financial, to help a company make more informed decisions about its future.

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What is the typical frequency of MAPs?

MAPs are typically produced monthly, although some companies may produce them more often, for example on a weekly, or even daily basis. Although technology has enabled more companies to move closer to the ideal of real-time information, monthly MAPs are still common and will include other relevant management information to be discussed at monthly board meetings. In addition, there is a difference between real-time data (which may just be numbers) and MAPs (which also include analysis and require professional judgement).

N/A

What is the legal requirement to produce MAPs?

Unlike financial accounts, which are a requirement under company law, there is no requirement to produce MAPs.

N/A

Which accounting standards cover MAPs?

While financial accounts are standardised through comprehensive accounting regulation, there are no accounting standards for MAPs. Indeed, one of their key advantages is that they can be tailored to business needs. There are, however, some established conventions and many MAPs follow the format of the primary financial statements (and hence accounting standards).

N/A

How accurate should MAPs be? Should they be more or less accurate than financial statements?

As management accounts are used to make critical business decisions, they will usually need to be as accurate as possible and indeed more accurate than financial accounts, depending upon the decision being made. Financial accounts need to be ‘true and fair’ and free from ‘material’ misstatements.

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Should MAPs just be restricted to financial information?

Certainly not. The ideal MAP will include non-financial information as well as financial. There should also be commentary to help management understand the ‘why’ and not just the ‘what’ and to make informed decisions.

N/A

Besides price, what are the other strategies can be used to maximise profit?

Besides price, the following strategies can also be used to maximise profit:

• ■Efficiency – through productivity of the workforce and reducing overheads.
• ■Attracting new customers.
• ■Retaining existing customers and encouraging repeat business.
• ■Increasing the frequency of customer transactions.
• ■Increasing the average value of each transaction by selling more to each customer.

Although all the above actions are beneficial, higher prices generally have the biggest impact, by far, on profit. In addition, compared to the other actions, pricing takes the least time, effort and cost to change.

Greggs plc is likely to employ a mixture of all these strategies. See Greggs plc’s business model in the 2020 annual report.

As noted in the business model, Greggs plc operates in an extremely competitive marketplace, making it challenging to increase prices much beyond that of its direct competitors.

(Annual Report and Accounts 2020, p. 8)

What are value differentiators?

Price is what customers pay. Value is what customers receive. Value differentiators are the factors that customers consider when making a purchase. Examples of value differentiators are:

• ■Quality of service including after sales service and support
• ■Other products and services offered (perhaps through ‘bundles’)
• ■Guarantees offered
• ■Efficiency of account management
• ■The degree of personalisation offered
• ■The reliability of the product or service
• ■The reputation and brand.

Delivering value is core to Greggs plc’s business model.

(Annual Report and Accounts 2020, p. 8)

What is value-based pricing?

Value-based pricing is a customer-centric approach to pricing which focuses on what customers are willing to pay, based on the value they receive from a product or service.

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What is the difference between margins and mark-ups?

Margin is profit as a percentage of the ‘sales price’ (gross profit/sales price). Mark-up is profit as a percentage of ‘direct costs’ (gross profit/direct costs). The margin will always be less than the mark-up.

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Explain price skimming using a real-life example.

’Price skimming’ is a strategy used for new products or services which are highly desirable, differentiated from the competition and generally high quality, for example the latest smart phone or accessory.

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Give examples of both variable and fixed costs.

Examples of variable costs are: costs of stock sold, the ‘labour’ cost of contractors who are paid by the hour/job, sales commissions.

Examples of fixed costs are: office rent, insurance, marketing, salaried employees.

Greggs plc’s variable costs are product ingredients, for example the puff pastry and filling of its vegan sausage rolls.

Greggs plc’s fixed costs include the cost of staff, shop occupancy costs and depreciation on the ovens required to heat its vegan sausage rolls.

Define ‘contribution’.

Contribution is short for ‘contribution towards fixed costs and profit’.

It is calculated as: sales revenue less variable costs

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What measures can be calculated using the CPS (contribution percentage of sales) ratio?

The CPS ratio can be used to calculate the following:

• ■The sales revenue required to break even.
• ■The sales revenue required to achieve a target profit.

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What is the impact on the CPS ratio of increasing prices? What is the risk of this strategy?

Greggs plc operates in an extremely competitive marketplace, making it challenging to increase prices much beyond those of its direct competitors.

(Annual Report and Accounts 2020, p. 8)

What is the impact on the CPS ratio of reducing variable costs? What is the risk of this strategy?

As noted in Greggs plc’s business model, quality is an important factor.

(Annual Report and Accounts 2020, p. 8)

What is the impact on the CPS ratio of increasing the quantity sold of a product or service? What is the risk of this strategy?

Increasing the quantity sold will be a continual focus of Greggs plc’s marketing team.

What is the impact on the CPS ratio of reducing fixed costs? What is the risk of this strategy?

Investment in efficiency initiatives in order to manage overheads is relevant to Greggs plc’s business.

Explain the difference between a budget and a forecast.

A budget is a financial and operational business plan. It is used to implement an organisation’s objectives by setting financial targets.

A forecast is an estimation of an organisation’s financial performance for specific periods in the future, for example the final quarter of the year.

Budgets are usually set annually in advance of a financial year, whereas forecasts are typically prepared more frequently and updated a number of times during a financial year. The budget is used to benchmark past performance, whereas the forecast is used to predict future performance.

Budgets and forecasts are relevant to Greggs plc, however, as they are internal, no information exists in the public domain.

What are the advantages of budgeting for an organisation?

• ■Planning
• ■Identification and utilisation of scarce resources
• ■Communication and coordination
• ■Organisational control
• ■Performance measurement and evaluation.

N/A

What are the disadvantages of budgeting for an organisation?

• ■Time and money
• ■Become out of date during the period covered by the budget
• ■A constraint
• ■Budgetary slack/padding and other behavioural game playing.
• ■Often formed and managed on spreadsheets which have a risk of errors.

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Explain the difference between a cost, revenue, profit and investment centre.

• ■Cost centres are just responsible for managing and controlling their costs.
• ■Revenue centres are just responsible for sales revenues.
• ■Profit centres are responsible for both sales revenue and costs, which can include just purchases (i.e. up to gross profit) or could include overheads as well (i.e. up to operating profit).
• ■Investment centres are responsible for managing profits as well as some balance sheet items, such as tangible fixed assets and working capital.

N/A

Explain the difference between incremental and zero-based budgeting.

An incremental approach is where budgets are based on the previous year’s budget plus or minus a set percentage. The opposite of incremental budgeting is zero-based budgeting. This approach calculates the budget from a ‘zero base’, i.e. starting from scratch.

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What benefits do ‘rolling’ budgets and forecasts bring to an organisation?

The advantage is that new information is incorporated as events unfold and the budget is more up to date. Additionally, as budget holders are aware that the budget will be updated, they may be less likely to build in ‘contingencies for unplanned events’.

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Explain the problem of ‘shrinking visibility’.

When budgets and forecasts do not extend beyond the financial year end. As the year end approaches the future time horizon ‘shrinks’ and organisations have less visibility of what lies ahead. This issue can be overcome by using rolling budgets and/or forecasts which are continually extended at least 12 months ahead.

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Why should organisations use investment appraisal techniques?

To evaluate opportunities and see if their benefit is greater than their cost on an objective, rational basis. Investment appraisal enables organisations to compare investments of different sizes and times on a comparable basis. Investment appraisal also enables organisations to prioritise projects when capital is limited.

Greggs plc has a continual investment plan, details of which are shared within the financial review section of its annual report, under the heading capital expenditure. In 2021, Greggs plc’s planned investments in its automated cold store, manufacturing capacity and in new shops. Each of these investments will have been through an investment appraisal process to ensure their viability and help prioritise their importance. Greggs plc has an Investment Board, a management committee where all capital expenditure is subject to rigorous appraisal before and after it is made.

(Annual Report and Accounts 2020, p. 43)

Does the payback period consider the total life of an investment opportunity?

No. It also does not consider the total life of an investment. It only looks to the point when payback is reached. It effectively ignores inflows and outflows after the payback period.

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What is the key benefit of the payback period method of investment appraisal?

It is simple to use and understand. It also provides a measure of risk.

For established companies like Greggs plc, although relevant, payback will not be a primary decision factor in their investment appraisal. Instead, they focus on return on capital and discounted cash flow analysis, which is noted in their annual report.

(Annual Report and Accounts 2020, p. 43)

What is the main reason for using the annual yield method for investment appraisal?

The annual yield calculation is synonymous with other internal and external performance measures such as return on investment. This method of investment appraisal is therefore useful as it benchmarks potential investments against a company’s performance measures.

Greggs plc uses return on capital to appraise investments before and after they are made. In Greggs plc’s 2020 annual report it noted that ‘For investments in new shops we target an average cash return on invested capital of 25%, with a hurdle rate of 22.5%.’

(Annual Report and Accounts 2020, p. 43)

Explain why money today is worth more than money in the future?

Money is worth more today because there is an ‘opportunity cost’ of having money now, rather than having to wait to have it in the future. This ‘opportunity cost’ will depend upon the following factors, which can be unique to each business and its economic environment:

• ■Interest paid if money is borrowed
• ■Returns to shareholders if the investment is equity financed
• ■Interest received on surplus funds if available
• ■The risk of the investment not performing as expected
• ■The risk of missing out on alternative opportunities
• ■Inflation.

Greggs plc recognises the time value of money in its investment appraisal as it uses discounted cash flow analysis.

(Annual Report and Accounts 2020, p. 43)

What factors determine whether NPV will be positive or negative?

If the PV of future returns (inflows) are greater than the PV of the investment (capital outflow/s), then the NPV will be positive. If the other way around the NPV will be negative.

Taking the example of a new Greggs shop: the future net returns will be the sales revenue generated, less the cost of products sold as well as staff costs, shop rent, heat, light and power etc. The investment will be the costs of fitting out the shop as well as the display cabinets, ovens, refrigerated cabinets etc. If the NPV is positive, then the new shop is likely to be a viable concern.

What does a negative NPV mean for an investment opportunity?

It is potentially not worthwhile as the financial benefits are less than the financial cost. This does not consider non-financial, strategic or other intangible benefits, which once taken into account may mean the project is actually worthwhile.

In 2020, Greggs plc launched its multi-channel, digital transformation programme, which included a phone app. This is an example of a strategic initiative with many non-financial benefits. These were likely to play a large role in the investment decision. When the programme was launched (prior to Covid-19) it was not known ‘that it was about to become even more important’.

(Annual Report and Accounts 2020, p. 27)

What is meant by IRR and how is it used in investment appraisal?

The IRR represents the ‘rate of return’ that an investment generates itself. It is expressed as a percentage and can be compared to an organisation’s cost of capital. If the IRR is greater than the cost of capital, then the investment is potentially worthwhile. If it is less, then the investment is likely to make a loss.

IRR will usually provide the same decision as NPV, although it is important to be cautious when they provide different outcomes

Greggs plc notes that it uses discounted cash flow analysis to appraise investments. This may or may not include IRR.

(Annual Report and Accounts 2020, p. 43)