fam support material

Session 1 : What is Management About 4

Page

Session 2 : Accounting Information 20

Accounting Principles & Transactions

Session 3 : Major Financial Statements 35

Session 4 : Working Capital 57

Session 5 : Cash Management 72

Session 6 : Profit, Profitability and Value Added 81

MANUAL CONTENTS

Session 7 : Assessing The Financial Position 101

Analysing & Interpreting Financial Statements (1)

Page

Session 10 : Budgets and Budgetary Control 110

Session 11 : Costs, Costing & Cost Behaviour (1) 128

Session 13 : Time Value of Money & Capital Investment Appraisal 169

Session 12 : Costs, Costing & Cost Behaviour (2)

Session 8 : Analysing & Interpreting Financial Statements (2)

Session 9 : Analysing & Interpreting Financial Statements (3)

Session 14 : Financing A Business 190

Annex 1 : Seminars

ANNEX

Annex 2 : Recommended Reading

Annex 3 : Sample Assignments & Sample Examination Papers

Annex 4 : Supporting Material

WHAT IS MANAGEMENT

DISCUSSION QUESTIONS

RATIONAL DECISION-MAKING FOR PLANNING & CONTROL

THE ROLE OF THE MANAGEMENT ACCOUNTANT AND THE MANAGEMENT PROCESS

THE FINANCIAL MARKET RELATIONSHIP BETWEEN SHAREHOLDERS, DIRECTORS & AUDITORS

THE MANAGEMENT DECISION PYRAMID

SESSION 1 MANAGEMENT FOR FINANCE

WHAT IS MANAGEMENT ABOUT ?

The primary functions of Management are : -

• Planning• Organising• Directing, Leading & Motivating• Coordinating & Communicating• Controlling• Evaluating

Management in any function will involve these activities in order to be effective.

Types of Management Decisions : -

• Routine day-to-day operational decisions• Short-term problem resolution• Medium term decisions at managerial level• Strategic, longer term decisions• Control Decisions

All requiring three basic qualities in management : -

• Technical Skills related to the scope of work• Interpersonal Skills to get the job done• The ability to see The BIG Picture, often called Strategic Level Thinking

Decision making therefore is part of the managerial role, these may be ad-hoc, rationalor impartial depending upon the nature of the decision to be taken.

RATIONAL DECISION MAKING FOR PLANNING & CONTROL

Step 1. Identify Business Objectives and Timelines for AchievementStep 2. Review the Environment within which achievement is to occurStep 3. Consider OptionsStep 4. Select Criteria to assess the Options & assess ResourcesStep 5. Select the most Viable OptionStep 6. Prepare Management Plans as appropriateStep 7. Prepare Operational Plans for Short-term ImplementationStep 8. ImplementStep 9. Collect Information for Monitoring PerformanceStep 10. Review and Evaluate to determine Divergence from the plan to achieve

controlStep 11. Revise Plans as needed.

This is a generic process which could be applied to any management function, includingfinance.

THE MANAGEMENT DECISION PYRAMID

Planning

Control

Em

phas

is o

n

Type 1Strategic Decisions

Type 2Tactical

Decisions

Type 3Operational

Decisions

Three decision types can be identified, namely Strategic, Tactical and Operational.

These may blend from time to time, particularly Type 2 and Type 3. The pyramid shows thevolume of decision types and how control increases at the operational level.

Strategic Decisions are concerned with direction and purpose so to provide for a missionto be accomplished over the longer term, whereas Tactical Decisions are narrow withspecific objectives to be achieved over the short to medium term.

Operational Decisions are specific, often routine with targets for performance monitoredover a short-term time horizon.

One important element in management decision-taking today is measurement.

Remember, if your decisions cannot be measured, they will be difficult to manage.

Financial Management Decisions at all three levels will be subjected to measurement forreporting purposes as part of a financial information system.

THE ROLE OF THE MANAGEMENT ACCOUNTANT AND THE MANAGEMENT PROCESS

• Planning The management accountant helps to formulate business plans byproviding information to assist product and selling decisions in selectedmarkets at the optimum price and in addition evaluates proposals forcapital expenditure. These may be longer term planning inputs. In theshorter term, the management accountant’s role is critical to budgetaryprocesses to plan income, expenditure and profit.

Information is produced by the management accountant on pastperformance, much needed to plan for the future.

The management accountant establishes budget processes & proceduresto ensure these harmonise with each other across the organisation and areaggregated into a master budget for the plans to create forecasted majorfinancial statements, all of which require top management approval.

• Control The management accountant produces performance reports periodicallyto assess actual outcome with those planned and budgeted for, for eachresponsibility centre of the organisation. Such centres are normallydepartments with designated management control.

The internal department organisation is essential to ensure that themanagement processes are efficient. This is central to the role of themanagement accountant. Efficient organisation is important for thedistribution of relevant and timely information flows.

• Organisation

This is critical, because the management accountant has the pivotal roleto ensure that all policies, procedures & methods are communicated andunderstood. Financial performance information must also becommunicated according to agreed time lines for organisational planningpurposes. One example, is the core role in budget reporting on a monthlyand quarterly basis.

• Communication

The communication role in itself provides a basis for motivating theentire organisation and can be the basis for employee recognition andreward. Communication extends to four main stakeholder groups ;employees, customers, shareholders and the government.

There are job functions within the accounting profession which should also be distinguished.

The Management Accounting role is concerned with the provision of information to peoplewithin the organisation for management decision-taking.

The Financial Accounting role is concerned with the provision of information for externalreporting outside the organisation.

Cost Accounting is part of the Management Accounting function but mostly concerned with costs,costing and cost behaviour to meet the requirements for internal and external reporting.

Financial Management is A GENERIC TERM covering all of the above.

MANAGEMENT AND ACCOUNTABILITY

Management for the Finance function must be fully aware of the regulations which governcompanies whether they are

• PRIVATE COMPANIES, called limited companies AND

• PUBLIC COMPANIES quoted on the stock exchange.

There are requirements for both private listed company and public operated companies to publishaudited financial statements for each reporting year, the details will be outlined later in thismanual.The regulations covering the publication of these functional statements are attached to

• Company Law• External Accounting Rules (SSAP’S)• International Accounting Standards (GAAPS)• Stock Exchange Rules for public companies

Management responsibility for the preparation of financial statements therefore extendsto : -

• Disclosure• Accountability• Fairness

which are the anchors of Financial Corporate Governance related to financialmanagement, which this manual will not extend to, but just to give an example of the‘combined code’.

• Every listed company should have a board of directors

• There should be a clear division of responsibilities between the chairman and the chiefexecutive officer

• There should be a balance between executive and non-executive directors

• The board should receive timely information

• Appointments to the board should be subject to rigorous, formal and transparentprocedures

• Boards should use the annual general meeting to communicate with private investors

• Internal controls should be in place to protect the shareholders’ wealth

• The board should set up an audit committee of non-executive directors to oversee theinternal controls and financial reporting

THE FINANCIAL MANAGEMENT RELATIONSHIP BETWEEN SHAREHOLDERS, DIRECTORS AND AUDITORS

Figure 1.1 Outlines the dimensions of the relationships which must be managed effectively

DIRECTORS

SHAREHOLDERS AUDITORS

elect account review

report

elect

The shareholders are the owners of the business, they elect the directors who areaccountable for business performance.

Auditors and appointed, by legal agreement, to agree to give a fair and accurateindependent report of business performance and behaviour with respect to accountingprocesses and management, by checking the financial system through a process called“ an audit ”.

The auditors will complete the annual audit to check that the accountancy function hascompiled with all regulations and procedures to draw up their internal financialdocuments.

The audit would examine some documents such as invoices, cheque stubs, time cardsetc. The Books of Prime entry will be examined which covers a purchases daybook, acash book and wages records.

The Ledger Accounts will be reviewed which covers the cash book, creditors & debtors ledgers.

Finally the audit will obtain information to assemble the financial statements to show the financial position through an income statement, a cash flow statement and a balance sheet (all will be explained in detail in later sessions).

The auditors report will then be sent to the directors for review and adjustments as may be needed and sent also to the shareholders before being signed off for publication.


1. WHY DOES FINANCE HAVE TO BE MANAGED ?

2. WHO ARE THE STAKEHOLDERS WHO BENEFIT FROM FINANCIAL

MANAGEMENT ?

3. WHAT ARE THE TYPICAL MANAGEMENT DECISIONS THAT ARE

TAKEN BY FINANCIAL MANAGEMENT ?

WHO USES ACCOUNTING INFORMATION

WHAT INFORMATION MEANS

THE ACCOUNTING INFORMATION SYSTEM

MAJOR ACCOUNTING PRINCIPLES

THE SYSTEM FOR RECORDING TRANSACTIONS

THE MAIN FINANCIAL STATEMENTS


WHAT IS MANAGEMENTSESSION 2 ACCOUNTING INFORMATION, PRINCIPLES & TRANSACTIONS

WHO USES ACCOUNTING INFORMATION ?

Financial Managements require information for decision-making, whereas shareholdersrequire information on the value of their investment and the dividend income to be receivedfrom their shareholding.

Management Accounting provides this internal information and the financial accountingprovides external information.

Employees need to know the company’s ability to pay salaries & wages. Creditors must knowif the firm can meet its financial obligations. Government Agencies collect accountinginformation on company performance. The Inland Revenue need to know the profit level fortax collection. In fact, there are many stakeholders requiring information who are bothinternal to the organisation and external.

KEY STAKEHOLDERS REQUIRING FINANCIAL INFORMATION

Investors

Company Directors

Financial Institutions

Company Shareholders

Company Managers

Lenders

Suppliers

Business Organisations

Existing & Future

Customers

Investment Analysts

Competitors

Employees

Government

The Community

Trade Associations

Unions

Tax Authority

FIGURE 2.1

The fundamental role of accounting is the process of identifying, measuring andcommunicating relevant economic information about the firm.

Data and Information are not the same.

Data are facts and figures, Information is the interpretation of data within the context ofenvironment, achieved through observation, discussion and different forms ofcommunication.

The importance of information is the relevant new messages it delivers to different levelsof management and to the wider group of stakeholders (see Figure 2.1).

In accounting, many of these messages are based on different types of measurement calledmetrics and a measurement system to capture the relevant data and information. Hence theneed for an accounting information system and the management of that system (seeFigure 2.2).

THE ACCOUNTING INFORMATION SYSTEM

Information Identification

FIGURE 2.2

Information Recording

Information Analysis

Information Reporting

Sources Specifications Applications

Processing Routines Responsibility Centres

Information Needs

INFORMATION COMMUNICATIONS TECHNOLOGY

The real value of accounting information will depend upon its end-use purpose, thereforethe value should be based on the cost of producing it in relation to the needs it satisfies.

There is a tendency for information overload. The main management informationchallenge is to produce just the optimal amount of information required.

This is the essence of the design of the Accounting Information System.

What influences the usefulness of Accounting Information ?

• Relevance• Reliability• Competencies• Comparability

• Understandability• Cost / Benefit• Accessibility• Timeliness

Stewardship - Reporting events performance and financial position periodically

MAJOR ACCOUNTING PRINCIPLES

Going Concern - The Business will continue to operate year to year, unless beingclosed to ‘wind up’ the business.

Accruals or - Matching effort to accomplishment, ie. the cost of resources usedMatching against the benefit received

Consistency - Selecting the most appropriate method and stay with these forcomparative analysis overtime

Prudence - Conservatism in valuation and in reporting

Objectivity - Avoiding personal bias when compiling accounting statements

Historical Records - Avoiding personal bias when compiling accounting statements

Materiality - Concern only with matters that are significant

Monetary - All accounting statements are expressed in monetary terms to useMeasurement money as the common denominator for measurement

ACCOUNTING POLICIES

Policies are the rules which the company applies to select the best approach to achieve the neededoutputs of the accounting function.

One simple definition commonly adopted by the accounting profession is : -

“ specific accounting methods selected and consistently followed by a business asbeing, in the opinion of management, appropriate to its circumstances and bestsuited to present fairly its results and financial position ”

(SSAP2 – Statements of Standard Accounting Practice)

THE SYSTEM FOR RECORDING TRANSACTIONS

All transactions must be recorded for disclosure so that a true and fair view can be reported in thefinancial statements which the company are required by law to produce.

The sequence in which transactions are recorded and reported is as follows : -

Transactions - The economic events of the company involving money, recorded as invoicesfor credit sales, cash sales and payments made in cash, cheques or electronictransfers.

Prime Documents - Provides Evidence of these transactions and summarises them, normally in a“Day Book’. There maybe a sales daybook, a purchases daybook and a cashbook, all of which are Books of Prime Entry.

Ledger Accounts - Classifies the transactions into separate books called ledger, for examplea creditor ledger, a debtors ledger and a general ledger.

Trial Balance - To ‘balance the books’ at the end of an accounting period.

Adjustments - To adjust the ledger balance in the case of pre-payments or partialpayments (accruals)

Financial - To enter the ledger balances into the financial statements (profit & loss/Statements income statement, cash flow statement and Balance Sheet)

PRINCIPLES OF RECORDING TRANSACTIONS

For every transaction, there is a dual effect on the business and therefore it should be recorded twiceto realise this effect.

This system is referred to as double-entry book-keeping. The rule is simple --- FOR EVERY DEBIT,THERE MUST BE A CREDIT.

DEBIT AND CREDIT

This tradition has been upheld since the middle ages whereby all debits must equal all credits.

This system of DEBIT & CREDIT has been the basis upon which the key financial statements areprepared.

[ There is no need for us on this programme to go into more detail about double entry book-keeping. ]

THE MAIN FINANCIAL STATEMENTS

The corporate report published by a company comprises a number of documents for externalreporting of information about the companies financial position. These documents are :

• THE BALANCE SHEET

• THE PROFIT & LOSS ACCOUNT OR INCOME STATEMENT

• THE CASH FLOW STATEMENT

• STATEMENT OF ACCOUNTING POLICIES

• THE DIRECTORS REPORT

• NOTES TO THE ACCOUNTS

• THE AUDITORS CERTIFICATE

THE BALANCE SHEET - shows the financial position at one particularmoment in time which sets the assets of abusiness against the liabilities if the liabilities. Ifthe liabilities are subtracted from the assets, thiswill disclose the shareholders investment in thebusiness.

THE PROFIT & LOSS - shows a summary of transactions for the sameACCOUNT OR INCOME period. It shows income that has been generatedSTATEMENT against which costs are charged to determine a

profit or loss for the period.

THE CASH FLOW - analyses the sources from which cost has flowedSTATEMENT into the business and the way in which this cash

has been spent


1. IT IS SAID THAT ‘INFORMATION IS THE GLUE THAT HOLDS ANY ORGANISATION TOGETHER’. HOW DOES FINANCIAL INFORMATION ACHIEVE THIS ?

2. WHAT ARE THE KEY CRITERIA TO USE TO ASSESS THE REAL ECONOMIC VALUE OF ACCOUNTING DATA & INFORMATION ?

3. WHAT ARE THE MAJOR PRINCIPLES UPON WHICH THE ACCOUNTING FUNCTION IN A BUSINESS IS BASED ?

THE BALANCE SHEET

-- The Balance Sheet Equation-- Assets-- Liabilities-- Horizontal & Vertical Layout in outline-- Vertical Layout Essentials

THE PROFIT & LOSS OR INCOME STATEMENT

-- Simple Presentation Format-- The Profit Cascade

WHAT IS MANAGEMENTSESSION 3 THE MAJOR FINANCIAL STATEMENTS

THE CASH FLOW STATEMENT

-- Typical Formats


THE BALANCE SHEET

The Balance Sheet is a statement that balances what the company owns against what thecompany owes.

ASSETS = CAPITAL + LIABILITIES[what is owned] = [what is owed]

The Balance Sheet Equation therefore is : -

The effect of trading will influence the Balance Sheet as shown : -

ASSETS = CAPITAL [ + or - PROFIT LOSS ] + LIABILITIES

ASSETS

These are items owned by a business which can be proved, have a monetary value, and thatthe value can be objectively measured.

Assets can be classified into : -* Fixed Assets* Current Assets

Fixed Assets are normally recorded at historical cost, at the time their purchase wasoriginally transacted, for example : -

Most of which are intended for the longer-term and are not intended for sale because mostare items concerned with the making of products which are to be sold at a profit.

• Land• Manufacturing Plant• Machinery• Vehicles• Long-term Investments

Fixed assets are depreciated overtime, estimated over their useful life, in accordance withagreed conventions relevant to the enterprise and the industry.

Long term investments are stakes that the business may have taken in other companies.

Current Assets are those which are held for a short period traditionally less than one year which areintended to convert back into cash for example.

• Stock (Inventory of finished goods & raw materials)• Debtors (The Customers who owe the company money)• Cash in hand and Cast at bank• Short term Investments

All current assets are expected to work their way through the business cycle.

THE TOTAL ASSETS OF THE COMPANY IS THEREFORE FIXED ASSETS +CURRENT ASSETS.

A liability is an amount owed by a business to a person or organisation who has provided funds tofinance the assets that are controlled by the business.

Liabilities therefore are classified into : -

LIABILITIES

LONG TERM • Equity Shareholders

• Reserves of the business from past profits owing to the equityshareholders (often called ‘retained earnings”)

• Long Term Loans

SHORT TERM Short term liabilities are referred to as current liabilities as these areamounts lent for a period of up to one year, these comprise : -

• Trade Creditors who have supplied Goods and Services andwho are waiting to receive payment

• Short Term Loans from the bank

• Overdraft that has been used from the facility granted by thebank

• Tax Provisions for payment on a due date

• Dividends yet to be paid

These liabilities are the current obligation of the company to make payment.

THE PRESENTATION FORM OF THE BALANCE SHEET

The balancing equation for the horizontal layout which today is somewhat outdated :

FIXED ASSETS

CURRENTASSETS

CAPITAL & RESERVES

LONG TERM LIABILITIES

CURRENT LIABILITIES+ = + +

The balance sheet equation in vertical layout, which is commonly applied today :

FIXED ASSETS

CURRENTASSETS+ - CURRENT

LIABILITIESLONG TERM LIABILITIES- CAPITAL &

RESERVES=

BALANCE SHEET -- SIMPLIFIED VERTICAL LAYOUT ESSENTIALS

1. FIXED ASSETSLand, Buildings, Vehicle, Plant (at cost) xxxInvestment in Associated Company xx

xxxx2. CURRENT ASSETS (CA)

Stock xxDebtors xxInvestment xCash x

3. TOTAL ASSETS xxxx

4. LESS CURRENT LIABILITIES (CL)Creditors xxShort Term Loans xTaxation & Dividends Payable x

5. NET CURRENT ASSETS (CA – CL) xxx6. TOTAL ASSETS – CURRENT LIABILITIES xxx

OOOO7. ADD LONG TERM LIABILITIES

Long Term Loans xx8. NET ASSETS (Net Worth) ++++9. FINANCED BY

Share Capital xxxxReserves xxx

++++

₤

The vertical layout shows

To show the Working Capital of the company

• Fixed Assets + Current Assets = Total Assets• Current Liabilities• Net Current Assets = Current Assets - Current Liabilities

• Total Assets - Current Liabilities• Minus Any Long Term Liabilities• This Balancing Figure has then to be supported and confirmed by

financing from share capital + reserves

NOTE : It will take time to understand and digest this Balance Sheet format, it isadvised that examples of published accounts are referred to. This willreinforce this essential learning component of the course.

The Profit & Loss account or what is know also as the INCOME STATEMENT reports therevenue earned in a period. Other terms used for revenue are ‘turnover’ and sales.

THE PROFIT & LOSS ACCOUNT OR INCOME STATEMENT

The accountant then changes the costs of earning that revenue to reveal a surplus or deficit knownas profit or loss.

The Income Statement is designed to measure the transactions which have taken place betweentwo balance sheet dates (see Figure 3.1). It is normally a statement therefore, “for the yearended..” because it is a summary of all trading transactions which have taken place during theperiod, not just to show the position at one point in time.

BALANCE SHEET AS AT

31 DECEMBER200X

BALANCE SHEET AS AT

31 DECEMBER200Y

PROFIT & LOSS ACCOUNT FOR THE PERIOD ENDED 31ST DECEMBER 200X

TOTAL REVENUE

LESS TOTAL COSTS

FOR THE PERIOD

Figure 3.1

THE SIMPLE PRESENTATION FORMAT FOR THE INCOME STATEMENT

₤

1. Sales Revenue xxxx

2. Cost of Sales xx

3. Gross Profit xxx

4. Expenses xx

5. Operating Profit xx

6. Interest Charges x

7. Taxation x

8. Net Operating Profit +

Less

Equals

Less

Equals

Equals

Less

This statement shows trading transactions, therefore the costs incurred are either the direct costs(eg. labour + materials) of creating sales or indirect costs incurred to support sales (eg.administration & distribution).

Therefore the Income Statement or Profit & Loss Account does not show Capital Transactions forthe purchase of fixed assets.

Capital Expenditure or CAPEX is the domain of the Balance Sheet and Operating Expenditure orOPEX is the domain of the Profit & Loss statement.

EXPENSES as understood in item 4 above (Pg. 49) also would include for example : -

• Administration

• Marketing & Distribution Costs

• Wages & Salaries

• Telephone Charges

• Sales Administration

• Sales Expenses

DEPRECIATION is also charged against the Gross Profit figure as a provision for replacing theassets of the company.

THE PROFIT CASCADE

1. Profit Before Interest & Tax

2. Profit Before Tax

3. Profit After Tax

4. Dividends

5. Retained Earnings

There are different measurements taken for profit depending upon the purposes for which thisinformation is required and as a basis for achieving the comparative analysis of performance.

THE CASH FLOW STATEMENT

1. CASH FLOW FROM OPERATING ACTIVITIES

2. CASH FLOW FROM INVESTING ACTIVITIES

3. CASH FLOW FROM FINANCING ACTIVITIES

4. A NET INCREASE (OR DECREASE) IN CASH OVERTHE TIME PERIOD FOR THE STATEMENT

The cash flow statement shows the flow of funds through a business between the two reportingperiods for the balance sheet, in the same way the Income Statement is derived across two pointsin time.

In simple terms the standard layout for the cash flow statement is : -

PLUS or MINUS

PLUS or MINUS

EQUALS

A TYPICAL CASH FLOW STATEMENT

* NET CASH INFLOW FROM OPERATING ACTIVITIES 340

NET OUTLOW FROM INVESTING ACTIVITIES (118)

NET CASH (OUTFLOW) INFLOW FROM OPERATING ACTIVITIES (63)

INCREASE IN CASH AND CASH EQUIVALENTS 1391

FORECAST EXCHANGE LOSSES (11)

CASH FLOW AT THE PERIOD ENDED 1539

* To assess the Net Cash Inflows from Operating Activities, more details can be shown, for example : -

Net profit before taxation

Depreciation expense

Interest expense

Increase (minus) or decrease (plus) in inventories (stock)

Increase (minus) or decrease (plus) in debtors

Increase (plus) or decrease (minus) in creditors

Interest paid

Corporation tax paid

Dividend paid

Net cash flows from operating activities

Plus

Plus

Plus or Minus

Plus or Minus

Plus or Minus

Less

Less

Less

Equals

The purpose is to show the movement of funds through the business, the services from which this cashwas derived and the applications to which it has been deployed as a matter of public record tosupplement the published statements for the balanced sheet and income statement.

These 3 statements can be further analysed, using Ratio Analysis, to assess the financial position of anybusiness which has financial statements published and available in the public domain.

DISCUSSION QUESTION

1. EXPLAIN THE PURPOSE AND CONTENT OF THE MAIN FINANCIAL STATEMENTS THAT ARE PRODUCED FOR PUBLIC SCRUTINY.

* THE PROFIT & LOSS OR INCOME STATEMENTS

* THE CASH FLOW STATEMENT

* THE BALANCE SHEET

WORKING CAPITAL DEFINITION

WORKING CAPITAL RATIO

SOURCES OF WORKING CAPITAL

WOKING CAPITAL MANAGEMENT

LIQUIDITY

THE CASH OPERATING CYCLE


WORKING CAPITAL POLICY

WHAT IS MANAGEMENTSESSION 4 WORKING CAPITAL

DEFINITION OF WORKING CAPITAL

Working capital is the money needed for a business to fund its day to day operations.Without working capital, a company cannot continue to trade. The working capitalcalculation is derived from the balance sheet values for current assets and current liabilities.

The working capital is thus the difference between what the company owns, currently, instock, debtors, cash and short term investments minus what the company owes currently tothe creditors.

CURRENT ASSETS --- CURRENT LIABILITIES

WORKING CAPITAL RATIO

It is expressed as a proportion eg. 2 :1; 1.5 : 1, 3 : 1 to demonstrate the level of COVER thecompany has from its current assets to pay current liabilities. The GOLDEN RULE is 2 : 1,but this will depend upon the industry, stockturn behaviour, general market conditions andfinancial control.

SOURCES OF WORKING CAPITAL

From Current Assets

• CASH AT BANK• SHORT TERM INVESTMENT CONVERTIBLE TO CASH• CURRENT AND FUTURE INCOME FROM DEBTORS• CASH CONVERTED FROM STOCK (INVENTORY)

From Current Liabilities

• CREDIT TAKEN FROM SUPPLIERS• SHORT TERM LOANS• OVERDRAFT FACILITIES

Another term for the working capital ratio is the ‘net current assets’. Working capital thereforeis an important measure of the company’s liquidity.

Working capital management is concerned with the management of the relationship betweencurrent assets and current liabilities and the decisions pertaining to achieving the relevantbalance between both key areas of financing a business on a day-to-day basis.

Managing liquidity is part of the responsibility often referred to as cash management toensure that the company has enough cash when its obligations for cash payments are due.

Managing the cash cycle for the business becomes vital, this is why cash flow statements areneeded for cash management to protect the liability of the business.

Working Capital Management involves the following key areas : -

• CASH MANAGEMENT

• DEBTOR MANAGEMENT

• CREDITOR MANAGEMENT

• INVENTORY MANAGEMENT

All of which are covered with the day to day management of working capital throughout thebusiness.

CASH MANAGEMENT Company income streams and regularity of them must be monitored in order to maintain apositive cash flow position to reduce the need for short term borrowing through overdraftfacilities. Negative cash flow means a cash deficit, the cost of which impacts upon workingcapital and also places pressure on relationships with suppliers should late payment to creditorsoccur.

DEBTOR MANAGEMENT

The debtor days outstanding should be controlled carefully to ensure that money comes into thebusiness before it is paid out by ensuring that creditors days exceed debtor days – otherwise thecost of uncontrolled cash receivables will impact upon working capital.

The number of debtor days outstanding must be closely monitored because the cost ofextending credits to debtors is a cost to the company This cost cannot be overlooked.Credit extended will increase the value of outstanding debtors and this has to be financed, oftenfrom short term borrowing using overdraft facilities, so therefore the ‘real’ cost of creditextension must be known and must be managed carefully.

CREDITOR MANAGEMENT

The key to creditor management is to take more credit from the companies’ creditors than areextended by the company to its debtors. In simple terms the creditor days should be greaterthan the debtor days so that money comes in before it is paid out. Often it is not possible, sotherefore an overdraft facility is used to bridge the gap between receipts and payments.However, if this overdraft has a hard core element of sustained borrowing, this impactsdirectly upon working capital balances.

The analysis of the creditor position must be managed so that the liquidity of the business ismonitored closely.

INVENTORY MANAGEMENT

Inventory, or stocks is usually the least liquid of current assets and therefore it is vital thatinventory is managed efficiently.

Stock held must convert to cash, every effort must be made to ensure that optimum stockturnis sustained in relation to the pattern of sales for the business – otherwise working capital istied up needlessly. Stockheld is cash tied up. Inventory management has the main purpose ofconverting stock to smooth flows of cash into the business.

LIQUIDITYLiquidity as mentioned earlier is the core theme of working capital management and isdefined as the short term ability of a business to meet its current short term liabilities.

An enterprise becomes illiquid when the liquid assets (cash, debtors & stock) as ‘near’ cashitems are insufficient to cover the short term obligations to creditors.

LIQUIDITY – Deals with Short Term Liabilities Only

Is measured by the working capital balances in a company

DERIVATION

Current Assets (Minus) Current Liabilities

What is currently owned (Minus) What is currently owed

e.g. Stock, Debtors, e.g. Trade Creditors, Short TermCash at Bank Loans and Overdrafts

LIQUID ASSETS These will vary from industry to industry, but normally would include cash and debtorsand may be stocks if they are readily convertible to cash, so therefore ratios are used toassess a company’s liquidity :-

RATIOS

• The Working Capital Ratio Current Assets(Or Current Ratio) Equals Current Liabilities

• The Acid Test Liquid Assets (cash + near items)Equals Current Liabilities

This is to provide an assessment of adequate ‘cash cover’ to meet to company’s short-termfinancial obligations. Ideally a 2:1 cash cover would be expected for the current ratio and1:1 for the Acid Test.

The cash operating cycle is the length of time elapsing between the company’s cashpayments for purchases of materials and labour in relation to cash received from the sale ofgoods and services.

• STOCK TURNOVER• DEBTORS TURNOVER• CREDITOR TURNOVER

The Cash Operating Cycle = Stock Period plus Customer Credit Period minusSupplier Credit Period

To assess this, the following ratios should be calculated :

THE CASH OPERATING CYCLE

And then convert these turnover ratios into the days in which cash is tied up in workingcapital.

AN EXAMPLE TO DETERMINE THE CASH OPERATING CYCLE

COST OF SALES

STOCK TURNOVER RATIO = VALUE OF STOCK HELD

SALES REVENUE

DEBTOR TURNOVER RATIO = AVERAGE DEBTOR VALUE

COST OF SALES

CREDITOR TURNOVER RATIO = AVERAGE CREDITOR VALUE

SAMPLE FIGURES

STOCK TURNOVER RATIO 3000= 5 times per annum

600

DEBTORS TURNOVER RATIO 5000= 12.5 times per annum

400

CREDITORS TURNOVER RATIO 3000= 8 times per annum

375

Therefore to convert this to days based upon 365 days per annum.

STOCK PERIOD = 365 = 73 days5

DEBTORS PERIOD = 365 = 29.2 days(Customer Credit) 12.5

+

CREDITORS PERIOD = 365 = 45.6 days(Supplier Credit) 8

-

The Cash Operating Cycle is therefore 73 + 29.2 - 45.6 days

This means it takes almost two months to convert business into cash and this is the number of days thatcash is tied up in working capital.

Policy relates to the rules which govern decisions, therefore the financial management of thecompany must lay down policies to govern working capital management.

• How should the working capital of the company be financed• Is an overdraft facility required and to what level• What is the level of cash that should be tied up in current assets, and for each type of current

asset• What rules must be applied to extending credit to customers, and what are our credit

collection in policies• How do we build relationships with suppliers to attain extended credit for our business• What level of risk can we take to achieve a threshold level for working capital cover to

prevent a liquidity crisis• How do we preserve the financial health of the company from a working capital perspective• How do we guard against being under-capitalised to avoid over trading, which could be fatal

for the company

Key questions must be asked to lay down such policies :-

WORKING CAPITAL POLICY


1. EXPLAIN THE TERM ‘WORKING CAPITAL’ AND DISCUSS THE CHALLENGESTHAT THE FINANCIAL ACCOUNTANT WILL HAVE IN DISCHARGING THEMANAGERIAL ROLE IN THIS AREA.

2. WHY IS LIQUIDITY SO IMPORTANT TO ANY BUSINESS? HOW CAN LIQUIDITYBE PROTECTED TO AVOID THE BUSINESS HAVING TO FACE A LIQUIDITYCRISIS

CASH

CASH FLOW

CASH BUDGETING

BUDGETED CASH FLOW STATEMENTS


WHAT IS MANAGEMENTSESSION 5 CASH MANAGEMENT

CASH

Cash plays a pivotal role in any business, in fact it is the lifeblood of the businesswhereby cash flows into the business to touch almost all parts of the business and alsoflows our into the external business environment.

The difference between cash in flows and cash out flows will of course influence thecalculation of absolute profit

This is shown in Figure 5.1.

CASH

EQUITY SHARECAPITAL

LOAN CAPITAL

OVERDRAFT

GOVERNMENT SOURCES

DEBTORS

TAXATIONWAGES & SALARIES

FIXED ASSETS

OPERATING COSTS

CREDITORS • LOAN REPAYMENTS • STOCKS • RAW MATERIALS• WORK IN PROGRESS

RESEARCH & DEVELOPMENT

In flows Out flows

Figure 5.1

Cash management is the management of ‘liquidity’ to ensure there is sufficient cash to meet thefinancial obligations to suppliers, employees, banks, the Inland Revenue and so on.

It makes sense to centralise the cash management of the business. The role of the financemanager in this respect will be to forecast cash needs and monitor the utilisation of cash tomanage complete cash flow.

CASH FLOWThe ‘Cash Flow Forecast’ or ‘Cash Budget’ is the primary tool used for short term financialplanning. The key to managing cash is planning.

Cash budgeting is the term given to the projection of inflows and outflows of cash a specifiedtime periods which may be weekly or monthly for periods of up to one year ahead.

The objective of cash flow planning is to make an early assessment of the expected levels ofcash surpluses or deficits at future dates so that plans can be made to either hold or investsurpluses or to arrange borrowing or even permanent financing where shortages are expected.

Preparation of the Cash Budget -- Four Distinct Steps.

1. Forecasting future cash inflows2. Forecasting future cash outflows3. Comparing forecasted inflows and outflows to determine the net cash flow for

each time period.4. Calculate the cumulative cash flow by adding the opening cash flow balance to

the net cash flow for the period.

By examining the forecasted movements in cash over several periods, cash flow can beanticipated for cash planning. Action can be taken in advance, for future cash acquisitions andutilisation.

The cash flow plan therefore is a forecasting tool to manage the cash flows betweendebtors and creditors through the company as the trading intermediary.

1) INCOME / CASH RECEIPTS

Cash SalesDebtor PaymentsSale of Fixed AssetsNew Share Issue / CapitalNew LoansRealised Investments

2) TOTAL INCOME

Step 1) Forecast the source of future cashinflows.

Step 2) Calculate total cash inflows

3) EXPENDITURE / PAYMENTSCash PaymentsCreditor PaymentsWages & SalariesRent & RatesHeating & LightingInterest PaymentsDividends

Step 3) Forecast future cash outflowsLoan RepaymentTaxationPurchase ofFixed Assets

PLANNING CASH FLOW FOR ANY SPECIFIED TIME PERIOD

4) TOTAL EXPENDITURE

5) NET CASHFLOW (+ or -)

Step 4) Calculate total cash outflows

Step 5) Determine net cash flow

6) OPENING CASH BALANCE (b/f) CLOSING CASH BALANCE (c/f)

Step 6) Calculate cumulative cash flow

This format will then be set to determine the cash budget for a specified period. As a controltool for financial management the actual cash movements can later be compared with thosethat have been forecasted to determine a variance in cash movement for the each time period ofthe budget.

A budgeted cash flow statement may have the appearance as shown in Figure 5.2.

BUDGETED CASH FLOW STATEMENT – FORMAT

MONTH 1 MONTH 2 MONTH N TOTALS

1. INCOME / CASH RECEIPTS

2. TOTAL INCOME

3. EXPENDITURE / PAYMENTS

4. TOTAL EXPENDITURE

5. NET CASH FLOW ( 2 minus 4 )

6. OPENING CASH BALANCE (B/F)

CLOSING CASH BALANCE (C/F)

• ___________• ___________• ___________

• ___________• ___________• ___________


1. EXPLAIN HOW CASH IS MANAGED IN A SUCCESSFUL BUSINESS ORGANISATION.

2. WHAT IS THE REAL PURPOSE OF PREPARING A CASH BUDGET ?

NEED FOR PROFIT

SESSION 6 PROFIT, PROFITABILITY & VALUE ADDED

ADEQUACY OF PROFIT

REALITY AND NATURE OF PROFIT

THE CONFLICT BETWEEN PROFITABILITY AND LIQUIDITY

PROFIT AND CASH

PROFIT AND PROFITABILITY

KEY RATIOS FOR MEASURING PROFITABILITY

VALUE ADDED

DEFINITION

EXPLANATION

KEY RATIOS


NEED FOR PROFIT

It is recognised that the management has responsibilities for the well-being of theemployees and the community as a whole, as well as to company’s shareholders. Incarrying out these responsibilities, the manager must always be aware of the impact ofdecisions on the company’s profit. Though short term decisions may reduce oreliminate profit, in the longer term, a company must earn profits in order to survive.The main criterion for assessing the efficiency of a business is its reported profits.

• Shareholders, who expect a return on their investment commensurate with alternativeinvestment opportunities and the risk involved, and a growth in the value of theirshareholding.

• Employees, whose security may depend on the continued existence of the company andwhose level of earnings may also depend on its prosperity.

Management’s responsibilities extend to :-

• The Community. It is becoming increasingly recognised that industry andcommerce have responsibility to the community in which they operate. This canextend to environmental aspects such as the prevention of pollution and theprovision and support of local amenities.

• Government, by making a contribution through taxes to the national exchequerwhich go towards social services, defense and public investment.

ADEQUACY OF PROFIT

Profit is a common denominator for measuring how well a business utilises the resourcesinvested in it.

In the longer term, the profit earned by a business must be adequate to ensure itscontinuity and fulfillment of the responsibilities referred to earlier. In particular, anadequate profit is one which ensures that :-

• Shareholders receive a dividend in line with going rates of return on alternativeinvestments

• The real capital of the business is preserved during an inflationary period

• Sufficient cash flow is generated to provide funds for expansion and for research anddevelopment

REALITY AND NATURE OF PROFIT

In spite of recent developments in accountancy principles and concepts the statedprofit figures are best only estimates in any situation. Some of the areas affecting thestated profit which are not always capable of exact determination include :-

• Provisional for depreciation or amortisation of fixed assets• Valuation of finished goods and work in progress• Credit taken for profit on partly completed long term contracts• The matching of expenses with income, especially where there is an element of

deferred revenue expenditure• Adjustments for changes in the value of money, especially foreign exchange• The treatment of exceptional gains or losses (including unrealised losses) whether

of a capital or revenue nature

In all but the simplest of business, the profit is an approximate figure very muchdependent on the conventions which have been applied.

THE CONFLICT BETWEEN PROFITABILITY AND LIQUIDITY

Recognising the need for profit for the long term survival of the firm, and the use ofprofitability as an index for measuring managerial performance, it is natural that mostcompany management should consider maximising return on investment to be theirprime objective.

Improved profitability can be achieved by application of cost reduction techniques suchas inventory control, value analysis, work study, etc., but in many cases the mostimportant source is from increased volume and the development of new products.

The investment necessary for growth requires substantial and normally irregular flowsof cash. Unless proper financial arrangements are made, a rapidly growing company,although profitable, may run into serious liquidity problems, which can be moredamaging to its survival than even a loss making situation.

It is important, therefore, that efforts to maximise profit through growth do not lead toover-trading and a liquidity crisis. It is the duty of the Finance Manger to coordinatethe growth plans of various departments such as production and sales and to interpretthem in financial terms so as to ensure that adequate finance is available to sustain theprojected growth.

SOME REASONS WHY PROFIT AND CASH ARE DIFFERENT

• Depreciation is charged in the profit and loss account as an expense but does notaffect the cash balance

• Stock is created by cash payments for material, labour, etc. Stock is not charged as anexpense in the profit and loss account until it is sold

• Debtors and creditors. Invoiced sales appear in the profit and loss account asturnover. Incurred expenses appear in the profit and loss account as costs. It may beseveral months before cash changes hands

• Stock valuation may be arrived at in many different ways. The valuation will affectthe reported profit but not he cash balance

• New capital introduces cash into the firm when isued but never appears in theprofit and loss account

• Research and development affect the cash balance when paid for but may becharged in the profit and loss account over several years.

NOTE : PROFIT IS A CONCEPT.

CASH AT BANK IS A FACT.

CASH IS KING ! ! !

MAIN RATIOS USED TO ASSESS PROFIT PERFORMANCE (PROFITABILITY)

1. ROI RETURN ON INVESTMENT

2. ROCE RETURN ON CAPITAL EMPLOYED

3. ROSHF RETURN ON SHAREHOLDERS FUNDS

4. ROA RETURN ON ASSETS

5. GROSS PROFIT AS A % OF SALES

6. PRE TAX PROFIT AS A % OF SALES

7. PROFIT BEFORE INTEREST & TAX AS A % OF SALES (PBIT)

8. EBITDA

RETURN

Ratios 1 to 4 use the term ‘return’, the term simply means the profit figure generatedfrom the income statement. It is important to use the same measure of profitability tobe able to compare performance over time. In this way comparative reference can betracked and assessed.

Pre-tax profit can be used or profit before interest and tax are charged simply because itgives a better reflection of the actual profit generated from trading as a business.

It is also common to use EBITDA which is Earnings before Interest, Tax Depreciationand Amortisation as a measure of profitability and a basis for comparative analysis.

The most fundamental aspect of return is to ensure the basis to measure it over time isconsistent.

MEASURES OF RETURN

1. ROI This measures the ‘return’ from investment made or to be made. Forexample for projects to the company has or will embark upon. Hence theimportant aspect is to ensure that the return is greater than the cost ofcapital and that the best of opportunity has been taken in comparison withother investment options. This term is used quite widely and can relate tothe business as a whole as well as to projects.

2. ROCE The total capital employed in a business again has to have a consistentapproach to its calculation as there are different approaches used. ROCEis the profit derived from all the capital the company has used in runningthe business. This will include its stakeholders funds and long term loansas one approach to determine capital employed OR by using total assetsminus current liabilities.

3. ROSHF This shows the return the company has achieved from the funds owned by itsshareholders. These include issued shares, capital reserves and revenuereserves from accumulated profits.

Capital revenues may arise from revaluation of fixed assets, premiums onshares issued at a price in excess of normal value.Revenue reserves are mainly in the form of retained earnings that haveaccumulated.

THIS COULD BE CONSIDERED AS THE MOST IMPORTANTRATIO IN BUSINESS FINANCE.

4. ROA Return on Assets as a measure of profitability is important because it showshow the financial management of the company is using the Total assets tomake profit.

It shows how efficiently the assets are being deployed in the business.Shareholders funds will have been invested in the assets in the assets of thebusiness, the shareholders as owners of the business will need to know howtheir assets are being used to make a sustainable return on their funds.

5. Gross Profit as a % of sales includes the margin of profit left after the direct costs of thebusiness have been charged, referred to as the ‘cost of sales’, therefore the Gross Profitmargin is determined by deducting the cost of sales from the revenue generated.

6. Pre tax Profit as a % of sales (also called net profit) is the profit made after deducting theindirect costs of the business from the Gross Profit Figure. These indirect costs include itemsof expense that must be paid from the revenue generated in order to produce the net profitfigure.

7. PBIT, a Profit Before Interest and Tax is charged is simply a variation on the Pre Taxformula, but it deducts the amounts paid by the business on tax and interest actually paidwithin the year.

8. EBITDA is yet a further development of the PBIT approach, but the measure of profitability (called earnings) is assessed after deducting amounts for interest, tax and depreciationamortisation. Note ‘E’ stands for ‘Earnings’, which is another term for profit.

VALUE ADDED

Value Added is the difference between the value of an enterprise’s outputs and the value of itsinputs.

DEFINITION

By converting inputs into outputs the enterprise literally adds value to the materials andservices it buys through a series of conversion processes to make a saleable output.

This added value in the conversion process is in fact wealth generated by the company. Akey issue to take into account is how that wealth is distributed, ie. normally throughwages and salaries (the main component) taxes, interest payments, dividendsdepreciation and in retained earnings.

EXPLANATION

Value added essentially is the result of trading to sell products as a result of atransformation process achieved from the inputs of raw materials and components,utilities, fees for professional services, advertising and promotion, hiring and leasingcharges and the cost of financing.

Labour is treated as a participant in the distribution of wealth rather than a charge in thevalue added statement.

PERFORMANCE INDICATORS / RATIOS

SALES TO CUSTOMERS less BROUGHT IN GOODS & SERVICES = VALUE ADDED

VALUE ADDED

PAYROLL TO VALUE ADDED RATIOS

1. TOTAL PAYROLL COSTS x 100VALUE ADDED

showing the % of wealth returned to employees

2. TOTAL VALUE ADDEDTOTAL PAYROLL

showing the value added created by employees for each dollar spent on labour

3. VALUE ADDED TO INVESTMENT RATIO

Similar to return on investment, but this shows the wealth created from the investment made.

VALUE ADDED x 100

INVESTMENT

The enterprise must aim to maximise value added through increasing productivity and efficiency.


1. WHAT IS THE DIFFERENCE BETWEEN PROFIT AND PROFITABILITY?

2. WHAT ARE THE MAIN MEASURES OF PROFITABILITY USED BY THE FINANCIAL ACCOUNTANT AND HOW ARE THEY DIFFERENT?

3. WHAT IS THE DIFFERENCE BETWEEN CASH AND PROFIT.

4. HOW IS PROFIT DIFFERENT FROM VALUE ADDED.

PROFITABILITY RATIOS

SESSIONS7, 8, 9

ASSESSING THE FINANCIAL POSITION, ANALYSING & INTERPRETING FINANCIAL

STATEMENTS

EFFICIENCY RATIOS

LIQUIDITY RATIOS

FINANCIAL GEARING RATIOS

INVESTMENT RATIOS


ANALYSING & INTERPRETING FINANCIAL STATEMENTS

The classical approach to this subject is commonly referred to as ratio analysis. Ratios areused in a consistent format to compare financial performance over time in order to determinethe current financial position of a company so that its financial health can be established.

• PROFITABILITY• EFFICIENCY• LIQUIDITY• FINANCIAL GEARING• INVESTMENT

The categories of ratios are as follow : -

Figures to calculate these ratios are mainly taken from the income statement and the balancesheet.

PROFITABILITY RATIOS

Name of Ratio Formula State result as 1. Return on investment (after interest

and tax)Net profit after tax Total net assets (1)

%

2. Return on investment (after tax before interest)

Net profit after tax but before interest Total net assets

%

3. Gross profit ratio Gross profit X 100Sales

%

4. Net profit ratio (before interest and taxation)

Net profit before interest and tax Sales

%

5. Net profit ratio (after tax and before interest)

Net profit after tax and before interest Sales

%

6. Net profit ratio (after interest and tax)

Net profit after interest and tax Sales

%

(1) NOTE : Total Net Assets = Total Assets Less Current LiabilitiesThis Is The ‘Net Worth’ Of The Business

Name of Ratio Formula State result as

1. Inventory turnover Cost of SalesAverage Stock

Times

2. Debtors to sales ratio Debtors X 100Sales

%

3. Debtor days (collection period)

Debtors X 365Sales

Days

4. Creditors turnover ratio Creditors X 100 Purchases

%

5. Creditor days (payment period)

Creditors X 365 Sales

Days

6. Cash conversion cycle Inventory days -Creditor days +Debtor days =Cash conversion days

Days

7. Sales to capital employed Sales revenue Share capital + reserves + long term liabilities

%

8. Sales per employee SalesNumber of employees

£

EFFICIENCY RATIOS

9. Return on shareholders funds

Net profit after tax and dividends Ordinary share + reserves

%

10. Return on capital employed

Net profit before interest and taxation Share capital + reserves + long term loans (2)

%

11. Asset utilisation ratios (1) SalesFixed assets

(2) Sales Current assets

(3) Sales Total assets

Times

Times

Times

(1) NOTE : Ordinary Shareholder + Reserves = Ownership Capital, these are the Shareholders Funds

(2) NOTE : Long Term Loans = Debt Capital Therefore The Total Capital Employed = Ownership Capital + Debt Capital

LIQUIDITY RATIOS


1. Current ratio Current assets Current liabilities

Ratio

2. Acid test ratio Monetary current assets Current liabilities

Ratio

3. Working capital turnover

Sales Working capital

Times

(1) NOTE : Working Capital = Current Assets Less Current Liabilities

FINANCIAL GEARING RATIOS

Gearing refers to the proportion of fixed interest (Debt), capital in relation to the equity capitalheld by the shareholders as owners of the firm. If this proportion is high, then the company isconsidered to be taking a high risk position.

These gearing ratios will also help to assess the solvency of the business.

GEARING

New business development plans which require loan financing will increase the gearing of theenterprise.

Gearing refers to the proportion of debt a company has in its capital structure.

Name of Ratio Formula State result as 1. Gearing ratio Long term liabilities

Share capital + reserves + long term liabilities %

2. Debt & Equity ratio Long term liabilities Equity share capital

%

3. Interest Cover ratio Profit before interest and tax Interest payable

%

INVESTMENT RATIOS


DIVIDEND PAYOUT RATIO

Dividends AnnouncedProfits for the year available for dividends

%

DIVIDEND YIELD RATIO

Dividend per share Market value per share

%

EARNINGS PER SHARE

Earnings (profit) available to ordinary shareholders Number of ordinary share issued

%

PRICE / EARNINGS RATIO (PIE)

Market value per shareEarnings per share

%


1. ASSUME YOU ARE ONLY ALLOWED TO USE 10 RATIOS TO ASSESS THEFINANCIAL POSITION OF A COMPANY, WHICH WOULD YOU USE ANDWHY?

2. IF YOU WERE REQUIRED TO ASSESS THE FINANCIAL POSITION OF 3MAJOR COMPETITORS IN A MATURE INDUSTRY FROM THEIR COMPANYFINANCIAL REPORTS, WOULD YOU CONSIDER COMPARATIVE RATIOANALYSIS TO BE AN EFFECTIVE TOOL ?

WHAT ARE THE STRENGTHS AND WEAKNESSES OF THIS APPROACH ?

BUDGETS AND BUDGETARY CONTROL

SESSION 10 BUDGETS AND BUDGETARY CONTROL

BUDGETING THE PURPOSE & BENEFITS

BUDGETING AS AN APPROACH TO MANAGEMENT

TOP DOWN AND BOTTOM UP BUDGETING

CLASSIFICATION OF BUDGETS AT STRATEGIC ANDOPERATIONAL LEVELS

THE PLANNING PROCESS

STAGES IN THE ANNUAL BUDGET PREPARATION

THE INTERRELATIONSHIPS BETWEEN BUDGETS

VARIANCE ANALYSIS

MAKING BUDGETARY CONTROL EFFECTIVE


BUDGETS AND BUDGETARY CONTROL

- “ A qualitative statement, for a defined period of time, which may include plannedrevenues, expenses, assets, liabilities and cash flows. A budget provides a focus for theorganisation, aids the co-ordination of activities, and facilitates control. Planning isachieved by means of a fixed master budget, whereas control is generally exercisedthrough the comparison of actual costs with a flexible budget. ”

• Budget

- “ The establishment of budgets relating the responsibility of executives to therequirements of a policy, and the continuous comparison of actual with budgeted results,either to secure by individual action the objectives of that policy, or to provide a basis forits revision.”

• Budgetary Control

Chartered Institute of Management Accountants

BUDGETING – THE PURPOSE & BENEFITS

• To aid the planning of annual operations

• To coordinate the activities of the business

• To provide a system for authorisation

• To communicate future intentions

• To motivate achievement of objectives and improve performance

• To control the business as a whole

• To evaluate the performance of managers through their budget management

• To promote forward thinking and identify short term problems

BUDGETING AS AN APPROACH TO MANAGEMENT

• Stating assumptions about the environment of the budget

• Setting objectives to prescribed time lines

• Establishing detailed financial estimates (eg. costs and revenue)

• Delegating specific responsibilities for authorisation

• Monitoring performance

• Reviewing variances between budgeted performance and achieved performances

• Reacting to exceptions through management decisions and actions

The management approach to budgeting is common across most organisations which useany form of budgetary control.

Effective budget management is often applied as a measure of managerial performance,hence these processes outlined above are a core component of the managerial role in anyarea of business.

TOP DOWN AND BOTTOM UP BUDGETING

Budgeting is often achieved through a two stage process.

The process then is either top down or bottom up, but will of course involve both approachesbefore the budget is approved and signed off.

TOP DOWN The Strategic Level

Whereby senior management will consider the future economic and industryprojections, then assess these in relation to the future corporate financialambition. An assessment of current resource availability and future resourceneeds then allow top management to assess the demands of and provisions fornext year’s budget. This is all achieved with an annual budgetary cycle andcalendar.

BOTTOM UP The Operational Level

Middle management and people down the organisation are involved at anoperational level. Preparing the budget must align with operational plans for thefuture within the domain of each department (or budget centre). Information isdrawn from the internal and external business environment to assist in budgetpreparation (eg. resource constraints, resource needs, competition and thedynamics of the market).

CLASSIFICATION OF BUDGETS

AT OPERATIONAL LEVEL

Operating Budgets showing the income and expenditure for individual functions ordepartments of an organisation in forms of Sales budget, Production budget, etc. Thesemay be allocated to cost centres or profit centres for managerial control at operationallevel.

• Functional and Departmental Budgets

AT STRATEGIC LEVEL

Financial Budgets showing the aggregate of functional and departmental budgets whichcomprises of the Profit and Loss Account, Balance Sheet and Cash Budget.

• The Master Budget

THE PLANNING PROCESS

• Long Term Planning

• Annual Budgeting

• The Annual Budget Cycle

• Budgetary Control

These are four key elements in achieving the budget planning & control process.

The key elements are shown in Figure 10.1.

PLANNING & THE ANNUAL BUDGET Confirm mission, vision

Analyse the business environment & set objectives

Identify strategy options

Evaluate alternative strategic options

Prepare strategic plan for the business with timelines

Implement the long-term plan in the form of the annual master budget

Monitor actual results

Respond to divergences from plan

Medium & Long Term Planning

Process At Strategic Level

Annual Budgeting

Process

Figure 10.1

SIMPLE BUDGETING PLANNING AND CONTROL CYCLE Assumptions

Objectives

Prepare budget

Confirm budgets

Implement plan

Monitor plan monthly & quarterly

Correct problems

Then re-enter the cycle

Annual Budget Cycle At

Operational Level

Budget Control At Operational

Level

Figure 10.2

Adjust budget

STAGES IN THE ANNUAL BUDGET PREPARATION

These are crucial underlying assumptions ofeconomic indicators such as inflation andexchange rates, together with anticipated growthrates for relevant industrial sectors and marketconditions.

1. Budget assumptions and guidelines

An audit of production, human and other resourcesshould be carried out to determine the limits onproduction and other constraints.

2. Determine the factors that restrict output

3. Preparation of the sales budget This is the single most important budget. It is afunction of the size of the market, the unit’s shareof that market and the selling price obtained in acompetitive market context.

Stages in budget preparation

4. Initial preparation of other functional budgets

Once sales volume is known, the production andoverhead departments can start putting together thebudgets for their specific areas.

5. Negotiation of budgets with superiors (Bottom up)

It is human nature to want to have some slack in thesystem, whether this is a generous expenses budgetof having plenty of stock to feed production.

It is usually the responsibility of financialmanagement to make sure the budget is consistent,e.g. that production is not making more thanmarketing say they can sell.

6. Coordination and review of budgets

General managers of individual units may be askedto present and commit to their budgets at divisionaland group levels before agreement.

7. Final acceptance of budgets (Top down)

8. Ongoing review of budgets This is part of managerial control.

BASIC ASSUMPTIONS + COMPANY OBJECTIVES FOR GROWTH, PROFIT AND FINANCIAL POSITION FOR THE PERIOD.

SALES FORECAST

Production, Purchasing, Marketing, Administration and R & D are analysed in physical and monetary terms

and then allocated to responsibility centres for revenue and expenditure budgeting

SALES BUDGET PURCHASES BUDGET PRODUCTION COST BUDGET

MARKETING COST BUDGET R & D COST BUDGET

PRODUCTION BUDGET SALES BUDGET

PURCHASES BUDGET Stock Changes

Stock Changes

BUDGETS SUBMITTED BY RESPONSIBILITY CENTRES

WORKING CAPITAL BUDGETS

STOCK DEBTORS CREDITORS

CAPITAL EXPENDITURE BUDGETS

CASH BUDGET

ESSENTIAL FINANCIAL

STATEMENTS

MASTER BUDGET FORECASTED PROFIT & LOSS A/C + BALANCE SHEET

THE BUDGETARY PLANNING PROCESS AND THE INTER RELATIONSHIPS BETWEEN BUDGETS

AN EXAMPLE OF A BUDGET – A SIMPLE 6-MONTH CASH BUDGET Jan Feb Mar April May June

(£000) (£000) (£000) (£000) (£000) (£000)(1) Income

Revenue forecasts 60 52 55 55 60 55

(2) Expenditure

Marketing & Distribution 10 10 10 10 10 10

Salaries & Wages 30 30 31 26 35 31

Electricity 14 9

Other Overheads 2 2 2 2 2 2

Capital Purchase ___ ___ 11 ___ ___ ___

(3) Total Payments 42 42 68 38 47 52

(4) Cash Surplus (Deficit) 18 10 (13) 17 13 3

(5) Opening Balance 12 30 40 27 44 57

(6) Cash balance (Closing) 30 40 27 44 57 60

NOTE : The budget anticipating a positive cash balance through the 6-Month period

SIMPLE EXPLANATION OF TERMS

- Cash to be received from trading1. INCOME

- Cash paid out for operating expenses 2. EXPENDITURE

3. TOTAL PAYMENTS - Equals total expenditure

4. CASH SURPLUS (DEFICIT) - Is the net cash flow derived from income minus expenditure. Note this could be a deficit!

5. OPENING BALANCE - The balance at the beginning of the month which includes the amount brought forward from the previous month.

6. CLOSING CASH BALANCE - The closing figure at the end of the month reflects the balance of income & expenditure.

VARIANCE ANALYSIS

The purpose of budgeting is to determine a forecast for expected financial behaviour andperformance. In this sense a budget is a estimate only.

Against this estimate, actual performance must be compared as part of the managementcontrol process. The difference between actual performance and budgeted performance isreferred to as a variance.

• An adverse variance is where the actual performance is worse than the budgeted

The relationships across all variances will influence profit in the following way : -

Budgeted profit (plus) All favourable variances (minus) All adverse variables =Actual profit

• A favourable variance is where actual performance is better than that budgeted

MAKING BUDGETARY CONTROL EFFECTIVE

• A serious attitude must be taken to the budgeting system by all levels of management,but often there is no choice

• Clear demarcation between areas of managerial responsibility for each budget domain

• Budget targets being reasonable and attainable

• Established data collection, analysis and routines for communication

• Fairly short reporting periods, normally monthly

• Variance reports being produced shortly after the end of the reporting period formonitoring performance

• Action being taken to get operations back under control


1. WHY DO COMPANIES NEED BUDGETS?

2. WHAT IS THE TYPICAL BUDGETING PROCESS USED IN MOSTCOMPONENTS?

3. WHAT IS THE PURPOSE ACHIEVED BY VARIANCE ANALYSIS ?

4. HOW COULD A BUSINESS FUNCTION WITHOUT A BUDGETARY CONTROLSYSTEM AND HOW WOULD THIS INFLUENCE FINANCIAL DECISIONTAKING ?

COSTING -- DIFFERENT TYPES

SESSION 11 & 12 COSTS, COSTING & COST BEHAVIOUR

DIRECT AND INDIRECT COSTS

FIXED AND VARIABLE COSTS

BASIC COSTING TERMS DEFINED

COSTING AND VARIANCE ANALYSIS

FULL ABSORPTION AND MARGINAL COSTING

ACTIVITY BASED COSTING

COST VOLUME PROFIT ANALYSIS


The management accounting function, among other roles, will be required to perform thetask of assessing costs for different types for costing purpose, for example : -

STANDARD COSTS When a product uses the same components & same time tocomplete a process. This is typical in manufacturing industries,whereby there maybe a standard labour cost and a set ofstandard materials costs which form part of the costing exercise.

JOB COSTS This is often made up of standard costs, but if costing isrequired for a unique job then the unique features of thedesign, content and processing may be costed on adedicated job – cost basis.

COSTING -- DIFFERENT TYPES

CONTRACT This is form of job costing, but for large contracts, for example,COSTING civil engineering contracts, where the costing exercise is

detailed with a profit motive to be embedded in the costingexercise.

PROCESS COSTING This type of costing applies normally with large quantitiesof product output, where products may be at different stagesof completion. Each stage is therefore a ‘production process’which requires separate costing for managerial control purposes.

Process costs are mostly concerned with material costs, labourcosts and overhead costs. The processed food manufacturingindustry, the agricultural chemicals industry, furnituremanufacturing, ball bearing manufacturing are such examples.

BATCH COSTING This applies where there is a definite quantity of output within asingle production run. Typically in the Brewing Industry, theContract Food Industry, the Pharmaceutical Industry.

Within each of these types of costing, the task is to : -

• Determine the cost structure ad types of costs

• Estimate costs

• Know how cost, if at all, varies with output

• Forecast any change to cost during the life of the costs incurred

• Determine a total cost to then be given to a centre of responsibility formanagement

Costs, in simple terms can be classified as : • Direct Costs• Indirect Costs

DIRECT AND INDIRECT COSTS

Direct costs are those that are specially incurred with the output of a product or service, forexample, the direct material used and the direct labour employed. These costsare therefore the prime costs associated with, for example, production of aspecific product.

However to achieve this output, there are other costs involved to be able to convert thematerials and labour into the finished product, these are known as ‘indirect costs’.

Indirect costs are all other costs incurred but which cannot be measured in respect of aparticular unit of output, hence the term ‘indirect’. These costs comprise theoverhead costs of the business, eg. Administration, marketing & sellingcosts, which are a necessary expense to the business.

These terms are important as they will be used to determine profit whereby : -

The understanding of Direct and Indirect Costs is hence essential to determine Gross Margin ofProfit as well as the Net Operating Profit. The proportions between each will vary from industryto industry.

(1) SALES REVENUE(2) MINUS DIRECT COSTS(3) EQUALS GROSS MARGIN OF PROFIT(4) LESS INDIRECT COSTS(5) EQUALS NET OPERATING PROFIT OR LESS

The significance of these two types of costs is that : -

(1) They must be managed, monitored & controlled(2) They should be contained within a budget for the purposes of (1) above.

FIXED AND VARIABLE COSTS

FIXED COSTS are those which do not change with output, they are incurred regardless ofsales or production. For example, premises rental – if a business has nosales, the rent still must be paid, therefore it is a fixed cost.

VARIABLE are those which will change with output and will therefore depend uponCOSTS output, for example the food costs in a restaurant will be influenced by the

number of restaurant guests ordering food.

TOTAL COSTS equal fixed costs plus variable costs.

There could be a relationship between these 4 Cost Categories and it may be helpful when completing acost exercise for a particular job.

FIXED COSTS

THE RELATIONSHIP BETWEEN DIRECT, INDIRECT, FIXED & VARIABLE COSTS

The challenge is to achieve a fair basis to apportion the indirect costs to a particular job costing exercise.Such a matrix maybe useful as a basis for managerial discussion on cost control, furthermore this couldapply at each stage in a manufacturing process.

VARIABLE COSTS

TOTALS

DIRECT COSTS

INDIRECT COSTS

TOTALS

•••

•••

•••

•••

TOTAL COST

Figure 11.1

COSTS INCURRED DURING A MANUFACTURING PROCESS TO BE USED TOESTIMATE THE FUTURE COST OUTPUT

PROCESS1

PROCESS2

PROCESS3

PROCESS4

Costs

Accumulated

Direct

Indirect

• Direct Materials

• Direct Labour

A Proportion of the Business Overheads

• Further Direct Costs

A Proportion of the Department Overheads

• Further Direct Costs

A Share of the Financial Departments Overheads

Any Direct Costs if at all

Allocation of Share Overheads

TOTALSTOTAL COSTS

TOTALSProduction

DeptMachining

DeptFinishing Dept Finished

Goods Store

Figure 11.2

BASIC COSTING TERMS DEFINED

DEFINITIONS

• Historical Cost - Cost at Date of Purchase

Before we continue further, the following are simple definitions of key costing terms : -

• Opportunity Cost - The Cost of the Alternative Forgone

• Replacement Cost - Present Day Cost of Replacement

• Fixed Cost - Those Which Do Not Change with Output

• Variable Cost - Those Which Do Change with Output

• Sunk Cost - Those Already Paid and Cannot Be Changed

• Direct Cost - Those Directly Attributable to Outputeg. Direct Labour, Direct Materials, Direct Expenses

• Indirect Cost - Incurred in Business Operations but not DirectlyAttributable eg. Rent rates, Insurance, AdminExpenses

• Overheads - Indirect Costs and not Directly Chargeable toOutput, Staff Salaries, Vehicle Leasing, RentMaintenance

• Marginal Costs - The Cost of ‘One’ EXTRA Unit of Outputwhich is the Incremental Cost Incurred

• Cost Centre - A Location where costs can be Sensibly Attachedeg. A Department such as Personnel or to a Functionsuch as Maintenance

Overheads may be Charged to a Cost Centre orApportioned between Cost Centres using anAppropriate Method of Overhead Absorption (eg.Rental Charge to the Square Feet Occupied by theCost Centre). Often such methods of AllocationCosts are Arbitrary as in the Case of Selling andDistribution Costs

• Cost Variance - The Amount of Difference Between the Actual CostsIncurred and the Budgeted Cost (or Standard Cost)

• Cost Behaviour - A Historical Review of How Costs are Incurredand Changed with the Rate of Output Overtime,Assessed by Cost Variance Analysis and used forFuture Budget Determination

• Standard Costs - Cost Estimates Applied in Forecasting FutureBudgets, Where the Budgeted Costs becomesknown as a Standard Cost eg. for Labour& Materials

• Inflation - Costs Incurred which are usually uncontrollableand must Be Considered in the Budgeting Processand in Contingency Cost Control

• Contribution - The amount derived from Sales Revenue less onlythe variable costs incurred. The amount remaining iscalled “the contribution’ in fact to fixed costs and profit)of the enterprise

• Cost Variance - The difference between the cost estimated and thecost actually incurred

ELEMENTS OF A PRODUCT COSTING SYSTEM

Overall Cost Control System

Product Costing System

Costing Method

Method of Cost Control

Treatment of Fixed Costs

Charging Overheads

Specific orders Continuous operations

Job Costing

BatchCosting

ContractCosting

ProcessCosting

Function / Service Costing

Standard Cash or Actual Costs Or Activity Based Costs

Fully Absorbed Or Apply Marginal Costing

A Rate for Absorption Using Marginal Costing

Figure 11.3

From Figure 11.3, the overall cost control system for product costing will comprise : -

1. Costs of Continuous Operations

2. Costs of Specific (Special) Orders

The costing methods applied to continuous operations will probably be based upon processcosting, whereas for the special orders costs will need to be applied to either : -

• The Job• The Batch• The Contract

To complete the costing exercise, decisions will have to be taken as how to change the fixedand variable costs. This could be completed using : -

• Full Absorption Costing• Marginal Costing OR• Activity Based Costing

• Full Absorption Costing means that all costs, both fixed and viable will becharged to obtain a full absorption cost for the product,assuming that the market can accept thefinal price aftera profit margin has been numbered up on the total costestimate.

• Marginal Costing means that the variable costs only is considered as ameans to determine the marginal cost of output andtherefore the basis for setting price. The selling pricedetermined minus the managerial costs, is referred to as‘the contribution’. This in fact is a contribution to fixedcost and profit.

FULL ABSORPTION AND MARGINAL COSTING

The two alternative approaches to costing are shown in Figure 11.4.

1. Total Direct Costs• Direct Materials• Direct Labour

FULL ABSORPTION COSTING

AND MARGINAL COSTING

• Total Production Overhead

2. Total Indirect Costs• Selling Overhead• Distribution Overhead• Admin Expenses• R & D Costs

PLUS

3. Total CostEQUALS

4. MarginPLUS %Mark Up

5. Total Selling PriceEQUALS

NOTE SELLING PRICE – TOTAL COSTS = NET PROFITBEFORE TAX

1. Total Variable Costs• Direct Materials• Direct Labour• Variable Production Overhead• Variable Selling & Distribution Overhead

2. Contribution Margin

Proposed Selling Price Minus The TotalVariable Cost

3. Less Fixed Costs

4. Less Profit (or Loss)

NOTE MARGINAL COSTING IS BASED UPON THE CONCEPT OF A CONTRIBUTION MARGIN

Figure 11.4

LESS

EQUALS

Why are these two approaches important ?

They are used to set Price in order to gain sales and profit.

The Marginal Approach argues that as long as variable costs are covered, that there will be acontribution to fixed costs and profit. This is provided the contribution margin is largeenough.

The Full Absorption Costing approach is more conventional because it ensures all elementsof cost are built into the pricing decision. Furthermore it helps to estimate profit in moreabsolute terms.

In practice, the two approaches may be used side by side in order to achieve desiredbusiness volumes and the overall profitability of the enterprise.

For example, a restaurant may have a lunch and dinner menu. The dinner menus maychange menu prices for individual dishes all based upon full absorption costing. Therestaurant is then positioned in the competitive market place according to the pricepositioning relative to others.

However the lunchtime menu could be a fixed price for a Business Lunch with afixed limited menu, or even a fixed price buffet lunch. This price will be lower thanthat for the dinner menu because the price is based upon managerial costing principlewhereby as long as the lunch menu price exceeds the variable cost of food ingredientsand the staff employed, there will be a contribution to the fixed costs of the businesseg. the rental and electricity overheads.

Probably no absolute profit will be made. But overall the restaurant will be profitablebecause the lunchtime business contributes to the business overheads as well ascovering the variable costs incurred.

ACTIVITY BASED COSTING

This approach to costing is based upon a different philosophy, rather than usingDirect and Indirect Costs as a basis to determine actual cost, the approach uses thedefined separate activities which together deliver value for the business. Theconversion process is separated into domains which normally are independentlymanaged but nevertheless coordinated in terms of fixed & variable costs incurred andthen aggregate these into a total cost estimate. Each domain will then cost itsactivities. It is very challenging to be applied in practice, but is widely applied.

Examples are shown in Figure 11.5.

ACTIVITY BASED VALUE CHAIN

FIXEDCOSTS

VARIABLECOSTS

TOTALCOSTS

TOTAL ACTIVITY BASED COST

“END TO END”

ProductDevelop-ment

Ware-housing

Marketing& Sales

CustomerOrderProcessing

CreditControl

StockControl

InvoicingProcess

Despatch & Delivery

After Sales Service

Figure 11.5

The key to activity based costing (ABC) is activity based management and theavailability of data and information flows to accurately assess current and futurecosts.

The realisation of the total cost per unit or for a total ‘end to end’ process cansometimes be alarming and then when this approach is used to set price, the level atwhich price needs to be charged may make the product or service uncompetitive.

COSTING AND VARIANCE ANALYSIS

Costing and total cost estimates are forecasts made upon assumptions aboutenvironmental conditions and the behaviour of costs. Sometimes, uncontrollable variableswill have an unanticipated impact upon cost, rendering the cost estimates invalid to someextent.

The difference between the cost estimates and the actual cost incurred is referred to as a‘cost variance’. This variance may be positive of the cost was actually less than planned or‘adverse’ if costs are greater than estimated.

The analysis of variance can be considered through the following hierarchy in Figure11.6.

PROFIT VARIANCE

Figure 11.6

SELLING & DISTRIBUTION COST

VARIABLES

TOTAL SALES MARGIN VARIANCE

Sales Price Variance

Sales Volume Variance

TOTAL PRODUCTION COST VARIANCE

DIRECT MATERIALS VARIANCE

DIRECT LABOUR COST

VARIANCE

VARIABLE OVERHEAD COST

VARIANCE

FIXED OVERHEAD

COST VARIANCE

COST – VOLUME – PROFIT ANALYSIS

• COSTS – FIXED & VARIABLE

• CONTRIBUTION

• BREAKEVEN ANALYSIS

• MARGIN OF SAFETY

• THE PROFIT – VOLUME CONCEPT

• RATIOS

One key area of financial management is cost-volume-profit analysis, which is intended toassess the levels of potential or actual profits for varying levels of output. Key concepts tobe applied are : -

THE BEHAVIOUR OF FIXED AND VARIABLE COSTS

Costs may be broadly be classified as we have seen into :

• FIXED COSTS - These stay fixed as long as the business stays in business

• VARIABLE COSTS - These change as the business activity level changes

These two types of costs will be applied to determine BREAK EVEN ANALYSIS.

BREAK – EVEN ANALYSIS

NOTE : THE FIXED COST IS HORIZONTAL TO THE BASELINE BECAUSE COST IS FIXEDREGARDLESS OF OUTPUT

COST( £ )

FIXED COST LINE

F

0

VOLUME OF ACTIVITY (UNITS OF OUTPUT)

Figure 11.7

STEP 1 GRAPH OF FIXED COST(S) AGAINST THE VOLUME OF ACTIVITY

NOTE : THE VARIABLE COST LINE STARTS AT THE AXIS OF THE CHART, THE STEEPNESS OF THELINE IS REFLECTED BY HOW VARIABLE COSTS CHANGE WITH THE VOLUME OF OUTPUT

COST( £ )

V

0VOLUME OF ACTIVITY (UNITS OF OUTPUT)

Figure 11.8

STEP 2 GRAPH OF VARIABLE COSTS AGAINST THE VOLUME OF ACTIVITY

NOTE : THE TOTAL COST LINE IS A SUMMATION OF FIXED PLUS VARIABLE COSTS. THE TOTALCOST LINE STARTS AT THE POINT AT WHICH FIXED COSTS HAVE BEEN PLOTTED

COST( £ )

F


Figure 11.9

STEP 3 GRAPH OF TOTAL COST AGAINST THE VOLUME OF ACTIVITY

Variable costs

Fixed costs

Total Cost LineTC

NOTE : THE BREAK-EVEN POINT IS WHERE TOTAL REVENUE EQUALS TOTAL COST. THE CHARTALSO SHOWS PROFIT AND LOSS ESTIMATES FOR DIFFERENT LEVELS OF OUTPUT

REVENUE & COST

( £ )

F


Figure 11.10STEP 4 GRAPH SHOWING TOTAL REVENUE TO ASSESS BREAK-EVEN

Variable costs

Fixed costs

Total Cost

Loss

Break Even Point

Total Sales Revenue

Loss

NOTE : From a management perspective, the relevant range of business activity can be forecasted andthen assessed against the breakeven point. In this way a margin of safety can be assessed, beingbetween the break even point and the forecasted (or actual) volume of output.

REVENUE & COST

( £ )

VOLUME (UNITS)

Figure 11.11BREAKEVEN CHART

Loss

Breakeven Sales

Breakeven Point

Breakeven Output

Profit

Relevant Range Of Business Activity

Sales Revenue

Total Costs

Variable Cost

Fixed Costs< Margin of Safety >

F

0

To complement the breakeven chart, the profit volume chart can be used to examine, through thechart, an estimate of profit or loss at different volumes of activity.

PROFIT( £ )

0

Figure 11.12THE PROFIT VOLUME CHART

VOLUME OF ACTIVITYFixed cost

Break Even Point

The PV Line Total Sales – Total Costs

LOSS( £ )

As $ Sales Revenue (or % capacity)LOSS

F

To draw a PV Chart the following steps can be taken : -

1. On the vertical axis, (the Y axis) the fixed costs are logged. This is the position where thecompany has no sales.

2. The breakeven point is then plotted along the base axis (the X axis)

3. The line can be drawn by connecting the points on the X and Y axis.

NOTE 1. With no sales, a company has losses equivalent to fixed costs2. When sales occur, variable costs are incurred3. Sales generate contribution to recover fixed costs4. When total contribution equals fixed costs, a breakeven point is achieved5. Beyond the breakeven point, total contribution exceeds fixed costs and a profit is generated.

Total Contribution = Total Sales – Total Variable CostsUnit Contribution = Unit Sales – Unit Variable CostsThe PV Ratio = Total Contribution or Unit Contribution

Total Sales Unit Selling Price

KEY RATIOS FOR COST – VOLUME - PROFIT ANALYSIS

Unit Break Even Point = Total Fixed CostsUnit Selling Price - Unit Variable Costs(ie. The Unit Contribution)

Break Even Sales Revenue = Total Fixed Costs x Total SalesTotal Fixed Costs + Net Profit Revenue

P.V. Ratio = Unit Contribution Total ContributionUnit Selling Price or Total Sales Revenue

Unit Margin of Safety = Total Sales in Units – The Break Even Point

Revenue Margin of Safety = Total Sales Revenue – The Break Even Point

Net Profit = PV Ratio x Margin of Safety

SIMPLE EXAMPLE -- DISCUSSION QUESTION

ALEXIS LTD

Alexis Ltd is a small company manufacturing industrial measuring devices for the surveying industry.They have a future investment ambition to take on a new product for the household market.

Using the following data, ascertain the company’s break even point.

Number of units produced 40,000Sales Forecasted 36,000Total Fixed Costs ( £ ) 201,600Variable Costs Per Unit ( £ ) 14.00Selling Price Per Unit ( £ ) 20.00

The Directors of the company would like to know the number of units that need to be sold if they areto recover 15% of the company’s initial investment of £330,000.

ALEXIS LTD -- SOLUTION

POINT (1) UNIT CONTRIBUTIONContribution Per Unit= Sale Price less Variable Costs= 20.00 - 14.00= £6.00

POINT (2) BREAK EVEN VOLUMEBreak Even Units= Fixed Costs divided by Contribution (per unit)= 201,600 / 6.00= 33,600 units

POINT (3) THE OBJECTIVE FOR 15% RECOVERY

15% of £330,000 = £49,500New Break Even Units= Fixed Costs Plus Target Profit divided by

Contribution (per unit)= (201,600 + 49,500) 6= 41,850 units to be sold

POINT (4) PROFIT FORECASTProfit on Selling 36,000 unitsSales x Price (36,000 x 20) = 720,000Less Cost of Sales (36,000 x 14) = 504,000EqualsContribution 216,000Less Fixed Costs 201,600EqualsProfit £ 14,400

POINT (5) = PROFIT SELLING PRICE x UNIT SALES FORECAST

Profit / Sales = 14,400 20 x 36,000

= 14,400720,000

= 0.02%

Conclusion, Alexis cannot recover the initial investment on current sales forecasted and theinitial profit on sales of £720,000 is only £14,400. It is unwise to pursue this further withoutcareful assessment of the costs and market potential.


1. YOU HAVE BEEN ASKED TO ADVISE A USED CAR DEALER ON DIFFERENTCOSTING APPROACHES TO DECIDE PRICES TO BE CHARGED, BUT HAVE TOTAKE INTO ACCOUNT THAT THE OWNERS OF THE BUSINESS MUST ACHIEVE ANEFFICIENT INVENTORY TURNOVER TO AVOID TOO MUCH CAPITAL BEING TIEDUP.

2. A NEW RESTAURANT HAS BEEN PLANNED IN YOUR RESIDENTIAL AREA, IT HASBOTH TAKE AWAY AND IN-DINING AVAILABLE, BUT NEEDS TO USE THEPRINCIPLES OF COST, COSTING AND COST BEHAVIOUR TO DECIDE HOW TO SETPRICES AT A LEVEL TO ACHIEVE PROFIT ABOVE THEIR COST OF CAPITAL. HOWWOULD YOU ADVISE THEM.

THE TIME VALUE OF MONEY

SESSION 13 THE TIME VALUE OF MONEY & CAPITAL INVESTMENT APPRAISAL DECISIONS

CAPITAL INVESTMENT DECISIONS

-- Accounting Rate of Return-- Payback Period-- Net Present Value-- The Internal Rate of Return

CAPITAL INVESTMENT APPRAISAL METHODS

INVESTMENT APPRAISAL IN PRACTICE


THE TIME VALUE OF MONEY

This concept considers the future value of money as it travels forward in time. Thereforeconsider the following question : -

Is a ₤ or a $ today worth more than tomorrow or less than tomorrow ?

If tomorrow was one year’s time what would be your answer !

So therefore, if you give a friend a loan of ₤100 today, how much would you expectback in 12 months’ time ?

If a bank lends you of ₤20,000 today to buy a car and gives you the loan for 5years, how much will they expect back in 5 years’ time ?

This is the CONCEPT of the TIME VALUE OF MONEY.

Consider the preset value of ₤1 today with a financing cost of 20% and look at the value ofthat ₤1 over a 10-year period and then realise how the preset value of that ₤1 diminishes.

If other concepts, such as inflation, opportunity cost, risk and even depreciation areconsidered then the value is further diminished.

Penc

e 100

90

80

70

60

50

40

30

20

10

01 2 3 4 5 6 7 8 9 10

Years into the future

₤1

CAPITAL INVESTMENT DECISIONS

The profitability of the enterprise is a function of its ability to generate projects orinvestments which provide greater returns than the cost of funds.

1. A creative search for investment opportunities. This may involve new projects expansionof existing facilities, replacement of existing facilities, research & development etc.

2. Long range plans and projections of the companies future direction and development.

3. A yardstick to measure economic growth.

4. Forecasting the results of development projects.

5. Expenditure controls of outlays prior to and during a project life.

Capital investment decisions form part of a capital budgeting procedure which involves :

To measure the economic worth and to provide a realistic estimation of return various commonmethods are in use called capital investment appraisal methods.

6. Time plans for income and expenditure streams.

7. Investment analysis for returns and value of the project at disposal.

CAPITAL INVESTMENT APPRAISAL METHODS

1. ACCOUNTING RATE OF RETURN (ARR)

2. PAYBACK PERIOD (PP)

3. NET PRESENT VALUE (NPV)

4. INTERNAL RATE OF RETURN (IRR)

ARR =

1. ACCOUNTING RATE OF RETURN (ARR)

Average Annual Profit

Average Investment to earn that Profitx 100%

This is also referred to as the average return on investment and is a simple yardstick to comparereturn against the cost of capital for the investment to determine if the accountancy rate of returnis sufficient in accordance with the company’s objectives or investment practices.

PAYBACK PERIOD (PP)

2. PAYBACK PERIOD (PP)

The payback period is the length of time it takesfor the initial investment to be repaid out of the netcash inflows from the project.

The 3 projects shown on the next page have different levels of initial investmentand different rates at which that investment is being repaid from net inflow ofcash.

PROJECT A

(£ m)

PROJECT B

PROJECT C

(£ m) (£ m)

(10) (15) (20)Initial Investment

Net Cash Flows 1 (5) 1Year 1

3 (2) 2Year 2

6 3 (5)Year 3

5 9 6Year 4

4 15 15Year 5

3 Years 5 Years Not AchievedPayback Period

This method is simplistic, assumes a real ability to forecast future net cash flows and ignores thefuture and/or residual value of the project, but it is a beginning.

3. NET PRESENT VALUE (NPV)

The NET PRESENT VALUE method of Capital Investment Appraisal is more superior than thepayback period or the Accountancy Rate of Return because it considers :

1. The timing of the cash flows

2. All relevant cash flows

3. The real objectives of the business in relation to cost of capital

The NPV method uses Discounted Cash Flow (DCF) tables which represent the time value ofmoney as discussed earlier.

The DCF Tables will show the present value factors at different rates of interest so that the networth of money received in future years can be understood in terms of its present day value.

INT

ER

EST

RA

TE

S

PROJECT A • Construction Project in Thailand with an initial $10 million

investment

• Using Discounted cash flow at 15% per annum

• Net Cash Flows are forecasted and present value factors applied

from the table of net present value factors

• The Total Cash Flow exceeds the assumed Rate of Return of

15% and on this criteria the project could be accepted

EXAMPLE OF TWO ALTERNATIVE PROJECTS

$ m Discount Factor* Present ValueNet Cash Flow @15% $ m

PROJECT A (COST OF CAPITAL 15%) THAILAND

Year (0) Investment

* See tables to confirm Present Value Factors at 15% for a 5-year period

(10) 1.0000 (10)

Year 1 1 .8696 .8696

Year 2 3 .7561 2.2683

Year 3 6 .6575 3.945

Year 4 5 .5718 2.859

Year 5 4 .4972 1.988

* NPV = Net Present Value which is beyond the Cost of Capital at 15% Per Annum, so is thereforefavourable

1.930*

NPV

PROJECT B • Real Estate Investment in Vietnam

• Using Discount Rate at 19%

• Net Cash Flows both Positive and Negative

• The Net Present Value Factors are applied to the Forecasted NetCash Flows to determine present value

• The value of these aggregated Cash Flow is still negative, evenafter 5-years

• The Project should be rejected based on these criteria

$ m Discount Factor* Present ValueNet Cash Flow @19% $ m

PROJECT B (COST OF CAPITAL 19%) VIETNAM

Year (0) Investment

* See tables to confirm Present Value Factors at 19% for a 5-year period

(15) 1.000 (15)

Year 1 (5) .8403 (4.215)

Year 2 (2) .7062 1.412

Year 3 3 .5934 1.780

Year 4 9 .4987 4.488

Year 5 15 .4190 6.285

NEGATIVE, REJECT

(8.074)*

NPV

CONCLUSION

Project A in Thailand has cost of capital at 15% but the NPV (Net Present Value) of thisProject is $1.930 million showing that the return from the project exceed the cost of capitalover the 5-years life of the project. Assuming the forecasts of Net Cash Flows have a goodlevel of tolerance, then the project should be accepted.

Project B in Vietnam has a higher cost of capital at 19% and yields after 5-years an NPV of(S8.07 million). This negative NPV shows that the returns from the project are for less than19% and therefore way below the cost of capital. Therefore the project should be rejected.

The NPV method shows if the returns from a capital investment project exceed the cost ofcapital, but to calculate the ACTUAL return, then the IRR method is used.

The Internal Rate of Return is the discount rate, which when applied to Future Cash Flow of aproject produces a Net Present Value of zero.

THE INTERNAL RATE OF RETURN (IRR)

The Actual Internal Rate of Return is calculated by a method called interpolation, by firstfinding a rate giving a positive return and another rate giving a negative return and findingthe rate in between these two points as shown in the example in (Figure 13.1).

This is the exact point at which the percentage return is determined.

PROJECT ABCZ has an initial investment of £40,000, with positive net cash flows for 4-years, which is the anticipated life of the project.

The company seeks to know what is the actual Internal Rate of Return in order to justify aGO / NO GO decision.

To assess the position, two Discount Rates have been selected, 18% and 20% to determinethe actual return. From the example, it shows that at 18% the project has a positive NPV, sotherefore the actual IRR is greater than 18%. Using the simple formula for interpretationbetween the two points of 18% and 20% the precise IRR can be calculated.

Year Net Cash Present Present Present PresentFlow Value Value Value Value

£ 18% £ 20% £

PROJECT ABCZ

That is the base of 18* + An Adjustment to determine the actual IRR which is between 18% and 20%.Here the IRR is 19.31%, which if it is beyond the cost of capital would be considered acceptable foradoption.

0 (40,000) 1.0000 (40,000) 1.0000 (40,000)

Internal Rate of ReturnIRR

978NPV

1 16,000 0.8475 13,560 0.8333 13,333

2 16,000 0.7182 11,491 0.6944 11,111

3 16,000 0.6086 9,738 0.5787 9,259

4 12,000 0.5158 6,189 0.4823 5,787

(510)NPV

= 18% + 978978 + 510 x 2% = 19.31%

FIGURE 13.1

INVESTMENT APPRAISAL IN PRACTICE

• Businesses use more than One Method to assess each Investment Decision

• There is an Increased Use of the Discounting Methods (NPV and IRR) Over Time

• There remains a Continued Popularity of ARR and Payback Period owing to its

simplicity

So therefore in conclusion, there are a number of dimensions to capital investmentdecisions, these appraisal techniques offer some insight into project viability from afinancial management perspective.

DISCUSSION QUESTION

1. WHY DO FINANCIAL ANALYSTS CONSIDER THAT THE TIME VALUE OF MONEY IS IMPORTANT ?

2. COMPARE AND CONTRAST THE 4 MAIN METHODS OF CAPITAL INVESTMENT APPRAISAL NAMELY : -

-- ACCOUNTING RATE OF RETURN

-- PAYBACK

-- NET PRESENT VALUE

-- INTERNAL RATE OF RETURN

SOURCES OF INTERNAL FUNDS

SESSION 14 FINANCING A BUSINESS

-- Long Term-- Short Term

SOURCES OF EXTERNAL FUNDS

SHARE ISSUES

FACTORING & INVOICE DISCOUNTING

-- Long Term-- Short Term

LONG AND SHORT TERM BORROWING

OTHER SOURCES OF FINANCE


FINANCING A BUSINESS

Funding any business is an essential requirement, it is important to know when funds areneeded and to the level they are required.

Once this is determined, companies should be aware of how funds can be raised, this isknown as ‘ the source of funds ’.

Funds can be sourced from both internally and externally.

THE MAJOR SOURCES OF INTERNAL FUNDS

LONG TERM -- From Retained Profits held in the business

SHORT TERM

-- Sale of Fixed Assets

-- Loans from Directors

-- Tighter Credit Control

-- Delayed Payments to Creditors

-- Reduced Stock Levels-- Personal Loans-- Cash Held at Banks-- Invoice Factoring

THE MAJOR SOURCES OF EXTERNAL FUNDS

LONG TERM -- Issue of Ordinary and/or Preference Shares

SHORT TERM

-- Long Term Bank Loans

-- Debentures-- Government Loans / Grants-- Pension Funds

-- Trade Credit Taken-- Bank Credit

• Overdraft Facility

-- Invoice Discounting

-- Debt Factoring

-- Short Term Loans

ISSUES OF SHARES

• RIGHTS ISSUES -- There are new shares offered to existing shareholders, easily the mostcommon method of raising equity capital for existing companies.Shareholders are offered the right to subscribe for new shares in theproportion to their existing shareholding, thus enabling them to retaintheir current voting control.

The common methods of share issues to generate cash are : -

This is a cheaper form of raising a public share issue and themethod namely fails.

• OFFERS FOR SALE AND PUBLIC ISSUANCE

-- Larger amounts of new capital can be sorted by a public listingthrough the stock exchange to the general public. This is also called‘Going Public’. The most common ways is an ‘offer for sale’ to anissuing house who then in turn offers the shares for sale to the generalpublic. This is desirable as the issuing house underwrites the value ofthe shares and thereby reduces the risk to the offering company.

• PRIVATE PLACING -- Private companies usually depend upon individual owners as themain source of equity finance. Additional equity is raised bywidening the ownership, without going to the general public.Hence it is called a private placing normally organised throughstock broking companies.

LONG TERM AND SHORT TERM BORROWING

In general terms for accounting purposes, short-term refers to a period of up to one year ie. thecurrent trading year for example. Therefore long-term borrowing would be loan finance for aperiod of greater than 1 year and often up to 5 years or more.

AND

Long term sources of funds should be used for long term applications.

There is ONE GOLDEN RULE : -

Short term sources of funds should be used for short term applications.

In this way, the source is MATCHED to the application. Interest rates should be carefullyconsidered and the ability to repay the loan together with the flexibility allowed.

FACTORING AND INVOICE DISCOUNTING

The financing of trade debtors may involve either the : -

OR

• Assignment of Debts (called invoice discounting)

The purpose is simply to use the company’s debtors as a means to raise finance for the business.

• The Selling of Debts (called factoring)

With invoice discounting, the risk of default by the debtor remains with the borrower.

With factoring, the factor bears the loss in the event of bad debt.

The common factoring process provides cash upfront of up to 80% of the value of invoices,repayments are paid, together with the interest charged, from the cash collected by the factoringagent from debtors.

OTHER SOURCES OF LONG TERM FINANCE

• VENTURE CAPITAL is a term to obtain ‘start-up’ capital. Venture CapitalCompanies (VCCs) select relatively high risk businesseswhere the ‘upside’ pay-off for a successful venture issubstantial so that the VCC can recoup their investment andmake an additional return. Participation on the Board isoften a requirement of the VCC’ as a condition foradvancing the required capital.

• GOVERNMENTASSISTANCE

is often available through grants, interest free loans, taxexemption schemes and tax honeymoons, all of which aredesigned to attract, in particular, foreign direct investmentinto a country.


• IMAGINE YOU ARE ABOUT TO START UP A NEW BUSINESS FOR THE FIRSTTIME. WHERE WOULD YOU SOURCE CAPITAL FOR YOUR NEW VENTURE ?

• HOW WOULD YOU KEEP THIS BUSINESS FINANCIALLY STABLE ?

• IF YOU WERE FACING DIFFICULTIES BECAUSE CUSTOMER DEMAND HASDROPPED AND YOU ARE ALSO FACING DIFFICULTIES IN COLLECTINGMONEY FROM DEBTORS . . . WHAT ACTIONS CAN BE TAKEN ?

fam support material

Documents

management plans

management function

management process

management accountant

cash management

types of management

operational level

operational plans