Accounting rate of return is a ratio based on profits. It ignores timing of returns.
Internal rate of return is an extrapolation based on cash flow analysis. It takes account of
the time value of money.
Advantages of DCF method of appraisal
a) Uses all cash flows relating to the project (unlike payback)
b) Allows for the timing of cash flows (unlike both payback and ARR)
c) There are universally accepted method of calculating the NPV and IRR (there are numerous ways in which ARR can be calculated)
Capital budgeting decisions in the public sector will often social and the social benefits. The cost of capital is the weighted average cost of all sources of capital for an enterprise, used as the discount rate in investment appraisal.
(1 + money rate) = (1 + real rate) x (1 x inflation rate) A is the discount rate which provides the positive NPV a is the amount of the positive NPV
B is the discount rate which provides the negative NPV b is the amount of the negative NPV
34 Part F: Chapter 18:
Credit control deals with a firm’s management of its working capital. Trade credit is offered to business customers.
Consumer credit is offered to household customers.
*Credit cards are largely responsible for the explosive growth in consumer credit. ‘a sale is not complete until the money is in the bank’
Total credit can be measured in a variety of ways. Financial analysts use days ales in receivables, but as this is annualized figure it gives no idea as to the make-up of total receivables.
Receivables often accounts for 30% of the total assets of a business. Receivables turn over =
The main cost of offering credit is the interest expense.
To determine whether it would be profitable to extend the level of a total credit, it is necessary to assess the following:
The additional sales volume which might result
The profitability of the extra sales
The extra length of the average debt collection period
The required rate of return on the investment in additional receivables
*Some markets are risker than other, which is why export credit insurance premiums are higher for some countries than others.
A credit utilization report (pg 303) can indicate the extent to which total limits are being utilized.
Reviewed in aggregate (total), it can reveal the following: The number of customer who might want more credit
The extent to which the company is exposed to receivables
The tightness of the policy
Credit utilization to total sales
35
‘receivables. Continued: pg304
Certain payments terms that means it will be paid on delivery CWO cash with order
CIA Cash in advance
COD cash on delivery
CND cash on next delivery
**Liquidity is often more important than profitability.
Percentage cost of an early settlement discount can be estimated by: Percentage cost of an early settlement discount can be estimated by: [
]
Where d = The discount offered (5% = 5, etc)
t = The reduction in the payment period in days that is necessary to obtain the early payment discount
*A customer may assume a charge for late payment might give the customer the authority to pay late
The credit control department is responsible for those stages in the collection cycle dealing with the offer of credit, and the collection of debts (pursuing overdue debts as well) The credit cycle consist of the order cycle (From customer order to invoice dispatch) and the collection cycle (from invoice dispatch to the receipt of cash)
Roles of the credit controller:
Keeping the receivables ledger up-to-date Pursuing overdue debts
Dealing with customer queries
Reporting to sales staff about new enquiries
Giving reference to third parties (Eg credit reference agencies) Checking out customers’ creditworthiness
36
EXAM FOCUS POINT:
You may be asked to spot weakness in a credit control system and to suggest improvement. Key issues to look out for are:
a) The type of system used b) Invoicing intervals
c) Payment method (direct debits are better) d) Staffing levels
e) Penalties for late payer (interest charge should accrue when debts become overdue to discourage late payment)
A contract is an agreement which legally binds the parties. a) The parties intend to create legal relations b) There is an offer and acceptance
c) It is a bargain for which something is offered for consideration Essential elements of contract
Form
For a sale or purchases of land and consumer credit agreements must be in writting
Legal intention
Offer
is a firm proposal to give or do something or to be bound on specific terms
Acceptance
is the unconditional and unqualified agreement to all the terms of the offer
Consideration
is what a person (the promise) must give in exchange for what has been promised to him.
*Read mistake and mispresentaiton page 314
Any such mistakes must be a mistake of fact; a mistake of law can never have this affect. A breach of contract
- Damages - Termination
- Quantum meruit : is when a contract is terminated half way, and one part has already performed part of his obligations (ex. Part of construction work), he is entitled to claim reasonable amount for the work done
37 - Action for the price
Lien. Any goods which have not been paid for can be retained by the seller at the seller’s premises providing the buyers has not lawfully obtained possession.
Chapter 19:
*Read the article written by the examiner on ‘Credit Policy’ in the October 2010 edition of Student accountant
Credit risk means that there is a possibility that debt will go bad. ***DRAW LEVEL OF RISK***
Many firms make profits from ‘high risk’ customer, by demanding slightly higher returns and by managing them carefully. Higher risk customers need not to be shunned simply because they are higher risk.
A credit assessment is a judgment about the creditworthiness of a customer Credit reference: Sources of information
a) Externally generated information
This is information produced by third parties such as banks about their customers which they make available to third parties on request
Banks owe a duty of care to their customers, so their credit status will be precisely worded.
*When writing to the banks, you should be precise p 325
Trade reference are useful, but should be used uncritically.
Credit ratings are formal opinion of the creditworthiness of an entity. *Enquiry to suppliers is preferred to be written as a questioner
Credit reference agencies supply a variety of legal and business information thereby saving time for the enquirer. An agency may have its own suggested rating
A typical agency report will contain the following:
- Legal Data - Commercial Data - Credit Data
38 A higher profit margins indicates:
a) Either costs are kept well under control b) And/or sales prices are high
Sources that may be converted into useful credit control information: -The press
- Historical financial data - Companies registry search -Country Court Records b) Internally generated information
This is information generated by the company about the potential customer. For example, financial ratios.
The quick ratio measures liquidity more precisely than current ratio
The payables payment period indicates the average length of time a company takes to pay its debts. Together with receivables turnover and inventory turnover it gives some idea as to the operations cycle
Gearing ratios put payables in the context of the firm’s overall borrowing: they are frequently unsecured
Comparison between ratios can be done by either:
a) Between one year and another: to identify trends or significantly better or worse results than before
b) Between one business and another: to establish which business has performed better, and in what ways
*the credit controller is mainly concerned with (a) Profit Margin:
Net Assets turnover:
Return on capital employed (ROCE) or Return on Investment (ROI)
ROCE =
39 Profit Margin x Asset Turnover = ROCE
x
=
*Increased Prices will result in less asset turnover
Strong revenue growth may mean volume growth or increase due to higher prices and volume growth is one sign of a prosperous company.
In profit margin and asset turnover, you cannot look at one without allowing for the other! Pg331!
Basic earnings per share (EPS) is calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the period.
(a) EPS is a figure based on past data
(b) It is an easily manipulated by changes in accounting policies and by mergers or acquisition
The price earning (P/E) ratio is the most important yardstick for assessing the relative worth of a share
This is the same as:
The value of P/E ratio refelects the market’s appraisal of the share’s future prospects. The market price of a share and its earning capacity.
Changes in EPS: the P/E ratio and the share price
a) The relationship between the EPS and the share price is measured by the P/E ratio b) The P/E ratio does not vary much over time normally
c) So if the EPS goes up or down, the share price should be expected to move up or down too, and the new share price will be the new EPS multiplied by the constant P/E ratio *CHECK Answer 69: Effect of grearing EPS
40 the total amount of inventories or of receivables will increase. These suggest rowing
liquidity problems in the potential customer.
*Remember if the customer is able to borrow substantial funds at short notice: these can be used to repay suppliers
If a company has a working capital less than 1. This means that to some extent,
current liabilities (ex. creditors, you the supplier) are helping to finance the non-current assets.
A ‘prudent’ current ratio said to be 2:1. In other words, current assets should be twice the size of current liabilities.
*Read pg 335
Debt/equity ratio =
=
Interest cover is a measure of financial risk which is designed to show the risk in terms of profit rather in terms of capital values
=
*The answer will be ‘times’. It means how many times the company can pay its interest
*read limitations of ratios page 338
Cash flow and credit risk
Item Comments
Net operational cash flow should be positive Priority payments
= Cash for discretionary spending Should be normally positive - Investment spending
= Cash after investment spending If negative, the company must obtain money from non-trading sources, perhaps by borrowing
Visits to the customer’s premises can provide useful information. The credit controller can get a feel for the business and those running it. He can also discuss any queries.
In-house credit rating is when the company have its own credit rating for its customers, etc. The UK Data Protection Act 1998 cover data about individuals – not data about
41 Question 8. Check page 325 table! Bank replies.
Chapter 20:
For control purposes, receivables are generally analyzed by age of debt. *Check other ratios page 357
If a company receivables is increase in the ageing, this will be unfavorable. Think on the cash forecasting!
Grapevine
Issuing invoices and receiving payments is the task of the receivables ledger staff. Chasing late payer might be a responsibility of the credit control staff or a specialist debt collection staff.
*A business can increase its chances of getting paid by ensuring, at various stages, that the customer has no right to plead ignorance of the due date.
Special cases:
Major Key accounts customer will receive a special treatment in the sales effort. The more valued the customer, the higher rank of the staff member will deal with them.
Reconciliation and ‘on account payment’: the customer might not state which invoices the payment refers to
Receipts on long-term contracts is very vital to be on time due to the possible cash flow implications.
Credit insurance can be obtained against some bad debts. They usually are available for up to 75% of a company’s potential bad debt loss. The company will bare the 25% so it will not become slack with credit control and involve in overtrading.
Premium on a whole turnover policy are usually 1% of the insured sales.
Under an annual aggregate excess of loss policy, the insurer pays 100% of debts above an agreed limit. (Like car insurance, you have to pay the first $150 musahama)
Export credit insurance:
(a) Buyer risks also known as commercial risks. In international sales, credit period is longer and suing someone overseas is harder and longer, and more expensive. (b) Country risks also known as market risks or political risks. (cancelation or non-renewal
42 Factoring is an arrangement to have debts collected by a factor company which advances a proportion of the money it is due to collect.
They are two main reasons for factoring:
(a) If a business’s sales are rising rapidly, its total receivables will rise quickly too. (b) If a business grants long credit to its customer, it might runs into cash flow difficulties The main aspects of factoring are:
- Administration - Credit protection
- Advance of collection the debts *Read how factoring works page 364
Too many small invoices would be uneconomical for factoring. There are two methods of invoicing:
1) The factor to send out all the invoices
2) The company to send out the invoices and send a copy of every invoice to the factor In both cases payment is to the factor, and the factor is responsible for accounting for receivables.
EXAM FOCUS POINT: Explaining factoring and invoice discounting are common in exam
questions. However, you must also be prepared to ‘do the number’ and decide whether or not it is financially viable for a company to use them.
*Read advantages of factoring pg365.
Growth can be financed through sales rather than by injecting fresh external capital The business gets finance linked to its volume of sales. Unlike overdraft.
The main disadvantage of factoring is the cost. Another possible disadvg. is that customer will be making payments direct to the factor ,which some may give some a negative impression of the organization.
Invoice discounting is the purchase (by the provider of the discounting service) of trade debts at a discount. It allows the company to raise working capital.
The invoice discounter does not take over the administration of the client’s receivables ledger. Confidential invoice discounting is an arrangement whereby a debt is confidentially
43 assigned to the factor, and the client’s customer will only become aware of the arrangement if he does not pay his debt to the client.
More personal intervention should be:
Lower value --- Higher Value Letter E-mail Fax Telephone (expensive) Personal Visit (time consuming) *A valued supplier may threat to refuse to sell any goods until the debt is cleared.
Credit control necessarily involves as an expense to the business.
A doubtful debt is a debt which there is some uncertainty as to whether it will be paid (provision).
A bad (irrecoverable) debt is a debt which will not be paid
Even if a doubtful debt is eventually paid, additional expenses will occur: (i) The effect on cash flow, especially if the debt is large
(ii) The administration expenses of debt recovery procedures
Some of the accounting ratio calculated may be contradictory. For example, the company may post an increase in sales whereas in fact is overtrading and running out cash.
Z-scoring is a technique where a ‘solvency model’ is developed and chosen ratios are input to it to give the company a Z-score: the higher the score, the safer the company.
A-scoring is more subjective, but is based on three main pillars:
1) Defects: before a collapse a company will have many defects such as the company is dominated by a single individual, poor accounting systems, etc.
2) Mistakes borrows too much, overtrading, depends on the success of big projects 3) Symptoms Financial ratios, z-scoring are in decline, sudden changes of accounting
policies, non-financial signs (eg fall in market share)
*The sale department needs to know if a customer is failing to pay his debt, so no further sales (loses) are made to him.
Monitoring irrecoverable debts: bad debts/ revenue ratios pg376 a) Bad debts recognized refers to the time when the debt went bad b) Bad debts originated refers to the date when the sale was initially made
44 Debt collection agencies (credit collection agencies) are the most effective way of pursuing debts.
Most debt collection offers a ‘no collection, no fee’ basis. Some agencies require an advance subscription fee.
*Abritration page 379
Bankruptcy is where an individual’s property is sold for the creditors benefit.
Insolvency is when the assets of a company are taken over by a third party appointed by creditors.. The company is run until the debts are paid, or maybe be wound up. A company is insolvent when it is unable to pay its debts. Pg 380 compelte Questions ANSWER inCLUDE