CAT T10/ FIA - FFM - Finance PassCard

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CAT Advanced Paper 10 Managing Finances

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First edition February 2005 Fourth edition January 2009 ISBN 9780 7517 5794 1 (Previous edition ISBN 9780 7517 4790 4) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd, BPP House, Aldine Place, London W12 8AA www.bpp.com/learningmedia Printed in Great Britain All our rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media. © BPP Learning Media 2009

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Preface

Contents

Welcome to BPP Learning Media’s new CAT Passcards  They save you time. Important topics are summarised for you.  They incorporate diagrams to kick start your memory.  They follow the overall structure of the BPP Learning Media Interactive Texts, but BPP Learning Media’s new CAT Passcards are not just a condensed book. Each card has been separately designed for clear presentation. Topics are self contained and can be grasped visually.  CAT Passcards are just the right size for pockets, briefcases and bags.  CAT Passcards focus on the exam you will be facing. Run through the complete set of Passcards as often as you can during your final revision period. The day before the exam, try to go through the Passcards again! You will then be well on your way to completing your exam successfully. Good luck!

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Preface

Contents

Page 1 2 3 4 5 6 7 8 9 10 11

Cash and cash flows Forecasting cash flows Cash forecasting techniques Cash and treasury management Investing surplus funds Working capital management Managing payables and inventory Managing receivables Assessing creditworthiness Monitoring and collecting debts The banking system and financial markets

1 9 21 25 29 39 43 51 61 69 83

Page 12 13 14 15 16 17 18 19

Economic influences Short and medium-term finance Long-term finance Financing of small and medium-sized enterprises Decision making CVP analysis Capital expenditure budgeting Methods of project appraisal

89 93 103 113 119 127 133 137

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1: Cash and cash flows

Topic List Cash flow cycle Cash transactions Cash flows and profits Accruals accounting

This chapter provides a reminder of the main types of receipts and payments you will encounter, and the differences between profits and cash flows. Calculation of the cash flow cycle is a particularly important technique.

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Cash flow cycle

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Cash transactions

Cash flows and profits

Accruals accounting

Need for cash flows

Operating/cash cycle

A business has to ensure it has sufficient cash to meet its obligations, as well as making profits.

Cycle describes the connection between working capital and cash movements.

Problem Although sales are made (and accrued) money may not be received until after the date suppliers need to be paid. Bank overdraft facilities may be limited.

Working capital Current assets – Current liabilities

Calculation of operating cycle Days Raw material inventory turnover period Credit taken from suppliers Finished goods inventory turnover period Receivables payment period Operating cycle

X (X) X X __ X __ __

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1: Cash and cash flows

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Cash flow cycle

Cash inflows Sales of Sales of goods assets

Cash transactions

Grants

Share capital

Cash flows and profits

Loans

Accruals accounting

Sales of investments

CASH

Cash outflows Purchases of inventories, wages

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Purchases of assets

Tax

Dividends

Interest

Purchases of investments, foreign currency

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Capital and revenue items

Exceptional and unexceptional items

Capital items relate to the long-term functioning of the business, eg purchasing non-current assets.

Exceptional items are unusual, one-off items eg closure of a business.

Revenue items relate to day-to-day operations, eg purchasing goods for resale.

Unexceptional items are ‘normal’ business receipts and payments.

Net cash flow The change in cash position from period beginning to period-end. Analysis is needed of component elements of net cash flow

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Example Cash flow from sales Cash flow from purchases Cash paid from wages Interest payments Tax payments Cash paid for assets Bank loan Share issue Net cash flow

$ X (X) (X) (X) (X) (X) X X __ X __ __ 1: Cash and cash flows

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Cash flow cycle

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Cash flows and profits

Cash transactions

Accruals accounting

Differences between profits and cash flow Items affecting profits but not cash flows  Depreciation  Increases in provisions

Cash flows ‡ Profit  Issue of shares/loan notes  Increase in bank overdrafts/loans

Items affecting cash flows but not profits  

Issued shares/loan notes Increase in bank overdrafts/loans

 Purchase of assets  Depreciation  Profit/loss on sale of non-current assets

Items where profit/loss is different to cash flow  Purchase of assets  Increase in provisions  Expense accruals and prepayments

 Cash received ≠ revenue  Cash paid ≠ cost of sales  Expense accruals and prepayments

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How to calculate: Cash receipts from customers Customers owing money at the start of the year Add: Sales during the year Total money due from customers Less: Customers owing money at end of year Cash receipts from customers during the year

$ X X __ X (X) __ X __ __

Cash payments to suppliers Payments owed to suppliers at start of year Add: Purchases during the year * Total money due to suppliers Less: Payments owing to suppliers at end of year Cash payments to suppliers during the year * Calculated as: Cost of sales Add: Closing inventory Less: Opening inventory Purchases during the year Page 7

X X __ X (X) __ X __ __ X X __ X (X) __ X __ __ 1: Cash and cash flows

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Cash flow cycle

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Cash transactions

Cash flows and profits

Accruals accounting

ACCOUNTS ARE NOT PREPARED ON A CASH BASIS, BUT ON AN ACCRUALS (OR EARNINGS) BASIS eg a sale or purchase is dealt with in the year in which it is made, even if cash changes hands in a later year. The accruals basis of accounting is described the IASB's Framework for the Preparation and Presentation of Financial Statements. 'Financial Statements are prepared on the accrual basis of accounting. Under this basis the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.' The accruals basis of accounting is a way of letting investors know how much profit a business has made by matching income and expenditure.

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2: Forecasting cash flows

Topic List

This chapter is one of the most significant.You need to know how to go about preparing a cash flow forecast, and comparing actual cash flow with budgeted forecasts.

Cash forecasts

This chapter sets out an appropriate format for preparing a cash budget and identifying cash needs. It also summarises the action an organisation can take if it runs short of cash.

Mark up and margin Statement of financial position forecasts Control reports Correcting cash deficits

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Mark up and margin

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Statement of financial position forecasts

Control reports

Correcting cash deficits

Forecasts Amount of cash required

When required

How long required for

Whether available from anticipated sources

Cash flow-based forecasts

Banks

In receipts and payments format

Banks often insist businesses provide:

 Monthly/quarterly cash budgets

 Cash forecasts  Business plans

 Actual flows against original budget  Revised budget/rolling budget  Actual flows against revised budget  Cleared funds forecast showing funds available for spending

Banks can monitor progress/control lending using these.

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A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals.

Enables management to make forward planning decisions 

 Overdraft

 Investments

1

Sort out cash receipts from customers

 Establish materials inventory changes → quantity and cost of materials purchases

2

Establish whether any other cash income will be received

 Establish when suppliers will be paid

3

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Sort out cash payments to suppliers

4

Establish when any other cash payments will be made

 Credit control

5

Bottom of budget must show   Net cash flow  Opening position  Closing position

2: Forecasting cash flows

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Cash forecasts

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Mark up and margin

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Statement of financial position forecasts

Control reports

In more complex cash forecasts, the assumptions made are critical. Credit terms given by suppliers Specific supply arrangements Past practice

Payments

Predictable dates Volume of purchases Volume of sales Cash/credit sales mixture Specific credit terms Receipt patterns Discounts allowed

Receipts

Correcting cash deficits

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PROFORMA CASH BUDGET Cash receipts Receipts from customers Loans etc Cash payments Payments to suppliers Wages etc

Net cash flow (receipts – payments) Opening balance Closing balance

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Month 1 $

Month 2 $

Month 3 $

X X __ X __ __

X X __ X __ __

X X __ X __ __

X X __ X __ __

X X __ X __ __

X X __ X __ __

X X __ X __ __

X X __ X __ __

X X __ X __ __

2: Forecasting cash flows

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Cash forecasts

Mark up

Mark up and margin

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Statement of financial position forecasts

Control reports

Profit element as fraction of cost

Profit element as fraction of selling price

Margin

Correcting cash deficits

Sales Mark up Costs

% 100 + x x 100

Sales Margin Costs

% 100 y 100 – y

Example

Example

Cost price 80 Profit 20 Selling Price 100

What is the unit sales price if unit cost price is $25 and margin is 20%?

Mark up = Margin =

20 ÷ 80 = 25% 20 ÷ 100 = 20%

Sales price =

25 (1 – 0.2)

= $31.25

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Mark up and margin

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Statement of financial position forecasts

Control reports

Correcting cash deficits

Statement of financial position forecasts A statement of financial position forecast is used to identify the cash surplus or funding shortfall in a company’s statement of financial position at the forecast date. They are longer term strategic estimates, and act as a check on cash forecasts.

Share capital > + Reserves

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Net assets (excl cash)

=

Cash surplus

Net > assets (excl cash)

Share capital + Reserves

=

Cash deficit

2: Forecasting cash flows

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Statement of financial position forecasts

Control reports

Correcting cash deficits

Estimating a future statement of financial position  Intangible non-current assets: Current value  Tangible non-current assets: Need to estimate purchases and disposals  Current assets: Same ↑/↓ by % % of revenue  Trade payables/accruals: As current assets     

Bank overdraft: Assume none Taxation/dividends: % of profits LT loans: Existing – Repayments Share capital: Same Retained profits: Estimate future profits

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Cash forecasts

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Mark up and margin

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Statement of financial position forecasts

Control reports

Correcting cash deficits

Current forecast v original forecast CONTROL REPORTS Actual cash flows v budget Signs of bad reports Why do budgets and actual flows differ?  Same amounts forecast for receipts and payments each month  No changes to receipts and payments as new rolling forecast prepared  Forecast end of period cash balances remain constant as forecasts updated Page 17

    

Poor forecasting Loss of major customer Insolvency of credit customer Changes in interest rates Inflation 2: Forecasting cash flows

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Cash forecasts

Cash receipts Revenue Cash payments Material Labour Overheads Non-current assets

Net cash flow Opening balance Closing balance

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Mark up and margin

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Statement of financial position forecasts

Control reports

Correcting cash deficits

Budget $

Month Actual $

Difference $

Budget $

Year to date Actual Difference $ $

X __ X __ __

X __ X __ __

X __ X __ __

X __ X __ __

X __ X __ __

X __ X __ __

X X X X __ X __ __

X X X X __ X __ __

X X X X __ X __ __

X X X X __ X __ __

X X X X __ X __ __

X X X X __ X __ __

X X __ X __ __

X X __ X __ __

X – __ X __ __

X X __ X __ __

X X __ X __ __

X – __ X __ __

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Cash forecasts

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Mark up and margin

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Statement of financial position forecasts

Losses Asset replacement Growth support Seasonal business One-off expenditure

Short-term borrowing Sale of short-term investments Reduce costs Reduce inventory levels Reduce receivables Increase payables

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Correcting cash deficits

Cash flow problems Longer-term solutions

Short-term remedies      

Control reports

     

Postpone capital expenditure Sell non-essential assets Reschedule loan repayments Change terms of business Reduce dividend payments Increase selling and marketing activity 2: Forecasting cash flows

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Notes

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3: Cash forecasting techniques

Topic List Index numbers Sensitivity analysis

The cash flows of the organisation you are asked about in the exam may be stable, volatile or subject to inflation. This chapter summarises the techniques for incorporating such uncertainties into forecasts.

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Index numbers

Index A measure over time of the average changes in values of a group of items. Indexes can be used to predict inflows and outflows and hence future borrowings. Index numbers are expressed as percentages, taking the base date value as 100.

Sensitivity analysis

Weightings An index normally consists of more than one item, therefore weightings are needed to reflect the relative importance of each item. 1 Calculate price relative (price of item as % of price in previous period). 2 Calculate weightings. 3 Multiply price relative by weighting. 4 Calculate index numbers by dividing total of 3 for all items by total for previous period.

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Price index

Quantity index

A price index measures the change in the money value of a group of items over time.

A quantity index measures the change in the non-monetary values of a group of items over time. Base period is usually the starting point of a series.

Price index = 100 ×

P1 P0 

 Price in base period Quantity in base period 

Quantity index = 100 ×

Q1 Q0 

 Base period index = 100  Also known as base year

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3: Cash forecasting techniques

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Index numbers

Sensitivity analysis

Sensitivity analysis Sensitivity analysis is a modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome.

Significant variables

Other methods of uncertainty analysis

    

 Preparing a series of different forecasts, each assuming a different outcome

Changes in capacity Material/labour costs Labour availability Sales volume Productivity

Seasonally adjusted data Additive model: Y = T + S + I Multiplicative model: Y = T x S x I Where: T = Trend series S = Seasonal component I = Irregular random component

 Preparing cash forecasts as range of possible outcomes  Using probability analysis by assigning probabilities to a range of values for key uncertain cash flow items

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4: Cash and treasury management

Topic List The focus of cash management Inventory approach Treasury management

Dealing with cash flow problems is vital for businesses, and the topic is likely to be examined regularly.

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The focus of cash management

Focus of cash management

Inventory approach

Treasury management

Float Time between payment being initiated and funds becoming available for use.



Profitability

Transmission delay + lodgement delay + clearance delay

Liquidity

Reducing float

Safety     

Minimum lodgement delay (bank receipts when received) Collecting cheque from customer Use of bank giro system BACS/CHAPS Standing order/direct debits

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The focus of cash management

Inventory approach

2FS i

Treasury management

Problems with inventory approach

Baumol's model seeks to minimise cash holding costs by calculating optimal amount of new funds to raise.

Q=

Inventory approach

where S is the amount of cash used in period F is the fixed cost of obtaining new funds i

 Amounts required in future are difficult to predict  Costs associated with running out of cash  Holding costs may vary with amount held  Model doesn’t work very well for large, irregular flows  Difficulty in predicting future interest rates

is the interest cost of holding cash

Q is the total amount to be raised to provide for S Page 27

4: Cash and treasury management

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The focus of cash management

Treasury management Treasury departments are set up to manage cash funds and currency efficiently, and make the best use of corporate finance markets. The main advantages of centralised treasury management are avoiding a mix of surpluses and overdrafts, and being able to obtain favourable rates on bulk borrowing/investments.

Improve exchange risk management Employ experts Smaller precautionary balances Focus on profit centre

Treasury management

Role of treasurer      

Centralised treasury management    

Inventory approach

Corporate financial objectives Liquidity management Funding management Currency management Corporate finance Others, eg taxation

Decentralised treasury management    

Finance matches local assets Greater autonomy for subsidiaries More responsive to operating units No opportunities for large sum speculation

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5: Investing surplus funds

Topic List Cash surpluses Cash investments Marketable securities Government and local authority stocks Other investments Risk and return

This chapter summarises the financial instruments that are available if an organisation has surplus funds that need to be invested. It also sets out principles and guidelines that need to be followed when investment decisions are made.

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Marketable securities

Liquidity

Government and local authority stocks

Safety

Other investments

Risk and return

Profitability

Cash management Cash for normal business commitments

Transactions motive Cash

Buffer for unforeseen contingencies Balances held in hope interest rates 

Precautionary motive One-off dividends Speculative motive Surplus

Cash for growth, noncurrent asset purchases, acquisitions

Increasing annual dividends

Strategic motive

Buying back own shares

Shareholders

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Marketable securities

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Government and local authority stocks

Other investments

Risk and return

Interest bearing accounts

Option deposits

Banks and building societies provide various interest bearing accounts, including current accounts, cheque accounts and deposit accounts.

Option deposits are for predetermined periods of time (2 to 7 years) with minimum deposits of say $2,500. Interest rates are higher as arrangements are longer-term and there is no facility for withdrawal.

Compound annual interest CAR =

⎛⎛ X⎞ n ⎞ ⎜ ⎜ 1 + ⎟ – 1⎟ ⎜⎝ n ⎠ ⎟ ⎝ ⎠

Guidelines for investment × 100

Where X is the annual rate specified (eg 0.0525 = 5.25%)

   

Certain investments allowed/prohibited All investments convertible into cash Certain proportion invested in lower risk items Credit rating obtained for certain investments

n is number of times in year interest is paid (eg 4 = quarterly/12 = monthly) Page 31

5: Investing surplus funds

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Marketable securities

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Government and local authority stocks

Other investments

Risk and return

Attractiveness of interest Risk of non-payment

Price of fixed interest stocks

Length of time to redemption/maturity Accrued interest Cum div (int) or Ex div (int)

Interest yield =

Coupon rate Market price

Gross redemption yield Redemption yield is a more realistic measure of overall return than interest yield, as it takes into account both the interest payable and the gain or loss due to the difference between the purchase price and the redemption value.

Investors will be looking for different levels of income and capital appreciation.

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Marketable securities

Gilts Gilts are marketable British government securities, which dominate the fixed interest market.

Convertible gilts Convertible gilts are gilts redeemable on date shown or convertible into longer-dated stock.

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Government and local authority stocks

Other investments

Risk and return

 Shorts

< 5 years

 Mediums

5 – 15 years

 Longs

> 15 years

 Undated

Irredeemable/one-way options

 Index linked

Interest and redemption value linked to rate of inflation. Interest is adjusted by RPI value 8 months before payment date.

Local authority stocks Local authority stocks are similar to government securities, but security isn’t considered as good and the market is less active. They are held by a few institutions.

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5: Investing surplus funds

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Marketable securities

Certificates of deposit Certificates of deposit are negotiable instruments providing evidence of a fixed term deposit with a bank.

Certificates of deposit     

Terms 7 days to 5 years, most often 6 months Minimum amount £50,000 Can be sold on certificates of deposit market Attractive rate of interest Liquidation at any time at prevailing market rate

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Government and local authority stocks

Other investments

Risk and return

Commercial paper Commerical paper is an unsecured short-term (3 months) loan note issued by companies. They are traded at a discount and unsecured, therefore they are risky.

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Bills of exchange Bill is drawn on company/person being ordered to pay. Drawer orders payment of money. Drawee is the party who is to pay. Payee receives funds:

Discounting bills Holder of the bill  Presents bill on maturity, or  Sells bill before maturity at discount depending on credit quality of drawee and market condition for bills

 Unconditional orders to pay  Negotiable instruments

Types of bill Trade bills

Bank bills Page 35

Drawn by one non-bank on another; to be tradeable both must have high credit ratings

Basis of trading  Interest rate basis

Principal sum lent, borrower repays principal plus interest at maturity

 Discount basis

Specified sum payable at maturity

Drawn and payable by banks 5: Investing surplus funds

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Cash surpluses

Political and economic climate

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Marketable securities

Inflation

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Government and local authority stocks

Products

Competition

Risk Income

Capital

Government securities RISK

Other investments

Company loans notes Preference shares Ordinary shares

Risk and return

Management

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Types of risk

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Risk and return

 Systematic risk – caused by factors affecting the whole market  Unsystematic risk – security/sectorspecific risks

Diversification The reduction of risk by investing in a range of securities.

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5: Investing surplus funds

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Notes

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6: Working capital management

Topic List Working capital Working capital ratios Overtrading

In the exam you may be asked not just to calculate working capital levels/ratios but to also explain their significance. The symptoms of over-capitalisation and overtrading are also important.You may be asked how to improve the management of working capital.

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Working capital

Working capital ratios

Overtrading

Working capital = current assets – current liabilities

Working capital management Minimise risk of insolvency

Maximise return on assets

Working capital cycle Average time raw materials are in inventory Less: Period of credit taken from suppliers Plus: Time taken to produce goods Plus: Time finished goods are in inventory after production is completed Plus: Time taken by customers to pay for goods

Working capital cycle is the length of time between cash being spent at start of production and cash being received from the customer

 Retailers often receive cash, pay for supplies by credit  Wholesalers mainly buy and sell on credit, need short-term borrowings  Small companies may have trouble obtaining credit, but may have to offer generous credit terms

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Working capital

Current ratio =

Current assets

Acid test/quick ratio =

Current liabilitie s

Accounts receivable days =

Trade receivables Credit sales

Inventory turnover period =

Average inventory Cost of sales

Inventory turnover =

Working capital ratios

Overtrading

Current assets less inventories Current liabilities

× 365 days

Accounts payable Average payables payment period = × 365 days Purchases on credit

× 365 days

Average inventory Cost of sales

Over-capitalisation is where there are excessive inventory, receivables and cash and very few payables. The funds tied up could be invested profitably.

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6: Working capital management

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Working capital

Working capital ratios

Overtrading

Overtrading occurs when a business is trying to support too large a volume of trade with the capital resources at its disposal.

Symptoms

Solutions

 ↑↑ revenue

 Finance from share issues

 ↑↑ current assets

 Better inventory and receivables control

 ↑↑ non-current assets

 Postpone expansion plans

 Assets financed by trade payables/bank overdraft

 Maintain/increase proportion of long-term finance

 Little/no ↑ in proprietors’ capital  ↓ current/quick ratios

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7: Managing payables and inventory

Topic List Trade payables Methods of payment Inventory costs JIT and purchasing mix

Inventory costs are a key topic in this chapter; the EOQ formula is particularly critical. You may be asked to explain the assumptions behind the formula, or asked about other inventory management techniques.

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Trade payables

Management of trade payables

Methods of payment

365 t

JIT and purchasing mix

Extending credit if cash short Good relations/loss of goodwill if payment delayed

Example X Co owes its supplier $1,000, it can either pay $1,000 in 45 days’ time or $980 in ten days’ time. It can invest funds at 25% interest.

−1

where d is % discount t is reduction in payment period in days necessary to obtain early discount

Inventory costs

Obtaining satisfactory credit levels/terms

Cost of lost cash discounts ⎛ 100 ⎞ ⎜ ⎟ ⎝ 100 - d ⎠

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Cost cash discount: $980 × Consider also interest gained through having monies for full period.

35 × 25% = 23.5 365

Cost: Accept discount $980 Refuse discount ($1,000 – $23.5) = $976.5 It is cheaper to refuse the discount, invest the money and pay after 45 days.

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Trade payables

Methods of payment

Inventory costs

JIT and purchasing mix

Cash

Cheques

Standing orders

Small payments/wages

Commonly used and widely accepted

Regular payments of fixed amounts

 Keep secure

 Convenient

 HP payments

 Easily lost

 Counterfoil/cheque number can be traced

 Rental payments

 Lack of payment evidence

 Keep secure

 Insurance premiums

 Slow method of payment

BACS

Telegraphic transfers

Direct debits

Payment information sent to BACS for processing. Most commonly used for salaries, can be used for suppliers.

Large payments made immediately.

Deductions from bank account, regular and irregular payments of fixed and varying amounts. Recipient sets the amount.

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7: Managing payables and inventory

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Trade payables

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Methods of payment

Inventory costs

JIT and purchasing mix

Economic order quantity (EOQ)

Safety inventory

EOQ is the optimal ordering quantity for an item of inventory which will minimise costs.

Safety inventory is held when demand is uncertain or supply lead time is variable.

EOQ =

2C O D CH

Average annual = safety inventory cost

Safety quantity

×

Annual unit holding costs

Exam formula

D = Usage in units CO = Cost of placing one order CH = Holding cost EOQ= Economic order quantity

Bulk discounts Total cost will be minimised:  At pre-discount EOQ level, so that discount not worthwhile or  At minimum order size necessary to earn discount Calculate: Purchasing costs + Holding costs + Ordering costs

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7: Managing payables and inventory

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Trade payables

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Methods of payment

Inventory costs

JIT and purchasing mix

Inventory costs Holding costs

Procuring costs

Shortage costs

    

Cost of capital Reorder level Warehouse/handling costs = Maximum usage × Maximum lead time Deterioration/obsolescence Insurance Maximum inventory level Pilferage = Reorder level + Reorder quantity – (Minimum usage × Minimum lead time)  Ordering costs  Delivery costs Minimum inventory level = Reorder level – (Ave usage × Ave lead time)

 Contribution from lost sales  Emergency inventory  Stock-out costs

Average inventory = Minimum level × (Reorder level ÷ 2)

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Trade payables

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Methods of payment

Just-in-time (JIT) procurement

Purchasing mix

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JIT and purchasing mix

Benefits of JIT

JIT describes a policy of obtaining goods from suppliers at the latest possible time. It avoids the need to carry materials/component inventory.

Quantity Quality Price Delivery

Inventory costs

     

↓ Inventory costs ↓ Manufacturing lead times ↑ Labour productivity ↓ Labour/scrap/warranty costs ↓ Material purchase costs (discounts) ↓ Number of transactions

Balance between holding, and ordering stock-out costs Good enough for production/customers Best value over time Lead time and reliability

7: Managing payables and inventory

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Notes

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8: Managing receivables

Topic List Credit control Total credit The credit cycle Payment terms Settlement discounts Legal aspects

You need to be familiar with all aspects of credit control, in particular the key decisions an organisation has to make. Should it offer credit? If so how much? Who to? Should it offer early settlement discounts?

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Credit control

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Total credit

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The credit cycle

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Payment terms

Settlement discounts

Legal aspects

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May report to

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Chief Accountant

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Sales Manager

Managing Director

Finance Director

CREDIT CONTROL DEPARTMENT Duties

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Updating receivables’ ledger

Customer queries

Liaison with sales staff

Third party references

Checking creditworthiness

Advising on payment terms

8: Managing receivables

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Credit control

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Total credit

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The credit cycle

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Payment terms

Settlement discounts

Legal aspects

Trade credit

Monitoring total credit

Credits issued by one business to another business eg stating payment is expected within 30 days.

Investment in receivables can be measured using:

Consumer credit Credit offered by businesses to endconsumers.  Hire purchase, loan to purchase goods  Credit cards

Receivables Receivables’ payment period = Sales (in 365 days)

Credit utilisation report Report shows extent to which total limits being utilised, indicating number of customers who might want more credit, and extent of exposure to receivables.

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Profit

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Cash flow

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Asset use

Interest cost

Total credit levels Setting total credit limits means balancing need to entice customers by favourable terms (but losing interest) and refusing opportunities for sales.

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Should credit be extended? 

Extra sales



Profitability of extra sales



Effect on inventory/payables



Length of extra debt collection period



Required rate of return on investment in additional receivables

8: Managing receivables

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Credit control

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Total credit

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The credit cycle

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Payment terms

Settlement discounts

Legal aspects

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Credit control

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Total credit

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The credit cycle

Payment terms

Settlement discounts

Legal aspects

Terms and conditions of sale Profit required from customer Competitors’ credit terms Special factors relating to customer Risk of default Seasonal factors

Methods of payment     

Cash BACS Cheques Bankers’ draft Travellers’ cheque

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Nature of goods Price Delivery Date of payment Frequency of payment Discounts

Payment terms    

Standing order Direct debit Credit/debit card Bills of exchange

     

Specified number of days after delivery Weekly/half monthly/monthly credit CWO Cash with order CIA Cash in advance COD Cash on delivery CND Cash on next delivery 8: Managing receivables

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Credit control

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Total credit

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The credit cycle

Advantages of early settlement discounts

Settlement discounts

Payment terms

Legal aspects

Cost of early settlement discount

 Encourage customers to pay earlier and thus reduce financing costs

⎛ 100 ⎞ ⎟ ⎜ ⎝ 100 – D ⎠

 Improve liquidity  Encourage customers to buy

365 T

−1 %

where D = Discount offered T = Reduction in payment period necessary to obtain discount

Example Henry Co is considering a 2% discount to all customers paying within 30 days. 365

⎛ 100 ⎞ 30 ⎟ − 1 % = 27.86% Cost of early settlement discount = ⎜ ⎝ 100 – 2 ⎠

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Credit control

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Total credit

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The credit cycle

Contract An agreement which legally binds parties. Validity of a contract affected by:     

Content – complete and precise Form – certain contracts in precise form Genuine consent Legality Capacity – some parties have restricted capacity

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Payment terms

Settlement discounts

Legal aspects

Essential elements of a contract  Legal relations (intention)  Offer and acceptance  Consideration (the price paid in exchange for a promise)

Breach of contract When one of the parties fails to perform. Remedies:  Damage  Termination  Quantum meruit (value for work done) Page 59

 Specific performance  Action for the price (recovery of agreed sum)

8: Managing receivables

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Credit control

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Total credit

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The credit cycle

Sale of goods

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Payment terms

Settlement discounts

Legal aspects

Failure to pay

Sale of Goods Acts govern sale of goods. Key conditions:

 Goods can be stopped in transit

 Title passes on delivery even if payment delayed

 Lien by seller if goods not passed (retain on seller’s premises if not delivered)

 Title passes on sale or return goods when buyer accepts  If conditions imposed, must be fulfilled

 Length of credit stated in contract (failure to pay = breach of contract)  Charge interest on late payments  Retention of title clauses (ownership does not pass until payment is received)

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9: Assessing creditworthiness

Topic List Credit assessment References Financial analysis Visits Other information Using information Data protection

This chapter takes you through the assessment of the reliability of potential credit customers. It summarises the sources of information you can use when making the assessment.You should be able to demonstrate that you can use evidence about potential customers to make sensible recommendations that are in line with organisational policies.

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Credit assessment

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References

Financial analysis

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Visits

Other information

Using information

Data protection

Credit risk means that there is a possibility that the debt will go bad. A credit assessment is a judgement about the creditworthiness of a customer, providing a basis for a decision as to whether credit should be granted. HIGH Unacceptable risk Customers responsible for most bad debt problems but can generate high revenue Customers who exploit trade credit in full/overseas customers who have difficulty remitting payments Customers with good reputation and no history of payment problems Zero or negligible risk (government institutions and major companies) LOW

Remember! Credit assessment will not only be needed when credit is first granted, but also when customers request higher limits or their volume of trade takes them above their existing limits.

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Credit assessment

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References

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Financial analysis

Bank references Should ask in precise terms ‘Do you consider X Co to be good for a trade credit of $1,000 per month on terms of 30 days?’

Trade references

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Visits

Other information

Using information

Data protection

Types of bank reference  Undoubted

BEST

 Considered good for your figures  Respectably constituted business which should prove good for your figures

 Referee should be offering similar terms

 Respectably constituted business whose resources would appear to be fully employed; we do not think they would undertake something they felt they could not fulfil

 References should be followed up

 Unable to speak for your figures

Remember  Customer may maintain untypically good relations with referees

WORST

 Unknown company’s reference should be treated with caution Page 63

9: Assessing creditworthiness

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Credit assessment

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References

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Financial analysis

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Visits

Other information

Using information

Data protection

Ratio analysis  Profit margin =

Profit Revenue

 Net asset turnover =

 Gearing = Revenue

Capital employed

 Return on capital employed =

Profit Capital employed

 Earnings per share = Profit attributable to ordinary shareholders Number of ordinary shares

Prior charge capital Equity

 Interest cover =  Debt ratio =

Profit before tax and interest Finance (interest) charges

Total liabilitie s Total assets

 Price earnings ratio =

Market price per share EPS

 Working capital ratios (see Chapter 6) Remember that the credit controller is predominantly interested in the indicators of future cash flow (liquidity, gearing, working capital). Financial information has limits because it is historical.

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Credit assessment

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References

Financial analysis

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Visits

Credit controller

Premises

Treatment of visitors

Using information

Data protection

Customer

Accounts department and accounts payable and receivable departments  Well run  Proper recording  Proper filing

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Other information

Payment methods

Overall impression  Prosperous  Slow-moving stock  Signs of decay/ obsolescence

9: Assessing creditworthiness

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Credit assessment

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References

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Financial analysis

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Visits

Other information

Using information

Data protection

Credit reporting agencies (credit bureaux) Credit bureaux provide information about businesses so that their creditworthiness can be assessed by suppliers.  Summary of information

 May not contain up-to-date information

 Means of cross-checking other information

 Suppliers’ references are out-of-date  Lack of information on new businesses

Contents of agency report

Other information

 Legal data

   

 Commercial data  Credit data (References agency assessment)

Press Historical, financial data Companies’ Registry search County Court records

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References

Financial analysis

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Visits

Other information

Using information

Data protection

Credit control information should be used in various ways.

1 Granting credit

Information used to decide  Whether to grant request in entirety  Whether to grant request provisionally subject to later review  Whether to give less generous terms than the customer wants

2 Credit ratings

Need for reliable credit ratings and details of credit taken  Invoices and receipts posted immediately  Queries cleared quickly  Orders vetted against credit limits  Customer history

3 Credit reviews

Overall review of payment record and aged analysis, high risk customers reviewed more frequently

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9: Assessing creditworthiness

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Credit assessment

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References

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Financial analysis

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Visits

Data Protection Act 1998 Aims to protect individuals (data subjects).  Data subjects have certain legal rights  Data users and computer bureaux (data holders) must register under the Act  Data holders must follow data protection principles Rights of data subjects  Compensation for loss/destruction/unauthorised disclosure  View personal data  Have inaccurate data corrected/destroyed

Other information

Using information

Data protection

Data protection principles  Apply to paper-based/microfilm/microfiche systems  Conditions under which processing is lawful prescribed  Processing of personal data forbidden unless subject consents/legal obligation  Processing of sensitive (racial, political, religious) data forbidden without consent  Data subjects must be told reasons for data processing

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10: Monitoring and collecting debts

Topic List Monitoring receivables Insurance, factoring and discounting Collecting debts Bad and doubtful debts Third party use Bankruptcy and insolvency

When monitoring receivables and pursuing debts, you need to know which methods are most likely to work and which methods should be used when dealing with certain customers. An organisation may use factoring to simplify administration or to raise money.

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Credit monitoring

Monitoring receivables

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Third party use

Bankruptcy and insolvency

Efficient administration 

Prompt dispatch of statements/invoices, recording and banking receipts

Individual customers 

Initial credit ratings, customer history, regular review of high risks

Ratio analysis 

Overdues/disputes as % of total debts, average payment period

Credit utilisation report 

Who might want more credit, tightness of credit policy, exposure to debt

Aged receivables  analysis

Balance and periods unpaid. Accounts/customer types highlighted

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Aged receivables analysis Account No

Customer name

Balance

90

1

A

X

X

X

X

X

2

B

X

X

X

X

X

3

C

X

X

X

X

X

4

D

X

X

X

X

X

Reports can highlight:  Overdue accounts  Sales revenue and days’ sales outstanding  Aggregate for customer classes eg region or industry sector

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10: Monitoring and collecting debts

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Monitoring receivables

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Third party use

Bankruptcy and insolvency

Credit insurance

Types of policy

Insurance may be obtainable from a specialist credit insurance firm.

Whole turnover policy – Up to 80% of entire receivables’ ledger

 Insurance will be assessed on a customer-bycustomer basis

Annual aggregate excess of loss

– All debts above a certain amount

 Insurance company will only insure up to 75% of potential bad debt loss if insurance covers whole receivables’ ledger

Specific customer amount

– Payable if specific customer becomes insolvent

Insurance company will review  Accounts receivable reports  Credit control and debt collection procedures  Sales administration

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Factoring Factoring is debt collection by factor company which advances proportion of money due.

Factor company

Benefits of factoring finance

 Pay suppliers promptly  Maintain optimum inventory levels  Growth financed through sales rather than external capital  Finance linked to volume of sales  Factor will chase slow payers Page 73

 Administration of invoices, sales accounting and debt collection service  Credit protection for client’s debts  Factor finance, payments in advance However, use of a factor may give a negative image of the organisation to the customer

Invoice discounting Invoice discounting is the sale of debts for discount in return for cash. The customer is unaware of the discounter’s involvement and continues to pay the supplier. 10: Monitoring and collecting debts

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Monitoring receivables

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Invoicing     

Customer fully aware of terms Invoice correct and issued promptly Knowledge of customer’s system used Queries resolved quickly Monthly statements issued promptly

Third party use

Customer awareness of terms  Payment dates and terms discussed during initial negotiations  Customer agreement to terms  Payment terms stated on order, invoice, monthly statement

Chasing slow payers      

Reminders or final demands Telephone calls Personal approach Notify debt collection section Legal action External debt collection agency

Bankruptcy and insolvency

Monthly statements     

New invoices Cash received Outstanding balance due Age analysis Payment reminder

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Customer payment systems

Key account customers

 Invoice and payment runs on monthly basis

Some customers are treated with special attention in sales effort. Credit control will involve

 Only pay certain amount each month  Only pay when sent reminder  Only pay when legal action threatened

 Senior staff time  Specific request for payment

Receipts on long-term contracts    

Take place over a number of years Precise terms Third party verification of work done Progress payments

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If payment is slow or disputed stopping work on the contract may involve significant costs and loss of significant revenues. However, customer failure to pay regularly can mean major cash flow problems.

10: Monitoring and collecting debts

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Monitoring receivables

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Third party use

Bankruptcy and insolvency

Methods of chasing customers

Reasons for short/non-payment

Value of debt

 Invoices not entered on system in time for payment run

High

Personal visit Telephone

Low

 Disputed amounts

Fax

 Short payment agreed with sales department

E-mail

 Deliberate under payment

Letter Accounts of most importance

 Largest outstanding balances  Largest arrears  No recent payments

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Monitoring receivables

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Insurance, factoring and discounting

Collecting debts

Bad debt

Bad and doubtful debts

Third party use

Bankruptcy and insolvency

Doubtful debt

Bad debt is a debt which is considered to be uncollectable and is written off against the income statement or doubtful debts provision.

Bad debts ratio = OR =

Bad debts × 100% Sales on credit Bad debts × 100% Total receivables

Bad debt report will give details of when original debt arose and when the debt was written off.

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Doubtful debt is a debt for which there is some uncertainty as to whether it is bad.

Doubtful debt provision Doubtful debt provision is an amount charged against profit and deducted from receivables to allow for estimated non-recovery of proportion of debts.

Writing debts off Consider  Success of attempts to collect debt  Expenses of pursuing debt  Likelihood of insolvency proceedings 10: Monitoring and collecting debts

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Monitoring receivables

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Third party use

Personal customers

Changes in payment patterns Requests for credit extension Court action Failure to communicate/reply

Business customers

Loss of major customer Bankruptcy of own customers Disaster Industrial action Slower payment Other suppliers having payment difficulties Signs of slow business Newspaper reports County Court judgements Credit vetting agency reports Bouncing cheques

Bankruptcy and insolvency

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Financial signs Warning signs in accounts, poor ratios, Z scores, imprudent accounting policies, also accounts being filed late.

A Scores Defects

Dominance by single individual Directors lack broad expertise Weak Finance Director Lack of management depth below board level Poor accounting systems Lack of responsiveness to change

Mistakes

Over-borrowing Over-trading Over dependent on single project

Symptoms

Financial signs (see above), Z-scores in decline Non-financial signs (eg fall in market share)

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10: Monitoring and collecting debts

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Third party use

Debt collection agencies

Court action

Agencies receive a percentage of debts collected. Some collect on letter/telephone basis, others collect on the doorstep.

Before taking action, check:

Arbitration agreement An arbitration agreement is a written agreement to submit differences to arbitration. The arbitrator will try and settle differences. Proceedings are less formal, quicker and cheaper than litigation. However, arbitration may be means of delay, and arbitrator may have insufficient powers.

Bankruptcy and insolvency

 Genuine debt not dissatisfied customer  Exact identity of customer  Customer’s financial resources The amount owed, type of transaction, and public interest issues will determine court used.

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Monitoring receivables

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Insurance, factoring and discounting

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Collecting debts

Bad and doubtful debts

Third party use

Bankruptcy and insolvency

Bankruptcy

Insolvency

Bankruptcy is the legal status of an individual against whom an order has been made by the court because of an inability to meet financial liabilities.

Insolvency is the inability of a debtor company to pay its debts when they fall due.

Creditors demand payment and petition for bankruptcy.

Company may suffer liquidation/winding-up (similar procedures to bankruptcy) or receivership (receiver appointed to obtain money by realising assets).

Debtor cannot dispose of property/settle legal claims. Official receiver appointed to investigate/realise assets.

Company may be able to use alternative procedures (administration, voluntary arrangements) depending on legal jurisdiction in an attempt to keep trading.

Assets realised and creditors paid in order of preference. Page 81

10: Monitoring and collecting debts

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Notes

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11: The banking system and financial markets

Topic List The banking system Financial markets

This chapter provides the knowledge you need of the banks and the markets on which organisations might raise long-term funds.

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The banking system

Financial intermediation

   

Financial intermediation is the bringing together of providers and users of finance.

Commercial banks The retail (High Street) and wholesale banks  Payments mechanism  Wealth store  Providers of funds

Financial markets

Convenient means of saving money Aggregating amounts lent for borrowing Pooling reduces risk Maturity transformation

Other financial intermediaries      

Building societies Finance houses Insurance companies Pension funds Unit trusts Investment trust companies

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Bank assets

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Bank liabilities

Notes and coin Bills Money market loans Customer loans and overdrafts Securities

$ X X X X X __ X __ __

Bank income Interest received Current account charges Commissions and fees Foreign exchange Mortgages

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Sterling current accounts Sterling deposit accounts Other currency deposits

$ X X X __ X __ __

Bank expenses $ X X X X X __ X __ __

Interest paid Running costs Wages/salaries Advertising Bad debts

$ X X X X X __ X __ __

11: The banking system and financial markets

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The banking system

Central bank

European central bank

A central bank controls the money supply of a country.

Roles of central bank         

Financial markets

Banker to central government Issuer of bank notes Supervises government borrowing Intervenes in foreign exchange markets Banker to commercial banks Lender of last resort Adviser on economic policy Agent of government Participant in international institutions

ECB supervises monetary policy in Euro area, trying to ensure price stability by influencing interest rates. ECB also imposes reserve requirements on credit institutions. The Eurosystem consists of ECB and central banks of countries that have adopted the Euro.

Role of Eurobanks  Conducting foreign exchange operations  Issuing bank notes  Promoting smooth operation of payment systems  Collecting and providing information

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The banking system

Financial markets

Money markets

Capital markets

Money markets are operated by banks/financial institutions and provide means of trading, lending and borrowing in the short-term.

Capital markets are markets for trading in long-term financial instruments, in particular shares and bonds. They enable organisations to raise new finance, investors to realise investments and companies to merge/takeover.

Main short-term markets       

Primary Interbank Eurocurrency Certificate of deposit Local authority Finance house Inter-company

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Main money market instruments    

Deposits Bills Commerical paper Certificates of deposit

11: The banking system and financial markets

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The banking system

Financial markets

Capital market participants Demand for funds comes from ... INDIVIDUALS (eg housing/consumer goods finance)

FIRMS (share capital; loans)

GOVERNMENT (budget deficit)

Capital markets Intermediaries Banks Building societies Insurance companies and pension funds Unit trust/investment trust companies Stock exchanges Venture capital organisations

Suppliers of funds INDIVIDUALS (as savers and investors)

FIRMS (with long-term funds to invest) GOVERNMENT (budget surplus)

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12: Economic influences

Topic List

This chapter examines the major economic influences on the finance available to organisations.

Interest rates

Capital markets and government policy are both very important in determining the conditions facing businesses and the availability (and cost) of finance.

Economic policies

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Interest rates

Factors affecting interest rates Various interest rates are available; they depend on risk, duration, size of loan, likely capital gain.

General factors affecting all rates       

Need for a real return Inflation/expectations Government borrowing Demand for individuals' borrowing Balance of payments uncertainty Monetary policy Foreign interest rates

Economic policies

Real rate of interest The real rate of interest is the rate of return that investors get from their investment, adjusted for inflation.

Nominal rate of interest The nominal rate of interest is the rate of interest expressed in money terms. Real rate of interest = 1 + nominal rate of interest - 1 1 + rate of inflation

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Interest rates

Monetary policy Regulation of the economy through control of money supply/interest rates. Increases in the money supply  Government prints more notes/ coins  Government spends more than it raises  Banks and building societies lend more money  Money from abroad enters UK accounts Page 91

Economic policies

Reserve requirements A proportion of a bank’s assets are held in reserve and not used for lending. Direct controls  Lending ceilings  How much is lent to particular sector  Supervisory controls over capital structure, liquidity and foreign exchange exposure  Open market operations

Interest rate policy Higher interest rates should reduce demand for borrowing, leading to less consumer demand/increased finance costs. 12: Economic influences

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Interest rates

Fiscal policy Fiscal policy is government spending money or collecting taxes. It can be a means of demand management and inflation control.

Inflation Inflation is a sustained increase in the general level of prices over time.

Economic policies

Problems of inflation  Redistribution of wealth (those on fixed incomes suffer)  Balance of trade (exports fall as more expensive, imports rise as cheaper)  Inefficient resource allocation (as real meaning of prices is unclear)  Cost of frequently changing prices (administration, seeking out lowest prices)  Reduced investment in the economy (if interest rates rise to counter inflation)  General uncertainty

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13: Short and medium-term finance

Topic List Bank/customer relationship Bank lending criteria Overdrafts Medium and long-term loans Leases

This chapter summarises various possible sources of business finance. Remember that some of them may not be readily available, and some might not be right for the organisation. Bear in mind that a complete analysis would also cover the flexibility of the finance, and what the organisation would have to commit in return. Probably the most important examination issues are choosing appropriate finance, and the criteria that an organisation must fulfil for banks to lend it money.

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Bank/customer relationship

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Bank lending criteria

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Overdrafts

Medium and long-term loans

Leases

Liquidity maintenance

Operational functioning (pay salaries, suppliers)

Minimise risk of losing finance sources

Guard against unexpected movements

Overdraft facility repayable on demand Term loan fixed repayment period, interest charged

Bank facilities

Committed facility stipulated amount made available on demand Uncommitted facility paperwork for lending is completed in advance. No obligation to lend Revolving facility renewable after a set period Acceptance facility for bills of exchange

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Debtor/ creditor

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Bailor/ bailee

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Mortgagor/ mortgagee

Principal/ agent

also a FIDUCIARY relationship (to act in good faith) Bank duties       

Honour cheques Receive funds Repay on demand Comply with customer instructions Provide a statement Confidentiality, care and skill Advise of forgeries

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Customer duties  Duty of care to deter fraud  Advise of forgeries

13: Short and medium-term finance

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Bank/customer relationship

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Bank lending criteria

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Overdrafts

Medium and long-term loans

Leases

Character

Past record Interviews Credit scoring/ratio analysis

Ability to borrow and repay

Legal capacity Re-investment of retained profit Problems (declining profits, overtrading, poor working capital control)

Margin of borrowing Purpose of borrowing

At fixed or discretionary rate

Amount of borrowing Repayment terms Insurance

Not too much (may not repay) or too little (may want more later)

May be cautious if purpose to finance new business venture/working capital increase

Timescale and instalments Security easy to take, value, realise Personal guarantees

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Bank/customer relationship

Overdrafts

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Bank lending criteria

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Overdrafts

Medium and long-term loans

Leases

Amount

Should not exceed limit, bank will want ‘hard core’ reduced

Margin

Interest on daily amount, margin over base rate

Purpose

Cover short-term/seasonal deficit

Repayment

Repayable on demand

Security

Over specific assets/whole business, depends on size of facility

Benefits

Flexible short-term borrowing for customer; bank has to accept fluctuation in balances 13: Short and medium-term finance

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Bank/customer relationship

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Bank lending criteria

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Overdrafts

Medium and long-term loans

Leases

Overdrafts and working capital Overdrafts may be used to:  Finance increased assets Banks may be happy for certain reasons (need inventory for large order or seasonal peaks), and less happy for others (increase due to poor control or needed for non-current asset purchase (loans preferred)).  Decrease liabilities Banks may be happy sometimes (take advantage of purchase discounts) but unhappy if used to pay pressing suppliers, as risk of default transferred to bank.

Hard core overdraft Where a business is permanently in overdraft it has a solid or hard core debit balance which may persist. Banks will want such a balance reduced or converted into a medium-term loan to ensure it is repaid.

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Bank/customer relationship

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Page 99

Bank lending criteria

Overdrafts

Medium and long-term loans

Leases

Uses of loans

Types of loans

 Easy for bank to monitor

 Bullet – all loan principal repaid at end of loan period

 Customers and banks know amounts paid/received  Customer doesn’t face threat of having to pay loan back on demand  Bank can obtain written safeguards Term of loan  Need for loan (not > than useful life of asset)

 Balloon – most of loan principal repaid at end of period  Amortising – loan principal repaid gradually, regular payments consist of interest and some of loan principal Interest rates

 Bank guidelines

 Fixed throughout loan period

 Government regulations

 Variable, depending on market conditions

 Banker-customer negotiations agreement Page 99

13: Short and medium-term finance

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Bank lending criteria

Page 100

Overdrafts

Medium and long-term loans

Leases

Costs of loans

Loan covenants

   

 Positive – borrower must do something

Interest Arrangement fee to bank Commitment fees Legal costs

Overdrafts     

Designed for day to day help Only pay interest when overdrawn Bank has flexibility to review Can be renewed Won’t affect gearing calculation

 Negative/restrictive – borrower must not do something (eg borrow more money)  Quantitative – limits on borrower’s financial position

Overdrafts v loans

Loans     

Medium-term purposes Interest and repayments set in advance Bank won’t withdraw at short notice Should not exceed asset life Can have loan-overdraft mix

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Bank lending criteria

Leasing Leasing is a contract between the lessor and lessee for the hire of a specific asset.

Page 101

Overdrafts

Medium and long-term loans

Leases

Leasing  Lessor has ownership of asset  Lessee has possession and ownership of asset on payment of specified rentals over period

Hire purchase Hire purchase is a form of instalment credit, where ownership passes to the customer on the payment of the final credit instalment. Hire purchase payments consist of capital element (towards asset cost) and interest.

Page 101

Hire purchase  Supplier sells goods to finance house  Supplier delivers goods to customer who purchases them  HP arrangement exists between finance house and customer 13: Short and medium-term finance

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Bank lending criteria

Page 102

Overdrafts

Medium and long-term loans

Leases

Operating leases

Finance leases

 Lessor supplies asset to lessee

 Third party supplies the asset, the lessor supplies the finance  Lessee responsible for servicing and maintenance

 Lessor responsible for servicing and maintenance  Period of lease short, less than useful economic life of asset  Asset not shown on lessee’s Statement of Financial Position

 Primary period of lease for asset’s useful economic life, secondary (low-rent) period afterwards  Asset shown on lessee’s Statement of Financial Position

Advantages of leasing

 Supplier paid in full  Lessor receives (taxable) income and capital allowances  Help lessee’s cash flow  Cheaper than bank loan?

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14: Long-term finance

Topic List Longer term finance Ordinary shares Preference shares Loan stock Convertibles and warrants The capital structure decision

This chapter considers the long-term financing decisions that businesses make. The amounts of money that are required can often only be obtained on the capital markets.

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Longer term finance

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Ordinary shares

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Page 104

Preference shares

Loan stock

Different sources of funds  Retained earnings  Capital markets – Share issues – Rights issues – Loan capital    

Bank borrowings Government sources Venture capital International money markets

Convertibles and warrants

The capital structure decision

The choice of financing methods          

Purpose of the finance Amount Repayment Term Cost Security Covenants Taxation treatment Control implications Effect on gearing

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Ordinary shares

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Preference shares

Page 105

Loan stock

Convertibles and warrants

The capital structure decision

Offer for sale

Placing

The company sells shares to the general public. Offer for sale by tender means allotting shares at the highest price they will be taken up.

Placing means arranging for most of an issue to be bought by a small number of institutional investors. It is cheaper than an offer for sale.

Costs of share issues

Timing of share issues

 Underwriting costs  Stock Exchange listing fees  Issuing house, solicitors, auditors, public relation fees

 High share prices generally = high confidence  High confidence = high issue price  High issue price = fewer shares need to be issued

 Printing and distribution costs  Advertising

 Fewer shares issued = reduced commitment on dividends  The reverse is true where share prices and business confidence is generally low

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Access to wider pool of finance Improved marketability of shares Transfer of capital to other uses Enhancement of company image Facilitation of growth by acquisition

Stock market listing

Disadvantages of obtaining a listing     

Loss of control Vulnerability to takeover More scrutiny Greater restrictions on directors Compliance costs

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Ordinary shares

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Preference shares

Convertibles and warrants

Loan stock

Rights issue Rights issue is an offer to existing shareholders enabling them to buy new shares.

The capital structure decision

Advantages of rights issues  Offer price will be lower than current market price of existing shares

 Lower issue costs than offer for sale  Shareholders acquire more shares at discount

 Relative voting rights unaffected

Scrip dividend

Scrip issue

Stock split

Scrip dividend is a dividend payment in the form of new shares, not cash.

Scrip issue is an issue of new shares to current shareholders, by converting equity reserves.

Stock split is the splitting, for example, of one $1 share into two 50c shares.

Page 107

14: Long-term finance

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Ordinary shares

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Preference shares

Page 108

Loan stock

Convertibles and warrants

The capital structure decision

Preference shares Preferences shares are shares which have a fixed percentage dividend, payable in priority to any dividend paid to ordinary shareholders.

 Can only be paid if sufficient distributable profits are available  Cumulative preference shares have the right to unpaid dividends carried forward to later years

Advantages

Disadvantages

 Can be issued on terms that suit the company  Dividends not paid when profits poor  Don’t dilute voting rights  Lower gearing  Don’t restrict borrowing power  No shareholder right to appoint receiver

 Dividend payments not tax-deductible  Not popular with investors (can’t be secured on assets, low dividend yield)  Loan stock ranks higher in liquidation  Issue costs more expensive than loan stock

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Ordinary shares

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Preference shares

Loan stock The stock has a nominal value, the debt owed by the company, and interest is paid on this amount. Security may be given.

Fixed and floating charges Fixed charge specific assets, can’t dispose without lender’s consent Floating charge class of assets, can dispose until default Deep discount bonds are issued at a large discount to nominal value of stock. Zero coupon bonds are issued at a discount, with no interest paid on them. Page 109

Page 109

Loan stock

Convertibles and warrants

The capital structure decision

Debentures Debentures are a form of loan stock. They are the written acknowledgement of debt including provisions about interest payment and capital repayment. The debenture trust deed allows the trustee to intervene if interest is not paid or borrowing limits are breached. Redemption is repayment of the loan stock. Floating rate loan stock protect borrowers if interest rates are falling, and allow lenders to benefit if interest rates are rising. Their market price depends on coupon rate relative to market rates. 14: Long-term finance

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Ordinary shares

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Preference shares

Loan stock

Convertibles and warrants

The capital structure decision

Convertible securities

Warrants

Convertible securities are fixed return securities convertible at pre-determined dates and at holder’s option into ordinary shares at a pre-determined rate.

Warrants are rights for an investor to subscribe for new shares at a future date at a fixed predetermined price. Theoretical Current share No of shares value = price – Exercise × from each price warrant

Conversion premium is the difference between issue value of stock and conversion value at issue date. The company will try to maximise it and thus have to issue fewer shares. Market price depends on    

Price of straight debt Current conversion value Time to conversion Expectations of future returns

Warrants Usually issued with unsecured loan stock.     

Don’t involve interest/dividends Make loan stock issue more attractive Don’t immediately dilute EPS Income in form of capital gains Low investor outlay/maybe high profit

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Preference shares

Page 111

Loan stock

Convertibles and warrants

The capital structure decision

Capital structure Matching assets with funds Assets yielding long-term profits should be financed by long-term funds.

Page 111

Replacement and growth Replacement of assets often financed by internal sources, growth by external finance.

Debts and financial risk Ultimately risk of liquidation but also risk shareholders receive no/inadequate dividend.

14: Long-term finance

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Ordinary shares

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Preference shares

Loan stock

Convertibles and warrants

The capital structure decision

Gearing increases variability of shareholder earnings and risk of financial failure.

Gearing     

The level of debt within a business High levels of gearing reduces market value of shares due to increased risk Level of gearing may affect willingness of lenders to make further advances Businesses subject to seasonal ups and downs should have low gearing Businesses with stable profits can have higher gearing Business confidence  Inflation  Interest rate expectations  Restrictions in company  constitution/trust deeds

Level of gearing

 Lender attitudes to increased debt levels  Shareholder attitudes to increased debt levels

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15: Financing of small and medium-sized enterprises

Topic List Problems of obtaining finance Sources of finance Venture capital Other sources Government aid

For small companies, the theoretical question of what the best capital structure is, may be less important than simply being able to obtain funds in the first place. Many small businesses use venture capital and government aid.

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Sources of finance

Small and medium-sized enterprises (SMEs) SMEs have three main characteristics:  Unquoted  Ownership restricted to a few individuals  Not micro-businesses that exist to employ just owner The basic problem of their finance is a limited supply of funds and having uncertain prospects.    

Lack of business history/track record Few accounting details available Assessed by credit scoring methods Need to supply security

Page 114

Venture capital

Other sources

Government aid

Government policy Government policy will have a major influence on funds.  Tax policy – concessions to investors  Interest rate policy – higher interest rates increase borrowing costs but also increase return to investors, making them more willing to supply funds

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Problems of obtaining finance

Owners

18:22

Sources of finance

Page 115

Venture capital

Bank overdrafts

Other sources

Bank loans

Government aid

Trade credit

SOURCES OF FINANCE Equity finance Page 115

Business angels

Venture capital

Leasing

Factoring

15: Financing of small and medium-sized enterprises

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Sources of finance

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Venture capital

Other sources

Government aid

Venture capital Venture capital is risk capital normally provided in return for an equity stake and possibly board representation.

Investment considerations       

Nature of product Production expertise Management expertise Market and competition Profit expectations Board membership Risk borne by current owners

   

Business startups Development of new products/markets Management buyouts Realisation of investments

Business angels Business angels are wealthy individuals who invest directly in small businesses.  Informal market  May be difficult to arrange  Business angels generally have industry knowledge

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Sources of finance

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Venture capital

Other sources

Government aid

Trade credit     

Short-term finance Decreases working capital Suppliers don’t charge interest May lose goodwill May lose discounts

Identification of owners/managers Lack of equity finance Owners’ preference

Equity finance    

Initial investment from owners Shares placed privately Further funds from owners limited Lack of exit route for external investor

Page 117

Industry/market

Capital structure

Stage of existence

15: Financing of small and medium-sized enterprises

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Sources of finance

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Venture capital

Other sources

Government aid

Loan guarantee scheme

Enterprise Initiative

Many companies/sole traders can apply. Banks can lend without personal security/guarantee being needed from the borrower. The government guarantees 75% of the loan up to a maximum of £250,000 provided the borrower pays a premium and puts up business assets as security.

Assistance such as Regional Selective Assistance and Regional Enterprise Grants help firms (particularly small firms) in Assisted and Development Areas.

Enterprise Investment Scheme

Development agencies

This scheme gives tax relief to qualifying (nonconnected) individuals who subscribe for shares in a qualifying (unquoted) company, up to maximum subscription of £400,000.

Agencies for Scotland and Wales concentrate on small company start-up and developments. Measures include accommodation, grants, loans, equity finance.

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16: Decision making

Topic List Relevant costs Product mix decisions Make or buy decisions Shut down decisions and one-off contracts

Management at all levels within an organisation take decisions. The overriding requirement of the information that should be supplied by the accountant to aid decision making is relevance.  A relevant cost is a future cash flow arising as a

direct consequence of a decision  All relevant costs are future, incremental cashflows

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Relevant costs

Page 120

Product mix decisions

Make or buy decisions

Shut down decisions and one-off contracts

Avoidable cost

Opportunity cost

Avoidable cost is a cost which would not be incurred if the activity to which it related did not exist.

Opportunity cost is the benefit which would have been earned but which has been given up, by choosing one option instead of another.

Differential cost Relevant cost of materials  Not owned  Owned

Differential cost is the relevant difference in the cost of alternatives.

Relevant costs

Controllable cost Controllable cost is an item of expenditure which can be directly influenced by a given manager within a given time span.

 current replacement cost  will be replaced  will not be replaced  higher of current resale value and value if put to an alternative use

Relevant cost of labour Relevant cost of labour is the direct labour cost plus the contribution lost by diverting labour to make another product.

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Non-relevant costs Sunk cost

Fixed costs

Sunk cost is a past (historical) cost which is not directly relevant in decision making.

Unless given an indication to the contrary, assume fixed costs are irrelevant and variable costs are relevant.

Direct and indirect costs may be relevant or irrelevant depending on the situation.

Deprival value of an asset Lower of Replacement cost

Higher of NRV

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Expected revenues

16: Decision making

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Relevant costs

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Product mix decisions

Shut down decisions and one-off contracts

Make or buy decisions

If there is a scarce resource (key or limiting factor), contribution will be maximised by earning the biggest possible contribution per unit of scarce resource.

Example Assume fixed costs remain unchanged, whatever the product mix

Assume the only relevant costs are variable costs

Direct labour ($5 per hour) Direct materials ($2 per kg) Variable overheads Fixed overheads

Selling price Maximum demand Maximum availability of labour

T $ 15 2 2 __3 22 __ __

J $ 10 5 2 __3 20 __ __

$25 10,000

$24 8,000

40,000 hours

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1

Confirm limiting factor is not sales Labour hours required to fulfil demand = (10,000 × 3) + (8,000 × 2) = 46,000 ∴ shortfall = 46,000 – 40,000 = 6,000 hours

2

Calculate the contribution per unit of scarce resource T J Unit contribution $6 (25 – 19) $7 (24 – 17) Labour hours per unit 3 2 $2 $3.50 Contribution per labour hour Rank 2nd 1st

3

Work out budgeted production and sales

Product

Hours

Production

Contribution per unit

8,000 8,000

7 6

Total contribution

$

J T

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(8,000 × 2) Balance

16,000 24,000 ______ 40,000 ______ ______

(÷ 2) (÷ 3)

56,000 48,000 ______ 104,000 ______ ______

16: Decision making

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Relevant costs

Page 124

Product mix decisions

Make or buy decisions

Shut down decisions and one-off contracts

A make or buy problem A make or buy problem involves a decision by an organisation about whether it should make a product/carry out an activity with its own internal resources, or whether it should pay another organisation to make the product/carry out the activity for it.

No scarce resource Relevant costs are the differential costs between the two options

With scarce resources Where a company must subcontract work to make up a shortfall in its own production capacity, its total costs are minimised by subcontracting work which adds the least extra marginal cost per unit of scarce resource saved by subcontracting.

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Example Joely makes three products and has limited labour time available.

Variable cost of making Variable cost of subcontracting Extra variable cost of subcontracting

A $ 10 19 __ __ __9

B $ 16 20 __ __ __4

C $ 14 19 __ __ __5

Labour hours saved by subcontracting (per unit) Extra variable cost of subcontracting per hour saved

3 $3

2 $2

2 $2.50

PRIORITY FOR MAKING IN-HOUSE

1st

3rd

Page 125

2nd

16: Decision making

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Relevant costs

Shut down decisions

Page 126

Product mix decisions

Make or buy decisions

Shut down decisions and one-off contracts

One-off contracts

 Whether or not to shut down a factory/department/product line because it is making a loss or too expensive to run

 Concerns a contract which would utilise spare capacity but will have to be accepted at a lower price than normally charged

 Only relevant fixed costs are directly attributable fixed costs

 Generally, an order will be accepted if it increases contribution and rejected if it reduces contribution

 The fact that a product makes a positive contribution is not enough if the fixed costs that could be avoided by ceasing production of it exceed contribution

 The effect on other customers and possible future uses of the spare capacity may have to be considered

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17: CVP analysis

Topic List

CVP analysis enables management to predict how changes in volume (production output and sales) will impact upon costs and revenues and hence profitability.

Terms and formulae

CVP analysis is one of the key areas of the syllabus. Most examination questions will require that you can recall the formulae included in this chapter – make sure that you learn them so that you can apply them when you need to.

Breakeven chart Profit/volume chart Advantages and limitations of CVP analysis

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Profit/volume chart

Breakeven chart

Terms and formulae

Advantages and limitations of CVP analysis

Contribution per unit

Profit

Contribution per unit is unit selling price – unit variable costs

Profit is (sales volume × contribution per unit) – fixed costs

Breakeven point is activity level at which there is neither profit nor loss. Total fixed costs Contribution per unit

Breakeven point

Contribution required to breakeven Contribution per unit

Required contribution P/V ratio

Sales revenue at breakeven point

Fixed costs P/V ratio

P/V ratio =

Required contribution Sales

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The margin of safety The margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. Fixed costs + target profit The sales volume to achieve a target profit = _________________________ Contribution per unit

$5,400 = 1,800 units $15 – $12  P/V ratio = 3/15 × 100% = 20% = 0.2

Example

 Breakeven point (units) =

 Breakeven point (revenue) =

5,400 = $27,000 0.2

 Sales volume to achieve profit of $3,300 =  Margin of safety (as a %) = Page 129

$(5,400 + 3,300)

Selling price = $15 per unit Variable cost = $12 per unit Fixed costs = $5,400 per annum Budgeted sales pa = 3,000 units = 2,900 units

$3

3,000 – 1,800 × 100% = 40% 3,000 17: CVP analysis

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Terms and formulae

18:23

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Breakeven chart

Profit/volume chart

Advantages and limitations of CVP analysis

Breakeven chart Breakeven chart shows the approximate level of profit or loss at different sales volume levels within a limited range. $

 Profit/loss is the difference between the sales revenue line and the total costs line  The breakeven point is where the total costs line and the sales revenue line meet

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Terms and formulae

18:23

Page 131

Breakeven chart

Profit/volume chart

Advantages and limitations of CVP analysis

Profit/volume chart Profit/volume charts are a variation on breakeven charts. They illustrate the relationship of costs and profit to sales and the margin of safety.  If the x axis is sales units, the gradient of the straight line is the contribution per unit  If the x axis is sales value, the gradient of the straight line is the P/V ratio  This type of chart shows clearly the effect on profit and breakeven point of changes in SP, VC, FC and/or sales demand Page 131

17: CVP analysis

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Terms and formulae

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Breakeven chart

Profit/volume chart

Advantages and limitations of CVP analysis

The advantages and limitations of CVP analysis Limitations

 Only applies to one single product or mix (fixed proportions) of a group of products.

 Assumes that fixed costs and variable costs per unit are the same at all levels of output. This is a simplification.

 Assumes that sales prices will be constant at all levels of activity. At higher volumes price may have to be reduced to win extra sales.

 Production and sales are assumed to be the

same. Changes as in inventory levels are ignored.



Uncertainty in the estimates of fixed costs and unit variable costs is usually ignored.

Advantages

 In spite of limitations, it is a useful technique for planning sales prices, desired sales mix, and profitability.

 If used with a full awareness of its limitations, it can provide simple and quick estimates of breakeven volumes or profitability within a 'relevant range' of output/sales volumes.

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18: Capital expenditure budgeting

Topic List What is capital expenditure? Authorisation and monitoring

Capital expenditure is often for very significant amounts. The need for it should be assessed before any firm commitments are made.

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What is capital expenditure?

Revenue expenditure

Investment Capital expenditure

Authorisation and monitoring

 For purpose of trade  To maintain asset’s existing earnings  Expensed through the income statement    

Acquisition of non-current assets Improvement in their earnings capacity Bigger outlay Accrue over time period

The correct and consistent calculation of profit for any accounting period depends on the correct and consistent classification of items as revenue or capital.

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What is capital expenditure?

Authorisation and monitoring

Tight control of the details concerning each non-current asset is required. This is generally achieved through the use of an ASSET REGISTER.

Not part of the double entry system

Shows an organisation’s investment in capital equipment

Points to note  Capital expenditure over a certain amount will need authorisation  Asset register must be reconciled to the nominal ledger  Physical inspections should be carried out  Asset register should be kept up to date

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18: Capital expenditure budgeting

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What is capital expenditure?

Details that might be held on an asset register  Description

 Sale proceeds

 Date of purchase

 Accumulated depreciation account

 Cost

 Depreciation expense account

 Accumulated depreciation

 Depreciation period

 Depreciation %

 Comments

 Depreciation type

 Residual value

 Date of disposal

 Cost account

Authorisation and monitoring

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19: Methods of project appraisal

Topic List Steps in project appraisal Accounting rate of return Payback Discounted cash flow NPV and IRR

This chapter considers how major investment projects are assessed.You must be able to use all of the methods shown, as well as being able to discuss their advantages and disadvantages.

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Steps in project appraisal

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Accounting rate of return

Decision-making and control cycle  Initial investigation  Detailed evaluation  Authorisation  Implementation  Project monitoring  Post-completion audit

Page 138

Payback

Discounted cash flow

NPV and IRR

Non-financial factors to consider  Legal issues  Ethical issues  Changes to regulations  Political issues  Quality implications  Level of competition

Can all affect a decision!

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Post-completion audit A post-completion audit is an objective and independent appraisal of the success of a capital project in progressing the business.

Page 139

Post-completion audit procedures  Requires independent and competent staff  Evaluation of performance against original objectives  Recommendation to improve cost-effectiveness

Benefits of post-completion audits

 Better forecasting techniques  Better future decisions  Better current decisions  Contributes to performance evaluation

Page 139

 Requires communication with staff directly involved in project

19: Methods of project appraisal

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Steps in project appraisal

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Accounting rate of return

Page 140

Payback

Discounted cash flow

NPV and IRR

Only use relevant costs when making project appraisal decisions.

Accounting rate of return ARR =

Estimated average profit Estimated average investment

Advantages

 Widely understood measure of accounting profitability

 Readily available from accounting data

Disadvantages

 Based on accounting profits rather than cash flow, giving too much emphasis to costs as conventionally defined which are not relevant to project performance

 Fails to take account of the timing of cash inflows and outflows

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Accounting rate of return

Page 141

Payback

Discounted cash flow

NPV and IRR

Payback Payback is the time taken for the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years.

It is used as a minimum target/first screening method.

Advantages

Disadvantages

 Simple to calculate and understand  Concentrates on short-term, less risky flows  Can identify quick cash generators

Page 141

   

Ignores total project return Ignores time value of money Ignores timing of flows after payback period Arbitrary choice of cut-off

19: Methods of project appraisal

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Steps in project appraisal

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Accounting rate of return

Page 142

Discounted cash flow

Payback

NPV and IRR

Example Investment Year 1 profits Year 2 profits Year 3 profits

P $’000 60 20 30 50

Q $’000 60 50 20 5

Q pays back first, but ultimately P’s profits are higher on the same amount of investment.

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Steps in project appraisal

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Accounting rate of return

Page 143

Payback

Discounted cash flow

NPV and IRR

Discounted cash flow analysis applies discounting arithmetic to the costs and benefits of an investment project, reducing value of future cash flows to present value equivalent. Conventions of DCF analysis  Cash flows incurred at beginning of project occur in year 0  Cash flows occurring during time period assumed to occur at period-end  Cash flows occurring at beginning of period assumed to occur at end of previous period

PV of cash flows in perpetuity $1/r, r is cost of capital

Page 143

Discounting Present value of 1 =

1 (1 + r)n

Annuity + –n Present value of annuity of 1 = 1 – (1 r) r

r = Discount rate n = number of periods 19: Methods of project appraisal

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Steps in project appraisal

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Accounting rate of return

Payback

Net present value (NPV)

Discounted cash flow

NPV and IRR

Features of NPV

Net present value is the value obtained by discounting all cash flows of project by target rate of return/cost of capital. If NPV is positive, the project will be accepted, if negative it will be rejected.

 Uses all cash flows related to project  Allows timing of cash flows  Can be calculated using generally accepted method

Example Year 0 1 2 3

Cash flow (90,000) 40,000 40,000 50,000

PV factor 12% 1.000 0.893 0.797 0.712

PV of cash flow (90,000) 35,720 31,880 35,600 ______ 13,000 ______ ______

 This simple layout is not recommended for complex cash flows. See over for recommended layout

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Year 0 Sales receipts Costs Sales less Costs Capital additions Capital disposals Discount factors @ Cost of capital (WACC) Present value

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Year 1 X (X) ___ X

Year 2 X (X) ___ X

Year 3 X (X) ___ X

Year 4 X (X) ___ X

(X) ___ (X)

___ X

___ X

___ X

X ___ X

X ___ (X) ___ ___

X ___ X ___ ___

X ___ X ___ ___

X ___ X ___ ___

X ___ (X) ___ ___

___

NPV is the sum of present values

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Steps in project appraisal

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Accounting rate of return

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Discounted cash flow

Payback

Rules of investment appraisal Include

Exclude

   

   

Effect of tax allowances After-tax incremental cash flows Working capital requirements Opportunity costs

Depreciation Dividend/interest payments Sunk costs Allocated costs and overheads

NPV and IRR

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Internal rate of return (IRR) The IRR method calculates the rate of return at which the NPV is zero.

1

2

3

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Calculate net present value using rate for cost of capital which

a

Is a whole number

b

May give NPV close to zero

Calculate second NPV using a different rate

a

If first NPV is positive, use second rate greater than first rate

b

If first NPV is negative, use second rate less than first rate

Use two NPV values to calculate IRR

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Accounting rate of return

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Payback

⎛⎛ a ⎞ ⎞ ⎟⎟ (B – A) ⎟ % IRR = A + ⎜⎜ ⎜⎜ ⎟ a – b ⎠ ⎝⎝ ⎠ where A B a b

is lower of two rates of return used is higher of two rates of return used is NPV obtained using rate a is NPV obtained using rate b

Discounted cash flow

NPV and IRR

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NPV  Simpler to calculate  Better for ranking mutually exclusive projects  Easy to incorporate different discount rates

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IRR

NPV and IRR comparison For conventional cash flows both methods give the same decision.

 More easily understood  Can be confused with ARR  Ignores relative size of investments  May be several IRRs if cash flows not conventional

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Notes

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Notes

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Notes

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Notes