Cat t10 Fia FFM Finance Passcard

(000) CT10PC_FP.
qxp
17/12/2008
18:10
Page i
CAT Advanced Paper 10

Managing Finances
(000) CT10PC_FP.qxp
17/12/2008
18:10
Page ii
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
(000) CT10PC_FP.qxp
17/12/2008
18:10
Page iii
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!
Page iii
(000) CT10PC_FP.qxp
17/12/2008
18:10
Page iv
Preface
Contents
Page
1
2
3
4
5
6
7
8
9
10
11
Cash and cash flows

Forecasting cash flows
Cash forecasting techniques
Cash and treasury management
Investing surplus funds
Working capital management
Managing payables and inventory
Managing receivables
Assessing creditworthiness
Monitoring and collecting debts
The banking system and financial
markets
1
9
21
25
29
39
43
51
61
69
83
Page
12
13
14
15
16
17
18
19
Economic influences
Short and medium-term finance
Long-term finance
Financing of small and medium-sized
enterprises
Decision making
CVP analysis
Capital expenditure budgeting
Methods of project appraisal
89
93
103
113
119
127
133
137
(001) CT10PC_CH01.qxp
17/12/2008
18:11
Page 1
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.
17/12/2008
18:11
Cash flow
cycle
Page 2
Cash
transactions
Cash flows
and profits
Accruals
accounting
Need for cash flows
Operating/cash cycle
A business has to ensure it has sufficient cash to

meet its obligations, as well as making profits.
Cycle describes the connection between working

capital and cash movements.
Problem
Although sales are made (and accrued) money may
not be received until after the date suppliers need to
be paid. Bank overdraft facilities may be limited.
Working capital
Current assets Current liabilities
Calculation of operating cycle

Days
Raw material inventory
turnover period
Credit taken from suppliers
Finished goods inventory
turnover period
Receivables payment period
Operating cycle
X
(X)
X
X
__
X
__
__
Page 3
17/12/2008
18:11
Page 3
17/12/2008
18:11
Cash flow
cycle
Cash inflows
Sales of
Sales of
goods
assets
Cash
transactions
Grants
Share capital
Cash flows
and profits
Loans
Accruals
accounting
Sales of
investments
CASH
Cash outflows
Purchases of
inventories,
wages
Page 4
Purchases
of assets
Tax
Dividends
Interest
Purchases of
investments,
foreign
currency
17/12/2008
18:11
Page 5
Capital and revenue items
Exceptional and unexceptional items
Capital items relate to the long-term functioning of

the business, eg purchasing non-current assets.
Exceptional items are unusual, one-off items eg

closure of a business.
Revenue items relate to day-to-day operations, eg

purchasing goods for resale.
Unexceptional items are normal business receipts

and payments.
Net cash flow

The change in cash position from period beginning
to period-end. Analysis is needed of component
elements of net cash flow
Page 5
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
__
__
17/12/2008
18:11
Cash flow
cycle
Page 6
Cash flows
and profits
Cash
transactions
Accruals
accounting
Differences between profits and cash flow

Items affecting profits but not cash flows
Depreciation
Increases in provisions
Cash flows Profit

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

Issued shares/loan notes

Increase in bank overdrafts/loans
Purchase of assets
Depreciation
Profit/loss on sale of non-current assets
Items where profit/loss is

different to cash flow
Purchase of assets
Increase in provisions
Expense accruals and prepayments
Cash received revenue

Cash paid cost of sales
Expense accruals and prepayments
17/12/2008
18:11
Page 7
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
__
__
17/12/2008
18:11
Cash flow
cycle
Page 8
Cash
transactions
Cash flows
and profits
Accruals
accounting
ACCOUNTS ARE NOT PREPARED ON A CASH BASIS, BUT ON AN ACCRUALS (OR EARNINGS) BASIS
eg a sale or purchase is dealt with in the year in which it is made, even if cash changes hands in a later year.
The accruals basis of accounting is described the IASB's Framework for the Preparation and Presentation of
Financial Statements.
'Financial Statements are prepared on the accrual basis of accounting. Under this basis the effects of
transactions and other events are recognised when they occur (and not as cash or its equivalent is received or
paid) and they are recorded in the accounting records and reported in the financial statements of the periods to
which they relate.'
The accruals basis of accounting is a way of letting investors know how much profit a business has made by
matching income and expenditure.
17/12/2008
18:12
Page 9
2: Forecasting cash flows
Topic List
This chapter is one of the most significant.You need to

know how to go about preparing a cash flow forecast,
and comparing actual cash flow with budgeted forecasts.
Cash forecasts
This chapter sets out an appropriate format for preparing

a cash budget and identifying cash needs. It also
summarises the action an organisation can take if it runs
short of cash.
Mark up and margin

Statement of financial position
forecasts
Control reports
Correcting cash deficits
17/12/2008
Cash forecasts
18:12
Mark up
and margin
Page 10
Statement of financial
position forecasts
Control reports
Correcting
cash deficits
Forecasts
Amount of
cash required
When
required
How long
required for
Whether available from

anticipated sources
Cash flow-based forecasts
Banks
In receipts and payments format
Banks often insist businesses provide:
Monthly/quarterly cash budgets
Cash forecasts
Business plans
Actual flows against original budget

Revised budget/rolling budget
Actual flows against revised budget
Cleared funds forecast showing funds available
for spending
Banks can monitor progress/control lending using

these.
17/12/2008
18:12
Page 11
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a
way as to show the forecast cash balance of a business at defined intervals.
Enables management to make

forward planning decisions
Overdraft
Investments
Sort out cash receipts

from customers
Establish materials inventory

changes quantity and cost of
materials purchases
Establish whether any

other cash income will
be received
Establish when suppliers will be

paid
Page 11
Sort out cash payments

to suppliers
Establish when any other

cash payments will be
made
Credit control
Bottom of budget must

show
Net cash flow
Opening position
Closing position
Cash forecasts
17/12/2008
18:12
Mark up
and margin
Page 12
position forecasts
Control reports
In more complex cash forecasts, the assumptions made are critical.

Credit terms given by suppliers
Specific supply arrangements
Past practice
Payments
Predictable dates
Volume of purchases
Volume of sales
Cash/credit sales mixture
Specific credit terms
Receipt patterns
Discounts allowed
Receipts
Correcting
cash deficits
17/12/2008
18:12
Page 13
PROFORMA CASH BUDGET

Cash receipts
Receipts from customers
Loans etc
Cash payments
Payments to suppliers
Wages etc
Net cash flow (receipts payments)

Opening balance
Closing balance
Page 13
Month 1
$
Month 2
$
Month 3
$
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
17/12/2008
Cash forecasts
Mark up
Mark up
and margin
18:12
Page 14
position forecasts
Control reports
Profit element as fraction of cost
Profit element as fraction of selling price
Margin
Correcting
cash deficits
Sales
Mark up
Costs
%
100 + x
x
100
Sales
Margin
Costs
%
100
y
100 y
Example
Example
Cost price 80 Profit 20 Selling Price 100
What is the unit sales price if unit cost price is $25 and margin is 20%?
Mark up =
Margin =
20 80 = 25%
20 100 = 20%
Sales price =
25
(1 0.2)
= $31.25
17/12/2008
Cash forecasts
18:12
Mark up
and margin
Page 15
position forecasts
Control reports
Correcting
cash deficits
Statement of financial position forecasts

A statement of financial position forecast is used to identify the cash surplus or funding shortfall in a
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
Page 15
Net
assets
(excl cash)
Cash
surplus
Net
>
assets
(excl cash)
Share capital
+ Reserves
Cash
deficit
Cash forecasts
17/12/2008
Mark up
and margin
18:12
Page 16
position forecasts
Control reports
Correcting
cash deficits
Estimating a future statement of financial position

Intangible non-current assets:
Current value
Tangible non-current assets:
Need to estimate purchases and disposals
Current assets: Same
/ by %
% of revenue
Trade payables/accruals: As current assets

Bank overdraft: Assume none

Taxation/dividends: % of profits
LT loans: Existing Repayments
Share capital: Same
Retained profits: Estimate future profits
Cash forecasts
17/12/2008
18:12
Mark up
and margin
Page 17
position forecasts
Control reports
Correcting
cash deficits
Current forecast v original forecast

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

Poor forecasting
Loss of major customer
Insolvency of credit customer
Changes in interest rates
Inflation
Cash forecasts
Cash receipts
Revenue
Cash payments
Material
Labour
Overheads
Non-current assets
Net cash flow

Opening balance
Closing balance
17/12/2008
18:12
Mark up
and margin
Page 18
position forecasts
Control reports
Correcting
cash deficits
Budget
$
Month
Actual
$
Difference
$
Budget
$
Year to date
Actual Difference
$
$
X
__
X
__
__
X
__
X
__
__
X
__
X
__
__
X
__
X
__
__
X
__
X
__
__
X
__
X
__
__
X
X
X
X
__
X
__
__
X
X
X
X
__
X
__
__
X
X
X
X
__
X
__
__
X
X
X
X
__
X
__
__
X
X
X
X
__
X
__
__
X
X
X
X
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
__
X
__
__
X
X
__
X
__
__
X
X
__
X
__
__
__
X
__
__
Cash forecasts
17/12/2008
18:12
Mark up
and margin
Page 19
position forecasts
Losses
Asset replacement
Growth support
Seasonal business
One-off expenditure
Short-term borrowing
Sale of short-term investments
Reduce costs
Reduce inventory levels
Reduce receivables
Increase payables
Page 19
Correcting
cash deficits
Cash flow problems

Longer-term solutions
Short-term remedies

Control reports

Postpone capital expenditure

Sell non-essential assets
Reschedule loan repayments
Change terms of business
Reduce dividend payments
Increase selling and marketing activity
17/12/2008
18:12
Page 20
Notes
17/12/2008
18:13
Page 21
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.
17/12/2008
18:13
Page 22
Index
numbers
Index
A measure over time of the average changes in
values of a group of items. Indexes can be used to
predict inflows and outflows and hence future
borrowings.
Index numbers are expressed as percentages,
taking the base date value as 100.
Sensitivity
analysis
Weightings
An index normally consists of more than one item,
therefore weightings are needed to reflect the
relative importance of each item.
1 Calculate price relative (price of item as % of
price in previous period).
2 Calculate weightings.
3 Multiply price relative by weighting.
4 Calculate index numbers by dividing total of 3
for all items by total for previous period.
17/12/2008
18:13
Page 23
Price index
Quantity index
A price index measures the change

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

change in the non-monetary values
of a group of items over time.
Base period is usually the
starting point of a series.
Price index = 100
P1
P0
Price in base period

Quantity in base period
Quantity index = 100
Q1
Q0
Base period index = 100

Also known as base year
Page 23
3: Cash forecasting techniques
17/12/2008
18:13
Page 24
Index
numbers
Sensitivity
analysis
Sensitivity analysis
Sensitivity analysis is a modelling and risk assessment procedure in which changes are made to significant
variables in order to determine the effect of these changes on the planned outcome.
Significant variables
Other methods of uncertainty analysis

Preparing a series of different forecasts, each

assuming a different outcome
Changes in capacity
Material/labour costs
Labour availability
Sales volume
Productivity
Seasonally adjusted data

Additive model: Y = T + S + I
Multiplicative model: Y = T x S x I
Where: T = Trend series
S = Seasonal component
I = Irregular random component
Preparing cash forecasts as range of possible

outcomes
Using probability analysis by assigning
probabilities to a range of values for key
uncertain cash flow items
17/12/2008
18:14
Page 25
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.
17/12/2008
18:14
Page 26
The focus of cash

management
Focus of cash management
Inventory
approach
Treasury
management
Float
Time between payment being initiated and funds becoming
available for use.
Profitability
Transmission delay + lodgement delay + clearance delay
Liquidity
Reducing float
Safety

Minimum lodgement delay (bank receipts when received)

Collecting cheque from customer
Use of bank giro system
BACS/CHAPS
Standing order/direct debits
17/12/2008
18:14
Page 27
The focus of cash

management
Inventory approach
2FS
i
Treasury
management
Problems with inventory approach
Baumol's model seeks to minimise cash holding

costs by calculating optimal amount of new funds
to raise.
Q=
Inventory
approach
where S is the amount of

cash used in period
F is the fixed cost of
obtaining new funds
i
Amounts required in future are difficult to

predict
Costs associated with running out of cash
Holding costs may vary with amount held
Model doesnt work very well for large,
irregular flows
Difficulty in predicting future interest rates
is the interest cost of

holding cash
Q is the total amount

to be raised to
provide for S
Page 27
4: Cash and treasury management
17/12/2008
18:14
Page 28
The focus of cash

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

Employ experts
Smaller precautionary balances
Focus on profit centre
Treasury
management
Role of treasurer

Centralised treasury management

Inventory
approach
Corporate financial objectives

Liquidity management
Funding management
Currency management
Corporate finance
Others, eg taxation
Decentralised treasury management

Finance matches local assets

Greater autonomy for subsidiaries
More responsive to operating units
No opportunities for large sum speculation
17/12/2008
18:15
Page 29
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.
Cash
surpluses
17/12/2008
Cash
investments
18:15
Page 30
Marketable
securities
Liquidity
Government and
local authority stocks
Safety
Other
investments
Risk and
return
Profitability
Cash management
Cash for normal business
commitments
Transactions motive
Cash
Buffer for unforeseen

contingencies
Balances held in hope
interest rates
Precautionary motive
One-off dividends
Speculative motive
Surplus
Cash for growth, noncurrent asset purchases,

acquisitions
Increasing annual dividends
Strategic motive
Buying back own shares
Shareholders
Cash
surpluses
17/12/2008
Cash
investments
18:15
Marketable
securities
Page 31
Government and
Other
investments
Risk and
return
Interest bearing accounts
Option deposits
Banks and building societies provide various interest

bearing accounts, including current accounts, cheque
accounts and deposit accounts.
Option deposits are for predetermined periods of

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

CAR =
X n
1 + 1
n
Guidelines for investment

100
Where X is the annual rate specified

(eg 0.0525 = 5.25%)

Certain investments allowed/prohibited

All investments convertible into cash
Certain proportion invested in lower risk items
Credit rating obtained for certain investments
n is number of times in year interest is paid

(eg 4 = quarterly/12 = monthly)
Page 31
Cash
surpluses
17/12/2008
Cash
investments
18:15
Marketable
securities
Page 32
Government and
Other
investments
Risk and
return
Attractiveness of interest
Risk of non-payment
Price of fixed interest stocks
Length of time to redemption/maturity

Accrued interest
Cum div (int) or Ex div (int)
Interest yield =
Coupon rate
Market price
Gross redemption yield

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

of income and capital appreciation.
Cash
surpluses
17/12/2008
Cash
investments
18:15
Marketable
securities
Gilts
Gilts are marketable British government securities,
which dominate the fixed interest market.
Convertible gilts
Convertible gilts are gilts redeemable on date
shown or convertible into longer-dated stock.
Page 33
Government and
Other
investments
Risk and
return
Shorts
< 5 years
Mediums
5 15 years
Longs
> 15 years
Undated
Irredeemable/one-way options
Index linked
Interest and redemption value

linked to rate of inflation. Interest
is adjusted by RPI value 8
months before payment date.
Local authority stocks

Local authority stocks are similar to government
securities, but security isnt considered as good
and the market is less active. They are held by a
few institutions.
Page 33
Cash
surpluses
17/12/2008
Cash
investments
18:15
Marketable
securities
Certificates of deposit
Certificates of deposit are negotiable instruments
providing evidence of a fixed term deposit with a
bank.

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
Page 34
Government and
Other
investments
Risk and
return
Commercial paper
Commerical paper is an unsecured short-term (3
months) loan note issued by companies.
They are traded at a discount and unsecured,
therefore they are risky.
17/12/2008
18:15
Page 35
Bills of exchange
Bill is drawn on company/person being ordered to
pay.
Drawer orders payment of money.
Drawee is the party who is to pay.
Payee receives funds:
Discounting bills
Holder of the bill
Presents bill on maturity, or
Sells bill before maturity at discount depending
on credit quality of drawee and market condition
for bills
Unconditional orders to pay

Negotiable instruments
Types of bill
Trade bills
Bank bills
Page 35
Drawn by one non-bank on another;

to be tradeable both must have high
credit ratings
Basis of trading
Interest rate
basis
Principal sum lent, borrower

repays principal plus interest at
maturity
Discount
basis
Specified sum payable at

maturity
Drawn and payable by banks

Cash
surpluses
Political and
economic climate
17/12/2008
Cash
investments
18:15
Marketable
securities
Inflation
Page 36
Government and
Products
Competition
Risk
Income
Capital
Government securities
RISK
Other
investments
Company loans notes

Preference shares
Ordinary shares
Risk and
return
Management
17/12/2008
Types of risk
18:15
Page 37
Risk and return
Systematic risk caused by factors

affecting the whole market
Unsystematic risk security/sectorspecific risks
Diversification
The reduction of risk by investing in a
range of securities.
Page 37
17/12/2008
18:15
Page 38
Notes
17/12/2008
18:15
Page 39
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.
17/12/2008
18:15
Page 40
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
17/12/2008
18:15
Page 41
Working capital
Current ratio =
Current assets
Acid test/quick ratio =
Current liabilitie s
Accounts receivable days =
Trade receivables
Credit sales
Inventory turnover period =
Average inventory
Cost of sales
Inventory turnover =
Working capital
ratios
Overtrading
Current assets less inventories

Current liabilities
365 days
Accounts payable
Average payables
payment period =
365 days
Purchases on credit
365 days
Average inventory
Cost of sales
Over-capitalisation is where there are excessive inventory, receivables and cash and very few payables. The
funds tied up could be invested profitably.
Page 41
6: Working capital management
17/12/2008
18:15
Page 42
Working capital
Working capital
ratios
Overtrading
Overtrading occurs when a business is trying to support too large a volume of trade with the capital resources
at its disposal.
Symptoms
Solutions
revenue
Finance from share issues
current assets
Better inventory and receivables control
non-current assets
Postpone expansion plans
Assets financed by trade payables/bank

overdraft
Maintain/increase proportion of long-term

finance
Little/no in proprietors capital

current/quick ratios
17/12/2008
18:16
Page 43
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.
17/12/2008
18:16
Trade payables
Management of
trade payables
Methods of
payment
365
t
JIT and
purchasing mix
Extending credit if cash short

Good relations/loss of goodwill if payment delayed
Example
X Co owes its supplier $1,000, it can either pay
$1,000 in 45 days time or $980 in ten days time.
It can invest funds at 25% interest.
where d is % discount
t is reduction in payment
period in days necessary
to obtain early discount
Inventory costs
Obtaining satisfactory credit levels/terms
Cost of lost cash

discounts
100
100 - d
Page 44
Cost cash discount: $980

Consider also
interest gained
through having
monies for full
period.
35
25% = 23.5
365
Cost: Accept discount $980

Refuse discount ($1,000 $23.5) = $976.5
It is cheaper to refuse the discount, invest the money
and pay after 45 days.
17/12/2008
18:16
Page 45
Trade payables
Methods of
payment
Inventory costs
JIT and
purchasing mix
Cash
Cheques
Standing orders
Small payments/wages
Commonly used and widely

accepted
Regular payments of fixed

amounts
Keep secure
Convenient
HP payments
Easily lost
Counterfoil/cheque number
can be traced
Rental payments
Lack of payment evidence
Keep secure
Insurance premiums
Slow method of payment
BACS
Telegraphic transfers
Direct debits
Payment information sent to BACS

for processing. Most commonly
used for salaries, can be used for
suppliers.
Large payments made

immediately.
Deductions from bank account,

regular and irregular payments of
fixed and varying amounts.
Recipient sets the amount.
Page 45
17/12/2008
18:16
Trade payables
Page 46
Methods of
payment
Inventory costs
JIT and
purchasing mix
Economic order quantity (EOQ)
Safety inventory
EOQ is the optimal ordering quantity

for an item of inventory which will
minimise costs.
Safety inventory is held when demand is uncertain or supply

lead time is variable.
EOQ =
2C O D
CH
Average annual
=
safety inventory cost
Safety
quantity
Annual unit
holding costs
Exam
formula
D = Usage in units
CO = Cost of placing one order
CH = Holding cost
EOQ= Economic order quantity
Bulk discounts
Total cost will be minimised:
At pre-discount EOQ level, so that discount not worthwhile or
At minimum order size necessary to earn discount
Calculate: Purchasing costs + Holding costs + Ordering costs
Page 47
17/12/2008
18:16
Page 47
17/12/2008
18:16
Trade payables
Page 48
Methods of
payment
Inventory costs
JIT and
purchasing mix
Inventory costs
Holding costs
Procuring costs
Shortage costs

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

Emergency inventory
Stock-out costs
Average inventory
= Minimum level (Reorder level 2)
17/12/2008
18:16
Trade payables
Page 49
Methods of
payment
Just-in-time (JIT) procurement
Purchasing mix
Page 49
JIT and
purchasing mix
Benefits of JIT
JIT describes a policy of obtaining goods from

suppliers at the latest possible time. It avoids the
need to carry materials/component inventory.
Quantity
Quality
Price
Delivery
Inventory costs

Inventory costs
Manufacturing lead times
Labour productivity
Labour/scrap/warranty costs
Material purchase costs (discounts)
Number of transactions
Balance between holding, and ordering stock-out costs

Good enough for production/customers
Best value over time
Lead time and reliability
17/12/2008
18:16
Page 50
Notes
17/12/2008
18:17
Page 51
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?
Credit
control
17/12/2008
Total
credit
18:17
The credit
cycle
Page 52
Payment
terms
Settlement
discounts
Legal
aspects
May report to
17/12/2008
Chief
Accountant
18:17
Page 53
Sales
Manager
Managing
Director
Finance
Director
CREDIT CONTROL DEPARTMENT

Duties
Page 53
Updating
receivables
ledger
Customer
queries
Liaison with
sales staff
Third party
references
Checking
creditworthiness
Advising on
payment terms
Credit
control
17/12/2008
Total
credit
18:17
The credit
cycle
Page 54
Payment
terms
Settlement
discounts
Legal
aspects
Trade credit
Monitoring total credit
Credits issued by one business to another

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

Report shows extent to which total limits being utilised,
indicating number of customers who might want more
credit, and extent of exposure to receivables.
Profit
17/12/2008
18:17
Cash flow
Page 55
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.
Page 55
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
Credit
control
17/12/2008
Total
credit
18:17
The credit
cycle
Page 56
Payment
terms
Settlement
discounts
Legal
aspects
Credit
control
17/12/2008
Total
credit
18:17
Page 57
The credit
cycle
Payment
terms
Settlement
discounts
Legal
aspects
Terms and conditions of sale

Profit required from customer
Competitors credit terms
Special factors relating to customer
Risk of default
Seasonal factors
Methods of payment

Cash
BACS
Cheques
Bankers draft
Travellers cheque
Page 57

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

Standing order
Direct debit
Credit/debit card
Bills of exchange

Specified number of days after delivery

Weekly/half monthly/monthly credit
CWO Cash with order
CIA
Cash in advance
COD Cash on delivery
CND Cash on next delivery
Credit
control
17/12/2008
Total
credit
18:17
Page 58
The credit
cycle
Advantages of early settlement discounts
Settlement
discounts
Payment
terms
Legal
aspects
Cost of early settlement discount
Encourage customers to pay earlier and thus

reduce financing costs
100
100 D
Improve liquidity
Encourage customers to buy
365
T
1 %
where D = Discount offered

T = Reduction in payment period necessary
to obtain discount
Example
Henry Co is considering a 2% discount to all customers paying within 30 days.
365
100 30
1 % = 27.86%
Cost of early settlement discount =
100 2
Credit
control
17/12/2008
Total
credit
18:17
The credit
cycle
Contract
An agreement which legally binds parties. Validity of
a contract affected by:

Content complete and precise

Form certain contracts in precise form
Genuine consent
Legality
Capacity some parties have restricted capacity
Page 59
Payment
terms
Settlement
discounts
Legal
aspects
Essential elements of a contract

Legal relations (intention)
Offer and acceptance
Consideration (the price paid in exchange for a
promise)
Breach of contract
When one of the parties fails to perform. Remedies:
Damage
Termination
Quantum meruit (value for work done)
Page 59
Specific performance
Action for the price (recovery of agreed sum)
Credit
control
17/12/2008
Total
credit
18:17
The credit
cycle
Sale of goods
Page 60
Payment
terms
Settlement
discounts
Legal
aspects
Failure to pay
Sale of Goods Acts govern sale of goods.

Key conditions:
Goods can be stopped in transit
Title passes on delivery even if payment delayed
Lien by seller if goods not passed (retain on

sellers premises if not delivered)
Title passes on sale or return goods when buyer

accepts
If conditions imposed, must be fulfilled
Length of credit stated in contract (failure to pay

= breach of contract)
Charge interest on late payments
Retention of title clauses (ownership does not
pass until payment is received)
17/12/2008
18:18
Page 61
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.
Credit
assessment
17/12/2008
References
Financial
analysis
18:18
Page 62
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.
Credit
assessment
17/12/2008
References
18:18
Financial
analysis
Bank references
Should ask in precise terms Do you consider X Co
to be good for a trade credit of $1,000 per month on
terms of 30 days?
Trade references
Page 63
Visits
Other
information
Using
information
Data
protection
Types of bank reference

Undoubted
BEST
Considered good for your figures

Respectably constituted business which
should prove good for your figures
Referee should be offering similar terms
Respectably constituted business whose

resources would appear to be fully
employed; we do not think they would
undertake something they felt they could
not fulfil
References should be followed up
Unable to speak for your figures
Remember
Customer may maintain untypically good
relations with referees
WORST
Unknown companys reference should be treated

with caution
Page 63
Credit
assessment
17/12/2008
References
18:18
Financial
analysis
Page 64
Visits
Other
information
Using
information
Data
protection
Ratio analysis
Profit margin =
Profit
Revenue
Net asset turnover =
Gearing =
Revenue
Capital employed
Return on capital employed =
Profit
Capital employed
Earnings per share =

Profit attributable to ordinary shareholders
Number of ordinary shares
Prior charge capital

Equity
Interest cover =
Debt ratio =
Profit before tax and interest

Finance (interest) charges
Total liabilitie s
Total assets
Price earnings ratio =
Market price per share

EPS
Working capital ratios (see Chapter 6)

Remember that the credit controller is predominantly interested in the indicators of future cash flow (liquidity,
gearing, working capital). Financial information has limits because it is historical.
Credit
assessment
17/12/2008
References
Financial
analysis
18:18
Page 65
Visits
Credit controller
Premises
Treatment of
visitors
Using
information
Data
protection
Customer
Accounts
department and
accounts payable
and receivable
departments
Well run
Proper
recording
Proper filing
Page 65
Other
information
Payment methods
Overall impression
Prosperous
Slow-moving stock
Signs of decay/
obsolescence
Credit
assessment
17/12/2008
References
18:18
Financial
analysis
Page 66
Visits
Other
information
Using
information
Data
protection
Credit reporting agencies (credit bureaux)

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

Lack of information on new businesses
Contents of agency report
Other information
Legal data

Commercial data
Credit data (References agency assessment)
Press
Historical, financial data
Companies Registry search
County Court records
Credit
assessment
17/12/2008
References
Financial
analysis
18:18
Page 67
Visits
Other
information
Using
information
Data
protection
Credit control information should be used in various ways.
1 Granting credit
Information used to decide

Whether to grant request in entirety
Whether to grant request provisionally subject to later review
Whether to give less generous terms than the customer wants
2 Credit ratings
Need for reliable credit ratings and details of credit taken

Invoices and receipts posted immediately
Queries cleared quickly
Orders vetted against credit limits
Customer history
3 Credit reviews
Overall review of payment record and aged analysis, high risk

customers reviewed more frequently
Page 67
Credit
assessment
17/12/2008
References
18:18
Financial
analysis
Page 68
Visits
Data Protection Act 1998

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

Apply to paper-based/microfilm/microfiche
systems
Conditions under which processing is
lawful prescribed
Processing of personal data forbidden
unless subject consents/legal obligation
Processing of sensitive (racial, political,
religious) data forbidden without consent
Data subjects must be told reasons for
data processing
17/12/2008
18:19
Page 69
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.
Credit monitoring
Monitoring
receivables
17/12/2008
18:19
Insurance, factoring
and discounting
Page 70
Collecting
debts
Bad and
doubtful debts
Third
party use
Bankruptcy
and insolvency
Efficient administration
Prompt dispatch of statements/invoices,

recording and banking receipts
Individual customers
Initial credit ratings, customer history,

regular review of high risks
Ratio analysis
Overdues/disputes as % of total debts,

average payment period
Credit utilisation report
Who might want more credit, tightness of

credit policy, exposure to debt
Aged receivables
analysis
Balance and periods unpaid.

Accounts/customer types highlighted
17/12/2008
18:19
Page 71
Aged receivables analysis

Account
No
Customer
name
Balance
<30
3060
Days
6090
>90
Reports can highlight:

Overdue accounts
Sales revenue and days sales outstanding
Aggregate for customer classes eg region or industry sector
Page 71
Monitoring
receivables
17/12/2008
and discounting
18:19
Page 72
Collecting
debts
Bad and
doubtful debts
Third
party use
Bankruptcy
and insolvency
Credit insurance
Types of policy
Insurance may be obtainable from a specialist credit

insurance firm.
Whole turnover policy Up to 80% of entire

receivables ledger
Insurance will be assessed on a customer-bycustomer basis
Annual aggregate
excess of loss
All debts above a

certain amount
Insurance company will only insure up to 75% of

potential bad debt loss if insurance covers whole
receivables ledger
Specific customer
amount
Payable if specific
customer becomes
insolvent
Insurance company will review

Accounts receivable reports
Credit control and debt collection procedures
Sales administration
17/12/2008
18:19
Page 73
Factoring
Factoring is debt collection
by factor company which
advances proportion of
money due.
Factor company
Benefits of factoring finance
Pay suppliers promptly

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

accounting and debt collection service
Credit protection for clients debts
Factor finance, payments in advance
However, use of a factor may give a negative image
of the organisation to the customer
Invoice discounting
Invoice discounting is the sale of debts for
discount in return for cash. The customer is
unaware of the discounters involvement and
continues to pay the supplier.
Monitoring
receivables
17/12/2008
and discounting
18:19
Page 74
Collecting
debts
Bad and
doubtful debts
Invoicing

Customer fully aware of terms

Invoice correct and issued promptly
Knowledge of customers system used
Queries resolved quickly
Monthly statements issued promptly
Third
party use
Customer awareness of terms

Payment dates and terms discussed during
initial negotiations
Customer agreement to terms
Payment terms stated on order, invoice,
monthly statement
Chasing slow payers

Reminders or final demands

Telephone calls
Personal approach
Notify debt collection section
Legal action
External debt collection agency
Bankruptcy
and insolvency
Monthly statements

New invoices
Cash received
Outstanding balance due
Age analysis
Payment reminder
17/12/2008
18:19
Page 75
Customer payment systems
Key account customers
Invoice and payment runs on monthly basis
Some customers are treated with special attention in

sales effort. Credit control will involve
Only pay certain amount each month

Only pay when sent reminder
Only pay when legal action threatened
Senior staff time

Specific request for payment
Receipts on long-term contracts

Take place over a number of years

Precise terms
Third party verification of work done
Progress payments
Page 75
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.
Monitoring
receivables
17/12/2008
and discounting
18:19
Page 76
Collecting
debts
Bad and
doubtful debts
Third
party use
Bankruptcy
and insolvency
Methods of chasing customers
Reasons for short/non-payment
Value of debt
Invoices not entered on system in time for

payment run
High
Personal visit
Telephone
Low
Disputed amounts
Fax
Short payment agreed with sales department
E-mail
Deliberate under payment
Letter
Accounts of most importance
Largest outstanding balances

Largest arrears
No recent payments
Monitoring
receivables
17/12/2008
18:19
and discounting
Collecting
debts
Bad debt
Bad and
doubtful debts
Third
party use
Bankruptcy
and insolvency
Doubtful debt
Bad debt is a debt which is considered to be

uncollectable and is written off against the income
statement or doubtful debts provision.
Bad debts ratio =

OR =
Bad debts
100%
Sales on credit
Bad debts
100%
Total receivables
Bad debt report will give details of when original debt

arose and when the debt was written off.
Page 77
Page 77
Doubtful debt is a debt for which there is some

uncertainty as to whether it is bad.
Doubtful debt provision

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

Consider
Success of attempts to collect debt
Expenses of pursuing debt
Likelihood of insolvency proceedings
Monitoring
receivables
17/12/2008
and discounting
18:19
Page 78
Collecting
debts
Bad and
doubtful debts
Third
party use
Personal customers
Changes in payment patterns

Requests for credit extension
Court action
Failure to communicate/reply
Business customers
Loss of major customer

Bankruptcy of own customers
Disaster
Industrial action
Slower payment
Other suppliers having payment difficulties
Signs of slow business
Newspaper reports
County Court judgements
Credit vetting agency reports
Bouncing cheques
Bankruptcy
and insolvency
17/12/2008
18:19
Page 79
Financial signs
Warning signs in accounts, poor ratios, Z scores, imprudent accounting policies, also accounts being filed late.
A Scores Defects
Dominance by single individual

Directors lack broad expertise
Weak Finance Director
Lack of management depth below board level
Poor accounting systems
Lack of responsiveness to change
Mistakes
Over-borrowing
Over-trading
Over dependent on single project
Symptoms
Financial signs (see above), Z-scores in decline

Non-financial signs (eg fall in market share)
Page 79
Monitoring
receivables
17/12/2008
and discounting
18:19
Page 80
Collecting
debts
Bad and
doubtful debts
Third
party use
Debt collection agencies
Court action
Agencies receive a percentage of debts collected.

Some collect on letter/telephone basis, others collect
on the doorstep.
Before taking action, check:
Arbitration agreement
An arbitration agreement is a written agreement to
submit differences to arbitration. The arbitrator will
try and settle differences.
Proceedings are less formal, quicker and cheaper
than litigation.
However, arbitration may be means of delay, and
arbitrator may have insufficient powers.
Bankruptcy
and insolvency
Genuine debt not dissatisfied customer

Exact identity of customer
Customers financial resources
The amount owed, type of transaction, and public
interest issues will determine court used.
Monitoring
receivables
17/12/2008
18:19
and discounting
Page 81
Collecting
debts
Bad and
doubtful debts
Third
party use
Bankruptcy
and insolvency
Bankruptcy
Insolvency
Bankruptcy is the legal status of an individual

against whom an order has been made by the court
because of an inability to meet financial liabilities.
Insolvency is the inability of a debtor company to

pay its debts when they fall due.
Creditors demand payment and petition for

bankruptcy.
Company may suffer liquidation/winding-up (similar

procedures to bankruptcy) or receivership (receiver
appointed to obtain money by realising assets).
Debtor cannot dispose of property/settle legal claims.

Official receiver appointed to investigate/realise
assets.
Company may be able to use alternative procedures

(administration, voluntary arrangements) depending
on legal jurisdiction in an attempt to keep trading.
Assets realised and creditors paid in order of

preference.
Page 81
17/12/2008
18:19
Page 82
Notes
17/12/2008
18:19
Page 83
11: The banking system and financial

markets
Topic List
The banking system
Financial markets
This chapter provides the knowledge you need of the

banks and the markets on which organisations might
raise long-term funds.
17/12/2008
18:19
Page 84
The banking
system
Financial intermediation

Financial intermediation is the bringing together of

providers and users of finance.
Commercial banks
The retail (High Street) and wholesale banks
Payments mechanism
Wealth store
Providers of funds
Financial
markets
Convenient means of saving money

Aggregating amounts lent for borrowing
Pooling reduces risk
Maturity transformation
Other financial intermediaries

Building societies
Finance houses
Insurance companies
Pension funds
Unit trusts
Investment trust companies
17/12/2008
Bank assets
Page 85
Bank liabilities
Notes and coin

Bills
Money market loans
Customer loans and overdrafts
Securities
$
X
X
X
X
X
__
X
__
__
Bank income
Interest received
Current account charges
Commissions and fees
Foreign exchange
Mortgages
Page 85
18:19
Sterling current accounts

Sterling deposit accounts
Other currency deposits
$
X
X
X
__
X
__
__
Bank expenses
$
X
X
X
X
X
__
X
__
__
Interest paid
Running costs
Wages/salaries
Advertising
Bad debts
$
X
X
X
X
X
__
X
__
__
11: The banking system and financial markets
17/12/2008
18:19
Page 86
The banking
system
Central bank
European central bank
A central bank controls the money supply of a country.
Roles of central bank

Financial
markets
Banker to central government

Issuer of bank notes
Supervises government borrowing
Intervenes in foreign exchange markets
Banker to commercial banks
Lender of last resort
Adviser on economic policy
Agent of government
Participant in international institutions
ECB supervises monetary policy in Euro area, trying

to ensure price stability by influencing interest rates.
ECB also imposes reserve requirements on credit
institutions.
The Eurosystem consists of ECB and central banks of
countries that have adopted the Euro.
Role of Eurobanks
Conducting foreign exchange operations
Issuing bank notes
Promoting smooth operation of payment
systems
Collecting and providing information
17/12/2008
18:19
Page 87
The banking
system
Financial
markets
Money markets
Capital markets
Money markets are operated by banks/financial

institutions and provide means of trading, lending
and borrowing in the short-term.
Capital markets are markets for trading in long-term

financial instruments, in particular shares and bonds.
They enable organisations to raise new finance,
investors to realise investments and companies to
merge/takeover.
Main short-term markets

Primary
Interbank
Eurocurrency
Certificate of deposit
Local authority
Finance house
Inter-company
Page 87
Main money market instruments

Deposits
Bills
Commerical paper
11: The banking system and financial markets
17/12/2008
18:19
Page 88
The banking
system
Financial
markets
Capital market participants

Demand for funds
comes from ...
INDIVIDUALS
(eg housing/consumer
goods finance)
FIRMS
(share capital; loans)
GOVERNMENT
(budget deficit)
Capital markets
Intermediaries
Banks
Building societies
Insurance companies
and pension funds
Unit trust/investment
trust companies
Stock exchanges
Venture capital organisations
Suppliers
of funds
INDIVIDUALS
(as savers and investors)
FIRMS
(with long-term funds to
invest)
GOVERNMENT
(budget surplus)
17/12/2008
18:20
Page 89
12: Economic influences
Topic List
This chapter examines the major economic influences on the

finance available to organisations.
Interest rates
Capital markets and government policy are both very

important in determining the conditions facing businesses
and the availability (and cost) of finance.
Economic policies
17/12/2008
18:20
Page 90
Interest
rates
Factors affecting interest rates

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

all rates

Need for a real return

Inflation/expectations
Government borrowing
Demand for individuals' borrowing
Balance of payments uncertainty
Monetary policy
Foreign interest rates
Economic
policies
Real rate of interest

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

The nominal rate of interest is the rate of interest
expressed in money terms.
Real rate of interest = 1 + nominal rate of interest - 1
1 + rate of inflation
17/12/2008
18:20
Page 91
Interest
rates
Monetary policy
Regulation of the economy through
control of money supply/interest rates.
Increases in the money supply
Government prints more notes/
coins
Government spends more than it
raises
Banks and building societies lend
more money
Money from abroad enters UK
accounts
Page 91
Economic
policies
Reserve requirements
A proportion of a 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
Interest rate policy

Higher interest rates should reduce demand for borrowing,
leading to less consumer demand/increased finance costs.
12: Economic influences
17/12/2008
18:20
Page 92
Interest
rates
Fiscal policy
Fiscal policy is government spending money or
collecting taxes.
It can be a means of demand management and
inflation control.
Inflation
Inflation is a sustained increase in the general level
of prices over time.
Economic
policies
Problems of inflation
Redistribution of wealth (those on fixed
incomes suffer)
Balance of trade (exports fall as more
expensive, imports rise as cheaper)
Inefficient resource allocation (as real meaning
of prices is unclear)
Cost of frequently changing prices
(administration, seeking out lowest prices)
Reduced investment in the economy (if interest
rates rise to counter inflation)
General uncertainty
17/12/2008
18:21
Page 93
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.
17/12/2008
Bank/customer
relationship
18:21
Bank lending
criteria
Page 94
Overdrafts
Medium and
long-term loans
Leases
Liquidity maintenance
Operational functioning
(pay salaries, suppliers)
Minimise risk of losing

finance sources
Guard against
unexpected movements
Overdraft facility repayable on demand

Term loan fixed repayment period, interest charged
Bank facilities
Committed facility stipulated amount made available on

demand
Uncommitted facility paperwork for lending is completed in
advance. No obligation to lend
Revolving facility renewable after a set period
Acceptance facility for bills of exchange
Debtor/
creditor
17/12/2008
18:21
Bailor/
bailee
Page 95
Mortgagor/
mortgagee
Principal/
agent
also a FIDUCIARY relationship (to act in good faith)

Bank duties

Honour cheques
Receive funds
Repay on demand
Comply with customer instructions
Provide a statement
Confidentiality, care and skill
Advise of forgeries
Page 95
Customer duties
Duty of care to deter fraud
Advise of forgeries
17/12/2008
Bank/customer
relationship
18:21
Bank lending
criteria
Page 96
Overdrafts
Medium and
long-term loans
Leases
Character
Past record
Interviews
Credit scoring/ratio analysis
Ability to borrow and repay
Legal capacity
Re-investment of retained profit
Problems (declining profits, overtrading, poor working capital control)
Margin of borrowing
Purpose of borrowing
At fixed or discretionary rate
Amount of borrowing
Repayment terms
Insurance
Not too much (may not repay) or too little (may want more later)
May be cautious if purpose to finance new business venture/working

capital increase
Timescale and instalments

Security easy to take, value, realise
Personal guarantees
17/12/2008
Bank/customer
relationship
Overdrafts
Page 97
18:21
Bank lending
criteria
Page 97
Overdrafts
Medium and
long-term loans
Leases
Amount
Should not exceed limit, bank will want hard core reduced
Margin
Interest on daily amount, margin over base rate
Purpose
Cover short-term/seasonal deficit
Repayment
Repayable on demand
Security
Over specific assets/whole business, depends on size of

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

accept fluctuation in balances
17/12/2008
Bank/customer
relationship
18:21
Bank lending
criteria
Page 98
Overdrafts
Medium and
long-term loans
Leases
Overdrafts and working capital

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

Where a business is permanently in overdraft it has a solid or hard core debit balance which may persist.
Banks will want such a balance reduced or converted into a medium-term loan to ensure it is repaid.
17/12/2008
Bank/customer
relationship
18:21
Page 99
Bank lending
criteria
Overdrafts
Medium and
long-term loans
Leases
Uses of loans
Types of loans
Easy for bank to monitor
Bullet all loan principal repaid at end of loan

period
Customers and banks know amounts paid/received

Customer 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)
Balloon most of loan principal repaid at end

of period
Amortising loan principal repaid gradually,
regular payments consist of interest and some
of loan principal
Interest rates
Bank guidelines
Fixed throughout loan period
Government regulations
Variable, depending on market conditions
Banker-customer negotiations agreement

Page 99
17/12/2008
Bank/customer
relationship
18:21
Bank lending
criteria
Page 100
Overdrafts
Medium and
long-term loans
Leases
Costs of loans
Loan covenants

Positive borrower must do something
Interest
Arrangement fee to bank
Commitment fees
Legal costs
Overdrafts

Designed for day to day help

Only pay interest when overdrawn
Bank has flexibility to review
Can be renewed
Wont affect gearing calculation
Negative/restrictive borrower must not

do something (eg borrow more money)
Quantitative limits on borrowers
financial position
Overdrafts
v
loans
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
17/12/2008
Bank/customer
relationship
18:21
Bank lending
criteria
Leasing
Leasing is a contract between the lessor
and lessee for the hire of a specific asset.
Page 101
Overdrafts
Medium and
long-term loans
Leases
Leasing
Lessor has ownership of asset
Lessee has possession and ownership of asset
on payment of specified rentals over period
Hire purchase
Hire purchase is a form of instalment
credit, where ownership passes to the
customer on the payment of the final
credit instalment.
Hire purchase payments consist of capital
element (towards asset cost) and interest.
Page 101
Hire purchase
Supplier sells goods to finance house
Supplier delivers goods to customer who
purchases them
HP arrangement exists between finance house
and customer
17/12/2008
Bank/customer
relationship
18:21
Bank lending
criteria
Page 102
Overdrafts
Medium and
long-term loans
Leases
Operating leases
Finance leases
Lessor supplies asset to lessee
Third party supplies the asset, the lessor supplies

the finance
Lessee responsible for servicing and maintenance
Lessor responsible for servicing and

maintenance
Period of lease short, less than useful
economic life of asset
Asset not shown on lessees Statement of
Financial Position
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?
17/12/2008
18:21
Page 103
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.
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Page 104
Preference
shares
Loan
stock
Different sources of funds

Retained earnings
Capital markets
Share issues
Rights issues
Loan capital

Bank borrowings
Government sources
Venture capital
International money markets
Convertibles
and warrants
The capital
structure decision
The choice of financing methods

Purpose of the finance

Amount
Repayment
Term
Cost
Security
Covenants
Taxation treatment
Control implications
Effect on gearing
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Preference
shares
Page 105
Loan
stock
Convertibles
and warrants
The capital
structure decision
Offer for sale
Placing
The company sells shares to the general public. Offer

for sale by tender means allotting shares at the
highest price they will be taken up.
Placing means arranging for most of an issue to be

bought by a small number of institutional investors. It
is cheaper than an offer for sale.
Costs of share issues
Timing of share issues
Underwriting costs
Stock Exchange listing fees
Issuing house, solicitors, auditors, public
relation fees
High share prices generally = high confidence

High confidence = high issue price
High issue price = fewer shares need to be
issued
Printing and distribution costs

Advertising
Fewer shares issued = reduced commitment

on dividends
The reverse is true where share prices and
business confidence is generally low
17/12/2008
18:21
Page 106
Access to wider pool of finance

Improved marketability of shares
Transfer of capital to other uses
Enhancement of company image
Facilitation of growth by acquisition
Stock
market
listing
Disadvantages of obtaining a listing

Loss of control
Vulnerability to takeover
More scrutiny
Greater restrictions on directors
Compliance costs
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Page 107
Preference
shares
Convertibles
and warrants
Loan
stock
Rights issue
Rights issue is an offer to existing
shareholders enabling them to buy
new shares.
The capital
structure decision
Advantages of rights issues

Offer price will be
lower than current
market price of
existing shares
Lower issue costs than offer for sale

Shareholders acquire more shares
at discount
Relative voting rights unaffected
Scrip dividend
Scrip issue
Stock split
Scrip dividend is a dividend

payment in the form of new
shares, not cash.
Scrip issue is an issue of new

shares to current shareholders,
by converting equity reserves.
Stock split is the splitting, for

example, of one $1 share into
two 50c shares.
Page 107
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Preference
shares
Page 108
Loan
stock
Convertibles
and warrants
The capital
structure decision
Preference shares
Preferences shares are shares which have a fixed
percentage dividend, payable in priority to any
dividend paid to ordinary shareholders.
Can only be paid if sufficient distributable profits

are available
Cumulative preference shares have the right to
unpaid dividends carried forward to later years
Advantages
Disadvantages
Can be issued on terms that suit the company

Dividends not paid when profits poor
Dont dilute voting rights
Lower gearing
Dont restrict borrowing power
No shareholder right to appoint receiver
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
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Preference
shares
Loan stock
The stock has a nominal value, the debt owed by the
company, and interest is paid on this amount. Security
may be given.
Fixed and floating charges

Fixed charge specific assets, 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.
Page 109
Page 109
Loan
stock
Convertibles
and warrants
The capital
structure decision
Debentures
Debentures are a form of loan stock. They are the
written acknowledgement of debt including
provisions about interest payment and capital
repayment. The debenture trust deed allows the
trustee to intervene if interest is not paid or
borrowing limits are breached.
Redemption is repayment of the loan stock.
Floating rate loan stock protect borrowers if interest
rates are falling, and allow lenders to benefit if
interest rates are rising.
Their market price depends on coupon rate relative
to market rates.
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Page 110
Preference
shares
Loan
stock
Convertibles
and warrants
The capital
structure decision
Convertible securities
Warrants
Convertible securities are fixed return securities

convertible at pre-determined dates and at holders
option into ordinary shares at a pre-determined
rate.
Warrants are rights for an investor to subscribe for

new shares at a future date at a fixed predetermined price.
Theoretical
Current share
No of shares
value = price Exercise from each
price
warrant
Conversion premium is the difference between

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

Price of straight debt

Current conversion value
Time to conversion
Expectations of future returns
Warrants
Usually issued with unsecured loan stock.

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
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Preference
shares
Page 111
Loan
stock
Convertibles
and warrants
The capital
structure decision
Capital structure
Matching assets with funds
Assets yielding long-term profits
should be financed by long-term
funds.
Page 111
Replacement and growth

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

Ultimately risk of liquidation but
also risk shareholders receive
no/inadequate dividend.
Longer term
finance
17/12/2008
Ordinary
shares
18:21
Page 112
Preference
shares
Loan
stock
Convertibles
and warrants
The capital
structure decision
Gearing increases variability of shareholder earnings and risk of financial failure.
Gearing

The level of debt within a business

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

debt levels
Shareholder attitudes to
increased debt levels
17/12/2008
18:22
Page 113
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.
17/12/2008
Problems of
obtaining finance
18:22
Sources
of finance
Small and medium-sized

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

Lack of business history/track record

Few accounting details available
Assessed by credit scoring methods
Need to supply security
Page 114
Venture capital
Other sources
Government aid
Government policy
Government policy will have a major influence on
funds.
Tax policy concessions to investors
Interest rate policy higher interest rates
increase borrowing costs but also increase return
to investors, making them more willing to supply
funds
17/12/2008
Problems of
obtaining finance
Owners
18:22
Sources
of finance
Page 115
Venture capital
Bank
overdrafts
Other sources
Bank
loans
Government aid
Trade
credit
SOURCES OF FINANCE
Equity
finance
Page 115
Business
angels
Venture
capital
Leasing
Factoring
15: Financing of small and medium-sized enterprises
17/12/2008
Problems of
obtaining finance
18:22
Sources
of finance
Page 116
Venture capital
Other sources
Government aid
Venture capital
Venture capital is risk capital normally provided in
return for an equity stake and possibly board
representation.
Investment considerations

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

Business startups
Development of new products/markets
Management buyouts
Realisation of investments
Business angels
Business angels are wealthy individuals who invest
directly in small businesses.
Informal market
May be difficult to arrange
Business angels generally have industry
knowledge
17/12/2008
Problems of
obtaining finance
18:22
Sources
of finance
Page 117
Venture capital
Other sources
Government aid
Trade credit

Short-term finance
Decreases working capital
Suppliers dont charge interest
May lose goodwill
May lose discounts
Identification of
owners/managers
Lack of equity finance
Owners preference
Equity finance

Initial investment from owners

Shares placed privately
Further funds from owners limited
Lack of exit route for external investor
Page 117
Industry/market
Capital
structure
Stage of existence
15: Financing of small and medium-sized enterprises
17/12/2008
Problems of
obtaining finance
18:22
Sources
of finance
Page 118
Venture capital
Other sources
Government aid
Loan guarantee scheme
Enterprise Initiative
Many companies/sole traders can apply. Banks can

lend without personal security/guarantee being
needed from the borrower. The government
guarantees 75% of the loan up to a maximum of
250,000 provided the borrower pays a premium and
puts up business assets as security.
Assistance such as Regional Selective Assistance

and Regional Enterprise Grants help firms
(particularly small firms) in Assisted and
Development Areas.
Enterprise Investment Scheme
Development agencies
This scheme gives tax relief to qualifying (nonconnected) individuals who subscribe for shares in a
qualifying (unquoted) company, up to maximum
subscription of 400,000.
Agencies for Scotland and Wales concentrate on

small company start-up and developments. Measures
include accommodation, grants, loans, equity
finance.
17/12/2008
18:23
Page 119
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
17/12/2008
18:23
Relevant costs
Page 120
Product mix
decisions
Make or buy
decisions
Shut down decisions

and one-off contracts
Avoidable cost
Opportunity cost
Avoidable cost is a cost which would

not be incurred if the activity to which it
related did not exist.
Opportunity cost is the benefit which

would have been earned but which has
been given up, by choosing one option
instead of another.
Differential cost
Relevant cost of
materials
Not owned
Owned
Differential cost is the

relevant difference in the
cost of alternatives.
Relevant
costs
Controllable cost
Controllable cost is an item of expenditure which can be
directly influenced by a given manager within a given
time span.
current replacement cost

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

Relevant cost of labour is the direct
labour cost plus the contribution lost by
diverting labour to make another
product.
17/12/2008
18:23
Page 121
Non-relevant costs
Sunk cost
Fixed costs
Sunk cost is a past (historical) cost which

is not directly relevant in decision making.
Unless given an indication to the contrary, assume fixed

costs are irrelevant and variable costs are relevant.
Direct and indirect costs may be relevant or irrelevant depending on the situation.
Deprival value of an asset

Lower of
Replacement cost
Higher of
NRV
Page 121
Expected revenues
16: Decision making
17/12/2008
Relevant costs
18:23
Page 122
Product mix
decisions
Shut down decisions

Make or buy
decisions
If there is a scarce resource (key or limiting factor), contribution will be maximised by earning the
biggest possible contribution per unit of scarce resource.
Example
Assume fixed costs
remain unchanged,
whatever the
product mix
Assume the only

relevant costs are
variable costs
Direct labour ($5 per hour)

Direct materials ($2 per kg)
Variable overheads
Fixed overheads
Selling price
Maximum demand
Maximum availability of labour
T
$
15
2
2
__3
22
__
__
J
$
10
5
2
__3
20
__
__
$25
10,000
$24
8,000
40,000 hours
17/12/2008
18:23
Page 123
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
Hours
Production
Contribution
per unit
8,000
8,000
7
6
Total
contribution
J
T
Page 123
(8,000 2)
Balance
16,000
24,000
______
40,000
______
______
( 2)
( 3)
56,000
48,000
______
104,000
______
______
16: Decision making
17/12/2008
18:23
Relevant costs
Page 124
Product mix
decisions
Make or buy
decisions
Shut down decisions

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.
17/12/2008
18:23
Page 125
Example
Joely makes three products and has limited labour time available.
Variable cost of making

Variable cost of subcontracting
Extra variable cost of subcontracting
A
$
10
19
__
__
__9
B
$
16
20
__
__
__4
C
$
14
19
__
__
__5
Labour hours saved by subcontracting (per unit)

Extra variable cost of subcontracting per hour saved
3
$3
2
$2
2
$2.50
PRIORITY FOR MAKING IN-HOUSE
1st
3rd
Page 125
2nd
16: Decision making
17/12/2008
18:23
Relevant costs
Shut down decisions
Page 126
Product mix
decisions
Make or buy
decisions
Shut down decisions

One-off contracts
Whether or not to shut down a

factory/department/product line because it is
making a loss or too expensive to run
Concerns a contract which would utilise spare

capacity but will have to be accepted at a lower
price than normally charged
Only relevant fixed costs are directly attributable

fixed costs
Generally, an order will be accepted if it

increases contribution and rejected if it reduces
contribution
The fact that a product makes a positive

contribution is not enough if the fixed costs that
could be avoided by ceasing production of it
exceed contribution
The effect on other customers and possible

future uses of the spare capacity may have to
be considered
17/12/2008
18:23
Page 127
17: CVP analysis
Topic List
CVP analysis enables management to predict how

changes in volume (production output and sales) will
impact upon costs and revenues and hence profitability.
Terms and formulae
CVP analysis is one of the key areas of the syllabus.

Most examination questions will require that you can
recall the formulae included in this chapter make sure
that you learn them so that you can apply them when
you need to.
Breakeven chart
Profit/volume chart
Advantages and limitations of CVP
analysis
17/12/2008
18:23
Page 128
Profit/volume
chart
Breakeven chart
Terms and
formulae
Advantages and
limitations of CVP analysis
Contribution per unit
Profit
Contribution per unit is unit selling

price unit variable costs
Profit is (sales volume contribution

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

Required contribution
P/V ratio
Sales revenue at
breakeven point
Fixed costs
P/V ratio
P/V ratio =
Required contribution
Sales
17/12/2008
18:23
Page 129
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 = _________________________
$5,400 = 1,800 units

$15 $12
P/V ratio = 3/15 100% = 20% = 0.2
Example
Breakeven point (units) =
Breakeven point (revenue) =
5,400
= $27,000
0.2
Sales volume to achieve profit of $3,300 =

Margin of safety (as a %) =
Page 129
$(5,400 + 3,300)
Selling price = $15 per unit

Variable cost = $12 per unit
Fixed costs = $5,400 per annum
Budgeted sales pa = 3,000 units
= 2,900 units
$3
3,000 1,800
100% = 40%
3,000
17: CVP analysis
17/12/2008
Terms and
formulae
18:23
Page 130
Breakeven chart
Profit/volume
chart
Advantages and
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
17/12/2008
Terms and
formulae
18:23
Page 131
Breakeven chart
Profit/volume
chart
Advantages and
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
17/12/2008
Terms and
formulae
18:23
Page 132
Breakeven chart
Profit/volume
chart
Advantages and
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.
17/12/2008
18:24
Page 133
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.
17/12/2008
18:24
Page 134
What is capital
expenditure?
Revenue expenditure
Investment
Capital expenditure
Authorisation
and monitoring
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.
17/12/2008
18:24
Page 135
What is capital
expenditure?
Authorisation
and monitoring
Tight control of the details concerning each non-current asset is required. This is generally achieved through the
use of an ASSET REGISTER.
Not part of the double

entry system
Shows an
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
Page 135
18: Capital expenditure budgeting
17/12/2008
18:24
Page 136
What is capital
expenditure?
Details that might be held on an asset register

Description
Sale proceeds
Date of purchase
Accumulated depreciation account
Cost
Depreciation expense account
Accumulated depreciation
Depreciation period
Depreciation %
Comments
Depreciation type
Residual value
Date of disposal
Cost account
Authorisation
and monitoring
17/12/2008
18:24
Page 137
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.
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Decision-making and control cycle

Initial investigation
Detailed evaluation
Authorisation
Implementation
Project monitoring
Post-completion audit
Page 138
Payback
Discounted
cash flow
NPV and
IRR
Non-financial factors to consider

Legal issues
Ethical issues
Changes to regulations
Political issues
Quality implications
Level of competition
Can all affect

a decision!
17/12/2008
18:24
Post-completion audit
A post-completion audit is an objective and
independent appraisal of the success of a capital
project in progressing the business.
Page 139
Post-completion audit procedures

Requires independent and competent staff
Evaluation of performance against original
objectives
Recommendation to improve cost-effectiveness
Benefits of post-completion audits
Better forecasting techniques

Better future decisions
Better current decisions
Contributes to performance evaluation
Page 139
Requires communication with staff directly

involved in project
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Page 140
Payback
Discounted
cash flow
NPV and
IRR
Only use relevant costs when making project appraisal decisions.
Accounting rate of return

ARR =
Estimated average profit

Estimated average investment
Advantages
Widely understood measure of accounting

profitability
Readily available from accounting data
Disadvantages
Based on accounting profits rather than cash

flow, giving too much emphasis to costs as
conventionally defined which are not relevant to
project performance
Fails to take account of the timing of cash

inflows and outflows
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Page 141
Payback
Discounted
cash flow
NPV and
IRR
Payback
Payback is the time taken for the cash inflows from
a capital investment project to equal the cash
outflows, usually expressed in years.
It is used as a minimum target/first screening method.
Advantages
Disadvantages
Simple to calculate and understand

Concentrates on short-term, less risky flows
Can identify quick cash generators
Page 141

Ignores total project return

Ignores time value of money
Ignores timing of flows after payback period
Arbitrary choice of cut-off
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Page 142
Discounted
cash flow
Payback
NPV and
IRR
Example
Investment
Year 1 profits
Year 2 profits
Year 3 profits
P
$000
60
20
30
50
Q
$000
60
50
20
5
Q pays back first, but ultimately Ps profits are higher on the same amount of investment.
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Page 143
Payback
Discounted
cash flow
NPV and
IRR
Discounted cash flow analysis applies discounting arithmetic to the costs and benefits of an
investment project, reducing value of future cash flows to present value equivalent.
Conventions of DCF analysis
Cash flows incurred at beginning of project
occur in year 0
Cash flows occurring during time period
assumed to occur at period-end
Cash flows occurring at beginning of period
assumed to occur at end of previous period
PV of cash flows in perpetuity

$1/r, r is cost of capital
Page 143
Discounting
Present value of 1 =
1
(1 + r)n
Annuity
+ n
Present value of annuity of 1 = 1 (1 r)
r
r = Discount rate
n = number of periods
17/12/2008
Steps in project
appraisal
18:24
Page 144
Accounting rate
of return
Payback
Net present value (NPV)
Discounted
cash flow
NPV and
IRR
Features of NPV
Net present value is the value obtained by

discounting all cash flows of project by target
rate of return/cost of capital. If NPV is positive,
the project will be accepted, if negative it will be
rejected.
Uses all cash flows related to project

Allows timing of cash flows
Can be calculated using generally accepted method
Example
Year
0
1
2
3
Cash flow
(90,000)
40,000
40,000
50,000
PV factor 12%
1.000
0.893
0.797
0.712
PV of cash flow
(90,000)
35,720
31,880
35,600
______
13,000
______
______
This simple layout is

not recommended for
complex cash flows.
See over for
recommended layout
17/12/2008
Year
0
Sales receipts
Costs
Sales less Costs
Capital additions
Capital disposals
Discount factors @
Cost of capital (WACC)
Present value
Page 145
18:24
Page 145
Year
1
X
(X)
___
X
Year
2
X
(X)
___
X
Year
3
X
(X)
___
X
Year
4
X
(X)
___
X
(X)
___
(X)
___
X
___
X
___
X
X
___
X
X
___
(X)
___
___
X
___
X
___
___
X
___
X
___
___
X
___
X
___
___
X
___
(X)
___
___
___
NPV is the sum

of present values
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Page 146
Discounted
cash flow
Payback
Rules of investment appraisal

Include
Exclude

Effect of tax allowances

After-tax incremental cash flows
Working capital requirements
Opportunity costs
Depreciation
Dividend/interest payments
Sunk costs
Allocated costs and overheads
NPV and
IRR
17/12/2008
18:24
Page 147
Internal rate of return (IRR)

The IRR method calculates the rate of return at which the NPV is zero.
Page 147
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
17/12/2008
Steps in project
appraisal
18:24
Accounting rate
of return
Page 148
Payback
(B A) %
IRR = 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
Discounted
cash flow
NPV and
IRR
17/12/2008
18:24
Page 149
NPV
Simpler to calculate
Better for ranking mutually
exclusive projects
Easy to incorporate different
discount rates
Page 149
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
17/12/2008
18:24
Page 150
Notes
Page 151
17/12/2008
18:24
Page 151
17/12/2008
18:24
Page 152
Notes
Page 153
17/12/2008
18:24
Page 153
17/12/2008
18:24
Page 154
Notes
Page 155
17/12/2008
18:24
Page 155
17/12/2008
18:24
Page 156
Notes

Cat t10 Fia FFM Finance Passcard

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cat t10 Fia FFM Finance Passcard

Uploaded by

Copyright:

Available Formats

(000) CT10PC_FP.

CAT Advanced Paper 10

First edition February 2005

BPP Learning Media

Welcome to BPP Learning Medias new CAT Passcards

Cash and cash flows

1: Cash and cash flows

This chapter provides a reminder of the main types of

Need for cash flows

A business has to ensure it has sufficient cash to

Cycle describes the connection between working

Calculation of operating cycle

1: Cash and cash flows

Capital and revenue items

Exceptional and unexceptional items

Capital items relate to the long-term functioning of

Exceptional items are unusual, one-off items eg

Revenue items relate to day-to-day operations, eg

Unexceptional items are normal business receipts

Net cash flow

Differences between profits and cash flow

Cash flows Profit

Items affecting cash flows but not profits

Issued shares/loan notes

Items where profit/loss is

Cash received revenue

Cash payments to suppliers

2: Forecasting cash flows

This chapter is one of the most significant.You need to

This chapter sets out an appropriate format for preparing

Mark up and margin

Whether available from

Cash flow-based forecasts

In receipts and payments format

Banks often insist businesses provide:

Monthly/quarterly cash budgets

Actual flows against original budget

Banks can monitor progress/control lending using

Enables management to make

Sort out cash receipts

Establish materials inventory

Establish whether any

Establish when suppliers will be

Sort out cash payments

Establish when any other

Bottom of budget must

2: Forecasting cash flows

In more complex cash forecasts, the assumptions made are critical.

PROFORMA CASH BUDGET

Net cash flow (receipts payments)

2: Forecasting cash flows

Profit element as fraction of cost

Profit element as fraction of selling price

Cost price 80 Profit 20 Selling Price 100

Statement of financial position forecasts

2: Forecasting cash flows

Estimating a future statement of financial position

Bank overdraft: Assume none

Current forecast v original forecast

Net cash flow

Cash flow problems

Postpone capital expenditure

3: Cash forecasting techniques