FINANCIAL ANALYSIS
20.10 Interest coverage
3. Sales budget
Product November December January
Product X
Desired closing inventory of finished goods
1 200 50
1 000 45 Total budgeted production needs
Opening inventory of finished goods
1 250 (60)
1 045 (50)
Required production 1 190 995
5. Problems:
The company will not be able to achieve the requirement of settling the overdraft by the end of October.
Although the initial overdraft is expected to be eliminated in June, a study of the closing cash balance each month thereafter suggests that the cash balance is expected to get worse each month.
Except for the first 2 months, a cash shortfall is expected for the rest of the budgeted period.
The company expects a decline in sales each month from July to October.
Dealing with the problems:
The shop refurbishment could be postponed.
The company could obtain funds from the shareholders or other investors.
It may try to stimulate sales in some way.
Ways could be found to reduce overhead expenses.
Sales were declining, yet selling expenses are high – investigate this.
6.1 Raw material usage variance
(Actual quantity – Standard Quantity) X Standard price
= (20 050 – 20 000) X R5
= R250 (unfavourable)
Possible reasons for the variance:
Poor control over materials Faulty standards
Changes in the quality of material supplied Etc
6.2 Direct labour rate variance
(Actual rate – Standard rate) X Actual hours
= (R48 – R50) X 39 500
= R79 000 (favourable)
6.3 Direct labour efficiency variance
(Actual time worked – Standard time allowed) X Standard rate
= (39 500 hrs – 40 000 hrs) X R50
= R25 000 (favourable)
6.4 Variable overhead efficiency variance
(Actual hours – Standard hours) X Standard rate
= (39 500 – 40 000) X R11
= R5 500 (favourable)
7.1 Fixed overhead spending variance
Actual fixed overheads – Budgeted fixed overheads
= R79 808 – R76 800
= R3 008 (unfavourable)
7.2 Fixed overhead volume variance
Budgeted fixed overheads – Standard fixed overheads
= R76 800 – (1 680 units X 4 hrs X R12)
= R76 800 – R80 640
= R3 840 (favourable) Note:
Standard fixed overheads =
Number of units produced X Standard time to make 1 product X Standard rate per hr
Standard time to make 1 product = 6 400 hrs ÷ 1 600 units = 4 hours
Standard rate per hour = Standard fixed overheads ÷ standard number of labour hrs = R76 800 ÷ 6 400
= R12
7.3 Variable overhead efficiency variance
(Actual hours – Standard hours) X Standard rate
= (6 880 – 6 720) X R5
= R800 (unfavourable) Note
Standard hours = Number of units produced X Standard time to make 1 product
= 1 680 X 4 hours
= R6 720
Standard rate = R32 000 ÷ 6 400 hours = R5 Possible reasons for the variance:
Absenteeism
Efficiency of employees Working conditions Etc
8.1 R
Sales (8 000 000 X R12) 96 000 000
Variable costs (8 000 000 X R9) (72 000 000)
Contribution margin 24 000 000
Fixed costs (4 656 000)
Operating profit 19 344 000
8.2 R
Differential revenue from accepting the offer (2 000 000 X R8.90) 17 800 000 Differential cost by accepting the offer (2 000 000 X [R9 – R0.50]) (17 000 000) Differential profit from accepting the offer 800 000
Accept the offer as a differential profit of R800 000 is expected.
9. A comparison of the sales offer of R42 with the selling price of R63 indicates that the offer should be rejected. However, Femino Enterprises has excess capacity and one should focus on the relevant cost, which in this case is the variable cost. The
differential profit from accepting the offer is calculated as follows:
Differential revenue from accepting the offer:
6 000 units @ R42
Differential cost by accepting the offer:
6 000 units @ R30 (R15+R9+R6)
R252 000
(R180 000)
Differential profit from accepting the offer. R72 000
The offer should therefore be accepted.
10.
10.1 The relevant cost of internal production of each component is:
Variable cost of production of the component
Opportunity cost of lost production of the other product R15 R12 R27
It is obviously more costly (R27) than the R20 per component which will have to be paid to the subcontractor. Dubai Ltd should therefore subcontract the component.
10.2 Loss of control of quality Potential unreliability of supply Etc.
11. The relevant cost is the variable cost per unit which is calculated as follow:
R
Direct Material 866 000
Labour and other variable costs 844 000 Total variable costs 1 710 000 Number of units produced 8 500
Variable cost per unit
(R1 710 000 ÷ 8 500) R201.18
The variable cost of making the component (R201.18) is cheaper than buying it (R210). Trike Enterprises should therefore make the component in its plant.
12.1 Project A
Investment (920 000)
Year 1 Cash flow 400 000
(520 000)
Year 2 Cash flow 280 000
(240 000)
Year 3 Cash flow 200 000
(40 000)
Year 4 cash flow 200 000
Payback period is 3 years 3months Note:
R40 000_ X 12 mths R200 000
= 2.4 months
12.2 Accounting rate of return (Project A)
= Average annual profit X 100
Average investment 1
= R104 000 X 100
R420 000 1
= 24.76%
Note:
Depreciation = R800 000 – R40 000 5
= R760 000
5
= R152 000 per year
Calculation of accounting profit Cash
flow
– Depreciation/Scrap value = Accounting profit
Year Cash inflow Discount Factor
ARR is higher than the cost of capital.
NPV is positive.
13.
13.1 Project Turbo
Year Cash inflow Discount Factor
Project Turbo should be chosen since the NPV is positive. The NPV for project Gusto is negative and is therefore rejected.
13.2 Project Turbo Step 1
We notice that the NPV is positive, and above zero, but not by a large margin.
Step 2
We now pick a higher rate e.g. 13%. (Trial-and-error is used to obtain the higher rate.)
Project Gusto Step 1
We notice that the NPV is negative.
Step 2
We now pick a lower rate e.g. 10%. (Trial-and-error is used to obtain the higher rate.)
Year
Interpolation: The IRR is between 8% and 9%.
IRR = 8% + 2 303 1 606 + 2 303
= 8% + 2 303
3 909
= 8.59%
Decision: Project Turbo should be chosen as the IRR is greater.
14.
14.1 Payback period (Project F)
Investment (140 000)
Year 1 Cash flow 30 000
(110 000)
Year 2 Cash flow 36 000
(74 000)
Year 3 Cash flow 40 000
(34 000)
Year 4 Cash flow 44 000
Payback period is 3 years 10 months Note:
R34 000 X 12 mths R44 000
= 9.27 months
14.2 Accounting rate of return (Project F)
= Average annual profit X 100 Average investment
= R7 200 X 100
R80 000
= 9%
Note:
Depreciation = R140 000 – R20 000 5
= R120 000
5
= R24 000 per year
Calculation of accounting profit Cash flow – Depreciation/Scrap
value
Year Cash inflow Discount Factor
Project G
Year Cash inflow Discount Factor
14.4 Choose project G. The NPV is positive.
15. Use trial and error method
Year Cash
TOPIC 8
TRANSFER PRICING FOR DECENTRALISED ENTERPRISES
1. These are the actual prices that the supplying division sells the product to external clients for or they may the prices a competitor is offering. If a perfectly competitive market exists, the current market price is the most suitable basis for setting the transfer price. The supply of transfer goods at market prices usually results in optimal profits for the entire enterprise.
In a perfectly competitive market, the supplying division should supply as much as is required by the receiving division at the current market price. If the receiving
division’s demand is greater then the supplying division can meet, additional supplies must be obtained from an outside supplier at market price.
If the supplying division cannot sustain a profit in the long term at the current outside market price, then the enterprise will be better off not producing the product
internally. It should rather purchase from outside suppliers
2.
2.1 Negotiated prices is suited to circumstances where there is an external market for the goods supplied by the buying and selling divisions and where divisional managers are free to accept or reject offers made by other divisions.
Negotiated transfer prices are also appropriate when there are market imperfections for the product.
2.2 By not being able to sell outside the enterprise, the selling division is likely to be in a weak bargaining position and the transfer price may result in an under-par divisional performance. The inability of the manager of the selling division to negotiate with authority would affect the division’s profitability negatively.
3.
3.1 The transfer price of product Alpha using the variable cost method would be R8.
3.2 Variable cost per unit R8.00 Fixed cost per unit R2.00
Total cost R10.00
Profit (12%) R1.20
Transfer price R11.20
3.3 Using variable cost method
Transfer price R8.00
Variable cost per unit R15.00 Fixed cost per unit R7.00
Total cost R30.00
Profit (12%) R3.60
Selling price R33.60
Using cost plus method
Transfer price R11.20
Variable cost per unit R15.00 Fixed cost per unit R7.00
Total cost R33.20
Profit (12%) R3.98
Selling price R37.18
3.4 The biggest problem with this method is that the receiving division will generate a profit at the expense of the supplying division.
Quite often supplying divisions are reluctant to transfer their products at variable costs.
Another problem is that variable cost per unit may not be constant over the entire range of output as increases may occur.
Where the division is operating at full capacity, variable cost transfers will mean that inter-divisional sales will be less profitable than sales to external customers.
TOPIC 9
CORPORATE GOVERNANCE
1. Yes.
Directors often abused their powers with regard to the duration of their contracts.
Directors remained in their posts even though company performance was poor.
Etc or No.
Directors want job security.
May lead to instability in the company.
Etc
2. Good corporate governance requires that the board takes responsibility for creating and sustaining an ethical corporate culture in the company.
The establishment and maintenance of an ethical corporate culture requires the
governance of ethics, that is, that the board should ensure that the company has a well designed and properly implemented ethics management process consisting of the following four aspects:
Ethics risk and opportunity profile: The board should ensure that an ethics risk profile is compiled, reflecting the company's negative ethics risks (threats) as well as
its positive ethics risk (opportunities).
Code of ethics: The board should ensure that a company code of ethics is developed, stipulating the ethical values or standards as well as more specific guidelines guiding the company in its internal and external stakeholders.
Integrating ethics: The board should ensure that the company's ethical standards (code of ethics and related ethics policies) are integrated into the company's strategies and operations. This requires, among others, ethical leadership, management practices, structures and offices, education and training, communication and advice, and prevention and detection of misconduct for example, through whistle-blowing.
Ethics performance reporting and disclosure: The board should assess the company's ethics performance, and report and disclose findings to internal and external
stakeholders.
An ethical corporate culture will require that:
-ethical practices for directors is a non-negotiable requirement;
-the stewardship of a director is firstly towards the company and its shareholders.
-sound moral values and ethics are propagated by the conduct of individuals;
-the effectiveness of free enterprise and the market economy demands responsibility and it is important that business activity is directed by people with integrity, fairness and vision;
-because fair competition is fundamental to the free enterprise system directors support laws regulating restraints of trade, unfair practices, abuse or the unscrupulous use of economic power and avoidance of collusion; and
-ethics can never become an excuse for poor performance
3. The board should ensure that the company, as a responsible corporate citizen, does not undermine the sustainability of its social and natural environments, but rather protects and enhances them. Responsible corporate citizenship is necessary to protect the sustainability of the company and to ensure the ability of future generations to meet their needs. The interests of shareholders and stakeholders coincide over the long term.
4. Internal audit plays an important role in providing assurance to the management and the board regarding the effectiveness of internal controls.
The board should ensure that assurance of internal control procedures provides reliable, valid and timely information for purposes of monitoring and evaluating the management and company performance.
Internal controls should be established not only over financial matters but also operational, compliance and sustainability matters to manage the risks facing the company.
The board should ensure that the internal audit plan is risk-centric, and that the internal audit function has given the audit committee a written assessment of the adequacy of the internal controls.
This assessment should be discussed by the audit committee, which should report the outcomes of that discussion to the board.
5. Boards should ascertain whether potential directors are competent to be appointed and can contribute to the business decisions to be made by the board. Prior to their
appointment, their backgrounds should be investigated along the lines of the approach required for listed companies by the JSE. It is also important to ensure that new
directors have not been declared delinquent nor are serving probation in terms of section 162 of the Act. The nomination committee should play a role in this process.
6. This means that the board should report to its shareholders and other stakeholders on the company’s economic, social and environmental performance. Although a company is an economic institution, it remains a corporate citizen and therefore has to balance economic, social and environmental value.
The triple bottom line approach enhances the potential of a company to create economic value. It ensures that the economic, social and environmental resources the company requires to remain in business are treated responsibly. By looking beyond immediate financial gain, the company ensures that its reputation, its most significant asset, is protected. There is growing understanding in business that social and environmental issues have financial consequences.
The triple bottom line performance approach recognises the effect of the modern
company on society and the natural environment. It acknowledges that companies need to act with economic, social and environmental responsibility. It is unethical for
companies to expect society and future generations to carry the economic, social and environmental costs and burdens of its operations. Business itself needs to ensure that its impact on society and the natural environment is socially and environmentally
sustainable. Good corporate citizenship is the establishment of an ethical relationship of responsibility between the company and the society in which it operates. As good corporate citizens of the societies in which they do business, companies have, apart from rights, also legal and moral obligations in respect of their social and natural environments.
The company as a good corporate citizen should protect, enhance and invest in the wellbeing of society and the natural ecology. Corporate citizenship and sustainability require business decision makers to adopt a holistic approach to economic, social, and environmental issues in their core business strategy. Only a holistic approach will allow for the effective management of business opportunities and risks.
The expectation that business has an important role to play in responding to social and environmental challenges has become widely accepted. The debate on the need for voluntary business action or government regulation is being superseded by an understanding that an appropriate mix of both approaches is important.
7. Conscience: A director should act with intellectual honesty in the best interest of the company and all its stakeholders in accordance with the enlightened shareholder value approach. Conflicts of interest should be avoided. Independence of mind should prevail to ensure the best interest of the company and its stakeholders is served.
Care: A director should devote serious attention to the affairs of the company. Relevant information required for exercising effective control and providing innovative direction to the company needs to be acquired.
Competence: A director should have the knowledge and skills required for governing a company effectively. This competence should be developed continuously. Willingness to be regularly reviewed is a prerequisite for ensuring competence
Commitment: A director should be diligent in performing directors’ duties. Sufficient time should be devoted to company affairs. Effort needs to be put into ensuring company performance and conformance.
Courage: A director should have the courage to take the risks associated with directing and controlling a successful sustainable enterprise, but also the courage to act with integrity in all board decisions and activities.
8. External audit is an independent assurance function performed primarily for the benefit of the shareholders.
The objective of an audit of financial statements is to enable the auditor to express an opinion as to whether the financial statements fairly present, in all material respects, the financial position of the company at a specific date and the results of operations and cash flow information for the period ended on that date, in accordance with an identified financial reporting framework and/or statutory requirements.
The auditor’s opinion enhances the credibility of the financial statements, but does not guarantee the future viability of the company or the effectiveness or efficiency with which the management has conducted the affairs of the company.