BACHELOR IN BUSINESS ADMINISTRATION (BBA YEAR 3)

BACHELOR IN BUSINESS ADMINISTRATION (BBA YEAR 3) MODULE 2 BUSINESS ADMINISTRATION 3A STUDY GUIDE Copyright 2013 MANAGEMENT COLLEGE OF SOUTHERN AFRICA All rights reserved; no part of this book may be reproduced in any form or by any means, including photocopying machines, without the written permission of the publisher REF: BA2013

MODULE CONTENTS FINANCIAL MANAGEMENT TOPIC NUMBER TOPIC PAGE(S) Preface 2 Reading 3 1 Financial Management: Important concepts 5 2 Financial projection 17 3 Management of working capital 37 4 Capital expenditure decisions 69 5 Financing decisions: Sources and costs 91 6 Financial Analysis 102 7 Budgets 129 Bibliography 156 MANCOSA BBA Year 3 1

PREFACE The aim of this module on Financial Management is to introduce you to the concepts of financial management and to understand the role of the financial manager in a business environment. Throughout the module think points and illustrative examples have been included. Self-assessment activities and solutions appear at the end of each topic in order to test your understanding of the section. You are strongly advised to do the self-assessment activities after studying each topic as it will stimulate your interest and enhance your understanding of the work covered in the section. In order to ensure a quality module, a number of reference books have been consulted to draw up this module. Since no single textbook covers all the topics of this module adequately, no textbook is prescribed. In order to enhance your knowledge, you are advised to consult the recommended books that are indicated at the start of each topic. MANCOSA BBA Year 3 2

READING Prescribed There is no prescribed book for this module. This study guide will serve as your prescribed reading. Additional reading The following books are recommended for further reading. The books that are recommended for each topic are indicated at the start of the topic. Correia, C., Langfield-Smith, K., Thorne, H. and Wilton, R.W. (2008) Management Accounting: Information for managing and creating value. 1 st Edition. Berkshire: McGraw-Hill Education. Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6 th Edition. Cape Town: Oxford University Press. Dempsey, A. and Pieters. (2005) H.N.Introduction to Financial Accounting 5 th Edition. Durban: LexisNexis. Hampton, J.J. (2003) Financial Decision Making: Concepts, Problems and Cases. 4 th Edition. New Delhi: Prentice-Hall. Helfert, E.A. (2003) Techniques of Financial Analysis. 11 th Edition. New York: McGraw-Hill/Irwin. Higgins, R.C. (2007) Analysis for Financial Management. 8 th Edition. New York: McGraw-Hill/Irwin. Keown, A., Martin, J.D., Petty, J.W. and David, F.J. (2002) Financial Management: Principles and Applications. 9 th Edition. New Delhi: Prentice-Hall. Marshall, D.H., Mcmanus W.W. and Viele D.F. (2007) Accounting: What the numbers mean. 7 th Edition. New York: McGraw-Hill. McLaney, E. (2003) Business Finance: Theory and Practice. 6 th Edition. Essex: Prentice Hall. Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1 st Edition. North Ryde: McDraw-Hill. Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5 th Edition. Durban: LexisNexis Butterworths. Van Horne, J.C. and Wachowicz Jr., J.M. (2003) Fundamentals of Financial Management. 11 th Edition. New Delhi: Prentice-Hall. MANCOSA BBA Year 3 3

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TOPIC 1 FINANCIAL MANAGEMENT: IMPORTANT CONCEPTS LEARNING OUTCOMES Students should be able to: explain the responsibilities of the financial function and financial management. discuss the goals of financial management in the pursuit of maximising wealth. familiarise themselves with the important concepts used in financial management. distinguish between fixed capital and working capital. CONTENTS 1. Introduction 2. Financial function 3. Financial management 4. Goals of financial management 5. Important concepts in financial management 6. Self-assessment activities 7. Solutions MANCOSA BBA Year 3 5

READING Recommended reading Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6 th Edition. Cape Town: Oxford University Press. pp.393-400 Hampton, J.J. (2003) Financial Decision Making: Concepts, Problems and Cases. 4 th Edition. New Delhi: Prentice-Hall. pp. 1-18 Van Horne, J.C. and Wachowicz Jr., J.M. (2003) Fundamentals of Financial Management. 11 th Edition. New Delhi: Prentice-Hall. pp.2-7 MANCOSA BBA Year 3 6

1. INTRODUCTION According to Hampton (2003: 1) the role of the financial manager has changed considerably over the years. Traditionally, their roles involved accurate record keeping, preparation of financial statements, and managing cash. Nowadays financial managers are involved with the amount of capital employed by the firm, the allocation of funds to various projects and activities, and the measurement of the results of each allocation. Financial managers need to acquire skills to make correct decisions in a fast-moving and technologically changing environment. THINK POINT 1! A student asks: I have no intention of becoming a financial manager, so why do I need to understand financial management? Respond to this question. 2. FINANCIAL FUNCTION Cronje et al. (2004:393) state that a business must acquire assets such as property, machinery, vehicles, equipment, raw materials and trade inventories in order to function efficiently. Resources such as management and labour, services such as electricity, and communication facilities are also required. In order to obtain the required assets, resources and services, a business requires funds (capital). Suppliers of these funds expected to be satisfactorily rewarded for making their funds available to the business as soon as income is generated through sales. Funds therefore flow continually to and from the business. Cronje et al. (2004:394) add that it is with this flow of funds that the financial function is concerned with. In particular the financial function is concerned with: the acquisition of funds (called financing), the application of funds to acquire assets (called investment), and the administration of, and reporting on, financial matters. MANCOSA BBA Year 3 7

3. FINANCIAL MANAGEMENT Financial management, according to Cronje et al. (2004:394), is responsible for the efficient management of all facets of the financial function. It must contribute to the achievement of the main objective of the enterprise (i.e. maximisation of shareholder wealth) through the performance of the following tasks: Efficient financial analysis, reporting, planning, and control Managing the acquisition of funds Managing the application of funds Horne and Wachowicz (2003:7) illustrates how financial management fits into the operations of a typical manufacturing firm: Figure 1-1 BOARD OF DIRECTORS PRESIDENT (Chief Executive Officer) VICE PRESIDENT Operations VICE PRESIDENT Finance VICE PRESIDENT Marketing TREASURER *Capital budgeting *Cash management *Commercial banking *Credit management *Financial analysis *Financial planning *Investor relations *Risk management *Tax planning CONTROLLER *Cost accounting *Cost management *Data processing *General ledger *Government reporting *Internal control *Financial statements *Prepare budgets *Prepare forecasts The Vice President of finance (or Chief Financial Officer) usually reports to the MANCOSA BBA Year 3 8

President or Chief Executive Officer. The controller s responsibilities are largely accounting in nature. The responsibilities of the treasurer falls into decision areas usually associated with financial management. 4. GOALS OF FINANCIAL MANAGEMENT The specific goals of financial management in pursuit of maximising wealth, according to Hampton (2003:9), may be summarised as follows: Maximise profit: Finance should aim towards a high level of primary long-term and secondarily short-term profits for the enterprise. Minimise risk: Finance should always pursue courses of action that avoid unnecessary risks and try to anticipate problem areas. Maintain control: There must be constant monitoring of funds that flow in and out of the enterprise to ensure that they are safeguarded and properly utilised. Achieve flexibility: Learning to deal with an uncertain future is important. It is through careful management of funds and activities that flexibility is gained. If the enterprise has identified adequate sources of funds in advance of needs, it will be flexible when cash is required. Liquidity: The enterprise must have sufficient cash at all times to meet its obligations. 5. IMPORTANT CONCEPTS IN FINANCIAL MANAGEMENT Important concepts in financial management include the following: Capital Money market and capital market Financial statements Financial structure Investment Financing Liquidity Solvency Profitability 5.1 Capital Capital may be defined as the funds invested in an enterprise. Capital may also include funds that have been earned by the enterprise but not distributed to the owners (i.e. retained profits). When determining the capital requirements for an enterprise one needs to estimate the fixed capital requirements as well as working MANCOSA BBA Year 3 9

capital requirements. Fixed capital refers to capital that is required for acquisition of non-current assets such as land, buildings, machinery, equipment, and vehicles. Assets are resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. Non-current assets are assets that have a useful life of more than one year. Working capital is capital required to obtain current assets. Current assets are assets that are expected to be turned into cash within a year e.g. inventories/materials, credit allowed to debtors. Capital may be classified as follows: Short-term capital: is capital usually available for a period of up to a year. Medium-term capital: is capital available for a period between one and five years. Long-term capital: is capital that is made available for a period of five years or more. Capital may be obtained from the following sources: Own capital: is capital provided by the owner(s) of the enterprise. Borrowed capital: is capital that is obtained from banks and other financial institutions on which interest is payable. 5.2 Money market and capital market When enterprise needs to borrow funds, it can approach institutions in the money market or capital market. The money market consists of institutions and individuals who lend or borrow money in the short-term i.e. for a period of one day or for months e.g. a bank overdraft facility. The period of transactions depends on the needs of users and institutions with a shortage of funds. The capital market consists of institutions and individuals who lend or borrow money in the long-term e.g. a mortgage bond repayable over a period of 20 years. MANCOSA BBA Year 3 10

5.3 Financial statements Financial statements report on the financial position of an organisation at a certain point in time and the changes in the financial position over a period of time. The financial statements and what they are intended to report on are illustrated below: FINANCIAL STATEMENT Balance sheet Income statement Statement of changes in equity Statement of cash flows REPORTS ON: Financial position on a certain date. Profit for a particular period. Investments by and distributions to owners. Cash flows during the period. 5.4 Financial structure The financial structure of an enterprise is graphically illustrated in the form of a balance sheet. The balance sheet reports on the financial position of an organisation at a specified point in time. It is basically a summary of an organisation s assets, equity and liabilities at a point in time. This is illustrated below: Figure 1-2 ASSETS Non-current assets Current assets EQUITY AND LIABILITIES Equity Liabilities Non-current liabilities Current liabilities Asset structure: Investment/ Application of funds Capital structure: Financing/ Suppliers of funds The following are brief explanations of the main items in the balance sheet: Assets are the resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. (Refer to paragraph 5.1 for a distinction between current assets and non-current assets.) Liabilities are claims on the assets of an organisation. Simply put, it refers to what an organisation owes. Non-current liabilities are debts that are payable after more than MANCOSA BBA Year 3 11

one year from the balance sheet date. Current liabilities are debts that are payable with 12 months of the balance sheet date. Equity or Owner s equity may be viewed as the residual claim that the owner(s) has on the assets of the organisation after all the liabilities have been settled. It normally consists of two parts viz. that which is invested in the organisation and that which is earned by the organisation and left in the organisation (i.e. retained profits). 5.5 Investment Investment may be described as the use of capital to acquire non-current assets such as property and machinery to be put to productive use as well the acquisition of current assets such as inventories in order to generate income. 5.6 Financing This refers to various ways by which an enterprise obtains its funds in order to meet its capital needs. Financing may be secured from owners, suppliers, and creditors while other funds may arise from the retained earnings in the enterprise. 5.7 Liquidity Liquidity is the measure of the ability of an enterprise to have sufficient cash on hand to meet its obligations at all times. In other words, the enterprise can pay all its bills when due. 5.8 Solvency Solvency refers to the ability of an enterprise to be able to repay its debts and satisfy any claims against it. The total debt (liabilities) must be covered by a realistic value of the total assets. An enterprise is considered to be insolvent if the total liabilities exceed the realistic value of assets. 5.9 Profitability Profitability is the effectiveness with which an enterprise has employed both the total assets and the net assets (equity). This is assessed by relating net profit to resources utilised in generating the profit. Measures to assess profitability are discussed in topic 6. MANCOSA BBA Year 3 12

6. SELF-ASSESSMENT ACTIVITIES 6.1 Match the terms in column A with the statements in column B. Write down the Column A 1. Assets letter of the correct answer. 2. Non-current assets 3. Current assets 4. Equity 5. Liabilities 6. Non-current liabilities 7. Current liabilities 8. Investment 9. Financing 10. Liquidity 11. Solvency 12. Profitability A B C D E F G H Column B The residual claim that the owner(s) has on the assets of the organisation after all the liabilities have been settled. Debts that are payable within 1 year of the balance sheet date. The resources that are controlled by an enterprise from which economic benefits will be derived either now or in the future. The claims on the assets of an organisation. The various ways by which an enterprise obtains its funds in order to meet its capital needs. The use of capital to acquire non-current assets to be put to productive use as well the acquisition of current assets. The measure of the ability of an enterprise to have sufficient cash on hand to meet its obligations at all times. The ability of an enterprise to be able to repay its debts and satisfy any claims against it. I J K L Assets that have a useful life of more than one year. Debts that are payable after more than one year from the balance sheet date. The effectiveness with which an enterprise has employed both the total assets and the net assets (equity). Assets that are expected to be turned into cash within a year. 6.2 What is the main responsibility of financial management? 6.3 Explain the following goals of financial management: Maximise profit Minimise risk Maintain control Achieve flexibility Liquidity MANCOSA BBA Year 3 13

6.4 Briefly state the function of each of the following financial statements. Balance sheet Income statement Statement of changes in equity Statement of cash flows 6.5 Study the following information and answer the questions that follow. Pixma Limited began operations in January 20.08 with R900 000 obtained from selling 450 000 ordinary shares at a par value of R2 each. During the year it purchased plant and equipment for R750 000 and land for R450 000, financing the purchase with a mortgage bond of R287 500, a long-term loan of R595 000, and cash for the balance. On 31 December 20.08: The amount owing by trade debtors totaled R43 000. R32 000 was owing to trade creditors. Inventories on hand amounted to R67 000. The bank balance was overdrawn by R24 000. Retained earnings at the end of the financial year amounted to R30 000. Calculate the following on 31 December 20.08: 6.5.1 Own capital 6.5.2 Borrowed capital 6.5.3 Current assets 6.5.4 Non-current assets 6.5.5 Total assets 6.5.6 Equity 6.5.7 Non-current liabilities 6.5.8 Current liabilities 6.5.9 Total liabilities MANCOSA BBA Year 3 14

7. SOLUTIONS THINK POINT 1! One needs to prepare oneself for the workplace of the future. In order to reduce costs, many businesses are reducing management jobs and squeezing together the various layers of the corporate pyramid. Consequently, the responsibilities of the remaining managers are being broadened. A successful manager must be able to move both vertically and horizontally within an organisation. Therefore, mastery of basic financial management skills is important requisite in the workplace. 6.1 1. C 2. I 3. L 4. A 5. D 6. J 7. B 8. F 9. E 10. G 11. H 12. K 6.2 Financial management is responsible for the efficient management of all facets of the financial function. It must contribute to the achievement of the main objective of the enterprise (i.e. maximisation of shareholder wealth). 6.3 Refer to paragraph 4. 6.4 Refer to paragraph 5.3. MANCOSA BBA Year 3 15

6.5 Amount (R) Workings 6.5.1 Own capital 930 000 R900 000 + R30 000 6.5.2 Borrowed capital 882 500 R287 500 + R595 000 6.5.3 Current assets 110 000 R43 000 + R67 000 6.5.4 Non-current assets 1 200 000 R750 000 + R450 000 6.5.5 Total assets 1 310 000 R110 000 + R1 200 000 6.5.6 Equity 930 000 R900 000 + R30 000 6.5.7 Non-current liabilities 882 500 R287 500 + R595 000 6.5.8 Current liabilities 56 000 R32 000 + R24 000 6.5.9 Total liabilities 938 500 R882 500 + R56 000 MANCOSA BBA Year 3 16

TOPIC 2 FINANCIAL PROJECTION LEARNING OUTCOMES Students should be able to: explain the purpose of pro forma statements. prepare pro forma income statements and balance sheet. explain the significance of cash budgets. CONTENTS 1. Introduction 2. Pro forma financial statements 3. Cash budgets 4. Self-assessment activities 5. Solutions MANCOSA BBA Year 3 17

READING Recommended reading Helfert, E.A. (2003) Techniques of Financial Analysis. 11 th Edition. New York: McGraw-Hill/Irwin. pp. 171-199 Higgins, R.C. (2007) Analysis for Financial Management. 8 th Edition. New York: McGraw-Hill/Irwin. pp. 87-107 MANCOSA BBA Year 3 18

1. INTRODUCTION According to Helfert (2003:171) business plans are usually structured around specific goals and objectives. The plans usually outline strategies and actions for achieving desired short-term, medium-term and long-term results. Eventually these plans are quantified in financial terms, in the form of pro forma statements (projected financial statements). Greater insight into the funding implications of projected activities may be gained through the use of detailed cash budgets and cash flow statements. The main techniques of financial projection may fall into two categories: Pro forma financial statements Cash budgets 2. PRO FORMA STATEMENTS According to Higgins (2007:87) pro forma statements are the most widely used means for financial projection (forecasting). Pro forma statements can be simply described as a prediction of what the company s financial statements will look like at the end of the forecast period. They include an income statement and a related balance sheet. A third key statement, the cash flow statement, may be prepared to display the expected movement of funds during the forecast period. One of the main purposes of pro forma statements is to estimate a company s future need for external funding, which is an important first step in financial planning. The process can simply be described as follows: If the forecast indicates that the enterprise s assets will increase to R400 000, but liabilities and owners equity will only amount to R300 000, then one can assume that R100 000 in external funding is required. THINK POINT 1! What deduction would you make if the pro forma statements of an enterprise indicate that assets will fall below projected liabilities and owners equity? Put in the form of an equation, one could say that: External funding required = Total assets (Liabilities + Owners equity) MANCOSA BBA Year 3 19

2.1 Pro Forma Income statement This statement represents a broad operational outlook for the enterprise. It projects the amount of profit the enterprise expects to earn for the forecast period. The pro forma income statement is prepared first because the amount of after-tax profit developed here must later be reflected in the pro forma balance sheet. The following four steps may be followed in developing a pro forma income statement: Sales projection Determine production (or purchases) schedule, cost of sales and gross profit Estimate other expenses Calculate expected profit by completing the pro forma income statement These steps will be explained using the example of Dunbar Manufacturers. Step 1: Sales projection The starting point for the income statement is a forecast of the unit and Rand value of sales. This may be estimated in a number of ways ranging from trend-line projections to detailed departmental forecasts by individual product. Assume that Dunbar Manufacturers estimates that its sales for the first six months of 20.9 to be R200 000. This comprises the sale of 1 000 units at a price of R200 per unit. This may be illustrated in Figure 2-1 as follows: Figure 2-1 Sales projection for 6 months 1 000 units @ R200 each = R200 000 Step 2: Determine production (or purchases) schedule, cost of sales and gross profit Based on the sales projection, the production plan (or purchases plan in the case of a merchandising enterprise) may now be determined. The number of units to be produced will depend upon of following three factors: Opening inventory Sales forecast Closing inventory MANCOSA BBA Year 3 20

Suppose that Dunbar Manufacturers expects an opening inventory of 150 units at R120 each and that its desired closing inventory is 200 units. The number of units that should be produced for the forecast period (6 months) is calculated in Figure 2-2: Figure 2-2 Production requirements for 6 months Sales forecast (See Figure 2-1) Desired closing inventory Total budgeted production/purchasing needs Opening inventory Required production/purchases 1 000 units 200 units 1 200 units (150) units 1 050 units We now examine the cost of producing these 1 050 units. Assume that Dunbar Manufacturers expect a 10% increase in all production costs. If the unit production cost of R120 (as indicated in the cost of opening inventory) comprises direct materials R60, direct labour R40 and factory overheads R20, then a 10% increase will result in the unit cost increasing by R12 as seen in Figure 2-3 below: Figure 2-3 Unit cost R Direct materials 66 Direct labour 44 Factory overheads 22 Total unit cost 132 The total cost of producing the required number of units may be calculated as follows: Figure 2-4 Total production cost for 6 months 1 050 units @ R132 each = R138 600 MANCOSA BBA Year 3 21

Now that the sales projection and production costs are available, the costs of sales can be determined. The value of cost of sales depends upon the inventory valuation method used. Suppose that Dunbar Manufacturers uses the FIFO (first-in-first-out) method. Using this method, the cost of sales will be calculated firstly from the sale of the opening inventory and then from the sale of the goods to be manufactured during the forecast period. The calculation is illustrated in Figure 2-5 below: Figure 2-5 Cost of sales for 6 months R Opening inventory 150 units @ R120 18 000 Production less closing inventory 1 050 200 = 850 units @ R132 112 200 Expected cost of sales 130 200 Using the FIFO method, Dunbar Manufacturers expected sales of 1 000 units would first come from the 150 units (at R120) in opening inventory. The remaining 850 units would come from the production of 1 050 units. This would result in the desired closing inventory of 200 units. The value of the closing inventory is required for the balance sheet and may be calculated as follows: Figure 2-6 Value of closing inventory R Opening inventory (Figure 2-5) 18 000 Total production cost (Figure 2-4) 138 600 Total inventory available for sale 156 600 Cost of sales (Figure 2-5) (130 200) Closing inventory 26 400 OR 200 units @ R132 = R26 400 MANCOSA BBA Year 3 22

Step 3: Estimate other expenses The figures from the previous period are often used as a base for expense projections. Estimates are required for selling, general, administrative and other operating expenses. Interest expense is then charged according to the provisions of the enterprise s outstanding debt. The income statement will be complete once the income tax (not applicable to sole proprietorships and partnerships) is estimated to determine the profit after tax. In the case of Dunbar Manufacturers the following estimates apply: General and administrative expenses R13 000 Interest expense R2 400 Income tax 25% Step 4: Calculate expected profit by completing the pro forma income statement Using estimates and other information from steps 1 to 3, the pro forma income statement of Dunbar Manufacturers can now be drawn up: Figure 2-7 Pro Forma Income Statement R Sales 200 000 Cost of sales (130 200) Gross profit 69 800 General and administrative expenses (13 000) Income from operations 56 800 Interest expense (2 400) Profit before tax 54 400 Income tax (13 600) Net profit 40 800 2.2 Preparing pro forma income statement and pro forma balance sheet using the percentage-of-sales method According to Higgins (2007:88) a straight forward yet effective way to forecast is to MANCOSA BBA Year 3 23

tie many of the income statement and balance sheet figures to future sales. The rationale for this approach is the tendency for variable costs and most current assets and current liabilities to vary directly with sales. Obviously, this will not hold true for all items in the financial statements, and certainly some independent estimates of individual items will be required. Percentage-of-sales forecast may be done using the following three steps: Step 1 Examine historical data to determine which financial statement items varied in proportion to sales in the past. This enables the forecaster to determine which items can be safely estimated as a percentage of sales and which must be forecast using other information. Step 2 A forecast of sales must now be done. Since many items are linked to the sales forecast, it is important to estimate sales as accurately as possible. Step 3 The last step is to extrapolate the historical patterns to the newly estimated sales e.g. if inventories have historically been about 15% of sales and next year s sales are forecast to be R1 000 000, then one would expect inventories to be R150 000. Figure 2-8 Consider the income statement of Dino Ltd for 20.8: Income Statement for 20.8 R Sales 240 000 Cost of sales (160 000) Gross profit 80 000 Operating expenses (36 000) Income from operations 44 000 Interest expense (4 000) Profit before tax 40 000 Income tax (25%) (10 000) Net profit 30 000 MANCOSA BBA Year 3 24

If Dino Ltd identified cost of sales, operating expenses and interest expense as varying in proportion to sales in the past, then the following percentages would be obtained: Figure 2-9 Expenses expressed as a percentage of sales Cost of sales = R160 000 = 66.667% Sales R240 000 Operating expenses = R36 000 = 15% Sales R240 000 Interest expense = R4 000 = 1.667% Sales R240 000 If the sales forecast of Dino Ltd for 20.9 is R300 000, then the pro forma income statement for 20.9 will appear as follows: Figure 2-10 Pro Forma Income Statement for 20.9 R Sales 300 000 Cost of sales (66.667% of R300 000) (200 000) Gross profit 100 000 Operating expenses (15% of R300 000) (45 000) `Income from operations 55 000 Interest expense (1.667% of R300 000) (5 000) Profit before tax 50 000 Income tax (25% of profit before tax) (12 500) Net profit 37 500 MANCOSA BBA Year 3 25

Consider the balance sheet of Dino Ltd for 20.8: Figure 2-11 Balance sheet for 20.8 ASSETS Non-current assets R Percentage of sales of R300 000 Equipment 80 000 26.667% Current assets 140 000 46.667% Inventories 50 000 16.667% Accounts receivable 80 000 26.667% Cash and cash equivalents 10 000 3.333% Total assets 220 000 73.333% EQUITY AND LIABILITIES Equity 160 000 53.333% Non-current liabilities - 0 Current liabilities Accounts payable 60 000 20% Total equity and liabilities 220 000 73.333% From the above one observes that the equipment represents 26.667% of sales, inventories of R50 000 is 16.667% o sales and so on. Total assets represent 73.333% of sales. Let us assume that the sales of Dino Ltd is expected to increase from R300 000 to R450 000 for 20.9. We further assume that the after tax return on sales is 20% and 50% of profits is paid out in dividends. Based on these figures, expected profit is R60 000 (20% of R300 000) of which R30 000 will be paid out as dividends. The pro forma balance sheet for 20.9 is expected to be as follows: MANCOSA BBA Year 3 26

Figure 2-12 Pro Forma Balance Sheet for 20.9 R ASSETS Non-current assets Equipment 120 000 Current assets 210 000 Inventories 75 000 Accounts receivable 120 000 Cash and cash equivalents 15 000 Total assets 330 000 EQUITY AND LIABILITIES Equity 190 000 (160 000 + 30 000 Retained profit) Non-current liabilities External funding required? Current liabilities Accounts payable 90 000 Total equity and liabilities? The percentages obtained from figure 2-11 were used to calculate the amounts for 20.9 with the exception of equity. For example, the equipment figure of R120 000 is 26.667% of the expected sales of R450 000 for 20.9. Equity increases by the portion of the net profit that is not expected to be given as dividends i.e. the portion retained by the company. Total equity and liabilities add up to R280 000 which is R50 000 less than the total assets of R330 000. The R50 000 represents the external funding required. This may be represented as follows: MANCOSA BBA Year 3 27

External funding required = = = = Total assets (Liabilities + Equity) R330 000 (90 000 + 190 000) R330 000 R280 000 R50 000 Another way of looking at the external funding required is as follows: If sales increases by R150 000 (from R300 000 to R450 000) then 20% will be financed by accounts payable, necessitating R80 000 (53.333%) in additional financing. Since R30 000 is available from the retained profit, only R50 000 is required from external funding. 3. CASH BUDGETS Higgins (2007:105) describes a cash budget as a simple listing of projected cash receipts and payments over a forecast period for the purpose of anticipating future cash shortages or surpluses. Company accounts are based on accrual accounting while cash budgets use strictly cash accounting. This necessitates translating projections regarding sales and purchases into their cash equivalents. For example, if customers are granted 60-day terms, cash receipts from debtors in any month would represent the credit sales made two months earlier. Helfert (2003:185) states that when preparing a cash budget, a time schedule of estimated receipts and payments of cash are stated. This schedule shows, period by period, the net effect of projected activity on the cash balance. Items that do not represent cash flows e.g. depreciation are omitted. The time intervals selected may be daily, weekly, monthly, or even quarterly. THINK POINT 2! Drawing up a cash budget is time-consuming. So why do you think an enterprise may find it necessary to do day-by-day projections (day-by-day budget)? Figure 2-13 shows a typical format of a cash budget: MANCOSA BBA Year 3 28

Figure 2-13 Dino Limited Cash budget for the period 01 April to 30 June 20.9 April May June Cash receipts 27 000 28 500 29 000 Cash sales Receipts from debtors 15 000 12 000 16 000 12 500 18 000 11 000 Cash payments (20 920) (21 320) 22 520 Cash purchases of merchandise Payments to creditors for merchandise Operating expenses Interest on loan 8 000 9 000 3 500 420 9 000 8 500 3 400 420 9 500 9 000 3 600 Cash surplus (shortfall) 6 080 7 180 6 480 Opening cash balance 8 000 14 080 21 260 Closing cash balance 14 080 21 260 27740 420 Since the preparation of cash budgets is discussed extensively in topic 7, it will not be duplicated here. 4. SELF-ASSESSMENT ACTIVITIES 4.1 Brad Limited sells a single product at a selling price of R50 per unit. The estimated sales volume for the next 4 months of 20.9 is as follows: Units April 7 000 May 10 000 June 8 000 July 9 000 Management s policy is to maintain ending finished goods inventory each month at a level equal to 50% of the next month s budgeted sales. The finished goods inventory on 31 March 20.9 was 3 500 units. To make one unit of finished product, 3 kilograms of materials are required. The cost per kilogram of raw material is R6. MANCOSA BBA Year 3 29

Other production costs per unit as at 31 march 20.9 are as follows: Direct labour R10 Overheads R7 As from 01 April 20.9 direct labour costs are expected to increase by 10%. Overheads are expected to increase by 2% per month. Required 4.1.1 Prepare the sales budget for April, May and June 20.9. 4.1.2 Calculate the number of units that must be produced for April, May and June 20.9. 4.1.3 Calculate the total production cost for April, May and June 20.9. 4.1.4 Calculate the cost of sales for April, May and June 20.9 using the FIFO method. 4.1.5 Calculate the value of closing inventory on 30 June 20.9. 4.2 In November 20.8 GHI Manufacturers started making budget plans for the 12 months commencing 01 January 20.9. Projected sales volume was R8 700 000 as compared to an estimated R7 350 000 for the financial year ended 31 December 20.8. The best estimates of the operating results for the current year (20.8) are shown in the income statement below. Following this statement are the specific working assumptions with which to plan the financial results for the next year. Income Statement for 20.8 R Sales 7 350 000 Cost of sales (4 634 000) Labour Materials Overheads Depreciation 1 838 000 1 044 000 1 486 000 266 000 Gross profit 2 716 000 Selling expenses General and administrative expenses (610 000) (646 000) Profit before tax 1 460 000 Income tax (438 000) Net profit 1 022 000 MANCOSA BBA Year 3 30

Assumptions for the financial year 20.9: Manufacturing labour will fall to 24% of sales because volume efficiency would more than offset higher wage rates. Materials cost would increase to 14.5% of sales because some price increases wouldn t be offset by better utilisation. Overhead costs would rise above the current level by 6% of the 20.8 Rand amount, reflecting higher costs. Additional variable costs would be incurred at the rate of 11% of the incremental sales volume. Depreciation will increase by R20 000, reflecting the addition of some production machinery. Selling expenses would rise more proportionately, by R250 000, since additional effort would be required to increase sales volume. General administrative expenses would drop to 8.1% of sales. Income tax is estimated at 30% of pre-tax profits. Required Prepare a pro forma income statement for GHI Manufacturers for 20.9. 4.3 In December 20.8, Finch Limited was planning its financial needs for the coming year. As a first indication, the firm s management required a pro forma balance sheet as at 31 December 20.9 to gauge the financial needs at that time. Estimated financial condition as at 31 December 20.8 was reflected in this balance sheet: MANCOSA BBA Year 3 31

Estimated Balance Sheet at 31 December 20.8 R ASSETS Non-current assets 451 800 Property, plant and equipment 843 000 Accumulated depreciation (434 600) Other non-current assets 43 400 Current assets 2 982 400 Inventories 1 825 400 Accounts receivable 722 400 Cash and cash equivalents 434 600 Total assets 3 434 200 EQUITY AND LIABILITIES Equity 992 800 Ordinary share capital Retained income 624 000 368 800 Non-current liabilities 240 000 Mortgage bond 240 000 Current liabilities 2 201 400 Accounts payable Other current liabilities 612 300 1 589 100 Total equity and liabilities 3 434 200 Additional information Operations for the following year were projected using the following working assumptions to plan the financial results: Sales (all credit) were forecast at R20 900 000, with a gross margin of 8.2%. Purchases (all credit) are expected to total R19 450 000. Accounts receivable would be based on a collection period of 12 days, while 24 days accounts payable would be outstanding. Depreciation is expected to be R62 800 for the year. A mortgage loan repayment of R20 000 is expected to be made. Other current liabilities will be allowed to fluctuate with seasonal needs. MANCOSA BBA Year 3 32

Capital expenditures were scheduled at R42 000 for a delivery van and R72 000 for warehouse improvements. Net profit after tax is expected at a level of 0.19% of sales. Dividends for the year were scheduled at R25 000. Cash balances are desired to be no less than R300 000. Required Prepare the pro forma balance sheet as at 31 December 20.9. 5. SOLUTIONS THINK POINT 1! The obvious implication is that the enterprise will generate more cash than necessary to run the business. Management will then have to decide how best to utilise the excess. THINK POINT 2! If daily fluctuations in cash are likely to be large, as in the banking business, then day-to-day projections are necessary. 4.1.1 Sales budget for April, May and June 20.9 Units Unit price (R) Budgeted Sales (R) April May June 7 000 10 000 8 000 R50 R50 R50 350 000 500 000 400 000 4.1.2 Production requirements (units) April May June Sales forecast 7 000 10 000 8 000 Desired closing inventory 5 000 4 000 4 500 Total budgeted production needs 12 000 14 000 12 500 Opening inventory (3 500) (5 000) (4 000) Required production 8 500 9 000 8 500 MANCOSA BBA Year 3 33

4.1.3 Unit cost R Direct materials 18.00 (3kg X R6) Direct labour 11.00 (R10 + R1) Factory overheads 7.14 (R7 + R0.14) Total unit cost 36.14 Total production cost April May June Required production (units) 8 500 9 000 8 500 X Unit cost R36.14 R36.14 R36.14 Total production cost R307 190 R325 260 R307 190 4.1.4 Cost of sales for April R Opening inventory [(R18+R10+R7) X 3 500] 122 500 Production (8 500 5 000) [R36.14 X 3 500] 126 490 Expected cost of sales 248 990 Cost of sales for May R Opening inventory [R36.14 X 5 000] 180 700 Production (9 000 4 000) [R36.14 X 5 000] 180 700 Expected cost of sales 361 400 Cost of sales for June R Opening inventory [R36.14 X 4 000] 144 560 Production (8 500 4 500) [R36.14 X 4 000] 144 560 Expected cost of sales 289 120 MANCOSA BBA Year 3 34

4.1.5 Value of closing inventory April (R) May (R) June (R) Opening inventory 122 500 180 700 144 560 Total production cost 307 190 325 260 307 190 Total inventory available for sale 429 690 505 960 451 750 Cost of sales (248 990) (361 400) (289 120) Closing inventory 180 700 144 560 162 630 April May June OR 5 000 X R36.14 4 000 X R36.14 4 500 X R36.14 = R180 700 = R144 560 = R162 630 4.2 GHI Manufacturers Pro Forma Income statement for 20.9 Sales 8 700 000 Cost of sales (5 359 160) Labour Materials Overheads Depreciation R 2 088 000 1 261 500 1 723 660 286 000 Gross profit 3 340 840 Selling expenses General and administrative expenses (860 000) (704 700) Profit before tax 1 776 140 [8 700 000 X 24%] [8 700 000 X 14.5%] [1 486 000 + 89 160* + 148 500**] [266 000 + 20 000] [610 000 + 250 000] [8 700 000 X 8.1%] Income tax (532 842) [1 776 140 X 30%] Net profit 1 243 298 N.B. * ** Overheads: 1 486 000 X 6% = 89 160 (8 700 000 7 350 000) = 1 350 000 X 11% = 148 500 MANCOSA BBA Year 3 35

4.3 Finch Limited Pro Forma Balance Sheet at 31 December 20.9 ASSETS Non-current assets 503 000 Property, plant and equipment Accumulated depreciation Other non-current assets R 957 000 (497 400) 43 400 Current assets 3 076 323 Inventories [843 000 + 42 000 + 72 000] [434 600 + 62 800] [no change] 2 089 200 [*see calculation below] Accounts receivable 687 123 [20 900 000 X 12 365] Cash and cash equivalents Total assets 3 579 323 300 000 [desired level] EQUITY AND LIABILITIES Equity 1 007 510 Ordinary share capital Retained income 624 000 383 510 [no change] [368 800 + 39 710** 25 000] Non-current liabilities 220 000 Mortgage bond 220 000 [240 000 20 000] Current liabilities 2 351 813 [3 579 323 1 007 510 220 000] Accounts payable Other current liabilities 1 278 904 1 072 909 [19 450 000 X 24 365] [2 351 813 1 278 904] Total equity and liabilities 3 579 323 * Inventories Opening inventory 1 825 400 Purchases 19 450 000 Goods available for sale 21 275 400 Cost of sales (19 186 200) [20 900 000 X (100% 8.2%)] Closing inventory 2 089 200 ** Retained income Net profit after tax = R20 900 000 X 0.19% = 39 710 MANCOSA BBA Year 3 36

TOPIC 3 MANAGEMENT OF WORKING CAPITAL LEARNING OUTCOMES Students should be able to: describe the cycle of working capital of manufacturers and traders. implement appropriate strategies in the management of each of the elements of working capital explain the costs and risks of holding cash and of holding little or no cash. provide reasons for the granting of credit. discuss the costs and risks of granting credit and of denying credit. provide reasons for holding inventory. identify the costs and risks of holding inventory and of holding little or no inventory. elaborate on the costs and risks of taking credit and of not taking credit. explain the use of liquidity ratios. CONTENTS 1. Introduction 2. Cycle of working capital 3. Management of cash 4. Management of accounts receivable/trade debtors 5. Management of inventory 6. Management of accounts payable/trade creditors 7. Management of bank overdraft and short-term loans 8. Measures of liquidity 9. Self-assessment activities 10. Solutions MANCOSA BBA Year 3 37

READING Recommended reading Dempsey, A. and Pieters. (2005) H.N.Introduction to Financial Accounting 5 th Edition. Durban: LexisNexis. pp. 241-243 Keown, A., Martin, J.D., Petty, J.W. and David, F.J. (2002) Financial Management: Principles and Applications. 9 th Edition. New Delhi: Prentice-Hall. pp. 606-688 McLaney, E. (2003) Business Finance: Theory and Practice. 6 th Edition. Essex: Prentice Hall. pp.341-370 Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1 st Edition. North Ryde: McDraw-Hill. pp. 247-281 Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5 th Edition. Durban: LexisNexis Butterworths. pp. 39-43 MANCOSA BBA Year 3 38

1. INTRODUCTION Working capital may be described as the difference between current assets and current liabilities. Meredith and Williams (2005:248) add that it represents funds needed for the day-to-day running of an enterprise i.e. funds that will work for the enterprise in generating profit, meeting short-term obligations and providing a pool of cash necessary for short-term liquidity. Current assets, a major component of working capital, are assets that are expected to be turned into cash within a year and include the following: Cash and bank balances Trade debtors Inventory Short-term investments Prepayments Current liabilities, the other component of working capital, are debts that are payable with 12 months. They include: Bank overdrafts Trade creditors Short-term loans Revenue received in advance 2. CYCLE OF WORKING CAPITAL Meredith and Williams (2005:249) illustrate (see Figure 3-1) and describe the cycle of working capital of a manufacturer. The cycle usually starts with cash available in some form or the other. The manufacturer may approach trade creditors for the purchase of raw materials and some of the cash will eventually be used to pay trade creditors. During manufacturing raw material will be converted into work in progress (partly manufactured goods). Wages and other factory overheads will also have to be paid for in cash. After the work in progress is converted into finished goods, these goods are sold (often on credit) and the asset becomes a trade debtor. When customers settle their debts, trade debtors are converted into cash and this cash may be used to pay for other commitments e.g. MANCOSA BBA Year 3 39

administration expenses, dividends and tax. Figure 3-1 Other commitments Cash Trade debtors Trade creditors Finished goods inventory Wages and overheads Raw material purchases Work in progress The necessity for the current asset component to exceed the current liability component is demonstrated in the cycle above. In other words, cash plus work in progress, finished goods inventory and trade debtors must exceed the commitments to pay trade creditors, wages and overheads. If the cash component is weak, the entire working capital cycle is weak, and thus every component in the cycle must be managed. We will be discussing the management of these components shortly. The cycle of working capital for retailers and wholesalers is relatively simple and is illustrated by Meredith and Williams (2005:251) in Figure 3-2. A feature of these two industry groups is that inventory and debtor levels are high, although these tend to be offset by high level of creditors and maybe an overdraft. The relationship between current assets and current liabilities may thus be virtually 1:1. MANCOSA BBA Year 3 40

Figure 3-2 Other commitments Cash Trade debtors Trade creditors/ Wages Inventory for resale The above cycle shows cash used to purchase inventory through creditors as well as paying wages and other commitments. Inventory is kept for resale and turned over as quickly as possible. Sales, when made on credit, lead to trade debtors and eventually to cash. The cycle is shortened if inventory is sold for cash only. We now examine the management of the components of working capital. 3. MANAGEMENT OF CASH Cash or its equivalents may include petty cash, cash in bank accounts and shortterm investments on call. Cash is crucial to the survival of any enterprise. Meredith and Williams (2005:252) provide the following reasons for the importance of the availability of cash: Lack of cash for a prolonged period leads to liquidation or bankruptcy. There are costs associated with the management of cash resources. A shortage of cash may increase costs in the form of financial and interest charges. Effective control of cash allows management to take advantage of investment opportunities that may arise at any time. Lenders insist that funds be available at any time to repay loans when necessary. 3.1 Motives for holding cash John Maynard Keynes cited in Keown et al. (2002:637) segmented an enterprise s motives for holding cash into three categories: MANCOSA BBA Year 3 41

3.1.1 Transaction motive Cash held for transaction purposes allows the enterprise to meet cash needs that arise in the ordinary course of business e.g. pay wages, purchase inventory etc. 3.1.2 Precautionary motive Cash is required to provide a safety cushion or buffer to meet unexpected cash needs e.g. a creditor demanding payment earlier than expected. 3.1.3 Speculative motive Cash is held in order to take advantage of potential profit-making situations that may arise at any time e.g. place a larger order for inventory than usual in order to exploit a temporary price advantage. THINK POINT 1! How can cash flow predictability affect an enterprise s demand for cash through the precautionary motive? 3.2 Cash management strategies Mclaney (2003:367) provides the following strategies in the management of cash and overdrafts: 3.2.1 Establish a policy The enterprise should establish a policy for cash. This policy should be adhered to until it is formally reviewed. 3.2.2 Plan cash flows Failure to plan cash inflows and outflows and to balance them can be fatal. This can be done by drawing up a cash budget. The cash budget (discussed in topics 2 and 7) shows expected cash receipts, expected cash payments and the net change in cash for the period (day, week, month, quarter etc.) under review. The cash budget helps to identify cash shortages and gives the enterprise adequate time to arrange the necessary credit (e.g. bank overdraft) to meet the short-term cash needs. MANCOSA BBA Year 3 42

THINK POINT 2! What advice would you offer to an enterprise whose budget reflects temporary cash surpluses? 3.2.3 Make judicious use of bank overdraft and deposit accounts Bank overdrafts should be avoided, if it is possible to do so. Temporary cash surpluses should be put into notice deposit accounts or invested in marketable securities. 3.2.4 Bank frequently Cheques received should be promptly banked to either generate income or save on interest on overdraft. Debtors should be encouraged to make direct or electronic payments in order to limit the time the bank takes to reflect such receipts. Other cash management strategies include the following: 3.2.5 Extending accounts payable This involves stretching the payment period to creditors beyond the credit terms allowed but without affecting credit ratings negatively. However, if a creditor offers a discount for prompt settlement of account, the enterprise must compare the benefit of early payment with the cost of forgoing the cash discount. The calculation for the cost of forgoing a cash discount is explained in topic 5 (paragraph 4.1). 3.2.6 Efficient purchasing and inventory management Another way of improving liquidity is to increase inventory turnover. This may be achieved in the following ways: Improving the accuracy of demand forecasts and better planning of purchases to coincide with these forecasts. Through better purchasing planning, an enterprise can reduce the length of the purchasing cycle. This should increase inventory turnover. MANCOSA BBA Year 3 43

3.2.7 Speeding up the collection of accounts receivable This may be achieved in the following ways: Offer a cash discount for early settlement of accounts. Use an aggressive collection policy. In order to ensure that debtors adhere to the credit terms, the enterprise must ensure that: The enterprise s credit policy has appropriate criteria to determine to whom credit should be extended. The enterprise s collection policy should clearly define the steps that should be followed to ensure prompt collection of accounts receivable. 3.3 Costs and risks of holding cash McLaney (2003:363) states three costs and risks of holding cash: 3.3.1 Loss of interest Cash deposited into a current banking account usually does not earn any interest. Even if cash is deposited in a short-term deposit account, there is still a cost because interest rates tend to be lower than longer-term ones. 3.3.2 Loss of purchasing power During a period of inflation the value of money erodes. Interest rates do not necessarily compensate for this. 3.3.3 Exchange rate cost Enterprises that hold cash in a foreign currency will incur a cost if that currency weakens against the home currency. 3.4 The costs and risks of holding little or no cash McLaney (2003:364) elaborates on the following costs and risks of holding no cash: MANCOSA BBA Year 3 44

3.4.1 Loss of supplier goodwill Failure to meet the financial obligations on time to suppliers, including employees, due to cash shortfalls may result in a loss of further supplies from the aggrieved parties. This can be very damaging especially in the case of labour. If the enterprise fails to meet a financial obligation to a creditor, the creditor may institute liquidation proceedings against the enterprise. 3.4.2 Loss of opportunities An enterprise would not be able to take advantage of a profitable opportunity if it has a cash shortage. 3.4.3 Inability to claim discounts It is usually very profitable to take advantage of discounts for prompt settlement of accounts payable. 3.4.4 Cost of borrowing Cash shortages inevitably expose an enterprise to the risk of short-term borrowing to meet obligations. Such borrowings are accompanied by high interest costs. 4. MANAGEMENT OF ACCOUNTS RECEIVABLE/TRADE DEBTORS Sales made on credit involve the creation of accounts receivable/trade debtors that must be converted into cash. Accounts receivable plays a major role in the conduct of business for many enterprises. For these enterprises the accounts receivable, which is a current asset, must be financed on a continuing basis. 4.1 Reasons for granting credit There are many reasons why enterprises grant credit. These reasons are linked to the advantages that credit offers to the enterprise. Some the reasons include: 4.1.1 To achieve growth in sales If an enterprise permits sales on credit, it usually sells more goods that if it insisted on immediate payment. Many customers prefer to write a cheque at a later time rather than pay cash when they purchase. MANCOSA BBA Year 3 45

4.1.2 To increase profits Additional sales normally results in higher profits for the enterprise. This occurs when the additional income earned is greater than the additional costs associated with administering the credit policy. 4.1.3 To meet competition Many firms establish credit policies similar to the policies of competitors as a defensive measure. By adapting its terms of trade to the industry norms, an enterprise avoids the loss of sales from customers who would purchase elsewhere if they did not receive the expected credit. 4.1.4 Increase market share Continued higher sales and stronger competitive position will result in greater market share. 4.1.5 An aid to sales promotion An enterprise that grants credit attracts more customers and gains their loyalty through the credit facilities made available to them. Credit is also an important advertising tool. 4.1.6 Products of quality sold Credit customers are usually less price sensitive compared to cash customers, and in many instances buy products of higher quality than they would if they were paying in cash. 4.1.7 Improving customer relations The regular visits of customers who purchase on credit create an opportunity to develop good relationships (goodwill) with them. 4.2 The cost and risks of granting credit McLaney (2003:359) identified the following costs and risks of granting credit: MANCOSA BBA Year 3 46

4.2.1 Loss of interest The equivalent of granting credit is to make interest-free loans. These tend to be fairly risky loans since trade debtors are not usually secured. The interest lost is thus at a fairly high rate. 4.2.2 Loss of purchasing power When price inflation is experienced, value transfers from the lender to borrower. This is because the borrower (trade debtor) settles the debt at a lower purchasing power value than at which it was borrowed. 4.2.3 Assessing the potential customer s creditworthiness Before granting credit to a new customer it is prudent or even required by law to assess the creditworthiness of customers. In doing so it is necessary to obtain references from the customer s bank and other traders, examine financial records and pay a credit agency for a report on the customer. Although these checks reduce the risk of bad debts, they do cost money. 4.2.4 Administration and record keeping costs Enterprises that grant credit have to employ people to administer and collect trade debts. 4.2.5 Bad debts No matter how cautious an enterprise is in granting credit to customers, the risk of bad debts is always present. 4.2.6 Discounts Offering credit customers a discount to encourage prompt settlement of account is fairly common. Such discounts, however, can represent a significant cost to the enterprise. 4.3 The costs and risks of denying credit McLaney (2003:360) elaborates on the following costs and risks of denying credit: MANCOSA BBA Year 3 47

4.3.1 Loss of customer goodwill It is very difficult for an enterprise to deny credit if its competitors are granting it. In a competitive market it becomes necessary to extend credit in order to attract large and recurring orders. 4.3.2 Inconvenience and loss of security of collecting cash From an administrative point of view, credit sales can be very convenient. Cash is usually collected by means of cheques in the post or by electronic payments. There is thus no need for delivery drivers to collect cash, thereby avoiding the administrative and security problems that are likely to arise. 4.4 Some practical points in the management of trade debtors McLaney (2003:361) provides the following suggestions for the management of trade debtors/accounts receivable: 4.4.1 Establish a credit policy The enterprise should consider whether it is appropriate to offer credit at all, and if so how much, to whom and under what circumstances. The policy should be clear and include credit terms and administrative arrangements. 4.4.2 Assess customers creditworthiness An enterprise should not grant credit unless it is satisfied that the risk of doing so for each applicant is an acceptable one. The following credit standards may be used to evaluate the creditworthiness of debtors: Character the willingness of the applicant to pay. Capacity the ability of the applicant to pay. Capital the financial resources of the applicant. Conditions the current economic or business conditions prevailing. Collateral security that the applicant can offer in the event of non-payment of account. Credit history the applicant s history of payments on previous credit sales. Common sense the sound judgement of the person analysing the credit data. MANCOSA BBA Year 3 48

4.4.3 Setting credit limits Credit limits should be set, and these will vary from customer to customer depending on the enterprise s confidence in the applicant s creditworthiness. These credit limits should be rigorously applied until such time there is a review by a senior employee. THINK POINT 3! Suppose that the accounting clerk compares an order with the file on a customer and discovers that the order exceeds the R8 000 single purchase limit authorised for the customer. A check also reveals that the order will place the total receivables balance over the R25 000 limit. If you are the financial manager, what possible actions could you take? 4.4.4 Setting terms of credit Some of the important terms of credit include the following: Credit period: The period for which credit is granted e.g. 30 days should be stipulated. Interest on overdue accounts: Usually interest is charged on overdue accounts at a stipulated rate. Methods of payment: The enterprise should specify how payment should be made. Payments may be made by cash, cheque, post-dated cheques, electronically, debit order or stop order. Types of credit: Various credit plans may be offered e.g. open credit account, hire purchase or revolving credit. Purchases on an open credit account must be paid for in full within the allotted credit period. In instalment/hire purchase credit, payment is made by means of a deposit and equal monthly payments (including finance charges) for the balance. With revolving credit the debtor has a credit limit and must pay a specified amount on the account monthly. If the credit limit is not reached, the debtor can buy on credit again. MANCOSA BBA Year 3 49

4.4.5 Establish an effective collection policy An effective collection policy should be geared towards ensuring that: debtors settle their accounts timeously as delays may lead to liquidity problems. bad debts are kept to a minimum. The following guidelines may be followed to achieve the above: Do a proper evaluation of creditworthiness and set lower credit terms initially. Credit terms may be reviewed at regular intervals. Once an account becomes overdue, the necessary steps to collect the outstanding amount must be immediately followed. At the very least, the debtor must be contacted immediately. Implement an effective system of control to identify overdue accounts immediately. A debtor age analysis is a common form of control used by managers. Each month, debtors are analysed in terms of the number of days that debts are outstanding. Suppose that at the end of a particular month, an enterprise has outstanding debtors totalling R170 000 and the credit terms are 30 days. Table 3-1 shows the debtor age analysis: Table 3-1 Period in arrear (days) Debtor Outstanding Current 01-30 30-60 60-90 90+ A R40 000 R10 000 R30 000 B R20 000 R10 000 R5 000 R5 000 C R70 000 R50 000 R10 000 R10 000 D R40 000 R40 000 Total R170 000 R60 000 R15 000 R45 000 R10 000 R40 000 Percent 100% 35% 9% 26% 6% 24% The debtor age analysis reveals that 65% of accounts are overdue of which 24% is over 90 days outstanding. MANCOSA BBA Year 3 50

4.4.6 Establish a policy on bad debts The enterprise should decide what its policy on writing off bad debts should be. It is important that accounts are written off only after all the steps in the policy have been followed. Previous experience may give management an idea of the trend of possible bad debts e.g. 1% of current debts, 5% of debts that are 01-30 days past due, 8% of debts that are 30-60 days past due, 20% of debts that are 60-90 days past due and 40% of debts that are over 90 days due. This is illustrated in Table 3-2 below: Table 3-2 Period in arrear (days) Debtor Outstanding Current 01-30 30-60 60-90 90+ Total R170 000 R60 000 R15 000 R45 000 R10 000 R40 000 Bad debts % 1% 5% 8% 20% 40% Bad debts R600 R750 R3 600 R2 000 R16 000 4.4.7 Ratios Ratios can be useful in management of debtors. The most widely used ratio is the debtor collection period. The formula is as follows: Debtor collection period = Accounts receivable X 365 Credit sales This ratio tells us how long trade debtors meet their obligations to pay following the sale on credit. If the collection period exceeds what is specified in the policy, then steps need to be taken to remedy matters. The calculation and interpretation of this ratio is discussed in topic 6 (paragraph 3.2.2). 4.4.8 Consider offering discounts for prompt payment The cost and advantages of offering such a discount should be assessed. MANCOSA BBA Year 3 51

5. MANAGEMENT OF INVENTORY McLaney (2003:352) states that manufacturing businesses hold inventories (stocks) at various stages of completion, from raw materials to finished goods. Generally the level of investment in inventory by manufacturers tends to be larger than that of traders. Since inventory is the least liquid of the current assets, it must be managed as efficiently as possible. 5.1 Reasons for holding inventory If an enterprise does not have goods available for sale, it will lose sales. Holding sufficient inventory prevents stoppages in a manufacturer s production process. The enterprise may be able to make bulk purchases of goods at large discounts. The costs associated with individual orders may be reduced if the enterprise places a few large rather than many small orders. Holding inventory is a safety measure against disruptions like strikes. Having products in stock ensures that deliveries are made on time. The enterprise may have the opportunity of taking advantage of price reductions and special offers. 5.2 The costs and risks of holding inventory Mclaney (2003:352) elaborate on the following costs and risks: 5.2.1 Lost interest Interest could have been earned on finance tied up in inventory. 5.2.2 Storage costs These costs include the rent of space occupied by the inventory and the cost of employing people to manage and guard the stock. 5.2.3 Insurance costs Inventory is exposed to risks such as fire and theft against which the enterprise has to insure against. MANCOSA BBA Year 3 52

5.2.4 Obsolescence Inventory can go out of fashion, lose their value through changes in product design or be on hand after the sell-by date. 5.3 The costs and risks of holding little (or no) inventory The following costs and risks were identified by Mclaney (2003:352): 5.3.1 Loss of customer goodwill Failure to supply a customer due to being out of stock may not only mean a loss of that order but further orders as well. 5.3.2 Production dislocation Running out of raw material will lead to loss of production time and loss of income as orders cannot be delivered on time. 5.3.3 Loss of flexibility Holding little or no inventory means that purchasing and manufacture must be very closely geared to sales. There is a risk that if there is a slight increase in demand, it may not be met. 5.3.4 Reorder costs An enterprise that survives on little or no inventory will have to place many small orders. The costs of each order include the physical placing of the order (buyer s time, telephone, postage) and the receipt of the goods (storemen s time, making payment). THINK POINT 4! In trying to minimise the costs of holding inventories, the major emphasis is on items considered important to the firm s operations. What types of inventory items do you consider most important to a firm? MANCOSA BBA Year 3 53

5.4 Economic order quantity With regard to the control of inventory, one of the problems that managers face is what quantity of any item should be ordered each time (Niemand et al., 2004:39). One must bear in mind that if too little is purchased, the enterprise may run out of stock. If too much is purchased, a lot of working capital is tied up unproductively in inventory and the cost of holding the stock is high. Therefore managers have to find a balance between purchasing too little and purchasing too much. Managers need to also consider the two main costs in any purchasing order viz. the cost of purchasing and the cost of holding the inventory. The cost of purchasing inventory includes the costs involved in negotiations, cost of telephone and faxes, stationery, internet usage and receiving the goods. The cost of holding inventory include the cost of storage, loss of interest on capital tied up in inventory, personnel costs, insurance, goods going out of fashion or becoming obsolete. Thus one finds that if small quantities are purchased each time, the cost of purchasing will be high as many orders need to be placed. On the other hand if larger quantities are purchased, the cost of holding inventory becomes high. Somewhere between these two extremes is a point where the total cost of purchasing and holding the inventory is at a minimum. The quantity ordered at this point is the economic order quantity (EOQ). The economic order quantity can be calculated using the following formula: EOQ = 2 H CU Where: C = cost of placing an order U = annual usage H = inventory (stock) holding cost per unit MANCOSA BBA Year 3 54

Example 1 Juno Limited purchases 800 school bags at R60 each per annum. The bags are sold at R80 each at a steady rate during the year. The cost of placing a single order amounts to R20,25. Inventory holding cost amounts to R4 per unit. Calculate the economic order quantity. Solution EOQ = 2 H CU = 2 X 20, 25 X 4 800 = 8100 = 90 units 5.5 Analysing inventory turnover In evaluating the effectiveness of an enterprise s inventory management, it is common to use the number of times inventory has turned over during the period of analysis. The higher the turnover rate the better, as this would improve cash inflows. Inventory turnover is calculated as follows: Inventory turnover = Cost of sales Average inventory The calculation and interpretation of inventory turnover is discussed in topic 6 (paragraph 3.2.1). 5.6 Inventory valuation The purchase price of inventory is often subject to constant change. These changes could be through the effects of inflation, shortages in supply, unstable markets etc. Inventory needs to be valued for two purposes viz.: to determine the value of inventory issued to production (affects cost of MANCOSA BBA Year 3 55

production). to determine the value of the inventory on hand (inventory valuation). Various methods are used to value inventory (Dempsey and Pieters, 2005:241-243). These include the first-in-first-out method (FIFO), the weighted average cost method (AVCO) and last-in-first-out method (LIFO). The LIFO method is usually not allowed when calculating profit for tax purposes. 5.6.1 First-In-First-Out method (FIFO) The basis of this method is that goods that are purchased first are sold first. This means that the latest purchases costs are applied to the inventory on hand. This method may be illustrated by the following example: Example 1 Determine the value of inventory on 28 February 20.6 using the first-in-first-out method (FIFO) from the following information: February Units of inventory Cost price 01 15 25 28 Opening inventory Purchases Purchases Sales for February 7 000 19 000 6 000 24 000 R20 R22 R23 Solution Closing inventory = 7 000+ 19 000 + 6 000 24 000 = 8 000 units From the 8 000 units on hand, 6 000 units were purchased at R23 and 2 000 units were purchased at R22. The value of inventory on 28 February 20.6 is therefore: 6 000 units X R23 2 000 units X R22 138 000 44 000 182 000 MANCOSA BBA Year 3 56

5.6.2 Weighted average cost method Using this method, the total cost of similar items for a certain period is divided by the total number of items bought during that period. This will result in the weighted average cost per unit. The value of inventories on hand is calculated by multiplying the closing inventories by the weighted average cost per unit. This method may be illustrated by the following example: Example 2 Refer to the information in example 1 in paragraph 5.6.1 above. Determine the value of inventory on 28 February 20.6 using the weighted average cost method. Solution Units Unit price Total 7 000 19 000 6 000 32 000 R20 R22 R23 140 000 418 000 138 000 696 000 Average cost per unit Closing inventory Value of closing inventory = R696 000 32 000 = R21,75 = 8 000 units = 8 000 X R21,75 = R174 000 5.6.3 Last-In-First-Out method (LIFO) The basis of this method is that goods that are purchased last are sold first. This means that the oldest purchases costs are applied to the inventory on hand. This method may be illustrated by the following example: Example 3 Refer to the information in example 1 in paragraph 5.6.1 above. Determine the value of inventory on 28 February 20.6 using the LIFO method. MANCOSA BBA Year 3 57

Solution From the 8 000 units on hand, 7 000 units were purchased at R20 and 1 000 units were purchased at R22. The value of inventory on 28 February 20.6 is therefore: 7 000 units X R20 1 000 units X R22 140 000 22 000 162 000 5.7 Some practical points on management of inventory McLaney (2003:356) provides the following advice: 5.7.1 Economic order quantities Economic order quantities for each item of inventory should be established (refer to paragraph 5.4). These quantities should be periodically revised. 5.7.2 Inventory reorder levels The level of inventory at which the next order must be placed should also be determined and adhered to. The order should be placed early enough for the inventory to arrive just as the safety level is expected to be reached. 5.7.3 Budgeting and planning Forward planning and budgeting is important for cost and risk reduction. 5.7.4 Reliable inventory records Inventory management is difficult without knowing what is in stock. 5.7.5 Security and authorisation Systems must be in place to ensure that inventory may only be ordered and used on authority of a senior employee. The inventory must also be stored in a secure area. MANCOSA BBA Year 3 58

6. MANAGEMENT OF ACCOUNTS PAYABLE/TRADE CREDITORS Trade creditors usually comprise the largest percentage of short-term credit. According to Mclaney (2003:369) trade credit is an important source of free finance. However, he contends that it is doubtful that trade credit is strictly free since suppliers will build the cost of granting credit in their pricing policy. 6.1 The costs and risks of taking credit Mclaney (2003:369) identified the following costs and risks: 6.1.1 Price Some suppliers offer lower prices for immediate payment effectively a discount for prompt payment. 6.1.2 Possible loss of supplier goodwill If credit is overstepped, suppliers may discriminate against delinquent customers if supplies become scarce. 6.1.3 Administration and accounting Taking credit brings with it administrative and accounting costs that would otherwise not been incurred. 6.1.4 Restrictions Many suppliers insist on orders being of some minimum size or regularity for credit to be granted. 6.2 The costs and risks of not taking credit These costs and risks according to Mclaney (2003:370) include the following: 6.2.1 Interest cost Trade credit is actually an interest-free loan and so the failure to take advantage of it has an interest cost. MANCOSA BBA Year 3 59

6.2.2 Inconvenience It may be inconvenient to pay at the time of delivery of the goods. 6.3 Some practical points on the management of trade creditors Mclaney (2003:370) provides the following advice: 6.3.1 Establish a policy A policy regarding trade credit should be established and followed. THINK POINT 5! What items do you think should be included in a firm s policy on trade creditors? 6.3.2 Exploit trade credit as far as possible The advantages of credit purchases usually outweigh the costs of claiming credit. 6.3.3 Ratios The most useful ratio in the monitoring of trade credit is the creditor payment period. This ratio tells us how long, on average, an enterprise takes to pay for goods bought following the purchase on credit. The formula to calculate it is as follows: Creditor payment period = Accounts payable X 365 Credit purchases The calculation and interpretation of this ratio is discussed in topic 6 (paragraph 3.2.3). 7. MANAGEMENT OF BANK OVERDRAFT AND SHORT-TERM LOANS According to Meredith and Williams (2005:262) bank overdraft facilities are convenient and logical if they are analysed carefully in terms of cost comparisons with other funding arrangements. However, overdraft facilities have the disadvantage of being subject to repayment at short notice by the bank. Furthermore, there may be other costs associated with bank overdrafts besides MANCOSA BBA Year 3 60

interest e.g. an overdraft facility fee. Short-term loans are another form of bridging finance provided by banks and other financial institutions. These are loans that are normally granted against expected funds such as awaiting payment for a major asset sold. However, interest and other charges associated with this service are usually high. Overdraft and short-term loan facilities should be managed and controlled through the budget system, with cash budgets monitored on a daily or at least weekly basis. 8. MEASURES OF LIQUIDITY One of the main issues in the management of working capital is the concept of liquidity. Liquidity ratios are used to measure the ability of an enterprise to meet its short-term obligations. The most commonly used liquidity ratios are the current ratio and acid test ratio. 8.1 Current ratio The current ratio attempts to show the ability of an enterprise to pay off the shortterm debts using its current assets. Current ratio is calculated as follows: Current ratio = Current assets Current liabilities The calculation and interpretation of this ratio is discussed in topic 6 (paragraph 3.1.1). 8.2 Acid test ratio The intention of the acid test ratio is to test the settlement of current liabilities under distress conditions, on the assumption that inventories would not be readily converted into cash. The calculation is done as follows: MANCOSA BBA Year 3 61

Acid test ratio = Current assets Inventory Current liabilities The calculation and interpretation of this ratio is discussed in topic 6 (paragraph 3.1.2). 9. SELF-ASSESSMENT ACTIVITIES 9.1 Match the motives for keeping cash in column A with the examples in column B. Column A Column B 9.1.1 Transaction motive A Sales are expected to slow down. 9.1.2 Precautionary motive B Take advantage of profitable opportunities. 9.1.3 Speculative motive C Pay expenses and purchase inventory. 9.2 Discuss the statement that businesses usually prepare to plan their cash flows. 9.3 Explain how businesses should make judicious use of bank overdraft and deposit accounts in their management of cash. 9.4 What is the danger of extending accounts payable? 9.5 Suggest two ways of speeding up the collection of overdue accounts. 9.6 Explain loss of interest as a cost of holding cash. 9.7 Apart from the loss of supplier goodwill, explain three costs/risks of holding little or no cash. 9.8 Provide some reasons why enterprises grant credit. 9.9 What possible negative consequences are there for enterprises that don t allow credit? 9.10 Name some credit standards that may be used to evaluate the creditworthiness of debtors. 9.11 Explain 3 types of credit plans that a hardware store may offer its customers. 9.12 Name two goals that an effective debtors collection policy should aim at. 9.13 FM Stores has a R60 000 balance of accounts receivables on 01 June. After checking the ledger cards for accounts receivable, the financial manager discovered that: MANCOSA BBA Year 3 62

R30 000 represented sales made in May R15 000 represented sales made in April R10 000 represented sales made in March R2 000 represented sales made in February R3 000 represented sales made prior to February Required Prepare a debtor age analysis showing the Rand amount outstanding and the percentage outstanding. 9.14 Explain obsolescence as a risk in holding inventory. 9.15 You are the newly appointed management accountant at Kelso Industries. The company uses the EOQ model to determine the quantity of raw material Z54 to order from REM Ltd. The following details regarding raw material Z54 are brought to your attention: Kelso Industries consumes 2 400 units of material Z54 each working day. It is estimated that there are 250 working days in the 20.7 financial year. The cost of placing an order amounts to R120. The cost of holding inventory per unit is estimated at R3,90 plus 11% of the invoice price per unit. The invoice price per unit is R10. Required Calculate the EOQ for raw material Z54 for the 20.7 financial year. 9.16 Determine the value of inventory on 31 March 20.6 using the first-in-first-out method (FIFO), weighted average cost method and last-in-first-out method (LIFO) from the following information: March Units of stock Cost price 01 Opening inventory 2 000 R12 14 Purchases 10 000 R13 20 Purchases 8 000 R13.50 31 Sales for march 20.6 11 000 MANCOSA BBA Year 3 63

9.17 Describe three costs and risks of purchasing inventories on credit. 9.18 Discuss the cost of making use of overdraft facilities. 10. SOLUTIONS THINK POINT 1! The more predictable the inflows and outflows of cash for an enterprise, the less the need for cash to be held for precautionary purposes. THINK POINT 2! The surplus cash should be put to effective use e.g. putting the cash on an interestyielding deposit e.g. 30 days notice deposit. Surplus cash may also be used to buy marketable securities that can be easily sold e.g. government bonds. THINK POINT 3! Several actions are possible: Raise the limits if the firm has demonstrated that it pays its accounts promptly. Investigate further by enquiring about the order from the customer e.g. Did the customer know the order was larger than the limit? Did it want to be considered for higher limits? After a review a new limit may be set. Deny the request if the information available does not favour raising the limit. THINK POINT 4! Answers may vary and may include the following: High-cost items: If a firm is holding expensive inventory e.g. jewellery, the loss of a single item can be costly. High-volume or high-profit items: A shortage of these items can be costly in terms of lost profits. Bottleneck items: These are items that are needed for many of the firm s finished goods and if they are not available, production may be forced to shut down. MANCOSA BBA Year 3 64

THINK POINT 5! Items in a policy on trade creditors may include: How the credit will be negotiated. Ensuring that discounts are received for prompt payments. Monitoring any restrictions on trade credit. 9.1.1 C 9.1.2 A 9.1.3 B 9.2 The cash budget shows expected cash receipts, expected cash payments and the net change in cash for the period (day, week, month, quarter etc) under review. The cash budget helps to identify cash shortages and gives the enterprise adequate time to arrange the necessary credit (e.g. bank overdraft) to meet the short-term cash needs. 9.3 Refer to paragraph 3.2.3 9.4 The firm s credit rating may deteriorate. Suppliers may be reluctant to allow credit in future. Creditors may charge interest. Etc. 9.5 Offer a cash discount for early settlement of accounts. Use an aggressive collection policy. 9.6 Refer to paragraph 4.2.1 9.7 Refer to paragraph 3.4 9.8 Refer to paragraph 4.1 MANCOSA BBA Year 3 65

9.9 Refer to paragraph 4.3 9.10 Refer to paragraph 4.4.2 9.11 Purchases on an open credit account must be paid for in full within the allotted credit period. In instalment/hire purchase credit, payment is made by means of a deposit and equal monthly payments (including finance charges) for the balance. With revolving credit the debtor has a credit limit and must pay a specified amount on the account monthly. If the credit limit is not reached, the debtor can buy on credit again. 9.12 Debtors must settle their accounts timeously. Bad debts must be kept to a minimum. 9.13 Debtors Age analysis Period in arrear (days) Debtor Outstanding Current 01-30 30-60 60-90 90+ Total 60 000 30 000 15 000 10 000 2 000 3 000 Percent 100% 50% 25% 17% 3% 5% 9.14 Refer to paragraph 5.2.4 9.15 EOQ = 2 H CU = 2 X 120 X 5 600000 = 28800000 = 5 367 units (rounded off) MANCOSA BBA Year 3 66

9.16 FIFO Closing inventory = 2 000+ 10 000 + 8 000 11 000 = 9 000 units From the 9 000 units on hand, 8 000 were purchased at R13,50 each and 1 000 were purchased at R13 each. The Value of stock on 31 March 20.6 is therefore: 8 000 units X R13,50 1 000 units X R13,00 108 000 13 000 121 000 Weighted Average Cost Units Unit price Total 2 000 10 000 8 000 20 000 Average cost per unit Closing inventory Value of closing inventory R12 R13 R13,50 = R262 000 20 000 = R13,10 = 9 000 units = 9 000 X R13,10 = R117 900 24 000 130 000 108 000 262 000 LIFO From the 9 000 units on hand, 2 000 were purchased at R12 each and 7 000 were purchased at R13 each. The Value of stock on 31 March 20.6 is therefore: 2 000 units X R12 7 000 units X R13 24 000 91 000 115 000 MANCOSA BBA Year 3 67

9.17 Refer to paragraph 6.1 9.18 Overdraft facilities have the disadvantage of being subject to repayment at short notice by the bank. Costs associated with bank overdrafts include interest (at a high rate) and overdraft facility/administration fees. MANCOSA BBA Year 3 68

TOPIC 4 CAPITAL EXPENDITURE DECISIONS LEARNING OUTCOMES Students should be able to: explain the steps in the capital expenditure approval process. apply the payback and accounting rate of return methods to capital expenditure appraisal. apply discounted cash flows methods to capital expenditure appraisal. explain the merits and drawbacks of the methods used to evaluate capital expenditure projects. CONTENTS 1. Introduction 2. Capital expenditure approval process 3. Techniques for analysing capital expenditure proposals 4. Self-assessment activities 5. Solutions MANCOSA BBA Year 3 69

READING Recommended reading Correia, C., Langfield-Smith, K., Thorne, H. and Wilton, R.W. (2008) Management Accounting: Information for managing and creating value. 1 st Edition. Berkshire: McGraw-Hill Education. pp. 1035-1084 Higgins, R.C. (2007) Analysis for Financial Management. 8 th Edition. New York: McGraw-Hill/Irwin. pp. 239-257 MANCOSA BBA Year 3 70

1. INTRODUCTION According to Correia et al. (2008: 1036) managers often face major decisions that involve cash flows over several years. Decisions relating to the purchase of machinery, equipment, vehicles, land, and buildings are examples. Other decisions may relate to radical changes to a production process or addition a new line of products or service. The competitive position of an enterprise depends upon these capital investments. The selection of the right project for future investment is an important decision for the long-term continuance of a company (Burke, 2006: 56). Capital investments often involve large sums of money and the selection of the wrong project may lead to the liquidation of the company should the project fail. Furthermore it is difficult and/or expensive to cancel the investment in a project once the investment is made. Decisions that require the evaluation of cash inflows and outflows over several years to determine the acceptability of a project are known as capital expenditure (or capital budgeting or capital investment) decisions. 2. CAPITAL EXPENDITURE APPROVAL PROCESS Since the sustainability of an organisation in the long-term is significantly affected by capital budgeting decisions, many large organisations have highly formalised capital expenditure approval processes. Emmanuel, Otley and Merchant cited in Correia et al. (2008: 1037) identified six stages in the capital expenditure decision process: Project generation: In many large companies, projects are usually initiated by managers of business units. These projects should be consistent with the strategic plan developed by top management. Estimation and analysis of projected cash flows: The cash flows over the life of the project must be estimated. Various techniques (see paragraph 3) may be used to analyse the cash flows. Progress to approval: Most capital expenditure proposals require the approval of senior management. The project must be justified on strategic, marketing, or environmental grounds. Analysis and selection of projects: After project initiators provide convincing MANCOSA BBA Year 3 71

justifications for their projects, corporate management will examine and select them. Implementation of projects: Successful projects, such as the purchase of a new asset, will be implemented. Post-completion audit of projects: This may take place after a year or even longer after the project is implemented. It may entail an evaluation of the accuracy of initial plans and cash flow estimates, and progress reports on the outcomes of the project in terms of operations and finance. 3. TECHNIQUES FOR ANALYSING CAPITAL EXPENDITURE PROPOSALS When deciding on whether to undertake a particular project or not, Correia et al. (2008: 1037) point out that the financial impact of the project must be considered. This implies that the costs of each project must be compared to the benefits it is expected to generate. When it comes to capital expenditure decisions, these costs and benefits extend over many years; they are known as cash outflows and cash inflows respectively. Cash outflows include the initial cost of the project and any increases in costs that are expected to be incurred as a result of the project over its life. Cash inflows include cost savings and additional revenues and any proceeds from the sale of assets that result from the project. Several techniques may be used to analyse these cash flows: Payback period Accounting rate of return Net present value (NPV) Internal rate of return (IRR) The first two methods ignore the time value of money i.e. they assume that a Rand received in a future period has the same value as the Rand received in the current period. The lat two methods consider the effect of the time value of money. 3.1 PAYBACK PERIOD Correia et al. (2008: 1049) describe the payback period of a capital investment proposal as the amount of time it would take for cash inflows from the project to accumulate to an amount that would cover the original investment. No adjustment is MANCOSA BBA Year 3 72

made for the time value of money. This means that a cash inflow in, for example, year 6 is treated in the same way as a cash inflow in year 1. Furthermore, the payback method ignores cash flows beyond the payback period. Payback period is calculated as follows if the net cash inflow is the same each year: Payback period = Initial investment Net annual cash inflow Example 1 Polokwane Ltd obtained information in respect of two projects, one of which it intends choosing. The following details are available: Cash outlay Economic lifetime Average annual net cash inflow over the economic lifetime Depreciation (straight-line method) Project M R600 000 6 years R200 000 100 000 Project N R600 000 4 years R280 000 150 000 Required Calculate the payback period of each project and recommend the project that should be chosen based on the payback period. Solution Payback period: Initial investment = Net annual cash inflow = Project M R600 000 R200 000 3 years Project N R600 000 R280 000 2,14 years or 2 years 1 month 26 days Note: 0.14 X 12 mths = 1,86 months 0,86 X 30 days = 26 days MANCOSA BBA Year 3 73

According to the calculation above Polokwane Ltd should choose project N since it can recover the cash outlay in a shorter time (2,14 years) than project M (3 years). However, the project manager of Polokwane Ltd must also consider that project M will be able to generate an income of R600 000 (R200 000 X 3) for 3 years after the payback period whereas project N will only be able to generate an income of R520 800 (for 1,86 years) after the payback period. When the cash inflows are not even, the payback formula stated above will not work. Instead, the cash flows must be accumulated on a year-to-year basis until the accumulated amount equals the initial investment. Consider the following example: Example 2 Consider two projects whose cash inflows are not even. Assume that the project costs R200 000. The net cash inflows for each year is as follows: Year 1 2 3 4 5 6 Project B R20 000 R40 000 R60 000 R80 000 R100 000 R100 200 Project C R100 000 R80 000 R60 000 R20 000 - - Required Calculate the payback period of each project and recommend the project that should be selected based on the payback period. MANCOSA BBA Year 3 74

Solution Project B Project C Investment (200 000) (200 000) Year 1 Cash flow 20 000 100 000 (180 000) (100 000) Year 2 Cash flow 40 000 80 000 (140 000) (20 000) Year 3 Cash flow 60 000 60 000 (80 000) Year 4 Cash flow 80 000 0 The payback period is 4 years 2 years 4 months Note: 20 000 X 12 mths 60 000 = 4 months Project C should be chosen since the payback period (2 years and 4 months) is less than that of project B (4 years). THINK POINT 1! Despite some serious shortcomings of the payback method, it is widely used in practice. Why do you think so? 3.2 ACCOUNTING RATE OF RETURN (ARR) According to Correia et al. (2008: 1050) the focus of the accounting rate of return is on the incremental profit that results from a project. Accounting profit is based on the accrual accounting procedures. Revenue is thus recognised during the period of sale and not necessarily when cash is received; likewise expenses are recognised during the period in which they are incurred and not necessarily when they are paid in cash. The accounting rate of return (ARR) on an investment project is calculated as follows: MANCOSA BBA Year 3 75

Accounting rate of return = Average annual profit X 100 Average investment 1 Using the ARR method, the project that is expected to realise a higher rate of return is chosen. Example 3 Use the figures from example 1 to calculate the accounting rate of return for each project. Solution Project M Project N ARR = Average annual profit X 100 Average annual profit X 100 Average investment 1 Average investment 1 = R100 000 X 100 R130 000 X 100 R300 000 1 R300 000 1 = 33,33% 43,33% In calculating the average annual profit, depreciation is deducted from the average annual net cash inflow (Project M: R200 000 R100 000 = R100 000). Using ARR, project N gives a higher rate of return and appears to be a better investment. The average investment is calculated as follows: (Initial investment + residue value) divided by 2. = (600 000+0) 2 =300 000 The advantage of the ARR method is that it is easy to calculate and it recognises profitability. Unlike the payback method, it considers the entire life of the project. However, it does not take into account the time value of money. Furthermore it uses accounting data instead of cash flow data. MANCOSA BBA Year 3 76

3.3 Net present value (NPV) Experience with money has taught us that R100 in cash today is not equivalent to R100 in cash in one year, two years or five years. We would rather receive R100 today than accept a promise to receive R100 in a year s time. There are several reasons for this. Suppose you received R100 today and invested it at, say, 10% interest. In a years time you would receive R110. Secondly, there is an element of risk. Lastly, one must consider the effects of inflation. Correia et al. (2008: 1042) point out that it is incorrect to simply add together cash flows that extend over several years. The appropriate approach is to use discounted cash flow analysis, which takes into account the time value of money. The cash flows of future years must be discounted to make them equivalent to those of the current year. The net present value method and the internal rate of return method (discussed in paragraph 3.4) are two widely used methods of discounted cash flow analysis. Correia et al. (2008: 1042) suggest four steps that one should follow to complete a net present value analysis of an investment proposal: Prepare a table showing the cash flows during each year of the proposed investment. Using the required rate of return, calculate the present value of each cash flow. (Note: The required rate of return, also called discount rate or hurdle rate, is the minimum acceptable rate of return on investments. It usually reflects the firm s cost of capital.) Present value tables that appear at the end of this topic may be used. Table 1 shows the present value of R1 at various interest rates receivable after n years (n can represent any number). Table 2 shows the present value of R1 at various interest rates receivable annually for n years. Calculate the net present value (NPV) which is the difference between the present values of the projected cash inflows and the present value of the cash outflows. If the NPV is positive, the project may be accepted on financial grounds. The higher the NPV, the more acceptable the project is. If the NPV is negative, the project is rejected since it would not be profitable. MANCOSA BBA Year 3 77

Example 4 Excel Ltd has a choice of two projects to invest in. The following details relate to these projects: Investment required Expected economic lifetime Minimum required rate of return Net annual cash inflows 1 st year 2 nd year 3 rd year 4 th year 5 th year 6 th year Project A R75 000 6 years 12% R20 000 R22 000 R24 000 R26 000 R23 000 R21 000 Project B R80 000 6 years 12% R22 000 R22 000 R22 000 R22 000 R22 000 R22 000 Required Use the net present value method to determine which project Excel Ltd should choose. Solution Project A Year 1 2 3 4 5 6 Cash inflow R20 000 R22 000 R24 000 R26 000 R23 000 R21 000 Discount Factor (see Table 1) 0,8929 0.7972 0,7118 0,6355 0.5674 0,5066 Present value R17 858 R17 538 R17 083 R16 523 R13 050 R10 639 Total PV R92 691 Investment (R75 000) NPV (positive) R17 691 MANCOSA BBA Year 3 78

Project B Net inflow R22 000 Discount factor (see Table 2) X 4,1114 Total Present value R90 451 Investment (R80 000) NPV (positive) R10 451 Decision: Project A should be chosen since it has a higher net present value. 3.4 Internal rate of return (IRR) Correia et al. (2008: 1043) describes a project s internal rate of return (or timeadjusted rate of return) as the actual economic return earned by a project over its life. Another way of stating this is that a project s internal rate of return (IRR) is the discount rate at which the present value of the projected cash inflows equals the present value of the cash outflows; therefore the IRR is the discount rate that makes the NPV of the cash flows equal to zero. A project is acceptable only if the IRR exceeds the required rate of return. The advantage of the IRR method is that it considers the time value of money and is therefore more realistic than the accounting rate of return (ARR). However, the calculation can be difficult especially when the cash flows are not even. When the cash flows are not even, the trial-and-error method for calculating IRR may be summarised as follows: Calculate the NPV at the cost of capital rate (r 1 ) Check if the NPV is positive or negative. If the NPV is positive, then pick another rate (r 2 ) higher than the cost of capital rate. (If the NPV is negative, pick a smaller rate.) The correct IRR at which NPV = 0 lies somewhere between these rates. Calculate the NPV using r 2. Use interpolation to calculate the exact rate. MANCOSA BBA Year 3 79

Example 5 Use the information in example 4 and determine which project should be selected using the internal rate of return. Solution Project A Step 1 We notice that the NPV is positive, and is far away from zero. Step 2 We now pick a higher rate e.g. 18%. (Trial-and-error is used to obtain the higher rate.) 1 2 3 4 5 6 Year Cash inflow R20 000 R22 000 R24 000 R26 000 R23 000 R21 000 Discount factor 18% 0,8475 0,7182 0,6086 0,5158 0,4371 0,3704 Project A Discount factor 19% 0,8403 0,7062 0,5934 0,4987 0,4190 0,3521 Discount factor 20% 0,8333 0,6944 0,5787 0,4823 0,4019 0,3349 Present value 18% 16 950 15 800 14 606 13 411 10 053 7 778 Present value 19% 16 806 15 536 14 242 12 966 9 637 7 394 Present value 20% R16 666 R15 277 R13 889 R12 540 R9 244 R7 033 Total PV 78 598 76 581 74 649 Investment (75 000) (75 000) (75 000) NPV R3 598 R1 581 (R351) Step 3 Interpolation: The IRR is between 19% and 20%. IRR= 19 + 1 581 1 581 + 351 = 19 + 1 581 1 932 = 19,82% MANCOSA BBA Year 3 80

Project B Step 1 We notice that the NPV is positive, and also far from zero. Step 2 We now pick a higher rate e.g. 16%. (Trial-and-error is used to obtain the higher rate.) Project B Year Cash inflow p.a. Discount Factor 16% Discount Factor 17% Present value 16% Present value 17% PV 1-6 R22 000 3,6847 3,5892 81 063 78 962 Investment (80 000) (80 000) NPV R1 063 (R1 038) Step 3 Interpolation: The IRR is between 16% and 17%. IRR= 16 + 1 063 1 063 + 1 038 = 16 + 1 063 2 101 = 16,51% Decision: Project A should be chosen since the IRR is greater. THINK POINT 2! What advantages do you think that the net present value method has over the internal rate of return method? MANCOSA BBA Year 3 81

4. 4.1 4.1.1 4.1.1.1 4.1.1.2 4.1.1.3 4.1.2 SELF ASSESSMENT ACTIVITIES An investment has the following cash flows: Year Cash flow 0 (R60 000) 1 R10 000 2 R12 000 3 R28 000 4 R20 000 5 R30 000 Required: Calculate the following: Payback period Net present value (NPV) at 12% cost of capital Accounting rate of return (ARR) (Assume that there is no depreciation.) Must the investment be considered positively or negatively? Give reasons for your answer. 4.2 The financial manager at Rico Ltd had to choose between these two projects, Alpha and Beta, which have the following after-tax cash inflows: Year 1 2 3 4 Alpha 0 R18 500 R36 200 R123 000 Beta R36 000 R36 000 R36 000 R36 000 Both projects require an initial investment of R117 700. Required: 4.2.1 Calculate the payback period for each project. Which project would you choose? Why? 4.2.2 Calculate the net present value (NPV) for each project, using a discount rate of 12%. Which project would you choose? Why? 4.2.3 Calculate the Internal Rate of Return (IRR) for both projects. Which project should be chosen? Why? MANCOSA BBA Year 3 82

5. SOLUTIONS THINK POINT 1! The payback period is easy to calculate and understand compared to discounted cash flow methods. It provides a tool for roughly screening investment proposals. If a firm is experiencing a shortage of cash, it may be critical to choose investment projects that recoup the initial investment quickly. The payback technique provides some insight into the risks of a project. The further into the future the cash flows are expected to occur, the greater the level of uncertainty. THINK POINT 2! It is easier to calculate a project s NPV than its IRR. One can adjust for risk when using the NPV method by using a higher discount rate for later cash flows. NPV always yields one answer. When cash flows change from positive to negative over the life of a project, more than one IRR can be calculated for the one project. 4.1.1.1 Investment (R60 000) Year 1 Cash flow R10 000 (R50 000) Year 2 Cash flow R12 000 (R38 000) Year 3 Cash flow R28 000 (R10 000) Year 4 Cash flow R20 000 The payback period is 3 years 6 months Note: R10 000 X 12 months R20 000 = 6 months MANCOSA BBA Year 3 83

4.1.1.2 Year 1 2 3 4 5 Cash inflow R10 000 R12 000 R28 000 R20 000 R30 000 Discount Factor (see Table 1) 0,8929 0.7972 0,7118 0,6355 0.5674 Present value R8 929 R9 566 R19 930 R12 710 R17 022 Total PV R68 157 Investment (R60 000) NPV (positive) R8 157 4.1.1.3 Accounting rate of return: Project M ARR= Average annual profit X 100 Note: Average investment 1 = R20 000 X 100 = 66,67% Average annual profit = R30 000 1 R10 000 + R12 000 + R28 000 + R20 000 + R30 000 5 years = R20 000 p.a. 4.1.2 * * * The investment should be considered positively because: The payback period is only 2 ½ years. The net present value (R8 157) is positive. The accounting rate of return (66,67%) is higher than the cost of capital (12%). MANCOSA BBA Year 3 84

4.2.1 Investment (R117 700 Year 1 Cash flow 0 (R117 700) Year 2 Cash flow R18 500 (R99 200) Year 3 Cash flow R36 200 (R63 000) Year 4 Cash flow R123 000 The payback period is 3 years 6 months 4 days Note: R63 000 X 12 mths R123 000 = 6,146 months 0,146 X 30 days = 4,38 days Project Beta Initial investment = Net annual cash inflow = R117 700 R36 000 3,27 years Note: 0,27 X 12 = 3,24 months 0,24 X 30 = 7,2 days The payback period is 3 years 3 months 7 days Project Beta should be chosen since the payback period (3 years 3 months 7 days) is less than that of Project Alpha (3 years 6 months 4 days) MANCOSA BBA Year 3 85

4.2.2 Project Alpha Year 1 2 3 4 Cash inflow 0 R18 500 R36 200 R123 000 Discount Factor (see Table 1) 0,8929 0.7972 0,7118 0,6355 Present value 0 R14 748 R25 767 R78 167 Total PV R118 682 Investment (R117 700) NPV (positive) R982 Project Beta Net inflow R36 000 Discount factor (see Table 2) X 3,0373 Total Present value R109 343 Investment (R117 700) NPV (negative) (R8 357) Project Alpha should be chosen since the NPV is positive. The NPV for project Beta is negative and is therefore rejected. 4.2.3 Project Alpha Step 1 We notice that the NPV is positive, and above zero, but not by a large margin. Step 2 We now pick a higher rate e.g. 13%. (Trial-and-error is used to obtain the higher rate.) MANCOSA BBA Year 3 86

Year 1 2 3 4 Cash inflow 0 R18 500 R36 200 R123 000 Discount Factor 12% 0,8929 0.7972 0,7118 0,6355 Project Alpha Discount Factor 13% 0,8850 0,7831 0,6931 0,6133 Present value 12% 0 R14 748 R25 767 R78 167 Present value 13% 0 R14 487 R25 090 R75 436 Total PV R118 682 R115 013 Investment (R117 700) (R117 700) NPV R982 (R2 687) Step 3 Interpolation: The IRR is between 12% and 13%. IRR= 12 + 982 982 + 2 687 = 12 + 982 3 669 = 12,27% Project Beta Step 1 We notice that the NPV is negative. Step 2 We now pick a lower rate e.g. 10%. (Trial-and-error is used to obtain the higher rate.) MANCOSA BBA Year 3 87

Project Beta Year Cash inflow p.a. Discount Factor 10% Discount Factor 9% Discount Factor 8% Present value 10% Present value 9% Present value 8% PV 1-4 R36 000 3,1699 3,2397 3,3121 114 116 116 629 119 236 Investment 117 700 117 700 117 700 NPV (R3 584) (R1 071) R1 536 Step 3 Interpolation: The IRR is between 8% and 9%. IRR= 8 + 1 536 1 536 + 1 071 = 8 + 1 536 2 607 = 8,59% Decision: Project Alpha should be chosen as the IRR is greater. MANCOSA BBA Year 3 88

TABLE 1 Table 1: Present value of R1: PVFA (k,n) = Number of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 25% Periods 1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8000 2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 0.6400 3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 0.5120 4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 0.4096 5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 0.3277 6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349 0.2621 7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791 0.2097 8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326 0.1678 9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938 0.1342 10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615 0.1074 11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346 0.0859 12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122 0.0687 13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935 0.0550 14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779 0.0440 15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649 0.0352 16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541 0.0281 17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451 0.0225 18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376 0.0180 19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313 0.0144 20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261 0.0115 25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105 0.0038 30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042 0.0012 40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0019 0.0013 0.0010 0.0007 0.0001 50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001 * 60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033 0.0019 0.0011 0.0007 0.0004 0.0002 0.0001 0.0001 * * * * MANCOSA BBA Year 3 89

TABLE 2 Table 2 : Present value of a regular annuity of R1 per period for n periods : PVFA (k,n) = n i=1 = Number of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Periods 1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278 3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065 4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887 5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906 6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255 7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046 8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372 9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.4506 4.3038 4.1633 4.0310 10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925 11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271 12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392 13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327 14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106 15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755 16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296 17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746 18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122 19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435 20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696 25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476 30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789 40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966 50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995 60 44.9550 34.7609 27.6756 22.6235 18.9293 16.1614 14.0392 12.3766 11.0480 9.9672 9.0736 8.3240 7.6873 7.1401 6.6651 6.2402 5.8819 5.5553 5.2630 4.9999 MANCOSA BBA Year 3 90

TOPIC 5 FINANCING DECISIONS: SOURCES AND COSTS LEARNING OUTCOMES Students should be able to: state the important factors relating to any particular source of new finance from the point of view of the enterprise and its existing owner(s) as well as the providers of new finance. distinguish between primary and secondary markets. distinguish between capital and money markets. explain the sources of short-term financing. discuss the sources of long-term financing. explain the concept of financial leverage. identify problems that may be experienced in obtaining finance. CONTENTS 1. Introduction 2. Factors relating to sources of new finance 3. Financial markets 4. Short-term financing 5. Long-term financing 6. Financial leverage 7. Problems in obtaining finance 8. Self-assessment activities 9. Solutions MANCOSA BBA Year 3 91

READING Recommended reading Cronje, G.J. de J., Du Toit, G.S. and Marais, A., de K. (2004) Introduction to Business Management. 6 th Edition. Cape Town: Oxford University Press. pp 452-478 Helfert, E.A. (2003) Techniques of Financial Analysis. 11 th Edition. New York: McGraw-Hill/Irwin. pp. 222-227; 355-380 Higgins, R.C. (2007) Analysis for Financial Management. 8 th Edition. New York: McGraw-Hill/Irwin. pp.199-210 McLaney, E. (2003) Business Finance: Theory and Practice. 6 th Edition. Essex: Prentice Hall. pp.213-239 MANCOSA BBA Year 3 92

1. INTRODUCTION Helfert (2003:355) states that it is the responsibility of management to fund its strategic business design with an appropriate combination of capital sources that will help to bring about the desired increase in shareholder value. It is therefore necessary to examine the key considerations in assessing the financing options open to management. 2. FACTORS RELATING TO SOURCES OF NEW FINANCE According to McLaney (2003:214) there are several important factors relating to any particular source of new finance from the point of view of the enterprise and its existing owner(s). These include: the administrative and legal costs of raising the finance; the cost of servicing the finance e.g. interest payments; the level of obligation to make interest or similar payments; the level of obligation to repay the finance; the tax deductibility of the costs related to the finance; the effect of the new finance on the level of control of the enterprise by its existing owners/shareholders and on their freedom of action. From the point of view of the supplier of new finance, the following are likely to be important factors: The level of return expected by investors; The level of risk attached to the expected returns; The potential for liquidating the investment either through direct repayment by the enterprise or via the secondary market; The personal tax position of investors in relation to returns from their investment; The degree of control or influence over the affairs of the enterprise that the investor is likely to acquire as a consequence of investing. MANCOSA BBA Year 3 93

3. FINANCIAL MARKETS Cronje et al (2004:453) maintain that financial markets and financial institutions play an important role in the financing of enterprises. They define financial markets as the channels through which holders of surplus funds (savers) make their funds available to those who require additional finance. Financial institutions act as intermediaries on financial markets between the savers and those with a shortage of funds. A distinction can also be made between the primary market where new capital is raised and the secondary market where trading in securities, after they have been issued, takes place. The Johannesburg Securities Exchange (JSE) is an example of a market that allows savers to convert their investments into cash. The money market is one where funds are borrowed or lent for short periods of time, usually less than a year e.g. bank overdraft. The capital market makes funds available for long periods of time e.g. mortgage bond. 4. SHORT-TERM FINANCING Short-term financing include debts/obligations where repayment has to be made within one year. From a cost point of view, it is advisable to finance current assets needs with short-term funds. Cronje et al (2004:456) elaborate on the following forms of short-term financing: Trade credit Accruals Bank overdraft 4.1 Trade credit Trade credit mainly takes the form of suppliers credit. Payment is not made when the goods or services are purchased. The enterprise is only expected to pay after 30, 60 or 90 days, depending on the credit terms granted. In order to encourage prompt payment, suppliers often offer a cash rebate/discount for early payment. Let s examine how the advantage of a cash discount may be calculated. The following formula may be used to determine the cost of not accepting a cash rebate/discount: MANCOSA BBA Year 3 94

Cost of not accepting a discount = % rebate x 365 x 100 100% % rebate Payment period discount period 1 Example 1 Vita Distributors normal credit terms to Nyrere Stores are 30 days but is prepared to allow a 2% rebate if Nyrere Stores pays the account within 10 days. Calculate the cost to Nyrere Stores of not accepting the discount. Solution Cost of not accepting a discount = 2% x 365 x 100 100% 2% 30 10 1 = 37,24% THINK POINT 1! Refer to example 1. What would be some of the consequences to Nyrere Stores if it did not pay its account within 30 days? 4.2 Accruals Accruals refer to liabilities for services provided to the enterprise for which payment has not yet been made. Wages and taxes are common examples. Employees are actually providing short-term financing for the enterprise by waiting for a week or month to be paid rather then being paid daily. Accrued tax also represents a form of financing. The extent of financing from accrued taxes is determined by the amount of tax payable and the frequency of payment. Since accruals have no associated cost, they are a valuable source of finance. 4.3 Bank overdrafts Banks provide this facility for enterprises to make payments from a cheque account in excess of the balance in the account. It provides a means to bridge the gap between cash receipts and cash payments. Overdraft limits are usually reviewed annually. Interest that is charged on an overdraft is negotiable and is MANCOSA BBA Year 3 95

linked to the risk profile of the borrower. Banks charge interest daily on the outstanding balance owing. This implies that interest is only charged on the portion of the overdraft limit that is used. Some banks even charge a fixed monthly overdraft facility fee. 5. LONG-TERM FINANCING Long-term financing can come from internal and external sources. Cronje et al (2004:461) analyse the following forms of long-term financing: Owner s equity Long-term debt Financial leasing 5.1 Owner s equity Owner s equity refers to funds made available by the legal owners in the form of capital as well as indirect contribution in the form of undistributed/retained profit. In the case of companies shareholders become owners of the company through the purchase of ordinary shares. This entitles the shareholder to a claim to profits. The portion of the profit paid to shareholders is called dividends. Retained profit represents profit that could have been paid out to shareholders but were retained by the company for the purpose of self-financing. The cost to the company for ordinary shares is the flow of dividends. THINK POINT 2! Dividends tend to be more expensive than a similar gross equivalent loan interest rate. Explain why. 5.2 LONG-TERM DEBT Long-term debt refers to debt that is repaid in more than a year s time. Although all long-term debts are subject to interest expense, interest payments are deductible for tax purposes. Some of the important forms of long-term debt will now be discussed. MANCOSA BBA Year 3 96

5.2.1 Debentures Debentures are the most common form of long-term debt for companies. A certificate is issued to the lender and this certificate is negotiable. Payment of the principal sum plus interest is made to the holder of the certificate. The cost to the company is a fixed interest charge. 5.2.2 Bonds Bonds are secured loans and these are granted using fixed assets like fixed property as security (mortgage bonds). The value of the property usually determines the amount that may be raised. If the enterprise is liquidated, the proceeds from the secured assets would first be used to settle the claim of the secured provider of the credit. The interest rate on mortgage bonds is not fixed but changes with market forces. 5.2.3 Registered term loans These are unsecured loans and are not freely negotiable. A fixed rate of interest is payable and the loan is repaid over a period agreed to with the bank. 5.2.4 Financial leasing A financial lease is a contract that makes provision for the right to use an asset, owned by the lessor, in exchange for a specified rental paid by the lessee. The lessee has the opportunity to own the asset at the end of the lease. The lease obligation is fixed and the lease payment is based on recovering the value of the asset for the lessor and the cost of any other services provided. The lease payments of a financial lease are deductible for tax purposes. Financial leasing must not be confused with an operating lease. In an operating lease the lessee can use the asset for a specified period, often less than the physical life, assumes none of the risks of ownership or technical obsolescence, and can replace or upgrade the asset while the lessor has the task of disposing of the used item. An operating lease can be terminated by giving the required notice but in the case of a financial lease the agreement is non-terminative. MANCOSA BBA Year 3 97

6. FINANCIAL LEVERAGE According to Higgins (2007:199) financial leverage is the device that increases the expected return to owners at the cost of greater risk. Financial leverage involves the substitution of fixed-cost debt financing for owners equity. Since this substitution increases fixed interest expenses, financial leverage increases the variability of return s to owners. Financial leverage can increase owners risk as well as return. Helfert (2003:222) notes that with financial leverage advantage is gained from the expectation that funds borrowed at a fixed interest rate can be used for investment opportunities earning rates of return greater then the interest paid on these funds. The difference accrues as profit to the owners of the enterprise and enhances the return on equity. However if the return earned is less than the interest rate on loans, the opposite would apply. The higher the proportion of debt and its fixed interest charges in the capital structure, the greater will be the leverage contribution to the return on equity for a given positive return achieved on the investment. Conversely, if achieved returns fall below the rate of interest, the fixed nature of the interest expense will begin to magnify the reduction in return on equity. 7. PROBLEMS IN OBTAINING FINANCE There are many factors that may influence the ability of an enterprise to secure adequate financing. These include: A lack of sufficient own capital Poor creditworthiness e.g. poor payment record, cash flow problems, high debt ratio Poor sales potential High business risk Incomplete or unimpressive business plan Inability to provide security Interest rate too high making finance unaffordable Lack of management skills by the owner to make the business successful MANCOSA BBA Year 3 98

8. SELF-ASSESSMENT ACTIVITIES 8.1 Would you consider the Johannesburg Securities Exchange (JSE) to be part of the secondary market? Explain why. 8.2 Distinguish between the capital market and money market. 8.3 Midrand Manufacturers normal credit terms to Gina Traders are 30 days but is prepared to allow a 3% discount if Gina Traders pays the account within 12 days. Calculate the cost to Gina Traders of not accepting the discount. 8.4 Explain how the employees of an enterprise may actually be a source of shortterm financing to the enterprise. 8.5 Explain how banks charge interest on bank overdrafts. 8.6 Evaluate loans as a source of finance to businesses. 8.7 Discuss the form of long-term debt available only to (public) companies. 8.8 Discuss a form of long-term debt where the interest rate is not fixed. 8.9 Distinguish between a capital lease and an operating lease. 8.10 What do you understand by financial leverage? 8.11 Return/Cost, risk and control are important considerations in deciding on a form of finance. Complete the following table by indicating how these considerations apply to long-term debt and owners equity. Consideration Long-term debt Return/Cost Owners equity Risk Control 9. SOLUTIONS THINK POINT 1! The cost of the discount foregone (37,24%). Interest may be charged by Vita Distributors. The firm s credit rating would deteriorate, along with its ability to obtain future credit. MANCOSA BBA Year 3 99

THINK POINT 2! Dividends are not tax-deductible in arriving at a company s tax liability while interest is tax-deductible. 8.1 Yes. The secondary market is one where trading in securities, after they have been issued, takes place. The JSE allows for trading of shares that have been already issued by public companies. 8.2 Refer to paragraph 3. 8.3 Cost of not accepting a discount = 3% x 365 x 100 100% 3% 30 12 1 = 62,71% 8.4 Employees are providers of short-term financing for the enterprise by waiting for a week or month to be paid rather then being paid daily. 8.5 Banks charge interest daily on the outstanding balance owing. This implies that interest is only charged on the portion of the overdraft limit that is used. 8.6 Loans offer businesses the following advantages: Costs are limited in that they are determined by the loan interest rate. Interest payments are deductible for tax purposes. The control of the owners is usually not influenced by the issue of more loans. Loans do not dilute the earnings of ordinary shares However, a disadvantage is that fixed interest payments and priority claims of loans in the case of liquidation increase the risks, inherent in the business, to the owners. 8.7 Refer to paragraph 5.2.1 (debentures). MANCOSA BBA Year 3 100

8.8 Mortgage bonds are secured loans and these are granted using fixed property as security. The value of the property usually determines the amount that may be raised. If the enterprise is liquidated, the proceeds from the property would first be used to settle the claim of the secured provider of the credit. The interest rate on mortgage bonds is not fixed but changes with market forces. 8.9 Refer to paragraph 5.2.4. 8.10 Refer to paragraph 6. 8.11 Consideration Long-term debt Return/Cost * Interest is tax deductible. * Debt increases return on equity by leveraging profits Risk * As the level of debt increases, so does the risk of financial distress. * Repayment of debt represents a fixed obligation that must be met. Control * Debt does not represent an ownership stake in the business * Owners retain full control Source: Cronje et al. (2004:477) Owners equity * Dividends are not tax deductible. * Higher levels of equity reduce the risk of financial distress. * No fixed obligations * Control may be diluted if the business issues new shares. MANCOSA BBA Year 3 101

TOPIC 6 FINANCIAL ANALYSIS LEARNING OUTCOMES Students should be able to: explain why it is important to analyse financial statements. calculate and interpret ratios from management s point of view. calculate and interpret ratios from the point of view of creditors and lenders. CONTENTS 1. Introduction 2. Ratio analysis 3. Ratio analysis: Management s point of view 4. Ratio analysis: Lenders and creditors point of view 5. Self-assessment activities 6. Solutions MANCOSA BBA Year 3 102

READING Recommended reading Helfert, E.A. (2003) Techniques of Financial Analysis. 11 th Edition. New York: McGraw-Hill/Irwin. pp.107-144 Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1 st Edition. North Ryde: McDraw-Hill. pp.75-93 MANCOSA BBA Year 3 103

1. INTRODUCTION According to Helfert (2003:107) when one wishes to assess the performance of a business, one looks for ways to measure the financial and economic consequences of past management decisions that shaped investments, operations, and financing over time. One needs to know whether resources were used effectively, whether profitability expectations were achieved or even exceeded, and whether financing choices were made prudently. In this topic we will analyse business performance based on information contained in financial statements. Meredith and Williams (2005:76) state that the analysis of financial statements is important in order to: explain and understand the reasons for levels of performance of sales, control of expenses, profits, funds, and investment in general. identify trends in performance and owner investment over time. identify the position of the enterprise in an industry in order to identify strengths, weaknesses, opportunities, and threats. understand past performance in order to plan for the future. assist managers and owners to make the best use of available resources. 2. RATIO ANALYSIS A ratio may be defined as the relationship between two sets of values obtained from financial statements. Ratios provide a means to summarise complex accounting information into a small number of key indicators. They make figures more easily comparable. Our discussion will focus on two major viewpoints of financial performance analysis viz.: Managers Lenders and creditors THINK POINT 1! Name 4 other groups who may wish to analyse the financial performance of an enterprise. Also indicate possible reasons for their interest in such analyses. MANCOSA BBA Year 3 104

Helfert (2003:110) indicates the main performance areas of interest to management and lenders in Figure 1-1, together with the most common ratios: Figure 1-1 MANAGEMENT Operational analysis Gross margin Profit margin Resource management Inventory turnover Debtors collection period Creditors payment period Profitability Return on assets (before interest and tax) Return on own capital LENDERS AND CREDITORS Liquidity Current ratio Acid test ratio Financial leverage Debt to assets Debt to equity Debt service Interest coverage We ll now follow the sequence shown in Figure 1-1 and discuss each sub-grouping within the two broad viewpoints. For the purposes of illustration we will use information from Figure 1-2 and Figure 1-3 adapted from Helfert (2003:111) that represent the simplified Income Statement and Balance Sheet respectively of Shilowa Enterprises. We will also follow his discussion of the ratios. MANCOSA BBA Year 3 105

Figure 1-2 Shilowa Enterprises Income Statements for the year ended 31 December 20.9 and 20.8 20.9 20.8 Sales (all credit) 1 672 400 1 574 800 Cost of sales (all credit) (878 700) (812 600) Gross profit 793 700 762 200 Operating expenses: (487 900) (466 600) Selling, general and administrative Other expenses 396 300 91 600 371 200 95 400 Operating profit 305 800 295 600 Other income: 2 700 3 300 Interest income 2 700 3 300 Profit before interest 308 500 298 900 Interest expense (11 100) (10 900) Profit before tax 297 400 288 000 Tax (74 350) (72 000) Net profit after tax 223 050 216 000 Figure 1-3 Shilowa Enterprises Balance Sheets the year ended 31 December 20.9 and 20.8 Assets 20.9 20.8 Non-current assets 814 300 783 000 Current assets: 637 900 606 600 Inventories Accounts receivable Cash and cash equivalents 231 200 289 100 117 600 203 000 277 800 125 800 Total assets 1 452 200 1 389 600 Owners equity and liabilities Owners equity 653 100 628 900 Non-current liabilities 323 700 378 800 Current liabilities 475 400 381 900 MANCOSA BBA Year 3 106

Accounts payable 108 100 100 800 Other current liabilities 367 300 281 100 Total owners equity and liabilities 1 452 200 1 389 600 3. RATIO ANALYSIS: MANAGEMENT S POINT OF VIEW Helfert (2003:109) maintains that management has a dual interest in the analysis of financial performance viz.: To evaluate the efficiency and profitability of operations. To assess how effective the resources of the enterprise are being used. Evaluating the operations of an enterprise is largely done by an analysis of the income statement whilst the effectiveness of resources is usually measured by a review of both the income statement and balance sheet. 3.1 Operational analysis An evaluation of operational effectiveness may be performed by a percentage analysis of the income statement. The use of sales as a common base permits a ready comparison of key costs and expenses from period to period, and against competitor and industry databases. 3.1.1 Gross margin Gross margin (also called gross profit margin) is one of the most common ratios in operational analysis. It is calculated by expressing the gross profit as a percentage of sales: Gross margin = Gross profit X 100 Sales 1 The gross margin ratio indicates the profit of the firm relative to sales after deducting the cost of sales. Apart from measuring the efficiency of the enterprise s operations, it also indicates how products are priced. In the case of Shilowa Enterprises gross margin is as follows: MANCOSA BBA Year 3 107

20.9 20.8 Gross margin = Gross profit X 100 Gross margin = Gross profit X 100 Sales 1 Sales 1 = R793 700 X 100 = R762 200 X 100 R1 672 400 1 R1 574 800 1 = 47,46% = 48,40% A gross margin decline of 0.94% occurred from the previous year. Gross margin can be affected by a combination of changes in: The price charged for products sold. The price paid for products purchased. Any variation in the product mix of the business. 3.1.2 Profit margin This ratio pertains to the relationship of net profit after taxes to sales and is indicative of management s ability to operate the enterprise profitably. To be successful an enterprise must not only recover the cost of the merchandise, the operating expenses, and the cost of borrowed funds but also there must also be reasonable compensation to the owners for putting their capital at risk. The profit margin ratio is important to operating managers since it reflects an enterprise s pricing strategy and its ability to control operating costs. Profit margin is calculated by expressing the net profit after taxes as a percentage of sales: Profit margin = Net profit after tax X 100 Sales 1 The profit margin of Shilowa Enterprises is as follows: MANCOSA BBA Year 3 108

20.9 20.8 Profit margin Profit margin = Net profit after tax X 100 = Net profit after tax X 100 Sales 1 Sales 1 = R223 050 X 100 = R216 000 X 100 R1 672 400 1 R1 574 800 1 = 13.34% = 13.72% A small decline of 0.38% from 20.8 is noted. Net profit margin is significantly lower than the gross margin and is probably due to the high operating expenses. 3.2 Resource management Resource management concerns the effectiveness with which management has employed the assets entrusted to it by the owners of the enterprise. We will focus on the rate at which inventory is sold, the time taken by debtors to pay accounts and the time taken to settle creditors accounts. 3.2.1 Inventory turnover In evaluating the effectiveness of an enterprise s inventory management, it is common to use the number of times inventory has turned over during the period of analysis. The higher the turnover rate the better, since low inventories usually suggest a minimal risk of non-saleable merchandise and also indicates efficient use of capital. Inventory turnover is calculated as follows: Inventory turnover = Cost of sales Average inventory Average inventories refer to the average of the beginning and ending inventories. The inventory turnover of Shilowa Enterprises is calculated as follows (Note: Inventories for 20.7 amounted to R224 680.): MANCOSA BBA Year 3 109

20.9 20.8 Inventory turnover Inventory turnover = Cost of sales = Cost of sales Average inventory Average inventory = R878 700 = R812 600 R217 100 R213 840 = 4,05 times = 3,80 times Note: Average inventory is calculated as follows: 20.9 20.8 = R231 200 + R203 000 = R203 000 + R224 680 2 2 = R217 100 = R213 840 The inventory turnover of Shilowa Enterprises shows an improvement from 3,80 times to 4,05 times per annum. The inventory turnover of 4,05 times for 20.9 implies that merchandise remains in inventory for an average of 90 days (365 days 4,05 times) before being sold. THINK POINT 2! What do you think are the implications for an enterprise if: inventory turnover is low? inventory turnover is high? 3.2.2 Debtor collection period This ratio tells us how long, on average, trade debtors meet their obligations to pay following the sale on credit. It highlight s the enterprise s management of debtors (or accounts receivable). One would want to know whether the accounts receivable that are outstanding at the end of the period closely approximate the amount of credit sales one would expect to remain outstanding under prevailing credit terms. This is done as follows: MANCOSA BBA Year 3 110

Debtor collection period = Accounts receivable X 365 Credit sales 20.9 20.8 Debtor collection period Debtor collection period = Accounts receivable X 365 = Accounts receivable X 365 Credit sales Credit sales = R289 100 X 365 = R277 800 X 365 R1 672 400 R1 574 800 = 63,10 days = 64,39 days The debtor collection period may be interpreted in two ways. One can say that Shilowa Enterprises has an average of 63,10 days worth of credit sales tied up in accounts receivable, or one can say that the average time lag between sale and receipt of cash from the sale is 63,10 days. This collection period allows us to compare it with the terms of sale. Thus if Shilowa Enterprises sells on 30 day terms, the collection period is very unsatisfactory. It could mean that some customers had difficulty paying, or were abusing their credit privileges, or that some sales were made on extended terms. 3.2.3 Creditor payment period This ratio tells us how long, on average, an enterprise takes to pay for goods bought following the purchase on credit. It is used to evaluate an enterprise s performance with regard to the management of accounts payable (creditors). The number of days of accounts payable (or creditor payment period) is compared to the credit terms under which the enterprise makes purchases. Significant deviations from this norm can be detected. Optimal management of accounts payable requires making payment within the stated terms and no earlier except taking advantage of discounts whenever offered for early payment. Creditor payment period may be calculated as follows: MANCOSA BBA Year 3 111

Creditor payment period = Accounts payable X 365 Credit purchases 20.9 20.8 Creditor payment period Creditor payment period = Accounts payable X 365 = Accounts payable X 365 Credit purchases Credit purchases = R108 100 X 365 = R100 800 X 365 R906 900 R790 920 = 43,51 days = 46,52 days Note: Credit purchases are calculated as follows: 20.9 20.8 Cost of sales 878 700 812 600 Add: Closing inventory 231 200 203 000 1 109 900 1 015 600 Less opening inventory (203 000) (224 680) Credit purchases 906 900 790 920 Shilowa Enterprises is probably allowed credit terms of between 30 days and 60 days by creditors. 3.3 Profitability Here we examine how effectively management has employed the total assets and own capital as recorded in the balance sheet. This is evaluated by relating net profit, defined in a variety of ways, to resources used to generate the profit. A satisfactory return is one that: exceeds the inflation rate. is higher than alternative investments e.g. fixed deposits. is higher than the cost of borrowing funds. MANCOSA BBA Year 3 112

3.3.1 Return on assets (Operating profit on total assets) Return on assets (ROA) measures the efficiency with which an enterprise allocates and manages its resources. It differs from return on own capital since it measures profit as a percentage of the funds provided by both owners and creditors as opposed to funds provided by the owners only. ROA is calculated as follows: Return on assets = Operating profit X 100 Total assets 1 Return on assets of Shilowa Enterprises is calculated as follows: 20.9 20.8 Return on assets Return on assets = Operating profit X 100 = Operating profit X 100 Total assets 1 Total assets 1 = R305 800 X 100 = R295 600 X 100 R1 452 200 1 R1 389 600 1 = 21,75% = 21,51% Shilowa Enterprises experienced a slight decline in profitability. It needs to compare this return to the inflation rate, return on alternative investments, and interest rate on borrowed capital to determine whether it is satisfied with the return. 3.3.2 Return on own capital This ratio is a means of assessing the amount of wealth generated for the amount of wealth invested by the owners. This return is often used by owners to decide whether to continue having their capital invested in the enterprise. Return on own capital is calculated as follows: Return on own capital = Profit after tax X 100 Own capital 1 MANCOSA BBA Year 3 113

Return on capital for the owners of Shilowa Enterprises is as follows: 20.9 Return on own capital = Profit after tax X 100 Own capital 1 = R223 050 X 100 R653 100 1 = 34,15% 20.8 Return on own capital = Profit after tax X 100 Own capital 1 = R216 000 X 100 R628 900 1 = 34,35% Owners often compare this return to the return offered on alternative investments e.g. fixed deposit. In the case of Shilowa Enterprises, the owners should be satisfied with the return of over 34%. 3. RATIO ANALYSIS: LENDERS AND CREDITORS POINT OF VIEW Lenders and creditors are interested in funding the needs of a successful enterprise that will perform according to expectations. However, they have to also consider the negative consequences of default and liquidation. Lenders and creditors have to carefully assess the risk involved in recovering the funds extended. They therefore have to look for a margin of safety in the assets held by the enterprise. Several ratios are used to evaluate this protection by testing the liquidity of the enterprise. Another set of ratios tests the leverage of the enterprise in order to weigh the position of lenders versus owners. Lastly, there are coverage ratios that relate to the enterprise s ability to provide debt service from the funds generated by operations. MANCOSA BBA Year 3 114

3.1 Liquidity Liquidity ratios measure the ability of an enterprise to meet its short-term obligations. They focus on the liquid assets of the enterprise i.e. current assets that can readily be converted into cash on the assumption that they form a cushion against default. The most commonly used liquidity ratios are the current ratio and acid test ratio. 3.1.1 Current ratio The current ratio shows the relationship between current assets and current liabilities and is an attempt to show the safety of current debt holders claims in the case of default. Current ratio is calculated as follows: Current ratio = Current assets Current liabilities The current ratio for Shilowa Enterprises is as follows: 20.9 20.8 Current ratio Current ratio = Current assets = Current assets Current liabilities Current liabilities = R637 900 = R606 600 R475 400 R381 900 = 1,34:1 = 1,59:1 A decline in the ratio (from 1,59:1 to 1,34:1) is largely due to the increase in current liabilities from the previous year. An enterprise with a low current ratio may not be able to convert its current assets into cash to meet maturing obligations. From a debt holder s point of view, a higher ratio appears to provide a cushion against losses in the event of business failure. A large excess of current assets over current liabilities seems to protect claims. However, from a management point of view a very high current ratio may point towards slack management practices. It may indicate idle cash, high inventory levels that may be unnecessary and poor credit management resulting in overextended accounts receivable. MANCOSA BBA Year 3 115

3.1.2 Acid test ratio This ratio is a more stringent test of liquidity. The intention of the acid test ratio is to test the collectibility of current liabilities under distress conditions, on the assumption that inventories would have no value at all. In the case of a real crisis creditors may realise little cash from the sale of inventory. The acid test ratio is similar to the current ratio except that the current assets (numerator) are reduced by the value of the inventory. The calculation is done as follows: Acid test ratio = Current assets Inventory Current liabilities Shilowa Enterprises acid test ratio is as follows: 20.9 20.8 Acid test ratio Acid test ratio = Current assets Inventory = Current assets Inventories Current liabilities Current liabilities = R637 900 R231 200 = R606 600 R203 000 R475 400 R381 900 = 0,86:1 = 1,06:1 It is clear that a ratio of less than 1:1 would pose liquidity problems in the event of a crisis. Shilowa Enterprises faces this position at the end of 20.9 as the ratio indicates there only R0,86 of liquid assets is available to settle every R1 of current liabilities. 3.2 Financial leverage An enterprise increases its financial leverage when it raises the proportion of debt relative to equity to finance the business. The successful use of debt enhances the earnings for the owners of the enterprises since returns on these funds, over and above the interest paid, belongs to the owners, and therefore increases the return on owners equity. However, from the point of view of the lender, when earnings are insufficient to cover the interest cost, fixed interest and principal commitments must MANCOSA BBA Year 3 116

still be met. The positive and negative effects of leverage increase with the proportion of debt in the enterprise. The most common measures of leverage compare the book value of an enterprise s liabilities to the book value of its assets or equity. 3.2.1 Debt to assets Debt to assets is used to reflect the proportion of debt to the total claims against the assets of the enterprise. The greater the ratio, the higher the risk. Debt to asset ratio is expressed as follows: Debt to assets = Total debt X 100 Total assets 1 The Debt to assets ratio of Shilowa Enterprises is as follows: 20.9 20.8 Debt to assets Debt to assets = Total debt X 100 = Total debt X 100 Total assets 1 Total assets 1 = R799 100 X 100 = R760 700 X 100 R1 452 200 1 R1 389 600 1 = 55,03% = 54,74% The ratio indicates that 55,03% of Shilowa Enterprises assets, in book value terms, come from creditors of one type or another. 3.2.2 Debt to equity This ratio attempts to show the relative proportions of all lenders claims to ownership claims, and is used as a measure of debt exposure. Debt to equity ratio is expressed as follows: MANCOSA BBA Year 3 117

Debt to equity = Total debt X 100 Owners equity 1 The Debt to equity ratio of Shilowa Enterprises is as follows: 20.9 20.8 Debt to equity Debt to equuity = Total debt X 100 = Total debt X 100 Owners equity 1 Owners equity 1 = R799 100 X 100 = R760 700 X 100 R653 100 1 R628 900 1 = 122,35% = 120,96% The ratio indicates that the creditors supply Shilowa Enterprises with 122,35 cents for every Rand supplied by the owners. 3.3 Debt service The above ratios still don t reveal a lot about the creditworthiness of the enterprise, which involves the ability of the enterprise to meet its interest and principal on schedule as contractually agreed upon. Our focus will be on interest coverage. 3.3.1 Interest coverage This ratio is based on the premise that annual operating earnings are the basic source for debt service, and that any major change in this relationship may signal difficulties. Debt holders often stipulate the number of times the business is expected to cover its debt service obligations. The ratio for interest coverage is as follows: Interest coverage = Operating profit Interest expense MANCOSA BBA Year 3 118

Shilowa Enterprises interest coverage ratio is as follows: 20.9 20.8 Interest coverage Interest coverage = Operating profit = Operating profit Interest expense Interest expense = R305 800 = R295 600 R11 100 R10 900 = 27,55 times = 27,12 times Shilowa Enterprises interest coverage of 27, 55 times means that the enterprise s profit covers its interest obligations 27, 55 times in 20.9; and 27, 12 times in 20.8. There is a slight increase, in its interest payment cover. MANCOSA BBA Year 3 119

4. SUMMARY OF THE RATIOS 4.1 Operational analysis 4.1.1 Gross margin = Gross profit X 100 Sales 1 4.1.2 Profit margin = Net profit after tax X 100 Sales 1 4.2 Resource management 4.2.1 Inventory turnover = Cost of sales Average inventory 4.2.2 Debtor collection period = Accounts receivable X 365 Credit sales 4.2.3 Creditor payment period = Accounts payable X 365 Credit purchases 4.3 Profitability 4.3.1 Return on assets = Operating profit X 100 Total assets 1 4.3.2 Return on own capital = Profit after tax X 100 Own capital 1 4.4 Liquidity 4.4.1 Current ratio = Current assets Current liabilities 4.4.2 Acid test ratio = Current assets Inventory Current liabilities 4.5 Financial leverage 4.5.1 Debt to assets = Total debt X 100 Total assets 1 4.5.2 Debt to equity = Total debt X 100 Owners equity 1 4.6 Debt service 4.6.1 Interest coverage = Operating profit Interest expense MANCOSA BBA Year 3 120

5. SELF-ASSESSMENT ACTIVITIES 5.1 Financial data for Zebcom Enterprises are as follows: 20.10 20.9 Sales (all credit) 3 201 150 1 937 300 Cost of sales (all credit) 2 618 010 1 599 370 Profit before tax 183 140 122 642 Tax (25%) 45 785 30 660 Net profit after tax 137 355 91 982 Balance sheet Current assets 2 866 530 4 974 530 Inventories 482 200 38 860 Accounts receivable 261 290 155 200 Marketable securities 326 950 2 306 440 Cash 1 796 090 2 474 030 Current liabilities 1 088 860 588 310 Accounts payable 190 660 192 040 Other current liabilities 898 200 396 270 Required 5.1.1 Calculate the gross margin and profit margin for 20.10 and 20.9. 5.1.2 Comment on your answers calculated in 5.1.1. 5.1.3 Calculate the current ratio and acid test ratio at the end of each year. How has the enterprise s liquidity changed over this period? 5.1.4 Compute the following for 20.10 (ratios for 20.9 are given in brackets): Inventory turnover (20.9: 20 times) Debtors collection period (20.9: 29,24 days) Creditors payment period (20.9: 43,83 days) 5.1.5 What is your interpretation of the enterprise s performance with respect to your answers in 5.1.4? MANCOSA BBA Year 3 121

5.2 Answer the questions below based on the following information. Tax is calculated at 35% of profit. Vuyo Sipho Traders Stores Operating profit R400 000 R420 000 Debt (at 10% interest) R200 000 R1 200 000 Owners equity R800 000 R300 000 Required 5.2.1 Calculate the return on assets for both enterprises. 5.2.2 Calculate the return on own capital for both enterprises. 5.2.3 Why is the return on own capital for Sipho Stores so much higher than Vuyo Traders? 5.2.4 Should Vuyo Traders be satisfied with its return on assets? Explain. 5.3 In 20.10, Mestle Wholesalers has R2 000 000 of assets and R800 000 of liabilities. Operating profit was R500 000, interest expense was R120 000 and the tax rate was 40%. Required 5.3.1 Calculate the following ratios: Debt to assets Debt to equity Interest coverage 5.3.2 Comment on your answers obtained in 5.3.1. 6. SOLUTIONS THINK POINT 1! Owners/Investors: are interested in the present and future returns on their investment. Employees: are interested in the ability of the enterprise to pay wages and the stability of their employment. Government: is interested in the reliability of tax payments. Society: is concerned with the ability of the enterprise to meet social and environmental obligations. MANCOSA BBA Year 3 122

THINK POINT 2! A low inventory turnover may mean that: Demand for merchandise available on sale is low. Items of inventory may be obsolete. There is too much inventory. A high inventory turnover may mean that: There is a potential for inventory shortages and the resultant poor customer service. Too little inventory is being carried in relation to the volume of sales. There is a lower dependency on capital to carry inventory. 5.1.1 20.10 20.9 Gross margin = Gross profit X 100 Gross margin = Gross profit X 100 Sales 1 Sales 1 = R583 140 X 100 = R337 930 X 100 R3 201 150 1 R1 937 300 1 = 18,22% = 17,44% 5.1.2 20.10 20.9 Profit margin Profit margin = Net profit after tax X 100 = Net profit after tax X 100 Sales 1 Sales 1 = R137 355 X 100 = R91 982 X 100 R3 201 150 1 R1 937 300 1 = 4,29% = 4,75% 5.1.2 Gross margin has increased marginally while profit margin showed a slight decrease. The cost of sales is high in relation to sales. It thus appears that Zebcom Enterprises is operating on very low profit margins. Operating expenses does appear to be high as there is a large difference between the gross margin and profit margin. MANCOSA BBA Year 3 123

5.1.3 20.10 20.9 Current ratio Current ratio = Current assets = Current assets Current liabilities Current liabilities = R2 866 530 = R4 974 530 R1 088 860 R588 310 = 2,63:1 = 8,46:1 20.10 20.9 Acid test ratio Acid test ratio = Current assets Inventory = Current assets Inventories Current liabilities Current liabilities = R2 866 530 R482 200 = R4 974 530 R38 860 R1 088 860 R588 310 = 2,19:1 = 8,39:1 The liquidity has deteriorated considerably from the previous year. However, one could say that high liquidity ratios for 20.9 may point towards slack management in respect of the idle cash. The ratios for 20.8 have dropped to more acceptable levels. 5.1.4 20.10 Inventory turnover = Cost of sales Average inventory = R2 618 010 R260 530 = 10,05 times N.B. Average inventory = (R482 200 + R38 860) 2 = R260 530 MANCOSA BBA Year 3 124

20.10 Debtor collection period = Accounts receivable X 365 Credit sales = R261 290 X 365 R3 201 150 = 29,79 days 20.10 Creditor payment period = Accounts payable X 365 Credit purchases = R190 660 X 365 R3 061 350 = 22,73 days Note: Credit purchases are calculated as follows: Cost of sales 2 618 010 Add: Closing inventory 482 200 3 100 210 Less opening inventory (38 860) Credit purchases 3 061 350 5.1.5 Inventory turnover has dropped sharply from 20 times to 10,05 times per annum suggesting that the enterprise may have lost control over inventory. Debtors collections seems to be good with the outstanding debt expected to be collected within 30 days. Creditors accounts are being settled earlier than the previous year and the enterprise should not settle accounts earlier than required unless a discount for early settlement is forthcoming. MANCOSA BBA Year 3 125

5.2.1 Vuyo Traders Sipho Stores Return on assets Return on assets = Operating profit X 100 = Operating profit X 100 Total assets 1 Total assets 1 = R400 000 X 100 = R420 000 X 100 R1 000 000 1 R1 500 000 1 = 40% = 28% N.B. Total assets = R200 000 + R800 000 = R1 000 000 (Vuyo Traders) Total assets = R1 200 000 + R300 000 = R1 500 000 (Sipho Stores) 5.2.2 Vuyo Traders Return on own capital = Profit after tax X 100 Own capital 1 = R247 000 X 100 R800 000 1 = 30,88% N.B. Profit before tax = R400 000 R20 000 (interest) = R380 000- R133 000 (tax) = R247 000 Sipho Stores Return on own capital = Profit after tax X 100 Own capital 1 = R195 000 X 100 R300 000 1 = 65% MANCOSA BBA Year 3 126

N.B. Profit before tax = R420 000 R120 000 (interest) = R300 000 R105 000 (tax) = R195 000 5.2.3 Sipho Stores higher return on own capital is due to its higher financial leverage. The enterprise is financed more by debt than own capital. 5.2.4 Yes. A 40% return is greater than the cost of borrowing funds (10%). It is also greater than the inflation rate and the return that one could get from alternative investments e.g. fixed deposits. 5.3.1 20.10 Debt to assets = Total debt X 100 Total assets 1 = R800 000 X 100 R2 000 000 1 = 40% 20.10 Debt to equity = Total debt X 100 Owners equity 1 = R800 000 X 100 R1 200 000 1 = 66,67% N.B. Owners equity = R2 000 000 R800 000 = R1 200 000 MANCOSA BBA Year 3 127

20.10 Interest coverage = Operating profit Interest expense = R500 000 R120 000 = 4,17 times 5.3.2 The debt to assets ratio indicates that 40% of Mestle Wholesalers assets come from borrowed funds. The debt to equity ratio indicates that the creditors supply Mestle Wholesalers with 66,67 cents for every Rand supplied by the owners. Mestle Wholesalers earned its interest obligations 4,17 times over in 20.10; or one could say that profit before interest and tax was 4,17 times as large as interest. MANCOSA BBA Year 3 128

TOPIC 7 BUDGETS LEARNING OUTCOMES Students should be able to: distinguish between the concepts budgets and budgetary control. explain the purposes of budgeting. discuss the advantages of budgets and budgetary control. prepare a sales budget, purchases or production budget, cost of sales budget, expenses budget, budgeted income statement, cash budget and budgeted balance sheet. CONTENTS 1. Introduction 2. Concepts of budgets and budgetary control 3. Purposes of budgeting 4. Advantages of budgets and budgetary control 5. Preparation of budgets 6. Self-assessment activities 7. Solutions MANCOSA BBA Year 3 129

READING Recommended reading Correia, C., Langfield-Smith, K., Thorne, H. and Wilton, R.W. (2008) Management Accounting: Information for managing and creating value. 1 st Edition. Berkshire: McGraw-Hill Education. pp. 416-432 Marshall, D.H., Mcmanus W.W. and Viele D.F. (2007) Accounting: What the numbers mean. 7 th Edition. New York: McGraw-Hill. Pp.533-546 Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1 st Edition. North Ryde: McDraw-Hill. pp.194-206 Niemand, A.A., Meyer, L., Botes, V.L. and van Vuuren, S.J. (2004) Fundamentals of Cost and Management Accounting. 5 th Edition. Durban: LexisNexis Butterworths. pp. 528-549 MANCOSA BBA Year 3 130

1. INTRODUCTION Planning is an integral element of management. It involves creating a path for achieving the enterprise s goals and objectives. Proper planning and effective control of costs are important if an enterprise wishes to maximize profit. Budgets and budgetary control are important management tools that assist management in planning and cost control. 2. CONCEPTS OF BUDGETS AND BUDGETARY CONTROL Niemand et al. (2004:528) make a distinction between the concepts of budgets and budgetary control. 2.1 Budgets A budget may be described as a plan expressed in financial terms. It is the path that must be followed from the present time to the future. A budget must reveal the plans to achieve the objective of the enterprise for a given period. 2.2 Budgetary control As indicated above a budget is the path that an enterprise must follow to achieve its objective. Budgetary control, on the other hand, includes measures put into place to monitor any deviations from the path and to ensure that the objective is realised within the budgeted period. This can be achieved by regularly comparing actual results with the budgeted targets. Budgetary control must ensure that deviations from the plan are analysed and if necessary remedial measures are put in place to remedy or prevent problems that may occur. 3. PURPOSES OF BUDGETING According to Correia (2008:416) the budgeting process can serve five primary purposes: Planning: The most important purpose of a budget is to put a plan of action into quantifiable terms. The budgeting process makes it mandatory for individuals within an enterprise to plan. Facilitating communication and co-ordination: There must be good communication and coordination between all managers for a business to plan operations effectively. MANCOSA BBA Year 3 131

The budgeting process provides a formal mechanism to enable this to occur. Allocating resources: Usually the resources of an enterprise are limited and budgets provide one way of allocating resources among competing uses. Controlling profit and operations: Budgets serve as benchmarks against which actual financial results at all levels of the enterprise may be compared to. Evaluating performance and providing incentives: The comparison of actual results with budgeted amounts also assists managers to evaluate the performance of individuals, departments, divisions, or the entire enterprise. As budgets are used to evaluate performance, they may also be used to provide incentives for individuals to perform well. 4. ADVANTAGES OF BUDGETS AND BUDGETARY CONTROL They act as means to achieving the objectives of the enterprise. Manufacturing costs can be carefully planned and controlled. Budgetary control facilitates the delegation of authority. Budgets can motivate managers and employees to better performance. Budgets can provide a basis for a system of control of employees. Budgets promote forward thinking and the identification of possible problems. THINK POINT 1! Whilst budgeting is an invaluable tool in financial planning, what do you think are some possible disadvantages of budgets? 5. PREPARATION OF BUDGETS The main budget called the master budget is developed from the operating budget and the financial budget. The operating budget consists of the sales budget, purchases or production budget, cost of sales or cost of production budget, operating expense budget, and budgeted income statement. The financial budget consists of the cash budget and budgeted balance sheet. Marshall et al. (2007:535) illustrate the hierarchy of budgets in Figure 7-1: MANCOSA BBA Year 3 132

Figure 7-1 Sales Budget Purchases or Production Budget Cost of Sales or Cost of Production Budget Operating Expense Budget Budgeted Income Statement Cash Budget Budgeted Balance Sheet Meredith and Williams (2005:201) outline the following steps in the budget process: Step 1: Establish guidelines Managers should establish overall guidelines on budget or expected profit performance, and these in turn become the basis for preparation of budgets. The objectives that an enterprise may achieve include the following: Efficiency: In budget terms this may be expressed as net profit to sales percentages, or productivity figures for personnel or equipment, or as a combination of these factors. Return on funds: Another measure of efficiency is an adequate return on funds invested by the owner(s). Financial reward: There should be an adequate financial reward for the owner(s), which may mean a satisfactory dividend level. Step 2: Prepare the sales budget The reliability of the sales budget is important as all other budgets are based on it. After the number of units that may be sold is estimated, the number of units that can MANCOSA BBA Year 3 133

be produced may be determined. The forecast sales unit and sales values form the basis of the sales budget. The following methods may be used in sales forecasting: Surveys of past and future customers may provide a basis for predicting whether there will be an increasing demand for products or services from the enterprise, a steady demand, or a falling demand. Market tests and market research may be undertaken using appropriate market research techniques. Statistical analyses may be used to predict demand. After using one or more of the above methods, the sales budget is drawn up. The following is an example of a sales budget: Table 1 Sales budget of Zenith Enterprises for 20.9 200 000 units of Product K @ R50 each = R10 000 000 Step 3: Prepare the production or purchases budget The production or purchases budget must be compatible with the sales budget. The inventory level held by the enterprise is an important consideration. Marshall et al. (2007:537) recommend the following model to determine the quantity of merchandise to be purchased or manufactured: Figure 7-2 Beginning inventory Add: Purchases (or Production) Goods available for sale Less: Ending inventory Quantity of goods sold units units units units units ` To use the model, first record the beginning and ending inventories (based on the enterprise s inventory management policies) and the quantity of goods sold from the sales budget. The goods available for sale is calculated by adding the quantity of goods sold to the ending inventory. The beginning inventory is then subtracted from the goods available for sale to obtain the purchase or production quantity. MANCOSA BBA Year 3 134

In the case of Zenith Enterprises (see Table 1), suppose that 10 000 units should be on hand at the end of the period and that 20 000 units will be on hand at the start of the period. The production or purchases budget will be 190 000 units, calculated as follows: Table 2 Beginning inventory Add: Purchases (or Production) Goods available for sale Less: Ending inventory Quantity of goods sold 20 000 units 190 000 units (210 000 20 000) 2nd 210 000 units (200 000 + 10 000) 1st (10 000) units 200 000 units Step 4: Prepare the cost of sales or cost of production budget Cost of sales budgets are drawn up by both merchandising and manufacturing entities. For a merchandising entity, the cost of goods available for sale is first calculated by adding the opening merchandise inventory to the budgeted purchases. Closing inventory requirements are then deducted from this amount to determine the budgeted cost of sales. In the case of Zenith Enterprises, the cost of sales budget is prepared as follows (assuming the cost price of Product K is R20): Table 3.1 Cost of sales budget R Beginning inventory 400 000 20 000 X R20 Add: Purchases 3 800 000 190 000 X R20 Goods available for sale 4 200 000 Less: Ending inventory (200 000) 10 000 X R20 Cost of goods sold 4 000 000 The process is identical for a manufacturing entity except that expected cost of goods manufactured replaces expected purchases (R3 800 000). Cost of goods MANCOSA BBA Year 3 135

manufactured is determined by the budgeted costs of each component of the production budget viz. raw materials budget, direct labour budget, and the manufacturing overhead budget. The following is an example of how the cost of goods manufactured is calculated: Table 3.2 Cost of goods manufactured budget Unit cost (R) Total cost (R) Raw materials 6 1 140 000 (190 000 X R6) Direct labour 4 760 000 (190 000 X R4) Manufacturing overheads 10 1 900 000 (190 000 X R10) Total 20 3 800 000 Step 5: Prepare the operating expense budget The operating expense budget includes selling, general, administrative and other operating expenses. Some of these expenses are variable e.g. commissions, delivery expenses while others are fixed e.g. rent expense, insurance. The following is an example of an operating expense budget: Table 4 Operating expense budget R Variable selling and administrative expenses Sales commissions 600 000 Delivery costs 300 000 Other variable expenses 200 000 Fixed selling and administrative expenses Rent expense 1 000 000 Salaries 2 000 000 Depreciation 200 000 Other fixed expenses 700 000 Total operating expenses 5 000 000 MANCOSA BBA Year 3 136

Step 6: Prepare the budgeted income statement The budgeted income statement is drawn up from the sales budget, cost of sales budget and operating expense budget. It is a summary of the various component projections of income and expenses for the budget period and indicates the expected profit (financial performance). The budgeted income statement of Zenith Enterprises is as follows: Table 5 Budgeted income statement R Sales (see Table 1) 10 000 000 Cost of sales (see Table 3.1) (4 000 000) Gross profit 6 000 000 Operating expenses (see Table 4) 5 000 000 Net profit 1 000 000 Step 7: Prepare the cash budget Once all the other budgets including the sales budget are prepared, the cash budget can be drawn up. The cash budget shows the expected receipts and expected payments for a certain period of time. It usually depicts the monthly cash position of the enterprise. The cash budget is prepared for the purpose of cash planning and control. It helps in avoiding to keep cash lying idle for long periods and identifying possible cash shortages. A schedule showing the amounts expected to be collected from debtors for credit sales is usually attached to the cash budget. Note that a cash budget only involves amounts that affect the cash balance of the enterprise. Therefore non-cash items such as depreciation, bad debts, discount allowed and discount received are not included. * * * Since budgets are used internally by an enterprise, the style may vary from business to business. However, most cash budgets have the following features: The budget period is broken down into sub-periods usually months. Receipts of cash are identified and totalled. Payments of cash are identified and totalled. MANCOSA BBA Year 3 137

* * The surplus (or shortfall) in cash for each month is calculated (receipts minus payments). The closing cash balance is calculated by taking into account the cash surplus (or shortfall) and the opening cash balance. The cash budget of Zenith Enterprises may be presented as follows: Table 6 Cash budget for 20.9 R Cash receipts 9 000 000 Cash sales Receipts from debtors 6 000 000 3 000 000 Cash Payments (8 800 000) Cash purchase of merchandise Payments to creditors Operating expenses (Table 4) Equipment purchased 2 000 000 1 500 000 5 000 000 300 000 Cash surplus 200 000 Opening cash balance 150 000 Closing cash balance 350 000 Note: Of the total expected sales of R10 000 000 (Table 1), R1 000 000 is still outstanding from debtors. Of the total expected purchases of R3 800 000 (Table 3.1), R300 000 is still owing to creditors. Zenith Enterprises expects to purchase equipment for R300 000. It also had R150 000 in the bank on 01 January 20.9. Step 8: Prepare the budgeted balance sheet A budgeted balance sheet is prepared by starting with the balance sheet for the period just ended and adjusting it using all the activities which are expected to take place during the budgeted period. A budgeted balance sheet can help management to calculate a variety of ratios. It also highlights future resources, obligations and possible unfavourable conditions. The budgeted balance sheet is affected by all the MANCOSA BBA Year 3 138

other budgets. Production and purchases budgets will indicate inventory estimates. Depreciation reflected in the operating expenses budget will affect the carrying value of non-current assets in the balance sheet. The expected net profit or loss reflected in the budgeted income statement will affect retained earnings. The cash budget is a source of many balance sheet amounts e.g. purchase of equipment, acquisition of loans etc. The budgeted balance sheet of Zenith Enterprises may be presented as follows Table 7 Budgeted balance sheet as at 31 December 20.9 ASSETS Non-current assets 3 800 000 Land and buildings Machinery and equipment Current assets Inventories (Table 3.1) Debtors (see note below Table 6) Bank (Table 6) R 3 000 000 800 000 1 550 000 200 000 1 000 000 350 000 Total assets 5 350 000 EQUITY AND LIABILITIES Equity Capital 5 050 000 Current liabilities 300 000 Creditors (see note below Table 6) 300 000 Total equity and liabilities 5 350 000 Illustrative example The following example illustrates how a cash budget, budgeted income statement and budgeted balance sheet is prepared from available information: MANCOSA BBA Year 3 139

The following information has been obtained from Aliwal Ltd: 1. Total sales figures (actual and budgeted) are: Actual Budgeted January February March April May June R R R R R R Total sales 320 000 260 000 400 000 420 000 380 000 360 000 2. The abridged balance sheet on 31 March 20.6 is as follows: Balance Sheet as at 31 March 20.6 ASSETS Non-current assets 200 000 Property, plant and equipment 200 000 Current assets Inventories Debtors Bank R 605 600 240 000 361 600 4 000 Total assets 805 600 EQUITY AND LIABILITIES Equity Capital 693 600 Current liabilities 112 000 Creditors 112 000 Total equity and liabilities 805 600 3. Rent amounts to R240 000 per annum and is payable monthly. 4. Selling and administration expenses are estimated to be 25% of sales and are payable in the same month as the sale. 5. The gross profit percentage on sales is 60%. MANCOSA BBA Year 3 140

6. Depreciation on fixed assets for the year amount to R28 000. 7. Cash sales account for 20% of total sales. Credit sales (80%) are usually collected as follows: 80% 1 month after the sale 20% 2 months after the sale. 8. Thirty percent (30%) of all purchases are for cash. The total purchases are as follows: March April May June R160 000 R168 000 R152 000 R144 000 9. Creditors are paid in full in the month after the purchase. 10. All other expenses are paid monthly and are expected to amount to R22 000 per month. Required Prepare a monthly cash budget for April, May and June 20.6. Prepare a budgeted income statement for the 3 months ended 30 June 20.6. Prepare a budgeted balance sheet on 30 June 20.6. MANCOSA BBA Year 3 141

Solution Cash budget for the period 01 April to 30 June 20.6 April May June Cash receipts 381 600 408 800 382 400 Cash sales Receipts from debtors 84 000 297 600 76 000 332 800 72 000 310 400 Cash payments (309 400) (300 200) (281 600) Cash purchases Payments to creditors Rent Selling and administrative costs Other expenses 50 400 112 000 20 000 105 000 22 000 45 600 117 600 20 000 95 000 22 000 43 200 106 400 20 000 90 000 22 000 Cash surplus (shortfall) 72 200 108 600 100 800 Opening cash balance 4 000 76 200 184 800 Closing cash balance 76 200 184 800 285 600 REMARKS Cash sales: are 20% of total sales. Receipts from debtors: are calculated as follows: Debtors collection schedule Month February (April R208 000 X 20%) March (April R320 000 X 80%) (May R320 000 X 20%) April (May R336 000 X 80%) (June R336 000 X 20%) May (June R304 000 X 80%) Credit sales R 208 000 320 000-336 000-304 000 April R May R June R 41 600 - - 256 000 - - - 64 000 - - 268 800 - - - 67 200 - - 243 200 297 600 332 800 310 400 MANCOSA BBA Year 3 142

Cash purchases and payments to creditors: The following calculations reflect the cash purchases and payments to creditors: Creditors payment schedule March April May June R R R R Total purchases 160 000 168 000 152 000 144 000 Cash purchases (30% of purchases) 48 000 50 400 45 600 43 200 Credit purchases (70% of purchases) 112 000 117 600 106 400 100 800 Payments to creditors (1 month after) 112 000 117 600 106 400 Rent: is paid monthly (R240 000 12 = R20 000) Selling and administrative expenses: are 25% of sales. Other expenses: are paid monthly. Opening cash balance: for April is obtained from the Balance sheet as at 31 March 20.6. Budgeted income statement for the 3 months ended 30 June 20.6 R Sales (R420 000 + R380 000 + R360 000) 1 160 000 Cost of sales (40% of sales) (464 000) Gross profit (60% of sales) 696 000 Expenses (423 000) Rent expense (R20 000 X 3) Selling and distribution (R1 160 000 X 25%) Depreciation (R28 000 4) Other expenses (R22 000 X 3) 60 000 290 000 7 000 66 000 Net profit 273 000 REMARKS Sales: reflects the total sales for April, May and June. Cost of sales: is 40% of sales since the gross profit percentage on sales is 60%. Rent expense: is R2 000 per month and includes rent for April, May and June. Selling and distribution: is 25% of the total sales (R1 160 000). Depreciation: is R28 000 per annum and this translates to R7 000 every 3 months. Other expenses: are R22 000 per month for 3 months. MANCOSA BBA Year 3 143

Budgeted Balance Sheet as at 30 June 20.6 ASSETS Fixed assets 193 000 Property, plant and equipment (200 000 7 000) 193 000 Current assets Inventories Debtors (60 800 + 288 000) Bank R 874 400 240 000 348 800 285 600 Total assets 1 067 400 EQUITY AND LIABILITIES Equity Capital (693 600 + 273 000) 966 600 Current liabilities 100 800 Creditors 100 800 Total equity and liabilities 1 067 400 REMARKS Plant, property and equipment: were subject to an annual depreciation of R28 000. For 3 months it would amount to R7 000 and this is the amount by which property, plant and equipment decreases. Inventories will remain the same as the previous month balance as all inventory sold is replaced during the month of sale. Debtors: The amount owing by debtors includes 20% of the credit sales for May (R60 800) and the entire credit sales for June (R288 000). Bank: The expected bank balance at the end of June is obtained from the cash budget. Capital: increases by the expected profit as calculated in the income statement. Creditors: The amount owing to creditors will be the credit purchases for June (R100 800). MANCOSA BBA Year 3 144

6. SELF-ASSESSMENT ACTIVITIES 6.1 The following is the sales forecast (in units) of Manco Ltd that manufactures two products viz. product X and product Y: November 20.6 December 20.6 January 20.7 Product X Product Y 3 000 4 000 4 500 6 000 4 000 5 000 The selling price per unit of product X is R20 and the selling price of product Y is R30. Required Prepare a sales budget for the period 1 December 20.6 to 31 January 20.7. 6.2 PC Solutions makes and sells computers. On 31 March 20.6, the entity had 60 computers in inventory. The company s policy is to maintain a computer inventory of 5% of the following month s sales. The sales forecast of the entity for second quarter of the year is: April 1 200 computers May 1 000 computers June 900 computers Required What is the projected production for May? 6.3 The following information is available for Timbuk Enterprises: 1. On 31 March 20.6 the bank account in the general ledger reflected a debit balance of R20 000. 2. Sales figures before taking any discounts in respect of cash or credit sales are: March R April R May R June R Cash sales Credit sales 30 000 21 000 34 000 18 000 32 000 16 000 35 000 20 000 3. The following discounts are given as incentives to customers: 12% on cash sales 5% on credit sales if accounts are settled 30 days after the sale MANCOSA BBA Year 3 145

4. Collections from debtors are expected to be as follows: 50% 30 days after the sale 30% 60 days after the sale 18% 90 days after the sale 2% written off after 90 days 5. The production records for finished goods reveal the following production costs: Actual Budgeted March R April R May R June R Direct material Direct labour Overheads 20 000 16 000 8 000 16 000 12 000 6 000 14 000 10 000 5 000 15 000 8 000 4 000 6. 50% of the material purchases are on credit. Creditors are usually paid as follows: 70% within the same month of the purchase 30% 30 days after the purchase. 7. Payment of overhead costs and selling and administrative costs are delayed by one month. Selling and administrative costs are as follows: March (actual) R6 500 April (expected) R7 000 May (expected) R7 200 June (expected) R8 000 8. Employees involved in the production of finished goods (direct labour) are paid wages. Since wages are paid on specific days, only 75% of a month s budgeted wages are paid in that month. The rest are paid in the following month. 9. The proprietor is expected to increase her capital contribution by R50 000 in June 20.6. Required Prepare the debtors collection schedule for the period 01 April to 30 June 20.6. Prepare a creditors payment schedule for the period 01 April to 30 June 20.6. Prepare the cash budget for the period 01 April to 30 June 20.6. MANCOSA BBA Year 3 146

6.4 The following is an abridged balance sheet of KMS Manufacturers on 31 December 20.6. KMS Manufacturers Balance Sheet as at 31 December 20.6 ASSETS Non-current assets 650 000 Land and buildings Machinery Current assets Inventories Debtors Bank R 500 000 150 000 300 000 200 000 90 000 10 000 Total assets 950 000 EQUITY AND LIABILITIES Equity Capital 900 000 Current liabilities 50 000 Creditors 50 000 Total equity and liabilities 950 000 Additional information 1. Costs for the year ended 31 December 20.6 are as follows: R Direct material 364 000 Direct labour 182 000 Variable overheads 91 000 Fixed overheads 208 000 2. The gross profit for the year ended 31 December 20.6 amounted to R65 000. MANCOSA BBA Year 3 147

3. Budgeted sales for 20.7 are as follows: R First quarter 200 000 Second quarter 220 000 Third quarter 240 000 Fourth quarter 250 000 4. Fixed costs for 20.7 will be the same as for 20.6. 5. Variable costs will vary in the same ratio to sales as for 20.6. 6. Fixed costs include depreciation on the machinery. Depreciation is 10% p.a. on cost. The cost price of the machinery is R200 000. 7. KMS Manufacturers plan to extend the factory during January 20.7. The cost of the extension is expected to be R200 000 and ten monthly instalments of R20 000 will commence on 01 February 20.7. 8. Inventory and debtors are expected to be equal to two (latest) months sales. 9. The amount owing to creditors is expected to equal two (latest) months purchases of direct materials. 10. Selling and administrative expenses are estimated to be 7% of the sales for each quarter. Required The budgeted income statement for each quarter of 20.7. The budgeted balance sheet on 31 December 20.7. MANCOSA BBA Year 3 148

7. SOLUTIONS THINK POINT 1! Disadvantages of budgets Predictions cannot be totally accurate as the information used to prepare budgets is obtained from estimates. If targets are badly set, they may stifle the enthusiasm and flair of managers and employees. Managers may spend to the limit of their budgets, although this may be wasteful. If budget targets are set at a more difficult level than can be achieved, comparing actual results with the budget becomes less meaningful. Budgets cannot be perfect since they have to adapt to changing circumstances. 6.1 Sales budget Product November December January Product X Product Y Units 3 000 4 000 R 60 000 120 000 Units 4 500 6 000 R 90 000 180 000 Units 4 000 5 000 R 80 000 150 000 180 000 270 000 230 000 6.2 Apr May Beginning inventory 60 50 Step 1 Add: Production *1 190 *995 Step 3 Goods available for sale 1 250 1 045 Step 2 Less: Ending inventory (50) (45) Step 1 Quantity of goods sold 1 200 1 000 Step 1 Projected production for August is 995 computers. OR MANCOSA BBA Year 3 149

6.2 Apr May Sales forecast (in units) Desired closing inventory of finished goods 1 200 50 1 000 45 Total budgeted production needs Opening inventory of finished goods 1250 (60) 1 045 (50) Required production 1 190 995 Projected production for August is 995 computers. 6.3 Debtors collection schedule Month March April May June Credit sales R 21 000 18 000 16 000 20 000 April R May R June R 9 975 6 300 3 780-8 550 5 400 - - 7 600 - - - 9 975 14 850 16 780 REMARKS Collections of credit sales for each month are calculated as follows: Credit sales for March Collection for April: (R21 000 X 50%) 5% = R9 975 Collection for May: R21 000 X 30% = R6 300 Collection for June: R21 000 X 18% = R3 780 Credit sales for April Collection for May: (R18 000 X 50%) 5% = R8 550 Collection for June: R18 000 X 30% = R5 400 Credit sales for May Collection for June: (R16 000 X 50%) 5% = R7 600 MANCOSA BBA Year 3 150

Creditors payment schedule Month March April May June Credit purchases R 10 000 8 000 7 000 7 500 April R May R June R 3 000 - - 5 600 2 400 - - 4 900 2 100 - - 5 250 8 600 7 300 7 350 REMARKS 50% of the purchase of materials is on credit. Payments to creditors each month are calculated as follows: Credit purchases for March Payment for April: R10 000 X 30% = R3 000 Credit purchases for April Payment for April R8 000 X 70% = R5 600 Payment for May: R8 000 X 30% = R2 400 Credit purchases for May Payment for May: R7 000 X 70% = R4 900 Payment for June R7 000 X 30% = R2 100 Credit purchases for June Payment for June: R7 500 X 70% = R5 250 MANCOSA BBA Year 3 151

Timbuk Enterprises Cash budget for the period 01 April to 30 June 20.6 April (R) May (R) June (R) Cash receipts 39 895 43 010 97 580 Cash sales (after discount) Receipts from debtors Capital 29 920 9 975-28 160 14 850-30 800 16 780 50 000 Cash payments (44 100) (37 800) (35 550) Cash purchases of materials Payments to creditors Wages Overheads Selling and administrative costs 8 000 8 600 13 000 8 000 6 500 7 000 7 300 10 500 6 000 7 000 7 500 7 350 8 500 5 000 7 200 Cash surplus (shortfall) (4 205) 5 210 62 030 Opening cash balance 20 000 15 795 21 005 Closing cash balance 15 795 21 005 83 035 REMARKS Cash sales: 12% cash discount has been deducted from the figures provided. Receipts from debtors: are obtained from the Debtors collection schedule. Capital: is expected to be received only in June. Cash purchases of materials: are 50% of the total purchases. Payments to creditors: are obtained from the creditors payment schedule. Wages: are calculated as follows: April: (March R16 000 X 25%) = R4 000 (April R12 000 X 75%) = R9 000 R13 000 May: (April R12 000 X 25%) = R3 000 (May R10 000 X 75%) = R7 500 R10 500 June: (May R10 000 X 25%) = R2 500 (June R8 000 X 75%) = R6 000 R8 500 Overheads: are paid in the month following the month in which they were incurred. Selling and administrative expenses: are paid in the month following the month in MANCOSA BBA Year 3 152

which they were incurred. Cash surplus: is expected for all May and June only as expected receipts exceed expected payments, whereas in April, payments exceed receipts (resulting in an expected cash shortfall). Opening cash balance: for April is the closing cash balance for March, the opening cash balance for May is the closing cash balance for April and the opening cash balance for June is the closing cash balance for May. Closing cash balance: is calculated using the cash surplus (shortfall) and the opening cash balance. 6.4 KMS Manufacturers Budgeted income statement 1 st Quarter R 2 nd quarter R 3 rd quarter R 4 th quarter R Total R Sales 200 000 220 000 240 000 250 000 910 000 Cost of sales (192 000) (206 000) (220 000) (227 000) (845 000) Direct material Direct labour Variable overheads Fixed overheads 80 000 40 000 20 000 52 000 88 000 44 000 22 000 52 000 96 000 48 000 24 000 52 000 100 000 50 000 25 000 52 000 364 000 182 000 91 000 208 000 Gross profit 8 000 14 000 20 000 23 000 65 000 Other expenses (14 000) (15 400) (16 800) (17 500) (63 700) Selling & admin 14 000 15 400 16 800 17 500 63 700 Net profit (loss) (6 000) (1 400) 3 200 5 500 1 300 MANCOSA BBA Year 3 153

REMARKS Since variable costs vary in the same ratio to sales as for 20.6, the sales figure for 20.6 and the percentage of direct materials, direct labour and variable overheads to sales are calculated: R % of sales Direct material 364 000 40 Direct labour 182 000 20 Variable overheads 91 000 10 Fixed overheads 208 000 Cost of sales 845 000 Gross profit 65 000 Sales 910 000 100 Sales forecast for each quarter is provided in the information. Cost of sales is the manufacturing cost of sales. Cost of sales = Direct material + Direct labour + Variable overheads + Fixed overheads Direct material = 40% of sales Direct labour = 20% of sales Variable overheads = 10% of sales Fixed overheads are the same as 20.6. Gross profit = Sales Cost of sales Selling and administration costs = 7% of sales. Net profit (loss) = Gross profit Other expenses A net loss is expected for the first two quarters while for the last two quarters a profit is predicted culminating in a net profit for the year of R1 300. MANCOSA BBA Year 3 154

KMS Manufacturers Budgeted balance sheet as at 31 December 20.7 ASSETS Non-current assets 830 000 Land and buildings (500 000 + 200 000) Machinery ([150 000] [200 000 X 10%]) Current assets Inventories (250 000 X 2 3) Debtors (250 000 X 2 3) Bank R 700 000 130 000 333 334 166 667 166 667 0 Total assets 1 163 334 EQUITY AND LIABILITIES Equity Capital (900 000 + 1 300) 901 300 Current liabilities 262 034 Creditors (100 000 X 2 3) Bank overdraft (balancing figure i.e. Total assets Capital Creditors) 66 667 195 367 Total equity and liabilities 1 163 334 MANCOSA BBA Year 3 155

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