CAT T10/ FIA - FFM - Finance PassCard

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CAT Advanced Paper 10 Managing Finances
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First edition February 2005 Fourth edition January 2009 ISBN 9780 7517 5794 1 (Previous edition ISBN 9780 7517 4790 4) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd, BPP House, Aldine Place, London W12 8AA www.bpp.com/learningmedia Printed in Great Britain All our rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media. BPP Learning Media 2009
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Preface
Contents
Welcome to BPP Learning Medias new CAT Passcards They save you time. Important topics are summarised for you. They incorporate diagrams to kick start your memory. They follow the overall structure of the BPP Learning Media Interactive Texts, but BPP Learning Medias new CAT Passcards are not just a condensed book. Each card has been separately designed for clear presentation. Topics are self contained and can be grasped visually. CAT Passcards are just the right size for pockets, briefcases and bags. CAT Passcards focus on the exam you will be facing. Run through the complete set of Passcards as often as you can during your final revision period. The day before the exam, try to go through the Passcards again! You will then be well on your way to completing your exam successfully. Good luck!
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Preface
Contents
Page 1 2 3 4 5 6 7 8 9 10 11 Cash and cash flows Forecasting cash flows Cash forecasting techniques Cash and treasury management Investing surplus funds Working capital management Managing payables and inventory Managing receivables Assessing creditworthiness Monitoring and collecting debts The banking system and financial markets 1 9 21 25 29 39 43 51 61 69 83 12 13 14 15 16 17 18 19 Economic influences Short and medium-term finance Long-term finance Financing of small and medium-sized enterprises Decision making CVP analysis Capital expenditure budgeting Methods of project appraisal
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1: Cash and cash flows
Topic List
Cash flow cycle Cash transactions Cash flows and profits Accruals accounting
This chapter provides a reminder of the main types of receipts and payments you will encounter, and the differences between profits and cash flows. Calculation of the cash flow cycle is a particularly important technique.
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Cash flow cycle
Cash transactions
Cash flows and profits
Accruals accounting
Need for cash flows

A business has to ensure it has sufficient cash to meet its obligations, as well as making profits.
Operating/cash cycle
Cycle describes the connection between working capital and cash movements.
Problem
Although sales are made (and accrued) money may not be received until after the date suppliers need to be paid. Bank overdraft facilities may be limited.
Calculation of operating cycle

Days Raw material inventory turnover period Credit taken from suppliers Finished goods inventory turnover period Receivables payment period Operating cycle X (X) X X __ X __ __
Working capital
Current assets Current liabilities
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Cash flow cycle
Cash transactions
Accruals accounting
Cash inflows Sales of Sales of goods assets Cash outflows Purchases of inventories, wages
Grants
Share capital
Loans
Sales of investments
CASH
Purchases of assets Tax Dividends Interest Purchases of investments, foreign currency
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Capital and revenue items

Capital items relate to the long-term functioning of the business, eg purchasing non-current assets. Revenue items relate to day-to-day operations, eg purchasing goods for resale.
Exceptional and unexceptional items

Exceptional items are unusual, one-off items eg closure of a business. Unexceptional items are normal business receipts and payments.
Net cash flow

The change in cash position from period beginning to period-end. Analysis is needed of component elements of net cash flow
Example
Cash flow from sales Cash flow from purchases Cash paid from wages Interest payments Tax payments Cash paid for assets Bank loan Share issue Net cash flow $ X (X) (X) (X) (X) (X) X X __ X __ __
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Cash flow cycle
Cash transactions
Accruals accounting
Differences between profits and cash flow

Items affecting profits but not cash flows
Depreciation Increases in provisions
Cash flows Profit Issue of shares/loan notes Increase in bank overdrafts/loans
Items affecting cash flows but not profits

Issued shares/loan notes Increase in bank overdrafts/loans
Purchase of assets Depreciation Profit/loss on sale of non-current assets Cash received revenue Cash paid cost of sales Expense accruals and prepayments
Items where profit/loss is different to cash flow

Purchase of assets Increase in provisions Expense accruals and prepayments
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How to calculate: Cash receipts from customers

Customers owing money at the start of the year Add: Sales during the year Total money due from customers Less: Customers owing money at end of year Cash receipts from customers during the year
$ X X __ X (X) __ X __ __
Cash payments to suppliers

Payments owed to suppliers at start of year Add: Purchases during the year * Total money due to suppliers Less: Payments owing to suppliers at end of year Cash payments to suppliers during the year
* Calculated as: Cost of sales Add: Closing inventory Less: Opening inventory Purchases during the year Page 7
X X __ X (X) __ X __ __
X X __ X (X) __ X __ __ 1: Cash and cash flows
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Cash flow cycle
Cash transactions
Accruals accounting
ACCOUNTS ARE NOT PREPARED ON A CASH BASIS, BUT ON AN ACCRUALS (OR EARNINGS) BASIS eg a sale or purchase is dealt with in the year in which it is made, even if cash changes hands in a later year. The accruals basis of accounting is described the IASB's Framework for the Preparation and Presentation of Financial Statements. 'Financial Statements are prepared on the accrual basis of accounting. Under this basis the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate.' The accruals basis of accounting is a way of letting investors know how much profit a business has made by matching income and expenditure.
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2: Forecasting cash flows
Topic List
Cash forecasts Mark up and margin Statement of financial position forecasts Control reports Correcting cash deficits
This chapter is one of the most significant.You need to know how to go about preparing a cash flow forecast, and comparing actual cash flow with budgeted forecasts. This chapter sets out an appropriate format for preparing a cash budget and identifying cash needs. It also summarises the action an organisation can take if it runs short of cash.
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Cash forecasts
Mark up and margin
Statement of financial position forecasts
Control reports
Correcting cash deficits
Forecasts
Amount of cash required When required How long required for Whether available from anticipated sources
Cash flow-based forecasts

In receipts and payments format Monthly/quarterly cash budgets Actual flows against original budget Revised budget/rolling budget Actual flows against revised budget Cleared funds forecast showing funds available for spending
Banks
Banks often insist businesses provide: Cash forecasts Business plans Banks can monitor progress/control lending using these.
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A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals. Overdraft Enables management to make forward planning decisions Investments Credit control
1 2
Sort out cash receipts from customers Establish whether any other cash income will be received Sort out cash payments to suppliers
Establish materials inventory changes quantity and cost of materials purchases Establish when suppliers will be paid
Bottom of budget must show
Net cash flow Opening position Closing position
Establish when any other cash payments will be made
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Cash forecasts
Mark up and margin
Control reports
In more complex cash forecasts, the assumptions made are critical. Credit terms given by suppliers Specific supply arrangements Past practice Predictable dates Volume of purchases Volume of sales Cash/credit sales mixture Specific credit terms Receipt patterns Discounts allowed
Payments
Receipts
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PROFORMA CASH BUDGET

Month 1 $ Cash receipts Receipts from customers Loans etc Cash payments Payments to suppliers Wages etc
X X __ X __ __ X X __ X __ __ X X __ X __ __
Month 2 $
X X __ X __ __ X X __ X __ __ X X __ X __ __
Month 3 $
X X __ X __ __ X X __ X __ __ X X __ X __ __
Net cash flow (receipts payments) Opening balance Closing balance
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Cash forecasts
Mark up and margin
Control reports
Mark up Margin Example
Profit element as fraction of cost
Sales Mark up Costs Sales Margin Costs
% 100 + x x 100 % 100 y 100 y
Profit element as fraction of selling price
Example
What is the unit sales price if unit cost price is $25 and margin is 20%? Sales price =
25 (1 0.2)
Cost price 80 Profit 20 Selling Price 100 Mark up = Margin = 20 80 = 25% 20 100 = 20%
= $31.25
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Cash forecasts
Mark up and margin
Control reports

A statement of financial position forecast is used to identify the cash surplus or funding shortfall in a companys statement of financial position at the forecast date. They are longer term strategic estimates, and act as a check on cash forecasts.
Share capital > + Reserves
Net assets (excl cash)
Cash surplus
Net > assets (excl cash)
Share capital + Reserves
Cash deficit
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Cash forecasts
Mark up and margin
Control reports
Estimating a future statement of financial position

Intangible non-current assets: Current value Tangible non-current assets: Need to estimate purchases and disposals Current assets: Same / by % % of revenue Trade payables/accruals: As current assets Bank overdraft: Assume none Taxation/dividends: % of profits LT loans: Existing Repayments Share capital: Same Retained profits: Estimate future profits
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Cash forecasts
Mark up and margin
Control reports
Current forecast v original forecast CONTROL REPORTS Actual cash flows v budget
Signs of bad reports Why do budgets and actual flows differ? Same amounts forecast for receipts and payments each month No changes to receipts and payments as new rolling forecast prepared Forecast end of period cash balances remain constant as forecasts updated
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Poor forecasting Loss of major customer Insolvency of credit customer Changes in interest rates Inflation
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Cash forecasts
Mark up and margin
Control reports
Budget $ Cash receipts Revenue Cash payments Material Labour Overheads Non-current assets
X __ X __ __ X X X X __ X __ __ X X __ X __ __
Month Actual $
X __ X __ __ X X X X __ X __ __ X X __ X __ __
Difference $
X __ X __ __ X X X X __ X __ __ X __ X __ __
Budget $
X __ X __ __ X X X X __ X __ __ X X __ X __ __
Year to date Actual Difference $ $

X __ X __ __ X X X X __ X __ __ X X __ X __ __ X __ X __ __ X X X X __ X __ __ X __ X __ __
Net cash flow Opening balance Closing balance
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Cash forecasts
Mark up and margin
Control reports
Losses Asset replacement Growth support Seasonal business One-off expenditure Short-term remedies Short-term borrowing Sale of short-term investments Reduce costs Reduce inventory levels Reduce receivables Increase payables
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Cash flow problems

Longer-term solutions Postpone capital expenditure Sell non-essential assets Reschedule loan repayments Change terms of business Reduce dividend payments Increase selling and marketing activity
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Notes
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3: Cash forecasting techniques
Topic List
Index numbers Sensitivity analysis
The cash flows of the organisation you are asked about in the exam may be stable, volatile or subject to inflation. This chapter summarises the techniques for incorporating such uncertainties into forecasts.
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Index numbers
Sensitivity analysis
Index
A measure over time of the average changes in values of a group of items. Indexes can be used to predict inflows and outflows and hence future borrowings. Index numbers are expressed as percentages, taking the base date value as 100.
Weightings
An index normally consists of more than one item, therefore weightings are needed to reflect the relative importance of each item. 1 Calculate price relative (price of item as % of price in previous period). 2 Calculate weightings. 3 Multiply price relative by weighting. 4 Calculate index numbers by dividing total of 3 for all items by total for previous period.
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Price index
A price index measures the change in the money value of a group of items over time. Base period is usually the starting point of a series.
Quantity index
A quantity index measures the change in the non-monetary values of a group of items over time.
Price index = 100
P1 P0
Price in base period Quantity in base period
Quantity index = 100
Q1 Q0
Base period index = 100 Also known as base year
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3: Cash forecasting techniques
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Index numbers
Sensitivity analysis is a modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome.
Significant variables
Changes in capacity Material/labour costs Labour availability Sales volume Productivity
Other methods of uncertainty analysis

Preparing a series of different forecasts, each assuming a different outcome Preparing cash forecasts as range of possible outcomes Using probability analysis by assigning probabilities to a range of values for key uncertain cash flow items
Seasonally adjusted data

Additive model: Y = T + S + I Multiplicative model: Y = T x S x I Where: T = Trend series S = Seasonal component I = Irregular random component
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4: Cash and treasury management
Topic List
The focus of cash management Inventory approach Treasury management
Dealing with cash flow problems is vital for businesses, and the topic is likely to be examined regularly.
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The focus of cash management
Inventory approach
Treasury management
Focus of cash management

Profitability
Float
Time between payment being initiated and funds becoming available for use. Transmission delay + lodgement delay + clearance delay
Liquidity
Safety
Reducing float Minimum lodgement delay (bank receipts when received) Collecting cheque from customer Use of bank giro system BACS/CHAPS Standing order/direct debits
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Inventory approach
Treasury management
Inventory approach
Baumol's model seeks to minimise cash holding costs by calculating optimal amount of new funds to raise.
2FS i
Problems with inventory approach Amounts required in future are difficult to predict Costs associated with running out of cash
Q=
where S is the amount of cash used in period F is the fixed cost of obtaining new funds i is the interest cost of holding cash
Holding costs may vary with amount held Model doesnt work very well for large, irregular flows Difficulty in predicting future interest rates
Q is the total amount to be raised to provide for S

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Inventory approach
Treasury management
Treasury management
Treasury departments are set up to manage cash funds and currency efficiently, and make the best use of corporate finance markets. The main advantages of centralised treasury management are avoiding a mix of surpluses and overdrafts, and being able to obtain favourable rates on bulk borrowing/investments. Centralised treasury management Improve exchange risk management Employ experts Smaller precautionary balances Focus on profit centre
Role of treasurer Corporate financial objectives Liquidity management Funding management Currency management Corporate finance Others, eg taxation
Decentralised treasury management Finance matches local assets Greater autonomy for subsidiaries More responsive to operating units No opportunities for large sum speculation
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5: Investing surplus funds
Topic List
Cash surpluses Cash investments Marketable securities Government and local authority stocks Other investments Risk and return
This chapter summarises the financial instruments that are available if an organisation has surplus funds that need to be invested. It also sets out principles and guidelines that need to be followed when investment decisions are made.
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Cash surpluses
Cash investments
Marketable securities
Government and local authority stocks
Other investments
Risk and return
Liquidity
Safety
Profitability
Cash management
Cash for normal business commitments Buffer for unforeseen contingencies Balances held in hope interest rates Cash for growth, noncurrent asset purchases, acquisitions Transactions motive Cash Precautionary motive One-off dividends Speculative motive Surplus Strategic motive Buying back own shares Shareholders Increasing annual dividends
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Cash surpluses
Cash investments
Other investments
Risk and return
Interest bearing accounts

Banks and building societies provide various interest bearing accounts, including current accounts, cheque accounts and deposit accounts.
Option deposits
Option deposits are for predetermined periods of time (2 to 7 years) with minimum deposits of say $2,500. Interest rates are higher as arrangements are longer-term and there is no facility for withdrawal. Guidelines for investment
Compound annual interest

CAR =
X n 1 + 1 n
100 Certain investments allowed/prohibited All investments convertible into cash Certain proportion invested in lower risk items Credit rating obtained for certain investments
Where X is the annual rate specified (eg 0.0525 = 5.25%) n is number of times in year interest is paid (eg 4 = quarterly/12 = monthly)
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Cash surpluses
Cash investments
Other investments
Risk and return
Attractiveness of interest Risk of non-payment Length of time to redemption/maturity Accrued interest Cum div (int) or Ex div (int) Interest yield =
Coupon rate Market price
Price of fixed interest stocks
Gross redemption yield

Redemption yield is a more realistic measure of overall return than interest yield, as it takes into account both the interest payable and the gain or loss due to the difference between the purchase price and the redemption value. Investors will be looking for different levels of income and capital appreciation.
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Cash surpluses
Cash investments
Other investments
Risk and return
Gilts
Gilts are marketable British government securities, which dominate the fixed interest market.
Shorts Mediums Longs Undated Index linked
< 5 years 5 15 years > 15 years Irredeemable/one-way options Interest and redemption value linked to rate of inflation. Interest is adjusted by RPI value 8 months before payment date.
Convertible gilts
Convertible gilts are gilts redeemable on date shown or convertible into longer-dated stock.
Local authority stocks

Local authority stocks are similar to government securities, but security isnt considered as good and the market is less active. They are held by a few institutions.
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Cash surpluses
Cash investments
Other investments
Risk and return
Certificates of deposit
Certificates of deposit are negotiable instruments providing evidence of a fixed term deposit with a bank.
Commercial paper
Commerical paper is an unsecured short-term (3 months) loan note issued by companies. They are traded at a discount and unsecured, therefore they are risky.
Certificates of deposit Terms 7 days to 5 years, most often 6 months Minimum amount 50,000 Can be sold on certificates of deposit market Attractive rate of interest Liquidation at any time at prevailing market rate
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Bills of exchange
Bill is drawn on company/person being ordered to pay. Drawer orders payment of money. Drawee is the party who is to pay. Payee receives funds: Unconditional orders to pay Negotiable instruments
Discounting bills Holder of the bill Presents bill on maturity, or Sells bill before maturity at discount depending on credit quality of drawee and market condition for bills Basis of trading Interest rate basis Discount basis Principal sum lent, borrower repays principal plus interest at maturity Specified sum payable at maturity
Types of bill
Trade bills Drawn by one non-bank on another; to be tradeable both must have high credit ratings Drawn and payable by banks
Bank bills
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Cash surpluses
Cash investments
Other investments
Risk and return
Political and economic climate
Inflation
Products
Competition
Management
Risk
Income Capital
Government securities RISK Company loans notes Preference shares Ordinary shares
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Types of risk
Systematic risk caused by factors affecting the whole market Unsystematic risk security/sectorspecific risks
Risk and return
Diversification
The reduction of risk by investing in a range of securities.
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Notes
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6: Working capital management
Topic List
Working capital Working capital ratios Overtrading
In the exam you may be asked not just to calculate working capital levels/ratios but to also explain their significance. The symptoms of over-capitalisation and overtrading are also important.You may be asked how to improve the management of working capital.
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Working capital
Working capital ratios
Overtrading
Working capital = current assets current liabilities
Working capital management

Minimise risk of insolvency Maximise return on assets
Working capital cycle

Average time raw materials are in inventory Less: Period of credit taken from suppliers Plus: Time taken to produce goods Plus: Time finished goods are in inventory after production is completed Plus: Time taken by customers to pay for goods Working capital cycle is the length of time between cash being spent at start of production and cash being received from the customer
Retailers often receive cash, pay for supplies by credit Wholesalers mainly buy and sell on credit, need short-term borrowings Small companies may have trouble obtaining credit, but may have to offer generous credit terms
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Working capital
Overtrading
Current ratio =
Current assets Current liabilitie s

Trade receivables Credit sales
365 days
Acid test/quick ratio =
Current assets less inventories Current liabilities
Accounts receivable days =
Inventory turnover period =
Average inventory Cost of sales
Accounts payable Average payables payment period = 365 days Purchases on credit
365 days
Inventory turnover =
Average inventory Cost of sales
Over-capitalisation is where there are excessive inventory, receivables and cash and very few payables. The funds tied up could be invested profitably.
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6: Working capital management
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Working capital
Overtrading
Overtrading occurs when a business is trying to support too large a volume of trade with the capital resources at its disposal.
Symptoms revenue current assets non-current assets Assets financed by trade payables/bank overdraft Little/no in proprietors capital current/quick ratios
Solutions Finance from share issues Better inventory and receivables control Postpone expansion plans Maintain/increase proportion of long-term finance
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7: Managing payables and inventory
Topic List
Trade payables Methods of payment Inventory costs JIT and purchasing mix
Inventory costs are a key topic in this chapter; the EOQ formula is particularly critical. You may be asked to explain the assumptions behind the formula, or asked about other inventory management techniques.
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Trade payables
Methods of payment
Inventory costs
JIT and purchasing mix
Management of trade payables Cost of lost cash discounts

100 100 - d
365 t
Obtaining satisfactory credit levels/terms Extending credit if cash short Good relations/loss of goodwill if payment delayed
Example
X Co owes its supplier $1,000, it can either pay $1,000 in 45 days time or $980 in ten days time. It can invest funds at 25% interest. Cost cash discount: $980
Consider also interest gained through having monies for full period.
35 25% = 23.5 365
where d is % discount t is reduction in payment period in days necessary to obtain early discount
Cost: Accept discount $980 Refuse discount ($1,000 $23.5) = $976.5 It is cheaper to refuse the discount, invest the money and pay after 45 days.
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Trade payables
Methods of payment
Inventory costs
Cash
Small payments/wages
Cheques
Commonly used and widely accepted Convenient Counterfoil/cheque number can be traced Keep secure Slow method of payment
Standing orders
Regular payments of fixed amounts HP payments Rental payments Insurance premiums
Keep secure Easily lost Lack of payment evidence
BACS
Payment information sent to BACS for processing. Most commonly used for salaries, can be used for suppliers.
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Telegraphic transfers
Large payments made immediately.
Direct debits
Deductions from bank account, regular and irregular payments of fixed and varying amounts. Recipient sets the amount.
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Trade payables
Methods of payment
Inventory costs
Economic order quantity (EOQ)

EOQ is the optimal ordering quantity for an item of inventory which will minimise costs.
Safety inventory
Safety inventory is held when demand is uncertain or supply lead time is variable. Average annual = safety inventory cost Safety quantity Annual unit holding costs
EOQ =
2C O D CH
Exam formula
Bulk discounts
Total cost will be minimised: At pre-discount EOQ level, so that discount not worthwhile or At minimum order size necessary to earn discount Calculate: Purchasing costs + Holding costs + Ordering costs
D = Usage in units CO = Cost of placing one order CH = Holding cost EOQ= Economic order quantity
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Trade payables
Methods of payment
Inventory costs
Inventory costs
Holding costs Cost of capital Reorder level Warehouse/handling costs = Maximum usage Maximum lead time Deterioration/obsolescence Insurance Maximum inventory level Pilferage = Reorder level + Reorder quantity (Minimum usage Minimum lead time) Ordering costs Delivery costs Minimum inventory level = Reorder level (Ave usage Ave lead time) Contribution from lost sales Emergency inventory Stock-out costs Average inventory = Minimum level (Reorder level 2)
Procuring costs
Shortage costs
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Trade payables
Methods of payment
Inventory costs
Just-in-time (JIT) procurement

JIT describes a policy of obtaining goods from suppliers at the latest possible time. It avoids the need to carry materials/component inventory.
Benefits of JIT Inventory costs Manufacturing lead times Labour productivity Labour/scrap/warranty costs Material purchase costs (discounts) Number of transactions
Purchasing mix
Quantity Quality Price Delivery
Balance between holding, and ordering stock-out costs Good enough for production/customers Best value over time Lead time and reliability
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Notes
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8: Managing receivables
Topic List
Credit control Total credit The credit cycle Payment terms Settlement discounts Legal aspects
You need to be familiar with all aspects of credit control, in particular the key decisions an organisation has to make. Should it offer credit? If so how much? Who to? Should it offer early settlement discounts?
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Credit control
Total credit
The credit cycle
Payment terms
Settlement discounts
Legal aspects
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May report to
Chief Accountant
Sales Manager
Managing Director
Finance Director
CREDIT CONTROL DEPARTMENT Duties

Updating receivables ledger Customer queries Liaison with sales staff Third party references Checking creditworthiness Advising on payment terms
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Credit control
Total credit
The credit cycle
Payment terms
Legal aspects
Trade credit
Credits issued by one business to another business eg stating payment is expected within 30 days.
Monitoring total credit

Investment in receivables can be measured using:
Receivables Receivables payment period = Sales (in 365 days)
Consumer credit
Credit offered by businesses to endconsumers. Hire purchase, loan to purchase goods Credit cards
Credit utilisation report

Report shows extent to which total limits being utilised, indicating number of customers who might want more credit, and extent of exposure to receivables.
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Profit
Cash flow
Asset use
Interest cost
Total credit levels

Setting total credit limits means balancing need to entice customers by favourable terms (but losing interest) and refusing opportunities for sales. Should credit be extended? Extra sales Profitability of extra sales Effect on inventory/payables Length of extra debt collection period Required rate of return on investment in additional receivables
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Credit control
Total credit
The credit cycle
Payment terms
Legal aspects
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Credit control
Total credit
The credit cycle
Payment terms
Legal aspects
Terms and conditions of sale Profit required from customer Competitors credit terms Special factors relating to customer Risk of default Seasonal factors Nature of goods Price Delivery Date of payment Frequency of payment Discounts
Methods of payment
Cash BACS Cheques Bankers draft Travellers cheque
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Payment terms
Standing order Direct debit Credit/debit card Bills of exchange Specified number of days after delivery Weekly/half monthly/monthly credit CWO Cash with order CIA Cash in advance COD Cash on delivery CND Cash on next delivery
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Credit control
Total credit
The credit cycle
Payment terms
Legal aspects
Advantages of early settlement discounts

Encourage customers to pay earlier and thus reduce financing costs Improve liquidity Encourage customers to buy
Cost of early settlement discount

100 100 D
365 T
1 %
where D = Discount offered T = Reduction in payment period necessary to obtain discount
Example
Henry Co is considering a 2% discount to all customers paying within 30 days.
100 30 1 % = 27.86% Cost of early settlement discount = 100 2
365
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Credit control
Total credit
The credit cycle
Payment terms
Legal aspects
Contract
An agreement which legally binds parties. Validity of a contract affected by: Content complete and precise Form certain contracts in precise form Genuine consent Legality Capacity some parties have restricted capacity
Essential elements of a contract

Legal relations (intention) Offer and acceptance Consideration (the price paid in exchange for a promise)
Breach of contract
When one of the parties fails to perform. Remedies: Damage Termination Quantum meruit (value for work done)
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Specific performance Action for the price (recovery of agreed sum)
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Credit control
Total credit
The credit cycle
Payment terms
Legal aspects
Sale of goods
Sale of Goods Acts govern sale of goods. Key conditions: Title passes on delivery even if payment delayed Title passes on sale or return goods when buyer accepts If conditions imposed, must be fulfilled
Failure to pay Goods can be stopped in transit Lien by seller if goods not passed (retain on sellers premises if not delivered) Length of credit stated in contract (failure to pay = breach of contract) Charge interest on late payments Retention of title clauses (ownership does not pass until payment is received)
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9: Assessing creditworthiness
Topic List
Credit assessment References Financial analysis Visits Other information Using information Data protection
This chapter takes you through the assessment of the reliability of potential credit customers. It summarises the sources of information you can use when making the assessment.You should be able to demonstrate that you can use evidence about potential customers to make sensible recommendations that are in line with organisational policies.
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Credit risk means that there is a possibility that the debt will go bad. A credit assessment is a judgement about the creditworthiness of a customer, providing a basis for a decision as to whether credit should be granted.
HIGH Unacceptable risk Customers responsible for most bad debt problems but can generate high revenue Customers who exploit trade credit in full/overseas customers who have difficulty remitting payments Customers with good reputation and no history of payment problems Zero or negligible risk (government institutions and major companies) LOW
Remember!
Credit assessment will not only be needed when credit is first granted, but also when customers request higher limits or their volume of trade takes them above their existing limits.
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Bank references
Should ask in precise terms Do you consider X Co to be good for a trade credit of $1,000 per month on terms of 30 days?
Types of bank reference

Undoubted Considered good for your figures Respectably constituted business which should prove good for your figures Respectably constituted business whose resources would appear to be fully employed; we do not think they would undertake something they felt they could not fulfil Unable to speak for your figures WORST BEST
Trade references
Remember Customer may maintain untypically good relations with referees Referee should be offering similar terms References should be followed up Unknown companys reference should be treated with caution
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Ratio analysis
Profit margin =
Profit Revenue
Revenue Capital employed Profit Capital employed
Gearing =
Prior charge capital Equity

Profit before tax and interest Finance (interest) charges
Net asset turnover =
Interest cover = Debt ratio =
Return on capital employed =
Total liabilitie s Total assets
Earnings per share = Profit attributable to ordinary shareholders Number of ordinary shares Working capital ratios (see Chapter 6)
Price earnings ratio =
Market price per share EPS
Remember that the credit controller is predominantly interested in the indicators of future cash flow (liquidity, gearing, working capital). Financial information has limits because it is historical.
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Credit controller
Customer
Premises
Treatment of visitors
Accounts department and accounts payable and receivable departments Well run Proper recording Proper filing
Payment methods
Overall impression Prosperous Slow-moving stock Signs of decay/ obsolescence
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Credit reporting agencies (credit bureaux)

Credit bureaux provide information about businesses so that their creditworthiness can be assessed by suppliers. Summary of information Means of cross-checking other information May not contain up-to-date information Suppliers references are out-of-date Lack of information on new businesses
Contents of agency report

Legal data Commercial data Credit data (References agency assessment)
Other information
Press Historical, financial data Companies Registry search County Court records
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Credit control information should be used in various ways.
1 Granting credit
Information used to decide Whether to grant request in entirety Whether to grant request provisionally subject to later review Whether to give less generous terms than the customer wants Need for reliable credit ratings and details of credit taken Invoices and receipts posted immediately Queries cleared quickly Orders vetted against credit limits Customer history Overall review of payment record and aged analysis, high risk customers reviewed more frequently
2 Credit ratings
3 Credit reviews
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Credit assessment
References
Financial analysis
Visits
Other information
Using information
Data protection
Data Protection Act 1998

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

Apply to paper-based/microfilm/microfiche systems Conditions under which processing is lawful prescribed Processing of personal data forbidden unless subject consents/legal obligation Processing of sensitive (racial, political, religious) data forbidden without consent Data subjects must be told reasons for data processing
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10: Monitoring and collecting debts
Topic List
Monitoring receivables Insurance, factoring and discounting Collecting debts Bad and doubtful debts Third party use Bankruptcy and insolvency
When monitoring receivables and pursuing debts, you need to know which methods are most likely to work and which methods should be used when dealing with certain customers. An organisation may use factoring to simplify administration or to raise money.
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Monitoring receivables
Insurance, factoring and discounting
Collecting debts
Bad and doubtful debts
Third party use
Bankruptcy and insolvency
Efficient administration Credit monitoring Individual customers Ratio analysis Credit utilisation report Aged receivables analysis
Prompt dispatch of statements/invoices, recording and banking receipts Initial credit ratings, customer history, regular review of high risks Overdues/disputes as % of total debts, average payment period Who might want more credit, tightness of credit policy, exposure to debt Balance and periods unpaid. Accounts/customer types highlighted
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Aged receivables analysis

Account No
1 2 3 4
Customer name
A B C D
Balance
X X X X
<30
X X X X
3060
X X X X
Days 6090
X X X X
>90
X X X X
Reports can highlight: Overdue accounts Sales revenue and days sales outstanding Aggregate for customer classes eg region or industry sector
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Collecting debts
Third party use
Credit insurance
Insurance may be obtainable from a specialist credit insurance firm. Insurance will be assessed on a customer-bycustomer basis Insurance company will only insure up to 75% of potential bad debt loss if insurance covers whole receivables ledger Insurance company will review Accounts receivable reports Credit control and debt collection procedures Sales administration
Types of policy
Whole turnover policy Up to 80% of entire receivables ledger Annual aggregate excess of loss Specific customer amount All debts above a certain amount Payable if specific customer becomes insolvent
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Factoring
Factoring is debt collection by factor company which advances proportion of money due.
Factor company
Administration of invoices, sales accounting and debt collection service Credit protection for clients debts Factor finance, payments in advance However, use of a factor may give a negative image of the organisation to the customer
Benefits of factoring finance
Pay suppliers promptly Maintain optimum inventory levels Growth financed through sales rather
than external capital Finance linked to volume of sales Factor will chase slow payers
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Invoice discounting
Invoice discounting is the sale of debts for discount in return for cash. The customer is unaware of the discounters involvement and continues to pay the supplier.
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Collecting debts
Third party use
Invoicing
Customer fully aware of terms Invoice correct and issued promptly Knowledge of customers system used Queries resolved quickly Monthly statements issued promptly
Customer awareness of terms Payment dates and terms discussed during initial negotiations Customer agreement to terms Payment terms stated on order, invoice, monthly statement Monthly statements New invoices Cash received Outstanding balance due Age analysis Payment reminder
Chasing slow payers

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

Invoice and payment runs on monthly basis Only pay certain amount each month Only pay when sent reminder Only pay when legal action threatened
Key account customers

Some customers are treated with special attention in sales effort. Credit control will involve Senior staff time Specific request for payment
Receipts on long-term contracts

Take place over a number of years Precise terms Third party verification of work done Progress payments
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If payment is slow or disputed stopping work on the contract may involve significant costs and loss of significant revenues. However, customer failure to pay regularly can mean major cash flow problems.
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Collecting debts
Third party use
Methods of chasing customers

Value of debt High Personal visit Telephone Fax E-mail Low Letter Accounts of most importance Largest outstanding balances Largest arrears No recent payments
Reasons for short/non-payment

Invoices not entered on system in time for payment run Disputed amounts Short payment agreed with sales department Deliberate under payment
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Collecting debts
Third party use
Bad debt
Bad debt is a debt which is considered to be uncollectable and is written off against the income statement or doubtful debts provision.
Doubtful debt
Doubtful debt is a debt for which there is some uncertainty as to whether it is bad.
Doubtful debt provision

Doubtful debt provision is an amount charged against profit and deducted from receivables to allow for estimated non-recovery of proportion of debts.
Bad debts ratio = OR =
Bad debts 100% Sales on credit Bad debts 100% Total receivables
Writing debts off Consider Success of attempts to collect debt Expenses of pursuing debt Likelihood of insolvency proceedings
Bad debt report will give details of when original debt arose and when the debt was written off.
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Collecting debts
Third party use
Personal customers
Changes in payment patterns Requests for credit extension Court action Failure to communicate/reply Loss of major customer Bankruptcy of own customers Disaster Industrial action Slower payment Other suppliers having payment difficulties Signs of slow business Newspaper reports County Court judgements Credit vetting agency reports Bouncing cheques
Business customers
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Financial signs
Warning signs in accounts, poor ratios, Z scores, imprudent accounting policies, also accounts being filed late.
A Scores Defects
Dominance by single individual Directors lack broad expertise Weak Finance Director Lack of management depth below board level Poor accounting systems Lack of responsiveness to change Over-borrowing Over-trading Over dependent on single project Financial signs (see above), Z-scores in decline Non-financial signs (eg fall in market share)
Mistakes Symptoms
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Collecting debts
Third party use
Debt collection agencies

Agencies receive a percentage of debts collected. Some collect on letter/telephone basis, others collect on the doorstep.
Court action
Before taking action, check: Genuine debt not dissatisfied customer Exact identity of customer Customers financial resources The amount owed, type of transaction, and public interest issues will determine court used.
Arbitration agreement
An arbitration agreement is a written agreement to submit differences to arbitration. The arbitrator will try and settle differences. Proceedings are less formal, quicker and cheaper than litigation. However, arbitration may be means of delay, and arbitrator may have insufficient powers.
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Collecting debts
Third party use
Bankruptcy
Bankruptcy is the legal status of an individual against whom an order has been made by the court because of an inability to meet financial liabilities. Creditors demand payment and petition for bankruptcy. Debtor cannot dispose of property/settle legal claims. Official receiver appointed to investigate/realise assets. Assets realised and creditors paid in order of preference.
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Insolvency
Insolvency is the inability of a debtor company to pay its debts when they fall due.
Company may suffer liquidation/winding-up (similar procedures to bankruptcy) or receivership (receiver appointed to obtain money by realising assets). Company may be able to use alternative procedures (administration, voluntary arrangements) depending on legal jurisdiction in an attempt to keep trading.
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Notes
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11: The banking system and financial markets

This chapter provides the knowledge you need of the banks and the markets on which organisations might raise long-term funds.
Topic List
The banking system Financial markets
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The banking system
Financial markets
Financial intermediation
Financial intermediation is the bringing together of providers and users of finance.
Convenient means of saving money Aggregating amounts lent for borrowing Pooling reduces risk Maturity transformation
Commercial banks
The retail (High Street) and wholesale banks Payments mechanism Wealth store Providers of funds
Other financial intermediaries Building societies Finance houses Insurance companies Pension funds Unit trusts Investment trust companies
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Bank assets
Notes and coin Bills Money market loans Customer loans and overdrafts Securities $ X X X X X __ X __ __
Bank liabilities
Sterling current accounts Sterling deposit accounts Other currency deposits $ X X X __ X __ __
Bank income
Interest received Current account charges Commissions and fees Foreign exchange Mortgages $ X X X X X __ X __ __
Bank expenses
Interest paid Running costs Wages/salaries Advertising Bad debts $ X X X X X __ X __ __
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The banking system
Financial markets
Central bank
A central bank controls the money supply of a country.
European central bank

ECB supervises monetary policy in Euro area, trying to ensure price stability by influencing interest rates. ECB also imposes reserve requirements on credit institutions. The Eurosystem consists of ECB and central banks of countries that have adopted the Euro.
Roles of central bank Banker to central government Issuer of bank notes Supervises government borrowing Intervenes in foreign exchange markets Banker to commercial banks Lender of last resort Adviser on economic policy Agent of government Participant in international institutions
Role of Eurobanks Conducting foreign exchange operations Issuing bank notes Promoting smooth operation of payment systems Collecting and providing information
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The banking system
Financial markets
Money markets
Money markets are operated by banks/financial institutions and provide means of trading, lending and borrowing in the short-term.
Capital markets
Capital markets are markets for trading in long-term financial instruments, in particular shares and bonds. They enable organisations to raise new finance, investors to realise investments and companies to merge/takeover. Main money market instruments Deposits Bills Commerical paper Certificates of deposit
Main short-term markets Primary Interbank Eurocurrency Certificate of deposit Local authority Finance house Inter-company
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The banking system
Financial markets
Capital market participants

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

Banks Building societies Insurance companies and pension funds Unit trust/investment trust companies Stock exchanges Venture capital organisations
Suppliers of funds
INDIVIDUALS (as savers and investors)
FIRMS (share capital; loans)
FIRMS (with long-term funds to invest) GOVERNMENT (budget surplus)
GOVERNMENT (budget deficit)
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12: Economic influences
Topic List
Interest rates Economic policies
This chapter examines the major economic influences on the finance available to organisations. Capital markets and government policy are both very important in determining the conditions facing businesses and the availability (and cost) of finance.
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Interest rates
Economic policies
Factors affecting interest rates

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

The real rate of interest is the rate of return that investors get from their investment, adjusted for inflation.
General factors affecting all rates Need for a real return Inflation/expectations Government borrowing Demand for individuals' borrowing Balance of payments uncertainty Monetary policy Foreign interest rates
Nominal rate of interest

The nominal rate of interest is the rate of interest expressed in money terms. Real rate of interest = 1 + nominal rate of interest - 1 1 + rate of inflation
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Interest rates
Economic policies
Monetary policy
Regulation of the economy through control of money supply/interest rates. Increases in the money supply
Reserve requirements
A proportion of a banks assets are held in reserve and not used for lending. Direct controls Lending ceilings How much is lent to particular sector Supervisory controls over capital structure, liquidity and foreign exchange exposure Open market operations
Government prints more notes/ coins Government spends more than it raises Banks and building societies lend more money Money from abroad enters UK accounts
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Interest rate policy

Higher interest rates should reduce demand for borrowing, leading to less consumer demand/increased finance costs.
12: Economic influences
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Interest rates
Economic policies
Fiscal policy
Fiscal policy is government spending money or collecting taxes. It can be a means of demand management and inflation control.
Problems of inflation Redistribution of wealth (those on fixed incomes suffer) Balance of trade (exports fall as more expensive, imports rise as cheaper) Inefficient resource allocation (as real meaning of prices is unclear) Cost of frequently changing prices (administration, seeking out lowest prices) Reduced investment in the economy (if interest rates rise to counter inflation) General uncertainty
Inflation
Inflation is a sustained increase in the general level of prices over time.
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13: Short and medium-term finance
Topic List
Bank/customer relationship Bank lending criteria Overdrafts Medium and long-term loans Leases
This chapter summarises various possible sources of business finance. Remember that some of them may not be readily available, and some might not be right for the organisation. Bear in mind that a complete analysis would also cover the flexibility of the finance, and what the organisation would have to commit in return. Probably the most important examination issues are choosing appropriate finance, and the criteria that an organisation must fulfil for banks to lend it money.
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Bank/customer relationship
Bank lending criteria
Overdrafts
Medium and long-term loans
Leases
Liquidity maintenance
Minimise risk of losing finance sources Guard against unexpected movements
Operational functioning (pay salaries, suppliers)
Overdraft facility repayable on demand Term loan fixed repayment period, interest charged Committed facility stipulated amount made available on demand Uncommitted facility paperwork for lending is completed in advance. No obligation to lend Revolving facility renewable after a set period Acceptance facility for bills of exchange
Bank facilities
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Debtor/ creditor
Bailor/ bailee
Principal/ agent
Mortgagor/ mortgagee
also a FIDUCIARY relationship (to act in good faith) Bank duties Honour cheques Receive funds Repay on demand Comply with customer instructions Provide a statement Confidentiality, care and skill Advise of forgeries
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Customer duties Duty of care to deter fraud Advise of forgeries
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Overdrafts
Leases
Character Ability to borrow and repay Margin of borrowing Purpose of borrowing Amount of borrowing Repayment terms Insurance
Past record Interviews Credit scoring/ratio analysis Legal capacity Re-investment of retained profit Problems (declining profits, overtrading, poor working capital control) At fixed or discretionary rate May be cautious if purpose to finance new business venture/working capital increase Not too much (may not repay) or too little (may want more later) Timescale and instalments Security easy to take, value, realise Personal guarantees
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Overdrafts
Leases
Amount Margin
Should not exceed limit, bank will want hard core reduced Interest on daily amount, margin over base rate Cover short-term/seasonal deficit Repayable on demand Over specific assets/whole business, depends on size of facility Flexible short-term borrowing for customer; bank has to accept fluctuation in balances
Overdrafts
Purpose Repayment Security Benefits
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Overdrafts
Leases
Overdrafts and working capital

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

Where a business is permanently in overdraft it has a solid or hard core debit balance which may persist. Banks will want such a balance reduced or converted into a medium-term loan to ensure it is repaid.
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Overdrafts
Leases
Uses of loans
Easy for bank to monitor Customers and banks know amounts paid/received Customer doesnt face threat of having to pay loan back on demand Bank can obtain written safeguards Term of loan Need for loan (not > than useful life of asset) Bank guidelines Government regulations Banker-customer negotiations agreement
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Types of loans
Bullet all loan principal repaid at end of loan period Balloon most of loan principal repaid at end of period Amortising loan principal repaid gradually, regular payments consist of interest and some of loan principal Interest rates Fixed throughout loan period Variable, depending on market conditions
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Overdrafts
Leases
Costs of loans
Interest Arrangement fee to bank Commitment fees Legal costs
Loan covenants
Positive borrower must do something Negative/restrictive borrower must not do something (eg borrow more money) Quantitative limits on borrowers financial position Loans Medium-term purposes Interest and repayments set in advance Bank wont withdraw at short notice Should not exceed asset life Can have loan-overdraft mix
Overdrafts Designed for day to day help Only pay interest when overdrawn Bank has flexibility to review Can be renewed Wont affect gearing calculation
Overdrafts v loans
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Overdrafts
Leases
Leasing
Leasing is a contract between the lessor and lessee for the hire of a specific asset.
Leasing Lessor has ownership of asset Lessee has possession and ownership of asset on payment of specified rentals over period
Hire purchase
Hire purchase is a form of instalment credit, where ownership passes to the customer on the payment of the final credit instalment. Hire purchase payments consist of capital element (towards asset cost) and interest. Hire purchase Supplier sells goods to finance house Supplier delivers goods to customer who purchases them HP arrangement exists between finance house and customer
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Overdrafts
Leases
Operating leases
Lessor supplies asset to lessee Lessor responsible for servicing and maintenance Period of lease short, less than useful economic life of asset Asset not shown on lessees Statement of Financial Position
Finance leases
Third party supplies the asset, the lessor supplies the finance Lessee responsible for servicing and maintenance Primary period of lease for assets useful economic life, secondary (low-rent) period afterwards Asset shown on lessees Statement of Financial Position
Advantages of leasing
Supplier paid in full Lessor receives (taxable) income and capital allowances Help lessees cash flow Cheaper than bank loan?
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14: Long-term finance
Topic List
Longer term finance Ordinary shares Preference shares Loan stock Convertibles and warrants The capital structure decision
This chapter considers the long-term financing decisions that businesses make. The amounts of money that are required can often only be obtained on the capital markets.
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Convertibles and warrants
The capital structure decision
Different sources of funds Retained earnings Capital markets Share issues Rights issues Loan capital Bank borrowings Government sources Venture capital International money markets
The choice of financing methods Purpose of the finance Amount Repayment Term Cost Security Covenants Taxation treatment Control implications Effect on gearing
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Offer for sale

The company sells shares to the general public. Offer for sale by tender means allotting shares at the highest price they will be taken up. Costs of share issues Underwriting costs Stock Exchange listing fees Issuing house, solicitors, auditors, public relation fees Printing and distribution costs Advertising
Placing
Placing means arranging for most of an issue to be bought by a small number of institutional investors. It is cheaper than an offer for sale. Timing of share issues High share prices generally = high confidence High confidence = high issue price High issue price = fewer shares need to be issued Fewer shares issued = reduced commitment on dividends The reverse is true where share prices and business confidence is generally low
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Stock market listing
Access to wider pool of finance Improved marketability of shares Transfer of capital to other uses Enhancement of company image Facilitation of growth by acquisition
Disadvantages of obtaining a listing Loss of control Vulnerability to takeover More scrutiny Greater restrictions on directors Compliance costs
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Rights issue
Rights issue is an offer to existing shareholders enabling them to buy new shares. Offer price will be lower than current market price of existing shares
Advantages of rights issues
Lower issue costs than offer for sale Shareholders acquire more shares Relative voting rights unaffected
at discount
Scrip dividend
Scrip dividend is a dividend payment in the form of new shares, not cash.
Scrip issue
Scrip issue is an issue of new shares to current shareholders, by converting equity reserves.
Stock split
Stock split is the splitting, for example, of one $1 share into two 50c shares.
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Preference shares
Preferences shares are shares which have a fixed percentage dividend, payable in priority to any dividend paid to ordinary shareholders. Can only be paid if sufficient distributable profits are available Cumulative preference shares have the right to unpaid dividends carried forward to later years Disadvantages Dividend payments not tax-deductible Not popular with investors (cant be secured on assets, low dividend yield) Loan stock ranks higher in liquidation Issue costs more expensive than loan stock
Advantages
Can be issued on terms that suit the company Dividends not paid when profits poor Dont dilute voting rights Lower gearing Dont restrict borrowing power No shareholder right to appoint receiver
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Loan stock
The stock has a nominal value, the debt owed by the company, and interest is paid on this amount. Security may be given.
Debentures
Debentures are a form of loan stock. They are the written acknowledgement of debt including provisions about interest payment and capital repayment. The debenture trust deed allows the trustee to intervene if interest is not paid or borrowing limits are breached. Redemption is repayment of the loan stock. Floating rate loan stock protect borrowers if interest rates are falling, and allow lenders to benefit if interest rates are rising. Their market price depends on coupon rate relative to market rates.
Fixed and floating charges

Fixed charge specific assets, cant dispose without lenders consent Floating charge class of assets, can dispose until default Deep discount bonds are issued at a large discount to nominal value of stock. Zero coupon bonds are issued at a discount, with no interest paid on them.
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Convertible securities
Convertible securities are fixed return securities convertible at pre-determined dates and at holders option into ordinary shares at a pre-determined rate. Conversion premium is the difference between issue value of stock and conversion value at issue date. The company will try to maximise it and thus have to issue fewer shares. Market price depends on Price of straight debt Current conversion value Time to conversion Expectations of future returns
Warrants
Warrants are rights for an investor to subscribe for new shares at a future date at a fixed predetermined price. Theoretical Current share No of shares value = price Exercise from each price warrant Warrants Usually issued with unsecured loan stock. Dont involve interest/dividends Make loan stock issue more attractive Dont immediately dilute EPS Income in form of capital gains Low investor outlay/maybe high profit
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Capital structure
Matching assets with funds
Assets yielding long-term profits should be financed by long-term funds.
Replacement and growth

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

Ultimately risk of liquidation but also risk shareholders receive no/inadequate dividend.
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Longer term finance
Ordinary shares
Preference shares
Loan stock
Gearing increases variability of shareholder earnings and risk of financial failure.
Gearing
The level of debt within a business High levels of gearing reduces market value of shares due to increased risk Level of gearing may affect willingness of lenders to make further advances Businesses subject to seasonal ups and downs should have low gearing Businesses with stable profits can have higher gearing Business confidence Inflation Interest rate expectations Restrictions in company constitution/trust deeds
Level of gearing
Lender attitudes to increased debt levels Shareholder attitudes to increased debt levels
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15: Financing of small and medium-sized enterprises
Topic List
Problems of obtaining finance Sources of finance Venture capital Other sources Government aid
For small companies, the theoretical question of what the best capital structure is, may be less important than simply being able to obtain funds in the first place. Many small businesses use venture capital and government aid.
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Problems of obtaining finance
Sources of finance
Venture capital
Other sources
Government aid
Small and medium-sized enterprises (SMEs)

SMEs have three main characteristics: Unquoted Ownership restricted to a few individuals Not micro-businesses that exist to employ just owner The basic problem of their finance is a limited supply of funds and having uncertain prospects. Lack of business history/track record Few accounting details available Assessed by credit scoring methods Need to supply security
Government policy
Government policy will have a major influence on funds. Tax policy concessions to investors Interest rate policy higher interest rates increase borrowing costs but also increase return to investors, making them more willing to supply funds
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Sources of finance
Venture capital
Other sources
Government aid
Owners
Bank overdrafts
Bank loans
Trade credit
SOURCES OF FINANCE Equity finance

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Business angels
Venture capital
Leasing
Factoring
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Sources of finance
Venture capital
Other sources
Government aid
Venture capital
Venture capital is risk capital normally provided in return for an equity stake and possibly board representation. Business startups Development of new products/markets Management buyouts Realisation of investments
Investment considerations Nature of product Production expertise Management expertise Market and competition Profit expectations Board membership Risk borne by current owners
Business angels
Business angels are wealthy individuals who invest directly in small businesses. Informal market May be difficult to arrange Business angels generally have industry knowledge
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Sources of finance
Venture capital
Other sources
Government aid
Trade credit Short-term finance Decreases working capital Suppliers dont charge interest May lose goodwill May lose discounts Equity finance Initial investment from owners Shares placed privately Further funds from owners limited Lack of exit route for external investor
Identification of owners/managers Lack of equity finance Owners preference Industry/market Stage of existence
Capital structure
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Sources of finance
Venture capital
Other sources
Government aid
Loan guarantee scheme

Many companies/sole traders can apply. Banks can lend without personal security/guarantee being needed from the borrower. The government guarantees 75% of the loan up to a maximum of 250,000 provided the borrower pays a premium and puts up business assets as security.
Enterprise Initiative
Assistance such as Regional Selective Assistance and Regional Enterprise Grants help firms (particularly small firms) in Assisted and Development Areas.
Enterprise Investment Scheme

This scheme gives tax relief to qualifying (nonconnected) individuals who subscribe for shares in a qualifying (unquoted) company, up to maximum subscription of 400,000.
Development agencies
Agencies for Scotland and Wales concentrate on small company start-up and developments. Measures include accommodation, grants, loans, equity finance.
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16: Decision making
Topic List
Relevant costs Product mix decisions Make or buy decisions Shut down decisions and one-off contracts
Management at all levels within an organisation take decisions. The overriding requirement of the information that should be supplied by the accountant to aid decision making is relevance. A relevant cost is a future cash flow arising as a direct consequence of a decision All relevant costs are future, incremental cashflows
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Relevant costs
Product mix decisions
Make or buy decisions
Shut down decisions and one-off contracts
Avoidable cost
Avoidable cost is a cost which would not be incurred if the activity to which it related did not exist. Relevant costs
Opportunity cost
Opportunity cost is the benefit which would have been earned but which has been given up, by choosing one option instead of another.
Differential cost Relevant cost of materials

Not owned Owned Differential cost is the relevant difference in the cost of alternatives. current replacement cost will be replaced will not be replaced
Controllable cost
Controllable cost is an item of expenditure which can be directly influenced by a given manager within a given time span.
Relevant cost of labour

Relevant cost of labour is the direct labour cost plus the contribution lost by diverting labour to make another product.
higher of current resale value and value if put to an alternative use
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Non-relevant costs Sunk cost

Sunk cost is a past (historical) cost which is not directly relevant in decision making.
Fixed costs
Unless given an indication to the contrary, assume fixed costs are irrelevant and variable costs are relevant.
Direct and indirect costs may be relevant or irrelevant depending on the situation.
Deprival value of an asset

Lower of Replacement cost NRV Higher of Expected revenues
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16: Decision making
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Relevant costs
If there is a scarce resource (key or limiting factor), contribution will be maximised by earning the biggest possible contribution per unit of scarce resource.
Example
Assume fixed costs remain unchanged, whatever the product mix
Direct labour ($5 per hour) Direct materials ($2 per kg) Variable overheads Fixed overheads T $ 15 2 2 3 __ 22 __ __ $25 10,000 J $ 10 5 2 3 __ 20 __ __ $24 8,000
Assume the only relevant costs are variable costs
Selling price Maximum demand Maximum availability of labour
40,000 hours
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1 2
Confirm limiting factor is not sales Labour hours required to fulfil demand = (10,000 3) + (8,000 2) = 46,000 shortfall = 46,000 40,000 = 6,000 hours Calculate the contribution per unit of scarce resource T J Unit contribution $6 (25 19) $7 (24 17) Labour hours per unit 3 2 $2 $3.50 Contribution per labour hour Rank 2nd 1st Work out budgeted production and sales
Product
J T (8,000 2) Balance
Hours
16,000 24,000 ______ 40,000 ______ ______ ( 2) ( 3)
Production
8,000 8,000
Contribution per unit

$
Total contribution
56,000 48,000 ______ 104,000 ______ ______
7 6
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Relevant costs
A make or buy problem

A make or buy problem involves a decision by an organisation about whether it should make a product/carry out an activity with its own internal resources, or whether it should pay another organisation to make the product/carry out the activity for it.
No scarce resource Relevant costs are the differential costs between the two options
With scarce resources Where a company must subcontract work to make up a shortfall in its own production capacity, its total costs are minimised by subcontracting work which adds the least extra marginal cost per unit of scarce resource saved by subcontracting.
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Example
Joely makes three products and has limited labour time available.
Variable cost of making Variable cost of subcontracting Extra variable cost of subcontracting Labour hours saved by subcontracting (per unit) Extra variable cost of subcontracting per hour saved PRIORITY FOR MAKING IN-HOUSE
A $ 10 19 __ 9 __ __
3 $3 1st
B $ 16 20 __ 4 __ __
2 $2 3rd
C $ 14 19 __ 5 __ __
2 $2.50 2nd
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Relevant costs
Shut down decisions Whether or not to shut down a factory/department/product line because it is making a loss or too expensive to run Only relevant fixed costs are directly attributable fixed costs The fact that a product makes a positive contribution is not enough if the fixed costs that could be avoided by ceasing production of it exceed contribution
One-off contracts Concerns a contract which would utilise spare capacity but will have to be accepted at a lower price than normally charged Generally, an order will be accepted if it increases contribution and rejected if it reduces contribution The effect on other customers and possible future uses of the spare capacity may have to be considered
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17: CVP analysis
Topic List
Terms and formulae Breakeven chart Profit/volume chart Advantages and limitations of CVP analysis
CVP analysis enables management to predict how changes in volume (production output and sales) will impact upon costs and revenues and hence profitability. CVP analysis is one of the key areas of the syllabus. Most examination questions will require that you can recall the formulae included in this chapter make sure that you learn them so that you can apply them when you need to.
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Terms and formulae
Breakeven chart
Profit/volume chart
Advantages and limitations of CVP analysis
Contribution per unit

Contribution per unit is unit selling price unit variable costs
Profit
Profit is (sales volume contribution per unit) fixed costs
Breakeven point is activity level at which there is neither profit nor loss.
Total fixed costs Contribution per unit
Breakeven point
Contribution required to breakeven Contribution per unit
Required contribution P/V ratio
Sales revenue at breakeven point P/V ratio =

Required contribution Sales
Fixed costs P/V ratio
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The margin of safety

The margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. Fixed costs + target profit The sales volume to achieve a target profit = _________________________ Contribution per unit
$5,400 = 1,800 units $15 $12 P/V ratio = 3/15 100% = 20% = 0.2
Breakeven point (units) = Breakeven point (revenue) =
5,400 = $27,000 0.2
Example
Selling price = $15 per unit Variable cost = $12 per unit Fixed costs = $5,400 per annum Budgeted sales pa = 3,000 units = 2,900 units
Sales volume to achieve profit of $3,300 =
$(5,400 + 3,300) $3
Margin of safety (as a %) =

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3,000 1,800 100% = 40% 3,000

17: CVP analysis
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Terms and formulae
Breakeven chart
Profit/volume chart
Breakeven chart
Breakeven chart shows the approximate level of profit or loss at different sales volume levels within a limited range.
$
Profit/loss is the difference between the sales revenue line and the total costs line The breakeven point is where the total costs line and the sales revenue line meet
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Terms and formulae
Breakeven chart
Profit/volume chart
Profit/volume chart
Profit/volume charts are a variation on breakeven charts. They illustrate the relationship of costs and profit to sales and the margin of safety. If the x axis is sales units, the gradient of the straight line is the contribution per unit If the x axis is sales value, the gradient of the straight line is the P/V ratio This type of chart shows clearly the effect on profit and breakeven point of changes in SP, VC, FC and/or sales demand
Page 131 17: CVP analysis
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Terms and formulae
Breakeven chart
Profit/volume chart
The advantages and limitations of CVP analysis

Limitations
Only applies to one single product or mix (fixed proportions) of a group of products. Assumes that fixed costs and variable costs per unit are the same at all levels of output. This is a simplification. Assumes that sales prices will be constant at all levels of activity. At higher volumes price may have to be reduced to win extra sales. Production and sales are assumed to be the same. Changes as in inventory levels are ignored. Uncertainty in the estimates of fixed costs and unit variable costs is usually ignored.
Advantages
In spite of limitations, it is a useful technique for planning sales prices, desired sales mix, and profitability. If used with a full awareness of its limitations, it can provide simple and quick estimates of breakeven volumes or profitability within a 'relevant range' of output/sales volumes.
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18: Capital expenditure budgeting
Topic List
What is capital expenditure? Authorisation and monitoring
Capital expenditure is often for very significant amounts. The need for it should be assessed before any firm commitments are made.
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What is capital expenditure?
Authorisation and monitoring
Revenue expenditure
Investment
Capital expenditure
For purpose of trade To maintain assets existing earnings Expensed through the income statement Acquisition of non-current assets Improvement in their earnings capacity Bigger outlay Accrue over time period
The correct and consistent calculation of profit for any accounting period depends on the correct and consistent classification of items as revenue or capital.
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Tight control of the details concerning each non-current asset is required. This is generally achieved through the use of an ASSET REGISTER.
Not part of the double entry system
Shows an organisations investment in capital equipment
Points to note
Capital expenditure over a certain amount will need authorisation Asset register must be reconciled to the nominal ledger Physical inspections should be carried out Asset register should be kept up to date
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18: Capital expenditure budgeting
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Details that might be held on an asset register

Description Date of purchase Cost Accumulated depreciation Depreciation % Depreciation type Date of disposal Sale proceeds Accumulated depreciation account Depreciation expense account Depreciation period Comments Residual value Cost account
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19: Methods of project appraisal
Topic List
Steps in project appraisal Accounting rate of return Payback Discounted cash flow NPV and IRR
This chapter considers how major investment projects are assessed.You must be able to use all of the methods shown, as well as being able to discuss their advantages and disadvantages.
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Steps in project appraisal
Accounting rate of return
Payback
Discounted cash flow
NPV and IRR
Decision-making and control cycle Initial investigation Detailed evaluation Authorisation Implementation Project monitoring Post-completion audit
Non-financial factors to consider

Legal issues Ethical issues Changes to regulations Political issues Quality implications Level of competition Can all affect a decision!
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Post-completion audit
A post-completion audit is an objective and independent appraisal of the success of a capital project in progressing the business.
Post-completion audit procedures
Requires independent and competent staff Evaluation of performance against original objectives Recommendation to improve cost-effectiveness
Benefits of post-completion audits
Better forecasting techniques Better future decisions Better current decisions Contributes to performance evaluation
Requires communication with staff directly involved in project
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Payback
NPV and IRR
Only use relevant costs when making project appraisal decisions.

ARR = Estimated average profit Estimated average investment Disadvantages Based on accounting profits rather than cash flow, giving too much emphasis to costs as conventionally defined which are not relevant to project performance Fails to take account of the timing of cash inflows and outflows
Advantages Widely understood measure of accounting profitability Readily available from accounting data
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Payback
NPV and IRR
Payback
Payback is the time taken for the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years. It is used as a minimum target/first screening method.
Advantages Simple to calculate and understand Concentrates on short-term, less risky flows Can identify quick cash generators
Disadvantages Ignores total project return Ignores time value of money Ignores timing of flows after payback period Arbitrary choice of cut-off
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Payback
NPV and IRR
Example
Investment Year 1 profits Year 2 profits Year 3 profits
P $000 60 20 30 50
Q $000 60 50 20 5
Q pays back first, but ultimately Ps profits are higher on the same amount of investment.
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Payback
NPV and IRR
Discounted cash flow analysis applies discounting arithmetic to the costs and benefits of an investment project, reducing value of future cash flows to present value equivalent. Conventions of DCF analysis Cash flows incurred at beginning of project occur in year 0 Cash flows occurring during time period assumed to occur at period-end Cash flows occurring at beginning of period assumed to occur at end of previous period
Discounting
Present value of 1 =
1 (1 + r)n
Annuity
+ n Present value of annuity of 1 = 1 (1 r) r
PV of cash flows in perpetuity

$1/r, r is cost of capital
r = Discount rate n = number of periods

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Payback
NPV and IRR
Net present value (NPV)

Net present value is the value obtained by discounting all cash flows of project by target rate of return/cost of capital. If NPV is positive, the project will be accepted, if negative it will be rejected.
Features of NPV Uses all cash flows related to project Allows timing of cash flows Can be calculated using generally accepted method
Example
Year 0 1 2 3 Cash flow (90,000) 40,000 40,000 50,000 PV factor 12% 1.000 0.893 0.797 0.712 PV of cash flow (90,000) 35,720 31,880 35,600 ______ 13,000 ______ ______
This simple layout is not recommended for complex cash flows. See over for recommended layout
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Year 0
Sales receipts Costs Sales less Costs Capital additions Capital disposals Discount factors @ Cost of capital (WACC) Present value ___ (X) ___ (X) X ___ (X) ___ ___
Year 1 X (X) ___ X

___ X X ___ X ___ ___
Year 2 X (X) ___ X

___ X X ___ X ___ ___
Year 3 X (X) ___ X

___ X X ___ X ___ ___
Year 4 X (X) ___ X

X ___ X X ___ (X) ___ ___ NPV is the sum of present values
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Payback
NPV and IRR
Rules of investment appraisal Include

Effect of tax allowances After-tax incremental cash flows Working capital requirements Opportunity costs
Exclude
Depreciation Dividend/interest payments Sunk costs Allocated costs and overheads
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Internal rate of return (IRR)

The IRR method calculates the rate of return at which the NPV is zero.
Calculate net present value using rate for cost of capital which
a b
Is a whole number May give NPV close to zero
Calculate second NPV using a different rate
a b
If first NPV is positive, use second rate greater than first rate If first NPV is negative, use second rate less than first rate
Use two NPV values to calculate IRR
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Payback
NPV and IRR
a IRR = A + a b (B A) %
where A B a b is lower of two rates of return used is higher of two rates of return used is NPV obtained using rate a is NPV obtained using rate b
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NPV Simpler to calculate Better for ranking mutually exclusive projects Easy to incorporate different discount rates
IRR
NPV and IRR comparison

For conventional cash flows both methods give the same decision.
More easily understood Can be confused with ARR Ignores relative size of investments May be several IRRs if cash flows not conventional
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Notes
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Notes
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Notes
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Notes

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CAT Advanced Paper 10 Managing Finances

Page 89 93 103 113 119 127 133 137

1: Cash and cash flows

Cash flow cycle

Cash flows and profits

Need for cash flows

Calculation of operating cycle

1: Cash and cash flows

Cash flow cycle

Cash flows and profits

Capital and revenue items

Exceptional and unexceptional items

Net cash flow

Cash flow cycle

Cash flows and profits

Differences between profits and cash flow

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

Items affecting cash flows but not profits

Items where profit/loss is different to cash flow

How to calculate: Cash receipts from customers

Cash payments to suppliers

Cash flow cycle

Cash flows and profits

2: Forecasting cash flows

Mark up and margin

Statement of financial position forecasts

Correcting cash deficits

Cash flow-based forecasts

Bottom of budget must show

Net cash flow Opening position Closing position

Establish when any other cash payments will be made

2: Forecasting cash flows

Mark up and margin

Statement of financial position forecasts

Correcting cash deficits

PROFORMA CASH BUDGET

Net cash flow (receipts payments) Opening balance Closing balance

2: Forecasting cash flows

Mark up and margin

Statement of financial position forecasts

Correcting cash deficits

Mark up Margin Example

Profit element as fraction of cost

Sales Mark up Costs Sales Margin Costs

% 100 + x x 100 % 100 y 100 y

Profit element as fraction of selling price

Mark up and margin

Statement of financial position forecasts

Correcting cash deficits

Statement of financial position forecasts

Share capital > + Reserves

Net assets (excl cash)

Net > assets (excl cash)

Share capital + Reserves

2: Forecasting cash flows

Mark up and margin

Statement of financial position forecasts

Correcting cash deficits

Estimating a future statement of financial position

Mark up and margin

Statement of financial position forecasts

Correcting cash deficits

Mark up and margin