CAT FFM Course Notes PDF

FFM Course notes
Syllabus A: Working Capital Management ............................. 5

Syllabus A1abc. Working Capital Management. .............................................5
Syllabus A1de. Cash Operating Cycle. .........................................................8
Syllabus A1d. Receivables Days. ............................................................... 11
Syllabus A1d. Payable days. .....................................................................13
Syllabus A1d. Inventory days. ....................................................................14
Syllabus A1f. Overtrading. .........................................................................15
Syllabus A1g. Over-capitalisation and Over-trading.. .....................................16
Syllabus A1g. Ratios and Strategy.............................................................. 18
Syllabus A2b. Work In Progress - WIP. ....................................................... 21
Syllabus A2acd. Economic Order Quantity .................................................. 22
Syllabus A2d. EOQ with Discounts. ........................................................... 25
Syllabus A2d. Buffer Stock. .......................................................................27
Syllabus A2e. Just-In-Time. .......................................................................28
Syllabus A3. Accounts payables. ............................................................... 30
Syllabus A3. Managing Receivables in Practice. ...........................................34
Syllabus A3g & C3d. Early Settlement Discounts (Creditors). ......................... 36
Syllabus A3g. Early Settlement Discounts. ................................................... 38
Syllabus B: Cash Budgeting .................................................. 42
Syllabus B1a. Cash, cash flow and funds. .................................................. 42
Syllabus B1b. Importance of cash flow management. ...................................43
Syllabus B1c. Sources of finance. .............................................................. 44
Syllabus B1de. CF and different types of organisations. ................................ 45
Syllabus B1fg. Cash vs. Accrual Accounting. ..............................................47
Syllabus B1h. Cash flow and profit. ............................................................ 48
Syllabus B1h. The effect of transactions on cash flows. ................................ 50
Syllabus B2a. Cash budget.......................................................................54
Syllabus B2b. Linear Regression. ............................................................... 55
Syllabus B2b. Time Series Analysis. ........................................................... 59
1 ©
Syllabus B2c. Inflation and the impact on CF. ..............................................63
Syllabus B2deg. Cashflow Forecasts. ........................................................ 66
Syllabus B2f. The Use of Simulation, Expected Values and Sensitivity. ............70
Syllabus C: Managing Cash Balances .................................. 73
Syllabus C1a. Main functions & treasury functions. .......................................73
Syllabus C1b. Advantages of a centralised treasury department..................... 79
Syllabus C1c. ADV and Disadv. of centralised cash control. .......................... 80
Syllabus C1d. Cash Handling Procedures................................................... 82
Syllabus C1ef. Optimal cash balances. ....................................................... 83
Syllabus C2a. Types of banks. ..................................................................85
Syllabus C2h. Financial Markets. ................................................................ 88
Syllabus C2bc. The Role of Financial Intermediaries. .....................................91
Syllabus C2d. Benefits of financial intermediation ..........................................93
Syllabus C2e. Relationships between financial institutions .............................. 95
Syllabus C2h. The role of money and capital markets ...................................97
Syllabus C2h. The role of banks in the operation of the money markets. .........99
Syllabus C2f. The characteristics and role of the principal money market ....... 101
Syllabus C2e. Equity: ............................................................................. 104
Syllabus C2e. Preference Shares............................................................. 106
Syllabus C2g. NCL - debts ..................................................................... 108
Syllabus C2i. Functions of Stock and Bond markets................................... 112
Syllabus C2j. Reasons for a stock exchange listing. ................................... 113
Syllabus C3aef. Short term finance........................................................... 115
Syllabus C3b. Different forms of bank loans. .............................................. 118
Syllabus C3b. Loan or overdraft?. ............................................................ 120
Syllabus C3c. Legal relationship between bank and customer. .................... 122
Syllabus C4abcd. Cash surpluses and deficits. ......................................... 125
Syllabus C4e. Risk and Return of different securities. .................................. 127
Syllabus C4f. Default Risk. ...................................................................... 129
2 ©
Syllabus C4gh. Baumol Model ................................................................ 131
Syllabus D: Financing Decisions ......................................... 133
Syllabus D1. Economic Policy.................................................................. 133
Syllabus D1. Monetary Policy................................................................... 139
Syllabus D2. Medium term finance. .......................................................... 141
Syllabus D3ab. Long term finance. ........................................................... 143
Syllabus D3b. Debt or Equity? ... ............................................................. 148
Syllabus D3c. Gearing considerations....................................................... 150
Syllabus D3d. Merits and limitations of LT finance. ...................................... 153
Syllabus D3e. Mix of finance in an organisation. ......................................... 155
Syllabus D3f. Internal funds. .................................................................... 157
Syllabus D4a. SMEs and stakeholder interests.. ........................................ 158
Syllabus D4bc. Reasons why a small business can find it difficult to obtain. ... 159
Syllabus D4d. Government and SME ....................................................... 161
Syllabus D4ef. Venture capital.................................................................. 163
Syllabus D4gh. Finance for SMEs. ........................................................... 164
Syllabus E: Investment Decisions ....................................... 167
Syllabus E1a. Simple and compound interest. ........................................... 167
Syllabus E1c. Concept of time value of money. ......................................... 170
Syllabus E1bde. Discounting. .................................................................. 171
Syllabus E2a. Importance of capital investment planning.............................. 173
Syllabus E2b. Preparation of a capital expenditure budget ........................... 174
Syllabus E2c. Capital and revenue expenditure. ......................................... 175
Syllabus E2d. Investment in NCA vs. investment in WC .............................. 177
Syllabus E2e. Investment appraisal process. ............................................. 178
Syllabus E3a. Payback method. .............................................................. 180
Syllabus E3a. Adjusted Payback. ............................................................. 185
Syllabus E3b. Accounting Rate of Return. ................................................. 187
Syllabus E3cd. Relevant costs. ................................................................ 191
3 ©
Syllabus E3ef. NPV. ............................................................................... 195
Syllabus E3f. Annuities & Perpetuities........................................................ 197
Syllabus E3gh. Internal Rate of Return....................................................... 199
Syllabus E3i. NPV v IRR. ......................................................................... 202
Syllabus E3j. Discounted Cashflows. ........................................................ 204
Syllabus F: Credit Management .......................................... 206
Syllabus F1a. Key elements of a contract. ................................................. 206
Syllabus F1b. Terms and conditions - contracts with credit customers.......... 208
Syllabus F1c. Collection of debts. ............................................................ 209
Syllabus F1d. Data protection. ................................................................. 211
Syllabus F1e. Bankruptcy and insolvency. ................................................. 213
Syllabus F2ab. Credit management.......................................................... 215
Syllabus F2c. Assessing the credit-worthiness. .......................................... 218
Syllabus F2de. Internal and external sources of information. ......................... 219
Syllabus F2f. Credit Score. ...................................................................... 220
Syllabus F2g. Rejecting or extending credit................................................ 221
Syllabus F2hi. Ratios and credit-worthiness. .............................................. 222
Syllabus F2j. Ratio limitations.................................................................... 224
Syllabus F3a. Accounts receivables records. ............................................. 226
Syllabus F3b. Internal sources ................................................................. 228
Syllabus F3b. Accounts Receivable Reconciliation ...................................... 231
Syllabus F3c. External sources. ............................................................... 232
Syllabus F4abc. Debt collection. .............................................................. 235
Syllabus F4c. Follow-up processes. ......................................................... 238
Syllabus F4d. Debt recovery methods ...................................................... 239
Syllabus F4e. Debt collection and court .................................................... 242
Syllabus F4e. Writing off debts ................................................................. 245
Syllabus F4fg. Factoring and invoice discounting. ....................................... 247
Syllabus F4h. Debt Factor. ...................................................................... 248
4 ©
Syllabus A: Working Capital Management
Syllabus A1. A1. Working capital management cycle.
Syllabus A1a. Define working capital.
b) Explain why working capital management is important.
c) Explain the relationship between cash flows and the working capital cycle.
Working Capital Management
What is it and why is it important?
Working capital is simply the money needed for day to day business.
This money is needed to keep the company alive so its importance cannot be over
emphasised.
It is the management of each current asset and each current liability that is essential
to the business.
• Working capital = net current assets = current assets - current liabilities
Current assets Current liabilities

Cash Overdraft
Inventories Payables <1 year
Receivables
5 ©
Liquidity v profitability problem
• Consider this.
You are the MD of a new company selling i-pads.
Demand is looking good.
Your natural inclination is probably to buy more in, to sell in the future.
We call this a short-term investment .
• You have invested in inventory to boost profits - this is one of the objectives of
working capital.
However, you know you also have to pay the lease on your office - luckily you
have set aside a little for this.
We call this liquidity.
• Maintaining enough to pay short term payables.

This is another of the objectives of working capital.
So we would like to use the working capital for both Short-term investment and
Liquidity
• Hopefully you can see that part of you wants to invest the money and another
wishes to save to pay bills.
This is the conflict of working capital objectives.

Minimising the risk of insolvency while maximising the return on assets.
Managing working capital
The management of working capital is important to the financial health of businesses

of all sizes.
The amounts invested in working capital are often high in proportion to the total
assets employed and so it is vital that these amounts are used in an efficient and
effective way.
However, there is evidence that small businesses are not very good at managing
their working capital.
6 ©
Given that many small businesses suffer from undercapitalisation, the importance of
exerting tight control over working capital investment is difficult to overstate.
The finance profession recognises the three primary reasons offered by economist
John Maynard Keynes to explain why firms hold cash.
All three of these reasons stem from the need for companies to possess liquidity
1. Speculation
To take advantage of special opportunities that if acted upon quickly will favour
the firm.
An example of this would be purchasing extra inventory at a discount.
2. Precaution
As an emergency fund for a firm.
3. Transaction
Firms hold cash in order to satisfy the cash inflow and cash outflow needs that
they have.
Efficient management of working capital is extremely important to any

organisation.
Holding too much working capital is inefficient, holding too little is dangerous to
the organisation’s survival.
7 ©
Syllabus A1de. Demonstrate the calculation of the working capital cycle (also known as the
cash operating cycle) .
e) Outline the possible relationships between inventory levels and sales.
Cash operating cycle (working capital cycle)
This is the time between cash paid for raw materials and cash received from
customers.
Day 1 Buy an item on credit (Payable)
Day 5 Sell the item on credit (Receivable)
Day 8 Pay for the item
Day 10 Receive the cash for the item
How long is the item in stock for? 4 days
How long is the receivable period? 5 days
How long is the payable period? 7 days
How long between having to pay and receiving the cash? 2 days
The 2 days is the cash operating cycle. It is how long between paying for an item
and eventually receiving the cash.
8 ©
This period needs funding somehow
Look again at the illustration and you may see how it is calculated:
Inventory Days 4 days
Receivable days 5 days
Payable days (7 days)
Cash operating cycle 2 days
Note the CASH needed in the gap can get bigger by:
1. Cycle gets longer (need more cash in proportion to the extra days in cycle)
2. Sales increase (need more cash in proportion to the extra sales made)
The length of the cycle will depend upon:
1. Liquidity v profitability decisions (eg credit terms offered)
2. Management efficiency
3. Industry norms (supermarkets very short - construction industry very long)
An increase in the length of the cash operating cycle will increase the level of
investment in working capital.
9 ©
Nature of business operations
• Different industries have, not surprisingly, different cash operating cycles.
My academies, for example, hold very little stock (because I’m tight?) - er no
because we sell services!
Compare that to WeSellLotsofStuff plc who hold lots of stuff (inventories).
Many retailers sell direct to the smelly, unwashed public and so have very few
receivables - others sell to other businesses and so offer credit terms.
If an operating cycle is long, then there is lower accessibility to cash for satisfying
liabilities for the short term.
A short cash cycle reflects sound management of working capital. A long cash cycle
denotes that capital is occupied when the commercial entity is expecting its clients to
make payments.
Negative cash operating cycle
Here they are getting payments from the clients before any payment is made to the
suppliers.
Instances of such business entities are commonly those companies, which apply
Just in Time techniques, for example Dell, as well as commercial enterprises, which
purchase on credit and sell for cash, for instance Tesco.
10 ©
Syllabus A1d. Demonstrate the calculation of the working capital cycle (also known as the
Receivables Days
The approximate amount of time that it takes for a business to receive payments
owed.
The Average Collection Period measures the average number of days it takes for the
company to collect revenue from its credit sales.
The company will usually state its credit policies in its financial statement, so the
Average Collection Period can be easily gauged as to whether or not it is indicating
positive or negative information.
11 ©
Importance of Average Collection Period:
• This ratio reflects how easily the company can collect on its customers. It also
can be used as a guage of how loose or tight the company maintains its credit
policies.
• A particular thing to watch out for is if the Average Collection Period is rising over
time. This could be an indicator that the company’s customers are in trouble,
which could spell trouble ahead.
• This could also indicate the company has loosened its credit policies with
customers, meaning that they may have been extending credit to companies
where they normally would not have.
This could temporarily boost sales, but could also result in an increase in sales
revenue that cannot be recovered, as shown in the Allowance for Doubtful Debts.
Illustration
• A company has total credit sales of $100,000 during a year and has an average
amount of accounts receivables of $50,000. Its average collection period is
therefore 182.5 days
• Possessing a lower average collection period is seen as optimal, because this

means that it does not take a company very long to turn its receivables into cash.
12 ©
Payable days
It means:
The approximate amount of time that it takes for a business to make payments
owed.
• It measures the average amount of time you use each dollar of your trade credit.
This measurement gauges the relationship between your trade credit and your
cash flow
• A longer average payable period allows you to maximize your trade credit.
This means that you are delaying spending cash and taking full advantage of
trade credit.
13 ©
Inventory Days
Explanation of Inventory Days:
• A financial measure of a company’s performance that gives investors an idea

of how long it takes a company to turn its inventory (including goods that are
work in progress, if applicable) into sales.
• Generally, the lower (shorter) the better, but it is important to note that the
average varies from one industry to another.
This measure is one part of the cash conversion cycle, which represents the
process of turning raw materials into cash.
14 ©
Syllabus A1f. Define and explain over-trading and over- capitalisation.
Overtrading
Overtrading or undercapitalisation arises when a company has too small a capital

base to support its level of business activity.
Difficulties with liquidity may arise as an overtrading company may have insufficient
capital to meet its liabilities as they fall due.
Overtrading
• is often associated with a rapid increase in turnover. Investment in working

capital does not match the increase in sales.
• could be indicated by a deterioration in inventory days. Possibly because of

stockpiling in anticipation of a further increase in turnover, leading to an increase
in operating costs.
• could also be indicated by deterioration in receivables days, possibly due to a

relaxation of credit terms.
As the liquidity problem associated with overtrading deepens, the overtrading

company increases its reliance on short-term sources of finance, including
overdraft, trade payables and leasing.
• can also be indicated by decreases in the current ratio and the quick ratio.
15 ©
Syllabus A1g. Identify and calculate over-trading and over- capitalisation financial indicators..
Over-capitalisation and Over-trading
Over-capitalisation
This is when the total owned and borrowed capital exceeds the fixed and current
assets.
It is when profits of the company are not sufficient to pay interest on debentures and
borrowings and dividend to shareholders.
There are 3 indicators of over-capitalisation:
1. Over-valued: Fixed assets may be having higher cost than that of its actual cost.
2. Lower Earnings
3. Idle Funds: Company may have funds which might not have been used properly
e.g. Money invested in such projects that are giving very low profits.
Effects of Over-capitalisation on Company:
1. The shares of the company may not be easily marketable because of reduced
earnings per share.
2. The company may not be able to raise fresh capital from the market.
3. Reduced earnings may force the management to follow unfair practices. It may
manipulate the accounts to show higher profits.
4. Management may cut down expenditure on maintenance and replacement of
assets. Proper amount of depreciation of assets may not be provided for.
5. Because of low earnings, reputation of the company would be lowered.
16 ©
Over-trading
Overtrading takes place when a business accepts work and tries to complete it, but
finds that fulfilment requires greater resources such as:
• more people
• working capital
than are available. This is often caused by unforeseen events such as when
manufacture or delivery take longer than anticipated, resulting in cashflow being
impaired.
17 ©
Syllabus A1g. g) Identify and calculate over-trading and over- capitalisation financial indicators.
Accounting Ratios
In your exam, you may be required to calculate some ratios.
This section shall only present a summary and list of ratios that could potential be
used in your exam for such purpose.
Ratios may be divided into the following categories:
• PROFITABILITY RATIOS
These are measures of value added being generated by an organisation and

include the following:
ROCE Operating Profit (PBIT)/Capital Employed

Capital Equity + LT liabilities
Employed
Capital Non current assets + net current assets

Employed
Capital Total assets - current liabilities

Employed
Gross Gross Profit/Sales

margin
Net Margin Net Profit/Sales

ROE Profit After Tax - Preference dividends/Shareholders’ Funds
(Ordinary shares + Reserves)
RI Profit After Tax - (Operating Assets x Cost of Capital)
18 ©
• EFFICIENCY RATIOS
These are measures of utilisation of Current & Non-current Assets of an

organisation. Efficiency Ratios consist of the following:
Asset Turnover Sales/Capital Employed
ROCE Margin X Asset Turnover
Receivables Days (Receivables Balance / Credit Sales) x 365
Payables Days (Payable Balance / Credit Purchases) x 365
Inventory Days (Inventory / Cost of Sales) x 365
• LIQUIDITY & GEARING RATIOS
Liquidity Ratios measure the extent to which an organisation is capable of

converting assets into cash and cash equivalents.
On the other hand, Gearing Ratios measure the dependence of an organisation

on external financing as against shareholder funds.
Liquidity and Gearing Ratios are outlined below:
Liquidity
Current Ratio Current Assets / Current Liabilities
Quick Ratio (Current Assets – Inventory) / Current Liabilities
Gearing
Financial Gearing Debt/Equity
Financial Gearing Debt/Debt + Equity
Operational gearing Contribution / PBIT
19 ©
• INVESTOR'S RATIOS
These ratios measures return on investment generated by stakeholders. Such

ratios include:
Dividend Cover Profit After Tax / Total Dividend

Dividend Yield Dividends per share / Share price
Interest Cover PBIT / Interest
Interest yield (coupon rate / market price) x 100%
Earnings Per Share Profit After Tax and preference dividends / Number of
Shares
PE Ratio Share Price / EPS
• In the exam you have to act like a detective.
You have to sift through evidence and extract meaningful messages for effective
business decisions.
The starting point is often the basic accounting documents that record the
progress of any business, the Income statement & SFP
These are closely related and so need reading together.
The balance sheet is a snapshot of a business at one point in time.
The income statement is dynamic and describes the flow of money through the
business over a period of time.
20 ©
Syllabus A2b. Define and explain work in progress.
Work In Progress - WIP
Material that has entered the production process but is not yet a finished product.
Work in progress (WIP) refers to:
1. partly finished products

2. all materials that are at various stages of the production process
WIP excludes
1. inventory of raw materials at the start of the production cycle

2. finished products inventory at the end of the production cycle.
21 ©
Syllabus A2acd.
a) Discuss the key considerations when developing an inventory ordering and storage policy.
c) Define economic order quantity (EOQ) .
d) Apply the EOQ model.
Economic order quantity
The level of inventory that minimises the total of inventory holding cost and ordering
cost
Holding Costs
• The more stock you hold the more it costs.
So you should keep stock low.
Ordering costs
• The more orders you make the more it costs.
So you should order lots at a time, meaning fewer orders (but higher stock).
• These two costs therefore work in opposite ways.
One suggests keep stocks low, the other keep stock high (to keep orders down).
So, this where the EOQ model will help.
It is mathematically the perfect position, the perfect amount to order.
22 ©
The position where total ordering and holding costs are at their lowest
This happens also to be where holding costs = ordering costs.
So, to repeat, the EOQ level is where the total (ordering and holding) costs will be
minimised.
How is this cute little baby calculated?:
(Well you lucky fruit nuts - this formula is given in the exam) - Anyway here it is….
Where Co = Order Costs; Ch = holding cost per unit and D = annual demand
Lets now see what these pesky HOLDING and ORDERING costs actually are
• Holding costs
1. Warehouse
2. Insurance
3. Obsolescence
4. Opportunity cost of capital
23 ©
• Ordering costs
1. Administration
2. Delivery costs
HOLDING AND ORDER COSTS
• Calculating Holding Costs:

Holding Cost per unit x (Order amount / 2)
• Calculating Order Costs:

Order costs per unit x (Annual Demand / Order amount)
• Assumptions/Criticisms:
o The ordering cost is constant.
o The annual demand for the item is constant and it is known to the firm.
o Quantity discounts don’t exist.
o The order is received immediately after placing the order.
o No buffer stock is required
o Ignores hidden stock holding costs (unreliable suppliers etc)
o Ignores benefit of stock holding (choice etc)
24 ©
Syllabus A2d. Apply the EOQ model.
EOQ with Discounts
Bulk buying discounts may be available if the order quantity is above a certain size.
To calculate the best order quantity then we need to:
1. Calculate EOQ in normal way (and the costs)

2. Calculate costs at the lower level of each discount above the EOQ
3. Then choose the lowest cost option!
Illustration
Demand is 100 units per month. Purchase cost per unit £10. Order cost £20
Holding cost 10% p.a. of stock value.
• Required
Calculate the minimum total cost with a discount of 2% given on orders of 350
and over
Solution
Calculate EOQ in normal way (and the costs)

Calculate costs at the lower level of each discount above the
EOQ
Sq root 2 x 20 x 1200 / 1 = 219
25 ©
• Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)

= 20 x 1200 / 219
= 110
• Holding Costs
= Holding Cost per unit x (Order amount / 2)

= 1 x 219 / 2
= 110
= 220
• At discount level 350
Ordering Costs
= Order cost per unit x (Annual Demand / Order amount)

= 20 x 1200 / 350 = 69
• Holding Costs
= Holding Cost per unit x (Order amount / 2)

= 0.98 x 350 / 2 = 171.5
= 240.5
240.5 is higher than 220 (it would be as EOQ is the best level)
However we now need to take into account the 2% price discount
Discount = 2% x 1200 x 10 = 240
Clearly with the discount being offered the company should take the discount and
order at 350
26 ©
Syllabus A2d. Apply the EOQ model.
Buffer Stock
Let’s say we sell 10 items of stock a week, and stock takes 2 weeks to come in.
Hopefully you can see that we need to make an order when stock levels fall to 20
If we order when they fall to 30, this must mean we like to keep a buffer (safety)
stock of 10
Re-order Level
Demand x Lead Time

• So, EOQ looks at how much to order, now lets look at when.
The answer should be obvious - it is when you run out of stock.
However you need to reorder before that, to give the stock time to arrive.
So the RE-ORDER level is not zero it is DEMAND x Time it takes to arrive in
stock.
This though presumes constant and known demand. Luckily that is all that is
needed in this examination!
Buffer Stock
Can be calculated if not given:

• Actual re-order level - Stock used in lead time
Using EOQ with Buffer Stock
1. Calculate Buffer stock (if not given)

2. Calculate EOQ and costs ignoring buffer stock
3. Add on HOLDING costs for buffer stock
27 ©
Syllabus A2e. Discuss the effects of just-in-time on inventory control.
Just-in-time (JIT)
An inventory strategy which reduces in-process inventory.
• In order to achieve JIT the process must have signals of what is going on
elsewhere within the process. These signals tell production processes when to
make the next part.
They can be simple visual signals, such as the presence of a part on a shelf.
• Quick communication of the consumption of old stock which triggers new stock to
be ordered is key to JIT and inventory reduction.
• JIT emphasises inventory as one of the seven wastes (overproduction, waiting

time, transportation, inventory, processing, motion and product defect), and so
aims to reduce buffer inventory to zero.
Zero buffer inventory means that production is not protected from external shocks
5 Key aspects to JIT
1. Multi skilled workers

2. Close relationship with suppliers
3. Reduced set up times
4. Quality
5. Teams working in cells
28 ©
Benefits
1. Lower level of investment in working capital

2. A reduction in inventory holding costs
3. A reduction in materials handling costs
4. Improved operating efficiency
5. Lower reworking costs due to the increased emphasis on the quality of
supplies
29 ©
Syllabus A3acdef.
a) Explain the role of accounts payables in the working capital cycle.
c) Explain the need to monitor accounts payables.
d) Explain accounts payables control operations and the importance of accounts payables
management.
e) Describe the various types and form of accounts payables.
f) Describe the various accounts payables payment methods and procedures (for example,
direct debit) .
Accounts payables
is money owed by a business to its suppliers shown as a liability on a company's

balance sheet.
Accounts payables include expenses such as:
• taxes
• insurance
• rent
• mortgage payments
• utilities
• loan payments
• interest
30 ©
Monitoring accounts payables
Every business should keep a reasonable balance between the money coming into
and flowing out.
It is crucial to the success of a small business that accounts payable be monitored

closely.
Entrepreneurs who find themselves struggling to meet their accounts payable
obligations have a couple of different options:
1. Don’t pay off debts until the business's financial situation has improved
Disadvantage: delays can destroy relations with vendors
2. Make partial payments to vendors and other creditors
This good-faith approach shows that an effort is being made to meet financial
obligations
It can avoid interest penalties from not paying.
Partial payments should be set up and agreed to as soon as payment problems

are foreseen.
Aged payables
One clean sign of cash flow problems is an increase in aged payables.
Aged payables are those for which the due date has passed.
Bills should never be allowed to be more than 45 to 60 days beyond the due date
unless a special payment arrangement has been made with the vendor in advance.
At 60 days, a company's credit rating could be jeopardised; this could make it harder
to deal with other vendors and/or loaning institutions in the future.
31 ©
Outstanding balances can drive interest penalties way up.
Such excessive interest payments can seriously damage a business.
Payment method - Direct Debit
Direct Debit is the way for you to pay regular bills.
1. Instruct your bank
A Direct Debit is an instruction from you to your bank.
Give them the details such as:

- amounts
- dates
- receiver 's details.
2. Suplliers get paid
Your bank authorises the organisation you want to pay to collect varying amounts
from your account.
The money is deducted automatically.
32 ©
Example 1
A company has the following non-current assets:
2015: $100,000
2016: $200,000
Depreciation for the year 2016 is $50,000.
No disposals were made in the period.
Whats is the current figure for cash purchase of NCA during 2016?
• Solution
NCA as at 2016 200,000
Add back depreciation 50,000
NCA as at 2015 (100,000)
Purchases in 2016 (200,000 + 50,000 - 100,000) 150,000
33 ©
Syllabus A3bh.
b) Explain the role of accounts receivables in the working capital cycle.
h) Identify the risks of taking increased credit and buying under extended credit terms.
Policy formulation
This is concerned with establishing the framework within which management of

accounts receivable in an individual company takes place.
The elements to be considered include:
1. establishing terms of trade, such as period of credit offered and early settlement
discounts:
2. deciding whether to charge interest on overdue accounts
3. determining procedures to be followed when granting credit to new customers
4. establishing procedures to be followed when accounts become overdue.
Credit Analysis
• Assessment of creditworthiness depends on the analysis of information relating

to the new customer.
• This information is often generated by a third party and includes bank references,
trade references and credit reference agency reports.
• The depth of credit analysis depends on the amount of credit being granted, as
well as the possibility of repeat business.
34 ©
Credit Control
• Once credit has been granted, it is important to review outstanding accounts on a

regular basis so overdue accounts can be identified.
This can be done, for example, by an aged receivables analysis.
It is also important to ensure that administrative procedures are timely and

robust.
For example sending out invoices and statements of account, communicating

with customers by telephone or e-mail, and maintaining account records should
utilise the ‘Credit Policy’ to receive, record, maintain, and most importantly,
control credit sales.
Collecting amounts owing
• Ideally, all customers will settle within the agreed terms of trade.
If this does not happen, a company needs to have in place agreed procedures for
dealing with overdue accounts.
These could cover logged telephone calls, personal visits, charging interest on
outstanding amounts, refusing to grant further credit and, as a last resort, legal
action.
With any action, potential benefit should always exceed expected cost.
Two other commonly used methods of debt collection are:
1. Early settlement discounts
2. Debt factoring
35 ©
Syllabus A3g. & C3d.
A3g) Evaluate and demonstrate the issues involved with early payment and settlement
discounts.
C3d) Explain the nature of trade credit and its use as a short-term source of finance.
Using Trade Credit Effectively
Clearly it is best to take as much advantage of trade credit as possible. Paying later
is almost always beneficial.
However, a company needs to ensure it does not annoy its vital suppliers by missing
deadlines and also the company may seek to take advantage of early settlement
discounts.
How to quickly calculate an annual interest rate
1. Take 100 and divide it by 100 - discount % offered
2. Multiply this by the power of 365 / reduction in days
3. Take the 1 off and voila!
36 ©
Illustration 1
5% early settlement discount if customers pay within 10 instead of 60 days.
1. Take 100 and divide it by 100 - discount % offered
100 / (100 - 5)
2. Multiply this by the power of 365 / reduction in days
((100/95) power of 365/50)
3. Take the 1 off and voila!
((100/95) power of 365/50) - 1 = 45.42%
Illustration 2
Cow Co is considering accepting a discount of 2% from his supplier if he pays within

20 days rather than the current 35 days.
There are 365 days in the year.
Required:
What is the annual interest rate (the compound percentage cost)?
• Annual interest rate = ((100/(100 – 2)) power of (365/15)) – 1 = 63·5%
37 ©
Syllabus A3g. Evaluate and demonstrate the issues involved with early payment and settlement
discounts.
Offering early settlement discounts
There are four main reasons why a business may offer its customers discounts to
pay early:
1. If cash is received earlier, it will improve the supplier’s liquidity position, because
it reduces the length of its cash operating cycle.
This will be particularly important if a seller is suffering from cashflow problems.
2. If the cash from customers is received early, the cost of financing receivables is
reduced.
For example, if the supplier has an overdraft agreement under which it borrows at
a cost of 10% per annum, then provided that the cost of offering the discount is
less than the cost of the overdraft, the supplier will be better off financially.
3. When customers are deciding which payments to make to suppliers and which
ones to delay, they are likely to pay those suppliers offering a discount for early
payment first.
From the point of view of the supplier offering the discount, this means that the
incidence of bad debts is likely to be reduced, since customers will choose to pay
them first if they are short of cash.
4. It is possible that offering a discount may provide an incentive to new customers,

because the cost of the goods from a supplier offering a discount may now be
less than those of a supplier not offering a discount, provided that the potentially
new customer pays within the specified time limit.
38 ©
Receivables aren’t cash. So they need funding.
Think of this being funded by an overdraft. Therefore, the overdraft rate x receivables
is the cost.
In questions you will be asked to compare the current policy cost, to a new policy
cost (offering early settlement discounts) to see which is cheaper
Let’s have a think about this:
1. Early settlement will mean receivables will get smaller and so the cost less
2. However the discount is a cost to the company too so needs to be taken into
account
The steps are as follows:
Step 1: Calculate current policy cost of receivables (receivables x Overdraft Interest

rate)
Step 2: Calculate NEW policy cost of NEW receivables (New receivables x overdraft
interest rate)
Step 3: Calculate cost of early settlement discount and add to the new policy cost
39 ©
Illustration
Company has credit sales of 1200 and a 3 month credit policy.

New policy is 2% early settlement discount (within 10 days) and a new credit policy
for others of 2 months
20% will take the discount. Cost of capital 10%
Step 1: Old Policy cost of Receivables = 3/12 x 1200 = 300 x 10% = 30
Step 2: New Policy cost of Receivables after = 2/12 x 80% x 1200 = 160 x 10% = 16
+ 10/365 x 20% x 1200 = 7 x 10% = 0.7
Step 3: Cost of early settlement discount 2% x 20% x 1200 = 4.8
Cost of Old Policy = 30

Cost of New Policy = 16+0.7+4.8 = 21.5
The cost of the new policy is less and so should be taken
Increase the credit term?
• Occasionally you may be told that a new policy of INCREASING the credit term
will also increase sales (as a larger credit term will attract more customers)
• Remember here that the company is not better off by the full sales amount, but
by the contribution (sales less variable costs) that these sales bring in.
For example if extra sales are 100 and the contribution to sales ratio is 20%, then
you will take an extra 20 income to the new policy calculation
• You then need to compare this to the extra cost caused by the extra credit term
(new receivables x overdraft rate)
40 ©
Illustration
A company currently has sales of 1,200 and a credit term of 1 month.
It is planning to offer a term of 2 months in order to attract more customers.
Their contribution to sales ratio is 20% and their overdraft rate is 10%. Sales are
expected to increase by 20%
Is the change in policy a good idea?
Current Policy New Policy
Cost of Receivables 1/12 x 1200 x 10% = 10 2/12 x 1,440 x 10% = 24
Extra Contribution 240 x 20% = (48)
The new policy has less costs than the current policy and so should be given the go-
ahead
41 ©
Syllabus B: Cash Budgeting
Syllabus B1. Nature and sources of cash
Syllabus B1a. Define cash, cash flow and funds.
Cash, cash flow and funds
Cash comprises:
1. Cash and bank deposits

2. Cash equivalents - short-term, highly liquid investments
The amount of cash held by a business at a point in time is found in the balance
sheet under “current assets”.
Cash flow
Cash flow refers to the movement of cash in and out of a business over a period of
time.
This information is found in a statement of cash flows, which is a primary financial
statement.
42 ©
Syllabus B1b. Explain the importance of cash flow management and its impact on liquidity and
company survival.
Importance of cash flow management
Planning, tracking and collecting cash are all important because cash PAYS THE
BILLS.
• The failure to pay bills puts a company in danger of bankruptcy.
• What begins as a condition of illiquidity can evolve into insolvency.
Having enough cash on hand is therefore critical in being able to settle obligations
when they fall due, however, holding too much cash in a business is costly.
43 ©
Syllabus B1c. Outline the various sources and applications of finance.
(i) Regular revenue receipts and payments

(ii) Capital receipts and payments
(iii)Drawings or dividends and disbursements
(iv)Exceptional receipts and payment.
Sources of finance
These are:
• Operating:
cash flow from trading activities.
e.g. cash received from customers, cash paid to suppliers and to employees
• Financing:
Cash paid on interest
• Taxation:
Actual cash paid during the year
• Investing:
Cash flows on purchase or sale of non-current assets
• Financing:
Cash flows on raising or redeeming long-term finance, such as shares or
debentures; dividends can also be included here.
44 ©
Syllabus B1de.
d) Distinguish between the cash flow patterns of different types of organisations.
e) Explain the importance of cash flow for sustainable growth of such organisations.
Different types of business
Different types of business have different operating cycle
• Retailing business
- most sales are for cash or by credit card and debit card, and the company
therefore receives most of its cash income at the time of sale.
• Large supermarket chains
- which sell goods within a few days of purchase might not pay their suppliers
until after the goods have been sold and the cash received.
• Manufacturing business
- many sales will be on credit, as will many purchases.
45 ©
Sometimes the operating cycle can be analysed into two elements:
1. A trading cycle, identifying when a firm acquired goods and when it sold them
2. A cash cycle identifying the movements of cash:
When was the inventory actually paid for?
When was cash received from customers?
46 ©
Syllabus B1fg.
f) Define “cash accounting” and “accruals accounting” .
g) Explain the difference between cash accounting and accruals accounting..
Cash vs. Accrual Accounting
There are two methods of recording a business's income and expenses.
These methods differ only in the timing of when sales and purchases are credited
or debited to your accounts:
1. Cash method (cash basis)
If you use the cash method, income is accounted for when cash (or a check) is
actually received, and expenses are counted when actually paid.
2. Accrual method (accrual basis)
Under accrual method, transactions are accounted for when they happen,
regardless of when the money is actually received or paid.
So income is counted when the sale occurs, and expenses are counted when
you receive goods or services.
You don't have to wait until you see the money or until you actually pay money
out of your checking account.
47 ©
Syllabus B1h. Reconcile cash flow to profit.
The distinction between cash flow and profit and the

relevance of cash flow to capital investment appraisal
Let’s say you buy some goods for $100 and sell them for $200. However, $80 of the
receipt is on credit and you have not received it yet.
Profit looks solely at the income and costs. It matches these together, regardless of
timing of the actual cash payment or receipt.
Sales $200
Costs (100)
Profit 100
Cash flow, on the other hand, does not attempt to match the sale with the cost but
rather the actual cash paid and received.
Cash received $120
Cash paid (100)
Increase in Cash flow 20
48 ©
Therefore, cash flows look at when the amounts actually come in and out: - the
money actually spent, saved and received. This is vital to capital investment decision
making - as the timing of inflows and outflows have a value too - the time value of
money.
Not only should the timing of the cash flows be taken into account when planning on
investments but also the type of cash flows to include. We call these relevant costs.
49 ©
Syllabus B1h. Reconcile cash flow to profit..
The effect of transactions on cash flows
IAS 7, Statements of Cash Flows
IAS 7, Statements of Cash Flows, splits cash flows into the following headings:
• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities
50 ©
Cash flows from operating activities
These represent cash flows derived from operating or trading activities.

There are two methods which can be used to find the net cash from operating
activities:
direct and indirect method.
Cash flows from investing activities
These are related to the acquisition or disposal of any non-current assets or

investments together with returns received in cash from investments
i.e. dividends and interest.
51 ©
Cash flows from financing activities
Financing cash flows comprise receipts from or repayments to external providers of

finance in respect of principal amounts of finance.
For e.g.
1. Cash proceeds from issuing shares
2. Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and
other short or long term borrowings
3. Cash repayments of amounts borrowed
4. Dividends paid to shareholders
In order to calculate such figures the closing statement of financial position figure for
debt or share capital and share premium is compared with the opening position for
the same items.
Statement of cash flows for the year ended 31 December 20X7 (INDIRECT METHOD)
$000 $000
cash flows from operating activities

profit before taxation 3390
adjustment for:
Depreciation 450
investment income -500
interest expense 400
------
3740
increase in trade and other receivables -500
decrease in inventories 1050
decrease in trade payables -
1740
cash generated from operations 2550
interest paid -270
income taxes paid -900
------
net cash from operating activities 1380
52 ©
cash flows from investing activities
purchase of property, plant and equipment -900

proceeds from sale of equipment 20
interest received 200
dividends received 200
------
net cash used in investing activities -480
cash flows from financing activities
proceeds from issue of share capital 250

proceeds from long-term borrowings 250
dividends paid* -1290
------
net cash used in financing activities -790
------
net increase in cash and cash equivalents 110
cash and cash equivalents at beginning of period 120
------
cash and cash equivalents at end of period 230
------
* This could also be shown as an operating cash flow.
53 ©
Syllabus B2a. Explain the objectives of a cash budget..
Cash budget
A cash budget is an estimate of the receipt and payments of cash in and out of the
business for a defined future period.
By understanding the nature and timing of cash receipts and expenditures,
management is better able to influence them and plan/budget for the future.
The purpose is to ensure that the company has sufficient cash on-hand to avoid
missing disbursements when they fall due.
There are statistical techniques which assist management in planning cash levels.
54 ©
Syllabus B2b. Explain and illustrate statistical techniques used in forecasting cash flows.
Linear Regression
This model says how dependent one variable is on another.
For example cost (X) and volume (Y).
These variables are called the dependent and independent variables.
The Dependent variable’ value depends on the value of the other variable.
E.g. Sales may be dependent on marketing spend
You would then need to determine the strength of the relationship between these two
variables in order to forecast sales.
For example, if the marketing budget increases by 1%, how much will your sales
increase?
Regression Equation
This helps us predict the variable we require.  

The formula for a simple linear regression is as follows:
Y = a + bx
where:
Y is the value we are trying to forecast (dependent)
“b” is the slope of the regression,
“x” is the value of our independent value, and
55 ©
“a” represents the y-intercept. (the value we are trying to
forecast when the independent value is 0)
A simpler way to picture this might be thinking of variable costs and fixed costs.
We are trying to forecast TOTAL COSTS
So
Y = Total costs
b = Variable cost per unit
a = Fixed Costs
x = Amount of units produced
In this graph, the dots represent the actual date.
Linear regression attempts to estimate a line that best fits the data, and the equation
of that line results in the regression equation
Once a linear relationship is identified and quantified using linear regression

analysis, values for (a) and (b) are obtained and these can be used to make a
forecast for the budget such as a sales budget or cost estimate for the budgeted
level of activity
56 ©
Covariance
• shows the direction of the relationship between 2 variables as well as its

relative strength. 
If one variable increases and the other variable tends to also increase, then we
experience positive covariance.
If one variable increases and the other tends to decrease, then the covariance
would be negative.
• Correlation
This is concerned with establishing how strong the relationship is:
1. Perfect Correlation
refers to a correlation where all pairs of values lie on a straight line and there
is an exact linear relationship between the two variables.
2. Partial Correlation
refers to a correlation where there is not an exact relationship, but low values
of (x) tend to be associated with low values of (y), and high values of (x) tend
to be associated with high values of (y).
They may also have low values of (x) associated with high values of (y) and
vice versa (negative correlation)
57 ©
3. No Correlation
refers to a situation where the two variables seem to be completely
unconnected
• Correlation Coefficient
The correlation calculation simply takes the covariance and divides it by the
product of the standard deviation of the two variables.
• The degree of correlation can be measured (r).
This gives a value of -1 and +1.

A correlation of +1 can be interpreted to suggest that both variables move
perfectly positively with each other, and a -1 implies they are perfectly negatively
correlated.
•  Coefficient of Determination (r2)
This measures how good the estimated regression equation is and is designated
as r2 and has the range of values between 0 and 1.
The higher the r2, the more confidence in the equation.
• Limitations of Simple Linear Regression Analysis
Assumes a linear relationship between variables;

Measures only the relationship between two variables where in reality many
variables exist;
Assumes that the historical behaviour of the data continues into the foreseeable
future;
Interpolated predictions are only reliable if there is a significant correlation
between the data.
58 ©
Syllabus B2b. Explain and illustrate statistical techniques used in forecasting cash flows.
Time Series Analysis
Any data collected over time (eg sales volumes) can be used here
Time series forecasting methods are based on the assumption that past patterns in
data, such as seasonality, can be used to forecast future data points.
Such patterns allow for more curved than linear predictions.
Let’s take a simple example.
Over the past 6 years, a particular company has noticed that on month 12 the sales
are usually 30% higher than typical monthly volumes.
Thus it makes sense to forecast that month 12 for the forthcoming year will follow a
similar pattern
59 ©
This graph shows a scenario where linear regression has predicted an increase in
sales of roughly €4M per quarter
However Time series has taken into account past trends which suggest that Q1
sales are usually €4M below trend, Q2 are €4M above and Q3 are €4M below.
In time series analysis, the trend line itself may also be curved.
Indeed it would only be linear as the above example, if the favourable and adverse
seasonal affects cancel each other out
• Time Series Analysis Components
Time Series Analysis is made up of three main components used in different

ways to produce future forecasts:
• Average
the mean of the observations over time
• Trend
a gradual increase or decrease in the average over time
• Seasonal influence
predictable short-term cycling behaviour due to time of day, week, month,
year, season and so on
• Forecast data might also be affected by cyclical movement (unpredictable long-

term cycling behaviour due to the business cycle or product/service lifecycle) and
random error (remaining variation that cannot be explained by the other four
components)
60 ©
• Variations of time series analysis
Time Series Analysis offers 2 main variations:
• Moving Averages
The forecast is based on an arithmetic average of a given number of past
data points.
This should make the trend become more obvious.
Let us take a simple example by considering the following data:
Period 1 2 3 4 5 6 7 8 9 10 11 12
Sales €M 47 50 51 48 48 52 52 49 50 52 54 50
• It is difficult to immediately spot the trend as the figures appear to be constantly

increasing and decreasing.
However, a moving average (average sales from periods 1-4, 2-5, 3-6 etc) of this
data using 4 period averaging would give the following result.
Moving
49.00 49.25 49.75 50.00 50.25 50.75 50.75 51.25 51.50
Average
• Exponential Smoothing
A type of weighted moving average that allows inclusion of trends etc. This gives
greater weighting to more recent data in order to reflect the more recent trend.
An exponential smoothing (average calculated by taking 4 times the 4th period, 3
times the 3rd period, 2 times the 2nd period and 1 times the 1st period and then
dividing by a total of 10) of the data would present a similar picture
Exponential
49.20 48.80 49.90 50.80 50.40 50.30 50.80 52.10 51.60
Smoothing
61 ©
• Advantages and Disadvantages
Advantages Disadvantages
Identifies seasonal variations Complicated
Can be non-linear ‘Seasons’ may change
Accurate Based on historical data
Less useful in the long term
Conclusion
Linear regression is most relevant when there is a linear relationship between the
variables.
On the other hand, time series analysis is most appropriate when seasonal
variations causes curved forecasts.
The reliability of a forecasting method can be established over time.
If the forecasts used, turn out to be inaccurate, management might decide to use
alternative methods of forecasting.
On the other hand, if forecasts prove to be accurate and successful, providing

management with key data for decision making, then it is more likely that
management will continue to use the same forecasting methods.
62 ©
Syllabus B2c. Explain inflation and the impact on cash flow and profit.
How Inflation affects budgets
If inflation is expected it should be included in the budget
In the annual budget simply use an average rate of inflation for the year
For cash budgets though, these are often done monthly or quarterly - making it
trickier
Including inflation in a MONTHLY cash budget
Estimate when costs or prices may rise.
1. For wages - estimate the annual increase, and include in the budget for the end
of the month after the pay rise takes effect.
2. For monthly utility bills estimated the increase in costs from the relevant payment
month.
3. Sales budget should increase from the time of the sales price review.
4. For other costs - just make a monthly inflationary estimate, for example, 2%every
month or higher in the last few months if you expect inflation to rise
With carefully-made assumptions, inflation can therefore be included within cash

budgets and forecasts.
63 ©
The effect of inflation on cash flow and profit
Affect on Profit
Inflation usually hits your costs before you then react and put up your prices to deal
with this. This reduces profitability - in that period where the costs have gone before
you put up your prices
However, price competition means you might not be able to put up your prices
enough to cover the inflated costs - thus reducing your profitability more
Affect on Cash-Flow
The same here - your costs increase before your sales so liquidity and cashflow is
reduced
• Inventory purchases increase first, then labour.
Both mean higher costs of finished goods.
• When sales prices are eventually increased, trade receivables rise, and so
working capital (Inventory + Receivables - Payables) will increase.
Inflation usually has the effect of decreasing liquidity and causing cashflow problems
64 ©
Illustration
Cow Co. has inventory of $60,000, receivables of $50,000 and trade payables of
$40,000.
There has been an increase of 10% in its costs, including costs of materials and
labour.
Sales prices have not yet been increased.
What will be the effect on working capital, and on cash flows in the short term?
ANSWER
In the short term inventory will increase by 10% ($6,000) and trade payables will
increase by $4,000.
Until sales prices are increased, trade receivables are unaffected.
The net increase in working capital - and reduction in liquidity - is $2,000.
65 ©
Syllabus B2deg.
d) Prepare a cash budget, including adjustments for timing of receipts and payments.
e) Discuss and illustrate how cash budgets can be used as a mechanism for monitoring and
control.
g) Prepare a simple cleared funds forecast.
The principles of cashflow forecasting
Cashflow forecasting enables you to predict peaks and troughs in your cash balance.
It helps you to plan borrowing and tells you how much surplus cash you’re likely to
have at a given time.
Many banks require forecasts before considering a loan.
The forecast is usually done for a year or quarter in advance and divided into weeks
or months.
In extremely difficult cashflow situations a daily cashflow forecast might be helpful.
It is best to pick periods during which most of your fixed costs - such as salaries - go
out.
It is important to base initial sales forecasts on realistic estimates
Short term cash flow forecasts
Cash Forecast for the Three Months Ended 31 March 20X1
This is the proforma that could be produced for a big, cashflow forecast question,
though there has not been one yet, it is a minor topic so far
66 ©
January February March
Cash Receipts
Sales
Issue of Shares
Cash Payments
Purchases
Dividends
Tax
Non Current Assets
Wages
Cash Surplus/defecit
Cash b/f
Cash c/f
Note that not all expenses in the income statement are cash eg
depreciation/accruals.
Not all sales are cash - only put them in the table when cash is RECEIVED.
Not all purchases of NCA are cash eg Finance leases - just put in the cash PAID to
the lessor.
When preparing cashflow forecasts make sure your work is clearly laid out and
referenced to workings.
There is nothing difficult just needs practice
67 ©
Illustration
• A lady decides to set her own business so needs to go to a bank with a cashflow
forecast.
She has £6,000 to invest herself. She expects to buy some non current assets for
10,000, which have a 5 year life.
These will be bought immediately.
• Then she will need buffer stock of £1,000 acquired at the beginning of January
and subsequent monthly stock to meet her expected sales demand
• Forecast sales are 5,000 in February and rising by 10% per month.
Selling price is calculated using a mark up of 50%. 1 months credit is allowed by

suppliers and 1 month given to customers also.
Operating costs are 500 per month plus drawings of 500.
Prepare a cashflow for Jan, Feb, March
January February March
Cash Receipts
Sales 5,000
Issue of Shares
Cash Payments
Purchases -1,000 -3,333

Dividends
Operating Costs -500 -500 -500
Non Current Assets -10,000
Drawings -500 -500 -500
Cash Surplus/defecit -11,000 -2,000 667
Cash b/f 6,000 -5,000 -7,000

Cash c/f -5,000 -7,000 -6,333
68 ©
Why might a forecast differ from the actual flows?
• Poor forecasting techniques
• Unpredictable events or developments, eg:
(i) Loss of a major customer

(ii) Insolvency of a major customer who owes the company money
(iii) Changes in interest rates
(iv) Inflation, which may affect various costs and revenues differently
69 ©
Syllabus B2f. Carry out simple sensitivity analysis on a cash budget or forecast.
Simulation
Simulation is a modeling technique used mainly in capital investment appraisal

decisions.
Computer models can be built to simulate real life scenarios. The model will predict
what range of returns an investor could expect from a given decision without having
risked any actual cash.
The models use random number tables to generate possible values for the
uncertainty the business is subject to.
Since the time and costs involved can be more that benefits gained, computer
technology is assisting in bringing down the cost of such risk analysis.
Models can become extremely complex and probability distributions may be difficult
to formulate.
Expected Values (EV)
The ‘expected value’ rule calculates the average return that will be made if a
decision is repeated again and again.
It does this by weighting each of the possible outcomes with their relative probability
of occurring.
It is the weighted arithmetic mean of the possible outcomes.
The likelihood that an event will occur is known as its probability.
This is normally expressed in decimal form with a value between 0 and 1.
A value of 0 denotes a nil likelihood of occurrence whereas a value of 1 signifies

absolute certainty.
70 ©
A probability of 0.4 means that the event is expected to occur four times out of ten.
The total of the probabilities for events that can possibly occur must sum up to 1.0.
An expected value is computed by multiplying the value of each possible outcome by

the probability of that outcome, and summing the results.
EV = ∑px
Where:
p = probability of the outcome
x= the possible outcome
A risk neutral investor will generally make his decisions based on maximizing EV.
Sensitivity Analysis
Sensitivity analysis can be used to assess the range of values that would still give
the investor a positive return.
It is a technique which is similar to the ‘what if?’ scenario.
The uncertainty may still be there, but the effect that it has on the investor’s returns
will be better understood.
Sensitivity calculates the % change required in individual values before a change of

decision results.
If only a (say) 2% change is required in selling price before losses result, an investor
may think twice before proceeding.
71 ©
Therefore, sensitivity analysis assesses how the net present value of an investment
project is affected by changes in project variables.
Considering each project variable in turn, the change in the variable required to
make the net present value zero is determined, or alternatively the change in net
present value arising from a fixed change in the given project variable.
In this way the key or critical project variables are determined.
However, sensitivity analysis does not assess the probability of changes in project
variables and so is often dismissed as a way of incorporating risk into the investment
appraisal process.
72 ©
Syllabus C: Managing Cash Balances
Syllabus C1. Treasury function
Syllabus C1a. Outline the basic treasury functions.
The functions of the treasury
Treasury management is the corporate handling of all financial matters, the

generation of external and internal funds for business, the management of currencies
and cash flows, and the complex strategies, policies and procedures of corporate
finance.
Roles of the Treasury management
1. Cash management
2. Managing financial risks
3. Raising finance
4. Sourcing finance
5. Currency management
6. Effective taxation administration
73 ©
The Association of Corporate Treasurers
cash management the treasury section will monitor the company's
cash balance and decide if it is advantageous
to give/take settlement discounts to/from
customers/suppliers even if that means the bank
account will be overdrawn.
financing the treasury section will monitor the company's
investment/borrowings to ensure they gain as
much interest income as possible and incur as
little interest expense as possible.
foreign currency the treasury section will monitor foreign exchange
rates and try to manage the company's affairs so
that it reduces losses due to changes in foreign
exchange rates.
tax the treasury section will try to manage the
company's affairs to legally avoid as much tax as
possible.
74 ©
The role of the finance function in determining business tax liabilities
One of the roles of the finance function is to calculate the business tax liability and to
mitigate that liability as far as possible within the law.
1. Tax avoidance
is the legal use of the rules of the tax regime to one’s own advantage, in order to
reduce the amount of tax payable by means that are within the law.
2. Tax evasion
is the use of illegal means to reduce one’s tax liability, for example by deliberately
misrepresenting the true state of your affairs to the tax authorities.
The directors of a company have a duty to their shareholders to maximise the post tax
profits that are available for distribution as dividends to the shareholders, thus they
have a duty to arrange the company’s affairs to avoid taxes as far as possible.
However, dishonest reporting to the tax authorities (e.g. declaring less income than
actually earned) would be tax evasion and a criminal offense.
While the traditional distinction between tax avoidance and tax evasion is fairly clear,
recent authorities have introduced the idea of tax mitigation to mean conduct
that reduces tax liabilities without frustrating the intentions of Parliament, while tax
avoidance is used to describe schemes which, while they are legal, are designed to
defeat (nullify) the intentions of Parliament.
Thus, once a tax avoidance scheme becomes public knowledge, Parliament will nearly
always step in to change the law in order to stop the scheme from working.
75 ©
Responsibilities of the finance function
The finance function of any company is responsible by law for:
1. maintaining proper accounting records that contain an accurate account of the

income and expenses incurred, and the assets and liabilities pertaining to the
company.
2. calculating the tax liability arising from the profits earned each year, and paying
amounts due to the tax authorities on a timely basis.
In practice, most companies (particularly small companies) will seek the advice of
external tax specialists to help them calculate their annual tax liability.
Investment appraisal and financing viable investments
Investment appraisal is concerned with long term investment decisions, such as

whether to build a new factory, buy a new machine for the factory, buy a rival company,
etc.
Typically money is paid out now, with an expectation of receiving cash inflows over a
number of years in the future.
There are two questions to be addressed:
1. Is the possible investment opportunity worthwhile?
2. If so, then how is it to be financed?
For example, if a company is offered an investment opportunity that requires paying

out €1m now, and will lead to cash inflows of €2m in one year’s time and €2m in two
years’ time, during a period when interest rates are 5%, you can see that this
investment is worthwhile in real terms.
If the €1m was invested to earn interest, it would be worth €1.05m in one year’s time.
76 ©
However the investment will give you €2m in one year’s time and another €2m in two
years’ time.
So the investment is worthwhile.
The second question is how this €1m required now should be financed.
Perhaps there is a surplus €1m sitting unused in a bank account.
It is more likely that fresh funds will be required, possibly by issuing new shares, or
possibly by raising a loan (e.g. from the bank).
There are advantages and disadvantages of each possibility.
Advantages of issuing new ordinary shares:
• Dividends can be suspended if profits are low, whereas interest payments have to
be paid each year.
• The bank will typically require security on the company’s assets before it will
advance a loan.
Perhaps there are no suitable assets available.
Advantages of raising loan finance:
• Interest payments are allowable against tax, whereas dividend payments are not
an allowable deduction against tax
• No change is required in the ownership of the company, which is governed by who

owns the shares of the company.
Generally the finance function and the treasury function will work together in
appraising possible investment opportunities and deciding on how they should be
financed.
77 ©
Management of working capital
A company must also decide on the appropriate level of investment in short term net
assets, i.e. the levels of:
• inventory
• trade receivables (amounts due from debtors for sales on credit)
• cash balances
• trade payables (amounts due to creditors for purchases on credit).
There are advantages in holding large balances of each component of working capital,
and advantages in holding small balances, as below.
advantage of large balance advantage of small balance

inventory customers are happy since low holding costs. less risk of
they
obsolescence costs.
can be immediately provided
with goods
trade customers are happy since less risk of bad debts, good
receivables they
for cash flow.
like credit.
cash creditors are happy since bills more can be invested
elsewhere
can be paid promptly
to earn profits.
trade payables preserves your own cash suppliers are happy and may
offer discounts
78 ©
Syllabus C1b. Discuss the advantages and disadvantages of a centralised treasury function.
Advantages of a centralised treasury department
These are:
1. foreign currency management becomes easier, since the foreign currency

expenditure in one company can be matched with receipts in the same currency
in another group company.
2. higher interest rates may be attainable on investments because the department

has larger amounts of cash available for investment.
3. the treasury department may be a profit centre in its own right, resulting in an
increased likelihood of a profit being made.
4. lower interest rates may be sought for borrowing, since borrowing can be
arranged for the group as a whole.
5. the level of cash held for precautionary purposes can be minimised since only
one amount will be required for the whole group.
6. experts can be employed with specialised knowledge, more qualified to manage

risk and make better investment decisions.
79 ©
Syllabus C1c. Discuss the advantages and disadvantages of centralised cash control.
Benefits of centralised Treasury management (Cash

Control)
The treasury of a multinational corporation relies, to a certain extent, on the expertise

of local business.
However, the benefits of centralisation sometimes come at the expense of losing

touch with this vital regional knowledge.
This could be avoided by careful restructuring of treasury operations. Oh yes baby.
The road starts with the selection of the treasury processes most suitable to
centralisation.
Each of the main treasury processes (short-term finance and liquidity management;
long-term finance; risk management) should be analysed to identify how
centralisation could create additional benefits.
The key argument
• for a centralised process is control and coordination of activities...
• Risk is controlled when the philosophy of the company is clear and implemented
from a central process.
This avoids the temptation of local management to put a local flair on company
philosophy.
80 ©
A sexy study
• A recent study by Michael Gold and Andrew Campbell of the London Business
School found that different and equally successful corporations balanced local
and corporate control in different ways.
• Some emphasised strong centralised strategy development with local freedom to

implement strategies; others set financial standards at the corporate level and left
business units to devise their own strategies and operational plans; others
practiced a mix.
• All of the companies in the study sought the benefits of local autonomy while not
giving up corporate control.
• Sorry it wasn’t THAT sexy…
Control v Responsiveness
• Control versus responsiveness is the underlying issue to address when

considering centralising or decentralising.
When controls and consistency are necessary to the organisation, centralisation
provides the cornerstone.
• Consistent reporting up and down the corporate chain and knowledge of where
the information resides without duplication, can be the greatest reason to keep
certain functions in a central location.
• Inherent in the concept of centralization is the potential delay in decision making
and information processing.
Centralised decisions require the local manager to seek permission from central
management.
The central manager has to deliberate and convey his decision back down to
local management for implementation.
• This process can take time and slow down decision making.
The overall responsiveness of the corporation may suffer, with potentially
damaging results.
81 ©
Syllabus C1d. Describe cash handling procedures including recording practises.
Cash Handling Procedures
Segregation of duties is essential to prevent one individual from having responsibility

for more than one component.
Components of cash handling are:
• collecting
• depositing
• reconciling
82 ©
Syllabus C1ef) & C4i.
C3e) Describe the issues to be considered when attempting to hold optimal cash balances.
C3f) Outline the statutory and the other regulations relating to the management of cash.
C4i) Suggest appropriate liquidity levels for a range of different organisations.
Optimal cash balances
In optimising cash balances there's a balance between liquidity and profitability
• If you keep lots of cash in your current account:
Good liquidity but poor profitability (lose interest from investing / deposit account)
• If you keep very little cash in your cuurent account:
Good profits (money kept in investments) but poor liquidity
Deviations from expected cash flows
Cash budgets are only estimates of cash flows.
So we need to consider this uncertainty when the cash budget is prepared.
So perhaps prepare additional cash budgets based on different estimates of sales

levels, costs, bad debts.
A cash budget model could show how cashflows change according to changes in
revenues estimates.
So management should be able to prepare measures in advance.
83 ©
Float
The term float is sometimes used to describe the amount of money tied up between:
1. The time when a payment is initiated (for example when a customer sends a
cheque in payment, probably by post)
2. The time when the funds become available for use in the recipient's bank account
Rasons why there might be a lengthy float:
• Transmission delay
When payment is posted, it will take a day or longer for the payment to reach the
payee.
• Delay in banking the payments received (lodgement delay)
The payee might delay taking the cheque or the cash to his/her bank, they may
only bank once a week for example
• The time needed for a bank to clear a cheque (clearance delay)
A payment is not available for use in the payee's bank account until the cheque
has been cleared.
This will usually take two or three days for cheques payable in the UK.
For cheques payable abroad, the delay is much longer.
84 ©
Syllabus C2a. Explain the role and functions of various types of banks (including the structure
of the banking system).
Types of banks
These are:
1. Retail Banks
2. Commercial banks
3. Investment Banks
4. Central banks
Types of banks
• Retail Banks:
Retail banks provide basic banking services to individual consumers.
Examples include savings banks, savings and loan associations.
Products and services include safe deposit boxes, checking and savings
accounting, certificates of deposit (CDs), mortgages, personal, consumer and car
loans.
• Commercial Banks:
Accept deposits of money from the public for the purpose of lending or
investment.
Commercial Banks provide financial services to businesses, including credit and

debit cards, bank accounts, deposits and loans, and secured and unsecured
loans.
Commercial banks in modern capitalist societies act as financial intermediaries,

raising funds from depositors and lending the same funds to borrowers.
85 ©
• Investment Banks:
An investment bank is a financial institution that assists individuals, corporations

and governments in raising capital by underwriting and/or acting as the client's
agent in the issuance of securities.
An investment bank may also assist companies involved in mergers and

acquisitions, and provide services such as trading of derivatives, fixed income
instruments, foreign exchange, commodities, and equity securities.
• Central Banks:
Central banks are bankers’ banks.
They guarantee stable monetary and financial policy from country to country and
play an important role in the economy of the country.
Typical functions include implementing monetary policy, managing foreign

exchange and gold reserves, making decisions regarding official interest rates,
acting as banker to the government and other banks, and regulating and
supervising the banking industry.
These banks buy government debt, have a monopoly on the issuance of paper
money, and often act as a lender of last resort to commercial banks.
86 ©
Covenants
1. Positive (Affirmative Covenant)
is a type of promise or contract which requires a party to do something.
For example, a bond covenant that provides that the issuer will maintain
adequate levels of insurance or deliver audited financial statements is an
affirmative covenant.
2. Negative (Restrictive) covenants
require a party NOT to do something, such as sell certain assets.
3. Quantitive covenants
are promises to keep within financial limits set by the lender.
87 ©
Syllabus C2h. Explain the basic nature of a money market.
Financial Markets
allow people to buy and sell
1. Financial securities (such as stocks and bonds)

2. Commodities (such as precious metals)
General markets (many commodities) and specialised markets (one commodity)

exist.
Markets work by placing interested buyers and sellers in one "place", thus making it
easier for them to find each other.
Direct Finance
• This is where borrowers borrow funds directly from lenders (people who saved
money) in financial markets by selling them securities (financial instruments).
• Typically a borrower issues a receipt to the lender promising to pay back the
capital.
These receipts are securities which may be freely bought or sold.
In return for lending money to the borrower, the lender will expect some
compensation in the form of interest or dividends
• As the financial markets are normally direct and no financial intermediaries used,
this is called financial disintermediation
88 ©
Indirect finance
• Borrowers obtain funds through financial intermediaries (banks, stock

exchanges).
So, Financial markets facilitate
1. The raising of capital (in the capital markets)
2. The transfer of risk (in the derivatives markets)
3. International trade (in the currency markets)
4. Match those who want capital to those who have it
Euromarkets
An overall term for international capital markets dealing in offshore currency deposits
held in banks outside their country of origin
Euro means external in this context. For example, eurodollars are dollars held by
banks outside the United States
It allows large companies with excellent credit ratings to raise finance in a foreign
currency. This market is organised by international commercial banks
89 ©
Key Features
• Size
Much bigger than the market for domestic bonds / debentures
• Cheap debt finance
Can be sold by investors, and a wide pool of investors share the risk
• Unsecured
Only issued by large companies with an excellent credit rating
• Long-term
Debt in a foreign currency Typically 5-15 years, normally in euros or dollars but
possible in any currency
• Less regulation
By using Euromarkets, banks and financiers are able to avoid certain regulatory
aspects such as reserve requirements and other rules
However, the reduction in domestic regulations have made the cost savings
much less significant than before
As a result, the domestic money market and Eurocurrency markets are closely
integrated for most major currencies, effectively creating a single worldwide
money market for each participating currency.
90 ©
Syllabus C2bc. Identify the major financial intermediaries.
Outline the general roles of financial intermediaries.
A financial intermediary is an entity who performs

intermediation between two parties
This means that the lender gives money to the borrower indirectly as the financial
intermediary sits in between
It is typically an institution that allows funds to be moved between lenders and

borrowers.
It works as follows:
1. Savers (lenders) give funds to
2. An intermediary institution (such as a bank), who then gives those funds to
3. Spenders (borrowers)
This may be in the form of loans or mortgages.
91 ©
The Roles include
1. Aggregating investments to meet needs of borrowers
To provide a link between many investors who may have small amounts of
surplus cash and fewer borrowers who may need large amounts of cash
2. Risk transformation
Intermediaries offer low-risk securities to primary investors to attract funds, which

are then used to purchase higher-risk securities issued by the ultimate borrowers
3. Maturity transformation
Investors can deposit funds for a long period of time while borrowers may require
funds on a short-term basis only, and vice versa. In this way the needs of both
borrowers and lenders can be satisfied
92 ©
Syllabus C2d. Outline the key benefits of financial intermediation.
Benefits of financial intermediation
These are:
1. Value transformation
Borrowers may require large sums of money.

Financial intermediaries can pool together many smaller deposits and lend a
smaller number of large amounts of money to borrowers.
2. Maturity transformation
Depositors may only want to deposit money in the short term, or retain a level of
liquidity.
Borrowers may want to borrow money over a long period of time.
By dealing with many customers over a long period of time, financial
intermediaries can provide long-term funds to borrowers, whilst ensuring that
depositors retain the level of liquidity they require.
3. Reduction in transaction costs
Financial intermediaries can reduce the transaction costs associated with, for
example, writing contracts for borrowers and lenders.
4. Risk diversification for savers
If a borrower defaults on a loan, the savers should not be directly affected as the
cost will be charged to the financial intermediary, not the depositors.
The return on an individual’s savings are not reliant on the performance of one
borrower.
93 ©
5. Expertise
Financial intermediaries have the specialist knowledge and resources to assess

the risk and anticipated profitability of proposed projects, so reducing the risk to
the lenders.
6. Ease of borrowing
Borrowers do not need to visit many banks to secure funding, but visit one
financial intermediary.
94 ©
Syllabus C2e. Outline the relationships between financial institutions
Relationships between financial institutions
Primary (retail) banks are banks that operate the payments mechanism and are
usually called commercial banks or clearing banks.
Secondary banks deal mostly with wholesale business in the secondary money
markets not in the high street.
The statement of financial position of a bank consists of its liabilities (mostly deposits
of one sort or another) and its assets (mostly loans to customers of one sort or
another).
Banks must make sure that their assets are sufficiently liquid to meet their
depositors' needs, but not so liquid that their profits suffer. Banks make a profit by
lending at a higher rate of interest than the rate they pay for deposits.
The central bank (the Bank of England in the UK) has various roles and is
particularly important for the government's monetary policy.
95 ©
Retail banking
is the banking activity of the traditional 'high street' bank, dealing with relatively small
deposits and small loans to customers.
Retail services are also now conducted over the telephone or the Internet by many
banks.
Retail banks:
• Provide a payments mechanism

• Provide a place where people store wealth
• Lend money on overdraft or by loan
• Offer a variety of services
Wholesale banking
involves small numbers of customers with larger deposits or requiring larger loans.
Because large sums are involved, customers expect the banks to trim their profit
margins and offer a cheaper, more competitive service (eg by offering higher rates of
interest to depositors or charging lower rates to borrowers).
All businesses have bank accounts.
Banks, like other businesses, are profit-making organisations.
A bank's policy towards its customers depends on:
• Its need to satisfy its own shareholders
• Government monetary policy (the level of interest rates and so on)
• Its own creditworthiness (e.g. how cheaply it can borrow money)
• The general economic context
96 ©
Syllabus C2h. The role of money and capital markets
Money Market
These are for short term lending and borrowing (up to 12 months).
This contrasts with the capital market for longer-term funding, which is supplied by
bonds and equity
Money market securities are essentially IOUs issued by governments, financial

institutions and large corporations.
These instruments are very liquid and considered extraordinarily safe.
Because they are extremely conservative, money market securities offer significantly
lower returns than most other securities
Examples of money market instruments include treasury bills, forwards and futures
The buying and selling of futures contracts here will help an organisation manage its
exposure to foreign currency and interest rate risk
The money markets include
• Repo market
• Iinterbank market
• CD market
• Commercial paper market
In London, the money markets are active in all the major currencies, and the term
'eurocurrency market' is used for the money market for wholesale lending and
deposits of currencies outside their country of origin.
97 ©
The money market is where short-term obligations are bought and sold such as
• Treasury bills
• Commercial paper and
• Bankers' acceptances
Capital Market
A capital market includes the stock market, commodities exchanges and the bond
market amongst others.
The capital market is an ideal environment for the creation of strategies that can
result in raising long-term funds for bond issues or even mortgages.
Along with the stock exchanges, support organisations such as brokerage firms also
form part of the capital market.
These outward expressions of the capital market make it possible to keep the
process ethical and more easily governed according to local laws and customs
98 ©
Syllabus C2h. Explain the basic nature of a money market.
The role of banks and other financial institutions in the

operation of the money markets
Lenders or savers give money to Financial Intermediaries
Financial intermediaries then use this money for loans to borrowers/spenders
These financial intermediaries are banks, insurance companies, pensions etc
Therefore these banks and other financial institutions provide indirect finance to
businesses. It’s also called financial intermediation
Why not borrow/lend money directly?
The banks and other financial institutions offer 2 advantages:
• Transaction cost reduction

These would be really high for individuals but banks with high volumes of
transactions use economies of scale to reduce them
• Credit Risk reduction

This is due to information. The borrower knows a lot more about their ability to
repay than the lender knows. This is asymmetric information. It causes credit
riskBanks etc though have many specialists who can assess the borrowers ability
to repay and at a cheaper cost than a lender could use individually. Hence they
can reduce the credit risk for the lender
99 ©
Securitisation
This turns illiquid assets into marketable securities (hence the name)
Banks, for example, could convert their long term receivable loans into securities and
selling them to big institutional investors
For the banks these mortgages will have different maturity times but selling them as
securities takes away this mis-match problem
The security will almost always be backed by an asset e.g. a house in a mortgage
backed security
100 ©
Syllabus C2f. Explain the purpose and main features of:
(i) Bank deposits

(ii) Certificates of deposit
(iii)Government stocks
(iv) Local authority bonds
(v) Bills of exchange
The characteristics and role of the principal money

market instruments
Money market instruments are short term and they can give interest, be discounted
or be derivative based
Interest Bearing
Any financial instrument that earns interest
• Certificates of deposit (CDs)
A CD is a receipt for funds deposited in a bank for a specified term and for a set
rate
With a CD - if they’re negotiable - they can be sold before maturity. Non-

negotiable ones just pay a set amount of interest (coupon) and is repaid as
normal
• Repurchase Agreement
A repo is where 2 parties agree to buy/sell an instrument at an agreed price and

then repurchase back at an agreed price a set time later
101 ©
• Bank Deposits
Bank deposits are made to deposit accounts at a banking institution.
The account holder has the right to withdraw any deposited funds, as set forth in
the terms and conditions of the account.
The "deposit" itself is a liability owed by the bank to the depositor (the person or
entity that made the deposit).
• Government Security
A bond (or debt obligation) issued by a government authority, with a promise of

repayment upon maturity that is backed by said government.
These securities are considered low-risk, since they are backed by the
government.
• Local authority bond
a fixed- interest bond, repayable on a specific date, used by a local authority in

order to raise a loan and similar to a Treasury bond
Non-interest-bearing
• Bill Of Exchange
Is an unconditional order in writing to pay the addressee a specified sum of

money either on demand or at a future date.
102 ©
Discount Instruments
These don’t pay interest as such. They are issued at a discount, which effectively
means the “interest” is all at the beginning
Think of it from the lenders viewpoint. They wish to lend $100, but actually only need
to lend $80 (discounted at the start) but are paid back the full $100.
• Treasury Bills
These are issued by governments with maturities from 1m to 12m. They are
issued at a discount to their face value
• Commercial paper
These are unsecured with a typical term of 30days.
There are issued by large organisations with good credit ratings - funding their
short term investment needs
• Bankers Acceptance
These again are issued by companies BUT are guaranteed by a bank
The banks will get a fee for this guarantee - and because the risk is low (for the
lender due to the bank guarantee) - the interest the companies offer on these will
be low
Again these are offered at a discount however they are negotiable, meaning they
can be traded before maturity
These are normally issued by firms who do not have a good enough credit rating
to offer commercial paper
103 ©
Syllabus C2e. Explain the purpose and main features of:
(i) Equity
Ordinary shares
Ordinary shares carry no right to a fixed dividend but ordinary shareholders are
entitled to all profits.
In fact, the amount of ordinary dividends fluctuates from year to year.
Ordinary shareholders are sometimes referred to as equity shareholders
Rights of Ordinary shareholders:
1. Shareholders can attend company general meetings.
2. They can vote on company matters such as:
- the appointment or re-election of directors

- the appointment of auditors
3. Ordinary shareholders are the effective owners of a company.
They own the 'equity' of the business including any reserves of the business.
4. They are entitled to receive dividends
5. They will receive the annual report and accounts
104 ©
Equity finance
• is raised through the sale of ordinary shares to investors.
Liquidation
• The ordinary shareholders are the ultimate bearers of risk as they are at the
bottom of the creditor hierarchy in a liquidation.
This means that they might receive nothing after the settlement of all the
company's liabilities.
105 ©
Syllabus C2e. Explain the purpose and main features of:
(ii) Preferrence shares
Preference shares
1. Carry the right to a final dividend
which is expressed as a percentage of their par value
e.g. a 5% $1 preference share carries a right to an annual dividend of 5c.
2. Have priority over ordinary dividends
The managers of a company are obliged to pay preference dividend first.
Also, preference shareholders have priority over ordinary shareholders to a return

of their capital if the company goes into liquidation.
3. If the preference shares are cumulative
it means that before a company can pay any ordinary dividend it must not only
pay the current year's preference dividend, but must also make good any arrears
of preference dividends which were not paid in previous years.
4. Do not carry a right to vote
However, Preference shares carry LIMITED voting rights where dividends are in
arrears.
5. Should be classified as liabilities
106 ©
Preference shares may be either redeemable or irredeemable
Redeemable preference shares
Redeemable preference shares mean that the company will repay the nominal value
of those shares at a later date.
For example, 'redeemable 6% $1 preference shares 20X8' means that the company
will pay these shareholders $1 for every share they hold on a certain date in 20X8.
Redeemable preference shares are treated like loans and are included as non-
current liabilities in the statement of financial position.
However, if the redemption is due within 12 months, the preference shares will be
classified as current liabilities.
Dividends paid (6c per share in our example) on redeemable preference shares are
included as a finance costs (added to interest paid) in the statement of profit or
loss.
Irredeemable preference shares
Irredeemable preference shares form part of equity and their dividends are treated
as appropriations of profit.
107 ©
Syllabus C2g. Explain the purpose and main features of:
(iii)Secured loan note
(iv) Unsecured loan note
(v) Convertible and redeemable debt
(vi) Warrants
Debt and other types of securities
Debt
• Is a liability of the business

• Pays interest which is tax deductible
• Does not represent ownership in the firm
Debt comes in many forms
Straight long-term debt (also called “loan capital”) includes:
• Bonds
Secured by a mortgage on tangible assets of the firm
• Debentures
Unsecured corporate debt
The term “bonds” is commonly used for both categories above.
In the event of default:
1. Debt holders with a security interest over assets enjoy a prior claim in the event
such assets are sold
2. Debenture holders can be paid only after (secured) bondholders have been
repaid.
108 ©
Other types of securities
• Convertible debt
This is debt which is convertible (at the option of the convertible debt holder) into
equity, based on pre-defined “conversion” conditions
• Subordinated loans
Refers to any kind of debt which ranks inferior to more senior debt; it cannot be
repaid until more senior-ranked creditors have been repaid
• Warrants
A security giving the holder the option to buy common shares from a company for
a pre-set price valid for a period of time. These are usually tradable in a
secondary market and therefore have a market price
• Deep discount bonds
Debt issued with a very low or no (zero) coupon, so that the issue price will be far
below the par value of the bond.
Such instruments with no coupon are also called “pure-discount” or “zero” bonds.
• Junk (high yield) bond
A speculative debt instrument that either carries no rating or a low rating by the
rating agencies (below “investment grade”);
• Redeemable bond
A bond which the issuer has the right to redeem prior to its maturity date, under
certain conditions.
The company pays the interest and the original amount (capital) back.
109 ©
Types of interest rates
1. Fixed rates
Interest rates can be set at a specific percentage rate and not change during the
contractual period of a loan.
Bonds issued with fixed (rate) coupons (making them “fixed rate” instruments) will
vary in value as market interest rates change.
2. Floating rates
Floating rates fluctuate with the movement in market interest rates.
They are used in debt instruments and (bank) loan contracts by defining how the
interest rate is to be set on a periodic basis.
Security
Loan notes will often be secured.
Security may take the form of either a fixed charge or a floating charge.
1. Fixed charge
Security can be related to a specific asset or group of assets, typically land and
buildings.
The company would be unable to dispose of the asset without providing a

substitute asset for security, or without the lender's consent.
2. Floating charge
With a floating charge on certain assets of the company (for example inventories
and receivables), the lender's security in the event of a default of payment is
whatever assets of the appropriate class the company then owns
The company would be able to dispose of its assets as it chose until a default
took place.
110 ©
Whatever form the security takes, if the interest on the loan is not paid, the lenders
or loan note holders can try to realise the security, to recover their investment.
Unsecured loan notes
Not all loan notes are secured.
Investors are likely to expect a higher yield with unsecured loan notes to compensate
them for the extra risk.
The rate of interest on unsecured loan notes may be around 1% or more higher than
for secured loan notes.
111 ©
Syllabus C2i. Describe the way in which a stock market (both main and second tier) operates.
A stock market (also known as a stock exchange) has

two main functions
1. to provide companies with a way of issuing shares to people who want to invest
in the company
2. to provide a venue for the buying and selling of shares
The first function allows businesses to be publicly traded, or raise additional capital
for expansion by selling shares of ownership of the company in a public market
This enables investors the ability to quickly and easily sell securities.
This liquidity is an attractive feature of investing in stocks, compared to other less

liquid investments such as real estate
Exchanges also act as the clearinghouse for each transaction, meaning that they
collect and deliver the shares, and guarantee payment to the seller of a security
This eliminates the risk to an individual buyer or seller.
The Alternative Investment Market is regulated by the London Stock Exchange.
112 ©
Syllabus C2j. Discuss ways in which a company may obtain a stock market listing and the
advantages and disadvantages of having a stock market listing.
Reasons for a stock exchange listing
These are:
1. Access to a wider pool of finance
The level of finance available to a private unlisted company is limited.
Therefore, if a company needs more finance than is currently available to it, it

may seek a stock exchange listing.
A stock exchange listing may also improve the company’s credit rating, meaning
that more investors are willing to invest in it.
2. Enhancement of the company’s image
A company’s image is generally improved when it becomes listed, as it is

perceived as being more financially stable.
This may result in increased custom and increased buying power.
3. Increased marketability of shares
It is not very easy for a shareholder in a private company to sell their shares.
Once a company is listed on the stock exchange, its shares become far more
marketable, thus making them far more attractive.
113 ©
4. Facilitation of growth by acquisition
Should a listed company wish to make an offer to takeover another company,

they are in a much better position to do so than in an equivalent unlisted
company.
This is because the terms of the offer will probably include an exchange of the
shares in the acquiring company for those of the target company.
5. Transfer of capital by the founder owners
A stock exchange listing gives the founder members more opportunity to sell their
shareholding, or part of it, leaving them free to invest in other projects.
114 ©
Syllabus C3aef. a) Discuss situations where it may be appropriate to raise short-term finance.
e) Evaluate the risks associated with increasing the amount of short-term finance in an
organisation.
f) Discuss the relative merits and limitations of short term finance.
Short term finance
The following are short terms forms of finance
- in the exam always remember to think about these when asked about possible
ways of raising finance
1. Overdraft
This is the riskiest type of finance as the bank can call it in at any time.
The bank has the right to be repaid overdrawn balances on demand, except
where the overdraft terms require a period of notice.
The bank can use the customers’ money in any legally or morally acceptable way
that it chooses
2. Short term Loan
Less risky than an overdraft but it will possibly need replacing and there’s a risk
that it would be on worse terms - if the economy changes
115 ©
3. Trade payables
Often seen as free finance - although you may actually be missing out on early
settlement discounts.
Be careful also not to annoy your creditors by taking too long to pay
4. Operating Lease
When recommending though - also think about how much overdraft they already
have - what their short term commitments are already
Operating Leases
This is a useful source of finance for the following reasons:
• Protection against obsolescence
Since it can be cancelled at short notice without financial penalty.
The lessor will replace the leased asset with a more up-to-date model in
exchange for continuing leasing business.
This flexibility is seen as valuable in the current era of rapid technological

change, and can also extend to contract terms and servicing cover
• Less commitment than a loan
There is no need to arrange a loan in order to acquire an asset and so the

commitment to interest payments can be avoided, existing assets need not be
tied up as security and negative effects on return on capital employed can be
avoided
Operating leasing can therefore be attractive to small companies or to companies

who may find it difficult to raise debt.
116 ©
• Cheaper than a loan
By taking advantage of bulk buying, tax benefits etc the lessor can pass on some
of these to the lessee in the form of lower lease rentals, making operating leasing
a more attractive proposition that borrowing.
• Off balance sheet finance
Operating leases also have the attraction of being off-balance sheet financing, in
that the finance used to acquire use of the leased asset does not appear in the
balance sheet.
The role of financial intermediaries in providing short-term finance is
• to provide a link between investors who have surplus cash and borrowers who
have financing needs.
• to aggregate invested funds in order to meet the needs of borrowers.
• to offer maturity transformation, in that investors can deposit funds for a long
period of time while borrowers may require funds on a short-term basis only
117 ©
Syllabus C3b. Describe the different forms of bank loans and overdrafts, their terms and
conditions.
Companies often have to rely on bank finance
Why does a company maintain liquidity?
1. The firm needs enough money to function operationally, pay salaries, suppliers.
2. The firm also needs to minimise the risk that some of its sources of finance will
be removed from it.
3. The firm also needs to provide against the contingency of any sudden
movements in cash.
WC and Investments
1. Working capital
- working capital is often financed by overdraft - this is a result of lagged

payments and receipts and the willingness of businesses to offer credit.
2. Long-term finance
- is used for major investments.
118 ©
Forms of bank loans and overdrafts:
• Overdraft
A company, through its current account, can borrow money on a short-term

basis up to a certain amount.
Overdrafts are repayable on demand.
• Term loan
The customer borrows a fixed amount and pays it back with interest over a period
or at the end of it.
• Committed facility
The bank undertakes to make a stipulated amount available to a borrower, on

demand.
• A revolving facility
Is a facility that is renewed after a set period.
Once the customer has repaid the amount, the customer can borrow again.
• Uncommitted facility
The bank can lend the borrower a specified sum.
The only purpose of this is that all the paperwork has been done up front.
The bank has no obligation to lend.
119 ©
Syllabus C3b. Describe the different forms of bank loans and overdrafts, their terms and
conditions.
Loan or overdraft?
Factors that the bank will consider when deciding whether to grant a loan or
overdraft
• The character of the borrower
The bank is likely to require a personal interview with at least some of the
directors of a Company.
The bank will also assess integrity by reading the financial press and searching
the internet for any signs of any disputes between the company or its directors
with any other companies, organisations or individuals.
• The ability to borrow and repay
The bank wants to be sure that a Company will be in a position to repay the
money.
This assessment of the ability to repay will include as assessment of the
company’s key ratios.
In considering the company’s ability to repay, the bank will consider the levels of
any outstanding debt.
120 ©
• The margin of profits
The bank lends money in order to make money.
Most banks have lending policies which require them to charge different interest
rates to customers depending on the reason for the borrowing.
This is because some types of lending are more risky that others, therefore
higher interest rates reflect higher risk.
The bank may want to take some form of security for the lending, probably over
the company’s property.
• Purpose of borrowing
The purpose of borrowing affects not only the interest rate but also the bank’s
decision as to whether to lend in the first place.
It will normally lend in order to finance working capital, provided that the
company’s liquidity position is still manageable.
• Amount of borrowing
Firstly, the bank will need to make sure that a Co is not asking for more money
that it needs for the purpose specified.
If it is, this casts doubt over its ability to repay.
• Repayment terms
Banks will pay close attention to the repayment terms when considering granting
a loan.
Obviously, being sure that a borrower will repay is critical and a bank should not
lend money just because the borrower has security for the loan.
Taking ownership of and selling any of the borrower’s assets is really a last
resort.
Payment terms need to be clearly agreed, documented and realistic given the
borrower’s financial position.
121 ©
Syllabus C3c. Explain the legal relationship between bank and customer.
The banker/customer relationship
The relationship between bank and customer arises from a legal contract between
them
These are the main types of relationship which may exist between bank and
customer:
Receivable/payable relationship
The customer deposits his/her money with the bank.
These funds go into the customer's account and can be withdrawn at any time.
The bank is the receivable (debtor) (for the money owed to the customer) and the
customer is the payable (creditor).
However, there are circumstances where this relationship can be reversed.
If, for example, a customer account is overdrawn, then the customer owes money to
the bank.
Bailor/bailee relationship
Banks have safes or strong rooms and will usually be willing to offer a safe deposit
service to customers.
There is a bailment whenever one person (the bailor) delivers personal property to
another person (the bailee).
122 ©
The bank has two obligations:
1. To take 'reasonable' care to safeguard it against damage or loss (In case of loss
or damage, the burden of proof rests on the bailee.)
2. To re-deliver it only to the customer or some person authorised by the customer.
Principal/agent relationship
In many transactions one person (the agent) acts for another (the principal), usually
for the purpose of making a contract between the principal and a third party.
1. A customer who receives payment of a debt by a crossed cheque must have a

bank account and employs his bank as agent to present the cheque for payment
and credit the proceeds to his account.
2. Where the bank arranges insurance such as household contents insurance, the
bank is acting as an insurance broker and is the agent of its customer.
The bank may have to employ other agents such as stockbrokers, solicitors and
other types of specialist qualified to handle particular transactions.
Mortgagor/mortgagee relationship
This relationship can come into being when the bank asks a customer to secure a
loan by a charge or mortgage over assets such as property.
• The customer is the mortgagor, granting the mortgage
• the bank is the mortgagee, accepting the mortgage
If the customer does not repay the loan, the bank can sell the asset and use the
proceeds to pay off or reduce the outstanding loan.
123 ©
Fiduciary relationship
If one of the parties in a relationship based on trust is in an influential position, then

that person could exert undue influence to make the other party enter into a contract.
The law therefore expects the 'superior' party in the relationship to act in good faith.
It is said to be a fiduciary relationship.
The law expects banks to act with utmost good faith, particularly where the bank is
advising the customer.
124 ©
Syllabus C4abcd.
a) Define what is meant by “surplus funds” .
b) Explain how surplus funds may arise.
c) Discuss the objectives to be considered in the investment of surplus funds.
d) Invest surplus funds according to organisational policy and within defined financial
authorisation limits.
Cash surpluses and deficits
Cash surpluses and deficits occur as a result in timing differences between the
receipt of cash and the necessity to settle obligations punctually.
Cash deficits
General rules:
• If a deficit results, then the company should have overdraft faciltities in place with
a bank
• If deficits prove to be short-term in nature, then the company should consider

short-term borrowing
• If deficits prove to be longer-term in nature, then the company should consider

longer-term borrowing
125 ©
Cash surpluses
Surplus Funds = Money remaining after all liabilities, including taxes, insurance,
and operating expenses, are paid.
Having surplus funds means that a company has made a profit or perhaps that it has
completed a project under budget.
In the event of surpluses, these can be invested in:
1. T-bills
2. Bank deposits
3. Money- market deposits
4. Certificates of deposit
5. Government bonds
6. Local authority stock
126 ©
Syllabus C4e. Define the risk-return trade-off.
The term "risk and return" refers to the potential

financial loss or gain experienced through
investments in securities
A profit is the "return".
The "risk" is the likelihood the investor could lose money
If an investor decides to invest in a security that has a relatively low risk, the potential
return on that investment is typically fairly small and vice-versa
Different securities—including common stocks, corporate bonds, government bonds,

and Treasury bills—offer varying rates of risk and return
The different types are as follows
• Treasury bills
These are about as safe an investment as you can get.

There is no risk of default and their short maturity means that the prices of
Treasury bills are relatively stable
• Long-term government bonds
These on the other hand, experience price fluctuations in accordance with

changes in the nation's interest rates.
Bond prices fall when interest rates rise, but they rise when interest rates drop
Government bonds typically offer a slightly higher rate of return than Treasury
bills
127 ©
• Corporate bonds
Those who invest in corporate bonds have the potential to enjoy a higher return
on their investment than those who stay with government bonds.
This is because the risk is greater.
The company may default on the bond.
Investors want to make sure that the company plays fair.
Therefore, the bond agreement includes a number of restrictive covenants on the
company
• Ordinary shares / Common stock
Common stockholders are the owners of a corporation in a sense, for they have
ultimate control of the company.
Their votes on appointments to the corporation's board of directors and other
business matters often determine the company's direction.
Common stock carries greater risks than other types of securities, but can also
prove extremely profitable
Earnings or loss of money from common stock is determined by the rise or fall in
the stock price of the company
• Preference shares
While owners of preferred stock do not typically have full voting rights in the
company, no dividends can be paid on the common stock until after the preferred
dividends are paid
128 ©
Syllabus C4f. Outline what is meant by risk of default, systematic risk and unsystematic risk.
Default Risk
The event in which companies or individuals will be unable to make the required
payments on their debt obligations.
To mitigate the impact of default risk, lenders often charge rates of return that
correspond the debtor's level of default risk.
The higher the risk, the higher the required return, and vice versa.
Unsystematic risk
also known as "specific risk," "diversifiable risk" or "residual risk,”
is the type of uncertainty that comes with the company or industry you invest in.
Unsystematic risk can be reduced through diversification.
For example, news that is specific to a small number of stocks, such as a sudden
strike by the employees of a company you have shares in, is considered to be
unsystematic risk.
129 ©
Systematic risk
also known as "market risk" or "un-diversifiable risk”
is the uncertainty inherent to the entire market or entire market segment.
Also referred to as volatility, systematic risk consists of the day-to-day fluctuations in

a stock's price.
Volatility is a measure of risk because it refers to the behaviour of your investment.
Because market movement is the reason why people can make money from stocks,
volatility is essential for returns, and the more unstable the investment the more
chance there is that it will experience a dramatic change in either direction.
130 ©
Syllabus C4gh. Outline how the Baumol cash management model works (note – calculations
are not required) .
Discuss the limitations of the Baumol cash management model.
How much cash should a company hold?
The target cash balance involves a trade off between the opportunity costs of holding
too much cash and the trading costs of holding too little.
For example if we know a division needs $100,000 during the year, how much
should we transfer into their account (from their deposit account)?
All of it would mean some of the cash lying in the current account doing nothing (not
getting interest unlike in a deposit account) at the early stages.
Whereas, transferring bits at a time (when the cash is needed) would mean lots of
transaction costs.
Step forward the….Baumol model!
This works just like EOQ for stock. It tells you how much cash to order (sell
investments / take from deposit account) at a time, in order to minimise holding
(losing out on deposit interest) and order costs (cost of transferring cash / selling
investments)..
Holding Cost
= Average cash balance x Interest rate;

= Cash transferred in / 2 x interest rate
= HC/2 x i
131 ©
Order Cost
= Total cash used during period / Cash transferred in X Transaction cost
(Annual Demand/Amount cash ordered (transferred) x Cost per Order
Total Cost = Opportunity cost + Trading cost
To calculate the optimum amount of cash to transfer use this equation:
√(2 x Order Cost x Annual demand for cash) / Holding cost (Interest)
Illustration
Subsonic Speaker Systems (SSS) has annual transactions of $9 million. The fixed
cost of converting securities into cash is $264.50 per conversion. The annual
opportunity cost of funds is 9%.
What is the optimal deposit size?
Square root (2 x 264.5 x 9,000,000 / 0.09)

= 230,000
Limitations of the Baumol model
• Assumes a constant disbursement rate; in reality cash outflows occur at

different times, different due dates etc.
• Assumes no cash receipts during the projected period, obviously cash is

coming in and out on a frequent basis
• No safety stock of cash is allowed for, reason being it only takes a short
amount of time to sell marketable securities
132 ©
Syllabus D: Financing Decisions
Syllabus D1. Money in the economy
Syllabus D1bcdef.
b) Outline how money supply may be controlled in an economy.
c) Outline the basic relationship between the demand for money and interest rates.
d) Explain briefly and illustrate the interaction between inflation and interest rates.
e) Discuss the possible consequences of inflation in an economy and its effect on

organisations in general.
f) Describe how the application of different monetary policies can affect the economy.
THE MAIN TYPES OF ECONOMIC POLICY
Economic policy objectives:
A macro-economic policy relates to economic growth, inflation, unemployment and

the balance of payments.
The objectives are:
1. Achieve economic growth
2. Control price inflation
3. Achieve full employment
4. Achieve balance between import and export
133 ©
THE IMPACT OF FISCAL AND MONETARY POLICY
1. Fiscal policy (Keynesian view)
Fiscal policy (Keynesian view) has to do with the government’s decisions about
spending and taxes.
This provides a method of managing aggregated demand in the economy.
There are several elements to the fiscal policy and that of the budget:
• Expenditure
The government spends money both nationally and regionally on such things
as health services, educational, roads, policing.
It also provides commercial incentives to the private sector through grants.
• Revenues
To spend the money on public services the government needs an income.

The majority of the income comes from taxes although some come from direct
charges like National Health Service charges.
A regressive tax takes a higher proportion of a poor person’s salary than a
rich person’s.
Example - road tax.
A proportional tax takes the same proportion of income in tax from all levels
of income.
A progressive tax takes a higher proportion of income in tax as income rises.
Example – Income tax.
• Borrowing
Should a governments’ spending exceed its income then it must borrow.

The amount it must borrow is known as the PUBLIC SECTOR NET CASH
REQUIREMENT (PSNCR).
This has a profound effect of the fiscal policy as a whole.
134 ©
2. Budget Surplus and Budget Deficit
Should the government use its fiscal policy to influence demand in the economy
then it needs to choose either expenditure changes or tax changes, as its policy
instruments, or a combination of both. The government could:
Increase demand by directly spending more itself, for example, future

investment and spending on the health service or employing more people. If the
government was to influence demand by spending more, this would have to be
financed either through increasing taxes or borrowing. However, by increasing
taxes, organisations, households and individuals would have less to spend.
Increase demand indirectly by reducing taxation - Tax cuts are often followed
by cuts in government spending. Therefore, total demand will not be stimulated
within the economy. Again, tax cuts could also be funded by an increase in
government borrowing. Should the government decide to lower tax then
organisations, households and individuals would have more money after tax thus
have the ability to spend more.
When the government is running a budget deficit it means that total public
expenditure exceeds revenue. As a result, the government has to borrow through
the issue of government debt.
If the government sector is taking in more revenue than it is spending, there is a

budget surplus allowing the government to repay some of the accumulated
debt, of perhaps cut the burden of tax or raise government expenditure.
135 ©
3. Monetary Policy
Monetary Policy looks at the supply of money, the monetary system, interest
rates, exchange rates and the availability of credit.
All of which are highly important to organisations, households and

individuals. Businesses can be affected by governments' taxation policies
outlined within the fiscal policy AND equally affected by high interest rates set out
within the monetary policy.
In the UK, the ultimate objective of monetary policy in recent years has been
principally to reduce the rate of inflation to a sustainable low level.
The intermediate objectives of monetary policy have related to the level of

interest rates, growth in the money supply, the exchange rate of sterling, the
expansion of credit and the growth of national income.
4. Money Supply within the Monetary Policy (Moneterists view)
This is an intermediate target and should be seen as a medium term target.
The argument is that by increasing money supply this will raise prices and
incomes and this will increase the demand for money to spend.
There are however three short-term unpredictable effects:
• May cause erratic (sudden) interest rates

• Time lag. It takes time to cut government spending!
• Time lag before control over money supply alters expectations
5. Interest Rates within the Monetary Policy
There are suggestions that there is a direct relationship between interest rates
and the levels of expenditure in the economy or put simply, between interest
rates and inflation.
136 ©
A rise in interest rates will raise the price of borrowing.
This could lead to a reduction in investments through the economy should

organisations perceive the high rate to be relatively permanent.
Profits would fall due to higher borrowing rates and organisations may have to
consider a reduction in inventory levels.
For individuals, there is less likelihood of borrowing for house purchases.
A strong reason for pursuing an interest rate policy is that it can be implemented
rapidly compared to other target policies.
6. The Exchange Rate within the Monetary Policy
There are few reasons why the exchange rate plays an important part of the
monetary policy
• If exchange rates fall, exports become cheaper to overseas buyers and so

more competitive in export markets. However, imports will become more
expensive.
Therefore, a fall in exchange rates might be good for a domestic economy, by

giving a stimulus to exports and reducing demand for imports.
• An increase in exchange rates will have the opposite effect, with dearer
exports and cheaper imports. If this happens, there should be a reduction in
the rate of domestic inflation.
However, the opposite would happen with a fall in exchange rates therefore,
adding to the rate of domestic inflation.
Rates of domestic inflation need to be controlled prior to introducing a robust

target for the exchange rates due to some country’s being heavily dependent
on overseas trade
137 ©
7. Monetary & Fiscal Policy
Monetary policy can act as a subsidiary to fiscal policy. As a budget is usually a

once a year event, the government may need to use non-fiscal measures to
control the economy.
These are typically:
• Low interest rates or lack of credit control to stimulate bank lending

• High interest rates to stop bank lending
• Strict credit control to reduce lending and reduce demand on the economy
Supply-side economic policies are mainly designed to improve the supply-side

potential for an economy, make markets and industries operate more efficiently and
thereby contribute a faster rate of growth of real national output. There are two
broad approaches to the supply-side.
Firstly policies focused on product markets where goods and services are produced
and sold to consumers and secondly the labour market is bought and sold.
138 ©
Syllabus D1abcdef.
a) Define what is meant by “money supply” in an economic context.
b) Outline how money supply may be controlled in an economy.
c) Outline the basic relationship between the demand for money and interest rates.
d) Explain briefly and illustrate the interaction between inflation and interest rates.
e) Discuss the possible consequences of inflation in an economy and its effect on

organisations in general.
f) Describe how the application of different monetary policies can affect the economy.
The regulation of the money supply and interest rates

by a central bank in order to control inflation and
stabilise currency
The volume of money in circulation is called the money supply
The price of money is called interest rates
Discussion:
Monetary policy is one of the ways the government can impact the economy.
By impacting the effective cost of money, the government can affect the amount of
money that is spent by consumers and businesses.
139 ©
1. Affect on Growth
When interest rates are high, fewer people and businesses can afford to borrow,
so this usually slows the economy down.
Also, more people will save (if they can) because they receive more on their
savings rate.
When the central banks set interest rates it is the amount they charge other
banks to borrow money.
This is a critical interest rate, in that it affects the entire supply of money, and
hence the health of the economy.
High interest rates can cause a recession.
2. Affect on Exchange rates
High interest rates attracts foreign investment ⇨ increase in exchange rates:
• exports dearer
• imports cheaper.
3. Effect on Inflation
High interest rates should restrict growth and inflation
140 ©
Syllabus D2abcd.
a) Discuss situations where it may be appropriate to raise medium-term finance.
b) Describe the main features of hire purchase, and leases.
c) Compare and contrast the main features of hire purchase, and leases (NB – lease or buy
decisions are not examinable).
d) Discuss the relative merits and limitations of medium term finance.
Medium term finance
are those that a company pays back in 1 to 5 years, and they include bank loans,
hire purchases and leases.
Advantages:
1. You can complete your loan in short period. Responsibility is over
2. You can take other loan if you need in future
Disadvantages
1. Normally banker is charging higher rate of interest for Medium Term loan
2. There is a risk if we fail to pay within the allotted period.
141 ©
Hire Purchase
A method of buying goods through making installment payments over time.
Under a hire purchase contract, the buyer is leasing the goods and does not obtain
ownership until the full amount of the contract is paid.
Finance lease
A finance lease is where the LESSEE takes the majority of the risks and rewards of
the underlying asset.
Therefore with a finance lease the lessee would show the asset on their SFP (and
the related finance lease liability).
When classifying look for substance rather than the form.
Finance Lease Indicators:
• The lessee gets ownership of the asset at the end of the lease term
• The lessee can buy the asset at such a low price that it is reasonably certain that
the option will be exercised;
• The lease term is for the major part of the economic life
• The PV of the lease payments is substantially the fair value of the leased asset;
and
• Only the lessee can use the asset as it is so specialised
142 ©
Syllabus C2j & D3ab.
a) Discuss situations where it may be appropriate to raise long-term finance.
b) Describe the key factors to be considered when deciding on an appropriate source of long
term finance (debt or equity).
j) Discuss ways in which a company may obtain a stock market listing and the advantages and
disadvantages of having a stock market listing.
Long term finance
These are:
1. Finance Lease
You will notice we have included both operating and finance leases as potential
sources of finance - don’t forget too to mention the possibility of selling your
assets and leasing them back as a way of getting cash.
Be careful though - make sure there are enough assets on the SFP to actually do
this - or your recommendation may look a little silly ;)
2. Bank loans and bonds/debentures
Bonds securities which can be traded in the capital markets.

Bond holders are lenders of debt finance.
Bond holders will be paid a fixed return known as the coupon.
Traded bonds raise cash which must be repaid usually between 5 and 15 years
after issue.
Bonds are usually secured on non-current assets thus reducing risk to the lender.
Interest paid on the bonds is tax-deductible, thus reducing the cost of debt to the
issuing company
143 ©
3. Equity
via a placing - does not need to be redeemed, since ordinary shares are truly
permanent finance.
The return to shareholders in the form of dividends depends on the dividend
decision made by the directors of a company, and so these returns can increase,
decrease or be passed.
Dividends are not tax-deductible like interest payments, and so equity finance is
not tax-efficient like debt finance.
4. Preference Share
These are seen as a form of debt
5. Venture Capital
For companies with high growth and returns potential

This is provided to early/start up companies with high-potential.
The venture capitalist makes money by taking an equity share and then realising
this in an IPO (Initial Public Offering) or trade sale of the company
6. Business angels
are wealthy individuals who invest in start-up and growth businesses in return for
an equity stake.
These individuals are prepared to take high risks in the hope of high returns.
7. Private equity
consists of equity securities in companies that are not publicly traded on a stock
exchange.
Private equity funds might require a 20 – 30% shareholding or/and Rights to
appoint directors
144 ©
Equity as finance
Rights For existing shareholders initially No dilution of control

Issue
Placing Fixed price to institutional Low cost - good for small

investors issues
Public Underwritten & advertised Expensive - good for large

issue
Rights Issue
For existing shareholders initially - means no dilution of control
• A 1 for 2 at $4 (MV $6) right issue means….
The current shareholders are being offered 1 share for $4, for every 2 they
already own.
(The market value of those they already own are currently $6)
Calculation of TERP (Theoretical ex- rights price)
• Calculation of TERP (Theoretical ex- rights price)
The current shareholders will, after the rights issue, hold:

1 @ $4 = $4
2 @ $6 =$12
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33
145 ©
Effect on EPS
Obviously this will fall as there are now more shares in issue than before, and the
company has not received full MV for them
• To calculate the exact effect simply multiply the current EPS by the TERP /
Market value before the rights issue
Eg Using the above illustration

EPS x 5.33 / 6
Effect on shareholders wealth
• There is no effect on shareholders wealth after a rights issue.
This is because, although the share price has fallen, they have proportionately
more shares
Equity issues such as a rights issue do not require security and involve no loss of
control for the shareholders who take up the right
Methods of obtaining a listing
An unquoted company can obtain a listing on the stock market by means of a:
1. Initial public offer (IPO)
When a company issues shares to the public for the first time.
They are often issued by smaller, younger companies looking to expand, or large
private companies wanting to become public.
For the individual investor it is tough to predict share prices on the initial day of
trading as there’s little past data about the company often, so it’s a risky
purchase.
Also expansion brings uncertainty in any case
146 ©
2. Placing
Is an arrangement whereby the shares are not all offered to the public.
Instead, the shares are bought by a small number of investors, usually

institutional investors (such as pension funds and insurance companies).
This means low cost - so good for small issues
Placings are likely to be quick.
3. Public Issues
These are underwritten & advertised.
This means they are expensive - so good for large issue
147 ©
Syllabus D3b. Describe the key factors to be considered when deciding on an appropriate
source of long term finance (debt or equity) ...
Debt v Equity
These are the things you need to think about when asked about raising finance - so
just put all these in your answer and link them to the scenario. Job done.
Gearing and financial risk
• Equity finance will decrease gearing and financial risk, while debt finance will
increase them
Target capital structure
• The aim is to minimise weighted average cost of capital (WACC).
In practical terms this can be achieved by having some debt in capital structure,
since debt is relatively cheaper than equity, while avoiding the extremes of too
little gearing (WACC can be decreased further) or too much gearing (the
company suffers from the costs of financial distress)
Availability of security
• Debt will usually need to be secured on assets by either:
a fixed charge (on specific assets) or

a floating charge (on a specified class of assets).
148 ©
Economic expectations
• If buoyant economic conditions and increasing profitability expected in the future,

fixed interest debt commitments are more attractive than when difficult trading
conditions lie ahead.
Control issues
• A rights issue will not dilute existing patterns of ownership and control, unlike an
issue of shares to new investors.
149 ©
Syllabus D3c. Calculate relative gearing and earnings per share under different financial
structures.
High Gearing problems
The higher a company’s gearing, the more the company is considered risky.
An acceptable level is determined by comparison to companies in the same industry.
A company with high gearing is more vulnerable to downturns in the business cycle
because the company must continue to service its debt regardless of how bad sales
are.
A greater proportion of equity provides a cushion and is seen as a measure of

financial strength.
The best known examples of gearing ratios include
1. debt-to-equity ratio (total debt / total equity),
2. interest cover (EBIT / total interest),
3. equity ratio (equity / assets), and
4. debt ratio (total debt / total assets).
150 ©
Dangers associated with high gearing:
1. Need to cover high fixed costs, may tempt companies to increase sales prices
and so lose sales to competition
2. Risk of non payment of a fixed cost and litigation
3. Risk of unsettling shareholders by having no spare funds for dividends
4. Risk of lower credit rating
5. Risk of unsettling key creditors
How finance can affect financial position and risk
Financial Position Gearing
Gearing can be a financially sound part of a business’s capital structure particularly if

the business has strong, predictable cash flows.
Operational gearing
Operating gearing is a measure which seeks to investigate the relationship between

the fixed operating costs and the total operating costs.
• In cases where a business has high fixed costs as a proportion of its total costs,
the business is deemed to have a high level of operational gearing.
Potentially this could cause the business problems in as it relies on continuing
demand to stay afloat.
• If there is a fall in demand, the proportion of fixed costs to revenue becomes even
greater. It may turn profits into serious losses.
Normally, businesses cannot themselves do a great deal about the operational
gearing, as it may be typical and necessary in the industry, such as the airline
business.
151 ©
The normal equation used is:
• Fixed operating costs / Total operating costs

In this sense total operating costs include both fixed and variable operating costs.
Interest cover
Interest cover is a measure of the adequacy of a company’s profits relative to

interest payments on its debt.
The lower the interest cover, the greater the risk that profit (before interest) will
become insufficient to cover interest payments.
It is:
It is a better measure of the gearing effect of debt on profits than gearing itself.
A value of more than 2 is normally considered reasonably safe, but companies with
very volatile earnings may require an even higher level, whereas companies that
have very stable earnings, such as utilities, may well be very safe at a lower level.
Similarly, cyclical companies at the bottom of their cycle may well have a low interest
cover but investors who are confident of recovery may not be overly concerned by
the apparent risk.
152 ©
Syllabus D3d. Discuss the relative merits and limitations of long term finance.
Merits and limitations of LT finance
Advantages of an overdraft over a loan
1. The customer only pays interest when he is overdrawn.
2. The bank has the flexibility to review the customer's overdraft facility periodically,
and perhaps agree to additional facilities, or insist on a reduction in the facility.
3. An overdraft can do the same job as a medium-term loan: a facility can simply be
renewed every time it comes up for review.
Don't forget that overdrafts are normally repayable on demand.
Advantages of a loan for longer term lending
1. Both the customer and the bank know exactly what the repayments of the loan
will be and how much interest is payable, and when.
This makes planning (budgeting) simpler.
2. The customer does not have to worry about the bank deciding to reduce or
withdraw an overdraft facility before he is in a position to repay what is owed.
There is an element of 'security' or 'peace of mind' in being able to arrange a loan

for an agreed term.
153 ©
However, a mix of overdrafts and loans might be suggested in some cases.
Consider a case where a business asks for a loan, perhaps to purchase a factory
with a warehouse of goods included.
The banker might wish to suggest a loan to help with the purchase of the warehouse,
but that goods ought to be financed by an overdraft facility.
The offer of part-loan part-overdraft is an option that might be well worth considering.
154 ©
Syllabus D3e. Describe the key factors that should be considered in deciding the mix of
short/medium/long term finance in an organisation.
The capital structure
An organisation can be financed by:
1. Equity and non-current liabilities
- ordinary shares and reserves, preference shares, loan notes and bank loans
2. Current liabilities
- such as a bank overdraft and payables
Principles of capital structure
When a business is growing, the additional assets must be financed by additional

capital.
The question for businesses is finding the right mix of the various finance
combinations available.
155 ©
Matching assets with funds
• Assets which yield profits over a long period of time should be financed by long-
term funds such as equity and non-current liabilities.
In this way, the returns made by the asset will be sufficient to pay either the
interest cost of the loans raised to buy it, or dividends on its equity funding.
• If a long-term asset is financed by current liabilities the company cannot be

certain that when the loan becomes repayable, it will have enough cash to repay
it.
• A company would not normally finance all of its current assets with current
liabilities, but instead finance current assets partly with current liabilities and
partly with long-term funding.
156 ©
Syllabus D3f. Discuss the nature and importance of internally generated funds.
Internal funds
Managers usually choose to finance new projects or investments by making use
of the following sources in the order shown:
1. Internal funds (retained earnings)
2. Debt
3. Equity
The above sequence is referred to as the “pecking order theory” and is based on
observations of business behaviour.
The first choice is a natural one: retained earnings are already at the disposal of the
company without involving costs or formalities.
They are not considered to be a free (costless) form of finance, however, they are
available for distribution to the shareholders.
As along as they are retained by the firm, management is expected to earn a cost of
equity return on such funds.
157 ©
Syllabus D4a. Outline the requirements for finance of SMEs (purpose, how much, how long)..
Here, often, shareholders are not different from

directors
Differences to a listed company
1. Often Family owned
2. Often no separation between management and owners
3. Little differences between owner and director objectives
4. Smaller number of shareholders - who are often in contact with the company - so
conflict less likely
In a listed Company it's different..
• Objectives of shareholders and directors may be different
• Asymmetry of information
Shareholders get less info than directors, making monitoring harder
• A separation between ownership and control
Shareholders and directors are different people
158 ©
Syllabus D4bc.
b) Describe the nature of the financing problem for SMEs in terms of the funding gap, maturity
gap and inadequate security.
c) Discuss the contribution of lack of information in SMEs to help explain the problems of SME
financing.
Reasons why a small business can find it difficult to

obtain finance
These are:
1. Difficulties in raising finance Security
Banks often require security for a loan.
A small company often does not have the assets on which to secure a loan.
2. Risk attitude
Banks can have a risk adverse attitude to new projects/businesses.
If a business/project is considered risky, the bank may charge a higher interest

rate, which a small business can not afford, or the bank may decide not to lend at
all.
3. Capital markets
Small businesses are not large enough to access the capital markets.
159 ©
4. Owners
Owners may not have the personal wealth to provide additional finance if
required.
5. Trade credit
Suppliers may be reluctant to offer trade credit to a small company due to the
increased credit risk.
6. Lack of skills
Owners may not have all the skills needed to attract the types of funding required
by small businesses e.g. business angels.
7. Cash flows
A start up business, without previous experience, has not demonstrated the

ability to generate adequate cash flows to repay the finance.
160 ©
Syllabus D4d. Describe and discuss the response of government agencies and financial
institutions to the SME financing problem
Governments help companies in their country
This is often in the form of grants.
European Union
The European Union (EU) provides businesses within its area access to grants in a
number of areas.
1. Regional development
Grants are available under the European Regional Development Fund to

encourage development in certain European regions.
2. Business support
The European Investment Fund supports venture capital provision for SMEs in
relation to innovation and job creation.
The Joint European Ventures Plan aims to stimulate joint ventures between
European SMEs.
161 ©
Australia
Australia's federal government and individual states and territories provide various
grants and assistance.
Examples of federal assistance include:
• Incentives to businesses that employ apprentices
• Import duty concessions on imported materials
• Taxation exemption for venture capital funds
• Financial support of SMEs who export products in certain industrial sectors
USA
In the USA there are 26 federal agencies that provide a number of support
programs.
The US Small Business Administration (SBA) provides loans, loan guarantees,

contracts, counselling sessions and other forms of assistance to small businesses.
The Small Business Investment Company (SBIC) program provides equity

investment and long-term debt to high risk small businesses.
UK
The UK government has introduced a number of assistance schemes to help

businesses, and several of these are designed to encourage lenders and investors
to make finance available to small and unquoted businesses.
162 ©
Syllabus D4ef. Describe the main features of venture capital.
Describe the key areas of concern to venture capitalists when evaluating an application for
funding.
Venture capital
Startup or growth equity capital or loan capital provided by private investors (the
venture capitalists) or specialized financial institutions (development finance houses
or venture capital firms).
Venture capital is a type of funding for a new or growing business.
It usually comes from venture capital firms that specialize in building high risk
financial portfolios.
With venture capital, the venture capital firm gives funding to the startup company in
exchange for equity in the startup.
163 ©
Syllabus D4gh.
g) Explain how the use of such measures as credit suppliers, hire purchase, factoring and
second tier listing can help to ease the financial problems of SMEs.
h) Outline appropriate sources of finance for SMEs.
Finance for SMEs
Possible sources of finance for SMEs include:
• Owner financing
• Overdraft financing
• Bank loans
• Trade credit
• Equity finance
• Business angel financing
• Venture capital
• Leasing
• Factoring
Owner financing
Finance from the owner(s)' personal resources or those of family connections is

generally the initial source of finance.
At this stage because many assets are intangible, external funding may be difficult to
obtain.
164 ©
Overdrafts and loans
Remember this is where payments from a current account exceed income to the
account for a temporary period, the bank finances the deficit by means of an
overdraft.
It is very much a form of short-term lending, available to both personal and business
customers.
Many SMEs require their bank to provide financial assistance for normal trading over
the operating cycle, if for example seasonal factors mean they face temporary cash
shortages.
Trade credit
Undoubtedly trade credit can be a useful source of finance early in a SMEs life.
Its principal problem is that taking extended credit will mean the loss of early
payment discounts, and the amounts involved may be significant.
Equity finance
Other than investment by owners or business angels, businesses with few tangible
assets will probably have difficulty obtaining equity finance when they are formed (a
problem known as the equity gap).
However, once small firms have become established, they do not necessarily need
to seek a market listing to obtain equity financing; shares can be placed privately.
Letting external shareholders invest does not necessarily mean that the original
owners have to cede control, particularly if the shares are held by a number of small
investors.
However small companies may find it difficult to obtain large sums by this means.
165 ©
Business angel financing
Business angel financing can be an important initial source of business finance.
Business angels are wealthy individuals or groups of individuals who invest directly
in small businesses.
Venture capital organisations
Venture capital is risk capital, normally provided in return for an equity stake.
166 ©
Syllabus E: Investment Decisions
Syllabus E1. Financing concepts
Syllabus E1a. Explain the differences between simple and compound interest.
The Difference Between:
Simple interest
Simple interest is calculated on the original principal only.
Example
You invest $100 for 3 years and you receive a simple interest rate of 10% a year on
the $100. This would be $10 each year. Simply $100 x 10% = $10.
Compound interest
The important thing to remember is that you get interest on top of the previous
interest. This is called compound interest.
Example
Suppose that a business has $100 to invest and wants to earn a return of 10%. What
is the future value at the end of each year using compound interest?
Yr 1 - 100 x 1.10 = $110

Yr 2 - 110 x 1.10 = $121 or 100 x (1.10)2
Yr 3 - 121 x 1.10 = $133 or 100 x (1.10)3
167 ©
This future value can be calculated as:
FV = PV (1+r)n
Where
FV is the future value of the investment with interest

PV is the initial or ‘present’ value of the investment
r is the compound annual rate of return or rate of interest expressed as a proportion
n is the number of years
e.g. (100 x 1.1)3 = 133
Nominal interest rate
The nominal interest rate is given as a percentage. A compounding period is also

given. In the above example, the 10% is the nominal rate and the compounding
period is a year.
The compounding period is important when comparing two nominal interest rates, for
example 10% compounded semi-annually is better than 10% compounded annually.
In the exam, unless told otherwise, presume the compounding period is a year.
Effective annual rate of interest (annual percentage rate – APR)
The effective interest rate, on the other hand, can be compared with another
effective rate as it takes into account the compounding period automatically, and
expresses the percentage as an annual figure.
In fact, when interest is compounded annually the nominal interest rate equals the
effective interest rate.
To convert a nominal interest rate to an effective interest rate, you apply the formula:
= (1 + i/m)mt – 1
168 ©
Where ‘m’ is the number of compound periods
‘i’ is the interest rate
‘t’ is the number of time periods
Example
What is the effective rate of return of a 15% p.a. monthly compounding investment?
Effective rate = (1 + (0.15/12))12 - 1 = (1 + 0.0125)12 - 1 = 0.1608 = 16.08%
Example
What effective rate will a stated annual rate of 6% p.a. yield when compounded
semi-annually?
Effective Rate = (1 + (0.06/2))2 - 1 = 0.0609 = 6.09%
169 ©
Syllabus E1c. Discuss the concept of time value of money.
Concept of time value of money
The time value of money
is based on the concept that money received now is worth more than the same sum
received in one year's time or at another time in the future.
Reasons why a present $1 is worth more than a future $1 can be:
• Uncertainty
The business world is full of risk and uncertainty, and although there might be the
promise of money to come in the future, it can never be certain that the money
will be received until it has actually been paid.
• Inflation
Because of inflation it is common sense that $1 now is worth more than $1 in the
future.
• Preference
An individual attaches more weight to current pleasures than to future ones, and
would rather have $1 to spend now than $1 in a year's time.
Discounted cash flow (DCF)
is a project appraisal technique that is based on the concept of the time value of
money, that $1 earned or spent sooner is worth more than $1 earned or spent later.
170 ©
Syllabus E1bde.
b) Calculate future values.
d) Discuss the concept of discounting.
e) Calculate present values, making use of present value tables to establish discount factors.
Calculating a present value (from future values)
Ok - so we have seen how to work out future values from present values.
(Using inflation as the example)
However, when looking at whether we should invest in something we will be looking

at future cashflows coming in.
We want to know what are these future cashflows worth now, in today’s money
ideally.
To do this we need to work the other way around ie. Take the future value (FV) and
work out the present value (PV). We do this by:
Discounting
• Discount Factors
It is the discounted cash flows that we want to end up with in an NPV question.
So we put the future cash flows in, and then discount them using a discount
factor. These are given in discount factor tables in the exam but can be
calculated as follows:
If you want to calculate a 10% discount factor for year 1 - It is 1 divided by 1.10 =
0.909
171 ©
If you want to calculate a 10% discount factor for year 2 - It is 1 divided by 1.10
divided by 1.10 = 0.826
If you want to calculate a 10% discount factor for year 3 - It is 1 divided by 1.10
divided by 1.10 divided by 1.10 = 0.751

0.943
0.893
Illustration
You are to receive £100 in one year’s time and the interest rate/discount rate is 10%.
What is the PV of that money?
• 100 x 1 /1.10
= 90.9
172 ©
Syllabus E2a. Discuss the importance of capital investment planning and control.
Capital Budgeting
is the process in which a business determines whether projects such as building a

new plant or investing in a long-term venture are worth pursuing.
Capital budgeting is important because it creates accountability and
measurability
Any business that seeks to invest its resources in a project, without understanding
the risks and returns involved, would be held as irresponsible by its owners or
shareholders.
Furthermore, if a business has no way of measuring the effectiveness of its

investment decisions, chances are that the business will have little chance of
surviving in the competitive marketplace.
173 ©
Syllabus E2b. Outline the issues to consider and the steps involved in the preparation of a
capital expenditure budget
Preparing capital expenditure budgets
The capital expenditure budget is a non-current assets purchase budget, and it will
form part of the longer term plan of a business.
Sales, production and related budgets usually cover a 12 month period.
This requires a consideration of the organisation's requirements for land, buildings,

plant, machinery, vehicles, fixtures and fittings and so on for the short, medium and
long term.
Suitable financing must be arranged
If available funds are limiting the organisation's activities then it will more than likely
limit capital expenditure.
The capital expenditure budget must be reviewed in relation to the other budgets.
Proposed expansion of production may require significant non-current assets

expenditure which should be reflected in the budget.
Before major capital expenditure is incurred, we need to be confident that the

expenditure is worthwhile.
We therefore need to appraise the project on which the expenditure is to be made, to

see if it is likely to be of positive value to the business.
174 ©
Syllabus E2c. Define and distinguish between capital and revenue expenditure.
Capital and revenue expenditure
Capital expenditure
can be defined as expenditure on productive assets e.g. non-current assets such as

buildings, lifts, heating, machinery, vehicles, and office equipment.
This can be for expansion and/or to improve quality for profitability purposes.
Capital expenditure appears as a non-current asset in the statement of financial

position.
Depreciation is charged in the income statement as an expense.
All the costs incurred in self constructed assets (a business builds its own non-
current asset) should be included as a non-current asset in the statement of financial
position.
Revenue Expenditure
This expenditure is on day to day items, i.e. where the benefit is received short
term.
This includes salaries, telephone costs or rent.
It is incurred for the purpose of trade, i.e. for expenditure classified as selling and
distribution expenses, administration expenses and fixed charges or to maintain the
existing earning capacity of non-current assets.
Revenue expenditure is included as an expense in the period in which it is incurred
175 ©
Capital Income
Capital income is the proceeds from the sale of non-current assets and non-current
asset investments
Revenue Income
Revenue income is derived from the sale of trading assets and from interest and
dividends received from investments held by the business.
176 ©
Syllabus E2d. Compare and contrast investment in non current assets and investment in
working capital
Why is the distinction important?
Revenue expenditure results from the purchase of goods and services that will
either:
• Be used fully in the accounting period in which they are purchased, and so be a
cost or expense in the statement of profit or loss (P&L), or
• Result in a current asset as at the end of the accounting period because the
goods or services have not yet been consumed or made use of
The current asset would be shown in the statement of financial position (SFP)
and is not yet a cost or expense in the (P&L).
Capital expenditure
results in the purchase or improvement of non-current assets, which are assets that
will provide benefits to the business in more than one accounting period, and which
are not acquired with a view to being resold in the normal course of trade.
The cost of purchased non-current assets is not charged in full to the P&L of the
period in which the purchase occurs.
Instead, the non-current asset is gradually depreciated over a number of accounting

periods.
177 ©
Syllabus E2e. Describe capital investment procedures (authorisation and monitoring).
Investment appraisal process
The nature of investment decisions and the appraisal process
Ok this is a bit dull, and a bit obvious, but hey not everything in life can be as cool as
cows.. so just learn them and stop moaning, you big fat money pants
Key stages:
1. Identifying investment opportunities
From an analysis of strategic choices, analysis of the business environment,

research and development, or legal requirements.
The key requirement is that investment proposals should support the

achievement of organisational objectives.
2. Screening investment proposals
Companies need to choose between competing investment proposals and select

those with the best strategic fit and the most appropriate use of economic
resources.
3. Analysing and evaluating investment proposals
This is the stage where investment appraisal plays a key role, indicating for example
which investment proposals have the highest net present value.
178 ©
4. Approving investment proposals
Very large proposals may require approval by the board of directors, while
smaller proposals may be approved at divisional level
5. Implementing, monitoring and reviewing investments
The time required to implement the investment proposal or project will depend on
its size and complexity.
Following implementation, the investment project must be monitored to ensure

that the expected results are being achieved and the performance is as expected.
The whole of the investment decision-making process should also be reviewed in

order to facilitate organisational learning and to improve future investment
decisions.
A benefits realisation review
takes place after the product has been delivered.
It revisits the business case to see if the costs predicted at the initiation of the project
were accurate and that the predicted benefits have actually accrued.
What might happen if a return on investment project decreases?
• More projects will be accepted if the rate is relaxed.
• The share price may decline if the directors do not appear confident.
• The economy may recover before the projects’ outcomes are determined.
179 ©
Syllabus E3a. Calculate the payback and discounted payback of a project and assess its
usefulness as a method of investment appraisal.
Payback method
This method focuses on liquidity rather than the profitability of a product. It is good
for screening and for fast moving environments
The payback period is the length of time that it takes for a project to recoup its initial
cost out of the cash receipts that it generates.
This period is some times referred to as “the time that it takes for an investment to
pay for itself.”
The basic premise of the payback method is that the more quickly the cost of an
investment can be recovered, the more desirable is the investment.
The payback period is expressed in years. When the net annual cash inflow is the
same every year, the following formula can be used to calculate the payback
period….
Formula / Equation:
• Payback period = Investment required / Net annual cash inflow*
*If new equipment is replacing old equipment, this becomes incremental net
annual cash inflow.
It simply measures how long it takes the project to recover the initial cost.
Obviously, the quicker the better.
180 ©
Illustration
Constant cashflow scenario
Initial cost $3.6 million

Cash in annually $700,000
What is the payback period?
• Solution
3,600,000 / 700,000 = 5.1429
Take the decimal (0.1429) and multiply it by 12 to get the months - in this case
1.7 months
So the answer is 5 years and 1.7 months
So how useful is this method?
The payback method is not a true measure of the profitability of an investment.
Rather, it simply tells the manager how many years will be required to recover the
original investment.
1. Whole life of Project?
Unfortunately, a shorter payback period does not always mean that one
investment is more desirable than another.
For example it doesn’t look at the whole life of the project
2. Time value of money
Another criticism of payback method is that it does not consider the time value of
money. A cash inflow to be received several years in the future is weighed
equally with a cash inflow to be received right now.
181 ©
3. Screening
On the other hand, under certain conditions the payback method can be very
useful. It can help identify which investment proposals are in the “ballpark.”
That is, it can be used as a screening tool to help answer the question, “Should I
consider this proposal further?” If a proposal does not provide a payback within
some specified period, then there may be no need to consider it further.
4. Cash poor companies
When a firm is cash poor, a project with a short payback period but a low rate of
return might be preferred over another project with a high rate of return but a long
payback period.
The reason is that the company may simply need a faster return of its cash
investment.
5. Quick changing environments
And finally, the payback method is sometimes used in industries where products
become obsolete very rapidly - such as consumer electronics.
Since products may last only a year or two, the payback period on investments
must be very short.
In summary, the benefits are:
1. Simple
2. Good when the project is subject to quick change like technology.
This is because cashflows in the future become harder and harder to predict so
recovering the money as soon as possible is vital.
3. It minimises risk (short term projects favoured)
4. It maximises liquidity
5. Uses cashflows not false profits
182 ©
Drawbacks
1. the item with the quickest payback is simply that. What about afterwards, does it
still do well or does it then become obsolete?
2. It ignores the whole profitability. Also the time value of money is ignored (more of
that later).
Irregular Cashflows
When the cash flows associated with an investment project changes from year to
year, the simple payback formula that we outlined earlier cannot be used.
• To understand this point consider the following data:
Cumulative
Capital out 800 -800
Cash in 100 -700
Cash in 240 -460
Cash in 200 -260
Cash in 250 -10
Cash in 120 110
When the cumulative cashflow becomes positive then this is when the initial payment
has been repaid and so is the payback period
So in the final year we need to make 10 more to recoup the initial 800. So, that’s 10
out of 120. 10/120 x 12 (number of months) = 1.
So the answer is 4 years 1 month
183 ©
Extension of Payback Method:
• The payback period is calculated by dividing the investment in a project by the

net annual cash constant inflows that the project will generate.
• If equipment is replacing old equipment then any scrap value to be received

on disposal of the old equipment should be deducted from the cost of the new
equipment, and only the incremental investment should be used in payback
computation.
184 ©
Syllabus E3a. Calculate the payback and discounted payback of a project and assess its
usefulness as a method of investment appraisal.
This incorporates risk into the payback method we

looked at earlier in the course
2 Methods
• Add payback to NPV - Only projects with +ve NPV and payback within specified
time chosen
• Discount cashflows used in payback with a risk adjusted discount rate
Illustration of method 2
Year Cashflow
0 (1,700)
1 500
2 500
3 600
4 900
5 500
185 ©
Calculate discounted payback at a rate of 12%
Solution
Year Cashflow 12% Cashflow Cumulative
0 (1,700) 1 (1,700) (1,700)
1 500 0.893 446.5 (1,253)
2 500 0.797 398.5 (855)
3 600 0.712 427.2 (427.8)
4 900 0.636 572.4 144.6
5 500 0.567 283.5 428.1
Discounted payback = 3 years 9 months

NPV = 428,100
Risk Adjusted Discount Rates
The discount rate should reflect:
1. Cost of debt
2. Cost of equity
The mix of the 2 above adjusted for riskiness
If a project gives additional risks then the discount factor should be altered
accordingly. This is called the risk premium
186 ©
Syllabus E3b. Calculate the accounting rate of return of a project and assess its usefulness as
a method of investment appraisal.
Return on capital employed (ROCE)
Note:
• Right, first thing you need to remember about this is that this is the ONLY
investment appraisal technique which uses profits and not cash in the F9 exam.
This is a drawback of the method - as profits can be manipulated
• The second thing to understand is that it has 2 names - ROCE (return on capital
employed) and ARR (Accounting rate of return)
Finally - there are 2 methods of calculating it:
1. Simple Method
This percentage is compared to the target return you would like to get.
Clearly it has to be higher than say the interest rate on the loan you used to buy
the capital item.
More correctly it has to be higher than the company’s cost of capital (more of that
later)
2. Average Method
The average investment is the average value it would be in the SFP over the
length of the project
187 ©
Illustration of 'average investment'
Cost 400 Residual Value 100
Average Investment = 400 + 100 / 2 = 250
Illustration
RCA are considering expanding their business into Canada by buying up a local
college over there.
The local college purchase will cost £500,000 and a further £300,000 to make the
premises sexy
Cashflow profits (ie not including depreciation) from the college over the next 5 years
are expected to be:
Year Cash Profits (£)
1 100,000
2 120,000
3 180,000
4 250,000
5 350,000
The sexiness of the premises will have disappeared by the end of the 5 years and so
sadly have a zero resale value. This will make RCA sad and so they expect to sell up
in order to buy a funky new college somewhere else. When they sell they hope to get
£400,000 for the college
Required
Calculate the ROCE of this investment (using the average investment method)
188 ©
Solution
Total profits = Cash - Depreciation
Depreciation = Cost - Residual value
So, Total profits = 1,000,000 - (500+300-400) = 600,000

Therefore Average profits = 600,000 / 5 = 120,000
Average Investment = (Cost + RV)/2

= (800+400) / 2 = 600,000
ARR = Average Profits / Average Investment = 120,000 / 600,000 = 0.2 = 20%
Points about ROCE
This is used when company’s are more interested in PROFITABILITY than liquidity
Unlike the other capital budgeting methods that we have discussed, the simple rate
of return method does not focus on cash flows. Rather, it focuses on accounting net
operating income.
If a cost reduction project is involved, formula / Equation becomes:
(Cost savings − Depreciation on new equipment) / Initial investment*

*The investment should be reduced by any salvage from the sale of old equipment.
So how useful is this method?
The most damaging criticism of the accounting rate of return method is that it does
not consider the time value of money. The simple rate of return method considers a
dollar received 10 years from now as just as valuable as a dollar received today.
Thus, the accounting rate of return method can be misleading if the alternatives
being considered have different cash flow patterns.
Additionally, many projects do not have constant incremental revenues and

expenses over their useful lives. As a result the simple rate of return will fluctuate
189 ©
from year to year, with the possibility that a project may appear to be desirable in
some years and undesirable in other years. In contrast, the net present value
method provides a single number that summarised all of the cash flows over the
entire useful life of the project.
In summary the benefits are:
1. Fairly simple
2. Understandable percentage figure
Drawbacks
• It disregards the project life and when the cash flows actually come in.
It focuses on profits not liquidity.
It uses accounting profits (which can be manipulated) rather than cash.
There is no mention of the actual gain made (just a percentage figure)
190 ©
Syllabus E3cd.
Discuss the concept of relevant cash flows for decision making.
Identify and evaluate relevant cash flows for individual investment decisions.
Relevant costs for decision making
The costs which should be used for decision making are often referred to as
"relevant costs".
To affect a decision a cost must be:
1. Future
Past costs are irrelevant, as we cannot affect them by current decisions and they
are common to all alternatives that we may choose.
2. Incremental
' Meaning, expenditure which will be incurred or avoided as a result of making a

decision.
3. Cash flow
Expenses such as depreciation are not cash flows and are therefore not relevant.
Similarly, the book value of existing equipment is irrelevant, but the disposal
value is relevant.
191 ©
Other terms:
• Common costs
Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on
a factory would be incurred whatever products are produced.
• Sunk costs
Another name for past costs, which are always irrelevant, e.g. dedicated fixed
assets, development costs already incurred.
• Committed costs
A future cash outflow that will be incurred anyway, whatever decision is taken
now, e.g. contracts already entered into which cannot be altered.
Opportunity cost
Relevant costs may also be expressed as opportunity costs.
An opportunity cost is the benefit foregone by choosing one opportunity instead of

the next best alternative.
Example
A company is considering publishing a limited edition book bound in a special

leather.
It has in stock the leather bought some years ago for $1,000.
To buy an equivalent quantity now would cost $2,000.
192 ©
The company has no plans to use the leather for other purposes, although it has
considered the following possibilities:
• of using it to cover desk furnishings, in replacement for other material which could
cost $900
• of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).
In calculating the likely profit from the proposed book before deciding to go ahead
with the project, the leather would not be costed at $1,000.
The cost was incurred in the past for some reason which is no longer relevant.
The leather exists and could be used on the book without incurring any specific cost
in doing so.
In using the leather on the book, however, the company will lose the opportunities of
either disposing of it for $800 or of using it to save an outlay of $900 on desk
furnishings.
The better of these alternatives, from the point of view of benefiting from the leather,
is the latter.
"Lost opportunity" cost of $900 will therefore be included in the cost of the book for
decision making purposes.
The relevant costs for decision purposes will be the sum of:
1. 'avoidable outlay costs', i.e. those costs which will be incurred only if the book
project is approved, and will be avoided if it is not
2. the opportunity cost of the leather (not represented by any outlay cost in
connection to the project)
This total is a true representation of 'economic cost'.
193 ©
The assumptions in relevant costing
• Cost behaviour patterns are known, e.g. if a department closes down, the
attributable fixed cost savings would be known.
• The amount of fixed costs, unit variable costs, sales price and sales demand are
known with certainty.
• The objective of decision making in the short run is to maximise 'satisfaction',

which is often known as 'short-term profit'.
• The information on which a decision is based is complete and reliable.
194 ©
Syllabus E3ef.
Explain the concept of net present value and how it can be used for project appraisal.
Calculate net present value and interpret the results.
(Note: NPV calculations will not include adjustments for inflation, tax or working capital)
Net Present Value method
This method is examined regularly
What it does is looks at all the projected future CASH inflows and outflows.
Obviously we hope the inflows are more than the outflows. If they are this is called a
positive NPV
However, it also introduces the concept of the “time value” of money.
The idea that money coming in today is worth more than the same amount of money
coming in in 5 years time. To do this we “discount down” all future cash flows.
This “discounting” takes into account not only the time value of money but also the
required return of our share and debt holders.
This means that if we have a positive NPV (even after discounting the future cash
flows) then the return beats not only the time value of money but it also beats what
the shareholders and debt holders require.
So they will be happy and the company value (and hence share price) will rise by the
+NPV amount (divided by the number of shares)
195 ©
So, let’s look at how we calculate NPVs in an exam..
NPV Proforma
0 1 2 3 4
Sales x x x x
Costs (x) (x) (x) (x)
Profit x x x x
Capital Expense (x)
Scrap x
Total Cashflows (x) x x x x
Discount Factors 1 0.9 0.8 0.7 0.6
Total Cashflows (x) x x x x
196 ©
Syllabus E3f. Calculate net present value and interpret the results.
(Note: NPV calculations will not include adjustments for inflation, tax or working capital)
Annuity
Lets us now look at discounting a future cash-flow that is constant every year for a
specified number of years (an annuity).
Illustration
100 received at the end of every year for the next 3 years. If cost of capital is 10%
what is the PV of these amounts together?
• Strictly speaking it is:
Yr 1 100 x 1/ 1.1 = 91
Yr 2 100 x 1/1.1 power of 2 = 83
Yr 2 100 x 1/1.1 power of 3 = 75
All added together = 249
Annuity Discount Factors
This is easier is to calculate using an annuity discount factor - this is simply the 3
different discount factors above added together - again luckily this is given to us in
the exam (in the annuity table)
• So using normal discount factors:

yr 1 1/1.1 = 0.909
yr 2 1/1.1/1.1 = 0.826
Yr 3 1/1.1/1.1/1.1 = 0.751
All added together 2.486 = Annuity factor (or get from annuity table!)
So 100 x 2.486 = 248.6 = 249
197 ©
Perpetuities
This is a constant amount received forever
Calculating the PV of a perpetuity:
Cashflow / Interest rate
• Illustration
What is the PV of an annual income of 50,000 for the forseeable future, given an
interest rate of 5%?
Answer
50,000 / 0.05 = 1,000,000
Perpetuity starting in the future
Don’t panic!
Just calculate the perpetuity as normal - then discount the answer down (discount
factor for 3 years - for example - if the perpetuity started at year 3)
198 ©
Syllabus E3gh.
Outline the concept of internal rate of return and how it can be used for project appraisal.
Calculate internal rate of return and interpret the results.
Internal Rate of Return
The IRR is essentially the discount rate where the initial cash out (the investment) is
equal to the PV of the cash in.
So, it is the discount rate where the NPV = 0
It is actual return on the investment (%).
Consequently, to work out the IRR we need to do trial and error NPV calculations,
using different discount rates, to try and find the discount rate where the NPV = 0.
The good news is you only need to do 2 NPV calculations and then apply this
formula:
Where..
• L = Lower discount rate

H = Higher discount rate
NPV L = NPV @ lower rate
NPV H = NPV @ higher rate
If the IRR is higher than the cost of capital, the project should be accepted.
199 ©
Illustration
If a project had an NPV of 50,000 when discounted at 10%, and -10,000 when
discounted at 15% - what is the IRR?
• Answer
10 + (50,000/60,000) x 5% = 14.17%
If you have a positive NPV, increase the discount rate to get a smaller NPV.
If you have a negative NPV, decrease the discount rate to get a bigger NPV.
Little Tricks
• If all the cashflows are the same
This is an annuity - simply take the Initial Cost / annual inflow - this gives you the
cumulative discount factor (annuity factor).
• Then go to the annuity table and look for this figure (in the row for the number of
years the project is for) - the column in which the figure is found is the IRR!
• If the cashflows are the same and go on forever
• This is a perpetuity - simply take the Annual inflow / Initial cost and turn it into a
percentage. That’s the IRR! Done.
Advantages of IRR
1. Considers the time value of money

2. Easily understood percentage
3. Uses cash not profits
4. Considers whole life of project
5. Increases shareholders wealth
200 ©
Disadvantages of IRR
1. Does not produce an absolute figure (percentage only)
2. Interpolation of the formula means it is only an estimate
3. Fairly complicated to calculate
4. Non conventional cashflows can produce multiple IRRs
Interpreting the IRR
• The IRR provides a decision rule for investment appraisal, but also provides
information about the riskiness of a project – i.e. the sensitivity of its returns.
• The project will only continue to have a positive NPV whilst the firm’s cost of
capital is lower than the IRR.
• A project with a positive NPV at 14% but an IRR of 15% for example, is clearly
sensitive to:
- an increase in the cost of finance

- an increase in investors’ perception of the potential risks
- any alteration to the estimates used in the NPV appraisal.
201 ©
Syllabus E3i. Discuss the relative merits of NPV and IRR, including mutually exclusive projects
and multiple yields.
NPV v IRR
Relative merits of NPV and IRR
The net present value (NPV) method has several important advantages over the
internal rate of return (IRR) method.
• NPV is often simpler to use. As mentioned earlier, IRR may require hunting for
the discount rate that results in a net present value of zero.
This can be a very laborious trial-and-error process, although it can be automated

to some degree using a computer spreadsheet.
• A key assumption made by IRR is questionable. Both methods assume that cash
flows generated by a project during its useful life are immediately reinvested
elsewhere.
However, the two methods make different assumptions concerning the rate of
return that is earned on those cash flow.
• NPV assumes the rate of return is the discount rate
• IRR assumes the rate of return is the internal rate of return on the project.
• So, if the IRR is high, this assumption may not be realistic. It is more realistic to
assume that cash can be reinvested at the discount rate - particularly if the
discount rate is the company’s cost of capital. For example, by paying off the
company’s creditors
• In short, when NPV and IRR do not agree, it is best to go with NPV. Of the two
methods, it makes the more realistic assumption about the rate of return that can
be earned on cash flows from the project.
202 ©
Absolute v percentage figure
• IRR has several weaknesses as a method of appraising capital investments.

Since it is a relative measurement of investment worth, it does not measure the
absolute increase in company value (and therefore shareholder wealth), which
can be found using the net present value (NPV) method
Mutually exclusive projects
• There is a potential conflict between IRR and NPV in the evaluation of mutually
exclusive projects, where the two methods can offer conflicting advice as which
of two projects is preferable.
• For example a small project may have a higher IRR but a lower NPV than a very
big project.
Where there is conflict, NPV always offers the correct investment advice
203 ©
Syllabus E3j. Explain the superiority of DCF methods over payback and accounting rate of
return.
This is the PV of future cashflows - value of debt
Ok so this example is difficult but let's take it one step at a time..
PBT 80 (all cash)

Capital Investment each year 48
Debt 10 ($120)
Tax = 30%
WACC = 10%
The profits are expected to continue for foreseeable future (perpetuity)
What is the value of equity?
First of all you need to know how to calculate the value of something that lasts
forever (like the profits here)
Well this is called a perpetuity
And calculating its PV is easy! Just Divide it by the discount factor!
So say it's a perpetuity of 60 at a discount rate of 4% = 60 / 0.04 = 1,500
In this question the income needs taxing remember!
204 ©
Solution
Cash inflow 80 x 70% = 56 - 48 = 8 (in perpetuity)
Value of business = 8 / 0.1 = 80m
So the Equity is the value of all the cashflows less value of debt remember
Equity = 80m - (10 x 1.2) = 68m
Advantages of DCF Method
1. Theoretically best method
2. Can value part of a company
Disadvantages of DCF Method
1. Need to estimate cashflows and discount rate
2. How long is PV analysis for?
3. Assumes constant tax, inflation and discount rate
205 ©
Syllabus F: Credit Management
Syllabus F1. Legal issues
Syllabus F1a. Explain the key elements of a basic contract (offer, acceptance, remedies for
breach of contract etc).
Key elements of a contract
A contract
A valid contract is a legally binding agreement, formed by the mutual consent of two
parties.
The 3 essentials of a contract
1. There must be an agreement usually made by offer and acceptance.
2. There must be a bargain by which the obligations assumed by one party are
supported by consideration (value) given by the other.
3. The parties must have an intention to create legal relations between themselves.
The following contracts must be in writing and signed by at least one of the
parties.
• A transfer of shares in a limited company
• The sale of a land
• Bills of exchange and cheques
• Consumer credit contracts
206 ©
Some definitions...
1. Offer
An offer is a definite promise to be bound on specific terms.
2. Acceptance
must be an unqualified agreement to all the terms of the offer.
3. Breach of contract
A party is said to be in breach of contract where, without lawful excuse, they do

not perform their contractual obligations precisely.
207 ©
Syllabus F1b. Briefly outline specific terms and conditions that may be included in contracts
with credit customers (eg length of credit period, amount of interest on late payments,
retention of title.
Terms and conditions - contracts with credit

customers
These are specific terms and conditions that may be included in

contracts with credit customers:
1. Length of credit period
The credit period is the number of days that a customer is allowed to wait before
paying an invoice.
If the company grants terms of 2/10 net 30, this means the credit period is 10
days if the customer chooses to take a 2% early payment discount, or the credit
period is 30 days if the customer chooses to pay the full amount of the invoice.
2. Amount of interest on late payments
Usually this type of phrase is included: "Accounts not paid within terms are
subject to a ___% monthly finance charge."
The charge is usually less than 10% interest per year.
3. Retention of title
A retention of title clause is a provision in a contract for the sale of goods that the
title to the goods remains vested in the seller until certain obligations (usually
payment of the purchase price) are fulfilled by the buyer.
208 ©
Syllabus F1c. Outline the basic legal procedures for the collection of debts.
Debt Collection Laws
Collectors are legally entitled to attempt to collect all owed debts.
There is a generalised guidance:
• According to debt collectors laws, a creditor can collect the debts he owns on
behalf of his own company’s trading name
He can also request late payment charges from the subject
• A creditor is NOT allowed to charge the debtor a fee as a debt collection agency
(DCA)
This means the creditor is not governed as a legal and registered debt recovery
agency, therefore he is cannot charge the debtor DCA’s fees and taxes
• A debt agent is NOT allowed to abuse with debtor’s personal information
• A collector can communicate with the debtor, using phone calls, emails and
personal letters during the pre-legal actions
• A debt collector is NOT allowed to contact the debtor at his work place
• A debt collector can involve a law representative in the collection process, such
as debt solicitors
• A debt recovery agency or a creditor can pass the debtor’s case to court (the so-
called court proceedings)
209 ©
Debt Collection Process
1. Step: Use an internal collector
For the first six month, you usually will deal with your creditor’s internal collector.
2. Step: Use the help of DCA
Once you have decided that the debt won't be repaid, it will be assigned to an
outside organisation, sometimes known as a third-party agency (DCA).
At this point, the debt is still owned by, and owed to, the original creditor.
If the third-party agency is successful in recovering all or part of the debt, it will
earn a commission from the creditor, which can either be in the form of a fee, or a
percentage of the total amount owed.
3. Step: Creditor writes off the debt
In the third phase of the process, your original creditor writes off the debt and
sells it to an outside collection agency, sometimes known as a debt buyer.
The creditor is no longer involved.
The collection agency is still trying to recoup as much of the debt as it can, in
order to turn a profit on its purchase.
210 ©
Syllabus F1d. Identify the main data protection issues that should be considered when dealing
with accounts receivables records.
Data protection legislation
The UK's Data Protection Act makes certain restrictions about the use of data about
individual customers and the use of personal data.
Credit reference agencies are exempt from the Data Protection Act, but are covered
by the Consumer Credit Act 1974.
The growth of information technology and the concern for civil freedoms and
individual privacy has meant that legislation has been passed restricting the use of
computer-held data.
In the UK the current legislation is the Data Protection Act 1998.
This Act is an attempt to protect the individual.
The terms of the Act cover data about individuals - not data about corporate bodies.
Therefore for a business offering credit to customers this is of concern for accounts
receivable who are sole traders as opposed to companies.
It is likely that the business will hold data about such individual sole trader credit
customers therefore a knowledge of the provisions of the Act are required.
211 ©
The coverage of the Act
Key points of the Act can be summarised as follows:
• With certain exceptions, all data users and all computer bureaux have had to
register under the Act with the Data Protection Registrar.
• Individuals (data subjects) have certain legal rights.
• Data holders must adhere to the data protection principles.
The rights of data subjects
1. A data subject may seek compensation through the courts for damage and any
associated distress caused by the loss, destruction or unauthorised disclosure of
data about himself or herself or by inaccurate data about himself or herself.
2. A data subject may apply to the courts for inaccurate data to be put right.
3. A data subject can ask to see his or her personal data that the data user is
holding.
4. A data subject can sue a data user (or bureau) for any damage or distress
caused to him by personal data about him which is incorrect or misleading as to
matter of fact.
212 ©
Syllabus F1e. Explain bankruptcy and insolvency.
Bankruptcy
An individual/company is unable to pay off its outstanding debts and files an

application with a court to get himself declared as an insolvent or the creditor can file
an application in the court against the insolvent.
Bankruptcy is when an individual’s assets are sold and the monies collected are
distributed to the creditors.
Now, the court may decide the appropriation of the personal property of the insolvent
among his various creditors.
It is the last stage of insolvency and gives a new lease to the insolvent to start a
fresh, i.e. it relieves the individual or a company from all the debts and other
disadvantages of insolvency.
Insolvency
Insolvency is a situation which arises due to the inability to pay off the outstanding
debts on time to the creditors because the assets are not enough to cover up the
liabilities.
In case of a company, this condition is caused due to the continuous fall in sales and
it doesn’t have enough cash to meet out its day to day expenses of the business, for
which it takes loans from the creditors or banks or any other financial institution.
This results in insolvency of the company in the form of liquidation, voluntary

administration.
213 ©
Key Differences Between Bankruptcy and Insolvency
• The Bankruptcy refers to a legal state in which an individual / company becomes

bankrupt, whereas the Insolvency refers to a financial state where an individual /
company becomes insolvent.
• The major difference between them is, Bankruptcy is the last stage of insolvency.
• The Insolvency may not necessarily leads to a bankruptcy, while all bankrupt
individuals / companies are insolvent.
• In Bankruptcy, the person / company goes to the court and voluntarily declares
himself as an insolvent.
214 ©
Syllabus F2ab.
a) Explain the importance of credit management, including the level of trade credit, the role of
the credit control function and the activities of the credit control function.
b) Explain the need to establish a credit policy and outline the steps involved, including setting
maximum credit amounts and periods and total credit levels.
The credit control department
The credit control department is responsible for:
1. the offer of credit
2. the collection of debts
The roles of the credit control department include:
• Keeping the receivables ledger up-to-date
• Pursuing overdue debts
• Dealing with customer queries
• Reporting to sales staff about new enquiries
• Giving references to third parties (e.g. credit reference agencies)
• Checking out customers’ creditworthiness
• Advising on payment terms
215 ©
What is credit control?
Credit control deals with a firm's management of its working capital.
Trade credit is offered to business customers.
Consumer credit is offered to household customers.
Types of credit
Many businesses, however, cannot demand payment on delivery, especially for

larger items.
• Trade credits
These are credits issued by a business to another business.
For example, many invoices state that payment is expected within thirty days of
the date of the invoice.
In effect this is giving the customer 30 days' credit.
The customer is effectively borrowing at the supplier's expense.
• Consumer credit
This is credit offered by businesses to the end-consumer.
(i) Many businesses offer hire purchase terms when the consumer takes out a
loan to repay when the goods purchased.
Failure to repay will result in the goods being repossessed.
(ii) In practice, much of the growth in consumer credit has been driven not so
much by retailers as by banks.
Credit cards are largely responsible for the explosive growth in consumer credit.
216 ©
Credit control
Credit control issues are closely bound up with a firm's management of liquidity.
Credit is offered to enhance sales and profitability- but this should not be to the
extent that a company becomes illiquid and insolvent.
• A business will also need to be aware of the normal credit terms offered in their
line of business.
In order to attract customers a business will need to be operating within the

industrial norm.
For example, if it is normal in an industry to offer 50 days' credit to customers, it

would be difficult for a supplier to ask for less generous terms, such as 20 days'
credit.
217 ©
Syllabus F2c. Explain the key categories that should be considered when assessing the credit-
worthiness of a customer.
Assessing the credit-worthiness
When assessing the creditworthiness of (potential) clients, companies can use the 5
C’s approach:
1. Character:
Focuses on the reputation of the principals/decision makers at a company; credit

checking agencies and bank references assist to this end
2. Capacity:
Examines the company’s cash flow generation in the context of management’s

ability to perform competently and reliably in meeting their obligations. Financial
statement analysis is a major part of the exercise here
3. Capital:
Identifies and assesses the financial “staying power” and resources of the
business
4. Collateral:
Assesses what security the company is willing to provide in support of the

intended transaction.
5. Conditions:
This is a general review of the economic environment to appreciate to what

extent a customer may be affected by a decline in general business conditions.
218 ©
Syllabus F2de. Outline the various internal sources of information that may be used in
assessing the credit-worthiness of a customer.
Outline the various external sources of information that may be used in assessing the credit-
worthiness of a customer.
Internal and external sources of information
The decision to grant credit to customers is the job of the credit manager.
In determining credit limits, the manager takes into consideration market intelligence.
Sources of information are:
Internal:
• This is based on the experience acquired over time, thanks to the long-term
relationship with a customer
External:
• Data obtained as a result of credit checkings (with credit agencies) or from

publicly available sources.
The resulting information must be evaluated and a decision taken as to how much
credit to approve for individual customers.
219 ©
Syllabus F2f. Define and explain credit scoring.
Credit Score
A statistically derived numeric expression of a person's creditworthiness that is used

by lenders to access the likelihood that a person will repay his or her debts.
A credit score is based on, among other things, a person's past credit history.
It is a number between 300 and 850 - the higher the number, the more creditworthy
the person is deemed to be.
220 ©
Syllabus F2g. Identify possible reasons for rejecting an application for credit or extending credit.
Rejecting or extending credit
The level of trade credit can have a significant effect on profitability
Extending credit can increase profitability.
If offering credit generates extra sales, then you should consider:
1. The amount of inventory maintained in the warehouse, to ensure that the extra
demand must be satisfied
2. The amount of money the company owes to its suppliers (as it will be increasing
its supply of raw materials)
If you want to extend the level of trade credit, assess the following:
• The additional sales volume which might result
• The profitability of the extra sales
• The extra length of the average debt collection period
• The required rate of return on the investment in additional receivables
221 ©
Syllabus F2hi. Describe how the financial statements of a customer can be used to assess
the creditworthiness of a customer.
i) Identify and apply the common ratios that may be used to analyse the financial statements of
a customer in order to assess their creditworthiness.
Ratio analysis
The credit controller is interested in a whole variety of accounting ratios, to build up a

broad picture of the customer.
A problem with financial ratio analysis is that historical information about profits,
assets and liabilities is used for an assessment of a future cash flow position.
The analysis and interpretation of the P&L and the SFP of a business can be done
by calculating certain ratios, between one item and another, and then using the
ratios for comparison.
222 ©
Internally generated information and financial analysis
Ratio analysis can give some idea as to trends and highlight areas for further
investigation
• The current ratio is the ratio of current assets to liabilities.
The quick ratio measures liquidity more precisely.
• The payables' payment period indicates the average length of time a company
takes to pay its debts.
Together with receivables' turnover and inventory turnover this gives some idea
as to the operations cycle.
• Gearing ratios put payables in the context of the firm's overall borrowing: they are
frequently unsecured.
• Return on capital employed (ROCE)
• Asset turnover
• Profit margin
• Changes in revenue
Strong revenue growth will usually indicate volume growth as well as turnover
increases due to price rises, and volume growth is one sign of a prosperous
company.
See the calculation of all ratios in Topic: A1g. Ratios and Strategy
223 ©
Syllabus F2j. Evaluate the usefulness and limitations of ratio analysis in assessing credit-
worthiness.
Ratios aren't always comparable
Factors affecting comaparability
1. Different accounting policies
Eg One company may revalue its property; this will increase its capital employed
and (probably) lower its ROCE
Others may carry their property at historical cost
2. Different accounting dates
Eg One company has a year ended 30 June, whereas another has 30 September
If the sector is exposed to seasonal trading, this could have a significant impact
on many ratios.
3. Different ratio definitions
Eg This may be a particular problem with ratios like ROCE as there is no

universally accepted definition
224 ©
4. Comparing to averages
Sector averages are just that: averages
Many of the companies included in the sector may not be a good match to the
type of business being compared
Some companies go for high mark-ups, but usually lower inventory turnover,
whereas others go for selling more with lower margins
5. Possible deliberate manipulation (creative accounting)
6. Different managerial policies
e.g. different companies offer customers different payment terms
Compare ratios with
1. Industry averages
2. Other businesses in the same business
3. With prior year information
225 ©
Syllabus F3a. Identify the main contents of accounts receivables records.
Accounts receivables records
When you sell goods or services to a customer and allow it to pay you at a later date,
this is known as selling on credit, and creates a liability for the customer to pay your
business.
Conversely, this creates an asset for your company, which is called accounts
receivable.
This is considered a short-term asset, since you are normally paid in less than
one year.
An account receivable is documented through an invoice, which you are responsible

for issuing to the customer through a billing procedure.
The invoice describes the goods or services you have sold to the customer, the
amount it owes you (including sales taxes and freight charges), and when it is
supposed to pay you.
• Cash accounting
If you are operating under the cash basis of accounting, you only record
transactions in your accounting records (which are then compiled into the
financial statements) when cash is either paid or received.
Since issuing an invoice does not involve any change in cash, there is no record
of accounts receivable in your accounting records.
Only when the customer pays you then you record a sale.
226 ©
• Accruals accounting
If you are operating under accrual basis of accounting, you record transactions
irrespective of any changes in cash.
This is the system under which you record an account receivable.
In addition, there is a risk that the customer will not pay you.
If so, you can either charge these losses to expense when they occur (known as
the direct write-off method) or you can anticipate the amount of such losses and
charge an estimated amount to expense (known as the allowance method).
The later method is preferred, because you are matching revenues with bad debt
expenses in the same period (known as the matching principle).
227 ©
Syllabus F3b. Describe the main internal sources that may be used to monitor accounts
receivables.
Internally generated information
Customer visits
Visits to the customer's premises can provide useful information.
Such a visit has the following purposes:
1. The credit controller can get a feel for the business and those running it
2. The credit manager should take a look around the business, and can speak to
people at a suitable level (e.g. the financial controller)
Credit control information
After analysing the relevant accounting data, visiting the client, and having received
assurances from a bank, we are now in a position to use this information.
We should use it effectively to come to a conclusion as to whether to provide credit
and on what terms
Trade credit
• A new customer will be offered a set level of credit

• Credit might be granted provisionally subject to a formal review at a later date.
• The level of credit should be increased, only after the customer has established a
suitable payments record
228 ©
The payment record must be monitored continually
1. Invoices must be posted at the right time

2. Receipts should be posted when they arrive, and allocated specifically to the
invoices to which they relate
3. A customer history analysis can be prepared
This is like a statement, but with:
(i) Total annual sales, on a rolling 12 month basis
(ii) Outstanding amounts owed
(iii) Days sales outstanding at each month end
The advantage of this is that trends in the account can be monitored, as can also the
ageing of the receivables balance, as illustrated below.
With this information it should be possible to develop in-house credit ratings.
229 ©
In-house credit ratings
Credit monitoring can be simplified by a system of in-house credit ratings. For

example, a company could have five credit-risk categories for its customers.
These cred it categories or ratings could be used to decide either individual credit
limits for customers within that category or the frequency of the credit review.
Guidelines could be provided to help credit controllers decide into which category a
customer belongs.
230 ©
Syllabus F3b. Describe the main internal sources that may be used to monitor accounts
receivables (including aged trade receivables analysis, average periods of credit, incidence of
bad debts).
Note - you may be required to prepare an aged accounts receivables analysis.
Accounts Receivable Reconciliation
The accounts receivable aging report itemises all receivables in the accounting
system, so its total should match the ending balance in the accounts receivable
general ledger account.
The accounting staff should reconcile the two as part of the period-end closing
process.
If there is a difference between the report total and the general ledger balance, the
difference is likely to be a journal entry that was made against the general ledger
account, instead of being recorded as a formal credit memo or debit memo that
would appear in the aging report.
The aged trade receivables analysis
is an important means of tracking outstanding balance.
With the information you have available, you need to be able to recognise when a
customer account is running into trouble.
Ultimately you may need to provide against certain debts as bad or doubtful
However you do need to know what remedies are available in law (particularly under
the insolvency legislation) to recover at least part of the debt.
231 ©
Syllabus F3c. Describe the main external sources that may be used to monitor accounts
receivables (including credit rating agencies, industry sources, financial reports, press
coverage, official publications, bank or supplier reference).
External sources
The main external sources that may be used to monitor accounts receivables:
1. Credit rating agencies
A credit rating agency (CRA) is a company that assigns credit ratings, which rate
a debtor's ability to pay back debt by making timely interest payments and the
likelihood of default.
An agency may rate the creditworthiness of issuers of debt obligations, of debt

instruments.
2. Industry sources
There are many sources of industry data available on the Internet.
These sources include free and fee-based information.
232 ©
3. Financial reports
Suppliers need Financial Statements to assess the credit worthiness of a

business and ascertain whether to supply goods on credit.
Suppliers need to know if they will be repaid.
Terms of credit are set according to the assessment of their customers' financial
health.
4. Press coverage
Is a report about something in newspapers, and magazines and other media
5. Official publications
Official publications are not limited to official journals.
They also include documents from parliament, collections of legal texts (laws,
decrees, treaties, etc.), and publications and administrative reports issued by
executive authorities (the President, Ministers, etc.) or public bodies.
Also included are statistics, local government publications, publications by the

European Union and intergovernmental agencies (the United Nations, the World
Bank, the IMF, the WTO, the Council of Europe, etc.)
6. Bank or supplier reference
Information released by a bank about a customer, to another bank or lending

institution.
233 ©
Bank references generally include
1. number of years of a customer's relationship with the bank,
2. number of loans and the amounts of their balances,
3. type and quality of collateral(s) provided, and
4. a copy of the customer's latest statement of financial affairs on file with the bank.
Banks usually are under no obligation to seek the customer's approval (or to reveal
the identity of the recipient) for releasing such information.
234 ©
Syllabus F4abc.
a) Identify the main methods used to identify potential problems with credit customers meeting
their payment obligations.
b) Describe ways in which credit customers could be encouraged to pay promptly including
effects of offering discounts.
c) Describe the main techniques and methods that may be used to assist in the collection of
overdue debts.
Debt collection
A company must have in place a clear policy on the collection of debts
Even if a good screening/assessment procedure is in place for accepting and

reviewing customers, late payments are a fact of life and must be handled pro-
actively.
Much time can be spent in chasing late payments and if this process is not well-
organised, management may come to the conclusion that it is not worthwhile.
This is especially true in cases where a company is growing very quickly and
celebrates the signing of contracts and issuance of invoices as signs of success.
If, however, these invoices are not collected in due time (or at all), then the company
is throwing away the rewards of “success”.
A company managing its receivables diligently will have the following:
1. A monitoring system that clearly “flags” late payers, known as an aging system.
2. A follow-up system that assigns responsibility to specific staff doing the follow-up;
this includes an elevating of difficult cases to more senior and/or more
experienced staff to handle;
235 ©
3. Training for staff involved in handing follow-ups, whether performed by phone,
mail or personal visits;
4. A policy determining when to involve refer the case to lawyers (preferably in-
house, for cost reasons) in preparation of follow-up letters. An external lawyer
may carry more weight, but is also more costly;
5. Use of a collection agent to chase the receivable. Here again, a company must
calculate the costs and benefits of involving an external agent. In such an
analysis, the savings of management time (opportunity cost) is the most difficult
to estimate.
Collecting debts
A company should have procedures for ensuring that overdue debts and slow payers
are dealt with effectively.
The earlier customers pay, the better.
Early payment can be encouraged by good administration and by discount policies.
The risk that some customers will never pay can be partly guarded against by
insurance.
Collecting debts is a two-stage process:
1. Task of receivables ledger staff
Having agreed credit terms with a customer, a business should issue an invoice
and expect to receive payment when it is due.
Issuing invoices and receiving payments is the task of receivables ledger staff.
They should ensure that:
(i) The customer is fully aware of the terms.

(ii) The invoice is correctly drawn up.
236 ©
2. Task of credit control staff
Chasing late payers might be a responsibility of credit control staff.
In the case of very late payers, the services of an external debt collection agency
might be employed.
Procedures for pursuing overdue debts must be established, for example:
(i) Issuing reminders or final demands

(ii) Chasing payment by telephone
(iii) Making a personal approach for payment from the credit manager
(iv) Notifying the debt collection section about what debts are overdue so that
further credit will not be given to the customer until he has paid the due amounts
(v) Getting a legal help to recover a debt
237 ©
Syllabus F4c. Describe the main techniques and methods that may be used to assist in the
collection of overdue debts.
Follow-up processes
Could include the following steps:
• (Before payment due date) – Reminder to prepare payment;
If payment is not made punctually (i.e. past due):
• Reminder to execute payment;
• Inform that penaties will be charged;
• Advice that further delivery is stopped;
• Advice that receivable will be sold to a factor or referred to legal action
238 ©
Syllabus F4d. Identify debt recovery methods appropriate to individual customers
Debt collection from difficult customers
Some customers are reluctant to pay
The debt collector should keep a record of every communication.
Debt collection techniques:
• Letters: cheap but not very effective
• Telephoning: expensive, but fairly effective
• Email: cheap and significantly more effective than letters
• Fax transmission: medium cost, medium effectiveness
• Personal visit: very expensive, but very effective
Final letters
If the first reminder fails to get an appropriate response, the firm may:
• Issue a second reminder, then a third reminder
• Issue a final demand, after which legal action is taken
239 ©
If the customer has already received and ignored an invoice and a reminder,
there may seem to be little point in adding a second reminder letter
However, the company may wish to increase the pressure gradually, as legal action
may unnecessarily upset an important customer.
1. The customer may only have paid part of the bill.
Short payment could mean any number of things:
(i) Invoices not input to the receivables ledger system before a cheque run
(ii) Agreement with sales staff
(iii) Deliberate under-payment
2. A valued customer might pay perhaps if the supplier threatens to refuse to sell
any more goods on credit until the debt is cleared.
This is less serious than legal action, but still significant.
Telephone
The telephone provides greater value than a letter, and the greater immediacy can
encourage a response.
However telephone calls may be more expensive than letters and the telephone may
take up more of the credit controller's time.
There may also be problems of getting through to the right person.
240 ©
Email
Email is used increasingly as a method of demanding payment.
It can give a sense of urgency and can also be used frequently without excessive
time being needed by the sender.
Email messages cannot be diverted by the recipient in the way that telephone
messages can be.
Fax transmission
A fax can be used to demand payment as a supplement to a phone call, or to give a

sense of 'urgency'.
Fax can also inconvenience the customer slightly: fax paper costs money, and your
(repeated) requests may prevent other faxes coming through.
Personal visits
Personal visits are time-consuming.
• They should never be made without an appointment.
• They should only be made to important customers who are worth the effort.
• Any agreement should be quickly confirmed in writing.
Personnel issues
As a rule of thumb, the older the debt, and the more problems with collecting it, the
more senior should be the company official sending the letters, and the more senior
should be the proposed recipient.
241 ©
Syllabus F4e. Explain procedures for writing off debts
Debt collection agencies and going to court
Debt collection agencies collect debts for a commission.
If it comes to court, a county court may issue a default summons.
The judgement may be enforced in a variety of ways, including bailiffs or insolvency

proceedings.
Debt collection agencies
Debt collection agencies (called 'credit collection agencies') are the most effective
way of pursuing debts.
Some debt collection agencies offer a variety of credit control services, including
running the credit control department in its entirety.
Unlike other sources of third party assistance, most debt collection agencies are
happy to be paid by results.
In other words, most debt collectors offer a 'no collection, no fee' basis.
Collection agency's techniques:
1. Some collect on a letter and telephone basis.
This is often the case where the client has passed on a large number of
consumer debts.
2. Others, especially for more difficult cases, collect 'on the doorstep'.
242 ©
Going to court
Before going to the expense and hassle of going to court, a firm must be sure of its
case, and should therefore do the following:
• Be sure that the customer genuinely owes the company money rather than just
being a dissatisfied customer
• Check who the customer is (individual, firm, limited company).
• Ensure the name is correct.
• Before suing, it is advisable to check the original credit information.
Is the customer likely to have sufficient assets?
Which court?
The Small Claims Court generally deals with amounts under £5,000 in the UK.
The parties can refer the case to an arbitrator, whose award is recorded as a county
court judgement.
In the UK County Courts deal with all actions in contract below £25,000, and some
between £25,000 and £50,000.
The High Court deals with amounts over £50,000 and some cases where the
amounts disputed lie between £25,000 and £50,000.
243 ©
Once the court has received the necessary paperwork
it will issue a default summons, normally by post, but for a fee the Court bailiff will
deliver it personally.
• If the customer does nothing (ie does not reply to the summons) judgement goes
against him.
• The customer can admit the claim: in other words they accept the amounts
owing.
• If the customer admits the claim, they may offer to pay by instalments.
The supplier can accept this, or, if not, has the right for the court to fix a suitable
means of payment.
On the day fixed for the trial
the supplier will be required to bring evidence to prove the claim and to defend
against any counterclaim the customer might bring.
A summary judgement is when the supplier draws up an affidavit (a statement of the

facts of the case).
If the defendant does not appear, the judgement may well go against him.
244 ©
Syllabus F4e. Explain procedures for writing off debts
Bad (irrecoverable) and doubtful debts
A debt can become irrecoverable for a variety of reasons.
It might have been 'high risk' in the first place.
A doubtful debt
is a debt for which there is some uncertainty as to whether it will be paid.
A bad (irrecoverable) debt
is a debt which will not be paid.
Doubtful debts and bad (irrecoverable) debts reduce profits
(Normally, a customer's receivable account is defined as a 'Current asset' which

should be liquidated within 12 months.)
1. An allowance may have to be made against doubtful debts in the accounts, either
against specific customers or as a percentage of total receivables, based on past
experience.
245 ©
2. Even if the doubtful debt is eventually repaid in full, there will still be additional
expenses relating to:
(i) The effect on cash flow, especially if the debt is large

(ii) The administration expenses of debt recovery procedures
3. Irrecoverable debts, which will never be recovered, can be written off against
profits.
Irrecoverable debts relating to a specific customer are allowable for tax purposes,
although general allowances are not.
246 ©
Syllabus F4fg.
f) Describe how factoring works and the main types of service provided by factors.
g) Define invoice discounting and outline how this form of factoring works.
Factoring and invoice discounting
The distinction between factoring and invoice discounting:
1. Invoice discounting
is effectively a short-term loan in which a company borrows against its

outstanding receivables.
The unpaid sales invoices are pledged as collateral to the company (or bank)
provides the financing.
The borrowing company receives less than the face value of the invoice, the
difference being the cost of borrowing, or discount.
2. Factoring
involves the administration of debt collection, in which the factor buying a

receivable manages the process.
The factor may do so on a recourse or non-recourse basis.
Recourse: In the event a debt is written-off, the factor has the right to demand
payment from the company from which it acquired the debt/receivable;
Non-recourse: The factor bears the full credit risk of the debtor’s failure to pay.
247 ©
Syllabus F4h. Calculate the cost of factoring arrangements, invoice discounting and changes
in credit policy.
Types of Arrangement
A factor can work in different ways…
It can simply be they take over a company’s credit control department for a fee
It may be that the factor forwards the company some money in advance, and then
collects the money from the debtors themselves and keeps the money.
The amount forwarded here would be like a loan and so the factor would also charge
interest
Finally, if the factor does “buy” the company’s debts then the deal may be “with
recourse” or “without recourse”
1. With Recourse - Any bad debts get returned to the company
2. Without Recourse - Any bad debts are suffered by the Factor
Advantages Disadvantages
Admin Costs Saved Can be expensive
Gets Cash Quickly Could lose customer goodwill
More cash available as sales grow May give a bad impression to customers
248 ©
How to do the numbers…
Compare:
• Current cost (Receivables x overdraft rate)
• New cost with Factor (New receivables x overdraft rate, Fee, net cost of
forwarding money less any increase in contribution, less admin savings)
Illustration
A Company has credit sales of 200,000pa. Credit term is 30 days. The factor offers
to buy 80% at an interest rate of 9%. The company can get an overdraft for 6%. The
factor charges 1.5% of current credit sales.
The factor will offer customers an early settlement discount if paid in 15 days, 40%
will accept this and the remainder will take 50 days to pay. Sales will increase by 5%
and contribution to sales ratio is 40%
Should the factor’s offer be accepted?
Solution
• Current cost
Receivables = 30/365 x 200000 =16,438
These are financed by an overdraft at 6% = 986
TOTAL = 986
• Cost of Factoring
New receivables = New sales x 15/365 x 40% = 3,452
New receivables = New sales x 50/365 x 60% = 17,260
Financed by overdraft cost at 6% = 1,242
Factor Fee = 200,000 x 1.5% = 3,000
Increase in contribution = sales increase x 40% = (4,000)
Forward Cost = new receivables x 80% x (9-6%) = 497.10
TOTAL = 739.1
• The factor option costs less - so the factor’s offer should be taken up
249 ©
Tricky bits
Forwarding of cash from Factor
• You will notice in the question above, I didn’t add the full cost of this forwarding
money (like a loan).
What I did was take the forwarding interest rate charged less the overdraft
interest rate.
• Think of it like this, the company has an overdraft of 6%. Then they get loaned
some money for 9%.
They will put the money from the loan in the bank and so it will lower their
overdraft.
This means they will be saving 6%. Therefore the net cost to them is 3%.
• So always take the net cost of the forwarding interest rate less the overdraft rate
Bad Debts
1. With recourse
No change here then (the company still keeps the bad debt risk). Therefore,
generally, as theres no change - keep bad debts completely out of the workings.
Easy-peasy-lemon-squeezy
Just be careful though if it stays with recourse but the bad debts reduce - in that
case treat this as a saving in the factor policy
2. Without recourse
Here the company gives its bad debts risk to the factor. Therefore this is a saving
for the company if they choose the factor option.
So treat it like this - show as a saving in the factor option
250 ©

CAT FFM Course Notes PDF

Enviado por

Dados do documento

Título original

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

CAT FFM Course Notes PDF

Enviado por

Direitos autorais:

Formatos disponíveis

FFM Course notes

Syllabus A: Working Capital Management ............................. 5

Syllabus A1. A1. Working capital management cycle.

Syllabus A1a. Define working capital.

b) Explain why working capital management is important.

Working Capital Management

What is it and why is it important?

• Working capital = net current assets = current assets - current liabilities

Current assets Current liabilities

We call this a short-term investment .

We call this liquidity.

• Maintaining enough to pay short term payables.

This is the conflict of working capital objectives.

Managing working capital

The management of working capital is important to the financial health of businesses

An example of this would be purchasing extra inventory at a discount.

As an emergency fund for a firm.

Efficient management of working capital is extremely important to any

e) Outline the possible relationships between inventory levels and sales.

Cash operating cycle (working capital cycle)

Day 1 Buy an item on credit (Payable)

Day 5 Sell the item on credit (Receivable)

Day 8 Pay for the item

Day 10 Receive the cash for the item

How long is the item in stock for? 4 days

How long is the receivable period? 5 days

How long is the payable period? 7 days

Inventory Days 4 days

Receivable days 5 days

Payable days (7 days)

Cash operating cycle 2 days

The length of the cycle will depend upon:

1. Liquidity v profitability decisions (eg credit terms offered)

3. Industry norms (supermarkets very short - construction industry very long)

• Different industries have, not surprisingly, different cash operating cycles.

Compare that to WeSellLotsofStuff plc who hold lots of stuff (inventories).

Negative cash operating cycle

• Possessing a lower average collection period is seen as optimal, because this

Explanation of Inventory Days:

• A financial measure of a company’s performance that gives investors an idea

Overtrading or undercapitalisation arises when a company has too small a capital

• is often associated with a rapid increase in turnover. Investment in working

• could be indicated by a deterioration in inventory days. Possibly because of

• could also be indicated by deterioration in receivables days, possibly due to a

As the liquidity problem associated with overtrading deepens, the overtrading

Over-capitalisation and Over-trading

There are 3 indicators of over-capitalisation:

Effects of Over-capitalisation on Company:

In your exam, you may be required to calculate some ratios.

Ratios may be divided into the following categories:

These are measures of value added being generated by an organisation and

ROCE Operating Profit (PBIT)/Capital Employed

Capital Non current assets + net current assets

Capital Total assets - current liabilities

Gross Gross Profit/Sales

Net Margin Net Profit/Sales

RI Profit After Tax - (Operating Assets x Cost of Capital)

These are measures of utilisation of Current & Non-current Assets of an

Asset Turnover Sales/Capital Employed

ROCE Margin X Asset Turnover

Receivables Days (Receivables Balance / Credit Sales) x 365

Payables Days (Payable Balance / Credit Purchases) x 365

Inventory Days (Inventory / Cost of Sales) x 365