ADVANCED CERTIFICATE IN FINANCIAL
PLANNING
FINANCIAL MANAGEMENT
STUDY GUIDE
Copyright © 2016
MANAGEMENT COLLEGE OF SOUTHERN AFRICA
All rights reserved; no part of this book may be reproduced in any form or by any means, including photocopying machines, without the written permission of the publisher. Please report all errors and omissions to the following email address:
MODULE CONTENTS
FINANCIAL MANAGEMENT
TOPICNUMBER TOPIC PAGE(S)
Preface 1
Reading, Aim of the Module and Module Outcomes 2
1 Financial Management: Important concepts 4
2 Financial projection 16
3 Management of working capital 34
4 Capital expenditure decisions 65
5 Financing decisions: Sources and costs 83
6 Financial Analysis 94
7 Budgets 121
PREFACE
Throughout the module, think points and illustrative examples have been included. Self-assessment activities and solutions appear at the end of each topic in order to test your understanding of the section. You are strongly advised to do the self-assessment activities after studying each topic as it will stimulate your interest and enhance your understanding of the work covered in the section.
In order to ensure a quality module, a number of reference books have been consulted to draw up this module. Since no single textbook covers all the topics of this module adequately, no textbook is prescribed. In order to enhance your knowledge, you are advised to consult the recommended books that are indicated at the start of each topic.
READING Prescribed
There is no prescribed book for this module. This study guide will serve as your prescribed reading.
Additional reading
The following books are recommended for further reading. The books that are recommended for each topic are indicated at the start of the topic.
► Correia, C., Langfield-Smith, K., Thorne, H. and Wilton, R.W. (2008) Management Accounting: Information for managing and creating value. 1st Edition. Berkshire: McGraw-Hill Education.
► Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6th Edition. Cape Town: Oxford University Press.
► Dempsey, A. and Pieters. (2005) H.N.Introduction to Financial Accounting 5th
Edition. Durban: LexisNexis.
► Hampton, J.J. (2003) Financial Decision Making: Concepts, Problems and Cases. 4th
Edition. New Delhi: Prentice-Hall.
► Helfert, E.A. (2003) Techniques of Financial Analysis. 11th
Edition. New York: McGraw-Hill/Irwin.
► Higgins, R.C. (2007) Analysis for Financial Management. 8th
Edition. New York: McGraw-Hill/Irwin.
► Keown, A., Martin, J.D., Petty, J.W. and David, F.J. (2002) Financial Management: Principles and Applications. 9th Edition. New Delhi: Prentice-Hall.
► Marshall, D.H., Mcmanus W.W. and Viele D.F. (2007) Accounting: What the numbers mean. 7th Edition. New York: McGraw-Hill.
► McLaney, E. (2003) Business Finance: Theory and Practice. 6th
Edition. Essex: Prentice Hall.
► Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1st Edition. North Ryde: McDraw-Hill.
► Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5th Edition. Durban: LexisNexis Butterworths. ► Van Horne, J.C. and Wachowicz Jr., J.M. (2003) Fundamentals of Financial
AIM OF THE MODULE
The aim of this module is to introduce you to the concepts of financial management and to understand the role of the financial manager in a business environment.
MODULE OUTCOMES
Upon successful completion of this module, the student should be able to:
Explain the responsibilities of the financial function and financial management. Discuss the goals of financial management in the pursuit of maximising wealth. Familiar with the important concepts used in financial management.
Distinguish between fixed capital and working capital. Explain the significance of cash budgets.
Implement appropriate strategies in the management of each of the elements of working capital.
Explain the costs and risks associated with cash and credit. Discuss the capital expenditure process.
Distinguish between capital and money markets. Identify the sources financing.
Calculate and interpret financial ratios.
Explain and undertake the process of budgeting.
TOPIC 1
FINANCIAL MANAGEMENT: IMPORTANT CONCEPTS
LEARNING OUTCOMES Students should be able to:
explain the responsibilities of the financial function and financial management. discuss the goals of financial management in the pursuit of maximising wealth. familiarise themselves with the important concepts used in financial management. distinguish between fixed capital and working capital.
CONTENTS
1. Introduction 2. Financial function 3. Financial management
4. Goals of financial management
5. Important concepts in financial management 6. Self-assessment activities
READING Recommended reading
► Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6th Edition. Cape Town: Oxford University Press. pp.393-400
► Hampton, J.J. (2003) Financial Decision Making: Concepts, Problems and Cases. 4th
Edition. New Delhi: Prentice-Hall. pp. 1-18
► Van Horne, J.C. and Wachowicz Jr., J.M. (2003) Fundamentals of Financial Management. 11th Edition. New Delhi: Prentice-Hall. pp.2-7
1. INTRODUCTION
According to Hampton (2003: 1) the role of the financial manager has changed considerably over the years. Traditionally, their roles involved accurate record keeping, preparation of financial statements, and managing cash. Nowadays financial managers are involved with the amount of capital employed by the firm, the allocation of funds to various projects and activities, and the measurement of the results of each allocation. Financial managers need to acquire skills to make correct decisions in a fast-moving and technologically changing environment.
THINK POINT 1!
A student asks: “I have no intention of becoming a financial manager, so why do I need to understand financial management?”
Respond to this question.
2. FINANCIAL FUNCTION
Cronje et al. (2004:393) state that a business must acquire assets such as property, machinery, vehicles, equipment, raw materials and trade inventories in order to function efficiently. Resources such as management and labour, services such as electricity, and communication facilities are also required. In order to obtain the required assets, resources and services, a business requires funds (capital). Suppliers of these funds expected to be satisfactorily rewarded for making their funds available to the business as soon as income is generated through sales. Funds therefore flow continually to and from the business.
Cronje et al. (2004:394) add that it is with this flow of funds that the financial function is concerned with. In particular the financial function is concerned with: ■ the acquisition of funds (called financing),
■ the application of funds to acquire assets (called investment), and ■ the administration of, and reporting on, financial matters.
3. FINANCIAL MANAGEMENT
Financial management, according to Cronje et al. (2004:394), is responsible for the efficient management of all facets of the financial function. It must contribute to the achievement of the main objective of the enterprise (i.e. maximisation of shareholder wealth) through the performance of the following tasks:
■ Efficient financial analysis, reporting, planning, and control ■ Managing the acquisition of funds
■ Managing the application of funds
Horne and Wachowicz (2003:7) illustrates how financial management fits into the operations of a typical manufacturing firm:
Figure 1-1
BOARD OF DIRECTORS
PRESIDENT (Chief Executive Officer) VICE PRESIDENT Operations VICE PRESIDENT Finance VICE PRESIDENT Marketing TREASURER *Capital budgeting *Cash management *Commercial banking *Credit management *Financial analysis *Financial planning *Investor relations *Risk management *Tax planning CONTROLLER *Cost accounting *Cost management *Data processing *General ledger *Government reporting *Internal control *Financial statements *Prepare budgets *Prepare forecasts
The Vice President of finance (or Chief Financial Officer) usually reports to the President or Chief Executive Officer. The controller’s responsibilities are largely accounting in nature. The responsibilities of the treasurer falls into decision areas usually associated with financial management.
4. GOALS OF FINANCIAL MANAGEMENT
The specific goals of financial management in pursuit of maximising wealth, according to Hampton (2003:9), may be summarised as follows:
■ Maximise profit: Finance should aim towards a high level of primary long-term and
secondarily short-term profits for the enterprise.
■ Minimise risk: Finance should always pursue courses of action that avoid
unnecessary risks and try to anticipate problem areas.
■ Maintain control: There must be constant monitoring of funds that flow in and out
of the enterprise to ensure that they are safeguarded and properly utilised.
■ Achieve flexibility: Learning to deal with an uncertain future is important. It is
through careful management of funds and activities that flexibility is gained. If the enterprise has identified adequate sources of funds in advance of needs, it will be flexible when cash is required.
■ Liquidity: The enterprise must have sufficient cash at all times to meet its
obligations.
5. IMPORTANT CONCEPTS IN FINANCIAL MANAGEMENT
Important concepts in financial management include the following:
■ Capital ■ Money market and capital market
■ Financial statements ■ Financial structure
■ Investment ■ Financing
■ Liquidity ■ Solvency
■ Profitability
5.1 Capital
Capital may be defined as the funds invested in an enterprise. Capital may also include funds that have been earned by the enterprise but not distributed to the
enterprise one needs to estimate the fixed capital requirements as well as working capital requirements.
Fixed capital refers to capital that is required for acquisition of non-current assets
such as land, buildings, machinery, equipment, and vehicles. Assets are resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. Non-current assets are assets that have a useful life of more than one year.
Working capital is capital required to obtain current assets. Current assets are assets
that are expected to be turned into cash within a year e.g. inventories/materials, credit allowed to debtors.
Capital may be classified as follows:
■ Short-term capital: is capital usually available for a period of up to a year.
■ Medium-term capital: is capital available for a period between one and five years.
■ Long-term capital: is capital that is made available for a period of five years or
more.
Capital may be obtained from the following sources:
■ Own capital: is capital provided by the owner(s) of the enterprise.
■ Borrowed capital: is capital that is obtained from banks and other financial
institutions on which interest is payable.
5.2 Money market and capital market
When enterprise needs to borrow funds, it can approach institutions in the money market or capital market. The money market consists of institutions and individuals who lend or borrow money in the short-term i.e. for a period of one day or for months e.g. a bank overdraft facility. The period of transactions depends on the needs of users and institutions with a shortage of funds. The capital market consists of institutions and individuals who lend or borrow money in the long-term e.g. a mortgage bond repayable over a period of 20 years.
5.3 Financial statements
Financial statements report on the financial position of an organisation at a certain point in time and the changes in the financial position over a period of time. The financial statements and what they are intended to report on are illustrated below:
FINANCIAL STATEMENT REPORTS ON:
Statement of Financial Position (Balance sheet)
Financial position on a certain date.
Statement of Comprehensive Income (Income Statement)
Profit for a particular period.
Statement of Changes in Equity Investments by and distributions to owners. Statement of Cash Flows Cash flows during the period.
5.4 Financial structure
The financial structure of an enterprise is graphically illustrated in the form of the statement of financial position (balance sheet). The balance sheet reports on the financial position of an organisation at a specified point in time. It is basically a summary of an organisation’s assets, equity and liabilities at a point in time. This is illustrated below: Figure 1-2 ASSETS Non-current assets Current assets Asset structure: Investment/ Application of funds
EQUITY AND LIABILITIES Equity Liabilities Non-current liabilities Current liabilities Capital structure: Financing/ Suppliers of funds
The following are brief explanations of the main items in the balance sheet:
distinction between current assets and non-current assets.)
Liabilities are claims on the assets of an organisation. Simply put, it refers to what an
organisation owes. Non-current liabilities are debts that are payable after more than one year from the balance sheet date. Current liabilities are debts that are payable with 12 months of the balance sheet date.
Equity or Owner’s equity may be viewed as the residual claim that the owner(s) has
on the assets of the organisation after all the liabilities have been settled. It normally consists of two parts viz. that which is invested in the organisation and that which is earned by the organisation and left in the organisation (i.e. retained profits).
5.5 Investment
Investment may be described as the use of capital to acquire non-current assets such as property and machinery to be put to productive use as well the acquisition of current assets such as inventories in order to generate income.
5.6 Financing
This refers to various ways by which an enterprise obtains its funds in order to meet its capital needs. Financing may be secured from owners, suppliers, and creditors while other funds may arise from the retained earnings in the enterprise.
5.7 Liquidity
Liquidity is the measure of the ability of an enterprise to have sufficient cash on hand to meet its obligations at all times. In other words, the enterprise can pay all its bills when due.
5.8 Solvency
Solvency refers to the ability of an enterprise to be able to repay its debts and satisfy any claims against it. The total debt (liabilities) must be covered by a realistic value of the total assets. An enterprise is considered to be insolvent if the total liabilities exceed the realistic value of assets.
5.9 Profitability
Profitability is the effectiveness with which an enterprise has employed both the total assets and the net assets (equity). This is assessed by relating net profit to resources utilised in generating the profit. Measures to assess profitability are discussed in topic 6.
6. SELF-ASSESSMENT ACTIVITIES
6.1 Match the terms in column A with the statements in column B. Write down the letter of the correct answer.
Column A Column B 1. Assets 2. Non-current assets 3. Current assets 4. Equity 5. Liabilities 6. Non-current liabilities 7. Current liabilities 8. Investment 9. Financing 10. Liquidity 11. Solvency 12. Profitability A B C D E F G H I J K L
The residual claim that the owner(s) has on the assets of the organisation after all the liabilities have been settled.
Debts that are payable within 1 year of the balance sheet date. The resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. The claims on the assets of an organisation.
The various ways by which an enterprise obtains its funds in order to meet its capital needs.
The use of capital to acquire non-current assets to be put to productive use as well the acquisition of current assets. The measure of the ability of an enterprise to have sufficient cash on hand to meet its obligations at all times.
The ability of an enterprise to be able to repay its debts and satisfy any claims against it.
Assets that have a useful life of more than one year. Debts that are payable after more than one year from the balance sheet date.
The effectiveness with which an enterprise has employed both the total assets and the net assets (equity).
Assets that are expected to be turned into cash within a year.
6.3 Explain the following goals of financial management: ■ Maximise profit ■ Minimise risk ■ Maintain control ■ Achieve flexibility ■ Liquidity
6.4 Briefly state the function of each of the following financial statements. ■ Statement of financial position (Balance sheet)
■ Statement of comprehensive income (Income statement) ■ Statement of changes in equity
■ Statement of cash flows
6.5 Study the following information and answer the questions that follow.
Pixma Limited began operations in January 20.08 with R900 000 obtained from selling 450 000 ordinary shares at a par value of R2 each.
During the year it purchased plant and equipment for R750 000 and land for
R450 000, financing the purchase with a mortgage bond of R287 500, a long-term loan of R595 000, and cash for the balance.
On 31 December 20.08:
The amount owing by trade debtors totaled R43 000. R32 000 was owing to trade creditors.
Inventories on hand amounted to R67 000. The bank balance was overdrawn by R24 000.
Retained earnings at the end of the financial year amounted to R30 000.
Calculate the following on 31 December 20.08: 6.5.1 Own capital
6.5.2 Borrowed capital 6.5.3 Current assets 6.5.4 Non-current assets
6.5.5 Total assets 6.5.6 Equity 6.5.7 Non-current liabilities 6.5.8 Current liabilities 6.5.9 Total liabilities 7. SOLUTIONS THINK POINT 1!
One needs to prepare oneself for the workplace of the future. In order to reduce costs, many businesses are reducing management jobs and squeezing together the various layers of the corporate pyramid. Consequently, the responsibilities of the remaining managers are being broadened. A successful manager must be able to move both vertically and horizontally within an organisation. Therefore, mastery of basic financial management skills is important requisite in the workplace.
6.1 1. C 2. I 3. L 4. A 5. D 6. J 7. B 8. F 9. E 10. G 11. H 12. K
6.2 Financial management is responsible for the efficient management of all facets of the financial function. It must contribute to the achievement of the main objective of the
6.3 Refer to paragraph 4. 6.4 Refer to paragraph 5.3. 6.5 Amount (R) Workings 6.5.1 Own capital 930 000 R900 000 + R30 000 6.5.2 Borrowed capital 882 500 R287 500 + R595 000 6.5.3 Current assets 110 000 R43 000 + R67 000 6.5.4 Non-current assets 1 200 000 R750 000 + R450 000 6.5.5 Total assets 1 310 000 R110 000 + R1 200 000 6.5.6 Equity 930 000 R900 000 + R30 000 6.5.7 Non-current liabilities 882 500 R287 500 + R595 000 6.5.8 Current liabilities 56 000 R32 000 + R24 000 6.5.9 Total liabilities 938 500 R882 500 + R56 000
TOPIC 2
FINANCIAL PROJECTION
LEARNING OUTCOMES Students should be able to:
explain the purpose of pro forma statements.
prepare pro forma income statements and balance sheet. explain the significance of cash budgets.
CONTENTS
1. Introduction
2. Pro forma financial statements 3. Cash budgets
4. Self-assessment activities
READING Recommended reading
► Helfert, E.A. (2003) Techniques of Financial Analysis. 11th
Edition. New York: McGraw-Hill/Irwin. pp. 171-199
► Higgins, R.C. (2007) Analysis for Financial Management. 8th
Edition. New York: McGraw-Hill/Irwin. pp. 87-107
1. INTRODUCTION
According to Helfert (2003:171) business plans are usually structured around specific goals and objectives. The plans usually outline strategies and actions for achieving desired short-term, medium-term and long-term results. Eventually these plans are quantified in financial terms, in the form of pro forma statements (projected financial statements). Greater insight into the funding implications of projected activities may be gained through the use of detailed cash budgets and cash flow statements. The main techniques of financial projection may fall into two categories:
■ Pro forma financial statements ■ Cash budgets
2. PRO FORMA STATEMENTS
According to Higgins (2007:87) pro forma statements are the most widely used means for financial projection (forecasting). Pro forma statements can be simply described as a prediction of what the company’s financial statements will look like at the end of the forecast period. They include an income statement and a related balance sheet. A third key statement, the cash flow statement, may be prepared to display the expected movement of funds during the forecast period.
One of the main purposes of pro forma statements is to estimate a company’s future need for external funding, which is an important first step in financial planning. The process can simply be described as follows:
If the forecast indicates that the enterprise’s assets will increase to R400 000, but liabilities and owners’ equity will only amount to R300 000, then one can assume that R100 000 in external funding is required.
THINK POINT 1!
What deduction would you make if the pro forma statements of an enterprise indicate that assets will fall below projected liabilities and owners’ equity?
Put in the form of an equation, one could say that:
External funding required = Total assets – (Liabilities + Owners’ equity)
2.1 Pro Forma Income statement
This statement represents a broad operational outlook for the enterprise. It projects the amount of profit the enterprise expects to earn for the forecast period. The pro forma income statement is prepared first because the amount of after-tax profit developed here must later be reflected in the pro forma balance sheet. The following four steps may be followed in developing a pro forma income statement:
■ Sales projection
■ Determine production (or purchases) schedule, cost of sales and gross profit ■ Estimate other expenses
■ Calculate expected profit by completing the pro forma income statement.
These steps will be explained using the example of Dunbar Manufacturers.
Step 1: Sales projection
The starting point for the income statement is a forecast of the unit and Rand value of sales. This may be estimated in a number of ways ranging from trend-line projections to detailed departmental forecasts by individual product. Assume that Dunbar Manufacturers estimates that its sales for the first six months of 20.9 to be R200 000. This comprises the sale of 1 000 units at a price of R200 per unit. This may be illustrated in Figure 2-1 as follows:
Figure 2-1
Sales projection for 6 months 1 000 units @ R200 each = R200 000
Step 2: Determine production (or purchases) schedule, cost of sales and gross profit
Based on the sales projection, the production plan (or purchases plan in the case of a merchandising enterprise) may now be determined. The number of units to be produced will depend upon of following three factors:
■ Opening inventory ■ Sales forecast ■ Closing inventory.
Suppose that Dunbar Manufacturers expects an opening inventory of 150 units at R120 each and that its desired closing inventory is 200 units. The number of units that should be produced for the forecast period (6 months) is calculated in Figure 2-2:
Figure 2-2
Production requirements for 6 months
Sales forecast (See Figure 2-1) 1 000 units Add: Desired closing inventory 200 units Total budgeted production/purchasing needs 1 200 units
Opening inventory (150) units
Required production/purchases 1 050 units
We now examine the cost of producing these 1 050 units. Assume that Dunbar Manufacturers expect a 10% increase in all production costs. If the unit production cost of R120 (as indicated in the cost of opening inventory) comprises direct materials R60, direct labour R40 and factory overheads R20, then a 10% increase will result in the unit cost increasing by R12 as seen in Figure 2-3 below:
Figure 2-3
Unit cost R
Direct materials 66
Direct labour 44
Factory overheads 22
Total unit cost 132
The total cost of producing the required number of units may be calculated as follows:
Figure 2-4
Total production cost for 6 months 1 050 units @ R132 each = R138 600
Now that the sales projection and production costs are available, the costs of sales can be determined. The value of cost of sales depends upon the inventory valuation method used. Suppose that Dunbar Manufacturers uses the FIFO (first-in-first-out) method. Using this method, the cost of sales will be calculated firstly from the sale of the opening inventory and then from the sale of the goods to be manufactured during the forecast period. The calculation is illustrated in Figure 2-5 below:
Figure 2-5
Cost of sales for 6 months R
Opening inventory 150 units @ R120 18 000 Production
Total inventory
Less: Closing inventory
1 050 @ R132 200 @ R132 138 600 156 600 (26 400)
Expected cost of sales 130 200
Using the FIFO method, Dunbar Manufacturers expected sales of 1 000 units would first come from the 150 units (at R120) in opening inventory. The remaining 850 units would come from the production of 1 050 units. This would result in the desired closing inventory of 200 units. The value of the closing inventory is required for the balance sheet and may be calculated as follows:
Figure 2-6
Value of closing inventory R
Opening inventory (Figure 2-5) 18 000 Total production cost (Figure 2-4) 138 600 Total inventory available for sale 156 600 Cost of sales (Figure 2-5) (130 200)
Closing inventory 26 400
OR
200 units @ R132 = R26 400
Step 3: Estimate other expenses
The figures from the previous period are often used as a base for expense projections. Estimates are required for selling, general, administrative and other operating
expenses. Interest expense is then charged according to the provisions of the enterprise’s outstanding debt. The income statement will be complete once the income tax (not applicable to sole proprietorships and partnerships) is estimated to determine the profit after tax.
In the case of Dunbar Manufacturers the following estimates apply: General and administrative expenses
Interest expense Tax
R13 000 R2 400 25%
Step 4: Calculate expected profit by completing the pro forma income statement Using estimates and other information from steps 1 to 3, the pro forma income statement of Dunbar Manufacturers can now be drawn up:
Figure 2-7
Pro Forma Income Statement for 20.7
R
Sales 200 000
Cost of sales (130 200)
Gross profit 69 800
General and administrative expenses (13 000) Income from operations (Operating income) 56 800
Interest expense (2 400)
Profit before tax 54 400
Tax (13 600)
Net profit after tax 40 800
2.2 Preparing pro forma income statement and pro forma balance sheet using the percentage-of-sales method
According to Higgins (2007:88) a straight forward yet effective way to forecast is to tie many of the income statement and balance sheet figures to future sales. The rationale for this approach is the tendency for variable costs and most current assets and current liabilities to vary directly with sales. Obviously, this will not hold true for all items in the financial statements, and certainly some independent estimates of individual items will be required.
Percentage-of-sales forecast may be done using the following three steps: Step 1
Examine historical data to determine which financial statement items varied in proportion to sales in the past. This enables the forecaster to determine which items can be safely estimated as a percentage of sales and which must be forecast using other information.
Step 2
A forecast of sales must now be done. Since many items are linked to the sales forecast, it is important to estimate sales as accurately as possible.
Step 3
if inventories have historically been about 15% of sales and next year’s sales are forecast to be R1 000 000, then one would expect inventories to be R150 000.
Consider the income statement of Dino Ltd for 20.8: Figure 2-8
Income Statement for 20.8
R
Sales 240 000
Cost of sales (160 000)
Gross profit 80 000
Operating expenses (36 000)
Income from operations (Operating income) 44 000
Interest expense (4 000)
Profit before tax 40 000
Tax (25%) (10 000)
Net profit after tax 30 000
If Dino Ltd identified cost of sales, operating expenses and interest expense as varying in proportion to sales in the past, then the following percentages would be obtained:
Figure 2-9
Expenses expressed as a percentage of sales
Cost of sales = R160 000 = 66.667% Sales R240 000 Operating expenses = R36 000 = 15% Sales R240 000 Interest expense = R4 000 = 1.667% Sales R240 000
If the sales forecast of Dino Ltd for 20.9 is R300 000, then the pro forma income statement for 20.9 will appear as follows:
Figure 2-10
Pro Forma Income Statement for 20.9
R
Sales 300 000
Cost of sales (66.667% of R300 000) (200 000)
Gross profit 100 000
Operating expenses (15% of R300 000) (45 000) Income from operations (Operating income) 55 000 Interest expense (1.667% of R300 000) (5 000)
Profit before tax 50 000
Tax (25%) of profit before tax) (12 500)
Net profit after tax 37 500
Consider the balance sheet of Dino Ltd for 20.9:
Figure 2-11 Dino Ltd
Balance sheet for 20.9
Percentage of sales of R300 000 R ASSETS Non-current assets Equipment 80 000 26.667% Current assets 140 000 46.667% Inventories 50 000 16.667% Accounts receivable 80 000 26.667%
Cash and cash equivalents 10 000 3.333%
EQUITY AND LIABILITIES Equity 160 000 53.333% Non-current liabilities - 0 Current liabilities Accounts payable 60 000 20%
Total equity and liabilities 220 000 73.333%
From the above one observes that the equipment represents 26.667% of sales, inventories of R50 000 is 16.667% of sales and so on. Total assets represent 73.333% of sales.
Let us assume that the sales of Dino Ltd is expected to increase from R300 000 to R450 000 for 20.10. We further assume that the after tax return on sales is 20% and 66.667% of profits is paid out in dividends. Based on these figures, expected profit is R90 000 (20% of R450 000) of which R60 000 will be paid out as dividends. The pro forma balance sheet for 20.10 is expected to be as follows:
Figure 2-12
Pro Forma Balance Sheet for 20.10
R ASSETS Non-current assets Equipment 120 000 Current assets 210 000 Inventories 75 000 Accounts receivable 120 000
Cash and cash equivalents 15 000
EQUITY AND LIABILITIES
Equity 190 000 (160 000 + 30 000 Retained
profit) Non-current liabilities
External funding required ?
Current liabilities
Accounts payable 90 000
Total equity and liabilities ?
The percentages obtained from figure 2-11 were used to calculate the amounts for 20.10 with the exception of equity. For example, the equipment figure of R120 000 is 26.667% of the expected sales of R450 000 for 20.10. Equity increases by the portion of the net profit that is not expected to be given as dividends i.e. the portion retained by the company.
Total equity and current liabilities add up to R280 000 which is R50 000 less than the total assets of R330 000. The R50 000 represents the external funding required. This may be represented as follows:
External funding required = = = =
Total assets – (Current Liabilities + Equity) R330 000 – (90 000 + 190 000)
R330 000 – R280 000 R50 000
3. CASH BUDGETS
Higgins (2007:105) describes a cash budget as a simple listing of projected cash receipts and payments over a forecast period for the purpose of anticipating future cash shortages or surpluses. Company accounts are based on accrual accounting while cash budgets use strictly cash accounting. This necessitates translating projections regarding sales and purchases into their cash equivalents. For example, if customers are granted 60-day terms, cash receipts from debtors in any month would represent the credit sales made two months earlier.
Helfert (2003:185) states that when preparing a cash budget, a time schedule of estimated receipts and payments of cash are stated. This schedule shows, period by period, the net effect of projected activity on the cash balance. Items that do not represent cash flows e.g. depreciation are omitted. The time intervals selected may be daily, weekly, monthly, or even quarterly.
THINK POINT 2!
Drawing up a cash budget is time-consuming. So why do you think an enterprise may find it necessary to do day-by-day projections (day-by-day budget)?
Figure 2-13 shows a typical format of a cash budget:
Figure 2-13
Dino Limited
Cash budget for the period 01 April to 30 June 20.9
April May June
Cash receipts 27 000 28 500 29 000
Cash sales
Receipts from debtors
15 000 12 000 16 000 12 500 18 000 11 000 Cash payments (20 920) (21 320) 22 520
Cash purchases of merchandise Payments to creditors for merchandise Operating expenses Interest on loan 8 000 9 000 3 500 420 9 000 8 500 3 400 420 9 500 9 000 3 600 420
Cash surplus (shortfall) 6 080 7 180 6 480
Opening cash balance 8 000 14 080 21 260
Closing cash balance 14 080 21 260 27 740
Since the preparation of cash budgets is discussed extensively in topic 7, it will not be duplicated here.
4. SELF-ASSESSMENT ACTIVITIES
4.1 Brad Limited sells a single product at a selling price of R50 per unit. The estimated sales volume for the next 4 months of 20.9 is as follows:
Units April May June July 7 000 10 000 8 000 9 000
■ Management’s policy is to maintain ending finished goods inventory each month at a level equal to 50% of the next month’s budgeted sales. The finished goods inventory on 31 March 20.9 was 3 500 units.
■ To make one unit of finished product, 3 kilograms of materials are required. The cost per kilogram of raw material is R6.
■ Other production costs per unit as at 31 march 20.9 are as follows: Direct labour
Overheads
R10 R7
As from 01 April 20.9 direct labour costs are expected to increase by 10%. Overheads are expected to increase by 2%.
Required
4.1.1 Prepare the sales budget for April, May and June 20.9.
4.1.2 Calculate the number of units that must be produced for April, May and June 20.9. 4.1.3 Calculate the total production cost for April, May and June 20.9.
4.1.4 Calculate the cost of sales for April, May and June 20.9 using the FIFO method. 4.1.5 Calculate the value of closing inventory on 30 June 20.9.
4.2 In November 20.8 GHI Manufacturers started making budget plans for the 12 months commencing 01 January 20.9. Projected sales volume was R8 700 000 as compared to an estimated R7 350 000 for the financial year ended 31 December 20.8. The best estimates of the operating results for the current year (20.8) are shown in the income statement below. Following this statement are the specific working assumptions with which to plan the financial results for the next year.
Income Statement for 20.8 R Sales 7 350 000 Cost of sales (4 634 000) Labour Materials Overheads Depreciation 1 838 000 1 044 000 1 486 000 266 000 Gross profit 2 716 000 Selling expenses
General and administrative expenses
(610 000) (646 000)
Profit before tax 1 460 000
Tax (438 000)
Net profit 1 022 000
Assumptions for the financial year 20.9:
■ Manufacturing labour will fall to 24% of sales because volume efficiency would more than offset higher wage rates.
■ Materials cost would increase to 14.5% of sales because some price increases wouldn’t be offset by better utilisation.
■ Overhead costs would rise above the current level by 6% of the 20.8 Rand amount, reflecting higher costs. Additional variable costs would be incurred at the rate of 11% of the incremental sales volume.
■ Depreciation will increase by R20 000, reflecting the addition of some production machinery.
■ Selling expenses would rise more proportionately, by R250 000, since additional effort would be required to increase sales volume.
■ General administrative expenses would drop to 8.1% of sales. ■ Taxation is estimated at 30% of pre-tax profits.
5. SOLUTIONS THINK POINT 1!
The obvious implication is that the enterprise will generate more cash than necessary to run the business. Management will then have to decide how best to utilise the excess.
THINK POINT 2!
If daily fluctuations in cash are likely to be large, as in the banking business, then day-to-day projections are necessary.
4.1.1 Sales budget for April, May and June 20.9 Units Unit price (R) Budgeted Sales (R) April May June 7 000 10 000 8 000 R50 R50 R50 350 000 500 000 400 000 4.1.2
Production requirements (units)
April May June
Sales forecast 7 000 10 000 8 000
Desired closing inventory 5 000 4 000 4 500
Total budgeted production needs 12 000 14 000 12 500
Opening inventory (3 500) (5 000) (4 000) Required production 8 500 9 000 8 500 4.1.3 Unit cost R Direct materials 18.00 (3kg X R6) Direct labour 11.00 (R10 + R1) Factory overheads 7.14 (R7 + R0.14)
Total production cost
April May June
Required production (units) 8 500 9 000 8 500
X Unit cost R36.14 R36.14 R36.14
Total production cost R307 190 R325 260 R307 190
4.1.4
Cost of sales for April R
Opening inventory [(R18+R10+R7) X 3 500] 122 500 Production (8 500 – 5 000) [R36.14 X 3 500] 126 490
Expected cost of sales 248 990
Cost of sales for May R
Opening inventory [R36.14 X 5 000] 180 700
Production (9 000 – 4 000) [R36.14 X 5 000] 180 700
Expected cost of sales 361 400
Cost of sales for June R
Opening inventory [R36.14 X 4 000] 144 560
Production (8 500 – 4 500) [R36.14 X 4 000] 144 560
Expected cost of sales 289 120
4.1.5
Value of closing inventory April (R) May (R) June (R)
Opening inventory 122 500 180 700 144 560
Total production cost 307 190 325 260 307 190
Total inventory available for sale 429 690 505 960 451 750
Cost of sales (248 990) (361 400) (289 120)
OR April May June 5 000 X R36.14 4 000 X R36.14 4 500 X R36.14 = R180 700 = R144 560 = R162 630 4.2 GHI Manufacturers
Pro Forma Income statement for 20.9
R Sales 8 700 000 Cost of sales (5 359 160) Labour Materials Overheads Depreciation 2 088 000 1 261 500 1 723 660 286 000 [8 700 000 X 24%] [8 700 000 X 14.5%] [1 486 000 + 89 160* + 148 500**] [266 000 + 20 000] Gross profit 3 340 840 Selling expenses
General and administrative expenses
(860 000) (704 700)
[610 000 + 250 000] [8 700 000 X 8.1%]
Profit before tax 1 776 140
Tax (532 842) [1 776 140 X 30%] Net profit 1 243 298 N.B. * ** Overheads: 1 486 000 X 6% = 89 160 (8 700 000 – 7 350 000) = 1 350 000 X 11% = 148 500
TOPIC 3
MANAGEMENT OF WORKING CAPITAL
LEARNING OUTCOMES Students should be able to:
describe the cycle of working capital of manufacturers and traders.
implement appropriate strategies in the management of each of the elements of working capital
explain the costs and risks of holding cash and of holding little or no cash. provide reasons for the granting of credit.
discuss the costs and risks of granting credit and of denying credit. provide reasons for holding inventory.
identify the costs and risks of holding inventory and of holding little or no inventory.
elaborate on the costs and risks of taking credit and of not taking credit. explain the use of liquidity ratios.
CONTENTS
1. Introduction
2. Cycle of working capital 3. Management of cash
4. Management of accounts receivable/trade debtors 5. Management of inventory
6. Management of accounts payable/trade creditors 7. Management of bank overdraft and short-term loans 8. Measures of liquidity
9. Self-assessment activities 10. Solutions
READING Recommended reading
► Dempsey, A. and Pieters. (2005) H.N.Introduction to Financial Accounting 5th
Edition. Durban: LexisNexis. pp. 241-243
► Keown, A., Martin, J.D., Petty, J.W. and David, F.J. (2002) Financial Management: Principles and Applications. 9th Edition. New Delhi: Prentice-Hall. pp. 606-688 ► McLaney, E. (2003) Business Finance: Theory and Practice. 6th
Edition. Essex: Prentice Hall. pp.341-370
► Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1st Edition. North Ryde: McDraw-Hill. pp. 247-281
► Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5th Edition. Durban: LexisNexis Butterworths. pp. 39-43
1. INTRODUCTION
Working capital may be described as the difference between current assets and current liabilities. Meredith and Williams (2005:248) add that it represents funds needed for the day-to-day running of an enterprise i.e. funds that will work for the enterprise in generating profit, meeting short-term obligations and providing a pool of cash necessary for short-term liquidity.
Current assets, a major component of working capital, are assets that are expected to be turned into cash within a year and include the following:
■ Cash and bank balances ■ Trade debtors
■ Inventory
■ Short-term investments ■ Prepayments
Current liabilities, the other component of working capital, are debts that are payable with 12 months. They include:
■ Bank overdrafts ■ Trade creditors ■ Short-term loans
■ Revenue received in advance
2. CYCLE OF WORKING CAPITAL
Meredith and Williams (2005:249) illustrate (see Figure 3-1) and describe the cycle of working capital of a manufacturer. The cycle usually starts with cash available in some form or the other. The manufacturer may approach trade creditors for the purchase of raw materials and some of the cash will eventually be used to pay trade creditors. During manufacturing raw material will be converted into work in progress (partly manufactured goods). Wages and other factory overheads will also have to be paid for in cash. After the work in progress is converted into finished goods, these goods are sold (often on credit) and the asset becomes a trade debtor. When customers settle their debts, trade debtors are
converted into cash and this cash may be used to pay for other commitments e.g. administration expenses, dividends and tax.
Figure 3-1
Other commitments Cash
Trade debtors Trade creditors
Finished goods inventory Wages and overheads Raw material purchases Work in progress
The necessity for the current asset component to exceed the current liability component is demonstrated in the cycle above. In other words, cash plus work in progress, finished goods inventory and trade debtors must exceed the commitments to pay trade creditors, wages and overheads. If the cash component is weak, the entire working capital cycle is weak, and thus every component in the cycle must be managed. We will be discussing the management of these components shortly.
The cycle of working capital for retailers and wholesalers is relatively simple and is illustrated by Meredith and Williams (2005:251) in Figure 3-2. A feature of these two industry groups is that inventory and debtor levels are high, although these tend to be offset by high level of creditors and maybe an overdraft. The
relationship between current assets and current liabilities may thus be virtually 1:1.
Figure 3-2
Other commitments Cash
Trade debtors Trade creditors/
Wages Inventory for
resale
The above cycle shows cash used to purchase inventory through creditors as well as paying wages and other commitments. Inventory is kept for resale and turned over as quickly as possible. Sales, when made on credit, lead to trade debtors and eventually to cash. The cycle is shortened if inventory is sold for cash only. We now examine the management of the components of working capital.
3. MANAGEMENT OF CASH
Cash or its equivalents may include petty cash, cash in bank accounts and short-term investments on call. Cash is crucial to the survival of any enterprise. Meredith and Williams (2005:252) provide the following reasons for the importance of the availability of cash:
■ Lack of cash for a prolonged period leads to liquidation or bankruptcy. ■ There are costs associated with the management of cash resources.
■ A shortage of cash may increase costs in the form of financial and interest charges.
■ Effective control of cash allows management to take advantage of investment opportunities that may arise at any time.
3.1 Motives for holding cash
John Maynard Keynes cited in Keown et al. (2002:637) segmented an enterprise’s motives for holding cash into three categories:
3.1.1 Transaction motive
Cash held for transaction purposes allows the enterprise to meet cash needs that arise in the ordinary course of business e.g. pay wages, purchase inventory etc.
3.1.2 Precautionary motive
Cash is required to provide a safety cushion or buffer to meet unexpected cash needs e.g. a creditor demanding payment earlier than expected.
3.1.3 Speculative motive
Cash is held in order to take advantage of potential profit-making situations that may arise at any time e.g. place a larger order for inventory than usual in order to exploit a temporary price advantage.
THINK POINT 1!
How can cash flow predictability affect an enterprise’s demand for cash through the precautionary motive?
3.2 Cash management strategies
Mclaney (2003:367) provides the following strategies in the management of cash and overdrafts:
3.2.1 Establish a policy
The enterprise should establish a policy for cash. This policy should be adhered to until it is formally reviewed.
3.2.2 Plan cash flows
Failure to plan cash inflows and outflows and to balance them can be fatal. This can be done by drawing up a cash budget. The cash budget (discussed in topics 2 and 7) shows expected cash receipts, expected cash payments and the net change in cash for the period (day, week, month, quarter etc.) under review. The cash
budget helps to identify cash shortages and gives the enterprise adequate time to arrange the necessary credit (e.g. bank overdraft) to meet the short-term cash needs.
THINK POINT 2!
What advice would you offer to an enterprise whose budget reflects temporary cash surpluses?
3.2.3 Make judicious use of bank overdraft and deposit accounts
Bank overdrafts should be avoided, if it is possible to do so. Temporary cash surpluses should be put into notice deposit accounts or invested in marketable securities.
3.2.4 Bank frequently
Cheques received should be promptly banked to either generate income or save on interest on overdraft. Debtors should be encouraged to make direct or electronic payments in order to limit the time the bank takes to reflect such receipts.
Other cash management strategies include the following: 3.2.5 Extending accounts payable
This involves stretching the payment period to creditors beyond the credit terms allowed but without affecting credit ratings negatively. However, if a creditor offers a discount for prompt settlement of account, the enterprise must compare the benefit of early payment with the cost of forgoing the cash discount. The calculation for the cost of forgoing a cash discount is explained in topic 5 (paragraph 4.1).
3.2.6 Efficient purchasing and inventory management
Another way of improving liquidity is to increase inventory turnover. This may be achieved in the following ways:
■ Improving the accuracy of demand forecasts and better planning of purchases to coincide with these forecasts.
purchasing cycle. This should increase inventory turnover.
3.2.7 Speeding up the collection of accounts receivable This may be achieved in the following ways:
■ Offer a cash discount for early settlement of accounts. ■ Use an aggressive collection policy.
In order to ensure that debtors adhere to the credit terms, the enterprise must ensure that:
■ The enterprise’s credit policy has appropriate criteria to determine to whom credit should be extended.
■ The enterprise’s collection policy should clearly define the steps that should be followed to ensure prompt collection of accounts receivable.
3.3 Costs and risks of holding cash
McLaney (2003:363) states three costs and risks of holding cash:
3.3.1 Loss of interest
Cash deposited into a current banking account usually does not earn any interest. Even if cash is deposited in a short-term deposit account, there is still a cost because interest rates tend to be lower than longer-term ones.
3.3.2 Loss of purchasing power
During a period of inflation the value of money erodes. Interest rates do not necessarily compensate for this.
3.3.3 Exchange rate cost
Enterprises that hold cash in a foreign currency will incur a cost if that currency weakens against the home currency.
3.4 The costs and risks of holding little or no cash
McLaney (2003:364) elaborates on the following costs and risks of holding no cash:
3.4.1 Loss of supplier goodwill
Failure to meet the financial obligations on time to suppliers, including
employees, due to cash shortfalls may result in a loss of further supplies from the aggrieved parties. This can be very damaging especially in the case of labour. If the enterprise fails to meet a financial obligation to a creditor, the creditor may institute liquidation proceedings against the enterprise.
3.4.2 Loss of opportunities
An enterprise would not be able to take advantage of a profitable opportunity if it has a cash shortage.
3.4.3 Inability to claim discounts
It is usually very profitable to take advantage of discounts for prompt settlement of accounts payable.
3.4.4 Cost of borrowing
Cash shortages inevitably expose an enterprise to the risk of short-term borrowing to meet obligations. Such borrowings are accompanied by high interest costs.
4. MANAGEMENT OF ACCOUNTS RECEIVABLE/TRADE DEBTORS
Sales made on credit involve the creation of accounts receivable/trade debtors that must be converted into cash. Accounts receivable plays a major role in the
conduct of business for many enterprises. For these enterprises the accounts receivable, which is a current asset, must be financed on a continuing basis.
4.1 Reasons for granting credit
There are many reasons why enterprises grant credit. These reasons are linked to the advantages that credit offers to the enterprise. Some the reasons include:
4.1.1 To achieve growth in sales
If an enterprise permits sales on credit, it usually sells more goods that if it insisted on immediate payment. Many customers prefer to write a cheque at a later time rather than pay cash when they purchase.
4.1.2 To increase profits
Additional sales normally results in higher profits for the enterprise. This occurs when the additional income earned is greater than the additional costs associated with administering the credit policy.
4.1.3 To meet competition
Many firms establish credit policies similar to the policies of competitors as a defensive measure. By adapting its terms of trade to the industry norms, an enterprise avoids the loss of sales from customers who would purchase elsewhere if they did not receive the expected credit.
4.1.4 Increase market share
Continued higher sales and stronger competitive position will result in greater market share.
4.1.5 An aid to sales promotion
An enterprise that grants credit attracts more customers and gains their loyalty through the credit facilities made available to them. Credit is also an important advertising tool.
4.1.6 Products of quality sold
Credit customers are usually less price sensitive compared to cash customers, and in many instances buy products of higher quality than they would if they were paying in cash.
4.1.7 Improving customer relations
The regular visits of customers who purchase on credit create an opportunity to develop good relationships (goodwill) with them.
4.2 The cost and risks of granting credit
McLaney (2003:359) identified the following costs and risks of granting credit:
4.2.1 Loss of interest
The equivalent of granting credit is to make interest-free loans. These tend to be fairly risky loans since trade debtors are not usually secured. The interest lost is thus at a fairly high rate.
4.2.2 Loss of purchasing power
When price inflation is experienced, value transfers from the lender to borrower. This is because the borrower (trade debtor) settles the debt at a lower purchasing power value than at which it was borrowed.
4.2.3 Assessing the potential customer’s creditworthiness
Before granting credit to a new customer it is prudent or even required by law to assess the creditworthiness of customers. In doing so it is necessary to obtain references from the customer’s bank and other traders, examine financial records and pay a credit agency for a report on the customer. Although these checks reduce the risk of bad debts, they do cost money.
4.2.4 Administration and record keeping costs
Enterprises that grant credit have to employ people to administer and collect trade debts.
4.2.5 Bad debts
No matter how cautious an enterprise is in granting credit to customers, the risk of bad debts is always present.
4.2.6 Discounts
Offering credit customers a discount to encourage prompt settlement of account is fairly common. Such discounts, however, can represent a significant cost to the enterprise.
4.3 The costs and risks of denying credit
McLaney (2003:360) elaborates on the following costs and risks of denying credit:
4.3.1 Loss of customer goodwill
It is very difficult for an enterprise to deny credit if its competitors are granting it. In a competitive market it becomes necessary to extend credit in order to attract large and recurring orders.
4.3.2 Inconvenience and loss of security of collecting cash
From an administrative point of view, credit sales can be very convenient. Cash is usually collected by means of cheques in the post or by electronic payments. There is thus no need for delivery drivers to collect cash, thereby avoiding the administrative and security problems that are likely to arise.
4.4 Some practical points in the management of trade debtors
McLaney (2003:361) provides the following suggestions for the management of trade debtors/accounts receivable:
4.4.1 Establish a credit policy
The enterprise should consider whether it is appropriate to offer credit at all, and if so how much, to whom and under what circumstances. The policy should be clear and include credit terms and administrative arrangements.
4.4.2 Assess customers’ creditworthiness
An enterprise should not grant credit unless it is satisfied that the risk of doing so for each applicant is an acceptable one. The following credit standards may be used to evaluate the creditworthiness of debtors:
■ Character – the willingness of the applicant to pay.
■ Capacity – the ability of the applicant to pay.
■ Capital – the financial resources of the applicant.
■ Conditions – the current economic or business conditions prevailing.
■ Collateral – security that the applicant can offer in the event of non-payment of
■ Credit history – the applicant’s history of payments on previous credit sales.
■ Common sense – the sound judgement of the person analysing the credit data.
4.4.3 Setting credit limits
Credit limits should be set, and these will vary from customer to customer depending on the enterprise’s confidence in the applicant’s creditworthiness. These credit limits should be rigorously applied until such time there is a review by a senior employee.
THINK POINT 3!
Suppose that the accounting clerk compares an order with the file on a customer and discovers that the order exceeds the R8 000 single purchase limit authorised for the customer. A check also reveals that the order will place the total receivables balance over the R25 000 limit. If you are the financial manager, what possible actions could you take?
4.4.4 Setting terms of credit
Some of the important terms of credit include the following:
■ Credit period: The period for which credit is granted e.g. 30 days should be
stipulated.
■ Interest on overdue accounts: Usually interest is charged on overdue accounts at
a stipulated rate.
■ Methods of payment: The enterprise should specify how payment should be
made. Payments may be made by cash, cheque, post-dated cheques, electronically, debit order or stop order.
■ Types of credit: Various credit plans may be offered e.g. open credit account, hire
purchase or revolving credit. Purchases on an open credit account must be paid for in full within the allotted credit period. In instalment/hire purchase credit, payment is made by means of a deposit and equal monthly payments (including finance charges) for the balance. With revolving credit the debtor has a credit limit and must pay a specified amount on the account monthly. If the credit limit is not reached, the debtor can buy on credit again.
4.4.5 Establish an effective collection policy
An effective collection policy should be geared towards ensuring that:
■ debtors settle their accounts timeously as delays may lead to liquidity problems. ■ bad debts are kept to a minimum.
The following guidelines may be followed to achieve the above:
■ Do a proper evaluation of creditworthiness and set lower credit terms initially. Credit terms may be reviewed at regular intervals.
■ Once an account becomes overdue, the necessary steps to collect the outstanding amount must be immediately followed. At the very least, the debtor must be contacted immediately.
■ Implement an effective system of control to identify overdue accounts immediately. A debtor age analysis is a common form of control used by
managers. Each month, debtors are analysed in terms of the number of days that debts are outstanding. Suppose that at the end of a particular month, an enterprise has outstanding debtors totalling R170 000 and the credit terms are 30 days. Table 3-1 shows the debtor age analysis:
Table 3-1
Period in arrear (days)
Debtor Outstanding Current 01-30 30-60 60-90 90+
A R40 000 R10 000 R30 000 B R20 000 R10 000 R5 000 R5 000 C R70 000 R50 000 R10 000 R10 000 D R40 000 R40 000 Total R170 000 R60 000 R15 000 R45 000 R10 000 R40 000 Percent 100% 35% 9% 26% 6% 24%
The debtor age analysis reveals that 65% of accounts are overdue of which 24% is over 90 days outstanding.
4.4.6 Establish a policy on bad debts
The enterprise should decide what its policy on writing off bad debts should be. It is important that accounts are written off only after all the steps in the policy have been followed. Previous experience may give management an idea of the trend of possible bad debts e.g. 1% of current debts, 5% of debts that are 01-30 days past due, 8% of debts that are 30-60 days past due, 20% of debts that are 60-90 days past due and 40% of debts that are over 90 days due. This is illustrated in Table 3-2 below:
Table 3-2
Period in arrear (days)
Debtor Outstanding Current 01-30 30-60 60-90 90+
Total R170 000 R60 000 R15 000 R45 000 R10 000 R40 000
Bad debts % 1% 5% 8% 20% 40%
Bad debts R600 R750 R3 600 R2 000 R16 000
4.4.7 Ratios
Ratios can be useful in management of debtors. The most widely used ratio is the debtor collection period. The formula is as follows:
Debtor collection period = Accounts receivable X 365 Credit sales
This ratio tells us how long trade debtors meet their obligations to pay following the sale on credit. If the collection period exceeds what is specified in the policy, then steps need to be taken to remedy matters. The calculation and interpretation of this ratio is discussed in topic 6 (paragraph 3.2.2).
4.4.8 Consider offering discounts for prompt payment
5. MANAGEMENT OF INVENTORY
McLaney (2003:352) states that manufacturing businesses hold inventories (stocks) at various stages of completion, from raw materials to finished goods. Generally the level of investment in inventory by manufacturers tends to be larger than that of traders. Since inventory is the least liquid of the current assets, it must be managed as efficiently as possible.
5.1 Reasons for holding inventory
■ If an enterprise does not have goods available for sale, it will lose sales.
■ Holding sufficient inventory prevents stoppages in a manufacturer’s production process.
■ The enterprise may be able to make bulk purchases of goods at large discounts. ■ The costs associated with individual orders may be reduced if the enterprise places
a few large rather than many small orders.
■ Holding inventory is a safety measure against disruptions like strikes. ■ Having products in stock ensures that deliveries are made on time.
■ The enterprise may have the opportunity of taking advantage of price reductions and special offers.
5.2 The costs and risks of holding inventory
Mclaney (2003:352) elaborate on the following costs and risks:
5.2.1 Lost interest
Interest could have been earned on finance tied up in inventory.
5.2.2 Storage costs
These costs include the rent of space occupied by the inventory and the cost of employing people to manage and guard the stock.
5.2.3 Insurance costs
Inventory is exposed to risks such as fire and theft against which the enterprise has to insure against.
5.2.4 Obsolescence
Inventory can go out of fashion, lose their value through changes in product design or be on hand after the sell-by date.
5.3 The costs and risks of holding little (or no) inventory
The following costs and risks were identified by Mclaney (2003:352):
5.3.1 Loss of customer goodwill
Failure to supply a customer due to being out of stock may not only mean a loss of that order but further orders as well.
5.3.2 Production dislocation
Running out of raw material will lead to loss of production time and loss of income as orders cannot be delivered on time.
5.3.3 Loss of flexibility
Holding little or no inventory means that purchasing and manufacturing must be very closely geared to sales. There is a risk that if there is a slight increase in demand, it may not be met.
5.3.4 Reorder costs
An enterprise that survives on little or no inventory will have to place many small orders. The costs of each order include the physical placing of the order (buyer’s time, telephone, postage) and the receipt of the goods (storemen’s time, making payment).
THINK POINT 4!
In trying to minimise the costs of holding inventories, the major emphasis is on items considered important to the firm’s operations. What types of inventory items do you consider most important to a firm?
