1
FOUNDATIONS IN ACCOUNTANCY
PAPER FFM
[Financial Management]
Text Book Summary
Please read through the text book. Do depend on this summary as errors & omissions
may occur.
Done By
Tariq Suhail Al Shaibani
2 Part A: Chapter 1
Working Capital is the capital available for conducting the day-to-day operations of an organization.
Current Assets – Current Liabilities A business may be
i. Overtrading is excessive trading with insufficient long-term capital at its disposal, raising the risk of liquidity problems
ii. Over-capitalization excessive inventories, receivables and cash, and very few payables (Ratio signs of over-capitalization = sales/working capital, liquidity ratios, turnover periods)
A company is said to be overtrading when its sales are expanding to o quickly for it to finance them.
Costs associated with running out of raw material:
Sales will be lost, therefore you will lose any contribution made from each lost sale If emergency deliveries are required, there will be an additional cost for these
If production ceases altogether and staff and machines sit idle, there will be costs of lost production
Loss of customer goodwill will arise if orders cannot be met. This may lead to loss of sales to this customer in the future
Working capital Cycle (cash operating cycle) is the period between the suppliers being paid and the cash being received from the customers.
The Cash Capital Cycle in a manufacturing business equals: The working capital cycle in a manufacturing business equals: The average time that raw material remain in inventory Less the period of credit taken from suppliers
Plus the time taken to produce the goods
Plus the time finished goods remain in inventory after production is completed Plus the time taken by customers to pay for the goods
3 Liquidity Ratio:
Current ratio =
Quick ratio or acid test ratio =
Accounts recievable days or accounts recievable payment period =
x 365days
Inventory turnover period =
x 365days
Average period between buying and sellingRaw materials inventory holding period =
x 365days
Raw materials inventory holding period =
x 365days
Inventory Turnover =
x 365days
*Its another measure of how vigorusly a bussiness is trading. A lenthing turnover period indicates: a slow down in trading or a build-up in inventory levels
Accounts payable payment period =
x 365days
Average period for payingSymptoms of overtrading: iii. Revenue
iv. Current/ non-current assets v. Inventory/receivables > sales vi. Current and quick ratios vii. Current liabilities > current assets
viii. Assets financed by credit and not proprietors’ capital
Other causes of over-trading: when a business repays a long without replacing it ; and in the period of inflation the profits may be insufficient to replace non-current assets and inventories
4 Chapter 2:
Inventory control levels:
Reorder level = maximum usage x maximum lead time
Minimum level (Safety/Buffer) = reorder level (average usage x average led time)
Maximum level = reorder level + reorder quantity (minimum usage x minimum lead time) Average inventory = safety inventory + ½ reorder quantity
Annual cost of holding inventory = [buffer inventory + (EOQ/2)] x Annual holding cost per component
*Remember ADD buffer + EOQ/2 then multiply!!
Reorder quantity is the quantity which to be ordered when inventory reaches the reorder level Economic order quantity (EOQ) model can assist in reducing inventory costs by determining the optimum order size for inventories which minimizes ordering and holding costs.
Economic order quantity (EOQ) is the order quantity which minimizes the inventory costs.
EOQ =
o
***FOCUS ON MONTH AND ANNUAL WHEN CALCULATING
*READ discounts pg28 *Read Page 30 for JIT
Revision Kit Question 6 EOQ assumptions:
1) It assumes that annual demand is constant
2) Does not take into account the credit terms and discount policies
3) It assumed that the lead time is constant therefore suppliers are completely dependable Chapter 3:
Payables as a source of short-term finance: ix. Bank overdraft
x. By raising finance from a bank or other organization against the security of recivables, for example through factoring or invoice discounting
xi. For larger companies, by issuing short-term debt, such as ‘commercial paper’ *Trade credit will have a cost, whenever a company is offered discount for early payments, but opts instead to take longer credit.
CH = Cost of holding one unit of inventory of one time period CO = Cost of ordering a consignment from a supplier
5 The cost of lost cash discounts:
( )
Where d is the size of the discount. For a 5% discount, d = 5
t is the reduction in the payment period in days which would be necessary to obtain the early payment discount\
Benefits of offering Settlement discounts - Reduced bad debt
- Increased cash flow - Reduced cost
*If a credit note is due or received against an invoice. It should be deducted before the cash discount is calculated
Direct debits and standing orders are becoming more popular than cheques Bank mandate form/ letter is a letter sent by the business to inform the bank who is authorized to sign the checks. (two are often required)
Standing Order Direct Debit
It’s a fixed amount
-uses standing order mandates
Receiver initiates each payment The amount varies
All changes in Direct Debit amounts must be notified to the payers 14 days in advance Indemnity: the originator (payee) must provide an indemnity to guarantee a refund of incorrect debts.
Type of payment Details
Telegraphic Transfer (TT) or cable payment Instructions for the payment are sent from the
order payer’s bank to the payee’s bank by cable
(over the telecommunications system). Mail Transfer (MT) or mail payment order Instructions are sent by mail
*For payments within the UK, TTs are more common
Bankers’ Automated Clearing Services (BACS) is a company owned by the major retail banks which operates the electronic transfer of funds between accounts within the banking system. *It reduces paperwork
6 Clearing House Automated Payments System (CHAPS) is a computerized system to enable same-day clearing, guaranteed if instruction are received before 2pm.
*It usually incur higher bank charges *BACS is slower than CHAPS Part B: Chapter 4:
The operating cycle (cash cycle) measures the period of time between the cash is paid out of for raw materials and the time cash is received from customers. (measured in
days/months)
A cash cycle may be analyzed into two elements
a) A trading cycle, identifying when a firm acquired goods and when it sold them b) A cash cycle identifying the movements of cash: when was the inventory actually
paid for? When was cash received from customers? Types of cash transactions:
1. Capital - increase capital, non-current assets 2. Revenue – day-day operations, overdraft interest
3. Exceptional – unusual such as closing down part of a business 4. Unexceptional – everything else
5. Regular – at predictable intervals, salary, rent, etc
6. Irregular – not at predictable intervals, such as buying new machine, disaster recover expense Accounts and treasury staff monitor these cash flows:
xii. Exceptional items xiii. Unexpected payments Revision Kit Pg131 Question 24
Factors a venture capitalist will take into account: (i) Level of expertise of the management (ii) Level of expertise in the area of service (iii) The nature of the product
(iv) The market and competition (v) Future prospects
7 Cash flow can be defined in many ways:
Net cash flow is the total change in a company’s cash balances over a period of time
Operational cash flow is the net cash flow arising over a period from trading operations
Priority cash flows do not relate to trade, but are vital to keep the company afloat (interest and tax payments)
Discretionary cash flows are cash payments/receipt that do not have to be made (investments, capital expenditures, ordinary and preference dividend)
Financial cash flows arise from variations in long-term capital (issue of shares, loans, payment of a long-term loan)
*A negative operational cash flow may arise if a business is overtrading Profit Operational cash flow Notes
Sales Cash in Cash in = Sales + Opening receivables – closing receivables
-Cost of Sales - Cash out Cash out = Purchases + Opening payable – closing payable
Purchases = COGS + Closing inventory – opening inventory
Profit Operational Cash flow
Operational cash flows could be improved by squeezing working capital, and: i) Reducing receivables
ii) Reducing Inventories, or (iii) Taking more credit from suppliers *If a company is making loses, it could try to maintain a positive operational cash flow by taking more credit (Increase payables; will reduce working capital)
The three main focuses of cash and credit management: 1) Profitability
2) Liquidity 3) Security/Safety
Cash budgets are prepared on the cash basis; not accruals concept. Revision Kit Pg137 Question 29
the purpose of a cash budget
1) To have sufficient cash to meet its payment obligations 2) Whether the business will have a cash surplus or deficit 3) For control purposes
8 Effect of inflation on cash flow:
It will indicate increases in costs. This will allows the business to raise prices before costs rise. If costs rises before rising prices it will have an adverse effect.
This means that prices rises will be proactive rather than reactive.
Accruals and going concern are linked pg59 Pg: 60 read key term Accruals
Chapter 5:
*Preparing cash budgets is vital for the exam
Cash flows forecasts provide an early warning of liquidity problems and funding needs. Leading and lagging is used to shorten the working capital.
They are two main ways of preparing a cash forecast:
From receipts, payments and net cash flows (cash flow based forecast)
From the SOFP or other financial statements (to establish a cash surplus or funding requirement)
SOFP forecasts are used for long-term strategic analysis.
A cash budget (cash flow budget) is a detailed forecast of expected cash receipts, payments and balances over a budget period.
A rolling forecast is a forecast that is continually updated.
*Any forecasts should include a clear statement of assumptions on which the figures are based. You must include them in the EXAM!
Adjustments made in the cash budgets are
Cash flow items not appearing in the income statement, or Items in the income statement which do not have a cash effect
9 Cash budget:
Receipts X
Less payments (X)
Net cash flow in month X
Closing cash balance X or (X)
Unused borrowing facilities X or (X)
X
*Discount allowed should be provided in the forecasts of recepits pg70
Read Questions pg 71 onwards
Cleared funds are used for short-term planning. They take clearance delays into accounts (until the checks or payments gets cleared)
Float refers to the amount of money tied up between the time a payment is initiated and cleared funds become available in the bank for immediate spending.
Uncertainty might happen due to:
The receipt might delay the banking of cheques
Cheques do sometimes get help up by bureaucracy (laws and regulations)
Check page 80 Example
The forecast for the SOFP is produced for management accounting purposes and so not for external publications or statutory financial reporting. It is not an estimate of cash inflows and outflows!
The SOFP should be checked for realism (e.g. by ratio analysis) to ensure that the proportion of the SOPF made by N.A. and working capital, etc. is sensible.
Check page 84 Example
Note:
An increase in current assets (inventories or receivables) will cause a cash outflow. Increase in current liabilities (such as payables) will cause cash inflow.
10 Control reports could be prepared for operational cash flows. The purpose of the report should be either:
Actual cash flows against a budget or target, or
A current forecast of cash flows against an original budget or target Cash flow problems may arise from:
xiv. Making Losses xvii. Seasonal business
xv. Inflation xviii. One-off items of expenditure
xvi. Growth
*A typical question on cash forecasts might ask you to prepare a budget, and then require you to explain how the organization might deal with the shortfall predicted.
A constant monthly amount (unchanged figures) of receipts and payments will often indicate a sloppy cash forecasting practice (weak forecasting system)
Inflation usually effects costs before revenues.
When prices are increased trade receivables will become higher, and the working capital of the business will increase.
Chapter 6:
A growth rate can be estimated from an analysis of the growth in (ex. Over the past years) (1 + g)n = Final year/first year
Linear regression analysis (the least squares method) is one technique for estimating a line of best fit. Once an equation for a line of best fit has been determined, forecasts can be made. Y = a + bX
b = ∑ ∑ ∑ ∑ ∑ a = ∑ ∑
The line of best fit that is derived represents the regression of Y upon X (X = a + bY) *Regression can be used to find a trend line
11 A time series is a series of figures or values recorded
ovetime There are four components of a time series
Trend they are three types: upwards, downward and no clear movement
seasonal variations are short-term fluctuations in recording values
cyclical variations are medium-term changes
random variations
The Actual Time Series, Y = T + S + C + R Where Y = the actual time series
T = the trend series S = seasonal component
C = cyclical component R = random component
The additive model is Y = T + S + R S = Y-T
The proportional (multiplicative model is Y = T x S x R S = Y/T
A moving average is an average of the results of a fixed number of periods. It is related to the mid-point of the overall period. It is another way to find the trend.
If a moving average of an even number, you’ll have to take the middle value. Ex. Quarters of years will be taken middle of 4 (Starting from 3rd number) Pg106
Forecasts can be made by calculating a trend line (using moving averages or linear regression), using the trend line to forecast future trend line values and adjusting the values by the average seasonal variations.
Sensitivity analysis tests the results of a forecast to see how sensitive they are to changes in inputs (eg interest rates). Spreadsheet modeling is used for this purpose.
Alternative methods of uncertainty analysis may include: xix. Preparing different forecasts (for different scenarios)
xx. Preparing cash forecasts as a range of possible outcomes
xxi. Using probability analysis by assigning probabilities to a range of value Part C: Chapter 7:
Key Principles on which a business cash management policy should be based on: Profitability
Liquidity
12 They are centralized and decentralized cash management systems.
In optimizing cash balances, the financial manager must try to balance liquidity with profitability.
Float refers to the amount of money tied up between the time a payment is initiated and cleared funds become available in the bank for immediate spending.
Three main reasons for a lengthy float:
a) Transmission delay – the time the check takes to reach the payee b) Lodgment Delay – delay in banking the payments received c) Clearance Delay – time needed for a bank to clear a cheques
You can reduce float by using BACS, CHAPS, standing orders, direct debit, etc. A lengthy float suggests inefficient cash management.
Baumol’s cash management model: Two costs are involved in having cash:
a) The fixed cost (cost of raising equity or the cost of negotiating an overdraft) – obtaining cash
b) The variable cost (opportunity cost) of keeping the money in form of cash – holding (interest)
Optimal Sale = ie Q = √ Where S = the amount of cash to be used each time
F = the fixed cost of obtaining new funds (cost per sale/purchase of securities) i = the interest cost of holding cash or near cash equivalents
Q = the total amount to be raised to provide for S
Treasury managements is the corporate handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows, and the complex strategies, policies and procedures of corporate finance.
13 The role of the treasurer (treasury department)
Corporate financial objectives
Liquidity management (Working capital)
Funding management
Currency management
Corporate finance (raising share capital)
Related subjects (corporate taxation, risk management, pension fund) *Read advg and disadvg of centralized and decentralized cash management systems. *Read Anser of Question 36
Advantages of a centralized treasury department: - Foreign currency management becomes easier
- “Higher interest rates may be attainable on investment because the department has larger amount of cash available for investment
- The treasury department may be a profit center in its own right - Lower interest rates may be sought for borrowing
- The level of cash held for precautionary purposes can be minimized - Experts can be employed
-
Chapter 8:
A financial intermediary brings together providers and users of finance, either as broker (an agent handling a transaction on behalf of others) as a principal (eg holding money balances of lenders for lending to borrowers)
Banks are intermediaries; they borrow money at an interest in order to lend it at a higher interest.
Other financial intermediaries:
xxii. Building societies xxv. Pensions funds
xxiii. Finance houses xxvi. Unit trusts
xxiv. Insurance companies xxvii. Investment trust companies
The importance of financial intimidation
a) Aggregating individual savings (rather than one lender lends a large sum of money to one borrower > many lenders lend a small amount of money to one borrower) b) Reduction and pooling of risks plus better credit assessment
c) Maturity transformation by dealing with long-term customers an intermediary can fun long-term and short-term (liquidity) needs
14
*EXAM FOCUS POINT: In the exam you may be asked to give examples financial intermediaries and explain how financial intermediation benefits the economy
Two categories of banks in the UK:
Primary banks (commercial, retail or clearing banks) are the banks which operate the payments mechanism.
Retail banking is the activity of the traditional ‘high street’ bank, dealing with relatively small deposits and small loans to customers.
Secondary banks consist of investment banks, and foreign banks un the UK. They do not themselves carry out cheques clearing, although retail banks may do the clearing for them.
Wholesale banking involves small numbers of customers with larger deposits or requiring larger loans. (Due to the large sums involved, customers expect banks to trip their profit margins by reducing loan rates or increasing deposit rates)
In banks the gross profit is the difference between the interest paid to depositors and interest received by the lenders. Net profit is the gross profit less operating expenses. A central bank is an institution which typically has the role of controlling the monetary systems of a country, acting as a banker to the banks, and acting as a lender of last resort. *the degree of independences varies between countries.
Building societies are regulated by the Financial Services Authority.
The money makers are markets just like any other with buyers, sellers and traders. The commodity that is traded is money that lent and borrowed in wholesale amounts. The term ‘money’ refers to the short duration of the loans or deposit
The traders or participations in the money markets are: Financial intermediaries
Government Local authorities Brokers, marker makers Firms and individuals
15 The main financial instruments in the market are:
Deposits they are simple deposits of money in bank accounts (both current & deposit accounts)
Bills means that you will pay the specified amount in at a future date. You may get a bank bill assuring your supplier that you will pay an amount at a specific date. Commercial paper this represents short-term IOUs issued by large companies which
can be held until maturity or sold to others
Certificate of deposits (CDs) is available for customer who deposit 50,000 or more with a bank for a fixed term. If a customer wishes to withdraw the amount before the term ends, a CD is created, which can be sold to others so they can redeem the amount + interest.
The UK short-term money markets
‘Repo’ is short for ‘sale and repurchase’ agreement of securities (bonds and bills). The seller promises to buy it at a future date at a higher price.
Interbank market this is a wholesale money market for unsecured loans between banks.
The inter-bank is used by banks for three purposes:
a) To smooth out fluctuations in receipts and payments
b) To use the market to borrow funds in its own name and lend funds to a less well established bank at a higher rate of interest
c) To sound out the market for the likely future trends in rates Certificates of deposit Market
Disintermediation refers to the bypassing of financial intermediaries in order to arrange lending and borrowing directly from the ultimate parties to the transaction. Ex. Commercial paper but a bank acts a ‘go-between, arranging transaction for the corporate borrower and investors’.
A Eurocurrency is a deposit of funds with a bank outside the currency’s country of origin. *Read Answer 37, Nature of instruments!
A bond (In UK called gilts) is a long-term debt security. A bon usually offers a fixed rate interest known as a coupon rate.
Treasury bills are issued at a discount to face value, and the interest rate is implicit in the difference between the issue price at a discount and the redemption price at par. Gilts and Treasury bills together are called government stocks
16 The foreign exchange market is the market for buying and selling a currency in exchange of another currency
Stock exchange is the main market. Alternative Investment Market (AIM) is more loosely regulated (not at full listing) market for small and emerging businesses. Stock market serves two main purposes:
xxviii. They enable organization to raise finance
xxix. They enhance the marketability of securities; the ease to buy and sell
*In UK FT-SE 100 or Footise 100 index covers the 100 largest companies
*EXAM FOCUS POINT: you may be asked in the exam to decide whether or not a stock
exchange listing is suitable for a particular company
Disadvantages of a stock market listing:
xxx. Greater public regulation, accountability and scrutiny xxxi. More investors = more owners
xxxii. More costs in making share issues (brokerage commissions and underwriting fees) Method of obtaining a listing
Offer for sale
a) Initial public offering
b) Offer for sale by tender (tendering to find out a minimum price; striking price is the highest price)
Prospectus issue although very rare and risky, it offers directly to the public Introduction the stock market grants a quotation. These only happen when a
large company is already widely held, so that a market can be seen to exist.
*There is a condition that the a minimum proportion of the company’s shares must be in the hand of general investing public
Introduction offers greater marketability for the shares Chapter 9:
Compound Annual Rate of interest (CAR) = *( ) + x 100
17 The yield (profitability) of a money market instrument depends on:
Its face value
The interest rate offered
The period of time before it is redeemed (i.e. converted into cash) by the issuer The interest yield (also known as the flat yield or running yield) is the interest or coupon rate expressed as a percentage of the market price
Interest yield =
The interest yield is influenced by other two factors:
xxxiii. Accrued interest : the time when it is resold and the time remaining for the interest to be given
xxxiv. Cum div (int) and Ex div (int): due to administration purposes the issuer of securities must close their books some time before the due date for the payment of interest/dividend (if you buy it after that, you will not receive the interest, the last holder will)
If yield is relatively low it can be concluded that the price is relatively high and that the demand is also high
The redemption yield is the interest yield plus/minus the yield on the gain or loss if held redemption
The security of a local authority stock is not considered as good as the enteral government The market in the local authority stock is thinner (not many transactions) than glits, ince the amounts involved is smaller and held by few investors
Certificate of deposit (CDs) are issued by an institution (bank or building society). A CD offers an attractive rate of interest and can be easily sold.
A bill of exchange is a unconditional order in writing from one person or company to another requiring the person or company to whom it is addressed to pay a specified sum of money on demand (sigh bill) or at a future date (term bill).
18 As an IOU, an accepted bill of exchange is a form of debt. It is a negotiable instrument
a) The holder can hold on the bill until maturity
b) Or, the bill holder can sell the bill before maturity for an amount below its payment value (i.e. at a discount)
Marketability of a specified bill depends on: a) The credit quality of the drawee
b) The existence of liquid secondary market in bills
Trade bills are bills drawn by Non-bank Company on another company Banks bills are bills of exchange drawn and payable by a bank
*The most common form of a bank bill is a banker’s acceptance, whereby a bank accepts a bill on behalf of a customer and promises to pay the bill at maturity
Bond is term given to any fixed interest (mostly) security whether it is issued by the govt. or company.
A yearling is a local authority bond redeemable after one or two years
Loan stock is issued in return for loans secured on a particular asset of the business. A right issue is an offer to existing shareholders for them to buy more shares, usually at a lower than the current share price. It does not affect the voting rights and reduce gearing. ****Retained Profits offers a simple low-cost source of finance, although it is may not be provide enough funds specially if the firm wants to grow.
New equity shares will be more common when share prices are high than when low.
A scrip dividend sis a dividend payment which takes the form of new shares instead of cash. It converts reserves (share premium) into issued share capital.
Enhanced scrip dividends: the value of shares offered is much greater than the cash alternative A stock split is when the shares are divided (from 1 share for $1 to 2 shares for $1). It
enhances the marketability of the shares.
Preference shares are shares which have a fixed percentage dividend, payable in priority to any dividend paid to the ordinary shareholders.
19 The main types of preference shares are:
Non-cumulative fixed rate of dividends and in priority to ordinary shareholders Cumulative the unpaid fixed rate dividend is cumulated (carried forward) until the
company is profitable and the directors recommend dividend to be paid
Participation the owner has the right to choose the fixed preference shares dividend or the ordinary dividend share being paid, whichever is higher
Redeemable the company will buy it back at some time in the future
Convertible the owner will have the right in the future to convert his shares into ordinary shares
Loan notes (or loan stock) are long-term debt capital raised by a company for which is interest is paid.
Debenture is a form of loan notes. It is usually secured with the interest plus capital. A debenture trust deed would empower a trustee (such a bank) to intervene on behalf of debenture holders if the condition of the borrowing is unfulfilled.
Deep discount bonds are loan notes issued at a price which at a large discount to their nominal value.
Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them.
*Check the redemption date of current loans in the SOFP to establish the new finance the company would likely need.
Interest charges on Debt capital reduce the profits chargeable to corporation tax. Implications of a fall in interest rates for a typical company
(i) The cost of floating rate borrowing will fall (ii) The value of the company’s shares will rise
(iii) The higher share value results in a lower cost of share capital (iv) Consumer will have more disposal income
Convertible securities are fixed return securities’ that may be converted, on pre-determined dates and at the option of the holder, into ordinary shares.
A warrant is a right given by a company to an investor, allowing him to subscribe for new shares at a future date at a fixed, pre-determined price (the exercise price)
20 The theoretical value of a price of warrant =
(current share price – Exercise price) x Number of shares obtainable from each warrant *Warrants do not have an immediate effect on earnings per share (important indicator of a company’s performance)
A capital gain is the increase in value of an investment. Ex. If you buy shares for $100 and sell them for $300; you make a capital gain of $200
Chapter 10:
The choice of obtaining a return is determined by considerations of: Profitability
Liquidity
Safety
Seasonal factors may lead to a cash surplus but this will be used to cover the shortfalls later. Reasons of why a business needs cash: economist JM eynes
Transactions motive: for regular commitments, day to day transactions
Precautionary motive: to cover unforeseen contingencies (overdraft now is used instead)
Speculative motive: in hope that interest may rise; though most business do not hold cash for a speculative motive
*Remember Profit/net assets will tell you if the buss. Is running effectively. **The higher the return, the higher the risk
An investment that is highly liquid will generally attract a lower return.
Authorities are restricted to invest in government securities, high-street bank and building societies.
Diversification is the process of reducing risk by increasing the number of separate investment in a portfolio.
Market or systematic risk is risk that cannot be diversified away.
Non-systematic or unsystematic risk applies to a single investment or class of investment, and can be reduced by diversification
21 Part D: Chapter 11:
Interest rates, inflation, and monetary policy are all interrelated. Liquidity means assets in the form of cash or ‘near-cash’.
Liquidity preference (used by Keyes) is the desire to hold money rather than other forms of wealth, arising from the transactions, speculative and precautionary motive.
The structure of interest rates refers to the many different interest rates there are. There is a greater risk in lending longer term than shorter term because of inflation and uncertain economic prospects.
The general level of interest rates is affected by several factors
The need for a real return: after inflation have been taken out
Inflation
Uncertainty about future rates of inflation
Changes in the level of government borrowing
Higher demand for borrowing from individuals
The balance of payments
Monetary policy
Interest rates abroad
*The type of asset purchased in a loan is important
The UK government has objectives for price stability, economic growth and employment which a government can influence in two ways:
Fiscal policy is concerned with government spending and taxation
Monetary policy are implemented by the Treasury and Bank of England (monetary authorities) and are aimed in influencing:
xxxv. Quantity of money
xxxvi. Price of money (interest rates) xxxvii. Availability of credit
*The interest rate is the price of money and so increasing the price should reduce the demand for money
A Public Sector Borrowing Requirement (PSBR) is an excess of public sector spending over revenue. The bigger the PSBR, the bigger increase in the money supply
A Public Sector Repayment (PSDR) is when public sector revenue is greater than public sector expenditure.
22 Inflation refers to a sustained increase in the general level of prices over time.
A Retail Prices Index (RPI) measures the percentage changes month by month in the average level of prices of the commodities and services including housing costs purchased by the great house holds in the UK.
*Inflation leads to a restitution of income and wealth.
In time of inflation those with economic power tend to gain at the expense of others, particularly those on on fixed incomes
Nominal rates of interest are rates of interest expressed in money terms Real r
Real rates of interest are the rates of return that investors get from their investment, adjusted for the rate of inflation
Fisher Equation: (1 + i) = ( 1 + r ) (1 + h)
Where h = Rate of inflation r = Real rate of interest
i = Nominal (money) rate of interest
The pricing policy of an organization should take in consideration the effects of inflation. However, the competitive position in which a firm finds itself in will be more important.
EXAM FOCUS POINT: in the exam you may be given the details of a specific bussiness, and be asked how inflation might affect that bussiness.
Chapter 12:
A Comparing of an overdraft and loan financing will be very important for exam purposes. Term loan: the customer borrows a fixed amount and pays it back with interest over a period or at the end of it
Committed facility: the bank undertakes to make a stipulated amount available to a borrower on demand
A revolving facility is a facility that is renewed after a set period. Once the customer has repaid the amount, the customer can borrow again
23 Uncommitted facility: when the bank feels like it.
Banker’s acceptance facilities: this relates to bills of exchange, discussed in chapter 5 The banker/customer relationship
Debtor/creditor
Bailor/Bailee safe deposit
Principal/agent when a bank arranges insurance; cheques
Mortgagor /mortgagee customer is mortgagor, bank is mortgagee
Fiduciary relationship means that the bank the superior party and is expected to act in
good faith.
The bank’s rights The bank’s duties
xxviii. Charges and commissions xliv. Honor customer’s cheques xxxix. Use of customer’s money xlv. Receipt of customer’s funds
xl. Overdrawn balances xlvi. Repayment on demand
xli. Customers drawing cheques xlvii. Comply with customer’s instructions xlii. Lien over securities (sell a customer xlviii. Provide a statement
asset) xlix. Confidentiality
xliii. Indemnification (to secure against l. Advice of forgery possible loss or damage) li. Care and skill
lii. Closure of accounts
Customer’s duties: liii. Duty of care liv. Advice of forgery
*A customer has no duty to check his or her bank statement for any incorrect entries. *With credit scoring, the CAMPARI approach to
credit assessment is not relevant and not used. *EXAM FOCUS POINT:
You may be required to apply your knowledge of lending criteria to a particular scenario.
Discretionary rates is when the bank decide on the return which it requires from lending depending on the nature of the risky venture (ex. New business)
CAMPARI – Lending Criteria Character of the customer
Ability to borrow and repay Margin of profit
Purpose of the borrowing Amount of borrowing Repayment terms
24 Features of a credit control system to encourage on time payments
- Timely and accurate dispatch of invoices - Supplier terms
- Management procedures - Customer awareness
Chrematistics of a security for a loan: a) Easy to take
b) Easy to value c) Easy to realize
*Security over a loan is only a safety net.
The banks will generally charge a commitment fee when a customer is granted an overdraft facility or ran increase in his overdraft facility.
An overdraft for day-to-day trading should be for:
to increase total current assets (receivables, inventory level or overall sales turnover)
Or to reduce other current liabilities The danger with business expansion is overtrading.
The term of the loan
lv. Length of the loan and the useful life of the asset lvi. Internal guidelines
lvii. Government regulations
lviii. Negotiations between customer and banker Loan repayment methods:
Bullet the borrower does not repay any of the loan principal until the end of the loan period
Balloon principal is repaid during the term of the loan
Amortising or straight repayment loan at regular intervals (principal + interest) Loan covenants:
Positive covenants requires a borrower to do something
Negative or restrictive covenants promises by a borrower not to do something
Qualitative covenants set limitations on the borrower’s SOFP *Overdrafts are normally repayable on demand
25 Types of leasing
Operating leases are rental agreements between a lessor and a lessee where the lessor is responsible for servicing and maintaining
Finance leases are lease agreement between the user of the leased asset (the lessee) and a provider of finance (the lessor) for most or all of the expected useful life.
The equipment is usually provided by a third party. The lessee is responsible for the servicing and maintaining
Sales and leaseback when a business already owns an asset agrees to sell it to a financial institution and to lease it back.
*A major advantage of the operating lease is that the leased equipment does not have to be shown in the lessee’s published SOFP!! Therefore; no increase in gearing ratio.
Hire purchase is a form of installment credit
a) Lender credit occurs when the buyer borrows money and uses the money to purchase goods outright.
b) Vendor credit occurs when the buyers obtains goods on credit and agrees to pay the vendor by installments. Hire purchase is an example of vendor credit.
Chapter 13:
Equity share capital is a key method of financing for companies of all sizes. The optimal mix of finance will determine how much a company should be geared. Source of funds:
Retained Earnings is the cheapest form of finance.
Capital markets
i) New shares issue ii) Rights issues
iii) Issue of loan capital – a means of borrowing from investors Bank borrowings
Government sources for example grants
Venture capital for new ventures which can carry a high level of risk
International money and capital markets (euro commercial paper, Eurobonds and Eurocurrency borrowing) only larger companies will make use of in practice
26 Primary markets enable organizations to raise new finance, by issuing new shares or
new debentures.
Secondary markets enable existing investors to sell their investment. *check out page 220 point b for a takeover!
Individuals invest in the stock market, but the most important participations are the institutions such as pension funds, insurance companies and unit trusts.
Providers of capital are investors:
a) Pension funds – are separate legal entities which consist of a pool of assets b) Insurance companies – invest premium paid on insurance policies
c) Investment trusts – they trade in investment
d) Unit trusts – offers the holder an opportunity to diversify their investment. The trust creates a large number of small units of low nominal value.
e) Venture capital – specialize in raising funds for new business ventures Equity means simply the ordinary shares of a company
Securities is commonly used to mean any sort of investment that can be bought and sold in the financial markets. (will be used as term in the exam, pg 221)
Loan stock or debentures are amounts loan to a company.
Bonds are very large loans which normally (but not necessarily) have a fixed rate of interest Eurobonds are bonds that bought and sold on an international basis.
A large public company is usually in a better position to raise capital than smaller companies. A public company is one that can invite the general public to subscribe shares
A private company is prohibited from offering its shares to the general public.
**The main source of new lending to companies both long term and short-term is the banks. Factors in the choice of financing method
- Purpose - Security
- Amount - Restrictive covenants
- Repayment - Control of the business
- Term - Effects on gearing
- Cost
Gearings: Irredeemable preferences share are not classed as debt and do not increase a company’s gearing ratio
27 When using retained earning you must put in mind the opportunity cost involved.
Capital structure refers to the way in which an organization is financed, by a combination of equity and non-current liabilities and current liabilities.
A company would finance current assets partly with current liabilities and partly with long-term funding.
Equity finance is generally more expensive than debt because equity investors take a greater risk. Additionally, interest payment on debt are tax deductible unlike dividend payment which payable after tax.
A highly geared company indicates that the company will less likely to be able to pay dividend. Therefore, gearing affects the market value of shares.
The level of gearing which the market will allow will therefore depend on the nature of the company and the industry in which it is engaged:
a) A company which in a cyclical business, where profits are subject to period up and downs, should have relatively low gearing
b) A company which profits are stable should be able to raise a larger amount of debt Gearing is a measure for comparing how much of the long-term capital of a business
is provided by capita Equity and creditors. Debt/equity ratio =
(i) Low geared less than 100% (ii) High-geared if more than 100%
Basic Earning per share is calculated by dividing the net profit or loss for the period attributable to ordinary shareholder by the weight average number of ordinary shares outstanding during the period.
28 Chapter 14:
Small and medium-zed enterprises (SMEs) often have difficulty raising finance. Characteristics of SMEs:
a) Firms are likely to be unquoted
b) Ownership is restricted to a few individuals, typically a family group
c) They are not micro business that are normally regarded as those very small businesses that act as a medium for self-employment to the owners
*If market conditions do change, small business may be more adaptable. However, a significant portion will not survive the first few years.
Finance may be difficult to obtain because of the risks faced by SMEs. Government policy will have a major influence on the level of funds available:
a) Tax policy
b) Interest rate policy
The main issue that face in accessing funds for SMEs is the problem of uncertainty.
A common problem is often that banks will be unwilling to increase loan funding without an increase in security given or an increase in equity funding.
Possible sources of finance for SMEs include:
Owner financing Business angel financing
Overdraft financing Venture capital
Banks loans Leasing (see chapter 13)
Trade credit Factoring (see chapter 10)
Equity finance
Equity gap is a when a business has few tangible asset will probably have difficulty obtaining equity finance when they are formed.
A funding gap is the difference between the amount of funds that is available or obtainable for a business and the amount of funds that it needs for developments and growth
A maturity gap for a small company is the difference between the maturity of its assets and the maturity of its liabilities
A major problem with obtaining equity finance can be the inability of the small firm to offer an easy exit route for investors.
29 Business angel are wealthy individuals or groups of individuals who invest direct in
small business. It is informal in terms of a market and can be difficult to set up. Venture capital is risk capital, normally provided in return for an equity stake. The type of venture that might attract investment are:
a) Businesses start-ups b) Businesses development
c) Management buyouts – the purchase of the all or part of a business from its owner by its managers
d) When one of the owners wants to realize all or part of his investment Venture capital trusts are a special type of funding giving investors tax reliefs.
Venture Capital Funding: is the provision of risk bearing capital, to companies with a high growth potential. Providers of finance will usually require a seat on the board and will be looking an ex exit route from the company via for example flotation.
Significant influences on the capital structure of small firms are: The lack of separation between ownership and management The lack of equity finance
Government aid for SMEs which is usually in the form of grants include Enterprise Finance Guarantee, Enterprise Initiates, Development agencies and Enterprise Investment Scheme.
*EXAM FOCUS POINT: you may use relevant examples from you country should you wish to do so.
30 Part E: Chapter 15:
Relevant costs is a future cash flow arising as a direct consequence of a decision Avoidable costs
Differential Costs is the difference in relevant cost between to alternatives
Opportunity costs (take the most profitable)
Directly attributable costs they are fixed cost that are affected like more supervisors if activity increases
Non-relevant costs
Sunk Cost which already have been incurred
Committed Cost it is incurred anyway, cannot avoid it
Notional Cost no actual expense such as depreciation!
General fixed overheads unaffected by decision
A notional cost or imputed cost is a hypothetical accounting cost to reflect the use of a benefit for which no actual cash expense is incurred.
The total relevant cost of a scarce resource consists of the following:
The contribution/incremental profit forgone from the next-best opportunity for using the scarce resource
The variable cost of the scarce resource Chapter 16:
A capital expenditure results in the acquisition of non-current assets or an improvement in their earning capacity.
Revenue expenditure is expenditure which is incurred for the purpose of the trade of the business or to maintain the existing earning capacity of non-current assets.
Capital income is the proceeds from the sale of non-trading assets
Revenue income is derived from the sale of trading assets or interest and dividends received from investments held by the business
Purchase of inventories is a revenue expenditure.
Revenue expenditure from purchasing inventories may either be charged as an expense or shown as a current asset (closing inventory) and not yet charged in the I/S
31 Addition and disposals over a certain amount must be authorized on a capital expenditure authorization form and a disposal authorization form respectively.
Discrepancies between the asset register and the actual non-current assets present and between the assets register and the nominal ledger must be investigated.
Recurring and minor non-current asset purchases may be covered by an annual allowance provided for in the capital expenditure budget.
A capital expenditure budget is essentially a non-current assets purchase budget. Chapter 17:
Check Question 82
The steps involved in project appraisal are:
Initial investigation Implementation Detailed evaluation Project monitoring
Authorization Post-completion audit
Benefits of a post completion audit: - Better future investment decision - Better current investment decision - Contribution to performance evaluation The key method of project appraisal:
Accounting rate of return (ARR) The payback period
Net present value
Discounted payback period Internal rate of return (IRR)
APR =
***there are numerous ways in which ARR can be calculated)
The payback period is the time taken for the initial investment to be recorded in the cash inflows from the project.
We must recognize if a capital investment is to be worthwhile, it must at least a minimum profit or return so the size of the return will compensate the cost of capital (opportunity cost)
32 Reasons could be suggested as why a present $1 is worth more than a future $1
a) Uncertainty b) Inflation
c) A person would like to spend it now rather than the future Time value of money:
- Compound interest is when the interest earned also earns interested itself in later periods
S = P ( 1 + r ) n
Note: S is the future value of investment and P is the amount invested now - Discounting
PV = S (x (1 + r)-n
Remember: (1 + r)-n and mean the same exactly thing!
***The discounting is taken from the Presenet Value Table
Discounted cash flow is technique of evaluating capital investment projects using arithmetic to determine whether or not they will provide a satisfactory return. *The main idea is: 1$ today is worth less in the future (due to cost of capital)
DCF can be used in two ways: the net present value method or the internal rate of return (DCF yield/ DCF rate of return)
If NPV is positive then benefits exceeds costs If NPV is negative then costs exceeds benefits
**The NPV method uses the Present Value Method!
The discounted payback method applies discounting to arrive at payback period which the NPV becomes positive.
Remember: Cost of capital is associated with the opportunity cost of finance
Annuities are annual cash payments or receipt which is the same amount every year for a number of years.
It uses the present value factors
*HINT: you can add all of the present value and multiply to by the annuity. And also deducted the undesired years
A breakeven NPV is when how much income would need to be generated for the NPV of a project to be zero. Check pg 285
33 NPV will be zero.
Step 1 Calculate the rate of return expected
Step 2 Compare the rate of return with the cost of capital IRR = A % + * + %
*The negative sign NPVa – NPVb become (+) . The answer should be
somewhere between the two rates.
*Remember you can use the IRR to determine the upper the higher % and take two thirds of it for the lower % Pg288
EXAM FOCUS POINT:
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
