Accounting and Financial Management

Tutorial 11 Answers – Internal Sources of Finance

1. Annabel Trading
(a) The business is probably concerned about its liquidity position because:
• it has a low current ratio of 1.1:1 (that is, 306/285) and a low acid test ratio of 0.6:1 (that is,
162/285)
• it has increased its investment in inventories during the past year (as shown by the income
statement)
• it has no cash and a substantial overdraft, which together with its non-current borrowings
means that it has borrowed an amount roughly equal to its equity (according to statement of
financial position values)

(b) The operating cash cycle can be calculated as follows:

No. of days
Average inventories turnover period:
(𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 + 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠) (125 + 143)
[ ] [ ]
2 2
× 365 = × 365 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 323 151

Add Average settlement period for trade receivables:

𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 163
× 365 = × 365 = 132
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 452
283

Less Average settlement period for trade payables:

𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 145
× 365 = × 365 =
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 341 (155)

Operating cash cycle 128

(c) Annabel Trading can reduce the operating cash cycle in a number of ways:
(i) The average inventories turnover period seems quite long. At present, average inventories held
represent about 5 months’ inventories usage. Reducing the level of inventories held can reduce
this period.
(ii) Similarly, the average settlement period for receivables seems long at more than 4 months’
sales revenue. Imposing tighter credit control, offering discounts, charging interest on overdue
accounts and so on may reduce this. However, any policy decisions concerning inventories and
receivables must take account of current trading conditions.
(iii) Extending the period of credit taken to pay suppliers would also reduce the operating cash cycle.
However, this option must be given careful consideration. The period of credit is quite long and
may already be breaching the payment terms required by suppliers. Delaying payments may
signal to suppliers that the business has financial problems, so that suppliers may be more
reluctant to grant credit in the future or impose stricter credit terms.

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Accounting and Financial Management

(d)
Increase /
(Decrease)
in cash flow
RM000

Inventories:
Previous balance
323 143
New balance = [(100 × 365 ) × 2] − 125 52 91
Trade receivables:
Previous balance
452 163
New balance = 120 × = 149 14
365
Trade payables:
Previous balance
341 145
New balance = 160 × = 149 4
365
Additional cash generated 109

Reducing the cash operating cycle as above will free up approximately RM109,000 in cash. This
increase in cash flow will substantially reduce the firm’s overdraft and improve its liquidity.

2. Superior Widgets
$1,000,000 Sales
0.24 Profit margin
240,000 Net income
– 96,000 Dividends (40%)
$ 144,000 Increase in retained earnings

$ 180,000 Increase in assets

– 144,000 Increase in retained earnings
$ 36,000 External funds needed

3. Wang Ban Yak

Earnings after taxes RM80,000
Profit margin = = = 16%
Sales RM500,000

Dividends RM24,000
Payout ratio = = = 30%
Earnings RM80,000

Change in Sales = 50% × RM500,000 = RM250,000

Spontaneous Assets = Cash + Acc. Rec. + Inventory

Spontaneous Liabilities = Acc. Payable + Accrued Wages & Taxes

A L
RNF = (∆S) – (∆S) – PS2 (1 – D)
S S
RM325,000 RM65,000
= (RM250,000) – (RM250,000) – 0.16(RM750,000)(1 – 0.30)
RM500,000 RM500,000

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Accounting and Financial Management

= 0.65(RM250,000) – 0.13(RM250,000) – 0.16(RM750,000)(0.70)

= RM162,500 – RM32,500 – RM84,000
= RM46,000
Wang Ban Yak needs RM46,000 in new funds. This can be obtained from external sources of
financing and/or from reducing its cash operating cycle by better managing its working capital.

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