financial management all articles

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Lecturer: Manek Page 1 Page 1 Year 2010.

UNIVERSITY OF WALES

&

MANAGEMENT DEVELOPMENT INSTITUTE OF SINGAPORE

SUBJECT

FINANCIAL MANAGEMENT

LECTURER Manek

COURSE MASTER OF BUSINESS ADMINISTRATION

ARTICLES For restricted use during the class room discussion only. .

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Financial Management — Basic Concepts Business Finance is the first stage at which you are tested on issues relating to corporate finance and financial management.

Remember that the finance section of Business Finance serves as a foundation stone for Corporate Finance &International Finance paper in year 3, and the two examination papers are quite closely related. Many of the topics which form part of the syllabus for Business Finance, for example, investment appraisal techniques, are re-examined in CIF paper at a more advanced level. By working hard and preparing well for Business Finance, you should find that you are building a solid foundation of knowledge which you will use again later in the 3rd year examinations.

It is helpful to gain an understanding of the meaning of financial management to start by breaking the relevant sections of the Business Finance syllabus down into key topic areas. The topics can actually be drafted as a series of questions:

• What are the aims/objectives of the organisation?

• What external economic factors might affect our success and/or our definition of objectives?

• How is the business to be funded?

• What techniques can we use to ensure that funds are invested wisely?

• How does working capital management affect the financial success of the organisation?

Financial management can thus be viewed as the process of developing a long term perspective on the funding and management of funds for all organisations. The longer term strategic emphasis contrasts, perhaps, with the traditionally perceived role of the management accountant. The traditional view of the management accountant has been as the person responsible for ensuring that systems are put in place and information provided to management, which serves to ensure the attainment of longer term financial objectives.

The dividing line between financial management and management accounting, at least in the context of Business Finance, is best understood by way of an example. The syllabus contains a section on financial objectives, which requires candidates to understand the nature and type of financial objectives which might be pursued by both profit and non-profit seeking organisations. In defining objectives, for example, the maximisation of growth of earnings per share, an organisation is making a strategic choice. Strategies and tactics will be selected which best serve the achievement of the specified objective. Identification of the appropriate financial strategies is the responsibility of the financial manager/finance director. This does not mean that the management accountant can ignore the issue of corporate objectives, because the objectives will affect the type of information which the management accountant will be excepted to provide. Hence the management accountant and the financial manager work together, linking short term and medium term information, to ensure achievement of the desired objectives.

If a question on financial objectives were to appear in Sections A or B of the paper, the emphasis in the question would be entirely different. It is useful to remember this point; the boundary between financial management and management accounting is not clear cut, but the aspects of a topic which are emphasised differ greatly.

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At this stage it is useful to look in more detail at the financial management aspects of Business Finance, by looking in turn at each of the financial management questions which define the key topic areas.

What are the aims/objectives of the organisation? As already indicated above, the financial management perspective on this topic is a long term strategic one. Specification of alternative objectives is reasonably straightforward, although the need to acknowledge the requirements of different interest groups needs to be recognised. In the context of Business Finance, you can expect that questions on this area of the syllabus will simply ask you to define and explain alternative organisational objectives and comment, with examples, on the factors which might affect their successful achievement. For example, a publicly quoted company may declare that its primary objective is the maximisation of shareholder wealth, but it must also recognise that it cannot totally ignore the needs/desires of its staff. Providing good staff facilities and services will potentially increase costs, thereby reducing earnings. The objective of profit or wealth maximisation is thus modified to meet the needs of different interest groups, and questions may require comment on this problem.

What external economic factors might affect our success and/or our definition of objectives? Your understanding of the basic theories of economics was tested earlier. In Business Finance it is intended that you apply the theories to specific business situations. For example, if government economic policy is such that interest rates are kept at a high level, and a currency is thus highly valued, what effect might this have on a business? Alternatively, if a government responds to economic problems by printing lots more money, what will happen to the economy and to business? The key issue for Business Finance candidates is the link between economics and business — economics is not just a set of theories, but a collection of policies which can significantly affect a business’ success. The theoretical arguments about the pros and cons of various economic viewpoints will not be examined: the focus is on the impact of policies on the business environment. One important point to note here is that as the European Union and the Euro approaches, the role of EU economic policy cannot be ignored.

How is the business to be funded? The mix of sources of funding available to business of different sizes, and the advantages and disadvantages of the various alternatives is seen as a core part of the syllabus for Business Finance. As with economic issues, however, it is expected that candidates will be able to take the theories and relate them to specific business situations. It is unlikely that questions will simply require candidates to, for example, list five sources of long term finance for a publicly quoted company. Instead questions will be set in a context, similar to that of question 1 on the June 1998 paper. In answering this question many candidates proved that they could write out long lists of finance sources, which appeared to have been learned by rote from a manual/textbook. The well prepared candidates thought about the list that they had learned, and only wrote about the sources of finance appropriate to the business in the question. Almost as many marks are earned for relevance in an exam answer as are given for general content. Remembering this can save you time in the examination hall. Look at the size and type of business described in the question, and suggest only those sources of funds which are relevant.

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What techniques can we use to ensure that money is invested wisely? There is perhaps an assumption, based on past examination papers, that an intrinsic part of the finance element of Business Finance is a question on discounted cash flow analysis. Certainly DCF is central to investment decision making, but it is not the only appraisal technique available. Indeed research suggests that, in practice, many firms use payback or ROCE in preference to the more complex net present value approach when making investment decisions. In examination questions candidates will be expected to be able to undertake calculations using any/all of payback, ROCE, NPV and IRR, and critically comment on the various approaches. No particular approach will be given precedence in the setting of exam questions, and lease versus buy decisions will also be examinable. Note also that the effects of risk, tax and inflation may be incorporated into questions, as these issues are regularly tested in paper 14 at a more advanced level.

The need to apply criteria for the selection of investments clearly arises because companies do not have an unlimited supply of funds. When capital is rationed it becomes important to ensure that the money available is used in the most effective manner. This means that candidates must also understand how to compare projects when capital is rationed: what alternative ranking systems are available and which is the preferred option? Capital rationing is just one part of the larger question of how investments should be appraised, and so in an examination it would account for just a few marks in the context of a broader question on investment decisions.

How does working capital management affect the financial success of the company? Investing money wisely assumes that there is money available to invest, but this will not be the case if working capital is ineffectively managed. An understanding of the importance of tight working capital management to the long term survival of a business is a core theme in financial management. The syllabus for Business Finance details a number of aspects of working capital management, covering cash, debtors, stock and creditors. Debtors, stock and credit control are regarded as financial management topics to be examined in Sections A or B of the paper. Cash management may appear in any of Sections A, B or C.

Note that cash flow patterns can be viewed from either a long term or a short term perspective. In the financial management part of the examination paper, the emphasis in questions on cash flow will be in respect of the longer term management of flows, which ensure the continued ability to trade; for example avoidance of the problem of over-trading. In the management accounting section of the paper, the emphasis is shorter term, requiring, say, the preparation of a cash budget which details the forecast monthly cash flows over a six month time scale.

Examination questions will test candidates’ understanding of these topics, and simply saying, for example, that cash flow can be improved by reducing debtors or taking on more trade credit will not be adequate to achieve high marks. The implications of the alternative choices must also be considered. Increasing trade credit can lead to a loss of goodwill from suppliers, or the forfeiting of early payment discounts, and these disadvantages must be compared to the gains derived from improved cash flow. It is also very useful to remember that many small companies often seek outside finance which is unnecessary, by requesting funds which could be raised by improvements to the internal management of working capital. Looking at internal sources of finance (which may be relatively low cost) should always pre-empt applications to external financial institutions.

This idea links working capital management back to the topic of sources of funds, and demonstrates how good financial management forms a type of control loop. Managers set their objectives (subject to external influences) and then seek to raise the required level of funding. If

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the funding mix is correct and good investment decisions are made, then the business should flourish. If sales are inadequate, or growth is very rapid, then cash flow can become a problem, and objectives need to be re-defined and the whole process re-commences. Working capital management completes the circle of financial management.

Non-financial objectives Few people would argue with the idea that commercial businesses aim to make profits, and that decisions in these businesses are focused around how best to achieve this objective. The desire to be profitable need not, however, be all embracing, and in practice it can be seen that companies are likely to pursue a wide range of objectives, which are both financial and non-financial in nature. This article seeks to explain how such diversity of objectives might arise, discuss examples of non-financial objectives, and consider the implications for company owners and society in general. It is useful to remember that although a company is a separate entity in the legal sense, in reality it is made up of a collection of individuals and interest groups, all of whom have personal objectives to fulfil. Management will constantly be trying to balance the return to these groups e.g., shareholders or employees, and discussion on corporate objectives really comes down to a compromise which takes account of what the different groups are seeking. Consequently some objectives may be financial in nature, such as a rise in earnings per share, whilst others will be non-financial e.g., shorter working hours, or an increase in the level of waste recycling in a manufacturing process.

A useful starting point for analysing non-financial objectives, is to specify the variety of interest groups which may seek to influence company objectives, because they are affected by a company's operations. The list includes:

• Equity investors In other words the owners of the business, who will be looking for a financial return on their investment.

• Creditors This group will want to ensure that the business maintains the liquidity level required to repay its debts on time.

• Customers Who will be concerned about product/service quality and price.

• Employees Improved working hours and conditions of work will be important to this group, and so they may have a mix of financial and non-financial concerns.

• Managers Whose personal objectives may to some extent conflict with those of the owners. For example, a manager may seek to increase staff levels, as a way of increasing his personal status, but this may be lead to reduced profits.

• The community at large Communities are affected by company activities in a number of ways such as the use of

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land in a local area, the potential for pollution from effluents, commercial sponsorship of community projects and the impact of business activity on local transport systems.

Faced with such a broad range of interest groups, managers are likely to find that they cannot simultaneously maximise profits and the wealth of their shareholders whilst also keeping all the other parties happy. In this situation, the only practical approach is to try and work to satisfy the various objectives rather than maximise any individual one. Adopting such a strategy means, for example, that the company might earn a satisfactory return for its shareholders, whilst at the same time paying reasonable wages to satisfy employees, and avoiding polluting the environment, hence being a "good citizen." As a result, profit is no longer the sole corporate objective, and the pursuit of non-financial objectives has begun to be increasingly important, as part of a portfolio of corporate objectives which spread right out into the community of which they are a part.

Non-financial objectives The range of possible non-financial objectives which might be pursued is broad, and the list below is not comprehensive, but may be viewed as indicative of the aims of a typical business at the start of the twenty first century. Non-financial objectives might include:

• Growth of sales;

• Diversification;

• Survival;

• Contented workforce;

• Leaders in technology development;

• Product/service quality;

• Environmental protection.

Clearly some of the objectives listed are specific to the interests of one particular group of people, and the extent to which they are pursued is dependent upon the bargaining power of that group. For example, employees may want to reduce working hours or raise the hourly rate of pay, but if management do not face a problem in recruiting staff to work under existing contract terms, it may be very difficult to persuade management to pursue objectives which serve the interests of staff. In one sense, the "controlling influence" is always the equity investors. Pursuit of alternative goals, relating to employees, the environment or whatever, will incur costs and reduce profits. Equity investors will be conscious of this trade off, and if they think that they are losing too much as a consequence, investors will sell shares and the market value of the firm will fall. Managers need to remember that the interests of shareholders are paramount, but those interests will be tempered by the influences and objectives of other parties.

The recent furore over the Millennium Dome in London is evidence of this. A large proportion of the finance for the Dome came from commercial sponsorship, from companies such as Roche, Boots, BSkyB and Mars, and low attendance figures at the Dome have led these sponsors to threaten non-payment of their last tranche of funding, unless something is done to improve visitor

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numbers. The reason behind the commercial sponsorship is ultimately that it buys publicity for the companies concerned - it is a form of advertising. If the adverts do not draw in the customers, raising corporate profits, then the money has not been well spent. The mix of objectives for the sponsoring companies is quite subtle; on the one hand they like the public relations benefits that come from being associated with a large public project such as the dome, but at the same time they want a commercial return on their investment. In some texts, sponsorship of community projects in this way is termed "corporate social responsibility", whereby the company recognises that its stakeholders extend well beyond the shareholders and out into the wider community. Regardless of the terminology, the fact is that companies now need to acknowledge some commitment to meeting the objectives of parties other than just the equity investors.

In a large number of instances, the willingness of management to pursue wider objectives is a matter of goodwill on their part, combined with strong bargaining power on the part of the outside parties. In other cases, non- financial objectives are "forced" upon companies via legislation. For example, the furniture company Ikea is very environmentally conscious. This reflects Ikea's Scandinavian origins, but at the same time it also reflects the fact that EU legislation, and the Kyoto Protocol are forcing companies to become more environmentally conscious. For example, Ikea banned the use of HFCs and CFCs in its products some years ago. The ban might indicate a strong environmental conscience on the part of the company, or it may simply indicate an anticipation of legislation that would ban such products anyway. Nonetheless, regardless of the reason behind the ban, its very existence indicates that Ikea is typical of the many companies which pursue non-financial as well as financial objectives.

Shareholder impact of non-financial objectives

The impact of the pursuit of non-financial objectives upon shareholder wealth is not clear cut. There are many writers who would argue that companies which pursue a wide range of objectives find that they create for themselves a very positive public image, and this serves to increase shareholder wealth. Others would argue that community type projects simply add to costs and thus erode profit, thereby reducing shareholder wealth. In reality, the truth probably lies somewhere between these two extremes. Carefully selected projects, particularly those which are community related, may well serve as a form of indirect advertising, and raise the corporate profile and associated shareholder wealth. Other projects may simply represent a gesture of goodwill, on which no return is either sought or earned.

For example, suppose that a company decides to pursue an image of high product quality as a secondary objective. The aim is clearly non-financial in nature, but it will involve spending money on quality control and management projects which could add to costs and reduce profits. There is substantial research evidence from people like Juran, which suggests that "quality is free". In other words, the gains from higher sales levels and reduced costs of warranty claims exceed the costs of the investment in quality improvements. Where this is the case, then the shareholders actually gain from the fact that the company has chosen to pursue a non-financial objective.

In other cases, the shareholder impact will be much more difficult to identify. Some companies have a very good reputation in terms of the facilities which they provide for employees. Such provision clearly costs money, and absorbs funds which could be used elsewhere within a business, and so it might be easy to take the view that pursuit of the objective of employee welfare is detrimental to shareholders. In fact, it may work that such policies serve to reduce staff turnover rates and increase productivity. It is quite possible for the aggregate benefits from such a policy to exceed the costs, so that shareholders see profits rise over the longer term. As with many things, whether a strategy has a positive or negative effect depends upon the time frame within which it is being judged.

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Not for profit organisations

This category of organisation includes public sector bodies such as the National Health Service or local councils, charitable bodies e.g., Oxfam, and other organisations whose purpose is to serve the broader community interests, rather than the pursuit of profit. In broad terms, such organisations seek to serve the interests of society as a whole, and so they give non-financial objectives priority of place.

It is reasonable to argue that they best serve society's interests when the gap between the benefits they provide, and the cost of that provision is greatest. This is commonly termed value for money, and it is not dissimilar to the concept of profit maximisation, but for the fact that public welfare is being maximised rather than profit.

In practice it is incredibly difficult to quantify, for example, the benefits from an operation such as the UK's National Health Service. How does one put a value on a life which has been prolonged by "x" number of years, or on the easing of pain which is brought about by the replacement of an arthritic joint? The benefits extend beyond factors which can be measured in purely financial terms. Nonetheless, financial criteria can be used to appraise the extent to which such organisations offer value for money, and hence make good use of the funds provided to them.

Value for money may be described as " getting the best possible combination of services from the least resources." This means maximising the benefits for the lowest possible cost, and is usually accepted as requiring the application of economy, effectiveness and efficiency. Economy measures the inputs that are required to achieve a certain level of outputs. Effectiveness measures the extent to which a service achieves its declared objectives/goals. Efficiency combines the other two measures to show the ratio of inputs : outputs. When an operation is efficient it will produce the maximum number of goods/services relative to the inputs required for their production. The three "Es" are the fundamental prerequisite of achieving Value For Money, and their importance cannot be over-emphasised.

The major difficulty for public sector bodies lies in precisely how to measure the achievement of the non-financial objectives. Value for money as a concept assumes that there is a yardstick against which to measure success i.e., achievement of objectives. In reality, the indicators of success are open to debate. For example, in the Health Service is success measured in terms of fewer patient deaths per hospital admission, shorter waiting lists for operations, average speed of patient recovery? etc., etc. As long as objectives are difficult to specify, so too will it remain difficult to specify where there is value for money. Comparative performance measures are useful, but care must be taken not to read too much into limited information.

Conclusion

We have seen that the pursuit of non- financial objectives is associated with all types of organisations, including what might typically be described as the commercial organisation. To seek non-financial objectives is not to ignore the financial , but merely to acknowledge that no single aim is of overriding importance. At the same time, non- financial objectives do not necessarily conflict with the financial, and can in fact serve to prosper the interests of shareholders. A strong public image, and good publicity must be important too, for example the Nationwide Building Society in sponsoring the Nationwide Football League, but it would be naive to believe that Nationwide did not also think that the associated publicity would also bring in business. The difficulty lies in reaching the right balance, which keeps shareholders happy but also allows other interest groups to believe that a company also has their interest at heart as well. The good manager must learn to be good at juggling.

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SHAREHOLDER VALUE What exactly is it? How do we achieve it? Should we report it in the financial statements? What are companies doing about it? Some answers are put forward for your considerations…

Introduction

The term "value" has gained increasing usage in the business literature in recent years For example, business managers and management accountants will make reference to the value chain and value-added activities, auditors are familiar with the concept of value for money and the preparation of value added statements was recommended but rejected some years ago It seems that we have come a long way since Oscar Wilde remarked that a cynic is one who knows the price of everything, and the value of nothing

This short article is about shareholder value This term began to feature prominently in the 1980s and was, in many respects, popularised by Alfred Rappaport in his book Creating Shareholder Value (Free Press, 1986) He reiterated the proposition that the appropriate goal for commercial organisations is to maximise shareholder value via dividends and increases in the market price of the company’s shares While this principle is widely accepted - corporate mission statements often proclaim this to be the primary responsibility of management - there is substantially less agreement about how this is to be accomplished and whether shareholder value metrics should be reported in the annual financial statements Some interesting material has recently been published in this regard and is covered in this article structured around the following questions:

· What is shareholder value?

· How do we achieve it?

· Should we report shareholder value in the financial statements?

· What are companies doing about it? What is shareholder value?

The fundamental assumption of shareholder value is that a business is worth the net present value of its future cash flows over a defined timeframe, discounted by the cost of capital appropriate for the business This assumption is well supported by modern corporate finance theory What is important is that a company adhering to shareholder value principles concentrates on cash flow rather than profits Secondly, it always puts the shareholder first in terms of company goals This seems to conflict with conventional wisdom that customer satisfaction/loyalty is the most important goal However, a company that fails to deliver value to customers is acting against the long-term interests of shareholders The corollary would be to offer products and services without regard to profit: customers would be delighted but shareholder value would be destroyed. How do we achieve it?

The corporate goal of creating shareholder value is determined by seven value drivers, highlighted in Table 1 below These seven macro level factors vary between industries but the assumption is that improvement in any of these value drivers leads to an increase in shareholder

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value These value drivers can be classified into three categories; operating, investing and financing that represent the major functions of any business

Operating decisions such as product mix, pricing, advertising and levels of customer service are impounded primarily in three value drivers – sales growth, operating profit margins and corporate tax rates The first two drive the amount of cash coming in to the business whereas the corporate tax rate drives the amount of cash going out Investment decisions are defined in terms of fixed asset and working capital investment In addition to these, there is the weighted average cost of capital (WACC) which is the rate of return demanded by investors – in relation to both debt and equity – based on the risk associated with the business and its capital structure For management, the insight offered by a ‘value’ focus is that the use of capital is not ‘free’ Rather, it is invested in the expectation of earning a return and this required return defines the company’s cost of capital The company creates shareholder value only if it generates returns in excess of its cost of capital Therefore, the seventh value driver is the planning horizon over which a particular strategy can be expected to deliver competitive advantage For example, a company may depend on a product that is expected to hold its place in the market for, say, five years After that, a new product will be needed So, the planning or competitive advantage period is five years.

The major benefit of using shareholder value comes from linking management decisions to value through the planing horizon and the key value drivers For example, in some companies, sales growth will destroy value because of the additional working capital requirements and fixed asset investment Value can also be destroyed through acquisition In fact, value can be destroyed even though reported accounting profits and EPS are positive

Thus far we have simply re-iterated a commonly held view that creating shareholder value has been central to the objective of firms since the foundation of corporate enterprises As a perspective, it has become enshrined in principles of corporate financial reporting We have also stressed the importance of cash flow in terms of valuing firms What is new, in terms of emphasis, is the realisation that management only creates value Management can only create value for shareholders if the company consistently, over the long term, generates a return on capital, which is greater than its cost Management creates value by developing a strategy that builds on the business’s competitive advantage In addition, management is required to implement that strategy, to recognise and manage the risk inherent in that strategy and to identify future sources of potential advantage, including market trends

Should we report shareholder value in the financial statements?

Why should companies report on shareholder value creation? One simple answer is that financial statements are supposed to be useful to investors (and other users) and an important characteristic of useful information is its long-term, future-orientation Currently, financial statements, prepared in accordance with accounting standards, are focussed on past events and historical financial performance and provide little information about future-orientated matters Relying only on financial statements for decision-making purposes has been likened to driving a car using the rear view mirror!

Admittedly, companies now produce an Operating and Financial Review (OFR), but surveys show that companies have been slow to respond to the challenge of providing forward-looking information Yet, investor surveys confirm both investors’ desire for more forward-looking information in a company’s annual report and the importance to their investment decisions of strategic matters and key drivers of future performance Thus, if management is entrusted with the responsibility of creating value through their strategic initiatives then, surely, they should report on their progress However, there are crude assumptions and extreme computational difficulties associated with the shareholder value calculations In such circumstances, it is reasonable to

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argue that investors (actual and potential) look for softer, more qualitative evidence that management has set its sight on creating shareholder value In other words, management should report more transparently to investors on the chosen strategy and the key indicators of successful implementation of that strategy Since this information may be unaudited, management credibility will become a crucial factor

This is the thrust of the 1999 discussion paper by the ICAEW Their proposals are intended to provide a framework for explaining a company’s strategy, and the progress that the company is making towards achieving that strategy The proposals create an important link between external financial reporting and the internal management practices and could be described as forming part of an integrated performance measurement system Interestingly, the proposals relate to all companies whose shareholders are remote from management The recommended disclosures help to address shareholder value considerations They relate both to the company as a whole and, to each significant business activity of the company, in respect to:

· Strategy

· Markets and competitive positioning

· Key performance indicators and ‘value’ based measures of performance

I have no doubt in suggesting that the recommended levels of disclosure will come as a surprise to many managers of Irish companies I would venture to suggest that some managers may be unable to comply with these recommendations simply because they have not been required to think in such dimensions! If managers choose to disclose a new measure, it is important to articulate why that measure is important and why it affects "value" The outlined proposals are viewed as providing a practical framework for the introduction of a more forward looking perspective into annual financial reports Many of the recommendations are based on practices observed in other countries What are companies doing about it?

Based on illustrations provided in the discussion paper from corporate reports, it is obvious that some companies have already (voluntarily) provided the disclosures suggested For example, some companies provide clear statements about the company’s objectives, business philosophy, the long-term targets management has set itself and the strategic direction pursued in each of the business segments In addition, performance against target is reported for a period of years Moreover, a large variety of performance measures (financial and non-financial) are highlighted Anyone curious about reporting performance measures and indicators could usefully look at the interesting disclosures contained in the 1999 report of our own Revenue Commissioners! Conclusion

We focused on shareholder value that may be described as a perspective which acknowledges that management is primarily responsible to shareholders Shareholder value is created only by management and so, it is reasonable to suggest that management should report both why their strategies are expected to lead to the creation of value over the long term and their own view of actual performance Such information will benefit individual shareholders and firms, and facilitate the Stock Exchange in allocating scare capital resources Really, there is nothing radically new about these proposals which may, in time, be referred to as strategic financial reporting They are attempting to address the criticism: "when I get my accounting report I am either happy or sad, but rarely wiser"!

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Capital investment appraisal Organisations operate in a dynamic environment. They must therefore continually make changes in different areas of their operations in order to meet the challenges that the dynamic nature of the environment brings and also in order to survive and prosper. It is believed that continuous change could improve the way things are done, thereby putting the organisation at an advantage over their competitors. Most changes involve capital expenditure, which can invariably involve large sums of money. The expenditure might involve replacing existing fixed assets with something more efficient and up to date or to acquire an entire business.

The decision to go ahead with any capital expenditure of a significant amount could necessitate spending a large sum of money. Managers must give careful thought to every step that they need to take before a final decision is made on whether or not to invest money on such a project. Most investments will have one form of return or another. The question to address is whether or not the future returns will be sufficient to justify the sacrifices the investing entity would have to make.

The intention of this article is to demonstrate how organisations justify capital investments using different appraisal techniques. It is hoped that the reader will supplement the knowledge gained from it with that gained elsewhere.

The article will be of interest to students taking paper 8, Managerial Finance, at the certificate level and also to those taking Paper 9, Information for Control and Decision-Making at the professional level.

Strategic needs Before an organisation goes out to appraise an investment opportunity a strategic need for the project must exist. The strategic need will determine, amongst other things, aspects such as which of the many investment opportunities before the entity will best help to meet their strategic objectives, how much to commit to the project and when to undertake the investment. The organisation may use SWOT and PEST analysis in order to be able to provide answers to these and similar questions. Basic information To appraise an investment project, the appraiser must have information about the following relevant areas: 1 Cost of investment project.

2 Estimated life of project.

3 Estimated net cash inflows from project.

4 Estimated residual value of project at the end of its life if applicable.

5 Cost of capital.

6 Taxation implications of project.

7 Inflation rates and effect on project.

Anyone who has had to plan for a future activity/event should understand that the future is never certain. Bearing this in mind, one must try to predict the future by drawing from past experience

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and using available information either from published statistics or from other sources. Some of the data required about the project would have to be estimated taking into consideration all available information. The accuracy of these estimated data would have a consequential effect on the final result of the decision, as such care must be taken in making these estimates.

Methods of investment appraisal When the decision-maker has at his/her disposal basic information about the project as stated above, he/she is then ready to use one or more of the four main methods used in appraising investment projects.

Payback method The payback method is used to determine how long it will take for future cash inflows from the project to equal the initial cost of the project. The method as the name implies establishes the payback period of each project. As the method stands, the shorter the payback period the better. It is often argued that industries where products get outdated quickly such as fashion and computers will prefer to use the payback method. The reason being that it is critical that the initial cost of the project is recovered quickly. In any case, most organisations have a set of standard payback periods for each investment project. They will in most cases compare the payback period from each investment project with the pre-determined payback period. Any project that falls short of the standard payback period will be rejected. Evidence has shown that apart from this fact, managers will prefer to use the method as an initial screening process because it is easy to use and understand by them. One important disadvantage of the method is that it ignores the time value of money. It also ignores profitability of the project but stresses the importance of liquidity. Whether this is an advantage or not will depend on the area of interest to the individual concerned.

Accounting Rate of Return (ARR) This method ARR is also referred to by some other names such as Return on Investment (ROI), Return on Capital Employed (ROCE). The most important thing to remember about this method is that it establishes rates of return on projects. There are different ways of determining a rate of return. For the purposes of this article, we will use Average Accounting Profits divided by Average Capital Employed multiplied by 100. That is: APR = Average accounting profits x 100 Average capital employed

Where: Average accounting profits = Profits over the life of the project Life of the project and Average capital employed = Initial cost of project + Scrap value 2 When there are two or more investment projects, rates of return are compared. A project, which has a higher rate, will be recommended, as this is an indication that it will give a higher return to the investing entity compared with the one with a lower rate.

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Discounted Cash Flow (DCF) methods The Net Present Value (NPV) and Internal Rate of Return (IRR) are the two investment appraisal methods under DCF. Let us now describe and comment upon the two methods.

Net Present Value (NPV) Method

Of all the investment appraisal methods, NPV is often argued to be the most superior. This is because it takes into account the time value of money. The method assumes that a pound today is worth more than a pound this time next year. It works under the assumption that if one is owed a pound and the borrower offers a choice of either giving the pound now or in a year’s time, the more rational option for the lender is to take the pound now. Provided the lender does not keep the pound under his mattress at home, it will be worth more than a pound in a year’s time. The reverse is true if the borrower has the option to pay either now or in a year’s time, the borrower would choose to pay in the future as the pound he/she pays in the future will be worth less than what he/she would have paid now. It stresses that future cash flows should be expressed in terms of what they are worth now when cash is expended on the project. The present values of these future cash flows can then be compared with what we are spending now on the project. In other words, the NPV is saying that one should compare like with like, which of course is a fair statement. By setting the future cash inflows from the project without discounting them against the initial capital cost, one is not being realistic and fair.

When present values of cash outflows and inflows are compared, if the result gives a positive NPV, then the project should be recommended. In a mutually exclusive situation, that is, when you can only undertake one project and not two projects at the same time, if two projects were to give positive NPVs, then the project with the higher NPV is the one to recommend.

Internal Rate of Return (IRR) method

Often an entity would want to establish its internal rate of a project for various reasons e.g., for decision-making purposes. By IRR we mean a rate that will be used to discount future cash inflows to make the total of the present values equal the cost of the project. The attempt being made under IRR is to find a rate that will equate the NPV of a project to be zero. The IRR therefore is the maximum rate of discount that will be used to finance a project without making a loss from it. Again in a mutually exclusive situation, the project that has the highest IRR is the one to recommend. The reason being that the IRR is showing the highest rate that can be used to finance a project without incurring a loss from it. Students often suggest to the author that the IRR should be called the break-even rate. His reply to them is often, if this makes you understand IRR you should use that term for it.

In order to find the IRR manually, this is done by the trial and error approach. By this we mean using a discount rate which gives a positive NPV and another rate which gives a negative NPV. Then apply the formula:

IRR = A + a x (B – A) a + b

Where:

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A = The lower discount rate which gives the positive NPV

B = The higher discount rate which gives the negative NPV

a = The value of the positive NPV

b = The value of the negative NPV

Please note that a and b should be added together as the negative sign in b is ignored.

Now let us demonstrate these various methods using a case from a fictitious company we shall call AICO Plc.

Case

Senior management of AICO Plc have identified that there is a strategic need for a replacement machine to be acquired in one of their production departments. They have to make a choice between two models of the machine — model 1 is called Super and model 2 is called Deluxe. They are unsure as to which of the two models they should buy. They have given you the following profiles of the two models. They want you to use the four investment appraisal techniques discussed above. You are required to recommend which of the two models is better under each appraisal technique and to explain briefly why you have recommended one in place of the others under each technique. You are told that funds are only available for only one model.

Super Deluxe Cost £500,000 £800,000 Net cash inflow £ £ Year 1 250,000 150,000 2 100,000 200,000 3 100,000 250,000 4 50,000 100,000 5 150,000 100,000 6 100,000 250,000 Scrap value 20,000 80,000

The cost of capital is 12% and AICO depreciates all its fixed assets on the straight-line basis. By cost of capital is meant what it costs to raise the required finance for the project.

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Payback method

Super Model

Cost £500,000 Year Cash inflows Accumulated Cash inflows 1 250,000 250,000 2 100,000 350,000 3 100,000 450,000 4 50,000 500,000 Payback Period = 4 years Deluxe Model Cost £800,000 Year Cash inflows Accumulated Cash inflows 1 150,000 150,000 2 200,000 350,000 3 250,000 600,000 4 100,000 700,000 5 100,000 800,000 Payback = 5 years

By comparing four years for the super model with five years for the deluxe model, one would recommend AICO Plc to buy the former, as its payback period is shorter than the latter.

The Accounting Rate of Return The information provided by AICO plc is based on hypothetical cash flows. This information is insufficient for establishing the ARR of the two models; therefore it will be necessary to calculate the annual depreciation figures for the two machines. To arrive at the annual accounting profits will necessitate a deduction from each year’s net cash inflows — the annual depreciation figure. Super model Depreciation per annum = Cost less scrap value Life of machine = £500,000 less 20,000 6 years = £80,000 per annum Deluxe model Depreciation per annum = £800,000 less 80,000 6 years = £120,000 per annum

Now that we have calculated the annual depreciation for each machine, let us establish the annual accounting profit or loss for each machine.

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Super model Year

Cash inflow less Depreciation =Accounting Profit/(Loss)

1 250,000 – 80,000 = 170,000 2 100,000 – 80,000 = 20,000 3 100,000 – 80,000 = 20,000 4 50,000 – 80,000 = (30,000) 5 150,000 – 80,000 = 70,000 6 100,000 – 80,000 = 20,000 Total accounting profit 270,000 Therefore the average accounting profit = £270,000 /6 = £45,000 Average Capital Employed ={ £500,000 + 20,000} / 2 = £260,000 ARR = 45,000 x 100 260,000 = 17·30% Deluxe Model Year Cash inflow less Depreciation = Accounting Profit/(Loss) 1 150,000 – 120,000 = 30,000 2 200,000 – 120,000 = 80,000 3 250,000 – 120,000 = 130,000 4 100,000 – 120,000 = (20,000) 5 100,000 – 120,000 = (20,000) 6 250,000 – 120,000 = 130,000 Total accounting profits 330,000 Average accounting profit = £330,000 /6 = £55,000 Average capital employed = {£800,000 + 80,000} / 2 = £440,000 Therefore ARR = £55,000 x 100 £440,000 = 12·50%

Using ARR, clearly the super model with a 17·30% will be recommended instead of the deluxe model, which has a lower rate of return of 12·50%.

Net Present Value

When using the NPV method the present value table is required in order to find out the present value factors of the pound at different rates over different time periods. Your examination question paper has often in the past provided the table for candidates’ use with the examination questions. There is no indication that this will not continue. However the figures in the table can be calculated if a table is unavailable.

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Super model Year

Cash flows PV factors Present values

0 (500,000) x 1 (500,000) 1 250,000 x 0·893 223,250 2 100,000 x 0·797 79,700 3 100,000 x 0·712 71,200 4 50,000 x 0·636 31,800 5 150,000 x 0·567 85,050 6 100,000 + 20,000 x 0·507 60,840 N. P. V. 51,840

Deluxe model

Year Cash flows PV factors Present values 0 (800,000) x 1 (800,000) 1 150,000 x 0·893 133,950 2 200,000 x 0·797 159,400 3 250,000 x 0·712 178,000 4 100,000 x 0·636 63,600 5 100,000 x 0·567 56,700 6 250,000 + 80,000 x 0·507 167,310 N. V. P. (41,040)

Under the NPV method super has a positive NPV of £51,840 whilst deluxe has a negative NPV of £41,040. Any project with a negative NPV should not be undertaken at all. On the basis of this super model will be recommended but not deluxe model.

Internal Rate of Return (IRR) Under NPV we have used 12% discount rate and arrived at both a positive and negative NPV respectively for the two machines. We need to use a higher rate for the Super model to arrive at a negative NPV and a lower rate for Deluxe model to arrive at a positive NPV. Remember that the higher the IRR the better. Let us now use 20% for Super model and 4% for Deluxe model. Super Model

Year Cash flows PV factors Present values 0 (500,000) x 1 (500,000) 1 250,000 x 0·833 208,250 2 100,000 x 0·694 69,400 3 100,000 x 0·579 57,900 4 50,000 x 0·482 24,100 5 150,000 x 0·402 60,300 6 100,000 + 20,000 x 0·335 40,200 N. P. V. (39,850)

Now that we have a negative NPV for Super model we can now use the IRR formula we had earlier to establish IRR for this model.

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IRR = A + a x (B – A) a – b = 12 + 51,840 x (20-12) 51,840 + 39,850 = 12 + 51,840 x 8 91,690 = 12 + 4·52 IRR = 16·52%

Now let us turn our attention to the second machine, but first we need to find a positive NPV for this machine. We have stated earlier that we will use 4%, let us use that straight away.

Deluxe Model

Year Cash flows PV factors Present values 0 (800,000) x 1 (800,000) 1 150,000 x 0·962 144,300 2 200,000 x 0·925 185,000 3 250,000 x 0·889 222,250 4 100,000 x 0·855 85,500 5 100,000 x 0·822 82,200 6 250,000+80,000 x 0·790 260,700 N. P. V. 179,950

Therefore IRR = 4 + 179,950 x (12–4)

179,950+41,040

= 4 + 179,950 x 8 220,990 = 4 + 6·51 IRR = 10·51%

The Deluxe module has an IRR of 10.51%. As this is lower than the super model’s 16.52%, once again super model will be recommended.

Conclusion It can be seen that all four methods of investment appraisal have consistently recommended the Super model. This has happened because the example was designed to do so. A real life exercise on investment appraisal will probably not be as easy and straightforward as this.

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Evaluation techniques for capital budgeting – article 2 Investment involves the sacrifice of current consumption opportunities in order to obtain the benefit of future consumption possibilities. The commitment of funds to capital projects gives rise to a management decision problem, the solution of which, if incorrectly arrived at, may seriously impair company profitability and growth.

The proper use of evaluation techniques and criteria should enable management to make more effective decisions which result in future success. The purpose of investment appraisal is to evaluate whether or not the current sacrifice is worthwhile.

Capital investment decisions have certain characteristics which are not always present in other management decisions, and as a result, special techniques are required to ensure that only the best information is available to the decision maker.

These characteristics are:

• a significant outlay of cash;

• long term involvement with greater risks and uncertainty because forecasts of the future are less reliable;

• irreversibility of some projects due to the specialised nature of, for example, plant which having been bought with a specific project in mind may have little or no scrap value;

• a significant time lag between commitment of resources and the receipt of benefits;

• management’s ability is often stretched with some projects demanding an awareness of all relevant diverse factors;

• limited resources require priorities on capital expenditure;

• project completion time requires adequate continuous control information as costs can be exceeded by a significant amount.

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Factors to consider with capital projects

When considering any capital investment project there are six factors to be examined:

• the initial cost of the project;

• the phasing of the expenditure;

• the estimated life of the investment;

• the amount and timing of the resulting cash flow;

• the effect, if any, on the rest of the undertaking;

• the working capital required.

There are different/multiple objectives for a company, for example, survival. These can change in priority at different stages of a company’s life cycle, but the one overriding objective is maximisation of owner’s wealth. Stated differently, it is the present value of future cash flows. Therefore, all investment opportunities should eventually be viewed in financial terms.

Evaluation techniques

There are a number of methods for evaluating capital expenditure projects but no matter what method is used it is important to realise that the information used for the evaluation has to be properly screened as it can materially affect the evaluation.

Some of the methods available are:

• accounting rate of return (ARR or ROCE or ROI);

• payback or discounted payback;

• discounted cash flow — net present value (NPV);

• internal rate of return (IRR).

Each of these methods will be described in turn and an example given of the calculations involved. Then the acceptance criterion for each will be stated:

• when there is only one project under consideration; and

• when there are two mutually exclusive projects under review.

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Calculations are performed for Project A only. Space is left for you to duplicate the calculations for Project B. Answers for Project B appear at the end of the article for your reference.

Project A B

£ £

Capital expenditure 75,000 75,000

Accounting profit/(loss)

Year 1 30,000 43,000

Year 2 30,000 6,000

Year 3 20,000 25,000

Year 4 (10,000) (1,000)

Year 5 (10,000) (13,000)

TOTAL PROFIT 60,000 60,000

Equipment estimated resale value at the end of 5 years will be: Project A B £ £ Resale value 5,000 5,000

Depreciation is calculated on the straight line method.

Solution

The Accounting Rate of Return (ARR) model uses ACCOUNTING PROFIT/LOSS.

For Payback and the Discount methods i.e., NPV or IRR models accounting profits/losses must be converted to CASHFLOWS.

ACCOUNTING RATE OF RETURN — calculates the average annual profits as a percentage of the cost of the project.

ROCE/ARR/ROI = average annual profits * 100 average investment 1

Average investment equals initial investment plus residual value (if any) divided by 2.

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• Advantages - uses readily available accounting information. - more readily understood by managers.

• Disadvantages - deals with accounting profit, rather than cash flow. - different methods for calculating depreciation/stock values. - fails to take account of time value of money.

• Acceptance - One project - accept if above management’s acceptable return cut-off point. - Mutually exclusive projects - whichever offers the highest return.

Cash flows Firstly, convert accounting profits to cashflows. This is done by adding the annual depreciation charge to the profit/loss each year. Remember straight line depreciation equals:

cost less residual value number of years expected use

Project Project A B £ £ Capital expenditure 75,000

Residual value 5,000 Total depreciation chargeable 70,000

No. of years expected use 5

Annual depreciation £14,000

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Project A Year Profit after depreciation Profit after depreciation Cash flow £ £ 1 30,000 44,000

2 30,000 44,000

3 20,000 34,000

4 (10,000) 4,000

5 (10,000) 4,000

60,000 130,000

Payback The length of time which is required for a stream of cashflows (proceeds) from an investment to recover the original cash outlay. An assumption can be made that cash flows accrue evenly throughout the year in the case of payback occurring some part way through a year.

Project A Year Net cash inflow Cumulative cash inflow £ £ 1 44,000 44,000

2 44,000 88,000

Project A’s outlay was £75,000. Of this only £44,000 was got back in year 1 and another £44,000 was got back in year 2. Therefore, payback took place somewhere between years 1 and 2. After the first year £31,000 was still needed. £44,000 was received in year 2 so payback equals:

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Payback method

• Advantages — simple to use and understand; — useful when liquidity is important when early recovery of funds is required; — promotes a policy of caution; — favoured by risk averse people.

• Disadvantages — disregards total contribution; — cash flows after payback are ignored; — fails to take account of the time value of money; — fails to take account of the magnitude of cash flows during the payback period.

• Acceptance — One project — accept as long as within management’s acceptable payback period; — Mutually exclusive projects — whichever pays back first.

Payback is usually expressed with no adjustment to the cashflows for the time value of money. It is proper and consistent with the other cashflow methods to express payback as a discounted payback figure. Therefore, Project’s payback period is 2.166 years.

Discounted cash flow These methods use the technique of discounting to take into account the time value of money. This refers to the fact that money can now be invested for a period of time and earn a return.

In capital budgeting we are concerned with finding the value now, i.e., its present day value, of a sum to be received in the future given the interest rate to be X%. The discount factor can be found using a calculator but it is normal to use discount tables which give the rate to be applied each year.

Net present value — calculates the present value of the future cash flows generated by the project and compares this present value of the cash inflow with the present value of any outflows. If the PV of the cash inflow is greater than the PV of the cash outflow the project will have a positive net present value (NPV).

A positive NPV indicates that the investment earns more for the firm than it has to pay for its funds.

Project A Year CF DF PV

£ 15% £

1 44,000 0.869 38,236

2 44,000 0.756 33,264

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3 34,000 0.657 22,338

4 4,000 0.571 2,284

5 4,000 0.497 1,988 5 5,000 0.497 2,485

Total of present values 100,595

Less initial outlay 75,000

Net present value 25,595

• Advantages — uses cash flow information; — takes into account both the magnitude and timing of cash flows; — maximises shareholder wealth.

• Disadvantages — cost and time involved in gathering information and making calculations may not be merited; — although uses DCF the results can conflict with what IRR recommends.

• Acceptance — One project — accept if NPV positive; — Mutual exclusive projects — whichever offers the highest NPV.

Internal rate of return — is the discount rate used by the company which gives a zero NPV. At this point the PV of the cash inflows will exactly equal the PV of the cash outflow. IRR can be solved by using — linear interpolation or — graphs.

Linear interpolation — calculate two NPVs, choosing a discount rate which will make one positive and one negative.

— using the following formula:

where:

• lower is the lower rate of return; • pos is the amount of the positive NPV; • neg is the amount of the negative NPV; • higher is the higher rate of return.

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Project A

Year Net cash flow Lower discount Present value Higher discount Present value

£ 15% £ 35% £

1 44,000 0.869 38,236 0.741 32,604

2 44,000 0.756 33,264 0.549 24,156

3 34,000 0.657 22,338 0.406 13,804

4 4,000 0.571 2,284 0.301 1,204

5 4,000 0.497 1,988 0.223 892

5 5,000 0.497 2,485 0.223 1,115

Total of present values 100,595 73,775

less initial outlay 75,000 75,000 Net present value 25,595 (1,225)

IRR = 15% + ( 25,595 * (35 - 15) = 34.09%

( 25,595 + 1,225)

• Advantages — takes into account both the magnitude and timing of cash flows.

• Disadvantages — in some cases there may be more than one IRR e.g., if there are net cash outflows in more than one period, and the outflows are separated by one or more periods of net cash inflows; — although uses DCF the results can conflict with what NPV recommends.

• Acceptance — one project — accept if IRR is above management’s return cut-off point; — mutually exclusive projects — whichever offers the highest IRR.

Project B answers: ARR/ROCE/ROI 30% Accept A or B Payback 1.90 years Accept A Discounted payback 2.40years Accept A NPV £25,681 Accept B IRR 34.47% Accept B

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Surveys of practice

Drury presents a table of “Evaluation techniques used by UK companies”. In the table, reproduced below, payback is the most frequent method used by evaluators at present, as evidenced by all researchers quoted and also over time as evidenced by Pike and Wolfe at three points in time from 1975 through to 1986.

Table 1: Evaluation techniques used by UK companies

* Pike and Wolfe’s survey focused on the largest UK companies, whereas McIntyre and Coulthurt’s survey focused on medium sized companies. The study by Drury et al is based on the replies of 300 UK manufacturing companies with an annual sales turnover in excess of £20 million.

Pike and Wolfe’s research also highlights that the discounted cash flow methods are rapidly increasing in popularity, none more so than NPV which has increased in use by 2.125 times over the survey periods.

Points to note NPV questions can be set in two contexts:

• profit situation (take highest or most positive NPV);

• cost reduction situation (take lowest NPV). Conversion of cashflows back to accounting profits is done by deducting the depreciation from the cashflow figure.

£ Cash flow 44,000 Depreciation 14,000 Accounting profit 30,000

For such a calculation to be performed the depreciation charged per annum would have to be given in the question.

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The Importance Of Working Capital

Manchester United may be kings of Europe, but how good are the treble winners at managing their working capital?

Many organisations that are profitable on paper are forced to cease trading due to an inabilty to meet short-term debts when they fall due. In order to remain in business it is essential that an organisation successfully manages its working capital. Too often however, this is an area which is ignored. This article will look at the items which comprise working capital, and using live examples will consider the level of working capital required by businesses operating in different industries. We will also look at the problems faced by small businesses before reviewing some of the ways in which an organisation can improve its management of working capital.

1. What is working capital?

The definition of working capital is fairly simple, it is the difference between an organisation’s current assets and its current liabilities. Of more importance is its function which is primarily to support the day-to-day financial operations of an organisation, including the purchase of stock, the payment of salaries, wages and other business expenses, and the financing of credit sales.

As Diagram 1 indicates, working capital comprises a number of different items and its management is difficult since these are often linked. Hence altering one item may impact adversely upon other areas of the business. For example, a reduction in the level of stock will see a fall in storage costs and reduce the danger of goods becoming obsolete. It will also reduce the level of resources that an organisation has tied up in stock. However, such an action may damage an organisation’s relationship with its customers as they are forced to wait for new stock to be delivered, or worse still may result in lost sales as customers go elsewhere.

Extending the credit period might attract new customers and lead to an increase in turnover. However, in order to finance this new credit facility an organisation might require a bank overdraft. This might result in the profit arising from additional sales actually being less than the cost of the overdraft.

Management must ensure that a business has sufficient working capital. Too little will result in cash flow problems highlighted by an organisation exceeding its agreed overdraft limit, failing to pay suppliers on time, and being unable to claim discounts for prompt payment. In the long run, a business with insufficient working capital will be unable to meet its current obligations and will be forced to cease trading even if it remains profitable on paper.

On the other hand, if an organisation ties up too much of its resources in working capital it will earn a lower than expected rate of return on capital employed. Again this is not a desirable situation.

2. The working capital cycle

The working capital cycle is summarised in Diagram 1. As the diagram illustrates, stock is purchased on credit from suppliers and is sold for cash and credit. When cash is received from debtors it is used to pay suppliers, wages and any other expenses. In general a business will want to minimise the length of its working capital cycle thereby reducing its exposure to liquidity problems. Obviously, the longer that a business holds its stock, and the longer it takes for cash to be collected from credit sales, the greater cash flow difficulties an organisation will face.

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In managing its working capital a business must therefore consider the following question. “If goods are received into stock today, on average how long does it take before those goods are sold and the cash received and profit realised from that sale?” The answer will depend upon a number of factors that we will consider later in this article. For now we will turn our attention to calculating the length of a business’s working capital cycle.

Dublin Ltd has provided the following information based upon the year to 31 January 1999.

Credit sales £1,200,000 Credit purchases £650,000 Average stock £80,000 Average debtors £200,000 Average creditors £54,000

With the help of a few simple ratios we can calculate the length of Dublin's working capital cycle as follows:

We can use the stock days ratio to calculate the average length of time that goods remain in stock:

Average stock *365 days = 80,000*365 = 45 days

Credit purchases

650,000

The average time taken by Dublin Ltd to pay suppliers may be calculated as follows:

Average creditors *365 days = 54,000*365 = 31 days

Credit purchases 650,000

Whilst the average time taken for cash to be collected from a credit sale is calculated as:

Average debtors *365days = 200,000*365 = 61 days

Credit sales 1,200,000

The working capital cycle for Dublin Ltd can be summarised as follows:

Stock received today is held for 45 days Less: Credit period offered by suppliers 31 days

14 days

Add: Credit period offered to customers 61 days

Length of working capital cycle 75 days

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The longer the cycle the greater the level of resources tied up in working capital. In the above example, if Dublin could reduce its stock turnover and debtors collection periods each by just five days, its investment in working capital would fall as follows:

Stock £71,000 Debtors £184,000

A saving of £25,000

3. Problems faced by small businesses

Although working capital problems can be experienced by businesses of any size, it is usually small businesses which have most problems, especially during their start up phase. We can illustrate this with the aid of a detailed example.

William Miller has recently started a business producing pine dining furniture. The furniture is produced by himself and two employees and is then sold to a national chain of furniture retailers. The retail chain insists on a two month credit period. However, since the business is new, suppliers require immediate payment for raw materials. Wages and other expenses are paid as incurred. At the end of each month, Miller has no stock remaining. The opening in cash balance in January was £1,000.

Miller has provided the following forecast figures from which he would like you to construct a cash budget and profit and loss account.

Sales Purchases of Wages and raw materials other expenses £ £ £ Jan 10,000 5,000 3,000 Feb 10,000 5,000 3,000 Mar 20,000 10,000 4,500 Apr 30,000 15,000 6,000

Table 1 contains the forecast cash budget, profit and loss account and summary of working capital for the business and illustrates the problems faced by many small businesses. The forecast profit and loss account shows that William Miller is running a profitable business (£18,500 profit during the four months), with monthly sales increasing threefold during the period under review. However, due to the credit terms offered to his customers, and the payment terms required by his suppliers, Miller has severe cash flow problems highlighted by the cash deficit of £30,500 at 30 April. Consequently the business has a weak working capital position, with net current liabilities of £18,500.

For small businesses that are starting up or expanding, the problems faced by William Miller are not uncommon. As sales increase, businesses are required to acquire more raw materials to produce enough goods to meet the increase in demand, whilst workers are required to work longer hours necessitating the payment of overtime wages. However, the cash from credit sales may not be received for several weeks, whilst suppliers and employees require immediate payment. In this situation a business is heavily dependent upon its bank overdraft and loans. In the long term, if the business survives, the problem will be reduced through negotiating better credit terms with customers and suppliers. Table 1

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4. The optimum level of working capital

As a guide many text books suggest that to be safe an organisation requires a 2:1 ratio of current assets to current liabilities. That is for every £1 of current liabilities, £2 of current assets is required to ensure that the organisation does not run into cash flow problems. However, this is much too simplistic, and the required level of working capital will vary from industry to industry. We can illustrate this point with reference to Table 2 which shows a breakdown of the working capital for three public limited companies (plc) operating in different industrial sectors. The figures are taken from recently published annual reports.

Each of our plcs is profitable and is considered successful in its field. However, it is apparent from Table 2 that only Manchester United plc meets the 'suggested' current ratio of 2:1. Indeed Tesco appears to be in real trouble with only 35 pence of current assets and 13 pence of 'quick' assets for every £1 of current liabilities. Worse still, if we consider the ratio of cash to current liabilities, Tesco has only one pence of cash coverage for every £1 of current liabilities suggesting severe liquidity problems. Yet Tesco is the largest supermarket chain in the UK with over 600 stores and an annual profit on ordinary activities before taxation in excess of £800 million.

Airtours also falls well short of the suggested current ratio of 2:1, although its quick assets ratio of 1:1 is satisfactory. These figures illustrate that the 2:1 ratio is inappropriate, and the amount of working capital required by an organisation will vary depending upon the nature of its business and the industry in which it operates.

Let us consider the figures shown in Table 2 in more detail starting with Tesco.

Although Tesco's level of working capital appears low, let us look at the nature of its business. Each day throughout the UK and Europe, millions of customers will purchase their groceries from Tesco paying for their goods in cash before they leave the store.

Most items sold by Tesco have a shelf life of only a few days. As market leader Tesco can rely on regular deliveries of stock from suppliers at fairly short notice. In addition the use of forecasting techniques will enable managers to reliably predict daily sales levels. All of these factors enable Tesco to operate with relatively low levels of stock.

Since almost all sales are on a cash rather than credit basis, the level of debtors is also low. In addition, the company is able to invest surplus cash balances in short-term investments (usually on the money markets), hence maximising the return to its investors.

Turning our attention to current liabilities, Tesco will purchase most of its stock on credit resulting in trade creditors in its 1998 annual accounts of £826million. Indeed most stock will have been sold and realised a profit before Tesco even pays its suppliers. Few organisations are in such a fortuitous position. Other creditors will include corporation tax and dividends, amounts which Tesco will know with certainty when they are to be paid.

We can see that due to the nature of its business, and in particular an abundance of cash sales, few debtors, low levels of stock, and most purchases being for credit, cash flow is not likely to be a problem, and hence Tesco is able to operate with negative working capital.

If we turn our attention to Airtours, customers will usually pay for their holidays well in advance of departure ensuring that cash flow is not a problem whilst also minimising the incidence of bad debts. Unlike Tesco, Airtours sales are seasonal with most cash being received during the period January to June. However, expenses will be incurred throughout the year and careful planning is necessary to ensure that Airtours is able to meet its current liabilities as they fall due.

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Being a tour operator, stock levels are relatively low. Debtors mostly comprise amounts paid in advance in respect of hotel accommodation and balances owing from customers for holidays. Whilst creditors compromise amounts owing for accommodation and advance payments made by customers.

We can see from Table 2 that like Tesco, Airtours can operate with a lower current ratio than the suggested 2:1, however due to the seasonal nature of its business, sound budgeting and forecasting is essential to ensure that liabilities can be met even during the close season.

Turning to Manchester United we can see little evidence of any working capital problems at 31 July 1997, with the company having a current ratio of 2:1. In addition the company has 79 pence of cash for every £1 of current liabilities. This is not surprising if we consider the nature of Manchester United’s business. During the period August to May cash flow is not likely to be a problem since almost every week over 50,000 fans will crowd into Old Trafford to watch their team play. Many of these fans pay for their seats in advance, purchasing a season ticket before the season commences. In addition the club will receive cash from sponsors, television companies and the sale of merchandise. However, as with Airtours, business is seasonal and careful planning is necessary to ensure that all liabilties are met as they fall due.

A review of the club’s working capital at 31 July shows that stock and debtors are relatively small, with the majority of working capital comprising short-term investments and cash, reflecting the cash received from season ticket sales.

From our review of Table 2 we can see that the optimum level of working capital will vary depending upon the industry in which an organisation operates and the nature of its transactions.

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5. Managing working capital

Having discussed what comprises working capital, let us now consider some of the methods that can be employed to assist in its management. We will review each of the key elements that comprise working capital in turn.

(a) Stock

The cost of holding stock is relatively easy to measure and will include:

• storage;

• security;

• losses due to theft, obsolescence, and goods perishing.

For example, consider a retail outlet selling home computers. Three years ago it acquired fifty state of the art PCs at a cost of £1,000 each. At the time each computer could be sold for £1,300 resulting in a profit of £300 per machine. Unfortunately today fifteen of these models remain in stock. Not only are they taking up valuable space, but due to rapid advances in technology they can only be sold for £300 each. If this outdated stock is sold, the overall position on this transaction is:

£ Sales of 35 computers at £1,300 each 45,500 Sale of 15 computers at £300 each 4,500

Total sales revenue 50,000

Cost of sales (50 computers at £1,000 each) (50,000)

Profit —

When we take into account administration and storage costs this transaction will actually result in a loss to the organisation.

We can therefore see the importance of not holding excessive levels of stock.

What is less easy to quantify is the cost of not holding sufficient levels of stock to meet the demand from customers. For example, if an organisation has insufficient stock to meet demand, it will initially result in lost sales. In the longer term it may also damage a business’s goodwill, with long-standing customers turning to other, more reliable suppliers.

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For most organisations the difficulty is determining the optimum level of stock.This will depend upon a number of factors including:

• the average level of daily sales (adjusted for seasonal variations);

• the lead time between ordering goods and their delivery;

• the reliability of suppliers;

• the type of good and the danger of their perishing or becoming obsolete;

• the cost of re-ordering stock;

• storage and security costs;

• other factors such as rumours of a shortage or an increase in price.

It is essential that systems are in place to ensure that stock levels are reviewed regularly and where necessary appropriate action taken.

(b) Debtors

Too often, especially during their start-up period, businesses concentrate on generating sales and pay little attention to the collection of money from debtors. As a result although sales exist on paper, the cash generated by these sales takes too long to materialise and cash flow problems occur (as our William Miller example illustrates). Additionally, the longer a debt is outstanding the greater the likelihood it will become bad.

With this in mind an effective credit control policy is necessary. This should include the following:

• Before allowing credit, an organisation should check the credit rating of potential customers, where necessary seeking references from a third party. Often this will involve using the services of a credit agency such as Dunn and Bradstreet.

• Based upon the results of a credit check, credit limits can be set. Once the credit limit is reached it cannot be exceeded without the authorisation of senior management.

• Credit customers should be informed in writing of the normal credit period (for example 30 days after the invoice date).

• A small cash discount is often used as an incentive to encourage early payment by debtors. For example, many firms offer a discount of 2.5% of the invoice value for payment within seven working days of the invoice date.

• It is essential that an organisation maintains accurate records detailing all transactions with customers and the amounts owing. An aged debtors’ list detailing the length of time that a debt has been owing is useful since it highlights those debts which management needs to concentrate on.

• An organisation should issue regular statements (normally monthly), and where necessary these should be followed up with reminders and phone calls/letters.

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Effective credit control will ensure that disputes are settled quickly without damaging the relationship with a customer, whilst at the same time reducing the occurrence of bad debts. However, such a system is often expensive and time consuming to set up, hence many organisations, especially those which have only recently commenced trading, utilise debt factoring.

Debt factoring involves an organisation passing responsibility for the management and collection of its trade debtors to a third party.The organisation ‘sells’ its invoices to a factor company and in return the factor immediately advances cash equal to between 50 and 85% of the total invoice value. The balance of the invoice value, less a charge for the factoring service, is paid when the debts are collected. In addition the factor is responsible for the administration of an organisation’s debtors, and can offer protection against bad debts.

The advantage of factoring is that it enables an organisation to concentrate upon generating sales and leaves the collection of cash to a third party. Most importantly it reduces the cash flow problems often experienced by new businesses by giving access to cash immediately rather than having to wait 30 or more days. Again our William Miller example highlights the problems experienced by small businesses, factoring would immediately solve Miller’s cash flow problem. However, factoring is expensive and in the long term it may be cheaper for an organisation to establish its own debtor management systems.

Invoice discounting is becoming increasingly common. Like debt factoring the business immediately receives cash representing a proportion of the total invoice value. Unlike debt factoring the business retains responsibility for the management of its credit control system.

When deciding the credit period offered to customers an organisation must consider several factors. A longer credit period (for example 45 days compared to 30 days offered by competitors) may generate additional sales, however these must be compared against the additional costs incurred by the business. These costs might include an increase in bad debts, higher administration costs and bank overdraft charges. If the profits arising from the additional credit period are less than the costs incurred, the credit period should be reviewed.

(c) Trade creditors

The practice of businesses extending trade credit to one another is probably the most important source of short-term funding available to most organisations. At first glance trade credit appears to represent a short-term interest free loan which enables a higher level of trade than if everything was paid for immediately in cash.

However, if we take a closer look at trade credit we can see that there are costs associated with it. Most suppliers offer customers a discount for early payment. Thus a supplier might allow 30 days’credit on all sales. However, in order to encourage early settlement of debts, customers paying within seven days are offered a cash discount equating to 2.5% of the invoice total. On an invoice of £10,000 (excluding VAT) this would equate to a saving of £250 (£10,000*2.5%).

Even if an organisation has an overdraft it may still be beneficial to take advantage of a cash discount. For example, Alanis purchases £5,000 of goods from Celine. Celine offers all customers the option of either 30 days’ credit or a 1.5% discount if cash is received within 5 days. If Alanis takes the cash discount she will incur an overdraft on which interest is charged at 20% per annum. Is the cash discount beneficial to Alanis?

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If Alanis takes the cash discount she will save: £5,000*1.5% = £75

However, she will incur an overdraft for 25 days (30 – 5 days) which will cost: £5,000*[20%*25/365] = £68.49

In this example Alanis will benefit by £6.51 if she pays the invoice within five days.

Another cost of trade credit, which is often ignored, is its impact upon the creditworthiness of a business. If a business consistently exceeds the credit period imposed by suppliers, in the long term its credit rating will be damaged. In the worst case scenario, suppliers will be forced to take legal action and may even withdraw their credit facility, requiring cash on delivery.

Whilst trade credit is undoubtedly a useful facility, it is important that businesses do not become too dependent upon it.

(d) Cash and bank balances

Liquidity problems often arise because inflows and outflows of cash do not coincide. For example, a small tour operator is likely to find itself awash with cash from January to June as customers book and pay for their summer holidays. Whilst from July to December sales and hence cash balances will be lower. However, business expenses such as wages and salaries, heat and light, rent and rates, and loan interest will remain more or less the same throughout the year. It is therefore essential that businesses plan ahead to ensure that sufficient cash is available to meet expenses in the off-peak period.

As demonstrated in Table 1, the preparation of a cash budget will indicate the flow of receipts and payments in and out of the business and will forecast periods of surplus and deficit cash balances thereby reducing the level of uncertainty. If a large surplus is forecast, cash can be invested in an interest earning account until it is required. If a deficit is forecast, our business can arrange a bank overdraft or loan. However, wherever possible overdrafts and loans should be avoided due to their high cost

6. Summary

During the course of this article we have looked at the items which make up working capital and considered how organisations can improve their management of working capital. We have seen that the ideal level of working capital is difficult to calculate and will vary from one organisation to another depending upon the industry in which they operate. What is essential is that a business avoids both the situation of too little or too much working capital.

Too little working capital is known as over-trading, and is common when a business is starting up or is experiencing a period of rapid growth. As we saw in our Willam Miller example, the level of sales might grow very quickly, but inadequate working capital is available to support this growth. The situation will then arise whereby a business may be profitable on paper but has insufficient funds available to pay debts as they become due. In the short term this situation can be solved through a combination of measures including:

• obtaining an increased overdraft facility; • negotiating a longer credit period with suppliers; • encouraging debtors to pay faster.

However, in the long term a business is unlikely to survive without a combination of:

• new capital from shareholders/proprietor;

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• better control of working capital; • the building up of an adequate capital base through retained profits.

Almost as bad is too much working capital or over-capitalisation. Poor management of working capital will result in excessive amounts tied up in current assets. Such a scenario will lead to a business earning a lower than expected return.

It must be remembered that the shorter an organisation’s working capital cycle, the faster cash, and hence profits, from credit sales will be realised. In order to achieve this an organisation must regularly review its working capital, taking action where necessary.

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Working Capital Management – article 2

Working capital management is a core area of the managing finances syllabus. As such it should form a key element of the study programme when preparing for the your examination.

Working capital is defined as, the excess of current asset over current liabilities. The composition and size of the various elements comprising current assets will vary depending on the type of industry, size of organisation and time of year. In addition, the relationship of current assets to current liabilities will vary considerably from one industry to another.

Efficient and effective working capital management is vital for the survival and prosperity of any organisation. To survive, a firm must remain solvent. Poor working capital management could result in the organisation not having enough cash to pay obligations as they fall due. This may place the business in danger of failure.

Current assets commonly comprise:

• Stocks

• Debtors

• Cash

Current liabilities commonly comprise payments due within one year:

• Creditors

• Taxation

• Bank overdraft

The theoretical lower limit is a current assets to current liabilities ratio of 1:1. The higher the ratio (excess of current assets to current liabilities) the better the organisation is positioned to meet its financial commitments as they fall due.

There is a general consensus that a current assets to current liabilities ratio of 2:1 is financially sound. This can vary considerably however, from industry to industry. Prudence would suggest that a manufacturing company should be closer to 2:1 whereas a services company could operate successfully close to the lower level of 1:1.

Consequently, it is important in assessing the current assets to current liabilities ratio to consider the type of business and the industry norm, rather than automatically expecting a target ratio of 2:1.

Cash operating cycle

The working capital (cash operating) cycle refers to the average period elapsing from the payment for purchases and other production expenditure (cash outflow) to the eventual cash receipt from the sale of finished goods (cash inflow).

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Diagrammatically the cash operating cycle can be shown as in Figure 1.

The length of the cash operating cycle can be calculated as in Figure 2.

Figure 2: calculating the cash operating cycle

Debtors days: Average debtors _______________ Credit sales Stockholding days: Average stocks _______________ Cost of sales

Less creditors: Average creditors _______________ Credit purchases Net cash operating cycle =

x 365 = x 365 = x 365 =

days days (days)

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Figure 3: operating cycle example

Operator Ltd (a distributor of calculators) sample data Y/E 31/12/1998

Sales Cost of sales

Opening stock

Closing stock

Purchases on credit

Debtors

Creditors

£133,000

£100,000

£40,000 (1/1/1998)

£50,000 (31/12/1998)

£110,000

£24,000

£11,000

Notes: (i) Operator Ltd intends to extend its product range in 1999. This is expected to increase sales by 10%.

(ii) The gross margin on these additional sales is expected to remain at current levels (i.e., £33,333/£133,333 = 25%)

(iii) To facilitate the business expansion, stock levels are expected to increase by £6,000 effective almost immediately.

(iv) The expansion is expected to lead to an immediate increase in the average period credit extended to customers of 5 days.

(v) Creditors days are not expected to change.

(vi) The increased investment will be financed via an increased bank overdraft at a cost of 12% p.a.

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Figure 4: operating cycles to the nearest day

Current cash operating cycle

Amended cash operating cycle

Debtor days Average debtors x 365 = Sales Stock days (Note 1) Average stocks x 365 = Cost of sales Less creditors days Average creditors x 365 = Credit purchases Net operating cycle

£24,000 £133,333 £45,000 £100,000 £11,000 £110,000

x 365 x 365 x 365

= 66 days = 164 days = (37 days) = 193 days

71 days (an increase of 5 days) 186 days (Note 2 & 3) (37 days) (no change) 220 days

This represents an increase of 27 days (i.e., a 14% increase)

Note 1: Current average stock = {£40,000 + £50,000} /2= £45,000

Note 2: The stock increase is immediate, therefore, the average stock will become £50,000 + £6,000 (increase) = £56,000 Cost of sales will become £100,000 x 1.1 = £110,000

Note 3: £56,000 x 365 = 186 days £110,000

Figure 5: additional investment required

Stocks Debtors Less creditors Net working capital

Current investment in working capital £50,000 £24,000 (£11,000) £63,000

Proposed investment in working capital £56,000 (increase of £6,000) £28,530 (Note 1) (£11,759) (Note 2 & 3) £72,771

This represents an increased investment of £9,771 which, if financed by a bank overdraft at 12%, will have an incremental finance cost of £1,173. Note 1: Debtors almost immediately increase by an average of 5 days. The new debtors level will be approx: Sales x 71 = £133,333 x 1.1 x 71 = £28,530 365 365 Note 2: Creditors days remain unchanged at 37 days. So the new creditors level will be approx: Purchases x 37 = £116,000 x 37 = £11,759 365 365 Note 3: Credit purchases will be: Cost of sales £100,000 x 1.1 = £110,000 + increase in stocks = £6,000 Total credit purchases £116,000

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Figure 6: the impact of the proposed change on profit

Sales will increase by 10% £133,333 x 10% = £13,333 The margin on sales is 25% So additional profit will be £13,333 x 25% = Less the incremental finance cost of the additional working capital investment (from Figure 5) = Net Marginal Profit Therefore, the change is beneficial to Operator Ltd as it improves profit by approximately £2,160

£3,333 (£1,173) £2,160

Analysis of the cash operating cycle

The objectives of working capital management are twofold:

(a) the determination of optimum investment in stock, debtors and cash appropriate to the industry type and size of business;

(b) the acquisition of optimum (minimum cost) working capital finance.

The length of the operating cycle has significant implications for working capital finance requirements. The longer the cycle time, the greater the required finance. The greater the required finance, the higher the finance cost needed to sustain the investment in current assets. The optimum level of working capital is, therefore, an amount which does not strain liquidity yet avoids excessive surplus cash.

It is important to appreciate that care needs to be exercised in attempting to reduce the operating cycle time so that it does not lead to a reduction in profits. For example, significantly reducing stocks to reduce the stockholding period could, if not properly managed, result in costly stockouts and a subsequent loss of sales and customer goodwill. If debtors were pressed for earlier payment they might opt to purchase from a competitor who offers longer credit terms. Therefore, reducing the operating cycle too far can have dangerous consequences.

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The example in Figure 3 may help to clarify the calculations involved in a simple cash operating cycle analysis.

The company may wish to consider: (a) the impact of the proposed expansion on the cash operating cycle (Figure 4). (b) the incremental investment in working capital (Figure 5). (c) the impact of the proposal on profit (Figure 6).

Figure 4 sets out detailed calculations of the existing cash operating cycle which is 193 days. The changes resulting from the increase in activity are then factored into a revised cash operating cycle calculation. The revised cycle time is 220 days. Consequently, the increase in sales combined with the anticipated changes in working capital are expected to lengthen the operating cycle time by 27 days.

Figure 5 shows the expected impact of the longer cycle time on the investment in working capital. Currently the net investment in working capital is £63,000. The longer cycle time is expected to lead to the net working capital investment increasing to £72,771 (an increase of £9,771). Make sure you follow the calculation for each of the elements comprising the revised net working capital investment of £72,771 in Figure 5.

Figure 6 rounds out the evaluation by assesing the impact of the changes in terms of financial benefits and costs. This analysis shows a marginal improvement in profit of £2,160, making the expansion financially viable.

Summary

With any change in working capital management, it is vital to comprehensively review the consequences, particularly the financial benefits and costs.

Reducing the operating cycle

When considering techniques to reduce the operating cycle it is

always important to attempt to review the implications and ensure that the expected benefits exceed the expected costs.

Selected techniques could include:

(a) Reducing the raw material stock holding period

l Introduction of J IT (J us t in time ) s tock ma na ge me nt s ys te ms . Re ducing the va rie ty of pa rts a nd compone nts us e d a nd, cons e que ntly, the va rie ty of s tock to hold.

(b) Reducing the production time

Re de s ign of the fa ctory la yout to fa cilita te a smoother flow through the production process. Introduction of TQM (Tota l Qua lity Ma na ge me nt) philos ophy. This s hould re duce or e lim ina te the level of rejects and costly rectification work.

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P rovide re le va nt s ta ff tra ining a nd de ve lopme nt focus e d on continuously seeking improvements in performance and efficient practices. Inve s t in the on going re vie w of product a nd proce s s de s ign to e ns ure only va lue a dding activities are undertaken in the manufacturing or service processes. Introduction of a utomated processes where appropriate.

(c) Reduce finished goods stockholding periods

If pos s ible , ope ra te a J IT philos ophy of only manufa cturing to orde r thus re ducing finis he d goods stock levels to zero. Re gula r re vie w of s tock turnove r by finis hed stock item with a view to eliminating slow or obsolete stock lines.

(d) Improved credit control procedures Efficie nt inte rna l controls to e ns ure tha t a ll dis pa tche s a re invoice d without de la y. Atte mpt to move cus tome rs onto e fficie nt pa yme nt methods to reduce the length of time from a customer initiating payment to the eventual receipt of cleared funds. P rompt lodge me nt of pa yme nts re ce ive d from cus tome rs to re duce tota l floa t time . Fa ctoring or invoice dis counting to re duce the pe riod from making a credit sale to the eventual receipt of payment.

(e) Management of creditors

Progressive companies have come to realise that there are significant benefits in developing a mutually beneficial relationship with their suppliers rather than attempting to delay payment beyond the agreed credit period. It is still possible however, to implement procedures which ensure that maximum benefit is achieved from efficient creditor management.

Effective and efficient management of creditors could involve the following:

• Availing of allowed credit periods.

• Only availing of early settlement discounts if the benefits exceed the cost.

• Avoiding the cost of frequently changing suppliers by operating prudence in the initial selection process.

These are only some of the techniques which could be employed in an effort to improve efficiency and increase profits.

Conclusion

Careful management of working capital is vital for the survival and prosperity of an organisation.

The mix and relative size of current assets and current liabilities varies considerably from industry to industry.

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Any proposed change in working capital should be comprehensively investigated to ensure the expected benefits exceed the expected costs of such a change.

Great care must be taken when attempting to reduce the working capital cycle as this policy can often have dangerous consequences if not managed properly.

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Debtor management One year after The Late Payment of Commercial Debts (Interest) Act 1998 was passed, market information specialists, Experian, recently reported that British companies are now taking two days longer to settle their bills with suppliers than before the legislation was introduced. The average time taken to pay for credit purchases by British companies is now 74 days. Although the 1998 legislation enables companies employing fewer than 50 staff to levy an 8% interest charge above the base rate on late-paying larger clients, few have done so in fear of alienating the enterprises on whom they frequently so heavily rely. The study also found that most large businesses now insist on a 60-day payment period. Reliant upon cash from trade debtors to pay suppliers, wages and other costs, the failure to receive the amounts owing from credit customers on the due dates creates enormous problems for businesses in paying their own way. This article reviews the major considerations at each stage of the credit management process and concludes with an illustration of how factoring can benefit companies suffering from late-paying customers.

Assessing the credit worthiness of customers

Before extending credit to a customer, a supplier should analyse the five Cs of credit worthiness, which will provoke a series of questions. These are:

• Capacity — will the customer be able to pay the amount agreed within the allowable credit period? What is their past payment record? How large is the customer's busiCapital — what is the financial health of the customer? Is it a liquid and profitable concern, able to make payments on time?

• Character — do the customers’ management appear to be committed to prompt payment? Are they of high integrity? What are their personalities like?

• Collateral — what is the scope for including appropriate security in return for extending credit to the customer?

• Conditions — what are the prevailing economic conditions? How are these likely to impact on the customer’s ability to pay promptly?

Whilst the materiality of the amount will dictate the degree of analysis involved, the major sources of information available to companies in assessing customers’ credit worthiness are:

• Bank references. These may be provided by the customer’s bank to indicate their financial standing. However, the law and practice of banking secrecy determines the way in which banks respond to credit enquiries, which can render such references uninformative, particularly when the customer is encountering financial difficulties.

• Trade references. Companies already trading with the customer may be willing to provide a reference for the customer. This can be extremely useful, providing that the companies approached are a representative sample of all the clients’ suppliers. Such references can be misleading, as they are usually based on direct credit experience and contain no knowledge of the underlying financial strength of the customer.

• Financial accounts. The most recent accounts of the customer can be obtained either direct from the business, or for limited companies, from Companies House. While subject to certain limitations (encountered in paper 1), past accounts can be useful in vetting customers. Where the credit risk appears high or where substantial levels of credit are

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required, the supplier may ask to see evidence of the ability to pay on time. This demands access to internal future budget data.

• Personal contact. Through visiting the premises and interviewing senior management, staff should gain an impression of the efficiency and financial resources of customers and the integrity of its management.

• Credit agencies. Obtaining information from a range of sources such as financial accounts, bank and newspaper reports, court judgements, payment records with other suppliers, in return for a fee, credit agencies can prove a mine of information. They will provide a credit rating for different companies. The use of such agencies has grown dramatically in recent years.

• Past experience. For existing customers, the supplier will have access to their past payment record. However, credit managers should be aware that many failing companies preserve solid payment records with key suppliers in order to maintain supplies, but they only do so at the expense of other creditors. Indeed, many companies go into liquidation with flawless payment records with key suppliers.

• General sources of information. Credit managers should scout trade journals, business magazines and the columns of the business press to keep abreast of the key factors influencing customers' businesses and their sector generally. Sales staff who have their ears to the ground can also prove an invaluable source of information.

Credit terms granted to customers

Although sales representatives work under the premise that all sales are good (particularly, one may add, where commission is involved!), the credit manager must take a more dispassionate view. (S)he must balance the sales representative's desire to extend generous credit terms, please customers and boost sales, with a cost/benefit analysis of the impact of such sales, incorporating the likelihood of payment on time and the possibility of bad debts. Where a customer does ‘survive’ the credit checking process, the specific credit terms offered to them will depend upon a range of factors. These include:

• Order size and frequency — companies placing large and/or frequent orders will be in a better position to negotiate terms than firms ordering on a one-off basis.

• Market position — the relative market strengths of the customer and supplier can be influential. For example, a supplier with a strong market share may be able to impose strict credit terms on a weak, fragmented customer base.

• Profitability — the size of the profit margin on the goods sold will influence the generosity of credit facilities offered by the supplier. If margins are tight, credit advanced will be on a much stricter basis than where margins are wider.

• Financial resources of the respective businesses — from the supplier's perspective, it must have sufficient resources to be able to offer credit and ensure that the level of credit granted represents an efficient use of funds. For the customer, trade credit may represent an important source of finance, particularly where finance is constrained. If credit is not made available, the customer may switch to an alternative, more understanding supplier.

• Industry norms — unless a company can differentiate itself in some manner (e.g., unrivalled after sales service), its credit policy will generally be guided by the terms

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offered by its competitors. Suppliers will have to get a ‘feel’ for the sensitivity of demand to changes in the credit terms offered to customers.

• Business objectives — where growth in market share is an objective, trade credit may be used as a marketing device (i.e., liberalised to boost sales volumes).

The main elements of a trade policy are:

• Terms of trade — the supplier must address the following questions: which customers should receive credit? How much credit should be advanced to particular customers and what length of credit period should be allowed? (See Example 1 for an illustration of a typical credit policy decision faced by a company).

• Cash discounts — suppliers must ponder on whether to provide incentives to encourage customers to pay promptly. A number of companies have abandoned the expensive practice of offering discounts as customers frequently accepted discounts without paying in the stipulated period.

• Collection policy — an efficient system of debt collection is essential. A good accounting system should invoice customers promptly, follow up disputed invoices speedily, issue statements and reminders at appropriate intervals, and generate management reports such as an aged analysis of debtors. A clear policy must be devised for overdue accounts, and followed up consistently, with appropriate procedures (such as withdrawing future credit and charging interest on overdue amounts). Materiality is important. Whilst it may appear nonsensical to spend time chasing a small debt, by doing so, a company may send a powerful signal to its customers that it is serious about the application of its credit and collection policies. Ultimately, a balance must be struck between the cost of implementing a strict collection policy (i.e., the risk of alienating otherwise good customers) and the tangible benefits resulting from good credit management.

Example 1 Henman Limited manufactures a tennis racket, which sells for £50. The variable unit costs of production are £26, while unit fixed costs (an apportionment of the total fixed costs incurred) are £10. Net profit per unit is therefore £14. Currently Henman has a turnover of £750,000, which has been stable for three years. To increase sales, the directors of Henman Limited are always considering whether to liberalise their credit policy and allow all customers more time to pay. At present, the average debtor collection period is 30 days. The two options available to the directorate are to either increase the collection period to 40 days (this would increase sales by £85,000) or, to raise the collection period to 50 days, which would raise turnover by £95,000. The cost of capital (before tax) of Henman Limited is 20%. Which credit policy should Henman offer its customers?

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Evaluation of credit policies 40 days 50 days £ £ Debtors £835,000 x 40/365 91,507 £845,000 x 50/365 115,753 Current debtors £750,000 x 30/365 61,644 61,644 Increase in debtors 29,863 54,109 No. of additional units sold £85,000/£50 1,700 £95,000/£50 1,900 £ £ Cost of additional debtors (at 20%) (5,973) (10,822) Increase in contribution 1,700 x £24 40,800 1,900 x £24 45,600 Increase in profits 34,827 34,778 The analysis shows that a ten-day liberalisation of the current 30-day credit policy will increase profits by slightly more than the twenty-day extension. However, the results are very close and subject to any inaccuracies in the estimates utilised.

Problems in collecting debts

Despite the best efforts of companies to research the companies to whom they extend credit, problems can, and frequently do, arise. These include disputes over invoices, late payment, deduction of discounts where payment is late, and the troublesome issue of bad debts. Space precludes a detailed examination of debtor finance, so this next section concentrates solely on the frequently examined method of factoring.

Factoring — an evaluation

Key features

Factoring involves raising funds against the security of a company's trade debts, so that cash is received earlier than if the company waited for its credit customers to pay. Three basic services are offered, frequently through subsidiaries of major clearing banks:

• sales ledger accounting, involving invoicing and the collecting of debts;

• credit insurance, which guarantees against bad debts;

• provision of finance, whereby the factor immediately advances about 80% of the value of debts being collected.

There are two types of factoring service. Non-recourse factoring is where the factoring company purchases the debts without recourse to the client. This means that if the client’s debtors do not pay what they owe, the factor will not ask for his money back from the client.

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Recourse factoring, on the other hand, is where the business takes the bad debt risk. With 80% of the value of debtors paid up front (usually electronically into the client’s bank account, by the next working day), the remaining 20% is paid over when either the debtors pay the factor (in the case of recourse factoring), or, when the debt becomes due (non-recourse factoring). Factors usually charge for their services in two ways: administration fees and finance charges. Service fees typically range from 0.5 – 3% of annual turnover. For the finance made available, factors levy a separate charge, similar to that of a bank overdraft.

Advantages

• provides faster and more predictable cash flows;

• finance provided is linked to sales, in contrast to overdraft limits, which tend to be determined by historical balance sheets;

• growth can be financed through sales, rather than having to resort to external funds;

• the business can pay its suppliers promptly (perhaps benefiting from discounts) and because they have sufficient cash to pay for stocks, the firm can maintain optimal stock levels;

• management can concentrate on managing, rather than chasing debts;

• the cost of running a sales ledger department is saved and the company benefits from the expertise (and economies of scale) of the factor in credit control

. Disadvantages

• the interest charge usually costs more than other forms of short-term debt;

• the administration fee can be quite high depending on the number of debtors, the volume of business and the complexity of the accounts;

• by paying the factor directly, customers will lose some contact with the supplier. Moreover, where disputes over an invoice arise, having the factor in the middle can lead to a confused three-way communication system, which hinders the debt collection process;

• traditionally the involvement of a factor was perceived in a negative light (indicating that a company was in financial difficulties), though attitudes are rapidly changing.

Example 2 Connors plc is a small engineering company with annual credit sales of £2m. Recently, the company has witnessed increasing problems in its credit control department. The average collection period for debtors has risen to 55 days, even though the stated policy of the business is for payment within 30 days. Moreover, 1% of sales are annually written off as bad debts. Connors plc has entered into negotiations with a factor who is prepared to make an advance to the company equivalent to 80% of trade debtors, based on the assumption, that in the future, customers will adhere to the 30 day payment period. The interest rate for the advance will be

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11% per annum. Trade debtors are currently financed at 12%, through a bank overdraft. The factor will take over the credit control procedures of the company. This will not only lead to an annual saving of £15,000, but will also eliminate all bad debts. The factor will, however, make a 2% charge of sales revenue for the provision of this service. Should Connors plc take advantage of the opportunity to factor its trade debts? Two of the ways of tackling such a question are presented. The first compares the cost of the current credit policy with that prevailing if the factoring agreement were employed. Cost of existing credit policy £ Cost of debtors (50/365 x £2m x 12%) 32,877 Bad debts written off (1% x £2m) 20,000 52,877 Cost of factor Factor charges (2% x £2m) 40,000 Factor finance charges [30/365 x (80% x £2m) x 11%] 14,466 Overdraft charges [30/365 x (20% x £2m) x 12%] 3,945 58,411 Less: Cost savings 15,000 Net cost of factor agreement 43,411

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Net saving from factoring agreement (52,877 – 43,411) 9,466 Secondly, cost-benefit analysis can be used to consider the proposed change in credit policy. Cost-benefit analysis of engaging a factoring company Costs Factor charges (2% x £2m) (40,000)

Benefits Credit control department savings 15,000 Bad debts saved (1% x £2m) Net savings in finance charges 20,000 (50/365 x 12% x £2m) – [(30/365 x 80% x £2m x 11%) + (30/365 x 20% x £2m x 12%)] 14,466 49,466

Net benefit from factoring 9,466 Connors plc would benefit from entering into an agreement with the factoring company.

Conclusion

Working capital management is of critical importance to all companies. Ensuring that sufficient liquid resources are available to the company is a pre-requisite for corporate survival. Companies must strike a balance between minimizing the risk of insolvency (by having sufficient working capital) with the need to maximize the return on assets, which demands a far less conservative outlook. In this paper, one of the elements of the working capital equation, debtor management, has been considered. Students should ensure that they can not only tackle computation-type questions, but also be able to discuss the numerous facets of operating a credit management policy.

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How Capital Structure Affects A Company's Cost Of Capital?

The term capital structure refers to the mix of different types of funds which a company uses to finance its activities. Capital structure varies greatly from one company to another. For example, some companies are financed mainly by shareholders’ funds whereas others make much greater use of borrowings. In this article we consider some of the arguments that have been put forward in answer to the question “Are some capital structures better than others?”

Firstly we must decide what we mean by a ‘good’ capital structure. This would be a capital structure which results in a low overall cost of capital for the company1, that is a low overall rate of return that needs to be paid on funds provided. If the cost of capital is low, then the discounted value of future cash flows generated by the company is high, resulting in a high overall company value. The objective is therefore to find the capital structure that gives the lowest overall cost of capital and, consequently, the highest company value.

Secondly, to simplify the problem, the only variation in capital structure we will consider is in the overall amount of borrowings which firms use. We will ignore the differences between the numerous types of debt and hybrid instruments that are available and focus purely on the ratio of debt to equity funds in the company’s capital structure. The question can then be rephrased as “Does borrowing affect a company’s cost of capital, and is there an optimal level of borrowing which will minimise the cost of capital and maximise the company’s value?”

In summary, then, we will assume that companies are financed by just two types of funds, shareholders funds (equity) and borrowings (debt), and we will consider the effect on the cost of capital of varying the proportion of debt in the capital structure.

Effects of borrowing Suppose our company is financed entirely by ordinary shares (equity). What would be the effects of issuing some debt capital? The main advantage of borrowing is that debt has a cheaper direct cost than equity. There are two distinct reasons for this:

i. debt is less risky to the investor than equity (low risk results in a low required return); and

ii. interest payments are allowable against corporate taxation, whereas dividends are not.

However, borrowing has two distinct disadvantages. Firstly it causes shareholders to suffer increased volatility of earnings. This is known as financial leverage. For example, if a firm is financed entirely by equity, a 10% reduction in operating earnings will result in a 10% reduction in earnings per share. But if the firm is financed by debt as well as equity, a 10% reduction in operating earnings causes a greater reduction in earnings per share than 10%, because debt interest does not reduce in line with operating earnings.

The increased volatility to shareholders’ returns resulting from financial leverage causes shareholders to demand a higher rate of return in compensation. In other words, any borrowing at all will cause the cost of equity capital to rise, off-setting the cheap direct cost of debt.

The second disadvantage of borrowing is that if the company borrows too much, it increases its bankruptcy risks. At reasonable levels of gearing this effect will be imperceptible, but it becomes significant for highly geared companies and results in a range of risks and costs which have the effect of increasing the company’s cost of capital.

In summary then, we have identified two distinct advantages of borrowing and two distinct disadvantages (Figure 1). There are other advantages and disadvantages, but for the moment let

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us just focus on these four effects. To what extent do the disadvantages offset the advantages? In the discussion that follows we will look at the effects of the firm’s weighted average cost of capital, or WACC (Figure 2).

Figure 1: Two advantages and two disadvantages of borrowing Advantages Disadvantages 1. Cheap direct cost because debt is less risky to the investor

1. Financial leverage causes shareholders to increase their cost of capital

2. Cheap direct cost because interest is a tax deductible expense. 2. Bankruptcy risks if borrowings are too high.

Effect of borrowing on WACC: traditional view

The so-called traditional view of capital structure states that when a company starts to borrow, the advantages outweigh the disadvantages. The cheap cost of debt, combined with its tax advantage, will cause the WACC to fall as borrowing increases.

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However, as gearing increases, the effect of financial leverage causes shareholders to increase their required return (i.e., the cost of equity rises). At high gearing the cost of debt also rises because the chance of the company defaulting on the debt is higher (i.e., bankruptcy risk). So at higher gearing, the WACC will increase.

The result is that we should be able to identify a minimum WACC and an optimal gearing, as shown on the graph in Figure 3.

Example 1

Suppose that when a company has no borrowings its cost of equity capital (Ke) is 20% per annum. Its WACC is of course also 20% because there is no debt. Now suppose it borrows at an after-tax cost (K d) of 10% per annum to a proportion of debt to equity of 3:7. Suppose the cost of equity rises because of financial leverage to 22%. What is the WACC?

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Solution WACC = 7/10 x 22% + 3/10 x 10% = 18.4%. The WACC has been lowered by borrowing.

Example 2 Now suppose the company borrows more so that the proportion of debt to equity is 1:1. Suppose the cost of equity rises to 27%. Suppose also that because of default risk, the average cost of the company’s debt is now 12%. What is the WACC? Solution WACC = 1/2 x 27% + 1/2 x 12% = 19.5%. The WACC has started to rise again, indicating that the borrowing is at an above-optimal level.

The main problem with the traditional view is that there is no underlying theory to show by how much the cost of equity should increase because of financial leverage or the cost of debt should increase because of default risk. The figures we have used in the calculations are entirely subjective. Although it is more or less realistic, the traditional view remains a purely descriptive theory.

Modigliani and Miller’s theory (1958)

In contrast to the traditional view, Modigliani and Miller (MM) set out to show what ought to happen to the cost of capital when a company increases or decreases borrowing. The approach for normative theories of this type is to state a set of assumptions and then to deduce the logical conclusions. The effect of relaxing some of the assumptions can then be examined.

In order to demonstrate a workable theory, MM’s 1958 paper made a number of simplifying assumptions which are common in the theory of finance: they assume that the capital market is perfect; there are therefore no transactions costs and the borrowing rate is the same as the lending rate and equal to the so-called risk free rate of borrowing; taxation is ignored and risk is measured entirely by volatility of cash flows.

If the capital market is perfect, MM argue, then all companies with the same business risk and the same expected annual earnings should have the same total value, regardless of capital structure, because the value of a company should depend on the present value of its operations, not on the way it is financed.

It follows from this that if all such companies have the same expected earnings and the same value, they must also have the same WACC, regardless of capital structure, because WACC is simply the rate of return that links earnings with value (see the numerical illustration below). Hence, for any individual company, WACC will be the same at all levels of gearing. In other words, there is no optimal level of gearing and no minimum WACC — one capital structure is as good as another.

MM offered a number of formal proofs of their theory. To gain a further understanding of the theory, consider the assumptions on which it is based.

Although perfect capital market assumptions are unrealistic, most of them do not pose serious problems for the theory. However, there are two assumptions which need to be highlighted because they have a significant effect on the result.

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1. It is assumed there is no taxation: this is a serious problem because one of the key advantages of debt is the tax relief on interest payments.

2. Risk in Modigliani and Miller’s theory is measured entirely by variability of cash flows. They ignore the possibility that cash flows might cease because of bankruptcy. This is another significant problem for the theory if borrowing is high.

Making these assumptions means that from Figure 1 there is only one advantage of borrowing (debt is cheaper because it is less risky to the investor) and one disadvantage (the cost of equity increases with borrowing because of financial leverage).

Modigliani and Miller show that these effects cancel out exactly. The use of cheap debt gives shareholders a higher rate of return, but this higher return is precisely what they need to compensate for the increased risk from financial leverage (Figure 4). The graph of cost of capital against gearing (as measured by debt/equity ratio) is shown in Figure 5.

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