Group 1

Case Study 10.1

Case Study 10.1

What

is understood by the terms balance

sheet and profit and loss account? What is
the difference between preference
shareholders and ordinary shareholders? Why
does a company retain profits and what effect
does this have on the value of its share price?
Who owns the assets of the company? Note
that in the case of the Skeldale Manufacturing
Company the dividends for the year were paid
out of retained profits. Do you consider this to
be a valid use of these profits?

Introduction
Balance sheet
-A financial statementthatsummarizes a

company's assets, liabilities

andshareholders' equityat a specific point
intime. These three balance sheet
segments give investors an idea as to what
the company owns andowes, as well as
the amount invested by the shareholders.

Introduction
Profit and Loss account
- Afinancial statement that summarizes
therevenues, costsand expenses
incurredduring a specific period of time usually a fiscal quarter oryear. These
recordsprovide information that shows the
ability of a company to generate profit
byincreasing revenue andreducing costs.

Difference between Preference

and Ordinary shareholders
Ordinary

shares are the most common kind

of shares. An ordinary share gives the holder
voting rights in the company and entitles the
person to all dividend distributions as a partowner of the company.
Since the profits of companies can vary wildly
from year to year, so can the dividends paid to
ordinary shareholders. In bad years, dividends
may be nothing whereas in good years they
may be substantial.

 Preference

shares allow holders to be

paid dividends before ordinary
shareholders and they also have
priority over asset claims if the
company goes bust. The downside is
that preference shareholders have a
fixed dividend and only limited
voting rights with respect to
company affairs.

Why does a company retain profits

and what effect does this have on
the value of its share price?
Retained profit is by some waythe most important and significant source of
financefor an established profitable business.
The principle is simple. When a business makes a net profit, the owners have a choice:
either extract it from the business by way of dividend, or reinvest it by leaving profits in the
business.
Where do retained profits sit? Some might be in the bank; some might be spent on
additional plant & machinery; perhaps some are reinvested in more inventories or used to
reduce overdrafts or loans.
The total value of retained profits in a company can be seen in the equity section of the
balance sheet.
Retained profits have several major advantages:
They are cheap (though not free) effectively the cost of capital of retained profits is
theopportunity costfor shareholders of leaving profits in the business (i.e. the return
they could have obtained elsewhere)
They are veryflexible management have complete control over how they are reinvested
and what proportion is kept rather than paid as dividends
Theydo not dilute the ownershipof the company

Consider the positive effect on the company's

dividends that results when the earnings of the
retained profits are compounded over the years. Let's
keep the numbers simple. Imagine you had $100
invested in a business that was earning 10% a year. In
year one, you made a $10 profit, took $5 as a dividend
and retained and reinvested the balance. At the end of
year two, you have a profit of $10.50, distribute $5.25
and reinvest $5.25. By year 10, your business would
be worth more than $160 in assets - asset growth of
more than 60%. What would 60% growth in dividends
mean to the shareholders of a company worth tens of
millions of dollars?

Who owns the assets of the

company?

Statement of the
Problem
Is

the paying of dividends by the

Skeldale Manufacturing Company
considered to be a valid use of the
profits?

Objective

To

be able to determine that the

paying of the dividends by the
Skeldale Manufacturing Company
considered to be valid use of the
profits.

Liabilities
Capital
Ordinary share of $1
100 000
Retained profits
20 000
10% preference shares
40 000

Current Liabilities
Trade creditors
20 000
Company tax
10 000
Dividends
20 000

Assets
Fixed assets
Property
80 000
Plant and equipment
90 000

Current assets
Stock and WIP
10 000
Trade debtors
30 000

210 000
Balance sheet for the Skeldale Manufacturing
Company

Profit and loss

Sales
800 000
Cost of Sales
600 000
Gross Profit
200 000
Administration Expenses
180 000
Net Profit
20 000
Tax
10 000
Profit for distribution
10 000
Dividends:
Preference
4
Profit & Loss account for the Skeldale Manufacturing Company

Alternative Course of
Action

Valid
-Invalid
-

Discussion:

Valid
The company had gained profits and it would be generous to

give dividends.
Having the ability of giving dividends to the shareholders will
gain trust on the shareholders to the company.
More opportunity for shareholders and future investments.

Invalid
profits could be used to other options like payments on

creditors
profits could be used for purchase of assets

Conclusion:
Paying

of dividends by the Skeldale

Manufacturing Company is
considered to be a valid use of the
profits.