CAT T10/ FIA - FFM - Finance PassCard

CAT Advanced Paper 10Managing Finances

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First edition February 2005Fourth 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 retrievalsystem 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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Page iii

ContentsPreface

Welcome to BPP Learning Media’s new CAT Passcards

� They save you time. Important topics are summarised for you.

� They incorporate diagrams to kick start your memory.

� They follow the overall structure of the BPP Learning Media Interactive Texts, but BPP Learning Media’snew CAT Passcards are not just a condensed book. Each card has been separately designed for clearpresentation. 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 daybefore the exam, try to go through the Passcards again! You will then be well on your way to completing yourexam successfully.

Good luck!

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ContentsPreface

Page

1 Cash and cash flows 1

2 Forecasting cash flows 9

3 Cash forecasting techniques 21

4 Cash and treasury management 25

5 Investing surplus funds 29

6 Working capital management 39

7 Managing payables and inventory 43

8 Managing receivables 51

9 Assessing creditworthiness 61

10 Monitoring and collecting debts 69

11 The banking system and financialmarkets 83

Page

12 Economic influences 89

13 Short and medium-term finance 93

14 Long-term finance 103

15 Financing of small and medium-sizedenterprises 113

16 Decision making 119

17 CVP analysis 127

18 Capital expenditure budgeting 133

19 Methods of project appraisal 137

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1: Cash and cash flows

Topic List

Cash flow cycle

Cash transactions

Cash flows and profits

Accruals accounting

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

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Accrualsaccounting

Cash flowsand profits

Cashtransactions

Cash flowcycle

Need for cash flowsA business has to ensure it has sufficient cash tomeet its obligations, as well as making profits.

Operating/cash cycleCycle describes the connection between workingcapital and cash movements.

ProblemAlthough sales are made (and accrued) money maynot be received until after the date suppliers need tobe paid. Bank overdraft facilities may be limited.

Working capital Current assets – Current liabilities

Calculation of operating cycleDays

Raw material inventory turnover period X

Credit taken from suppliers (X)Finished goods inventory

turnover period XReceivables payment period X__Operating cycle X____

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1: Cash and cash flowsPage 3

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Accrualsaccounting


Cashtransactions

Cash flowcycle

Sales ofassets

Share capitalSales ofgoods

Loans Sales ofinvestments

Grants

DividendsTax InterestPurchases of assets

Purchases ofinvestments,

foreigncurrency

Purchases ofinventories,

wages

CASH

Cash inflows

Cash outflows

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Capital and revenue itemsCapital items relate to the long-term functioning ofthe business, eg purchasing non-current assets.

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

Net cash flow

Exceptional and unexceptional itemsExceptional items are unusual, one-off items egclosure of a business.

Unexceptional items are ‘normal’ business receiptsand payments.

Example$

Cash flow from sales XCash flow from purchases (X)Cash paid from wages (X)Interest payments (X)Tax payments (X)Cash paid for assets (X)Bank loan XShare issue X__Net cash flow X____

The change in cash position from period beginningto period-end. Analysis is needed of componentelements of net cash flow

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Accrualsaccounting


Cashtransactions

Cash flowcycle

Differences between profits and cash flow

� Issue of 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

Cash flows ‡ ProfitItems affecting profits but not cash flows� Depreciation� Increases in provisions

Items affecting cash flows but not profits� Issued shares/loan notes� Increase in bank overdrafts/loans

Items where profit/loss isdifferent 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 XAdd: Sales during the year X__Total money due from customers XLess: Customers owing money at end of year (X)__Cash receipts from customers during the year X____

Cash payments to suppliersPayments owed to suppliers at start of year XAdd: Purchases during the year * X__Total money due to suppliers XLess: Payments owing to suppliers at end of year (X)__Cash payments to suppliers during the year X____

* Calculated as:Cost of sales XAdd: Closing inventory X__

XLess: Opening inventory (X)__Purchases during the year X____

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Accrualsaccounting


Cashtransactions

Cash flowcycle

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 ofFinancial Statements.

'Financial Statements are prepared on the accrual basis of accounting. Under this basis the effects oftransactions and other events are recognised when they occur (and not as cash or its equivalent is received orpaid) and they are recorded in the accounting records and reported in the financial statements of the periods towhich they relate.'

The accruals basis of accounting is a way of letting investors know how much profit a business has made bymatching income and expenditure.

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2: Forecasting cash flows

Topic List

Cash forecasts

Mark up and margin

Statement of financial positionforecasts

Control reports

Correcting cash deficits

This chapter is one of the most significant.You need toknow 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 preparinga cash budget and identifying cash needs. It alsosummarises the action an organisation can take if it runsshort of cash.

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Mark upand margin

Cash forecasts Statement of financialposition forecasts

Correctingcash deficits

Control reports

Forecasts

Amount of cash required

Whenrequired

How longrequired for

Whether available fromanticipated sources

Cash flow-based forecastsIn 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 availablefor spending

BanksBanks often insist businesses provide:

� Cash forecasts� Business plans

Banks can monitor progress/control lending usingthese.

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2: Forecasting cash flowsPage 11

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

Enables management to makeforward planning decisions �

Sort out cash receiptsfrom customers

Establish whether anyother cash income willbe received

Sort out cash paymentsto suppliers

� Establish materials inventorychanges → quantity and cost ofmaterials purchases

� Establish when suppliers will bepaid

Establish when any othercash payments will bemade

Bottom of budget mustshow �

1

2

34

5

� Overdraft � Investments � Credit control

� Net cash flow

� Opening position

� Closing position

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Mark upand 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 BUDGETMonth 1 Month 2 Month 3

$ $ $Cash receiptsReceipts from customers X X XLoans etc X X X__ __ __

X X X__ __ ____ __ __

Cash paymentsPayments to suppliers X X XWages etc X X X__ __ __

X X X__ __ ____ __ __

Net cash flow (receipts – payments) X X XOpening balance X X X__ __ __Closing balance X X X__ __ ____ __ __

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Mark upand margin



Control reports

Mark up

Margin

ExampleCost price 80 Profit 20 Selling Price 100

Mark up = 20 ÷ 80 = 25%Margin = 20 ÷ 100 = 20%

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

Sales price = = $31.250.2)–(1

25

Profit element as fraction of cost

Profit element as fraction of selling price

%

Sales 100 + xMark up x Costs 100

%

Sales 100Margin yCosts 100 – y

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Mark upand margin




Control reports

Net Share capital Cash> =assets + Reserves deficit(excl cash)

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

Share capital Net Cash> =+ Reserves assets surplus(excl cash)

Statement of financial position forecasts

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Mark upand 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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Mark upand margin




Control reports

CONTROL REPORTS

� Same amounts forecast for receipts andpayments each month

� No changes to receipts and payments as newrolling forecast prepared

� Forecast end of period cash balances remainconstant as forecasts updated

Signs of bad reports

Current forecast v original forecast

Actual cash flows v budget

� Poor forecasting� Loss of major customer� Insolvency of credit customer� Changes in interest rates� Inflation

Why do budgets and actual flows differ?

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Mark upand margin



Control reports

Month Year to dateBudget Actual Difference Budget Actual Difference

$ $ $ $ $ $Cash receiptsRevenue X X X X X X__ __ __ __ __ __

X X X X X X__ __ __ __ __ ____ __ __ __ __ __

Cash paymentsMaterial X X X X X XLabour X X X X X XOverheads X X X X X XNon-current assets X X X X X X__ __ __ __ __ __

X X X X X X__ __ __ __ __ ____ __ __ __ __ __

Net cash flow X X X X X XOpening balance X X – X X –__ __ __ __ __ __Closing balance X X X X X X__ __ __ __ __ ____ __ __ __ __ __

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Mark upand margin




Control reports

LossesAsset replacementGrowth supportSeasonal businessOne-off expenditure

Cash flow problems

� Short-term borrowing

� Sale of short-term investments

� Reduce costs

� Reduce inventory levels

� Reduce receivables

� Increase payables

Short-term remedies

� Postpone capital expenditure

� Sell non-essential assets

� Reschedule loan repayments

� Change terms of business

� Reduce dividend payments

� Increase selling and marketing activity

Longer-term solutions

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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 aboutin the exam may be stable, volatile or subject to inflation.This chapter summarises the techniques forincorporating such uncertainties into forecasts.

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WeightingsAn index normally consists of more than one item,therefore weightings are needed to reflect therelative importance of each item.

Calculate price relative (price of item as % ofprice in previous period).

Calculate weightings.

Multiply price relative by weighting.

Calculate index numbers by dividing total offor all items by total for previous period.

Sensitivityanalysis

Indexnumbers

Index

Index numbers are expressed as percentages,taking the base date value as 100.

1

2

3

34

A measure over time of the average changes invalues of a group of items. Indexes can be used topredict inflows and outflows and hence futureborrowings.

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3: Cash forecasting techniquesPage 23

A price index measures the changein the money value of a group of

items over time.

Base period is usually thestarting point of a series.

Price index = 100 × �0

1

PP

Quantity index = 100 × �0

1

QQ

A quantity index measures thechange in the non-monetary values

of a group of items over time.

� Also known as base year

� Base period index = 100

� Price in base period

Quantity in base period �

Price index Quantity index

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Sensitivityanalysis

Indexnumbers

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

Seasonally adjusted dataAdditive model: Y = T + S + I

Multiplicative model: Y = T x S x I

Where: T = Trend seriesS = Seasonal componentI = Irregular random component

Other methods of uncertainty analysis� Preparing a series of different forecasts, each

assuming a different outcome

� Preparing cash forecasts as range of possibleoutcomes

� Using probability analysis by assigningprobabilities to a range of values for keyuncertain cash flow items

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

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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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Treasurymanagement

Inventoryapproach

The focus of cashmanagement

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

Reducing float

FloatTime between payment being initiated and funds becomingavailable for use. �

Transmission delay + lodgement delay + clearance delay

Focus of cash management

Profitability

SafetyLiquidity

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Treasurymanagement

Inventoryapproach


4: Cash and treasury managementPage 27

Inventory approach

i2FS

Q =where S is the amount of

cash used in period

F is the fixed cost ofobtaining new funds

i is the interest cost ofholding cash

Q is the total amountto be raised toprovide for S

Baumol's model seeks to minimise cash holdingcosts by calculating optimal amount of new fundsto raise.

� Amounts required in future are difficult topredict

� Costs associated with running out of cash

� Holding costs may vary with amount held

� Model doesn’t work very well for large,irregular flows

� Difficulty in predicting future interest rates

Problems with inventory approach

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Treasurymanagement

Inventoryapproach


Treasury managementTreasury departments are set up to manage cashfunds and currency efficiently, and make the best useof corporate finance markets.

The main advantages of centralised treasurymanagement are avoiding a mix of surpluses andoverdrafts, and being able to obtain favourable rateson bulk borrowing/investments.

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

Centralised treasury management

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

Decentralised treasury management

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

Role of treasurer

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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 thatare available if an organisation has surplus funds thatneed to be invested. It also sets out principles andguidelines that need to be followed when investmentdecisions are made.

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Cash surpluses

Cash investments

Risk andreturn

Other investments

Government andlocal authority stocks

Marketablesecurities

Liquidity Safety Profitability

Cash managementCash for normal businesscommitments

Buffer for unforeseencontingencies

Balances held in hopeinterest rates �

Cash for growth, non-current asset purchases,acquisitions

One-off dividends

Increasing annual dividends

Buying back own shares

Shareholders

Precautionary motive

Strategic motive

Speculative motive

Transactions motive

Cash

Surplus

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Cash surpluses

Cash investments

Risk andreturn

Other investments



5: Investing surplus fundsPage 31

Interest bearing accountsBanks and building societies provide various interestbearing accounts, including current accounts, chequeaccounts and deposit accounts.

Option depositsOption deposits are for predetermined periods oftime (2 to 7 years) with minimum deposits of say$2,500. Interest rates are higher as arrangementsare longer-term and there is no facility forwithdrawal.Compound annual interest

CAR = × 100

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)

⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎠⎞⎜⎝

⎛+ 1–

n

X1

n

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

Guidelines for investment

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Cash surpluses

Cash investments

Risk andreturn

Other investments



Interest yield = price Market

rate Coupon

Gross redemption yieldRedemption yield is a more realistic measure ofoverall return than interest yield, as it takes intoaccount both the interest payable and the gain orloss due to the difference between the purchaseprice and the redemption value.

Investors will be looking for different levelsof income and capital appreciation.

Attractiveness of interest

Risk of non-payment

Length of time to redemption/maturity

Accrued interest

Cum div (int) or Ex div (int)

Price of fixed interest stocks

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Cash surpluses

Cash investments

Risk andreturn

Other investments




Gilts

Convertible gilts

Local authority stocks are similar to governmentsecurities, but security isn’t considered as goodand the market is less active. They are held by afew institutions.

� Shorts < 5 years

� Mediums 5 – 15 years

� Longs > 15 years

� Undated Irredeemable/one-way options

� Index linked Interest and redemption value linked to rate of inflation. Interestis adjusted by RPI value 8 months before payment date.Convertible gilts are gilts redeemable on date

shown or convertible into longer-dated stock.

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

Local authority stocks

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Cash surpluses

Cash investments

Risk andreturn

Other investments



Certificates of deposit are negotiable instrumentsproviding evidence of a fixed term deposit with abank.

Certificates of depositCommerical paper is an unsecured short-term (3months) loan note issued by companies.

They are traded at a discount and unsecured,therefore they are risky.

Commercial paper

� 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

Certificates of deposit

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Types of billTrade bills Drawn by one non-bank on another;

to be tradeable both must have highcredit ratings

Bank bills Drawn and payable by banks

Holder of the bill

� Presents bill on maturity, or

� Sells bill before maturity at discount dependingon credit quality of drawee and market conditionfor bills

Discounting bills

� Interest rate Principal sum lent, borrowerbasis repays principal plus interest at

maturity

� Discount Specified sum payable at basis maturity

Basis of trading

Bills of exchangeBill is drawn on company/person being ordered topay.

Drawer orders payment of money.

Drawee is the party who is to pay.

Payee receives funds:

� Unconditional orders to pay� Negotiable instruments

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Cash surpluses

Cash investments

Risk andreturn

Other investments



Political andeconomic climate

Inflation Products Competition Management

Risk

Income Capital

Government securities

Company loans notes

Preference shares

Ordinary shares

RISK

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Types of risk� Systematic risk – caused by factors

affecting the whole market

� Unsystematic risk – security/sector-specific risks

DiversificationThe reduction of risk by investing in arange of securities.

Risk and return

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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 calculateworking capital levels/ratios but to also explain theirsignificance. The symptoms of over-capitalisation andovertrading are also important.You may be asked how toimprove the management of working capital.

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OvertradingWorking capitalratios

Working capital

Working capital = current assets – current liabilities

Working capital managementMinimise risk of insolvency Maximise return on assets

Working capital cycle is the lengthof time between cash being spentat start of production and cashbeing 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

Working capital cycleAverage time raw materials are in inventory

Less: Period of credit taken from suppliersPlus: Time taken to produce goodsPlus: Time finished goods are in inventory after production is completedPlus: Time taken by customers to pay for goods

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Working capital

6: Working capital managementPage 41

Acid test/quick ratio =

Accounts payablepayment period = 365 days×

Average payables

Purchases on credit

Current assets less inventories

Current liabilitiesCurrent ratio =

Accounts receivable days =

Inventory turnover period =

Inventory turnover =Average inventory

Cost of sales

days365salesofCost

inventoryAverage×

365 days×Trade receivables

Credit sales

sliabilitieCurrent

assetsCurrent

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

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Working capital

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

� ↑↑ revenue

� ↑↑ current assets

� ↑↑ non-current assets

� Assets financed by trade payables/bankoverdraft

� Little/no ↑ in proprietors’ capital

� ↓ current/quick ratios

Symptoms

� Finance from share issues

� Better inventory and receivables control

� Postpone expansion plans

� Maintain/increase proportion of long-termfinance

Solutions

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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 EOQformula is particularly critical. You may be asked toexplain the assumptions behind the formula, or askedabout other inventory management techniques.

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Trade payables Inventory costs JIT andpurchasing mix

Methods ofpayment

Management oftrade payables

Obtaining satisfactory credit levels/terms

Extending credit if cash short

Good relations/loss of goodwill if payment delayed

Cost of lost cashdiscounts

where d is % discountt is reduction in payment

period in days necessaryto obtain early discount

ExampleX 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 × × 25% = 23.5

Cost: Accept discount $980

Refuse discount ($1,000 – $23.5) = $976.5

It is cheaper to refuse the discount, invest the moneyand pay after 45 days.

365

35

Consider alsointerest gainedthrough havingmonies for full

period.

1d-100

100 t365

−⎟⎠

⎞⎜⎝

⎛

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Methods ofpayment

7: Managing payables and inventoryPage 45

CashSmall payments/wages

ChequesCommonly used and widely

accepted

Standing ordersRegular payments of fixed

amounts

� Keep secure

� Easily lost

� Lack of payment evidence

� Convenient

� Counterfoil/cheque numbercan be traced

� Keep secure

� Slow method of payment

� HP payments

� Rental payments

� Insurance premiums

BACSPayment information sent to BACSfor processing. Most commonlyused for salaries, can be used forsuppliers.

Telegraphic transfersLarge payments made immediately.

Direct debitsDeductions from bank account,regular and irregular payments offixed and varying amounts.Recipient sets the amount.

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Methods ofpayment

Economic order quantity (EOQ)EOQ is the optimal ordering quantityfor an item of inventory which willminimise costs.

Bulk discountsTotal 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

Safety inventorySafety inventory is held when demand is uncertain or supplylead time is variable.

Average annual = Safety × Annual unitsafety inventory cost quantity holding costs

Exam formula

H

O

C

D2CEOQ =

D = Usage in unitsCO = Cost of placing one orderCH = Holding costEOQ= Economic order quantity

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Methods ofpayment

Inventory costs

� Contribution from lost sales� Emergency inventory� Stock-out costs

� Ordering costs� Delivery costs

� Cost of capital� Warehouse/handling costs� Deterioration/obsolescence� Insurance� Pilferage

Reorder level= Maximum usage × Maximum lead time

Maximum inventory level= Reorder level + Reorder quantity

– (Minimum usage × Minimum lead time)

Minimum inventory level = Reorder level – (Ave usage × Ave lead time)

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

Holding costs

Shortage costs

Procuring costs

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Methods ofpayment


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

Just-in-time (JIT) procurement

QuantityQualityPriceDelivery

Purchasing mix

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

Benefits of JIT

Balance between holding, and ordering stock-out costs

Good enough for production/customers

Best value over time

Lead time and reliability

(007) CT10PC_CH07.qxp 17/12/2008 18:16 Page 49

Notes

(007) CT10PC_CH07.qxp 17/12/2008 18:16 Page 50

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 tomake. Should it offer credit? If so how much? Who to?Should it offer early settlement discounts?

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 51

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle

Creditcontrol

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 52

8: Managing receivablesPage 53

CREDIT CONTROL DEPARTMENT

May report to

Duties

ChiefAccountant

SalesManager

ManagingDirector

FinanceDirector

Updatingreceivables’

ledger

Customerqueries

Liaison withsales staff

Third partyreferences

Checkingcreditworthiness

Advising onpayment terms

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 53

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle

Creditcontrol

Trade credit

Consumer credit

Investment in receivables can be measured using:

Receivables’ payment period = days) 365 (in SalessReceivable

Report shows extent to which total limits being utilised,indicating number of customers who might want morecredit, and extent of exposure to receivables.

Credits issued by one business to anotherbusiness eg stating payment is expected within30 days.

Credit offered by businesses to end-consumers.

� Hire purchase, loan to purchase goods� Credit cards

Credit utilisation report

Monitoring total credit

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 54


Profit Cash flow Asset use Interest cost

Total credit levelsSetting total credit limits means balancing need toentice customers by favourable terms (but losinginterest) and refusing opportunities for sales.

� Extra sales

� Profitability of extra sales

� Effect on inventory/payables

� Length of extra debt collection period

� Required rate of return on investment inadditional receivables

Should credit be extended?

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 55

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle

Creditcontrol

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 56

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle


Creditcontrol

Methods of payment� Cash � Standing order� BACS � Direct debit� Cheques � Credit/debit card� Bankers’ draft � Bills of exchange� Travellers’ cheque

Payment terms� 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

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

Terms and conditions of sale

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 57

ExampleHenry Co is considering a 2% discount to all customers paying within 30 days.

Cost of early settlement discount = = 27.86%% 12 – 100

100 30365

−⎟⎠

⎞⎜⎝

⎛

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle

Creditcontrol

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

where D = Discount offered

T = Reduction in payment period necessaryto obtain discount

% 1D – 100

100 T365

−⎟⎠

⎞⎜⎝

⎛

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 58

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle


Creditcontrol

Essential elements of a contract� Legal relations (intention)

� Offer and acceptance

� Consideration (the price paid in exchange for apromise)

ContractAn agreement which legally binds parties. Validity ofa contract affected by:

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

Breach of contractWhen one of the parties fails to perform. Remedies:

� Damage� Termination� Quantum meruit (value for work done)

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

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 59

Totalcredit

Legalaspects

Settlementdiscounts

Paymentterms

The creditcycle

Creditcontrol

Sale of goodsSale 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 buyeraccepts

� If conditions imposed, must be fulfilled

� Goods can be stopped in transit

� Lien by seller if goods not passed (retain onseller’s 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 notpass until payment is received)

Failure to pay

(008) CT10PC_CH08.qxp 17/12/2008 18:17 Page 60

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 thereliability of potential credit customers. It summarises thesources of information you can use when making theassessment.You should be able to demonstrate that youcan use evidence about potential customers to makesensible recommendations that are in line withorganisational policies.

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 61

Dataprotection

Usinginformation

Creditassessment

Otherinformation

VisitsFinancialanalysis

References

Credit risk means that there is a possibility that the debt will go bad. A credit assessment is a judgement aboutthe creditworthiness of a customer, providing a basis for a decision as to whether credit should be granted.

Unacceptable risk

Customers responsible for most bad debt problems but cangenerate high revenue

Customers who exploit trade credit in full/overseas customerswho have difficulty remitting payments

Customers with good reputation and no history of paymentproblems

Zero or negligible risk (government institutions and majorcompanies)

HIGH

LOW

Remember!Credit assessment will not onlybe needed when credit is firstgranted, but also when customersrequest higher limits or theirvolume of trade takes them abovetheir existing limits.

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 62

Dataprotection

Usinginformation

Creditassessment

Otherinformation


References

9: Assessing creditworthinessPage 63

Bank referencesShould ask in precise terms ‘Do you consider X Coto be good for a trade credit of $1,000 per month onterms of 30 days?’

Trade referencesRemember

� Customer may maintain untypically goodrelations with referees

� Referee should be offering similar terms

� References should be followed up

� Unknown company’s reference should be treatedwith caution

Types of bank reference� Undoubted

� Considered good for your figures

� Respectably constituted business whichshould prove good for your figures

� Respectably constituted business whoseresources would appear to be fullyemployed; we do not think they wouldundertake something they felt they couldnot fulfil

� Unable to speak for your figures

BEST

WORST

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 63

Dataprotection

Usinginformation

Creditassessment

Otherinformation


References

� Profit margin =

� Net asset turnover =

� Return on capital employed =

� Earnings per share =

� Working capital ratios (see Chapter 6)

� Gearing =

� Interest cover =

� Debt ratio =

� Price earnings ratio = EPS

share per price Market

assets Total

sliabilitie Total

charges (interest) Finance

interest and tax before Profit

Equity

capital charge Prior

sharesordinary of Numberrsshareholdeordinary toleattributab Profit

employed CapitalProfit

employed Capital

Revenue

Revenue

Profit

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.

Ratio analysis

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 64

Dataprotection

Usinginformation

Creditassessment

Otherinformation


References


Credit controller Customer

Premises Treatment ofvisitors

Accountsdepartment andaccounts payableand receivabledepartments

� Well run

� Properrecording

� Proper filing

Payment methods Overall impression

� Prosperous

� Slow-moving stock

� Signs of decay/obsolescence

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 65

Dataprotection

Usinginformation

Creditassessment

Otherinformation


References

Credit reporting agencies (credit bureaux)Credit bureaux provide information about businesses so that their creditworthiness can beassessed 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

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 66

Dataprotection

Usinginformation

Creditassessment

Otherinformation


References


Credit control information should be used in various ways.

Granting credit

Credit ratings

Credit reviews

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 riskcustomers reviewed more frequently

1

2

3

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 67

Dataprotection

Usinginformation

Creditassessment

Otherinformation


References

Data Protection Act 1998Aims 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

� Compensation for loss/destruction/unauthoriseddisclosure

� View personal data

� Have inaccurate data corrected/destroyed

Rights of data subjects

Data protection principles� Apply to paper-based/microfilm/microfiche

systems

� Conditions under which processing islawful prescribed

� Processing of personal data forbiddenunless subject consents/legal obligation

� Processing of sensitive (racial, political,religious) data forbidden without consent

� Data subjects must be told reasons fordata processing

(009) CT10PC_CH09.qxp 17/12/2008 18:18 Page 68

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, youneed to know which methods are most likely to work andwhich methods should be used when dealing with certaincustomers. An organisation may use factoring to simplifyadministration or to raise money.

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 69

Monitoringreceivables

Insurance, factoringand discounting

Bankruptcyand insolvency

Thirdparty use

Bad anddoubtful debts

Collectingdebts

Aged receivables ��analysis

Credit

mon

itorin

gPrompt 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

Efficient administration ��

Individual customers ��

Ratio analysis ��

Credit utilisation report ��Balance and periods unpaid.Accounts/customer types highlighted

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 70

10: Monitoring and collecting debtsPage 71

Reports can highlight:

� Overdue accounts

� Sales revenue and days’ sales outstanding

� Aggregate for customer classes eg region or industry sector

Account Customer DaysNo name Balance <30 30–60 60–90 >90

1 A X X X X X

2 B X X X X X

3 C X X X X X

4 D X X X X X

Aged receivables analysis

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 71




Thirdparty use


Collectingdebts

Credit insuranceInsurance may be obtainable from a specialist creditinsurance firm.

� Insurance will be assessed on a customer-by-customer basis

� Insurance company will only insure up to 75% ofpotential bad debt loss if insurance covers wholereceivables’ ledger

Insurance company will review

� Accounts receivable reports

� Credit control and debt collection procedures

� Sales administration

Types of policyWhole turnover policy – Up to 80% of entire

receivables’ ledger

Annual aggregate – All debts above aexcess of loss certain amount

Specific customer – Payable if specificamount customer becomes

insolvent

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 72


Factoring Factoring is debt collectionby factor company whichadvances proportion ofmoney due.

Pay suppliers promptlyMaintain optimum inventory levels Growth financed through sales ratherthan external capitalFinance linked to volume of salesFactor will chase slow payers

Benefits of factoring finance

Factor company� Administration of invoices, sales

accounting and debt collection service

� Credit protection for client’s debts

� Factor finance, payments in advance

Invoice discountingInvoice discounting is the sale of debts fordiscount in return for cash. The customer isunaware of the discounter’s involvement andcontinues to pay the supplier.

However, use of a factor may give a negative imageof the organisation to the customer

��

��

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 73




Thirdparty use


Collectingdebts

Invoicing� Customer fully aware of terms

� Invoice correct and issued promptly

� Knowledge of customer’s system used

� Queries resolved quickly

� Monthly statements issued promptly

Chasing slow payers� Reminders or final demands

� Telephone calls

� Personal approach

� Notify debt collection section

� Legal action

� External debt collection agency

� Payment dates and terms discussed duringinitial negotiations

� Customer agreement to terms

� Payment terms stated on order, invoice,monthly statement

Customer awareness of terms

� New invoices

� Cash received

� Outstanding balance due

� Age analysis

� Payment reminder

Monthly statements

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 74


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 customersSome customers are treated with special attention insales 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

If payment is slow or disputed stopping work on thecontract may involve significant costs and loss ofsignificant revenues. However, customer failure topay regularly can mean major cash flow problems.

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 75




Thirdparty use


Collectingdebts

Methods of chasing customersValue of debt

High Personal visit

Telephone

Fax

E-mail

Low Letter

� Largest outstanding balances

� Largest arrears

� No recent payments

Accounts of most importance

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

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 76





Thirdparty use


Collectingdebts

Bad debt is a debt which is considered to beuncollectable and is written off against the incomestatement or doubtful debts provision.

Bad debtDoubtful debt is a debt for which there is someuncertainty as to whether it is bad.

Doubtful debt

Bad debts ratio = × 100%

OR = × 100%

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

sreceivable Total

debts Bad

credit on Sales

debts Bad Doubtful debt provision is an amount charged againstprofit and deducted from receivables to allow forestimated non-recovery of proportion of debts.

Doubtful debt provision

Consider� Success of attempts to collect debt� Expenses of pursuing debt� Likelihood of insolvency proceedings

Writing debts off

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 77




Thirdparty use


Collectingdebts

Personal customers Changes in payment patternsRequests for credit extensionCourt actionFailure to communicate/reply

Loss of major customerBankruptcy of own customersDisasterIndustrial actionSlower paymentOther suppliers having payment difficultiesSigns of slow businessNewspaper reportsCounty Court judgementsCredit vetting agency reportsBouncing cheques

Business customers

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 78


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

A Scores Defects Dominance by single individualDirectors lack broad expertiseWeak Finance DirectorLack of management depth below board levelPoor accounting systemsLack of responsiveness to change

Over-borrowingOver-tradingOver dependent on single project

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

Mistakes

Symptoms

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 79




Thirdparty use


Collectingdebts

Debt collection agenciesAgencies receive a percentage of debts collected.Some collect on letter/telephone basis, others collecton the doorstep.

An arbitration agreement is a written agreement tosubmit differences to arbitration. The arbitrator willtry and settle differences.

Proceedings are less formal, quicker and cheaperthan litigation.

However, arbitration may be means of delay, andarbitrator may have insufficient powers.

Arbitration agreement

Court actionBefore taking action, check:

� Genuine debt not dissatisfied customer

� Exact identity of customer

� Customer’s financial resourcesThe amount owed, type of transaction, and publicinterest issues will determine court used.

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 80





Thirdparty use


Collectingdebts

Bankruptcy is the legal status of an individualagainst whom an order has been made by the courtbecause of an inability to meet financial liabilities.

Bankruptcy

Creditors demand payment and petition forbankruptcy.

Debtor cannot dispose of property/settle legal claims.

Official receiver appointed to investigate/realiseassets.

Assets realised and creditors paid in order ofpreference.

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

Insolvency

Company may suffer liquidation/winding-up (similarprocedures to bankruptcy) or receivership (receiverappointed to obtain money by realising assets).

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

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 81

Notes

(010) CT10PC_CH10.qxp 17/12/2008 18:19 Page 82

11: The banking system and financial markets

Topic List

The banking system

Financial markets

This chapter provides the knowledge you need of thebanks and the markets on which organisations mightraise long-term funds.

(011) CT10PC_CH11.qxp 17/12/2008 18:19 Page 83

Financial markets

The bankingsystem

Financial intermediation

Commercial banksThe retail (High Street) and wholesale banks

� Payments mechanism� Wealth store� Providers of funds

� Convenient means of saving money

� Aggregating amounts lent for borrowing

� Pooling reduces risk

� Maturity transformation

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

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

Other financial intermediaries

(011) CT10PC_CH11.qxp 17/12/2008 18:19 Page 84

11: The banking system and financial marketsPage 85

Bank assets$

Notes and coin XBills XMoney market loans XCustomer loans and overdrafts XSecurities X__

X____

Bank liabilities$

Sterling current accounts XSterling deposit accounts XOther currency deposits X

__X____

Bank income$

Interest received XCurrent account charges XCommissions and fees XForeign exchange XMortgages X__

X____

Bank expenses$

Interest paid XRunning costs XWages/salaries XAdvertising XBad debts X__

X____

(011) CT10PC_CH11.qxp 17/12/2008 18:19 Page 85

The bankingsystem

Financial markets

Central bank European 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

Roles of central bank

� Conducting foreign exchange operations� Issuing bank notes� Promoting smooth operation of payment

systems� Collecting and providing information

Role of Eurobanks

A central bank controls the money supply of a country. ECB supervises monetary policy in Euro area, tryingto ensure price stability by influencing interest rates.ECB also imposes reserve requirements on creditinstitutions.

The Eurosystem consists of ECB and central banks ofcountries that have adopted the Euro.

(011) CT10PC_CH11.qxp 17/12/2008 18:19 Page 86

Financial markets

The bankingsystem

11: The banking system and financial marketsPage 87

Money marketsMoney markets are operated by banks/financialinstitutions and provide means of trading, lendingand borrowing in the short-term.

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

� Deposits� Bills� Commerical paper� Certificates of deposit

Main money market instruments

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

Main short-term markets

(011) CT10PC_CH11.qxp 17/12/2008 18:19 Page 87

Financial markets

The bankingsystem

Capital market participants

INDIVIDUALS(eg housing/consumergoods finance)

Banks

Building societies

Insurance companiesand pension funds

Unit trust/investmenttrust companies

Stock exchanges

Venture capital organisations

INDIVIDUALS(as savers and investors)

FIRMS(share capital; loans)

GOVERNMENT(budget deficit)

FIRMS(with long-term funds toinvest)

GOVERNMENT(budget surplus)

Demand for fundscomes from ...

Capital marketsIntermediaries

Suppliersof funds

(011) CT10PC_CH11.qxp 17/12/2008 18:19 Page 88

12: Economic influences

Topic List

Interest rates

Economic policies

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

Capital markets and government policy are both veryimportant in determining the conditions facing businessesand the availability (and cost) of finance.

(012) CT10PC_CH12.qxp 17/12/2008 18:20 Page 89

Economicpolicies

Interestrates

Factors affecting interest ratesVarious interest rates are available; they depend onrisk, duration, size of loan, likely capital gain.

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

General factors affecting all rates Nominal rate of interest

Real rate of interest = - 1inflation of rate 1

interest of rate nominal 1+

+

The nominal rate of interest is the rate of interestexpressed in money terms.

The real rate of interest is the rate of return thatinvestors get from their investment, adjusted forinflation.

Real rate of interest

(012) CT10PC_CH12.qxp 17/12/2008 18:20 Page 90

Economicpolicies

Interestrates

12: Economic influencesPage 91

Monetary policy Reserve requirements

Interest rate policyHigher interest rates should reduce demand for borrowing,leading to less consumer demand/increased finance costs.

� Lending ceilings

� How much is lent to particular sector

� Supervisory controls over capital structure, liquidity andforeign exchange exposure

� Open market operations

Direct controls

A proportion of a bank’s assets are held in reserve and notused for lending.

Regulation of the economy throughcontrol of money supply/interest rates.

� Government prints more notes/coins

� Government spends more than itraises

� Banks and building societies lendmore money

� Money from abroad enters UKaccounts

Increases in the money supply

(012) CT10PC_CH12.qxp 17/12/2008 18:20 Page 91

Economicpolicies

Interestrates

Fiscal policyFiscal policy is government spending money orcollecting taxes.

It can be a means of demand management andinflation control.

Redistribution of wealth (those on fixedincomes suffer)

Balance of trade (exports fall as moreexpensive, imports rise as cheaper)

Inefficient resource allocation (as real meaningof prices is unclear)

Cost of frequently changing prices(administration, seeking out lowest prices)

Reduced investment in the economy (if interestrates rise to counter inflation)

General uncertainty

Problems of inflation

InflationInflation is a sustained increase in the general levelof prices over time.

�

�

�

�

�

�

(012) CT10PC_CH12.qxp 17/12/2008 18:20 Page 92

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 ofbusiness finance. Remember that some of them may notbe readily available, and some might not be right for theorganisation. Bear in mind that a complete analysiswould also cover the flexibility of the finance, and whatthe organisation would have to commit in return.

Probably the most important examination issues arechoosing appropriate finance, and the criteria that anorganisation must fulfil for banks to lend it money.

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 93

Bank/customerrelationship

LeasesMedium andlong-term loans

OverdraftsBank lendingcriteria

Bank facilities

Liquidity maintenance

Operational functioning(pay salaries, suppliers)

Minimise risk of losingfinance sources

Guard againstunexpected movements

Overdraft facility repayable on demand

Term loan fixed repayment period, interest charged

Committed facility stipulated amount made available ondemand

Uncommitted facility paperwork for lending is completed inadvance. No obligation to lend

Revolving facility renewable after a set period

Acceptance facility for bills of exchange

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 94

13: Short and medium-term financePage 95

Principal/agent

Bailor/bailee

Mortgagor/mortgagee

Debtor/creditor

also a FIDUCIARY relationship (to act in good faith)

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

Bank duties

� Duty of care to deter fraud� Advise of forgeries

Customer duties

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 95




Character Past record

Interviews

Credit scoring/ratio analysis

Ability to borrow and repay Legal capacity

Re-investment of retained profit

Problems (declining profits, overtrading, poor working capital control)

Margin of borrowing At fixed or discretionary rate

Purpose of borrowing May be cautious if purpose to finance new business venture/working

capital increase

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

Repayment terms Timescale and instalments

Insurance Security easy to take, value, realise

Personal guarantees

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 96





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

Margin Interest on daily amount, margin over base rate

Purpose Cover short-term/seasonal deficit

Repayment Repayable on demand

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

facility

Benefits Flexible short-term borrowing for customer; bank has to

accept fluctuation in balances

Overdrafts

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 97




Overdrafts and working capitalOverdrafts may be used to:

� Finance increased assets

Banks may be happy for certain reasons (need inventory for large order or seasonal peaks), and less happyfor 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 paypressing suppliers, as risk of default transferred to bank.

Hard core overdraftWhere 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.

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 98





Uses of loans� Easy for bank to monitor

� Customers and banks know amounts paid/received

� Customer doesn’t face threat of having to pay loanback on demand

� Bank can obtain written safeguards

� Need for loan (not > than useful life of asset)

� Bank guidelines

� Government regulations

� Banker-customer negotiations agreement

Term of loan

Types of loans� Bullet – all loan principal repaid at end of loan

period

� Balloon – most of loan principal repaid at endof period

� Amortising – loan principal repaid gradually,regular payments consist of interest and someof loan principal

� Fixed throughout loan period

� Variable, depending on market conditions

Interest rates

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 99




Costs of loans� Interest� Arrangement fee to bank� Commitment fees� Legal costs

Loan covenants� Positive – borrower must do something

� Negative/restrictive – borrower must notdo something (eg borrow more money)

� Quantitative – limits on borrower’sfinancial position

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

Overdrafts

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

LoansOverdrafts

v loans

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LeasingLeasing is a contract between the lessorand lessee for the hire of a specific asset.

Hire purchaseHire purchase is a form of instalmentcredit, where ownership passes to thecustomer on the payment of the finalcredit instalment.

Hire purchase payments consist of capitalelement (towards asset cost) and interest.

� Lessor has ownership of asset

� Lessee has possession and ownership of asseton payment of specified rentals over period

Leasing

� Supplier sells goods to finance house

� Supplier delivers goods to customer whopurchases them

� HP arrangement exists between finance houseand customer

Hire purchase

(013) CT10PC_CH13.qxp 17/12/2008 18:21 Page 101




Supplier paid in fullLessor receives (taxable) income and capital allowancesHelp lessee’s cash flowCheaper than bank loan?

Advantages of leasing

Operating leases� Lessor supplies asset to lessee

� Lessor responsible for servicing andmaintenance

� Period of lease short, less than usefuleconomic life of asset

� Asset not shown on lessee’s Statement ofFinancial Position

Finance leases� Third party supplies the asset, the lessor supplies

the finance� Lessee responsible for servicing and maintenance

� Primary period of lease for asset’s useful economiclife, secondary (low-rent) period afterwards

� Asset shown on lessee’s Statement of FinancialPosition

��

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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 decisionsthat businesses make. The amounts of money that arerequired can often only be obtained on the capitalmarkets.

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 103

Longer termfinance

Ordinaryshares

The capitalstructure decision

Convertiblesand warrants

Loanstock

Preferenceshares

� Retained earnings

� Capital markets

– Share issues– Rights issues– Loan capital

� Bank borrowings

� Government sources

� Venture capital

� International money markets

Different sources of funds

� Purpose of the finance

� Amount

� Repayment

� Term

� Cost

� Security

� Covenants

� Taxation treatment

� Control implications

� Effect on gearing

The choice of financing methods

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 104

Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares

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

� Underwriting costs

� Stock Exchange listing fees

� Issuing house, solicitors, auditors, publicrelation fees

� Printing and distribution costs

� Advertising

Costs of share issues

PlacingPlacing means arranging for most of an issue to bebought by a small number of institutional investors. Itis cheaper than an offer for sale.

� High share prices generally = high confidence

� High confidence = high issue price

� High issue price = fewer shares need to beissued

� Fewer shares issued = reduced commitmenton dividends

� The reverse is true where share prices andbusiness confidence is generally low

Timing of share issues

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 105

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

Loss of controlVulnerability to takeoverMore scrutinyGreater restrictions on directorsCompliance costs

Disadvantages of obtaining a listing

Stockmarketlisting

�

��

�

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 106

Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares

14: Long-term financePage 107

� Offer price will belower than currentmarket price ofexisting shares

Rights issueRights issue is an offer to existingshareholders enabling them to buynew shares.

Scrip dividendScrip dividend is a dividendpayment in the form of newshares, not cash.

Scrip issueScrip issue is an issue of newshares to current shareholders,by converting equity reserves.

Lower issue costs than offer for sale

Shareholders acquire more sharesat discount

Relative voting rights unaffected

Advantages of rights issues

Stock splitStock split is the splitting, forexample, of one $1 share intotwo 50c shares.

��

�

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 107

Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares

Preference sharesPreferences shares are shares which have a fixedpercentage dividend, payable in priority to anydividend paid to ordinary shareholders.

� Can only be paid if sufficient distributable profitsare available

� Cumulative preference shares have the right tounpaid dividends carried forward to later years

Can be issued on terms that suit the companyDividends not paid when profits poorDon’t dilute voting rightsLower gearingDon’t restrict borrowing powerNo shareholder right to appoint receiver

Advantages

Dividend payments not tax-deductibleNot popular with investors (can’t be secured onassets, low dividend yield)Loan stock ranks higher in liquidationIssue costs more expensive than loan stock

Disadvantages

�

�

�

�

��

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 108

Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares


DebenturesDebentures are a form of loan stock. They are thewritten acknowledgement of debt includingprovisions about interest payment and capitalrepayment. The debenture trust deed allows thetrustee to intervene if interest is not paid orborrowing limits are breached.

Redemption is repayment of the loan stock.

Floating rate loan stock protect borrowers if interestrates are falling, and allow lenders to benefit ifinterest rates are rising.

Their market price depends on coupon rate relativeto market rates.

Loan stockThe stock has a nominal value, the debt owed by thecompany, and interest is paid on this amount. Securitymay be given.

Fixed and floating chargesFixed charge specific assets, can’t dispose withoutlender’s consent

Floating charge class of assets, can dispose untildefault

Deep discount bonds are issued at a large discountto nominal value of stock.

Zero coupon bonds are issued at a discount, withno interest paid on them.

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Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares

Convertible securitiesConvertible securities are fixed return securitiesconvertible at pre-determined dates and at holder’soption into ordinary shares at a pre-determinedrate.

WarrantsWarrants are rights for an investor to subscribe fornew shares at a future date at a fixed pre-determined price.

Conversion premium is the difference betweenissue value of stock and conversion value at issuedate. The company will try to maximise it and thushave to issue fewer shares.

Theoretical Current share No of sharesvalue = price – Exercise × from each

price warrant

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

Market price depends on Usually issued with unsecured loan stock.

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

Warrants

(014) CT10PC_CH14.qxp 17/12/2008 18:21 Page 110

Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares


Capital structureDebts and financial risk

Ultimately risk of liquidation butalso risk shareholders receiveno/inadequate dividend.

Replacement and growthReplacement of assets oftenfinanced by internal sources,growth by external finance.

Matching assets with fundsAssets yielding long-term profitsshould be financed by long-termfunds.

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Longer termfinance

Ordinaryshares



Loanstock

Preferenceshares

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

Level ofgearing

Business confidence �

Inflation �

Interest rate expectations �

� Lender attitudes to increaseddebt levels

� Shareholder attitudes toincreased debt levels

Restrictions in company �constitution/trust deeds

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15: Financing of small and medium-sizedenterprises

Topic List

Problems of obtaining finance

Sources of finance

Venture capital

Other sources

Government aid

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

(015) CT10PC_CH15.qxp 17/12/2008 18:22 Page 113

Problems ofobtaining finance

Government aidOther sourcesVenture capitalSourcesof finance

The basic problem of their finance is a limited supplyof 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 policyGovernment policy will have a major influence onfunds.

� Tax policy – concessions to investors

� Interest rate policy – higher interest ratesincrease borrowing costs but also increase returnto investors, making them more willing to supplyfunds

Small and medium-sizedenterprises (SMEs)

SMEs have three main characteristics:

� Unquoted

� Ownership restricted to a few individuals

� Not micro-businesses that exist to employ justowner

(015) CT10PC_CH15.qxp 17/12/2008 18:22 Page 114



15: Financing of small and medium-sized enterprisesPage 115

Owners

Equityfinance FactoringBusiness

angels

Bankoverdrafts

Venturecapital

Bankloans

Tradecredit

Leasing

SOURCES OF FINANCE

(015) CT10PC_CH15.qxp 17/12/2008 18:22 Page 115



Venture capitalVenture capital is risk capital normally provided inreturn for an equity stake and possibly boardrepresentation.

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

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

Investment considerations Business angelsBusiness angels are wealthy individuals who investdirectly in small businesses.

� Informal market

� May be difficult to arrange

� Business angels generally have industryknowledge

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15: Financing of small and medium-sized enterprisesPage 117

Capitalstructure

Identification ofowners/managers

Lack of equity finance

Owners’ preference

Industry/market

Stage of existence

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

Trade credit

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

Equity finance

(015) CT10PC_CH15.qxp 17/12/2008 18:22 Page 117



Loan guarantee schemeMany companies/sole traders can apply. Banks canlend without personal security/guarantee beingneeded from the borrower. The governmentguarantees 75% of the loan up to a maximum of£250,000 provided the borrower pays a premium andputs up business assets as security.

Enterprise InitiativeAssistance such as Regional Selective Assistanceand Regional Enterprise Grants help firms(particularly small firms) in Assisted andDevelopment Areas.

Enterprise Investment SchemeThis scheme gives tax relief to qualifying (non-connected) individuals who subscribe for shares in aqualifying (unquoted) company, up to maximumsubscription of £400,000.

Development agenciesAgencies for Scotland and Wales concentrate onsmall company start-up and developments. Measuresinclude accommodation, grants, loans, equityfinance.

(015) CT10PC_CH15.qxp 17/12/2008 18:22 Page 118

16: Decision making

Topic List

Relevant costs

Product mix decisions

Make or buy decisions

Shut down decisions and one-offcontracts

Management at all levels within an organisation takedecisions. The overriding requirement of the informationthat should be supplied by the accountant to aid decisionmaking is relevance.

� A relevant cost is a future cash flow arising as adirect consequence of a decision

� All relevant costs are future, incremental cashflows

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 119

Avoidable cost Opportunity cost

Differential cost Controllable costRelevant cost ofmaterials� Not owned � current replacement cost

� Owned � will be replaced

� will not be replaced

Relevant costs

Shut down decisionsand one-off contracts

Make or buydecisions

Product mixdecisions

Relevant costs

Avoidable cost is a cost which wouldnot be incurred if the activity to which itrelated did not exist.

Opportunity cost is the benefit whichwould have been earned but which hasbeen given up, by choosing one optioninstead of another.

Differential cost is therelevant difference in thecost of alternatives.

Controllable cost is an item of expenditure which can bedirectly influenced by a given manager within a giventime span.

� higher of current resale value andvalue if put to an alternative use

Relevant cost of labourRelevant cost of labour is the directlabour cost plus the contribution lost bydiverting labour to make anotherproduct.

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16: Decision makingPage 121

Non-relevant costs

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

Sunk costUnless given an indication to the contrary, assume fixedcosts are irrelevant and variable costs are relevant.

Fixed costs

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

Lower of

Replacement cost Higher of

NRV Expected revenues

Deprival value of an asset

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 121




Relevant costs

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

Assume fixed costsremain unchanged,whatever theproduct mix

Assume the onlyrelevant costs arevariable costs

ExampleT J$ $

Direct labour ($5 per hour) 15 10Direct materials ($2 per kg) 2 5Variable overheads 2 2Fixed overheads 3 3__ __

22 20__ ____ __

Selling price $25 $24Maximum demand 10,000 8,000

Maximum availability of labour 40,000 hours

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 122


Confirm limiting factor is not salesLabour 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 resourceT J

Unit contribution $6 (25 – 19) $7 (24 – 17)Labour hours per unit 3 2Contribution per labour hour $2 $3.50Rank 2nd 1st

Work out budgeted production and salesContribution Total

Product Hours Production per unit contribution$

J (8,000 × 2) 16,000 (÷ 2) 8,000 7 56,000T Balance 24,000 (÷ 3) 8,000 6 48,000______ ______

40,000 104,000______ ____________ ______

1

2

3

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 123




Relevant costs

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

No scarce resource

With scarce resources

Relevant costs are the differential costs between the two options

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

A make or buy problem

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 124


ExampleJoely makes three products and has limited labour time available.

A B C$ $ $

Variable cost of making 10 16 14Variable cost of subcontracting 19 20 19__ __ __Extra variable cost of subcontracting 9 4 5__ __ ____ __ __

Labour hours saved by subcontracting (per unit) 3 2 2Extra variable cost of subcontracting per hour saved $3 $2 $2.50

PRIORITY FOR MAKING IN-HOUSE 1st 3rd 2nd

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 125




Relevant costs

� Whether or not to shut down afactory/department/product line because it ismaking a loss or too expensive to run

� Only relevant fixed costs are directly attributablefixed costs

� The fact that a product makes a positivecontribution is not enough if the fixed costs thatcould be avoided by ceasing production of itexceed contribution

Shut down decisions

� Concerns a contract which would utilise sparecapacity but will have to be accepted at a lowerprice than normally charged

� Generally, an order will be accepted if itincreases contribution and rejected if it reducescontribution

� The effect on other customers and possiblefuture uses of the spare capacity may have tobe considered

One-off contracts

(016) CT10PC_CH16.qxp 17/12/2008 18:23 Page 126

17: CVP analysis

Topic List

Terms and formulae

Breakeven chart

Profit/volume chart

Advantages and limitations of CVPanalysis

CVP analysis enables management to predict howchanges in volume (production output and sales) willimpact 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 canrecall the formulae included in this chapter – make surethat you learn them so that you can apply them whenyou need to.

(017) CT10PC_CH17.qxp 17/12/2008 18:23 Page 127

Terms andformulae

Advantages andlimitations of CVP analysis

Profit/volumechart

Breakeven chart

unitperonContributibreakeventorequiredonContributi

Contribution per unitContribution per unit is unit selling

price – unit variable costs

ProfitProfit is (sales volume × contribution

per unit) – fixed costs

Breakeven point is activity level at which there is neither profit nor loss.

ratio P/VoncontributiRequired

ratio P/Vcosts Fixed

unitperonContributicostsfixedTotal

P/V ratio = Sales

oncontributiRequired

Sales revenue atbreakeven point

Breakeven point

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17: CVP analysisPage 129

� Breakeven point (units) = = 1,800 units

� P/V ratio = 3/15 × 100% = 20% = 0.2

� Breakeven point (revenue) = = $27,000

� Sales volume to achieve profit of $3,300 = = 2,900 units

� Margin of safety (as a %) = × 100% = 40%3,000

1,800– 3,000

$3

3,300)$(5,400 +

0.25,400

12$15$5,400

$–

Fixed costs + target profitThe sales volume to achieve a target profit = _________________________Contribution per unit

ExampleSelling price = $15 per unitVariable cost = $12 per unitFixed costs = $5,400 per annumBudgeted sales pa = 3,000 units

The margin of safetyThe margin of safety is the difference in units between the budgeted sales volume and the breakeven salesvolume. It is sometimes expressed as a percentage of the budgeted sales volume.

(017) CT10PC_CH17.qxp 17/12/2008 18:23 Page 129

Terms andformulae


Profit/volumechart

Breakeven chart

Breakeven chartBreakeven chart shows the approximate level of profit or loss at different sales volume levels within a limitedrange.

� Profit/loss is the difference between thesales revenue line and the total costsline

� The breakeven point is where the totalcosts line and the sales revenue linemeet

$

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17: CVP analysisPage 131

Terms andformulae


Profit/volumechart

Breakeven chart

Profit/volume chartProfit/volume charts are a variation on breakeven charts.They illustrate the relationship of costs and profit to salesand the margin of safety.

� If the x axis is sales units, thegradient of the straight line isthe contribution per unit

� If the x axis is sales value, thegradient of the straight line isthe P/V ratio

� This type of chart showsclearly the effect on profit andbreakeven point of changes inSP, VC, FC and/or salesdemand

(017) CT10PC_CH17.qxp 17/12/2008 18:23 Page 131

Terms andformulae


Profit/volumechart

Breakeven chart

� Only applies to one single product or mix (fixedproportions) of a group of products.

� Assumes that fixed costs and variable costs perunit are the same at all levels of output. This is asimplification.

� Assumes that sales prices will be constant at alllevels of activity. At higher volumes price mayhave to be reduced to win extra sales.

� Production and sales are assumed to be thesame. Changes as in inventory levels are ignored.

� Uncertainty in the estimates of fixed costs andunit variable costs is usually ignored.

Limitations

� In spite of limitations, it is a useful technique forplanning sales prices, desired sales mix, andprofitability.

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

Advantages

The advantages and limitations of CVP analysis

(017) CT10PC_CH17.qxp 17/12/2008 18:23 Page 132

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 firmcommitments are made.

(018) CT10PC_CH18.qxp 17/12/2008 18:24 Page 133

Authorisationand monitoring

What is capitalexpenditure?

InvestmentRevenue expenditure

Capital expenditure

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

statement

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

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

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18: Capital expenditure budgetingPage 135

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

Not part of the doubleentry system

Shows anorganisation’s investment in

capital equipment

Points to note� Capital expenditure over a certain amount will need authorisation

� Asset register must be reconciled to the nominal ledger

� Physical inspections should be carried out

� Asset register should be kept up to date

(018) CT10PC_CH18.qxp 17/12/2008 18:24 Page 135



Details that might be held on an asset register� Description � Sale proceeds

� Date of purchase � Accumulated depreciation account

� Cost � Depreciation expense account

� Accumulated depreciation � Depreciation period

� Depreciation % � Comments

� Depreciation type � Residual value

� Date of disposal � Cost account

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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 projectsare assessed.You must be able to use all of the methodsshown, as well as being able to discuss their advantagesand disadvantages.

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 137

PaybackSteps in projectappraisal

NPV andIRR

Discountedcash flow

Accounting rateof return

� Initial investigation

� Detailed evaluation

� Authorisation

� Implementation

� Project monitoring

� Post-completion audit

Decision-making and control cycle Non-financial factors to consider� Legal issues

� Ethical issues

� Changes to regulations

� Political issues

� Quality implications

� Level of competition

Can all affecta decision!

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19: Methods of project appraisalPage 139

Post-completion auditA post-completion audit is an objective andindependent appraisal of the success of a capitalproject in progressing the business.

� Requires independent and competent staff

� Evaluation of performance against originalobjectives

� Recommendation to improve cost-effectiveness

� Requires communication with staff directlyinvolved in project

Post-completion audit procedures

Better forecasting techniquesBetter future decisionsBetter current decisionsContributes to performance evaluation

Benefits of post-completion audits

��

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 139


NPV andIRR

Discountedcash flow


ARR = Estimated average profitEstimated average investment

� Widely understood measure of accountingprofitability

� Readily available from accounting data

Advantages

� Based on accounting profits rather than cashflow, giving too much emphasis to costs asconventionally defined which are not relevant toproject performance

� Fails to take account of the timing of cashinflows and outflows

Disadvantages

Accounting rate of return

Only use relevant costs when making project appraisal decisions.

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 140


NPV andIRR

Discountedcash flow



PaybackPayback is the time taken for the cash inflows froma capital investment project to equal the cashoutflows, usually expressed in years.

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

� Simple to calculate and understand

� Concentrates on short-term, less risky flows

� Can identify quick cash generators

Advantages

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

Disadvantages

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 141


NPV andIRR

Discountedcash flow


ExampleP Q

$’000 $’000Investment 60 60Year 1 profits 20 50Year 2 profits 30 20Year 3 profits 50 5

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

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 142


NPV andIRR

Discountedcash flow



Discounted cash flow analysis applies discounting arithmetic to the costs and benefits of aninvestment project, reducing value of future cash flows to present value equivalent.

� Cash flows incurred at beginning of projectoccur in year 0

� Cash flows occurring during time periodassumed to occur at period-end

� Cash flows occurring at beginning of periodassumed to occur at end of previous period

Conventions of DCF analysis

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

Discounting

Annuity

Present value of annuity of 1 = r

–nr)(1–1 +

Present value of 1 = nr)(1

1

+

r = Discount raten = number of periods

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 143


NPV andIRR

Discountedcash flow


Net present value (NPV)Net present value is the value obtained bydiscounting all cash flows of project by targetrate of return/cost of capital. If NPV is positive,the project will be accepted, if negative it will berejected.

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

Features of NPV

ExampleYear Cash flow PV factor 12% PV of cash flow

0 (90,000) 1.000 (90,000)1 40,000 0.893 35,7202 40,000 0.797 31,8803 50,000 0.712 35,600______

13,000____________

� This simple layout isnot recommended forcomplex cash flows.See over forrecommended layout

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 144


Year Year Year Year Year0 1 2 3 4

Sales receipts X X X XCosts (X) (X) (X) (X)___ ___ ___ ___ ___Sales less Costs X X X XCapital additions (X)Capital disposals X___ ___ ___ ___ ___

(X) X X X XDiscount factors @Cost of capital (WACC) X X X X X___ ___ ___ ___ ___Present value (X) X X X (X)___ ___ ___ ___ ______ ___ ___ ___ ___

NPV is the sumof present values

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 145


NPV andIRR

Discountedcash flow


Rules of investment appraisal

Include Exclude� Effect of tax allowances � Depreciation� After-tax incremental cash flows � Dividend/interest payments� Working capital requirements � Sunk costs� Opportunity costs � Allocated costs and overheads

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 146


Calculate net present value using rate for cost of capital which

Is a whole number

May give NPV close to zero

Calculate second NPV using a different rate

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

1

2

a

b

a

b

3

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

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 147


NPV andIRR

Discountedcash flow


%A)–(Bb–a

aAIRR ⎟

⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛+=

where

A is lower of two rates of return usedB is higher of two rates of return useda is NPV obtained using rate ab is NPV obtained using rate b

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 148


� Simpler to calculate

� Better for ranking mutuallyexclusive projects

� Easy to incorporate differentdiscount rates

NPV

� More easily understood

� Can be confused with ARR

� Ignores relative size of investments

� May be several IRRs if cash flowsnot conventional

IRR

NPV and IRRcomparison

For conventional cashflows both methods give

the same decision.

(019) CT10PC_CH19.qxp 17/12/2008 18:24 Page 149

Notes

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Notes

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Notes

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Notes

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CAT T10/ FIA - FFM - Finance PassCard

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Transcript of CAT T10/ FIA - FFM - Finance PassCard