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Finance for
non-financial
managers
THIRD EDITION
Johan Marx
Sam Ngwenya
Gerhard Grebe
Van Schaik
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Contents
About the authors ...................................................................................................... . X
Chapter 1 The financial goal of a firm .................................................................. . 1

1.1 Introduction ........................................................................................................ . 2
1.2 Forms of business organisation ......................................................................... 3
1.3 The financial goal of a firm ............................................................................... . 4
1.4 Financial management and accounting .......................................................... . 6
1.4.1 Handling of funds ...................................................................................... 6
1.4.2 Decision making ....................................................................................... . 7
1.5 The functions of a financial manager .............................................................. . 7
1.6 Financial management and the non-financial manager ............................... . 8
1. 7 The fundamental principles of financial management.. ................................ . 8
1.7.1 The cost-benefit principle ........................................................................ . 9
1.7.2 The risk-return principle .......................................................................... . 9
1.7.3 The time value of money principle ........................................................ .. 9
1.8 Financial management and the operating environment of the firm ........... . 10
1.8.1 The economic environment ..................................................................... . 10
1.8.2 The regulatory and political environment ............................................ .. 14
1.8.3 The natural environment .......................................................................... 14
1.9 The agency problem ........................................................................................... 14
1.10 Summary ............................................................................................................ . 15
References ................................................................................................................... . 15
Self-test questions ...................................................................................................... . 16
Solutions to self-test questions ............................................................................... .. 17
Chapter 2 Understanding financial statements ................................................. . 19

2.1 Introduction ....................................................................................................... . 20
2.2 Users of financial statements ........................................................................... . 21
2.3 Key generally accepted accounting principles ................................................ . 21
2.3.1 Accounting entity ....................................................................................... 21
2.3.2 Money measurement ................................................................................ . 21
2.3.3 Conservatism ............................................................................................. . 21
2.3.4 The consistency concept. .......................................................................... . 22
2.3.5 Materiality .................................................................................................. . 22
2.3.6 Historic cost ............................................................................................... . 22
2.3.7 The double-entry system .......................................................................... . 22
2.3.8 The going-concern concept ..................................................................... . 22
2.3.9 The accounting period .............................................................................. 22 V
2.3.10 The realisation principle ........................................................................ . 22 ~ (2
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2.3.11 The accrual principle .............................................................................. . 23 u-<:

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2.4 The classification of financial information ...................................................... 23 "'~

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2.5 Recording changes in the financial position.................................................... 24
2.6 Summarising financial information in the financial statements................... 26
2.6.1 The statement of comprehensive income................................................ 27
2.6.2 The statement of financial position ......................................................... 29
2.6.3 The statement of cash flows...................................................................... 32
2. 7 The auditors' report............................................................................................. 34
2.8 The directors' report............................................................................................ 35
2.9 Summary.............................................................................................................. 35
References.................................................................................................................... 35
Self-test question........................................................................................................ 36
Suggested solution to self-test question................................................................... 36
Chapter 3 The analysis of financial statements ................................................... 39

3.1 Introduction ......................................................................................................... 40
3.2 Types of comparisons ........................................................................................ 40
3.2.1 Industry comparative analysis.................................................................. 40
3.2.2 Time-series analysis ................................................................................... 40
3.3 Caution when using ratios ................................................................................ 41
3.4 Basic financial ratios .......................................................................................... 41
3.4.1 Profitability ratios....................................................................................... 42
3.4.2 Liquidity ratios........................................................................................... 46
3.4.3 Activity ratios............................................................................................. 49
3.4.4 Measures of debt........................................................................................ 52
3.4.5 Securities market ratios............................................................................. 54
3.5 Summary.............................................................................................................. 58
References.................................................................................................................... 58
Self-test question ........................................................................................................ 58
Suggested solution to self-test question................................................................... 59
Chapter 4 Profit planning and control .............. .............. .............. .............. ......... 61
4.1 Introduction......................................................................................................... 61
4.2 Management accounting versus financial accounting ................................... 62
4.3 Information needs of managers and other users............................................. 63
4.4 Cost classifications for assigning costs to cost objects.................................. 64
4.4.1 Costs in a retailing firm............................................................................. 64
4.4.2 Costs in a service firm............................................................................... 65
4.4.3 Costs in a manufacturing firm................................................................. 65
4.5 Cost classifications for decision making.......................................................... 65
4.6 Understanding cost behaviour .......................................................................... 66
vi 4. 7 Breakeven analysis ............................................................................................. 68
4.7.1 Underlying assumptions ofbreakeven analysis..................................... 69
4.7.2 Formulae for breakeven analysis.............................................................. 69
4.7.3 Limitations ofbreakeven analysis............................................................ 71
4.8 The budgeting process ..................................................................................... . 71
4.8.1 Operating budgets .................................................................................... 72
4.8.2 Financial budgets ..................................................................................... . 73
4.9 Responsibility centres ....................................................................................... . 73
4.10 Responsibility accounting ................................................................................ . 74
4.11 Advantages of budgeting .................................................................................. . 74
4.12 Principles of budgeting ...................................................................................... 75
4.12.1 Management involvement .................................................................... . 75
4.12.2 Adaptability ............................................................................................ . 75
4.12.3 Accountability according to responsibility.......................................... 75
4.12.4 Effective communication ...................................................................... . 76
4.12.5 Realistic expectations ............................................................................ . 76
4.12.6 Acknowledgement .................................................................................. 76
4.12.7 Follow-up and feedback. ....................................................................... . 76
4.13 Summary ............................................................................................................ . 76
References ................................................................................................................... . 77
Self-test question 1 .................................................................................................... . 77
Solution to self-test question 1 ................................................................................ . 78
Self-test question 2: Cost terms ............................................................................... . 79
Self-test question 3: Breakeven analysis .................................................................. 80
Self-test question 4: Cash budget ............................................................................ . 80
Solution to self-test question 4 ................................................................................. 81
Chapter 5 The time value of money ...................................................................... . 83

5.1 Introduction ....................................................................................................... . 84
5.2 Future value ...................................................................................................... . 85
5.2.1 Annual compounding ............................................................................. 85
5.2.2 Intra-year compounding ....................................................................... . 87
5.2.3 The future value of an annuity .............................................................. . 88
5.3 Comparing future value and present value ................................................... . 92
5.4 Present value ..................................................................................................... . 92
5.4.1 The present value of a single amount ................................................... . 93
5.4.2 The present value of a mixed stream .................................................... . 94
5.4.3 The present value of an annuity ............................................................ . 95
5.5 Variations of future and present value techniques ........................................ . 97
5.5.1 Deposits to accumulate a future sum ................................................... . 97
5.5.2 Loan amortisation .................................................................................. . 98
5.5.3 Determining growth rates ..................................................................... . 100
vii
5.6 The role of time value of money in financial management ......................... . 101
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5.6.1 Financing decisions ................................................................................ . 101 ,:
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5.6.2 Investment decisions .............................................................................. . 101 C .(l
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5.6.3 Working capital management ................................................................. 102
5.6.4 Valuation .................................................................................................... 102
5.7 Summary .............................................................................................................. 103
References .................................................................................................................... 103
Self-test questions ....................................................................................................... 103
Solutions to self-test questions ................................................................................. 105
Chapter 6 Capital budgeting................................................................................... 107
6. 1 Introduction ......................................................................................................... 107

6.2 Approaches to decision making........................................................................ 108
6.2.1 The accept-reject approach ...................................................................... 108
6.2.2 The ranking approach .............................................................................. 108
6.3 Capital budgeting techniques ............................................................................ 109
6.3.1 Non-discounted cash flow methods ....................................................... 109
6.3.2 Discounted cash flow techniques ............................................................ 111
6.4 Comparison of techniques ................................................................................ 114
6.5 Sum mary .............................................................................................................. 115
References .................................................................................................................... 115
Solution to self-test question..................................................................................... 116
Chapter 7 Financing................................................................................................. 117

7.1 Introduction ........................................................................................................ 118
7.2 Long-term financing ........................................................................................... 118
7.2.1 Characteristics of debt versus equity ...................................................... 119
7.3 The cost of capital ................................................................................................ 121
7.4 Financial leverage ............................................................................................... 122
7.5 Important considerations in financing assets .................................................. 123
7.5.1 Suitability ................................................................................................... 124
7.5.2 Control ....................................................................................................... 124
7.5.3 Flexibility ................................................................................................... 125
7.5.4 Timing ........................................................................................................ 125
7.5.5 Characteristics of the economy ............................................................... 126
7.5.6 Characteristics of the industry ................................................................ 126
7.5.7 Characteristics of the company............................................................... 127
7.6 Summary .............................................................................................................. 128
References .................................................................................................................... 128
Suggested solution to self-test question ................................................................... 129
viii
Chapter 8 The managem ent of working capital.................................................. 131
8.1 Introduction ......................................................................................................... 132
8.2 The cash conversion cycle .................................................................................. 133
8.2.1 The operating cycle ................................................................................... 133
8.2.2 Managing the CCC ................................................................................... 134
8.3 Managing inventory............................................................................................ 134
8.3.1 Managing inventory as an investment ................................................... 135
8.3.2 Classification of inventory ....................................................................... 136
8.3.3 Ordering economic quantities of inventory .......................................... 137
8.3.4 Setting the reorder point.. ........................................................................ 139
8.3.5 Inventory control systems ........................................................................ 139
8.3.6 Preventing losses of inventory ................................................................ 140
8.4 The management of accounts receivable .......................................................... 142
8.4.1 Credit selection ......................................................................................... 142
8.4.2 Credit standards ........................................................................................ 147
8.4.3 Credit limits ............................................................................................... 148
8.4.4 Credit terms ............................................................................................... 148
8.4.5 Collection policy ....................................................................................... 148
8.4.6 Monitoring and controlling accounts receivable .................................. 149
8.4.7 Follow-up of delinquent accounts .......................................................... 151
8.5 The management of cash .................................................................................... 151
8.5.1 Motives for holding cash and marketable security balances ............... 152
8.5.2 The cost of cash ......................................................................................... 153
8.5.3 Strategies for cash flow management ..................................................... 153
8.5.4 The cash budget ......................................................................................... 155
8.5.5 Preventing cash losses .............................................................................. 159
8.6 Summary .............................................................................................................. 161
References .................................................................................................................... 161
Solution to self-test question ..................................................................................... 162
Glossary ...... .. .............. ......... ...... .............. .............. ............... .............. .............. .......... 163
Appendices ................................................................................................................. 180
Index ..... ...................................................................................................................... 185
ix
About the authors
Johan Marx is the Director of the School of Management Sciences at the Univer-
sity of South Africa (Unisa). He holds a DCom (Business Management) and has
been in academia since 1987. He was a Trade and Industry Advisor at DTI from
1984-1987, and he was Chair of the Department of Finance, Risk Management
and Banking from 2007-2012. He has offered several Finance for Non-Financial
Managers workshops on behalf of the Unisa Centre for Business Management
(CBM) for OTK (before the firm became AFGRI), Iscor and Kumba Iron Ore.
These days his research interests are in risk management and insurance.
Sam Ngwenya is an Associate Professor in the Department of Finance, Risk Man-

agement and Banking at Unisa; he also serves as the Chair of the department. His
highest qualification is a PhD in Business Management. He has been lecturing
Financial Management at undergraduate and post-graduate level for a period of
thirteen years. He has also facilitated the in-house short course: Finance for Non-
Financial Managers, to companies, governmental departments and agencies for a
period of eight years. He has published articles on financial management in local
and international accredited journals, and has presented conference papers at both
local and international conferences.
Gerhard Grebe is a lecturer at Unisa. He is currently working within the Depart-

ment of Finance, Risk Management and Banking. His areas of specialisation
include financial management and risk management. He currently holds an Hon-
ours degree in Financial Management, which he obtained at the University of
Pretoria. He has also completed the operational level as part of the Chartered Insti-
tute of Management Accounting (CIMA) qualification. He is currently busy with
his Master's degree in Risk Management.
X
CHAPTER ONE
THE FINANCIAL
GOAL OF A FIRM
What's the problem?

It is 28 February 2014 in South Africa, and Joe Vermeulen is vacating his office. He has
worked for his employer for 18 years, but has reached the ceiling of his career, and there
are no further opportunities for advancement. Joe has decided to resign and take the RI .6
million pension he has accumulated thus far in order to buy an existing courier business.
His pension pay-out will be subject to tax, and he will have R 1.12 million available for the
investment he needs to make. As a result of the affirmative action policy, his son cannot
find employment. Joe will employ his son in his new business venture.
It is with mixed emotions that he says farewell to his colleagues. He realises he will miss
the fun and the jokes Jabulani used to make, and the opportunities he had to attend annual
planning and training retreats.
He will have to turn the courier business around and continue it under a new name as it
has struggled during the past year due to the previous owner's ill health. T he firm has two
drivers and an administrative manager. There are also two delivery vehicles, and if more
transport is needed, an extra one can be rented.
Joe's courier business intends to make use of the SA Post Office for some of its deliver-
ies. Other operators in the industry are Fedex, Skynet, United Parcel Services (UPS), RAM
couriers, DHL Express, Aramex, UTi Sun Couriers, Globeflight, TNT and Speed Services
Couriers (a division of the SA Post Office). Joe realises the courier industry in South Africa
is competitive, especially since some Chinese firms have opened new firms in southern
Africa recently.
The improvement in bandwidth and increasing access to the Internet makes it possible
for firms, governmental departments and individuals to send documents via e-mail. During
February 2013, the SA Post Office employees went on strike, and this year the same is
expected. Some courier firms do w ell, but these are usually the ones that have won ten-
ders to render their services to big organisations and government departments, or retail
firms. Unisa may once have been a great opportunity for the courier industry, but they
have converted to the delivery of their study material on line.
Joe has considered lowering the salaries of the current employees, and has wondered
how else he could reduce the cost of running the business. To make matters worse, an
increase in the levy has just pushed up the price of fuel.
CHAPTER 1 THE FINANCIAL GOAL OF A FIRM
Earlier that morning he collected the documentation from the Department of Trade
and Industry (DTI) confirming the registration of his new business as JVS Courier Services
(Pty) Ltd. His business cards have also been delivered. "That was probably the easy part
of my venture", he says to Bongani at security as he leaves the building. Now to make it
work.He wishes he had known about the franchises offered by Fastway Couriers before
he signed the contract to buy his courier business, but he realises now that it is too late for
regrets. As he drives out of the gates of his previous employer for the final time, he feels
the pressure of realising that failure is not an option.
Question: What are the dilemmas one faces in business?
I.I INTRODUCTION
Some of our most basic human needs are for food, liquid refreshments, clothing, per-
sonal hygiene, medicine and medical care, accommodation, transport, sport and recre-
ation, education, rest and security. Firms exist because they satisfy a need by providing
a product or service. However, this is not always for consumers, as some firms meet
the needs of other firms. An example might be a company that manufactures the steel
required by vehicle and ship manufacturers.
The emphasis on customers' needs and on providing a quality product or service to
meet the needs of customers is normally articulated in a firm's mission statement. A
mission statement describes the fundamental purpose that sets a firm apart from other
firms of its type and identifies the scope of its operations in product and market terms
(Pearce & Robinson 2011: 27).
A mission statement is vital in providing focus and direction to the firm's manage-
ment in deciding how best to utilise the resources of the firm in the competitive envi-
ronment in which it functions. This environment contains five main forces, namely
rivalry within an industry, the bargaining power of suppliers, the bargaining power of
clients, the threat of new entrants, and the threat of new technology. This is illustrated
in Figure 1.1.
Threat of new entrants
Rivalry within an
Bargaining power of industry Bargaining power of
suppliers
ITHE FIRM I clients
Figure I . I Competitive forces

Source: Adapted from Porter ( 1979)
THE FINANCIAL GOAL OF A FIRM
1
Starting up and managing a firm successfully in a competitive environment requires
a sustainable competitive advantage. This can be achieved by means of one of three
generic strategies, namely cost leadership, differentiation and focus strategy:
• Cost leadership involves the sustainable mass production and marketing of stan-
dardised items at a cost below that of competitors.
• Differentiation involves the supply of products or services that are unique, and
which provide good value to customers. In order to sustain differentiation, the
product or service must be capable of offering high perceived value to buyers on a
continuing basis, and competitors must not be able to imitate such differentiation.
• Focus strategy involves concentrating on serving a narrowly defined market, called
a market niche. Focus enables a relatively small firm to respond more rapidly to the
needs of customers than larger, diversified competitors. Focus may involve the use
of cost leadership or differentiation in serving the chosen market niche.
A firm's cost leadership, differentiation or focus strategy needs to be reflected in its
marketing plan. This describes customers' needs, the product or service to be provided,
the price at which it can be sold, the promotion methods to be used and the distribu-
tion of the product or service to the client.
1.2 FORMS OF BUSINESS ORGANISATION

The size and nature of a firm will determine whether it should be organised as a sole
proprietorship, a partnership, or a private or public company.
Example
A fish and chips shop may need a manager and three people to run it, as well as
equipment costing R200 000. This firm could be organised as a sole proprietorship or a
partnership. A coalmine, on the other hand, may need a management team of 40 people,
400 employees and equipment costing millions of rand, and in this case it makes more
sense to organise the firm as a company.
There are different types of companies:

• Private companies, identifiable to outsiders by the words "(Proprietary) Limited"
following the name of the company - more commonly abbreviated to (Pty) Ltd
• Public companies, identifiable to outsiders by the word "Limited" following the
name of the company - more commonly abbreviated to "Ltd". Note that not all
public companies are listed on the JSE. While it is necessary for a company to be
a public company to obtain a listing, it must, in addition, comply with the listing
3
requirements of the JSE.
One of the essential differences between private and public companies is that a pri-
vate company may have between one and 50 shareholders, whereas the minimum for
a public company is seven shareholders, and there is no maximum. Furthermore, a

private company must have at least one director, and a public company must have a
minimum of two.
Another important difference between private and public companies is that the pri-
vate company's articles (part of the founding documents which set rules and restric-
tions for the legal conduct of the company) must restrict the transferability of its shares,
and prohibit any offer to the public at large inviting them to subscribe to any shares of
the company. The right to the transfer of shares in a public company is not restricted,
and the public may be invited to subscribe to its shares.
The reporting requirements of private and public companies are also different.
The financial statements of a private company need only be made available to share-
holders and directors, or people selected by them, such as managers in the business
or bank managers. A public company is obliged to lodge a certified copy of its annual
financial statements with the Registrar of Companies. It must also send its members
(shareholders) half-yearly interim reports and audited annual financial statements.
There are other differences, but a full discussion of them falls beyond the scope of this
chapter.
1.3 THE FINANCIAL GOAL OF A FIRM

Since the size, organisational structures and forms of business organisation vary, it is
not possible to depict the role of a financial manager in a manner which would be
universally applicable to all firms.
However, if the role of financial management is assessed from the viewpoint of an
investor in a firm, a few common aspects become evident. Investors need to diversify
their investments. Diversification means not placing all one's money in a single invest-
ment, but spreading it over various investments - in other words, not placing all one's
eggs in one basket. An investor may combine various kinds of assets in order to achieve
a diversified portfolio. The investor has a choice between various asset classes, the main
ones of which are the following:
• Real estate (rent-generating assets)
• Shares (dividend-generating assets)
• Fixed-interest securities (interest-generating assets)
• Cash
Investors want to achieve the highest possible return for the lowest possible risk. Inves-
tors not only run the risk of losing the money they have invested, but also incur an
opportunity cost when making an investment.
4
THE FI N ANCIAL GOAL OF A FIRM
1
Example
Let us assume that the shareholders of a company could have earned interest (say I 0%
per annum) from a savings account, but have decided instead to invest in the shares of a
company listed on a securities exchange. They must therefore receive compensation for
this opportunity cost and the risk they are accepting. The shareholders would require a
return of at least 15% from their investment in shares, because the greater the risk, the
greater the required rate of return.
Both investors (the joint owners or shareholders) and management's long-term finan-
cial goal should be to increase the value of the firm, thereby increasing the wealth of the
owners. This may be accomplished by
• investing in assets that will add value to the firm
• keeping the firm's cost of capital as low as possible.
The short-term financial goal should be to ensure the profitability, liquidity and sol-
vency of the firm.
Profitability is the firm's ability to generate revenues that will exceed total costs by
using the firm's assets for productive purposes. Profitability may be achieved by mar-
keting products or services to include a sufficient profit margin, with the support of
promotion at competitive prices to appropriate target markets through appropriate
distribution channels.
Liquidity is the firm's ability to satisfy its short-term obligations as they become due.
Liquidity may be achieved by
• accelerating cash flows from accounts receivable (debtors)
• delaying cash flows by paying creditors (accounts payable) as late as possible with-
out damaging the firm's credit record and relations with suppliers
• not over-investing in inventory (stock) and by stocking a range of products that is
in demand and will turn over rapidly.
Solvency is the extent to which the firm's assets exceed its liabilities. Solvency differs
from liquidity in that liquidity pertains to the settlement of short-term liabilities, while
solvency pertains to the excess of total assets over total liabilities.
Some believe that the owners' objective is to maximise profit, while others believe
it is to maximise wealth. From a financial management point of view, the goal is to
maximise the shareholders' wealth.
Wealth maximisation is preferred to profit maximisation for several reasons, of
which the following three are generally agreed on:
1. Shareholders expect to receive a return in the form of periodic cash dividend pay-
ments and increases in the value of their shares (in the case of a company). The 5
market price of a company's shares reflects a perceived value of expected future
dividends as well as actual current dividends. If a shareholder in a company wishes
to sell the shares, he or she will have to do so at or near the prevailing market price.
Since it is the market price of the share that reflects an owner's (shareholder's)
wealth in a firm at any time, the financial manager's goal should be to maximise
the market price of the shares, and thus the shareholder's wealth.
Example
A firm wishing to maximise profits could use inferior-quality materials in products

while making a strong sales effort to market the product at a price that yields a high
profit per unit. This short-term strategy could result in high profits for the current
year, but in subsequent years, sales might decline significantly as a result of the poor
quality of the product.
2. Profit maximisation is a short-term approach, while wealth maximisation is based

on long-term prospects.
3. Profit maximisation does not take risk into consideration, whereas with a wealth-
maximisation approach, differences in risk receive high priority when evaluating
alternative investments. A basic premise of financial management is that there is
a trade-off between risk and return: shareholders expect to receive greater returns
from greater risk investments, and vice versa. Financial managers should therefore
consider risk from their viewpoint when evaluating potential investments.
1.4 FINANCIAL MANAGEMENT AND ACCOUNTING

Many people consider the accounting and finance functions within a business to be
virtually the same. There are, however, two key differences between them - one relates
to the handling of funds and the other to decision making.
1.4. 1 Handling of funds

The accountant, whose primary functions are to develop and provide data for measur-
ing the performance of the firm, to assess its financial position and see to the payment
of taxes, differs from the financial manager in the way in which he or she views the
firm's funds.
• The accountant uses certain standardised and generally accepted international
accounting practices to prepare financial statements. One of these principles is
that revenues should be recognised at the point of sale, and expenses when they
are incurred; in other words, when transactions have occurred. This is commonly
6 referred to as the accrual principle. Income resulting from the sale of merchandise
on credit, for which the actual cash payment has not yet been received, appears
on the firm's financial statements as accounts receivable (debtors). Expenses are
treated in a similar way, in that certain liabilities are established to represent goods
1
or services that have been received but have yet to be paid for. These items are usu-
ally listed on the balance sheet as accounts payable (creditors).
• The financial manager is more concerned with maintaining a firm's liquidity and
solvency by providing the cash flows necessary to satisfy its obligations and by
acquiring and financing the current and fixed assets needed to achieve the firm's
goals. Instead of recognising revenues at the point of sale and expenses when
incurred, the financial manager recognises revenues and expenses only in respect
of inflows or outflows of cash.
Gitman (1994: 12) uses a simple analogy to clarify the basic difference in viewpoint
between the accountant and the financial manager:
If we look on the human body as a business firm in which each pulsation of the heart
represents a new sale, the accountant is concerned with each of these pulsations, entering
these sales as revenues. The financial manager is concerned with whether the resulting
flow of blood through the arteries reaches the right cells and keeps the various organs of
the body functioning. It is possible for the body to have a strong heart but cease to func-
tion because of the development of blockages or clots in the circulatory system. Similarly,
a firm may be profitable but still fail because it has an insufficient inflow of cash to meet
its obligations as they come due.
Accounting data therefore does not fully describe the circumstances of the firm. The
financial manager should look beyond financial statements to obtain insight into devel-
oping or existing problems.
1.4.2 Decision making

The duties of the financial manager differ from those of the accountant in that the latter
devotes the majority of his or her attention to the collection and presentation of his-
torical financial data. The financial manager evaluates the accountant's financial state-
ments, processes additional data and makes decisions based on subsequent analyses.
The accountant's role is to provide consistently processed and easily interpreted data on
the firm's past and present operations.
The financial manager uses the financial statements as an important input into deci-
sion making about the future of the firm. This, however, does not mean that accountants
never make decisions and financial managers never gather data; rather, the primary
focuses of accounting and finance are different. The financial manager has to translate
the strategy and plans of the firm into budgets, thus enabling the management team of
a firm to assess the impact of their proposals on the future financial performance and
position. Since long-term sustainability is desired, the firm has to identify and assess
the risks it will face, and find ways of mitigating them.
I.S THE FUNCTIONS OF A FINANCIAL MANAGER 7
A financial manager's function may be evaluated in terms of the firm's financial goals.
He or she has the following primary functions:
• Making investment decisions

• Making financing decisions
• Ensuring profitability - in other words, revenue must exceed expenses
• Ensuring a positive cash flow - that is, cash inflow must exceed outflow
• Ensuring solvency - in other words, assets must exceed liabilities
In making investment decisions, the financial manager must determine the cost effec-
tiveness of the assets on the firm's balance sheet. He or she must attempt to maintain
certain optimal levels of each type of current asset (cash, inventory and accounts receiv-
able) and also decide which are the best non-current assets (e.g. buildings, equipment
and vehicles) to acquire, and must know when existing non-current assets may require
maintenance, modification or replacement.
Financing involves two major decisions:
1. Raising enough equity and loan financing to acquire and maintain non-current
and current assets
2. Determining which individual short- and long-term sources of financing should
be used in order to achieve the lowest possible cost of capital
Some of these decisions are dictated by necessity, but some require an in-depth
analysis of the available alternatives, their cost and their benefits as part of financial
planning.
1.6 FINANCIAL MANAGEMENT AND THE NON-FINANCIAL

MANAGER
The management of a firm's assets is not exclusively in the hands of a financial manager.
The other functional departments, especially the procurement and marketing depart-
ments, play a significant role in determining inventory (stock) levels, for example. It is
important for the procurement, marketing and financial departments to cooperate to
ensure that optimum inventory levels are maintained. Inventory represents an invest-
ment of a portion of the firm's available funds and should be managed judiciously.
Since most business decisions are measured in financial terms, people in all the func-
tional departments are, to a greater or lesser extent, involved in the financial decision
making of the firm. All functional departments in the business firm (such as procure-
ment, operations, marketing and human resources) devote their energy to the achieve-
ment of the firm's goal. It is therefore important for them to have an understanding of
the principles of financial management (discussed in section 1.7 below) and to apply
them vigorously.
1.7 THE FUNDAMENTAL PRINCIPLES OF FINANCIAL

MANAGEMENT
8
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• Cost-benefit principle
• Risk-return principle
• Time value of money principle
1. 7. 1 The cost-benefit principle

Sound financial decision making requires making an analysis of the total cost and the
total benefits. Decision making that is based on the cost of resources only will not
necessarily lead to the most economic utilisation of resources. As far as possible, the
benefits should be greater than the cost of any decision.
The cost-benefit principle may be used by means of the following steps:
• Obtain clarity about the objective to be attained.
• Identify alternative ways in which the objective may be attained .
• Calculate the cost and benefits of each of the alternatives .
• Determine the effectiveness of the benefits of each alternative.
• Decide on a criterion or standard to be used against which the acceptability of an
alternative may be weighed.
• Take a decision about the most appropriate course of action. This step may have to
be preceded by consultation in situations where there is enough time available to
do so and where certain members of staff have relevant expertise, or if they will be
affected by or involved in the implementation of a decision.
1. 7.2 The risk-return principle

Risk is an integral component of any decision.
Risk is the probability that the actual result of a decision may deviate from the
planned end result, with an associated financial loss or waste of funds. Risk differs
from uncertainty in that where there is uncertainty there is no probability or measure
of the chances that an event will take place, whereas risk is measurable by means of
probabilities.
As with the cost-benefit principle, the risk-return principle is a trade-off between
risk and return. The greater the risk, the greater the required rate of return. As far
as possible, the return should exceed the risk involved in any business decision. Risk
should also be minimised or managed.
1. 7.3 The time value of money principle

The time value of money principle states that a person could increase the value of an
amount of money by investing it and earning interest on the amount. If, however, the
amount is invested in real assets, such as inventory, equipment or vehicles, the amount
cannot earn interest. This ties up with the previous two principles. From a cost-benefit 9
point of view, the investor will have to earn a greater return on the investment in inven-
tory, equipment and vehicles than on the best alternative type of investment. From a
risk-return point of view, the return must compensate adequately for the risk incurred.
The time value of money principle also invokes the concept of opportunity cost. If a
person were to invest RS00 000 in a business, then the opportunity of earning interest
on that amount would be forfeited, because the amount could have been invested in,
say, a fixed deposit to earn 15% interest, with less risk involved.
The return that could be earned is strongly influenced by the supply and demand for
capital in the financial markets.
1.8 FINANCIAL MANAGEMENT AND THE OPERATING

ENVIRONMENT OF THE FIRM
The firm operates in a constantly changing yet competitive environment.
The economy typically goes through economic cycles. An economy expands for a
number of years, but this is normally followed by periods of contraction. It is impera-
tive for the sustainability of a firm to take cognisance of the state of the economy and to
manage the firm accordingly. During periods of growth in the economy, firms increase
their marketing efforts, invest more in equipment, appoint more staff members and
budget for expansion. However, during periods of economic decline (such as a reces-
sion) a firm needs to control its expenses and reduce them to the bare minimum in
order to survive until the next economic upswing, which invariably leads to budget
cuts. A recession is typically two consecutive quarters of decline in the gross domestic
product (GDP) of a country. The economic environment is therefore crucial for the
sustainability of a firm.
1.8.1 The economic environment

A business can benefit from an expanding economy, but that requires a careful analy-
sis of the leading and lagging economic indicators. Data about these indicators are
published by the South African Reserve Bank, Stats SA and the JSE.
Examples of leading indicators are the following:
• The indices of the stock exchange. These give an indication of whether the economy
is expected to grow or decline. In the case of the JSE, the All Share Index (ALSI)
could be used for this purpose. Investors in shares listed on the stock exchange
forecast the future financial performances of such listed firms, and they will be
keen to invest in those that they believe are undervalued in view of their expected
increases in profitability.
• Manufacturing statistics provided by Stats SA. These are a leading indicator because
an increase in manufacturing output signals that growth in the GDP is under way.
• Increases in stock levels. These could indicate one of two things. Retailers could
be expecting an increase in consumer spending and are increasing stock levels
in anticipation in order to have adequate stock to take advantage of the upswing.
10 Alternatively it could indicate declining consumer confidence and an accompany-
ing decrease in sales. However, the latter is normally only the case during periods
of rising interest rates.
1
• Statistics about retail sales. An increase in retail sales could be an early indication
of growth in the GDP.
• Statistics about building plans approved. An increase in the number of build-
ing plans approved indicates that construction work will commence soon, thus
creating jobs and a demand for building materials, leading to increased produc-
tion and consumption, and an increase in the GDP as a result of these economic
activities.
• Statistics about the housing market. Increases in house prices indicate an increase
in the wealth of homeowners, which leads to increased revenue from property
taxes, thus providing much-needed resources for government. This also leads to
the construction of new houses - provided that the cost of newly constructed
houses is lower than that of existing houses. This activity contributes to growth in
the GDP.
• Statistics about new company registrations and business start-ups. An increase in
new business ventures also provides an early indication of an improvement in the
growth of the GDP as a result of jobs that will be created, revenue earned, taxes
generated, and increased consumer spending that stimulates the economy.
Examples of key lagging economic indicators include the following:
• The economic growth rate, as measured by the growth in the GDP of a country. An
increase in the GDP signals that an economy is expanding, which is beneficial to
everyone because it indicates more employment, increases in income and expen-
diture, and increases in business and consumer confidence, leading to more new
businesses and increased wealth.
• The inflation rate, as measured by the production price index (PPI) and consumer
price index (CPI). An increase in the PPI and CPI means goods and services are
becoming more expensive, reducing the volume of items consumers are able to pur-
chase. Only once their salaries increase can they resume their spending patterns.
• Interest rates. Normally an increase in inflation leads to an increase in the rate at
which the South African Reserve Bank is prepared to lend money to banks - this is
called the repo rate. The repo rate is determined by the monetary policy committee
of the South African Reserve Bank. An increase in the repo rate is passed on by
banks to their customers who have vehicle and home mortgages with them, and
increases interest rates in general. This reduces the disposable income of consum-
ers and lowers consumption.
• Employment and unemployment statistics. These determine the disposable income
of the economically active part of the population.
• The exchange rate of the local currency against the currencies of major trading
partners. Examples are the rand exchange rate against the US dollar($), the pound
sterling (£) and the euro (€). A weakening of the rand makes it more attractive
for tourists to visit South Africa and makes exports more competitively priced
compared to those of other countries exporting the same type of goods. However, 11
importing equipment and raw materials becomes more expensive, as does overseas
travel for South Africans.
• The financial performance (profitability) of corporate firms. An increase in the

financial performance signals an improvement in economic conditions and wealth
created.
• The balance of trade. A trade surplus indicates that a country is exporting more
than it is importing, while a trade deficit indicates the opposite. A trade surplus
positively influences the balance of payments, which should also positively influ-
ence the exchange rate of the country with the trade surplus and positive balance
of payments.
The economic cycles are published by the South African Reserve Bank, an example
of which is shown in Figure 1.2.
SARB Leading Business Cycle Indicator

30 5
4
20
3
2
10
. 1
0.28
0 ~
0
'#. I
.
I
I
I ' ·1.08 -1
- 10 I
I
-2
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"'
-3
-20 ~1
l
-4
-30 .5
- Leading Business Cycle Indicator • year-on-year percent.age change
--- m/m % change (Right Axls)
Figure 1.2 Economic cycles 2006-2013

Source: Moneywe b (http://www.moneyweb.eo.za/moneyweb-economic-trends/reserve-bank-business-cycle-indicators-weakens)
The above-mentioned indicators are also associated with the required and actual
rates of return in the financial markets of a country.
Financial markets provide a forum in which suppliers and borrowers of funds nego-
tiate and transact their business. The financial market is not necessarily a physical
place. Essentially it involves buyers and sellers who contact one another in order to do
business, which includes using the Internet. Financial institutions participate in the
financial markets on behalf of lenders and borrowers.
The two key financial markets are the money market and the capital m arket.
The money market deals only in short-term funds (also referred to as marketable secu-
rities) with a maturity or lifespan of three years or less. The South African Reserve Bank
12
acts as the lender of last resort in the money market. While the banking sector may be
regarded as the primary source of funds for the money market, the following financial
1
institutions may be regarded as the primary source of funds for the capital market:
• Short- and long-term insurers (e.g. Mutual & Federal and Sanlam respectively)
• Pension and provident funds
• Collective investment schemes (unit trusts)
• The Public Investment Commission (investing the retirement fund contributions
of government officials)
• The JSE
The capital market deals in long-term funds, with a maturity of three years and longer.
In practice, funds flow back and forth between the two markets. Some institutions even
serve both markets. A significant feature of the South African capital market is the JSE,
the basic functions of which include the following:
• Raising finance for public companies listed or wishing to list on the JSE by facilitat-
ing the trading of the company's shares
• Providing a market for listed securities
• Affording protection to investors by enforcing the rules and regulations of the
Stock Exchange Control Act
In both the money and capital markets, there is a primary and a secondary sector. The
primary sector deals only in new securities (such as shares and bonds issued for the
first time). The secondary market trades only in existing securities (e.g. the shares of
companies that have been listed on the JSE for some time).
The financial markets consist of various role players, most significantly the financial
institutions.
A financial institution may be defined simply as the intermediary or agent that
channels funds from the savings of investors to investment in either financial assets
(such as shares or bonds) or real assets (such as office blocks or industrial parks).
Financial institutions include banks, insurance companies, pension funds and
investment trusts. Financial institutions may buy the shares of companies (in other
words, make equity investments) or lend money to firms needing finance. The financial
institutions obtain their funds from customers of theirs who have surplus funds avail-
able. The financial institutions need to invest or lend out their available funds at a rate
that exceeds the rate they are paying to their depositors. The difference between the rate
charged and the rate paid is called the spread.
Example
Standard Bank may offer its savings account holders 9% interest per annum, and may
lend out money to risky clients at 12% per annum. The spread of 3% in this example
must be used to cover the operating expenses of the bank (such as rent of premises,
salaries, advertising and losses due to bad debts), to pay insurance and taxes, and to
earn a return for the shareholders of the bank. The interest rate quoted by the bank for 13
customers with the lowest risk of default is known as the prime rate, which may be, say,
11%.
From the foregoing, we may gather that the financial markets facilitate the trading of
funds between the suppliers and the borrowers of funds. The significance of this is that
their actions influence the cost of financing, such as interest rates. This has important
implications for the cost of capital of firms.
1.8.2 The regulatory and political environment

The governing party drives the policy and legislative agenda in the parliament of any
country.
Business firms are required to comply with a plethora oflaws, and regulations pro-
mulgated in terms of such legislation. The following is a short list of some of the more
prominent acts that business firms have to adhere to:
• The Companies Act 71 of 2008
• The Basic Conditions of Employment Act 75 of 1997
• The Employment Equity Act 55 of 1998
• The Labour Relations Act 66 of 1995
• The Occupational Health and Safety Act 85 of 1993
• The Competition Act 89 of 1998
• The Income Tax Act 58 of 1962
• The Natural Environment Management Act 107 of 1998
Compliance with these and other acts require many firms to appoint a compliance
officer who needs to ensure no legislation is contravened. Compliance contributes to
the cost of doing business, and any increases in regulatory requirements discourage
entrepreneurs from starting up new businesses and reduce the profitability of exist-
ing firms, unless such costs can be transferred to customers. The more legislation, the
greater the barrier to entry to the business world. Equally, foreign investors compare
countries with one another in deciding where they will invest - or not.
1.8.3 The natural environment

The natural environment provides opportunities for business firms, especially in food
production, tourism, mining and energy. However, if the natural environment is not
protected from pollution and not rehabilitated, then the sustainability of any human
activity is under threat.
These challenges require management teams to deal with the environment on behalf
of the owners - the shareholders.
1.9 THE AGENCY PROBLEM

In the case of a sole proprietorship, one person accepts all the risk. In a small business,
14
the owner is also the manager of a firm. The owner-manager will pursue the goal of
wealth maximisation and act in his or her own best interests.
1
However, the owners and management of a firm are not always the same people. In
many cases, the size of the business requires the appointment of managers to act on
behalf of the owners. In larger firms such as public companies, ownership is spread
over a huge number of shareholders. The dispersion of ownership means that managers
have to act on behalf of owners.
Managers do not necessarily act in the best interests of the shareholders, creating
a possibility of conflict of interest between the principal (the owners) and the agent
(managers). Such a conflict is called an agency problem.
The agency problem results in costs, such as the cost oflost business opportunities if
managers are too risk averse, the cost of benefits payable to managers, and the cost of
monitoring management actions and auditing financial statements.
The agency problem challenges the remuneration committees of firms to find cre-
ative ways of remunerating their management teams for the value that they create.
Some of the options used include profit sharing, share option schemes and incentives
based on economic value added (EVA).
1.10 SUMMARY
This chapter has explained the mission and strategies a firm may pursue in a com-
petitive environment. The forms of business organisation, the financial goals of the
firm and the role of management in achieving these goals were explained. It should
be evident that the cooperation of all departments (procurement, marketing, human
resources, operations, financial, etc.) is vital in achieving the goal of maximising share-
holders' wealth.
The chapter also explained the fundamental principles of financial management,
namely the cost-benefit principle, the risk-return principle and the time value of money
principle. The agency problem was also discussed.
The result of the management of a firm is measured in accounting terms, and more
specifically by means of the statement of financial performance (also known as the
income statement) and the statement of financial position (balance sheet) . Attention
will now be focused on how financial reporting takes place by providing a brief over-
view of financial statements in Chapter 2.
REFERENCES
Gitman, L.J. 1994. Principles of managerial finance, 7th ed. New York: Harper Collins.
Marx, J. (Ed.). 2012. Investment management, 4th ed. Pretoria: Van Schaik.
Marx, J. & De Swardt, C.J. 2013. Financial management in southern Africa, 3rd ed. Cape Town: Pearson.
Pearce, J.A. & Robinson, R.B. 2011. Strategic management: formulation, implementation and control, 12th
ed. Boston, MA: McGraw-Hill.
Porter, M.E. 1979. How competitive forces shape strategy. Harvard Business Review, March/ April.
15
Self-test questions
1. Which statement is correct?
The financial goal of the firm is to ...
a. maximise return
b. optimise solvency
c. increase the value of the firm
d. optimise liquidity
e. limit losses due to bad debts
2. Which of the following statements is/are correct?
a. Profitability is the firm's ability to generate cash sales.
b. Solvency is the extent to which the firm's assets exceed its liabilities.
c. Liquidity is the firm's ability to satisfy its short-term obligations as they
become due.
(i) (a)
(ii) (b)
(iii) (b) and (c)
(iv) (a) and (c)
(v) None of the above
3. Which of the following statements are correct?
a. Financial management and accounting are not synonymous.
b. Accounting uses a cash flow basis.
c. Financial management emphasises cash inflow and outflow.
d. The receipt of funds sooner rather than later is preferred.
(i) (a) and (b)
(ii) (c) and (d)
(iii) (a), (b) and (c)
(iv) (a), (c) and (d)
(v) (b), (c) and (d)
4. Financial management is based on the following principles:
a. Cost of resources
b. Risk-return
c. The time value of money
d. (b) and (c)
e. None of the above
5. The cost-benefit principle means that .. .
a. decisions based on cost only will yield the best benefits
b. the greater the costs, the greater the benefits
c. clarity about the objective to be attained is vital
16 d. benefits should outweigh costs
~~ e. (c) and (d)
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6. The risk-return principle states that ...
a. every business decision may result in either a profit or a loss
b. the greater the risk, the greater the required rate of return
c. risk and uncertainty are synonyms
d. the greater the risk, the greater the actual rate of return
e. (a) and (b)
7. According to the time value of money principle ...
a. there is an opportunity cost involved in waiting to receive an amount of
money
b. money should at all times be invested to earn a return
c. cash flows received later rather than earlier are in order
d. (a) and (b)
e. (a), (b) and (c)
Solutions to self-test questions

1. (c) - the financial goal of the firm is to maximise shareholders' wealth, which
may be accomplished by increasing the value of the firm or investing in
assets that will add value to the firm.
2. (iii) - statements (b) and (c) are correct.
3. (iv) - statements (a), (c) and (d) are correct.
4. (d) - the other principle of financial management is the cost-benefit principle.
5. (e) - the cost-benefit principle means that clarity about the objective to be
attained is vital and that benefits should outweigh costs.
6. (b) - the greater the risk, the greater the required rate of return.
7. (d) - statements (a) and (b) are correct.
17
CHAPTER TWO
UNDERSTANDING
FINANCIAL
STATEMENTS
What's the problem?

On 12 December 2014, the construction industry closed for business for the year. It has been
an eventful year for Tshepo, Brian and Andre. Their broad-based black economic empower-
ment (BBBEE) construction firm known as TB Construction (Pty) Ltd has survived its first
year of operation. They have focused on providing quality construction on time and within
budget. They are accredited National Home Builder Registration Council (NHBRC) contrac-
tors, and are also registered and verified on the government's supplier database.
Tshepo completed a BSc (Quantity Surveying), while Brian and Andre both graduated
at the end of the previous year with BSc (Construction Management) degrees. They have
applied their knowledge of construction techniques and succeeded 80% of the time on com-
pleting projects on time. They are able to identify tasks that need to be done consecutively,
arrange them in order of execution, and schedule those that can be done concurrently with
others. Their suppliers are reliable, and in 90% of the cases provide the required materials
on site when needed.
However, they have several suppliers who are now no longer willing to sell building mate-
rials to them on credit. The South African Revenue Service (SARS) has sent them notice of an
overdue tax assessment, hence they are liable for added interest and penalties. In addition,
the Department of Labour (DoL) has also contacted them regarding their outstanding contri-
butions to the Unemployment Insurance Fund (UIF). Four of their customers have disputed
their invoices and are refusing to settle their accounts in full.
They have a revolving cheque account with Barclays Africa Ltd, but the bank is not pre-
pared to extend any further credit to them because they have reached their maximum.
The Department of Human Settlements (OHS) has announced a tender to construct 140
single-storey units (40 m 2 each) and 700 double-storey units (42 m2 each) in the Midrand area.
TB Construction has the know-how to manage the project and a BBBEE certificate, but cannot
provide a tax clearance certificate (TCC) as part of the required tender documentation.
Despite succeeding at construction, they now face the mammoth task of working through
several boxes full of purchase invoices, account statements, receipts, credit notes, salary slips,
bank statements and delivery notes.
19
Question: W hat do they need to do in order to confirm their profitability and eliminate
the challenges they are facing w ith SARS, Barclays Africa, the DoL and the DHS?
CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS
2.1 INTRODUCTION
Every company or firm should periodically provide a report of its financial activities
to its stakeholders. Such reports are known as financial statements. In order to ensure
the integrity of the information they contain, guidelines to prepare and maintain them
are set by the accounting profession's rule-setting body in South Africa, the Accounting
Practices Board (APB). Until recently, the South African Generally Accepted Account-
ing Principles (SA GAAP) were authorised as the main guidelines for companies.
During March 2012, the Accounting Practices Board (APB) and the Financial Report-
ing Standards Council (FRSC), in pursuit of being more aligned with international
standards, issued a joint communication reflecting their decision to discontinue the
use of SA GAAP. Effective from annual periods commencing on or after 1 December
2012, companies are no longer allowed to apply SA GAAP and instead are required by
the Companies Act 71 of 2008 to use full International Financial Reporting Standards
(IFRS) or the IFRS for small and medium-sized entities (SMEs), which was developed
by the International Accounting Standards Board (IASB) in recognition of the diffi-
culty and cost to private companies of preparing financial statements that are compli-
ant with full IFRS.
The International Accounting Standard 1 (IAS 1) Presentation of Financial State-
ments prescribes the basis for the presentation of general purpose financial statements.
This ensures that the firm's financial statements are comparable with previous periods,
as well as with those of other firms. The key financial statements required by IAS 1 for
reporting to shareholders are as follows:
• The statement of financial performance (also known as the statement of profit
and loss and other comprehensive income). This statement measures the financial
performance of a firm during a certain period (i.e. whether a profit or a loss was
recorded). It was previously known as the income statement.
• The statement of financial position. This statement indicates the financial position
of the firm at a specific point in time (say 28 February 2014); in other words, what
the assets of the firm are worth (at book value) and how they were financed - by
means of equity and debt financing. Equity refers to the capital provided by the
owners of the firm for an indefinite period; debt financing refers to liabilities which
need to be paid back by a certain date.
• The statement of shareholders' changes in equity summarises the movement in the
equity accounts during the year, namely share capital, share premium, retained
earnings, revaluation surplus, unrealised gains on investments, etc.
• The statement of cash flows indicates what cash flows were generated from operat-
ing activities, from financing and from investment activities.
Financial statements may be used by both owners and managers of firms to assess their
progress towards their objectives. To this end they need accurate and reliable financial
20 information at their disposal. There are also several other users of financial statements.
UNDERSTANDING FINANCIAL STATEME NTS
2
2.2 USERS OF FINANCIAL STATEMENTS
Financial statements are used by various stakeholders, for a variety of purposes. Some
of these stakeholders are the following:
• Shareholders need them to assess the worth of their business. Shareholders finance
the company or firm, and require compensation because they are sacrificing the
opportunity of earning a return on alternative investments (e.g. earning interest on
a fixed deposit or rental income from property).
• Management requires them to help plan and control the activities of the firm in a
way that will accomplish the objectives that have been set.
• Lenders to (or creditors of) the business require them to assess the likelihood of the
repayment of their funds or of default.
• Labour unions need them as a basis for wage negotiations .
• Investment analysts, who are investigating the firm for investment purposes,
require them for investment decision making.
• The state requires them for the purpose of checking whether the amount of taxes
paid is correct, and also for statistical purposes.
• Credit bureaux need them to issue credit ratings .
2.3 KEY GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Although firms in South Africa are now required by the new Companies Act to use full
IFRS, the following generally accepted accounting principles are still applicable:
2.3. 1 Accounting entity

For financial statements to be meaningful, the entity to which the information pertains
must be clearly defined. Only transactions concerning the specific accounting entity
must be recorded, and transactions that do not concern the entity must be excluded.
2.3.2 Money measurement

Money measurement is a universal accounting denominator used to express the assets,
liabilities and owners' equity so as to describe the financial position of a firm accurately.
2.3.3 Conservatism
Conservatism refers to the use of the most conservative approach of profit determina-
tion whenever alternative procedures exist for the treatment of a transaction or event
in the accounting process.
21
2.3.4 The consistency concept

In terms of the consistency concept, there must be consistency of accounting treat-
ment oflike items within each accounting period and from one period to another. Any
change in methods or policies must be reported, together with the financial statements.
2.3.5 Materiality
Materiality requires that transactions and events which are not material in relation to
the nature and scope of an entity's activities need not be taken into account if the cost
and difficulty of recording them are not justified by the resulting benefit.
2.3.6 Historic cost

Historic cost refers to the phenomenon that assets are initially brought into account in
the accounting process at the cost the entity incurred in acquiring them.
2.3. 7 The double-entry system

The assets are a reflection of the interests in them. The interests refer to the liabilities
and owners' interest, thus for every debit entry, there must be a credit entry of the same
amount of money (and vice versa) - the double-entry system.
2.3.8 The going-concern concept

The going-concern concept gives the users of financial statements the assurance of the
continuity of the firm. The business entity will continue in operational existence for the
foreseeable future. This means in particular that the income statement and balance sheet
assume no intention or necessity to liquidate or significantly curtail the scale of operation.
2.3.9 The accounting period

Income and expenses incurred in generating income must be brought into account
during the same accounting period (say the same financial year). Revenue and costs
are accrued (i.e. recognised as they are earned or incurred, not as money is received or
paid), matched with each other insofar as their relationship can be established or justi-
fiably assumed, and dealt with in the statement of financial performance for the period
to which they relate. This is also referred to as the matching principle.
2.3.10 The realisation principle

22 The realisation principle refers to two conditions that must be met in recognising
~~ income: it must have been earned and realised. Income is earned when the party giving
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J:: ] value has completed its obligation towards the party receiving value. To be realised,
~~
@ income must be measurable and the ability to recover it must be reasonably certain.
2
2.3.11 The accrual principle
The accrual principle states that in calculating the profit for a specific period, only
income earned during that period (regardless of when it was received) may be brought
into account, and that only value consumed during that period can be brought into
account as expenses (regardless of when payment was made) in the determination of
profit. Value which has been received but not yet earned constitutes an obligation, and
is therefore treated as a liability. Value which has been earned but not yet received is
treated as an asset. Expenditure on services or goods not yet consumed is treated as an
asset. Value which has been consumed but not yet paid for is treated as a liability.
To provide up-to-date financial information about a business, it is necessary for an
accountant to record all daily business transactions. To this end he or she must
• classify
• record
• summarise financial information .
Each of the above-mentioned functions will now be explained.
2.4 THE CLASSIFICATION OF FINANCIAL INFORMATION

A logical classification of the vast amount of financial information generated in a
firm requires a system of accounts. The accountant may use a computerised system
(e.g. AccPac, Pastel, Baan or SAP) or a manual system. The approach here will be to
explain manual accounting procedures using the financial statements of a company.
The knowledge gained in this manner is readily transferable to any type of automated
accounting system and to various forms of business organisations.
Regardless of the system used, it must provide for five types of accounts, namely:
1. Asset accounts
2. Liabilities
3. Owners' equity
4. Revenue accounts
5. Expense accounts
The purpose of the asset, liability and owners' equity accounts is to determine the liquid-
ity and solvency of the firm by means of the statement of financial position and cash flow
statement.
The purpose of the income and expense accounts is to determine the profitability of
the firm by means of the statement of financial performance.
The record in which increases and decreases in a single item of these financial state-
ments is noted down is called an account or a ledger account.
An entire group of accounts is known as a ledger. Various ledgers are used, such
as the general ledger, the debtors' ledger and the creditors' ledger. A total or control 23
account for all debtors, and a total or control account for all creditors, are kept in the
general ledger. The individual accounts for debtors and creditors are kept in subsidiary
ledgers called debtors' and creditors' ledgers respectively.
Total or control accounts for raw materials inventory, manufacturing overheads,

work-in-process and merchandise inventory are kept in the general ledger. In the case
of manufacturing firms, individual accounts are kept in the material subsidiary ledger,
manufacturing overheads subsidiary ledger and the work-in-process subsidiary ledger.
All other accounts are kept in the general ledger.
Accounts are usually arranged in the general ledger in financial statement order: asset
accounts first, followed by liabilities, owners' equity, revenue (income) and expense
(cost) accounts. The number of accounts needed by a business will depend upon its
size, the nature of its operations and the extent to which management and government
departments require a detailed classification of information.
An identification number is assigned to each new account opened. A listing of the
account titles and account numbers being used by a business is usually provided in a
chart of accounts, which can be consulted if a particular account needs to be traced.
An example of a chart of accounts is shown in the appendix to Chapter 2 on page 38.
Business transactions can be recorded or classified by making use of an accounting
equation.
Assets (A) = Liabilities (L) + Owners' equity (OE)
While the listing of assets shows us what the business owns, the listing of liabilities and
owners' equity tells us who supplied the finance to the business and how much each
group supplied. Everything that a business owns has been supplied to it by either the
owners or the creditors, therefore the total claims of the owners plus the claims of the
creditors equal the total assets of the business. It is for this reason that the total assets
will balance the owners' equity and the liabilities in the statement of financial position.
2.S RECORDING CHANGES IN THE FINANCIAL POSITION

A business enters into hundreds and even thousands of transactions each day. It would
be impractical to prepare the financial statements after each transaction, and it is quite
unnecessary to do so. Instead, the many individual transactions are recorded in the
accounts that make up the various ledgers, and at the end of the accounting period, the
balances of all the accounts are determined with a view to summarising all the informa-
tion in the financial statements.
The recording of accounting information starts with a transaction that took place.
A transaction is a business event that can be expressed in monetary terms and must
be recorded in the accounting records. Business transactions are evidenced by busi-
ness documents such as receipts, invoices, cheques or cash register tapes. These
source documents are the starting point of the flow of information through the
accounting system.
The recording of accounting information is diagrammatically illustrated in
24 Figure 2.1.
UNDERSTANDING FINANCIAL STATEMENTS
2
Occurrence of business transaction
Preparation of business document
Information recorded in journal
Debits and credits posted to ledger accounts
Financial statements prepared at end of accounting period
Figure 2.1 Recording financial information
Every business transaction affects two or more accounts. The double-entry system
derives its name from the fact that equal debit and credit entries are made for every
transaction. Since every transaction results in an equal amount of debits and credits
in the ledger, it follows that the total of all debit entries is equal to the total of all the
credit entries in the ledger. The rules of debit and credit for all the types of accounts are
summarised in Table 2.1.
Table 2.1 The rules of debit and credit
Type of account Rule

Increases are recorded by debits
Assets
Decreases are recorded by credits
Increases are recorded by credits
Liabilities
Decreases are recorded by debits
Increases are recorded by credits
Owners' equity
Decreases are recorded by debits
Since revenue increases owners' equity, it is recorded by a
Revenue (income)
credit
Since an expense decreases the owners' equity, it is
Expenses (cost)
recorded by a debit
An account normally has a balance when more increases than decreases, or the
opposite, have been recorded. In asset accounts, increases are recorded as debits, so
these accounts normally have debit balances. In liability and owners' equity accounts, 25
increases are recorded as credits, so these accounts normally have credit balances. Rev-
enue (income) accounts (e.g. sales and interest earned) normally have credit balances.
Expense (cost) accounts (e.g. electricity and fuel) normally have debit balances.
Occasionally an account may acquire a balance contrary to its normal balance. For
example, an account payable may acquire a debit balance (instead of the usual credit
balance) because the account has been overpaid. An accounting error could also have
been made.
Although transactions can be entered directly into a ledger account, it is convenient
and efficient to first record the information shown on business documents in a journal,
and later to transfer the debits and credits to ledger accounts. The journal, or book of
original entry, is a chronological (day-by-day) record, showing the debit and credit
changes in specific ledger accounts resulting from a particular transaction. A brief
explanation is also included for each transaction. At convenient intervals, the debit and
credit entries that have been recorded in the journal are transferred to the accounts
in the ledger. The updated ledger accounts in turn provide the basis for preparing
financial statements.
The use of both a journal and a ledger has the following advantages, which are lacking
if transactions are entered directly into ledger accounts:
• The journal shows all information about a transaction in one place and also pro-
vides an explanation of the transaction.
• The journal provides a chronological record of all the events in the life of a firm.
• The journal helps to prevent errors, since the offsetting debits and credits for each
transaction appear together.
Some firms prefer to use an analysis cash book rather than the journal as the book of
original entry.
2.6 SUMMARISING FINANCIAL INFORMATION IN THE

FINANCIAL STATEMENTS
The accountant summarises the financial information in financial reports, known as
financial statements. The summary of the process leading to the preparation of the
financial statements is provided in Figure 2.2.
ln_p_u t_ _ _ __:- - - -::::, '-

'------
7
1- -P-ro_c_es_s_ _ _,---~E
26
Transactions and their
source documents
,- -~1 A = L + OE
::::,
Financial
statements
Figure 2.2 Process leading to the preparation of financial statements

2
The statement of financial performance, the statement of financial position and the
statement of cash flow are three typical financial statements. The following sections
illustrate and explain them.
2.6.1 The statement of financial performance (comprehensive

income)
The nature and purpose of the 'financial performance statement
The statement of financial performance provides a financial summary of the firm's
financial performance during a period of time by comparing revenue to expenses.
In short, the purpose of the statement is to evaluate the profitability of a business by
matching the revenue earned during a given period with the expenses incurred in the
process of obtaining that revenue. If revenue exceeds expenses, the firm is operating at
a profit, therefore ensuring its sustainability.
The statement of financial performance is also known as the statement of profit and
loss and other comprehensive income. It was previously known as an income statement.
The accounting period

Every business concern prepares a yearly statement of financial performance, and most
businesses also prepare quarterly and monthly statements.
Management needs to know from month to month whether revenue is rising or
falling, whether expenses and losses are being held at the anticipated level, and how net
income compares with that of the preceding month and of the corresponding month of
the preceding year. The term "accounting period" refers to the period of time covered
by the statement of financial performance. It may be a month, a quarter of a year, half
a year or a year.
Generally, a business finds it more convenient to end its annual accounting period
during a slack season rather than during a time of peak activity.
Transactions affecting more than one accounting period

Since the operation of a business entails a continuing stream of transactions, many
transactions begin in one accounting period but affect several succeeding periods.
Not all transactions can be so precisely divided by accounting periods. The purchase
of a building, fire-fighting equipment, vehicles, alarm systems, and so forth, provides
benefits to the business over all the years in which such assets are used. No one can
determine in advance exactly how many months or years of service will be received
from such long-lived assets. Nevertheless, in measuring the net income of a business
for a period of one year or less, the accountant must estimate what portion of the cost
of the building and other long-lived assets is applicable to the current year.
Since the apportionment of these and many other transactions which overlap two 27
or more accounting periods is in the nature of estimates rather than precise measure-
ments, it follows that income statements should be regarded as useful approximations
of annual income rather than absolutely accurate determinations.
General format
The general format of the statement of financial performance can best be demonstrated
by means of the example provided in Table 2.2.
A feature to note concerning the statement of financial performance in Table 2.2 is
that interest paid is placed after the figure showing profit from operations. The same
would have applied to interest earned from investments. Other examples of such non-
operating revenues are dividends on shares owned in other companies, and rent earned
by leasing property not presently needed in the operation of the business.
Any items of expense not related to selling or administrative functions may also be
placed at the bottom of the statement of financial performance, after profit from opera-
tions. Separate headings, such as non-operating revenue and non-operating expenses,
are sometimes used.
Condensed statement of"financial performance

The statements of financial performance prepared by different companies vary con-
siderably in the amount of detail shown. Often they are greatly condensed because the
public is presumably not interested in the details of operations. For strategic reasons, a
company may also prefer not to disclose the details of its operations to competitors or
investment analysts.
Table 2.2 Example of statement of financial performance
Statement of financial performance for the year ended R'OOO

28 February 20 I 3
Revenue 6148
Less: cost of sales (4 176)
Gross profit 1972
Less: operating expenses
Selling expenses 200
General and administrative expenses 388
Lease expenses 70
Depreciation expense 478
Total operating expenses .(_lli__fil
Operating profits 836
Less: interest expense .(_llifil
Net profits 650
Less: tax (28%) .(lfil}
Profit for the year 468
28
2
2.6.2 The statement of financial position
The nature and purpose of the statement of'financial position
The purpose of the statement of financial position is to show the financial position of a
business at a particular date. A statement of financial position consists of a listing of the
assets, shareholders' interest and liabilities of a business.
Table 2.3 shows an example of a statement of financial position. This statement also
demonstrates the effect of a decision not to pay all the net profit out as cash dividends,
but to retain some of it as retained earnings.
Note that the statement of financial position consists of three distinct elements,
namely assets, owners' equity and liabilities. The following sections will focus on each
of these elements. However, it is necessary to comment briefly on the business entity
before proceeding with a discussion of these three aspects.
The statement of financial position shown refers only to the financial affairs of the
business entity and not to the personal financial affairs of the shareholders (owners).
The shareholders may own property, shares in other companies, vehicles, etc., but these
assets are the personal property of the various shareholders and do not form part of this
particular company. For this reason they are not included in the statement of financial
position of the business entity concerned.
Table 2.3 Example of statement of financial position
Statement of financial position at 3 I December 20 I 3 R'OOO

ASSETS
Non-current assets
Property and plant 4156
Machinery and equipment 142
Vehicles 266
Other financial assets 196
Total non-current assets 4760
Current assets
Inventories 578
Trade and other receivables I 006
Cash and cash equivalents 862
Total current assets 2446
Total assets 7206
EQUITY AND LIABILITIES
Equity attributed to owners
Share capital 1638
Retained earnings 2262
Other components of equity 20
Total equity 3920
Non-current liabilities
29
Long-term borrowings 1636
Deferred tax 410 ~~
~~
Total non-current liabilities 2046 C -Cl
~ ct
@
Current liabilities
Trade and other payables 764
Short-term borrowings 158
Current portion of long-term borrowings 318
Total current liabilities 1240
Total liabilities 3286
Total equity and liabilities 7206
A business entity can be regarded as an economic unit which enters into busi-
ness transactions that must be accounted for. The entity is separate from its owner or
owners; it owns its own property and incurs its own debts. Consequently, each business
entity should have a separate set of accounting records that provides information on its
financial position and profitability.
Assets
Assets are economic resources which are owned by a business and are expected to be
of benefit during future operations. Assets may have a definite physical form, as in the
case of buildings, machinery or merchandise. However, some assets do not exist in a
physical or tangible form, but in the form oflegal claims or rights, such as amounts due
from customers and patent rights.
The distinction between non-current and current assets

Non-current assets are assets that will be retained for a longer period than the account-
ing period of the business, which is usually a year. They include land and buildings,
plant and equipment, and motor vehicles. As the non-current asset is used up or worn
out over time, its original cost is reduced in order to reflect this usage. This reduction
in value is known as depreciation. A non-current asset will initially be shown at its
original cost, but if depreciation is applicable, it will be shown in subsequent state-
ments of financial position at the depreciated value. Some firms may show the original
cost minus the accumulated depreciation in their statement of financial position. One
reason for using cost rather than present market values in accounting for non-current
assets is the need for a common, definite and factual basis. The cost of land, build-
ings and many other assets purchased for cash may be fairly accurately determined.
Accountants use the objectivity principle, meaning that asset valuations are factual and
easy to verify. Management has to keep track of all the non-current assets of the firm by
maintaining an asset register.
Current assets are those that change with the transactions that take place as business
is conducted. Current assets include inventory (stock), accounts receivable (debtors)
and cash deposited or on hand. In a trading business, inventory is usually made up of
merchandise for resale, whereas a manufacturing firm usually has an inventory of raw
30 material, work-in-process and finished goods.
When examining a statement of financial position, it is important to bear in mind
that the rand amounts listed do not indicate the prices at which the assets could be
2
sold, nor the cost at which they could be replaced. One useful generalisation that can
be made from this is that a statement of financial position does not show the real value
of the business at all times. This is because of the going-concern concept. According to
this concept, land and buildings are used to house the business and have been acquired
for use and not for resale; in fact, these assets cannot be sold without disrupting the
business process.
Owners' equity
Owners' equity represents the financial resources invested by the owners, and is equal
to the total assets minus the liabilities.
Total assets R9100000
- Total liabilities R3100000
= Owners' equity R6000000
The equity of the owners is a residual claim because legally the claims of creditors come
first.
In the case of a public company, the shareholders' interest (owners' equity) may take
the form of ordinary share capital and retained earnings, and is indicated as "share-
holders' interest" in the statement of financial position. If the firm uses preference
shares which are not redeemable, then these could also be classified as shareholders'
interest. Shareholders' interest is based on the par value at which the shares were sold,
and may be calculated by multiplying the number of shares issued by the par value per
share. Once the shares trade on the stock exchange, they will take on a market value,
which will differ from the par value. The statement of financial position will, however,
not reflect changes in the market value of the shares, but will always reflect the original
par value figures. Shareholders may come and go as they buy and sell the shares of a
company. The amount of capital provided by the original shareholders does not alter
and is at the disposal of the firm for as long as it exists and remains solvent.
Liabilities
Liabilities are debts. All business concerns have liabilities to a greater or lesser extent.
Liabilities can generally be divided into two basic categories, namely non-current lia-
bilities in the form of loans with a maturity exceeding one year, and current liabilities,
which are debts with a maturity ofless than one year. Examples of current liabilities are
accounts payable, notes payable, tax payable, and wages and salaries payable. Current
liabilities result from the normal operation of a business and are regarded as a spon-
taneous source of short-term finance. Accounts payable result from the purchase of
m erchandise, goods and services on credit rather than paying cash at the time of each
purchase. The person or company to whom the account payable is owed is known as a
creditor. 31
When a firm borrows money to buy merchandise, or to buy new and more efficient
m achinery, a liability is created and the lender becom es a creditor of the business. The
document that records liability when money is borrowed is commonly called a note
payable - in other words, a formal written promise to pay a certain amount of money,
plus interest, at a definite future date during the next 12 months.
An account payable, in contrast to a note payable, does not involve the issuing of a
formal written promise to the creditor. The two types ofliabilities are shown separately
in the balance sheet.
The valuation issue, which poses so many difficulties in accounting for assets, is a
far smaller problem in the case of liabilities, because the amounts of most liabilities
are specified by contract. The creditors have claims against the assets of the business -
usually not against any particular asset, but against the assets in general. The claims of
the creditors are liabilities of the business and have priority over the claims of owners
(shareholders in the case of a company). Creditors are entitled to be paid in full even if
such payment exhausts the assets of the business, leaving nothing for the owners.
To summarise, a statement of financial position is simply a detailed statement of
the accounting equation. Every business transaction, no matter how simple or com-
plex, can be expressed in terms of its effect on the accounting equation. Regardless of
whether a business grows or contracts, the equality between the assets and the claims
against them is always maintained. Any increase in the amount of total assets is neces-
sarily accompanied by an equal increase on the other side of the equation - that is, by
an increase in either the liabilities or the owners' equity.
2.6.3 The statement of cash flows

The statement of financial position shows the financial position of a firm at a particular
date. The statement of financial performance goes part of the way in explaining how
the statement of financial position came about. It also details the operating income for
the year (between consecutive statements of financial position) and is based on accrual
accounting concepts. The statement of cash flows, however, focuses on the cash receipts
and payments between two consecutive statements of financial position. The statement
of financial performance and the statement of cash flows deal with essentially different
aspects of the same business activity.
The statement of cash flows shows the sources (cash inflows) and uses (cash out-
flows) of all the financial resources of a firm.
The three objectives of the statement of cash flows are to provide information regard-
ing cash utilised or generated by:
• operating activities
• investing activities
• financing activities.
Drawing up the statement of cash flows requires information from the statement of
financial position, a statement of financial performance for the financial year, details
of non-current assets, and information on the gross movement of cash that may not be
32 reflected in the other financial statements.
2
Operating activities
Operating activities include all transactions and other events that are not investing or
financing activities. Typically, cash receipts from customers and cash paid to suppliers
and employees would be part of cash generated by operations.
Investing activities
Investing activities generally include transactions involving the acquisition or dis-
posal of non-current assets and investments, including advances (loans) which are not
described as cash. Cash inflow from investing activities thus includes cash received
from the sale of property, plant and equipment, and cash received from the collection
of loans made to others. Cash outflow from investing activities includes cash paid to
purchase property, plant and equipment.
Financing activities
Financing activities generally include the cash effects (inflow and outflow) of transactions
and other events involving long-term creditors and owners - in other words, those
activities resulting in changes in the size and composition of the debt and capital of
the reporting entity. Cash inflow from financing activities includes cash received from
issuing shares, mortgages and other short- or long-term borrowing. Cash outflow for
financing activities includes repayments of amounts borrowed from owners or other
parties. Payments of dividends and interest are not regarded as financing activities
because they appear in the statement of comprehensive income and are therefore
included in operating activities.
Format ofa statement ofcash '{lows

The format and presentation of the statement of cash flow will depend on the particular
circumstances of the firm. The amount of detail disclosed in a particular statement
depends on
• the nature of the firm's activities
• the materiality of the items involved.
Table 2.4 provides an example of a statement of cash flows.
33
CHAPTER 2 UNDERSTANDING FINANCIA L STATE M ENTS
Table 2 .4 Example of statement of cash flows
Consolidated statement of cash flows for the year ended R'OOO

31 December 2013
Cash flow from operating activities
Net profits after taxes 454

Depreciation 478
Increase in trade receivables (276)
Decrease in inventories 22
Increase in accounts payable 224
Current portion of long-term borrowings (increase) 90

Cash provided by operating activities 992
Cash flow from investment activities
Increase in non-current assets (228)
Cash provided by investment activities (228)
Cash flows from financing activities
Decrease in notes payable (40)

Increase in long-term debts 92
Changes in shareholders' equity 22
Dividends paid .(1_Qfil
Cash provided by financing activities .(l.1ll

Net increase in cash equivalents 622
Note that the statement in Table 2.4 has been presented using the direct method.
An indirect method can also be adopted whereby net cash from operating activities is
derived by adjusting net profit changes in working capital, non-cash and non-operating
cash transactions. The statement of cash flows would normally be accompanied by
notes to explain the calculation of the figures shown.
2.7 THE AUDITORS' REPORT

The auditors' report states that the auditors have audited the annual financial state-
ments and that these statements fairly represent
34
• the financial position of the firm at the financial year-end date
~ ~
;: ~
u -<:
(/) ~
• the results of the firm's operations for the year under review
C -Cl
~~ • the cash flow information.
@
2
However, if the auditors are dissatisfied with certain aspects, they will qualify their
report accordingly. It is therefore important for the user of financial statements always
to read the auditors' report carefully.
2.8 THE DIRECTORS' REPORT

The directors' report gives the user of the financial statements an overview of the firm
and its state of affairs. It deals with all matters that are relevant to the understanding of
the nature of the firm's business (including the mission statement, the influence of the
state of the economy on the firm, and prevailing conditions in the industry), profit or
loss, and state of affairs. It will contain information on, inter alia, the following:
• Additional financing raised
• Any major changes in the nature of the firm's fixed assets
• Dividends paid and/or declared
2.9 SUMMARY
Managers need financial statements to measure their progress towards their objectives.
Financial statements are the result of classifying, recording and summarising financial
information.
The most important types of financial statement are the statement of financial per-
formance, the statement of financial position and the statement of cash flows. The state-
ment of financial performance of the firm calculates the difference between the revenue
(income) and the expenses (costs) for a particular accounting period, such as a year, a
quarter or a month. The statement of financial position shows the assets, owners' equity
and liabilities of a firm at a specific date, for example 28 February 2014. The statement
of cash flows provides information on cash utilised or generated by means of operating,
investment and financing activities.
REFERENCES
Bradshaw, J. & Brooks, M. 1996. Business accounting and finance. Cape Town: Juta.
Faul, M.A., Pistorius, C.W.I., Van Vuuren, L.M. & De Beer, C.S. 1994. Accounting: an introduction, 4th ed.
Durban: Butterworths.
Larson, K.D. & Pyle, W.W. 1986. Financial accounting, 3rd ed. Homewood, IL: Irwin.
Marx, J., & De Swardt, C.J., 2013. Financial management in southern Africa, 3rd ed. Cape Town: Pearson.
Ngwenya, S. 2014. Financial statements and ratio analysis. In Gitman, L.J., Principles of m anagerial
finance, global and South African perspectives, 2nd ed. Cape Town: Pearson.
35
Self-test question
Compile a statement of financial performance and a statement of financial position
based on the following ending balances of Etwatwa Limited. The firm is subject to a
28% tax rate.
Revenue 5134
Cost of sales 3422
General and administrative expenses (374)
Lease expenses (70)
Interest expense (182)
Property and plants 3806
Vehicles 260
Inventories 600
Trade and other receivables 730
Share capital 16 16
Deferred tax 390
Suggested solution to self-test question

Etwatwa Limited
Statement of financial performance for the year ended 28 February 2013
R'OOO
Revenue 5 134
Cost of sales (3 422)
Gross profit I 712
Less: operating expenses
General and administrative expenses (374)
Lease expenses (70)
Total operating expenses I 106
Operating profits 606
36 Less: interest expense Dfil).
Net profits 424
Less: tax (28%) .(llfil
Profit for the year 296
2
Etwatwa Limited
Statement of financial position at 31 December 2013
R'OOO
ASSETS
Non-current assets
Property and plants 3806
Vehicles 260
Total non-current assets 4532
Current assets
Inventories 600
Trade and other receivables 730
Total current assets 1608
Total assets 6540
EQUITY AND LIABILITIES
Equity attributed to owners
Share capital 1616
Total equity 3640
Non-current liabilities
Deferred tax 390
Total non-current liabilities 1934
Current liabilities
Total current liabilities 966
Total liabilities 2900
Total equity and liabilities 6540
37
CHAPTER 2 UNDERSTANDING FINANCIA L STATE M ENTS
APPENDIX TO CHAPTER 2
The table below sets out a few accounts listed in a chart of accounts
Account category Account title Account number

Assets 01-00-000
Non-current 01-01-000
Land 01-01-001
Equipment 01-01-002
Current 01 -02-000
Cash 01 -02-001
Accounts receivable 01 -02-002
Inventory 01-02-003
Liabilities 02-00-000
Long term 02-01 -000
Mortgage loan 02-01-001
Current 02-02-000
Accounts payable 02-02-001
Equity 03-00-000
Share capital 03-01 -000
Ordinary share capital 03-01-001
Revenue 04-00-000
Trade revenue 04-01 -000
Sales 04-01 -001
Investment income 04-02-000
Interest earned 04-02-001
Expenses 05-00-000
Purchases 05-01 -001
38
CHAPTER THREE
THE ANALYSIS OF
FINANCIAL
STATEMENTS
What's the problem?

The Association of Mineworkers and Construction Union (AMCU) declared a strike at Lonmin
Mines in the Rustenburg area of South Africa on 23 January 2014. Underground workers were
demanding a minimum salary of RI 2500 per month. At the time they were earning between
RS 000 and R6 000 per month. Owing to unemployment in South Africa, there was an oversupply
of workers who were prepared to work underground in order to make a living. The mine offered
a 9% salary increase - well above the inflation rate of approximately 6%. Owing to a lack of finan-
cial literacy, many mine workers had entered into loans with so-called " loan sharks" and were
paying 3% interest per month (36% per year) on unsecured loans. This left them with hardly any
earnings per month in order to pay their other living expenses. The strike dragged on for several
months - the longest and most costly strike in the history of South Africa.
Platinum is used by the motor manufacturing industry as a catalytic converter in the exhaust
systems of vehicles. It assists in converting gases such as carbon monoxide into less-harmful carbon
dioxide and water vapour. South Africa has 80% of the world's reserves of platinum, and at the
time produced 90% of world demand. Anglo American Platinum Ltd (Amplats) alone was respon-
sible for producing 40% of world output. Other platinum mining companies operating in South
Africa are BHP Billiton Ltd and Lonmin pie. Lonmin is a publicly listed company (pie) in the UK.
Mpho attended his graduation ceremony barely two months after the strike had commenced.
He majored in Industrial Psychology and Human Resource Management, and particularly enjoyed
the modules in Labour Relations and Labour Law.
He has always wanted to join a platinum mine as an HR practitioner. These mines require multi
million rand investments and it is difficult to enter the industry without major capital and years of
exploration prior to the commencement of actual mining operations. This, in his mind, makes it a
fairly secure industry from a sustainability point of view.
However, now he is no longer so sure. Will he be able to discuss t heir financial demands if he
does not fully understand the financial statements of Lonmin pie? How could the figures and ratios
of Lonmin be compared to those of Amplats, BHP Billiton and others? T he Chief Financial Officer
(CFO) would not be at the negotiations all the time and he could be expected t o lead some of t he
negotiations on behalf of Lonmin pie.
39
Question: What could Mpho do in order to better negotiate with the labour unions and to assess
the impact of their demands on the profitability and sustainability of the firm?
CHAPTER 3 THE ANALYSIS OF FINANCIAL STATEMENTS
3.1 INTRODUCTION
The purpose of financial analysis is either to evaluate the financial performance and
position of the firm during the previous accounting period, or to evaluate the future
plans of the firm based on the budgeted (or so-called pro forma) statement of financial
performance (income statement) and statement of financial position (balance sheet).
The primary inputs in financial analysis (or ratio analysis as it is sometimes called)
are the firm's statement of financial performance and statement of financial position
for the periods under evaluation. The data provided by these statements can be used
to calculate various ratios that make it possible to evaluate certain aspects of financial
performance and position.
This chapter explains the calculation and interpretation of the more commonly used
ratios, and the possible corrective action management may consider. You may think of
the calculation and interpretation of the ratios as the "diagnosis" of the firm's condition,
and the corrective action as the "prognosis" or potential for recovery. Attention will
first be given to the types of comparisons that can be made.
3.2 TYPES OF COMPARISONS

Ratio analysis is not simply a matter of applying a formula to financial data in order
to calculate a given ratio. More important is the interpretation of the ratio. To answer
questions such as: "Is it too high or too low?" or "Is it good or bad?': a meaningful
benchmark or basis for comparison is needed. Two types of comparisons can be made,
namely industry comparative and time-series analysis.
3.2.1 Industry comparative analysis

Industry comparative analysis involves the comparison of the financial ratios of dif-
ferent firms at the same point in time. The typical business firm is interested in how
well it has performed in relation to its competitors. This is also called a "benchmarking
approach'', because the firm's performance can be compared either to that of the indus-
try leader or to industry averages.
The analyst must recognise that ratio comparisons resulting in large deviations
from the norm are only a symptom; further analysis of the firm's financial statements,
coupled with discussions with key managers, is generally required to isolate the cause
of such symptoms and to develop corrective actions. The fundamental issue is that
ratio analysis merely directs the analyst to potential areas of concern. It does not
provide conclusive evidence that a problem exists or that management has made an
outstanding effort.
40 3.2.2 Time-series analysis

Time-series analysis is undertaken when a financial analyst evaluates the performance
of a firm over time. Comparison of current with past performance utilising ratio
THE ANALYSIS OF FINANCIAL STATEME NTS
3
analysis allows the firm to determine whether it is progressing as planned. As in indus-
try comparative analysis, any significant year-to-year changes should be evaluated to
assess whether they are symptomatic of major problems.
The most informative approach to ratio analysis is one that combines industry com-
parative and time-series analyses.
Before discussing specific ratios, some words of caution are necessary regarding the use
of ratios.
3.3 CAUTION WHEN USING RATIOS

Firstly, a single ratio generally does not provide sufficient information to allow one to
judge the overall performance of the firm; only when a group of ratios is used do realis-
tic judgements become possible. It is also sensible to take the competitive environment
and the economic conditions into account. These are normally reviewed in the finan-
cial statements as part of the directors' report.
Secondly, an analyst should be sure that the dates of the financial statements being
compared correspond. If not, the effects of seasonality may lead to incorrect conclusions.
Thirdly, it is best to use audited financial statements, otherwise the data might not
reflect the firm's true financial performance and position.
Fourthly, care should be taken not to adopt a "bigger is better" approach, which
could be misleading. Quite often, a ratio value that has a large but positive deviation
from the norm may signal problems that may, upon more careful analysis, be more
severe than would have been the case had the ratio been below the industry average.
Finally, it is important to make sure that the data being compared have been devel-
oped in the same way. The use of different accounting treatments - especially regarding
depreciation and inventory - may distort the results of ratio analysis, regardless of the
method applied.
3.4 BASIC FINANCIAL RATIOS

Financial ratios can be divided into the following five basic groups:
1. Profitability ratios
2. Liquidity ratios
3. Activity ratios
4. Debt (or solvency) ratios
5. Securities market ratios
These ratios are all explained in this chapter, using figures from the statement of financial
performance and statement of financial position contained in Table 3.1 and Table 3.2
respectively. 41
CHAPTER 3 THE ANALYSIS OF FINANCIAL STATE M ENTS
Table 3 . 1 Example of a statement of financial performance
Statement of financial performance for the year ended 28 February 20 14

Sales 9000000
Less: cost of goods sold 4500000
Gross profit 4500000
Less: operating expenses 3090000
Operating profit 1410000
Less: interest expense 24000
Net profit before tax I 386000
Less: tax (28%) 388080
Net profit after tax 997920
Net profit distributed as follows:
Dividends to ordinary shareholders 277200
997920
Table 3.2 Example of a statement of financial position
Statement of financial position as at 28 February 2014

Fixed assets 7 500000 Shareholders' interest:
Current assets: Ordinary shares 5000000
Cash 100000 Retained earnings I 000000
Accounts receivable 900000 Long-term debt 1900000
Inventory 600000 Current liabilities:
Accounts payable I 200000
Total assets 9 I 00000 Equity and liabilities 9 100000
Additio nal information:
• Number of ordinary shares issued: 2500000 at 200 ce nts each
• Current market price of the share: 350 cents
3.4. 1 Profitability ratios

There are many measures of profitability, all of which relate the returns of the firm
to its sales, assets or equity. As a group, these measures allow the analyst to evaluate
the effectiveness and efficiency of the firm's management and employees in generat-
ing profit by means of sales, and the productive use of assets and of the capital of the
owners. Without profits, present owners and creditors would become concerned about
the company's survival due to the negative impact of losses on the firm's liquidity and
solvency.
Typical measurements of the profitability of firms are the following:
• Gross profit margin
• Net profit margin
42 • Return on investment (ROI)
• Return on equity (ROE) or return on net assets (RONA)
Each of these ratios is now explained.
3
The gross profrt margin
The gross profit margin is calculated as follows:
Gross profit margin = sales - cost of goods sold x 100

sales 1
The gross profit margin indicates the contribution from the firm's core business towards
covering the firm's operating expenses. Core business refers to the excavation of metals
and minerals (in the case of mining firms), the manufacturing of goods (in the case of
manufacturing firms), and buying and selling (in the case of retail firms). Examples of
operating expenses are advertising, salaries, interest paid, maintenance, depreciation,
insurance and taxes. The gross profit must be sufficient to enable the firm to pay its
operating expenses, and hence the greater the gross profit margin, the better the firm's
ability to cover its operating expenses.
Example
Based on the financial statements provided in Tables 3. 1 and 3.2, the gross profit
margin may be calculated as follows:
Gross profit margin = R4 500 000 x I 00 = SO%

R9000000 I
The gross profit margin is not the same as the mark-up percentage of the firm, although
it is indicative of this. For a firm to achieve a certain gross profit margin, an appropriate
mark-up percentage based on cost is required.
Example
The cost price of a firm 's product is RI 00 and the firm wishes to achieve a gross profit
margin of 50%. To achieve this, the firm needs to mark up and sell each product at R200:
Gross profit margin = R200 - RI 00 x I 00 = 50%

R200 I
From the above calculations it should be evident that gross profit is influenced by the
sales level and the cost of goods sold.
Corrective action
43
If a firm's gross profit margin is not satisfactory, management could consider increasing
income from sales and/or decreasing expenses. More specifically, management should
consider the following:
• Increase sales through improved marketing. This might include changes to the
product, price, promotion and distribution of the product.
• Procurement and material managers could lower the levels of inventory.
• Attempt to produce at a lower cost (in the case of mining and manufacturing firms)
or to buy at better prices (in the case of retailing firms). The latter may include
importing goods.
• Produce fewer quantities (in the case of mining and manufacturing firms) or buy
less stock (in the case of retailing firms) during periods of declining sales.
The net profit margin

The net profit margin measures the percentage of each sales rand remaining after all
expenses, including taxes, have been deducted.
Net profit margin = net profit after tax x 100

sales 1
Example
Based on the statement of financial performance in Table 3. 1, the firm 's net profit margin
may be calculated as follows:
Net profit margin = R997 920 x I 00 = I I .09%

R9000000 I
The higher the net profit margin, the better. The net profit margin is a commonly cited
measure of a firm's success with respect to earnings on sales.
Corrective action
If a firm's net profit margin is not satisfactory, management could consider increasing
income from sales and/or decreasing expenses. More specifically, management should
consider the following:
• Increase sales through more efficient and effective marketing.
• Reduce expenses. This may be done by determining the percentage of sales absorbed
by each type of expense, ranking it from the greatest to the lowest, and considering
reductions in each type of expense, starting with the greatest expenses.
The return on investment

The return on investment (ROI), sometimes also called return on assets (ROA), mea-
sures the overall effectiveness of management in generating profits with its available
44 assets. The greater the firm's return on investment, the better. The return on investment
is calculated as follows:
3
ROI= net profit after tax x 100
total assets 1
Example
Based on the financial statements in Tables 3.1 and 3.2, the firm's ROI may be
calculated as follows:
ROI= R997920 x 100 = 10.97%

R9 I00000 I
The above value appears unacceptable, but only when it is compared with an industry
average of, for example, 20%. This figure may also be compared to the firm's cost of
capital (or required rate of return). If the firm's cost of capital amounts to 18%, then
corrective action will have to be taken.
Corrective action
If a firm's ROI is not satisfactory, management could consider the following:
• Increase revenue by increasing sales or the price of goods and services.
• Lower the operating expenses, such as salaries, by retrenching some of the employees.
• Reduce the investment in current assets, such as inventory and accounts receivable
during periods of declining sales.
• Evaluate the effectiveness and efficiency of the fixed assets with a view to improving
productivity and/or unbundling business units with low or no profitability.
• Improve the effectiveness and efficiency of employees through training. This, how-
ever, would only have a positive influence in the medium to long term.
The return on equity

The ROE measures the return earned on the owners' investment.
ROE = net profit after tax x 100

shareholders' equity 1
Alternatively:
ROE = net profit x sales X total assets X 100

sales total assets shareholders' equity 1
The ROE is therefore determined by three variables, namely profitability (the net profit
margin), activity (asset turnover) and leverage (also called gearing) . Leverage or gear-
ing is the extent to which debt is used to finance the firm.
45
The value in the example overleaf appears to be unacceptable when the comparison
is with an industry average of, say, 20% or the firm's cost of capital of, say, 18%.
Example
Based on the figures from the financial statements in Tables 3.1 and 3.2, the ROE may
be calculated as follows:
ROE = R997 920 x I 00 = 16.6%

R6000000 I
Corrective action
If a firm's ROE is not satisfactory, then management could consider the following:
• Increase revenue by increasing sales or the price of goods and services.
• Lower the operating expenses.
• Improve marketing to improve the asset turnover rate.
• Increase the leverage (gearing) by making greater use of debt to finance the firm.
This may include buying back some of the firm's ordinary shares. The amount
needed to buy back the shares may be obtained by selling debentures (or bonds) or
raising long-term loans.
The return on net assets (RONA) is closely related to ROE. This may be calculated as
follows:
RONA = net profit X 100

total assets - liabilities 1
RONA is an ideal tool in situations where the amount of equity has to be determined
by means of the accounting equation. An example would be if the Newcastle plant of
Mittal Steel Ltd wanted to determine the return generated for ordinary shareholders.
Mittal Steel Ltd can determine its equity for the firm as a whole, but Mittal Newcastle
can only determine its equity by using the book value of the Newcastle assets (after
depreciation) minus its liabilities.
3.4.2 Liquidity ratios

The liquidity of a business firm is measured by its ability to satisfy its short-term obli-
gations as they become due. Liquidity can be measured by calculating net working
capital, current ratio and the quick (acid-test) ratio.
Net working capital

This is calculated by subtracting current liabilities from current assets.
46 Net working capital = current assets - current liabilities
Sometimes net working capital is also referred to as net current assets.

THE ANALYSIS OF FINANCIAL STATEMENTS
3
Example
The net working capital for the firm being studied (the financial statements of which
can be seen in Tables 3. 1 and 3.2) is as follows:
Net working capital = RI 600 000 - RI 200 000 = R400 000
The above figure is not useful for comparing the performance of different firms, but it
is quite useful for internal purposes. Often the contract under which a long-term debt
is incurred requires that a minimum level of net working capital be maintained by the
firm. This requirement is intended to force the firm to maintain sufficient liquidity, and
reduces the risk to which the creditor is exposed. On the other hand, the firm itself can
set a certain level of net working capital to reduce the risk of not being able to pay its
accounts as they come due.
Corrective action
If a firm's net working capital is not satisfactory, management could consider the
following:
• Accelerate cash inflow by offering cash discounts for early settlement of debtors'
accounts or factoring accounts receivable (these measures are explained in Chapter 8).
• Buy fewer goods on credit (as long as the firm has adequate cash inflow) in order
to reduce the current liabilities.
• Decrease inventory by selling more goods, thus improving sales and increasing
cash or accounts receivable. The firm will, however, have to manage accounts
receivable well to prevent losses due to bad debts.
• Increase current assets by increasing the level of ending inventory, as long as the
inventory can be sold soon after the commencement of the new accounting period.
Current ratio
The current ratio is one of the most commonly cited financial ratios and is expressed
as follows:
Current ratio = current assets
current liabilities
Example
The current ratio for the data of the firm as indicated in Tables 3.1 and 3.2 is as follows:
Current ratio = RI 600 000 = 1.33
RI 200000
47
This means the firm has only RI .33 (in cash, accounts receivable and inventory) for
every one rand owed to creditors.
A current ratio of 2.0 is usually cited as an acceptable value. However, this depends
on the industry in which a firm operates. For example, a current ratio of 1.0 could be
considered acceptable in the service industry, but might be unacceptable for a manu-
facturing firm. Acceptability depends on the predictability of the firm's cash flows. The
more predictable the cash flows, the lower the acceptable current ratio will be.
If the figure of 1 is divided by the firm's current ratio and the resulting quotient is
subtracted from 1, the difference multiplied by 100 represents the percentage by which
the firm's current assets can shrink without making it impossible for the firm to cover its
current liabilities. For example, a current ratio of 2.0 means that the firm would still be
able to cover its current liabilities ifits current assets shrank by 50% ([l - (1 + 2)] x 100).
A final point worthy of note is that whenever a firm's current ratio is 1.0, its net
working capital is zero. If a firm has a current ratio of less than 1.0, it will have a nega-
tive net working capital. Net working capital is a useful indicator only when comparing
the liquidity of the same firm over time and should not be used for comparing the
liquidity of different firms; the current ratio should be used instead.
Corrective action
If a firm's current ratio is not satisfactory, management could consider the following:
• Increase current assets by increasing the level of ending inventory, as long as the
inventory can be sold soon after the commencement of the new accounting period.
Quick (acid-test) ratio

The quick (acid-test) ratio is similar to the current ratio except that it excludes inven-
tory from current assets. Inventory takes longer than accounts receivable to be con-
verted into cash; in other words, it does not have the same liquidity. As a result, the
inventory is not used in this ratio. The basic assumption of the quick ratio is that inven-
tory is generally the least liquid current asset and should therefore be excluded. The
quick ratio is calculated as follows:
Quick ratio = current assets - inventory

current liabilities
48
3
Example
The quick ratio for the data of the firm as indicated in Tables 3. 1 and 3.2 is 0.83:
Quick ratio= RI 600000- R600000 = 0.83

RI 200000
A quick ratio of 1.0 or greater is usually acceptable, because it means the firm has at
least RI in cash and accounts receivable available to cover each rand of its accounts
payable. Again, the acceptability of the value depends largely on the industry. In gen-
eral, this ratio provides a better measure of overall liquidity only when a firm's inven-
tory cannot easily be converted into cash. If the inventory is fairly liquid, the current
ratio is preferable as a measure of overall liquidity.
Corrective action
If a firm's quick ratio is not satisfactory, management could consider the following:
3.4.3 Adivity ratios

Activity ratios are used to measure the speed with which various accounts are con-
verted into sales or cash. Measures of overall liquidity are generally inadequate because
differences in the composition of a firm's current assets and liabilities may significantly
affect the firm's "true" liquidity.
A number of ratios are available for measuring the activity of the most important
current accounts, which include inventory, accounts receivable and accounts payable.
The activity of fixed and total assets can also be assessed. A basic simplifying assump-
tion used in many of the calculations is that there are 360 days in the year and 30 days
in each month.
Inventory turnover
The activity, or liquidity, of a firm's inventory is commonly measured by its turnover. 49
This is calculated as follows: t ~
~~
j~
@
Inventory turnover = cost of goods sold

average inventory
The average inventory may be found thus:
(beginning inventory+ ending inventory)--;- 2
Example
The inventory turnover of the firm as indicated in Tables 3. 1 and 3.2 is 7.5 times per
annum (assuming the average inventory is R600000) :
Inventory turnover = R4 500000 = 7.5 times p.a.

R600000
The turnover is meaningful only if it is compared with that of other firms in the same
industry or with the firm's inventory turnover performance in the past. An inventory
turnover of 30 would not be unusual for a grocery store, whereas a common inventory
turnover for an aircraft manufacturer would be 1. Differences in turnover rates result
from the differing operating characteristics of various industries.
For each industry, there is a range of inventory turnover figures that may be con-
sidered good. Values below this range may signal illiquid or inactive inventories, while
values above this range may indicate insufficient inventories and high stock-outs.
Corrective action
If a firm's inventory turnover is not satisfactory, management could consider lowering
inventory levels. The marketing management could organise specials and sales (in the
case of retail firms) and/or procurement managers would need to buy smaller quanti-
ties of goods. Equally important, material managers would need to ensure lower levels
of inventory in the case of manufacturing firms.
Average collection period

The average collection period (ACP), or average age of accounts receivable, is useful for
evaluating credit and collection policies. It is determined by dividing the average daily
credit sales into the accounts receivable balance.
ACP = accounts receivable
annual sales --;- 360
This equation assumes a 360-day year.
50
3
Example
The average collection period for the firm in our example is as follows:
ACP = R900000 = 36 days

R9000000..,.. 360
On average, it takes the firm 36 days to collect an account receivable.
The average collection period is meaningful only in relation to the firm's credit terms.
If the company being studied extends one-month (30-day) credit terms to customers,
an average collection period of 36 days would indicate a poorly managed credit or
collection department, or both. If it extended 60-day credit terms, the 36-day average
collection period could be acceptable.
The important thing to realise here is that due to the time value of money and the
opportunity cost concept, the firm is losing interest because of cash that is tied up in
accounts receivable - cash that could have been invested elsewhere (such as a 30-day
fixed deposit) to earn interest - or the firm may be paying interest on an overdraft in
order to finance the accounts receivable.
Corrective action
If a firm's average collection period is not satisfactory, management could consider
doing the following:
• Increase cash sales, thereby reducing sales on credit and lowering the accounts
receivable.
• Offer discounts for early settlement to debtors, thus accelerating the collection
period.
• Factor all or part of the accounts receivable - this will improve cash flow, but will
reduce the profitability of the firm due to the fees charged by the factoring firm.
• Send out account statements earlier and ensure that mistakes in them are kept to a
minimum.
• Charge interest on overdue accounts.
Average payment period

The average payment period (APP) is determined by dividing the average daily credit
purchases into the accounts payable balance.
APP = accounts payable
annual purchases on credit + 360
51
This equation assumes a 360-day year.
Example
The average payment period for the firm is as follows (assume credit purchases
amounted to R4400000)
APP= RI 200000 = 98 days

R4400000-,- 360
On average, it takes the firm 98 days to pay its accounts payable.
The average payment period is meaningful only in relation to the credit terms provided
by suppliers. If the company being studied were granted 90 days' credit by suppliers, an
average payment period of 98 days would indicate that the creditors are being paid late.
Corrective action
If a firm's average payment period is not satisfactory, and to prevent suppliers from
changing their terms to cash on delivery, the firm would have to investigate the reasons
for late payment and attempt to ensure prompt payment. One of the reasons for late
payment might be incorrect invoices and account statements.
3.4.4 Measures of debt

The debt position of a firm indicates the amount of other people's money that is being
used in the attempt to generate profits. It therefore provides an indication of the sol-
vency of the firm.
Typically, the financial analyst is most concerned with long-term debts, since these
commit the firm to paying interest over the long run and eventually to repaying the
borrowed funds. Since the claims of creditors must be satisfied before earnings can be
distributed to shareholders, present and prospective shareholders pay close attention to
the extent of a firm's indebtedness and its ability to repay debts. Lenders are also con-
cerned about these matters since the more indebted the firm, the higher the probability
that it will be unable to satisfy the claims of all its creditors. Obviously, management
must be concerned with indebtedness in recognition of the attention paid to it by other
parties and in the interest of keeping the firm solvent.
In general, the greater the extent to which a firm makes use of debt, the greater its
financial leverage. Financial leverage is a term used to describe the magnification of
risk and return introduced through the use of fixed-cost financing, such as debt and
preference shares. The more debt or financial leverage a firm uses, the greater its risk
and required return will be.
When measuring the extent of a firm's indebtedness, only statements of financial
52
position data are generally used. Two of the most commonly used measures are the
debt ratio and the debt-equity ratio.
3
The debt ratio
The debt ratio measures the proportion of total assets provided by the firm's creditors.
The higher this ratio, the greater is the amount of other people's money being used in
an attempt to generate profits. The ratio is calculated as follows:
Debt ratio = total liabilities x 100

total assets 1
Example
The debt ratio for the firm as indicated in Tables 3. 1 and 3.2 is 34.07%:
Debt ratio= R3 100000 x 100 = 34.07%

R9 100000 I
This indicates that the firm has financed 34.07% of its assets with debt.
The higher this ratio, the more financial leverage the firm has. This figure is of particu-
lar importance during periods of rising interest rates. Higher interest rates result in
larger instalments on loans (and leases), which means that the firm will have to ensure
that it generates sufficient cash inflow in order to cover the increased instalments. If the
firm sells a product (such as clothing or furniture) to consumers, then an increase in
interest rates will lower the disposable income of the consumers, which may lead to a
drop in sales and cash inflow, as well as an increase in bad debts.
Corrective action
If a firm's debt ratio is too high, management could consider the following:
• Issue new ordinary shares, as long as this is done by means of a rights issue to pre-
vent dilution of the shareholding of current shareholders - the equity raised in this
fashion may be used to replace long-term loans.
• Reduce the current liabilities by accelerating cash inflow and use this to pay off
creditors or any overdraft the firm might have.
If a firm's debt ratio is too low, management could consider these measures:
• Buy back some of its ordinary shares by raising long-term loans or selling bonds/
debentures to pay for the shares. This reduces the number of ordinary shares issued,
lowers the supply of shares and could increase the share price. It also results in an
increase in earnings per share due to the smaller number of ordinary shares, and
could lower the cost of capital. This is explained in greater detail in Chapter 7.
• Increase purchases of goods on credit from suppliers. 53
The debt-equity ratio

The debt-equity ratio indicates the relationship between the long-term funds provided
by creditors and those provided by the firm's owners. It is commonly used to measure
the degree of financial leverage of the firm and is defined as follows:
Debt-equity ratio= long-term debt x 100

shareholders' equity 1
Example
For the firm as indicated in Tables 3.1 and 3.2, the debt-equity ratio is 31.67%:
Debt-equity ratio= RI 900000 x 100 = 31.67%

R6000000 I
The firm 's long-term debts are therefore only 31.67% as large as owners' (shareholders')
equity.
This figure is meaningful only if viewed against the background of the nature of the
firm's business. Firms with large numbers of fixed assets, stable cash flows, or both,
typically have high debt-equity ratios, while less capital-intensive firms, or those with
volatile cash flows, or both, tend to have lower debt-equity ratios. The industry average
will generally provide a good basis for comparison of the debt-equity ratio.
Corrective action
If a firm's debt-equity ratio is too high, management could consider issuing new ordi-
nary shares, as long as this is done by means of a rights issue to prevent dilution of the
shareholding of current shareholders. The equity raised in this fashion m ay be used to
replace long-term loans.
If a firm's debt-equity ratio is too low, management could consider buying back some
of its ordinary shares by raising long-term loans or selling bonds/debentures to pay
for the shares. This reduces the number of ordinary shares issued, lowers the supply of
shares and could increase the share price. It also results in an increase in earnings per
share due to the smaller number of ordinary shares, and could lower the cost of capital.
This is explained in greater detail in Chapter 7.
3.4.5 Securities market ratios

The ratios discussed in this section, namely the earnings per share (EPS), dividend p er
share (DPS), dividend yield (DY) and price-earnings ratio (PIE ratio), are only appli-
54 cable to companies listed on a securities exch ange such as the JSE.
3
Earnings per share
EPS measures the return earned on behalf of each ordinary share that has been issued.
It is usually carefully monitored by investment analysts and portfolio managers. EPS is
EPS = earnings after tax - preference dividend ..;- number of ordinary shares
issued
Example
Using the figures from Table 3.2 and assuming that 2 500 000 ordinary shares were
issued at a par value of R2 each, the EPS may be found as follows:
EPS = R997 920 = 40 cents

2500000
EPS does not represent the amount of earnings actually distributed to shareholders.
The earnings distributed to ordinary shareholders are reflected by the dividend per
share.
Corrective action
If a firm's EPS is too high, management could consider issuing new ordinary shares, as
long as this is done by means of a rights issue to prevent dilution of the shareholding
of current shareholders. The equity raised in this fashion may be used to replace long-
term loans. In this regard, management could also use share dividends - that is, pay
existing shareholders a dividend in the form of new ordinary shares.
If a firm's EPS is too low, management could consider the following:
• Buy back some of its ordinary shares by raising long-term loans or selling bonds/
debentures to pay for the shares. This reduces the number of ordinary shares issued,
lowers the supply of shares and could increase the share price. It also results in an
increase in EPS due to the smaller number of ordinary shares, and could lower the
cost of capital. This is explained in greater detail in Chapter 7.
• Improve the profitability of the firm through better marketing and/or reducing
expenses.
• Discontinue the use of preference share financing, if possible.
Dividend per share

DPS is calculated as follows:
DPS = dividends for ordinary shareholders 55
number of ordinary shares issued
Example
The dividend per share for the firm as indicated in Tables 3. 1 and 3.2 is I I cents:
DPS = R277200 = 11 cents

2500000
Investors tend to prefer to invest in the shares of companies with good prospects,
particularly if increases in the EPS and DPS are expected to be announced in the
financial statements.
Corrective action
If a firm's DPS is too high, management could consider declaring a lower dividend
and/or reducing the number of ordinary shares. If a firm's DPS is too low, it will have
to improve profitability and/or reduce the number of ordinary shares.
Price-earnings ratio
The PIE ratio is calculated as follows:
PIE ratio= current market price per ordinary share
earnings per share
Example
For the firm as indicated in Tables 3.1 and 3.2, the P/E ratio is 8.75:
P/E ratio = 350 cents = 8.75

40 cents
A P/E of 8.75 means that investors are paying R8.75 for each RI of earnings. It could also
be seen as the number of years it will take for the earnings to equal the current market
price. Clearly, different investors will set their own limits of what they would find
acceptable and will buy shares accordingly.
Some investors also multiply the PIE by the expected EPS to find a rough approxima-
tion of the value of an ordinary share.
Corrective action
56 Management has no direct control over the market price of the shares of the firm. If the
PIE is too low, management will have to focus on improving profitability and lowering
the cost of capital (if possible) in order to improve the firm's ability to create value and
attract investors' interest.
3
Earnings yield
The earnings yield indicates the current income-producing power per ordinary share at
the current market price. This is the opposite of the PIE ratio.
Earnings yield = earnings per share x 100

current market price 1
Example
Using the figures for the firm indicated in Tables 3. 1 and 3.2 gives an earnings yield of
11.4%:
Earnings yield = 40 x I 00 = I I .4%

350
Corrective action
The earnings yield may be improved by increasing profitability and using leverage to
reduce the number of shares, thus increasing the earnings per share.
Dividend yield
The EPS is not all paid out to shareholders, but rather the dividends per share is the
actual cash flow shareholders receive - that is, the DY (dividend yield).
DY = dividends per share x 100
current market price 1
Example
Using the figures for the firm indicated in Tables 3.1 and 3.2, the DY is 3%:
Dividend yield = _I_I x I 00 = 3%

350
Corrective action
A firm that needs to improve its DY must improve its profitability.
57
3.S SUMMARY
Financial ratios may be used to evaluate the profitability, liquidity, activity and solvency
of a firm.
A firm applying for finance from a bank may be required to submit its financial
statements and a business plan. These will be analysed by means of financial ratios in
order to assess the firm's ability (capacity) to repay any loans, overdrafts or leases.
A variety of financial ratios can be used to evaluate a firm's performance. On the
whole, a single ratio does not provide sufficient information to judge the overall perfor-
mance of a firm; a group of ratios is generally required. The most accurate comparisons
are obtained if ratios are consistently applied to similar time periods. The use of audited
financial statements is strongly recommended, as well as the assistance of an accoun-
tant and/or financial manager to calculate and interpret the different ratios.
REFERENCES
Becker, H . 2002. How to read financial statements, 3rd ed. Lansdowne: Juta.
Gitman, L.J. 2009. Principles of managerial finance, 12th ed. New York: Pearson.
Marx, J. & De Swardt, C.J. 2013. Financial m anagement in southern Africa, 3rd ed. Cape Town: Pearson.
Self-test question
A firm has the following financial ratios for the past year:
Type of ratio Ratio Industry average

Gross profit margin 50% 42%
Net profit margin 22% 15%
Return on investment (ROI) 18% 12%
Return on equity (ROE) 11% 10%
Net working capital RI 868000 R865443
Current ratio 4.1 1.9
Quick ratio 3.2 I. I
Average collection period* 29 42
Debt ratio 14% 40%
Debt-equity ratio 10% 35%
Earnin~s per share (EPS) 92 cents 115 cents
Price/earnings ratio (P/E) 17 14
Current market price per share I 564 cents I 610 cents
*Standard credit terms require payment in 30 days.
Evaluate the profitability, liquidity and solvency of the above-mentioned firm by inter-
preting each ratio and suggesting appropriate courses of action.
58
3
Profitability
The firm is profitable as evidenced by the gross profit, net profit and ROI figures. The
ROE can be improved by increasing financial leverage (gearing).
Liquidity
The firm has too much liquidity. The firm is a takeover target, because it could be bought
and the statement of financial position restructured to include more debt financing;
certain assets may be sold and the company could be resold to make a capital gain. The
firm could consider paying out bigger dividends if no investment opportunities are
available. Alternatively, the firm should make investments in new capital projects or
take over similar firms to reduce competition.
Solvency
The firm is solvent, but too little financial leverage (gearing) is applied, as mentioned
above.
Securities market ratios
The EPS could be improved by reducing the number of ordinary shares, which could
also improve the PIE ratio. The firm needs to use its capital more efficiently and pro-
ductively.
59
CHAPTER FOUR
PROFIT PLANNING
AND CONTROL
What's the problem?

By all outward appearances, Mr Ferreira is a CEO of a successful renovation company. He
owned his own office building, which he leased to the company that housed his renovation
activities (he owned all shares in the company). His company generated annual revenues
of more than RS 000 000 and paid him an annual salary of RI 300 000.
However, Mr Ferreira recently received a registered letter from the South African Rev-
enue Service (SARS) threatening to impound his business and sell its assets due to the
company's failure to pay payroll taxes for the past seven months. In addition, the company
has had difficulty paying its suppliers. The company owed one of its suppliers more than
R800000, and had agreed and arranged to pay interest, but Mr Ferreira missed the pay-
ments. These same kinds of difficulties have been experienced repeatedly for the past
three years.
In the past, Mr Ferreira had solved similar problems by borrowing money on the equity
in either his personal residence or his office building in order for additional capital to be
infused into the company. This time, however, Mr Ferreira was determined to get to the
root of the cash flow difficulties encountered by his company. He consequently contacted
Mr Peterson, a financial manager at a local certified private accounting firm, and requested
a consultant to look into the matter and determine the cause of the company's recurring
financial difficulties.
Question: What dilemma does the firm face and what solutions are needed?
4.1 INTRODUCTION
Profit planning and control are vital in assuring the profitability of a firm. A firm needs
to keep costs under control and increase revenue as much as possible by means of effec-
tive marketing. 61
Profit planning and control are short-term aspects of financial management and are
done in most business organisations by means of budgets. A budget can be seen as a
formal written plan of future action, expressed in monetary terms and aimed at achiev-
CHAPTER 4 PROFIT PLANNING AND CONTROL
ing the objectives of the business with limited resources. As a result of these limited
resources, the firm needs to set priorities when allocating them. The firm's mission,
objectives and goals help managers determine the priorities of the firm.
Profit planning and control start by estimating the expected sales of the firm. A firm
cannot simply use the previous year's actual expenditure as the point of departure and
effect minor adjustments to make provision for changing circumstances, such as infla-
tion. Such adjustments create a built-in bias towards continuing the same activities year
after year without critically re-evaluating priorities and possible changes in the external
and internal environments.
Profit planning and control may be carried out by comparing the actual results with
the planned (budgeted) results periodically or on a continuous basis. In this way, devia-
tions can be identified and corrective action taken in time.
Before further elaborating on profit planning and control and the budgeting process,
it is necessary to look at the meaning and purpose of management accounting as well as
differentiating management accounting from financial accounting. The management
accountant is responsible for the profit-planning and control process, and therefore
this requires further attention.
4.2 MANAGEMENT ACCOUNTING VERSUS FINANCIAL

ACCOUNTING
There are two basic kinds of accounting information systems: management accounting
and financial accounting.
• Financial accounting is concerned with producing information for external users.
The general objective is the preparation of external reports (financial statements)
for investors, creditors, government agencies and other external users. This infor-
mation is used for investment decisions, monitoring organisational performance
and regulatory measures.
• Management accounting produces information for internal users, such as man-
agers, executives and employees. The management accounting system identifies,
collects, measures, classifies and reports information that is useful to internal users
in planning, controlling and decision making. Management accounting therefore
has three broad objectives:
- To provide information for costing out products and services
- To provide information for planning, controlling and continuous improvement
• To provide information for decision making
A number of differences exist when comparing management accounting to financial
accounting, the most important of which are summarised in Table 4.1.
62
PROFIT PLANNING AND CONTROL
4
Table 4.1 Management accounting versus financial accounting
Management accounting Financial accounting

Internally focused Externally focused
No mandatory rules Must follow externally imposed rules
Emphasis on the future Historical orientated
Broad, multidisciplinary More self-contained, focused
• Intended users. As mentioned, management accounting focuses on providing

information for internal users, while financial accounting focuses on providing
information for external users.
• Restrictions on inputs and processes. The inputs and procedures of financial
accounting are well defined and restricted. Only certain kind of economic events
qualify as inputs, and processes must follow generally accepted methods. Manage-
ment accounting has no official body that prescribes the format, content and rules
for selecting inputs and procedures, and in preparing financial reports. Manage-
ment accountants therefore have the freedom to choose whatever information they
want to use - provided it can be justified on a cost -benefit basis.
• Time orientation. Financial accounting has a historical orientation. It recognises
records, and reports events that have already occurred. Although management
accounting also does so, it places strong emphasis on the provision of information
about future events. For example, if the management of a company wants to know
what it will cost to produce a product next year, this information assists in planning
material purchases and making pricing decisions.
• Breadth/extent. Management accounting is much broader than financial account-
ing. It includes aspects of managerial economics, industrial engineering and man-
agement sciences, to name but a few. A management accountant therefore has a
holistic approach when evaluating the performance of an organisation, having the
knowledge, appreciation and ability to apply a wide spread of skills in order to
manage the financial wellbeing of an organisation.
4.3 INFORMATION NEEDS OF MANAGERS AND OTHER USERS

Management accounting information is needed by a number of individuals. In particular,
managers and empowered employees need comprehensive, up-to-date information for
the following three activities, which include planning, controlling and decision making.
• The detailed formulation of action to achieve a particular end is the management
activity called planning. After a plan is created, it must be implemented, and this
must be monitored by managers and workers to ensure that the plan is being car-
ried out as intended.
63
• The managerial activity of monitoring a plan's implementation and taking cor-
rective measures when required is referred to as controlling. Control is usually
achieved by comparing actual with expected performance.
• Finally, decision making is the process of choosing among competing alternatives.

Decisions can be improved if information about alternatives is gathered and pro-
vided by managers. One of the chief roles of management accounting is to supply
information that facilitates decision making.
4.4 COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST

OBJECTS
Cost may be regarded as sacrifices made to acquire goods and/or services. Costs are
assigned to objects for a variety of purposes, including pricing, profitability studies and
control of spending. A cost object refers to anything for which cost data are desired -
including products, product lines, customers, jobs and organisational subunits. For the
purpose of assigning costs to cost objects, costs are classified as either direct or indirect.
• Direct cost. This is a cost that can easily be allocated and traced towards the par-
ticular cost object under consideration. For example, if Adidas is assigning costs to
its various regional and national sales offices, then the salary of the sales manager
in its Singapore office would be a direct cost of that office.
• Indirect cost. This is very difficult to allocate or trace to the particular cost object
under consideration. For example, SAB may produce a wide variety of beers. The
manager's salary of the brewery would be an indirect cost of a specific type of beer,
say Windhoek, the reason being that the manager's salary is not caused by one type
of beer, but rather incurred as a consequence of running the entire brewery.
Assignable product costs include direct materials, direct labour and all indirect costs
necessary to produce a finished product ready for sale to customers. However, for
retailing and service firms the cost of meeting their product and/or service needs to be
calculated differently, as explained below.
4.4. 1 Costs in a retailing firm

Retail firms buy and sell goods. For a retailing firm, product costs include the price paid
for the goods purchased, shipping costs, insurance during transit and import taxes (in
the case of imported goods).
Example
Assume a retailing firm has purchased and imported I 00 items that involved the
following costs:
Cost of goods: I00 units X R200 each 20 000
Import duties: 100 units X R20 each 2 000
Shipping costs 4600
64 Insurance in transit 1200
Subtotal 27 800
Less: discount received (2% on R20000) 400
Total product cost 27400
Cost per unit = R27 400 + I00 = R274
4
4.4.2 Costs in a service firm
Service firms determine their product costs in much the same way as retail firms do.
Their financial statements are also very similar to those of retail firms, except that they
do not normally contain inventories and cost of goods sold.
4.4.3 Costs in a manufacturing firm

The inventory of a manufacturing firm consists of raw materials (direct materials), work-
in-process and finished goods. Manufacturing firms determine their product cost in terms
of direct materials, direct labour and indirect costs (manufacturing overheads).
• Direct materials include the cost of all materials directly traceable to a finished
product that are necessary to produce the product.
• Direct labour includes the salaries paid to employees who work directly on the
transformation of direct materials into a finished product, as well as payments to
quality inspectors.
• Indirect costs (also called common costs) consist mainly of manufacturing over-
heads, which consist of all costs that are not classified as direct material or direct
labour. Examples are machine lubricants (indirect material), factory cleaning staff
(indirect labour), depreciation of factory machinery, and other factory costs, such
as electricity, heating and telephones used in the factory.
The marketing and administrative costs of the firm are regarded as period costs. These
benefit a specific period of time and are not related to production or product costs.
4.S COST CLASSIFICATIONS FOR DECISION MAKING

To assist managers in decision making regarding budgeting, it is important to distin-
guish between two concepts, namely opportunity cost and sunk cost:
• Opportunity cost. This is the potential benefit that is given up when one alterna-
tive is selected over another. To illustrate this important concept, consider the fol-
lowing examples:
- While completing his BCom degree in Management, Michael has a part-time
job as a waiter that pays him R800 per week. He would like to spend a week at
Umhlanga Rocks during the spring break, and his employer has agreed to give
him time off, but without pay. The R800 in lost wages would be treated as an
opportunity cost of taking the week off to be at the beach.
- Suppose a company is considering investing R2 000 000 in land that may be a
site for a future shop. An alternative could be to invest the funds in high-grade
securities. If the company decides to purchase the land, the opportunity cost
will be the investment income that could have been realised if the securities
65
had been purchased instead.
• Sunk cost. This is a cost that has already been incurred and cannot be changed by
any decision made, now or in the future. Sunk cost should therefore be ignored
when making a decision. To illustrate this important concept, consider the follow-
ing example:
- Rose and Sons Ltd paid R200000 several years ago for a special-purpose
machine. The machine was used to make a product that is now obsolete and is
no longer being sold. Even though in hindsight the purchase of the machine
may have been unwise, nothing can be done to reverse the decision. The
R200 000 originally paid for the machine has already been incurred and should
be ignored in any future decision making.
4.6 UNDERSTANDING COST BEHAVIOUR

A firm's costs react to changes in sales, production or activity levels. The sales, produc-
tion or activity levels may be measured in terms of the number of units completed
and sold by a production unit in a specific period, or the number of direct labour or
machine hours during a specific period. In this regard, costs may be classified as fixed,
variable or semi-variable.
Fixed costs are those which remain constant during a given period for a given
potential capacity, irrespective of the degree to which the capacity is utilised during
the period. An example would be a 500m2 shop leased at Rl00m 2 per month, which
means that the lease of the shop would amount to RS0 000 per month or R600 000 per
annum. This rental remains constant at R600 000 per annum, regardless of the number
of products sold during the year.
Fixed costs usually relate to facilities that provide the capacity for the firm to carry
out its activities, such as the cost of providing buildings, machinery, equipment and
vehicles. The cost of permanent staff may also be regarded as a fixed cost to the firm.
Total fixed costs can be represented as shown in Figure 4.1.
"C
C
&! Total fixed costs
66
Volume
Figure 4.1 Total fixed costs

4
It is evident from this figure that the total fixed costs remain constant, regardless of
the number of units produced and sold. However, the fixed cost per unit will decrease
as more units are produced and sold.
Example
Assume that a firm's total fixed costs amount to R600 000. Regardless of whether I 00 or
I 000 units are manufactured, this figure remains the same. The fixed costs per unit will
be as follows for different levels of production:
If I 00 units are produced, the fixed cost per unit will be R6 000 per unit:
Fixed cost per unit = R600 000 = R6000 per unit
100
If I 000 units are produced, the fixed cost per unit will be R600 per unit:
Fixed cost per unit = R600 000 = R600 per unit

1000
From the above we may conclude that a firm should recover its fixed costs by producing
and selling as many units as possible, within the limitations of the existing production
capacity.
Unlike fixed costs, variable costs change with fluctuations in the number of units pro-
duced and sold. Examples of variable costs might be packaging materials for a product,
such as a cellular phone, and instruction pamphlets and a battery to accompany each
unit sold. Total variable costs can be represented as shown in Figure 4.2.
Total variable costs
"C
C
~
Volume
Figure 4.2 Total variable costs

67
This figure illustrates how total variable costs will increase for each unit produced
and sold. The variable cost per unit tends to remain constant. The cost of packaging for
each cellular phone sold could, for example, be RIO per unit.
Not all costs can be classified as fixed or variable costs. Some costs consist of fixed and
variable cost elements and do not, therefore, vary in direct proportion to changes in
production volume. An example of a semi-variable cost is the maintenance of manu-
facturing equipment. Some maintenance costs are incurred irrespective of whether the
equipment is used, and these constitute the fixed cost element. It may happen that the
more the equipment is used, the greater the maintenance costs incurred will be, and the
greater the variable cost element of maintenance costs.
The significance of fixed and variable costs will become clear in the following sec-
tions when breakeven analysis and leverage are explained.
4.7 BREAKEVEN ANALYSIS

Breakeven analysis provides a framework for understanding the interrelationships
between the following:
• Variable costs
• Fixed costs
• Sales volume
• Selling prices
The activity level at which total costs equal total revenues is called the breakeven point.
At the operating breakeven point, there is neither profit nor loss. It is not necessary for
a breakeven point to be calculated for the entire firm. A division, a single product, a
group of products, or any other well-defined cost objective may also be used. Figure 4.3
gives a graphical illustration of the breakeven point.
Breakeven point
"Cl
C:
~ Total fixed costs
Volume
Figure 4.3 The breakeven point

68
The area between total fixed costs and total costs represents the variable cost. At the
breakeven point no profit or loss will be made. The firm will earn a profit above the
breakeven point, and will suffer a loss if sales are below the breakeven point.
4
Breakeven analysis is used by the firm for the following reasons:
• To find the level of operations necessary to cover all operating costs
• To evaluate the profitability associated with various levels of sales.
The firm's operating breakeven point is the level of sales necessary to cover all operating
costs. At the operating breakeven point, the earnings before interest and taxes (EBIT)
equal zero.
4. 7.1 Underlying assumptions of breakeven analysis

The usefulness of the breakeven analysis is limited only by the degree of validity of the
assumption that the following are constant throughout the normal range of activity:
• The variable cost per unit
• The selling prices for products sold
• The total fixed cost
• The sales mix
• The inventory levels
4. 7.2 Formulae for breakeven analysis

The following formulae are used in breakeven analysis:
1. Marginal income:
Marginal income = sales - variable cost
2. Marginal income per unit:
Marginal income per unit = selling price per unit - variable cost per unit
3. Profit:
Profit = sales - variable cost - fixed cost
4. Breakeven point (measured in units):
BE point (units) = total fixed cost
marginal income per unit
5. Breakeven point value (measured in rand):
BE point (value)= BE point units x selling price per unit
6. Margin of safety ratio:
Expected sales volume - breakeven volume x 100
expected sales volume 1
The margin of safety ratio indicates the extent to which sales volume may decrease 69
before profits reach nil (the breakeven point). From a profitability and risk perspective,
a high margin of safety is preferable to a low one.
Example
The following are the data for a firm for the next year:
Selling price per unit R2 000
Variable cost per unit RI 000
Total fixed cost R600 000
Expected sales (units) I 200
Calculate the following:
I. Breakeven volume
2. Breakeven value
3. Margin of safety ratio
I . Breakeven volume:
R600000 = 600 units
R2000 - RI 000
2. Breakeven value:
600 units x R2 000 = RI 200 000
3. Margin of safety ratio:
I 200 - 600 x I 00 = 50%
1200 I
The above example shows that the firm should sell at least 600 units to break even.
Selling more than 600 units will yield a profit, but at 600 units no profit or loss will be
achieved. If the firm sells fewer than 600 units, it w ill suffer a loss.
From the above it should be evident that volume, cost and the selling price play a sig-
nificant role in the profitability of a firm. The marginal income is sensitive to the pric-
ing policy of a firm. Table 4.2 illustrates some of the mark-up percentages, based on
cost, required to achieve particular gross profit margins.
Table 4.2 Mark-up percentage required
Gross profit Mark-up Translates to Explanation

margin percentage cost x
75% 400% 4 400- 100 X 100 = 75%

400 I
66% 300% 3 300- 100 X 100 = 66%
300 I
50% 200% 2 200 - 100 X 100 = 50%
200 I
33% 150% 1.5 150 - I00 x I00 = 33%
ISO I
70 25% 133% 1.333 133.30- 100 X 100 = 25%
133.30 I
20% 125% 1.25 125 - 100 X 100 = 20%
125 I
4
4. 7.3 Limitations of breakeven analysis
A number of limitations are commonly mentioned in relation to breakeven analysis:
1. The analysis assumes a linear revenue function and a linear cost function.
2. The analysis assumes that what is produced is sold.
3. The analysis assumes that fixed and variable costs can be accurately identified.
4. For multiple product analysis, the sales mix is assumed to be known.
5. The selling prices and costs are assumed to be known with certainty.
Limitations (1) to (3) pose fewer problems than limitations (4) and (5). It is virtually
impossible to predict with certainty the sales mix, the selling prices and the costs for
an upcoming period. However, there are formal ways of explicitly building uncertainty
into breakeven analysis.
4.8 THE BUDGETING PROCESS

The budgeting process needs to start with the projection of the expected sales during the
period for which the planning is done. The latest financial statements and the financial
ratios may provide guidelines to the financial performance of the firm during the past
financial period, but the firm needs to look ahead to the next financial period. The firm's
sales forecast will be influenced by expectations about the growth in gross domestic prod-
uct (GDP) and the extent to which the industry in which the firm operates contributes to
it. The firm will have to estimate its market share and how much a change in the GDP will
benefit or harm the sales of the industry and of the firm. Other economic variables include
expected interest rate movements, the inflation rate, the exchange rate between countries,
employment levels and the government's budget deficit.
Example
Assume a manufacturing firm produces steel products and sells 50% of its production
locally, and exports the other 50%. Growth in the local GDP of 3% may benefit the
firm's sales locally. The firm's revenue from exports will be influenced by the exchange
rate of the local currency to that of its trading partners. A strengthening of the local
currency makes the locally produced product less competitive overseas and may lead to
a decline in export orders (and vice versa).
In essence, an integrated budgeting system for a manufacturing business consists of

two main types of budgets:
1. Operating budgets
2. Financial budgets 71
4.8.1 Operating budgets

Operating budgets parallel three of the responsibility centres, namely cost, income and
profit:
• Cost budgets. There are two types of cost budget - the manufacturing and the
discretionary cost budget. Manufacturing cost budgets are used where outputs can
be accurately measured. These budgets usually describe the material and labour
costs involved in each production item, as well as the estimated overhead costs.
They are designed to measure efficiency, and if the budget is exceeded, it means
that manufacturing costs were higher than they should have been. Discretionary
cost budgets are used for cost centres in which output cannot be measured accu-
rately (e.g. administration and research). Discretionary cost budgets are not used
to assess efficiency because performance standards for discretionary expenses are
difficult to devise.
• Income budgets. These budgets are developed to measure marketing and sales
effectiveness. They consist of the expected sales quantity multiplied by the expected
unit selling price of each product. The income budget is the most critical part of
a profit budget, yet it is also one of the most uncertain because it is based on pro-
jected future sales.
• The profit plan or profit budget. This budget combines cost and income budgets
and is used by managers who have responsibility for both the expenses and income
of their units. Such managers frequently head an entire division or business.
The diagram in Figure 4.4 shows the operating and financial components of an inte-
grated budgeting system of a manufacturing business.
Operating budgets Financial budgets
Research &
Sales budget Capital Budget
Development
Direct labour
r
Production Cash
Direct materials
budget budget
Overheads
Purchasing Proforma Proforma

budget income balance
statement sheet
Marketing Indirect
Admin
expense labour
72 budget
budget
budget
Figure 4.4 The operating and financial components of an integrated budgeting system
4
4.8.2 Financial budgets
Financial budgets, which are used by financial management in carrying out the finan-
cial planning and control task, consist of the capital budget, the cash budget, the pro
forma income statement and the pro forma balance sheet. These budgets, prepared
from information contained in the operating budgets, integrate the financial planning
of the business with its operational planning. Financial budgets serve the following
three major purposes:
• They verify the viability of the operational planning (operating budgets).
• They reveal the financial actions that the business must take to make execution of
its operating budgets possible.
• They indicate how the operating plans of the business will affect its future financial
performance and position. If these future actions and conditions are undesirable
(e.g. borrowing too much in order to finance additional facilities), appropriate
changes in the operating plans may be required.
The capital budget indicates the expected (budgeted) future capital investment in
physical facilities (buildings, equipment, etc.) to maintain the firm's present productive
capacity or expand its future productive capacity.
The cash budget indicates
• the extent, time and sources of expected cash inflows
• the extent, time and purposes of expected cash outflows
• the expected availability of cash in comparison with the expected need for it.
The pro forma income statement is developed to evaluate the budgeted income relative
to expenses in the short term, and to evaluate plans which could improve profitability.
The pro forma balance sheet brings together all the other budgets to project how
the financial position of the firm will look at the end of the budget period if actual
results conform to planned ones. An analysis of the pro forma balance sheet by means
of financial ratios may suggest problems (e.g. a poor solvency situation due to borrow-
ing too much) or opportunities (e.g. excessive liquidity, creating the opportunity to
expand), which may require alterations to the other budgets.
Operating and financial budgets may be achieved by means of responsibility cen-
tres. Control systems are devised to ensure that a specified strategic business function
or activity (e.g. manufacturing or sales) is carried out properly. Consequently, control
systems should focus on, and budgets be devised for, various responsibility centres in
a business.
4.9 RESPONSIBILITY CENTRES

A responsibility centre can be described as any organisational or functional unit in a
business which is headed by a manager responsible for the activities of that unit. All 73
responsibility centres use resources (inputs or costs) to produce something (outputs or
income). Typically, responsibility is assigned to income, cost (expense), profit and/or
investment centres.
In the case of an income centre, outputs are measured in monetary terms, but the
size of these outputs is not directly compared with the input costs. The sales depart-
ment of a business is an example of an income centre. The effectiveness of the centre is
not measured in terms of the amount by which the income (units sold x selling prices)
exceeds the cost of the centre (e.g. salaries and rent). Instead, budgets in the form of
sales quotas are prepared and the budgeted figures compared with actual sales. This
provides a useful picture of the effectiveness of individual sales personnel or of the
centre itself.
In a cost centre, inputs are measured in monetary terms, but outputs are not. The
reason for this is that the primary purpose of such a centre is not the generation of
income. Good examples of cost centres are the maintenance, research and administra-
tive departments of a business. Budgets should be developed only for the input portion
of the operations of these centres.
In a profit centre, performance is measured by the monetary difference between
income (outputs) and costs (inputs). A profit centre is created whenever an organisa-
tional unit is given the responsibility of earning a profit. In this case, budgets should be
developed in such a way that provision is made for the planning and control of inputs
and outputs.
In an investment centre, the monetary value of inputs and outputs is again mea-
sured, but the profit is also assessed in terms of the assets (investment) employed to
produce this profit.
It should be clear that any profit centre could also be regarded as an investment
centre because its activities require some form of capital investment. However, if the
capital investment is relatively small, or if its manager(s) have no control over the capi-
tal investment, it is more appropriate, from a planning and control and thus from a
budgeting point of view, to treat it as a profit centre.
4.10 RESPONSIBILITY ACCOUNTING

The basic idea behind responsibility accounting is that the manager should be made
accountable for each line item in the budget. The manager is therefore held accountable
for subsequent deviations between budgeted goals and actual results.
Being held responsible for costs does not mean that the manager is penalised if/
when the actual results do not measure up to the budgeted goals. However, the manager
should take the initiative to correct any unfavourable discrepancies, understand the
source of significant favourable or unfavourable discrepancies, and be able to explain
the reasons for discrepancies to management above his or her own level.
4.11 ADVANTAGES OF BUDGETING
74 Organisations realise many benefits from a budgeting programme. The following are
some of the key benefits of budgeting:
• Budgets make it possible to communicate management's plans throughout the
entire organisation.
4
• Budgets force managers to think proactively and plan for the future. In the absence
of urgency to prepare budgets, too many managers would spend all their time deal-
ing with daily emergencies.
• The budgeting process enables resources to be allocated to those parts of the organ-
isation where they can be used more effectively.
• The budgeting process can prevent and resolve potential bottlenecks before they
occur.
• Budgeting assists with ensuring that every employee in the organisation is pulling
in the same direction.
• Budgets serve as benchmarks for evaluating future performance.
4.12 PRINCIPLES OF BUDGETING

Managers who draw up a budget must accept responsibility for it. Normally the finan-
cial manager and the finance department serve in an advisory capacity. Very often,
head office sets broad guidelines or targets (e.g. that fixed costs need to be reduced by
5% or that sales need to be increased by 10%) . Following are some of the principles of
budgeting that may contribute to meaningful budgets.
4. 12. 1 Management involvement

The top management of a firm is responsible for the strategic management of the firm
and, as such, determines its mission, objectives and goals. As part of strategic man-
agement, it has to do a SWOT analysis to determine the firm's strengths, weaknesses
and opportunities, and any threats to the firm. Top management should have superior
information about the current and forecast financial performance and position of the
firm, and should therefore provide guidelines to the middle and lower levels of man-
agement that may be used in drawing up budgets for their areas of responsibility. It is,
however, the responsibility of middle and lower management to execute the plans and
budgets that are drawn up. The inputs of middle and lower management must be taken
into account before the plans and budgets are finalised
4. 12.2 Adaptability
Circumstances can and will change as the budgets are implemented during a financial
year. Budgets should not be so rigid that no changes can be made during the course of
a year. Any changes must, however, be justifiable.
4. 12.3 Accountability according to responsibility

Accountability means being obliged to give a reckoning, explanation or account of your
75
actions and decisions regarding the use of money entrusted to your care. Managers
must be made accountable for their actions, but should also be given responsibility and
be empowered to achieve the goals that have been set.
4.12.4 Effective communication

Effective communication refers to the process of communicating the guidelines from
top management to lower levels, but it also refers to the response received from lower
levels of management as indicated in their budgets. To be effective, communication
must succeed in getting realistic plans and budgets in place which will serve to motivate
managers and employees. Failure to do so will create a climate of non-cooperation,
mistrust and negativity.
4.12.5 Realistic expectations

Realistic expectations have an important influence on the motivation of the managers
who have been given the responsibility for their budgets. If budgets are unrealistic, the
chances are that managers will not seriously attempt to meet their budgets.
4.12.6 Acknowledgement
Acknowledgement of performance is key to successful budgeting. The closer manag-
ers get to achieving actual figures that match the budgeted figures, the greater their
acknowledgement should be. Care should, however, be exercised to ensure that no
manipulation has taken place. Large deviations should be investigated to determine the
reasons for them. Large surpluses might indicate poor planning or poor execution of
the budget, or that too much "fat" was built into it.
4.12.7 Follow-up and feedback

Follow-up and feedback should involve regular reports, preferably on a monthly basis.
The budgeted versus actual figures should be compared and any deviations investi-
gated. If possible, action should be taken to rectify matters where necessary.
4.13 SUMMARY
Profit planning and control are vital in assuring the profitability of a firm. They are
short -term aspects of financial management and can be achieved by means of budgets.
Profit planning and control may be carried out by comparing the actual results with
the planned (budgeted) results periodically or on a continuous basis. It is, however,
important to take note of the differences that exist between management accounting
and financial accounting. When profit planning and control are considered, this activ-
ity is executed by the management accountant and not the financial accountant.
For the purpose of assigning costs to cost objects, costs are classified as either direct
or indirect. The classification of costs depends on the type of firm. In manufacturing
76 concern, costs may be classified as direct labour, direct material and overheads. Two
additional concepts are important for managers when the budgeting process is under-
taken: opportunity costs and sunk cost. Cost can also be classified based on its behav-
iour as a fixed cost, a variable cost and a semi-variable cost. Based on cost behaviour,
4
a firm can determine its breakeven point. The breakeven point is where total revenue
equals total cost - in other words, no profit is made, but no loss is made either. The
mark-up percentage on a product is not equal to the gross profit margin. A firm needs
to use an appropriate mark-up percentage in order to achieve a certain gross profit.
The budgeting process starts with an estimate of expected sales. These are influ-
enced by variables that are beyond the control of the firm, such as the expected growth
in GDP, interest rates, inflation and exchange rates. The firm's mission, objectives
and goals assist in determining the priorities of the firm when allocating the limited
resources at its disposal. Budgets may be achieved by means of responsibility centres.
A responsibility centre may be an income centre, a cost centre, a profit centre or an
investment centre. The manager may further be held accountable for subsequent devia-
tions between budgeted goals and actual results. This concept is known as responsibil-
ity accounting. The budgeting process has many benefits and is therefore a must for any
firm seeking longevity and sustainability in business operations. Successful budgeting
depends to a large extent on whether the principles of budgeting have been applied
correctly. These principles require management involvement, adaptability, accountabil-
ity, effective communication, realistic expectations and acknowledgement, as well as
follow-up and feedback.
REFERENCES
Cant, M., Brink, A. & Machado, R. 2003. Pricing management. Claremont: NAB.
CIMA. 2009. Enterprise strategy. United Kingdom: BBP Learning Media Ltd.
Cloete, M. 2013. Cost and management accounting. Cape Town: Juta.
Cronje, G.J. de J. (Ed.). 2008. Introduction to business management, 8th ed. Johannesburg: Southern.
Engler, C. 1993. Managerial accounting, 3rd ed. Homewood, IL: Ir win.
Higgins, R.C. 2003. Analysis for financial management, 7th ed. New York: McGraw-Hill.
Horngren, C.T. 2014. Introduction to management accounting. Boston , MA: Pearson .
Mowen, M.M. & Hansen, D.R. 2008. Cornerstones of managerial accounting, 2nd ed. United States of
America: Thomson South-Western.
Reid, J. 2003. Seven fundamentals for effective financial management. Cape Town: Juta.
Seal, W., Garrison, R.H . & Noreen, E.W 2006. Management Accounting, 2nd ed. United Kingdom:
McGraw-Hill Education.
Walker, J. 2009. Fundamentals of management accounting. United Kingdom: Elsevier Ltd.
Self-test question 1
Compile a pro forma statement of financial performance (income statement) and a
statement of financial position (balance sheet) based on the following budgeted figures:
Sales 4000000
Inventory (beginning) 400000
Net purchases 1800000
Inventory (ending) 200000
Operating expenses 500000
Interest expected to be paid 75000 77
The tax rate is 30% of earnings before tax.

Net profit is to be distributed as follows:

• Dividends to be paid to ordinary shareholders = 40%
• Retained earnings = 60%
Land and buildings 3 500000
Plant and equipment 4000000
Furniture I 000000
Vehicles 1400000
Cash 100000
Accounts receivable 400000
Inventory 200000
Ordinary share capital 6000000
Long-term debt 500000
Accounts payable 100000
Solution to self-test question 1

Proforma statement of financial performance (income statement) for the next
year
Net sales 4000000
Less: cost of goods sold
Inventory (beginning) 400000
Plus: purchases 1800000
Less: inventory (ending) 200000
Cost of goods sold 2000000
Gross profit 2000000
Less: operating expenses 500000
Profit from operations I 500000
Less: interest paid 75000
Earnings before tax 1425000
Tax (30%) 427500
Net profit 997500
Distributed as follows:
Dividends payable to ordinary shareholders R399000
Retained earnings R598500
Pro forma statement of financial position (balance sheet) at year end
Fixed assets Equity

Land and buildings 3 500000 Ordinary share capital 6000000
Plant and equipment 4000000 Retained earnings 4000000
Furniture I 000000 Liabilities
Vehicles 1400000 Long-term debt 500000
78 Current assets Current liabilities
Cash 100000 Accounts payable 100000
Accounts receivable 400000
Inventory 200000
Tot:.11 ;u,..,Pt"- I 0f.00000 Fm 1itv ::mrl li:::ihilit iP«: I0f.00000
PROFIT PLANNING AND CONTRO L
4
Self-test question 2: Cost terms
Woodworld Ltd manufactures furniture, specialising in wooden tables. Selected costs
associated with the manufacturing of the tables and the general operation of the com-
pany are given below:
1. The tables are made of yellowwood, which costs RS 000 per table.
2. The tables are assembled by workers at a wage cost of RS00 per table.
3. The workers assembling the tables are supervised by a factory supervisor who is
paid R320 000 per year.
4. Electrical costs are calculated at R20 per machine hour.
5. The depreciation cost of the machines used to make the tables totals R90 000 per year.
6. The salary of the managing director of Woodworld Ltd is Rl 000 000 per year.
7. The company spends RlO0 000 per year to advertise its products.
8. Sales personnel are paid a commission of RS00 for each table sold.
9. Instead of manufacturing the tables, the company could rent its factory space out
at a rental income of R300 000 per year.
Classify these costs according to various cost terms used in the chapter.

...
V,
...
0 V,
olS V V, 0
... OOQJ
C: >
"i,j
·;: ...:::, 00
V
V,
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ai ~
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~
Q)
0
.0
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·;:
:::, V,
... -~
C:
... ...e 0
V V, ... "C :::,
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V
-c ·c ... ...
V V
V
~
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Q)
V
V V
t:'.
0
Ill
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.g
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·c E e e C:
Ill
...
Q) e '6 ~
C:
:::,
a.
a.
u:: ~~ 0 0 I: fl 0 ..!: Vl 0
I . Wood used in a table X X X
2. Labour cost to assemble a
X X X
table
3. Salary of the factory
X X X
suoervisor
4. Cost of electricity to
X X X
produce tables
5. The depreciation cost of
machines used to produce X X X x*
tables
6. Salary of the managing
X X
director
7. Advertisinj:! expense X X
8. Commission paid to sales
X X
oersonnel
9. Rental income forgone on
x **
factorv space
79
* This is regarded as a sunk cost, because the outlay for the equipment was made in a previous period.
** This is an opportunity cost, because it represents the potential benefit that is lost or sacrificed as a
result of using the factory space to produce tables.
Self-test question 3: Breakeven analysis

Parrot Pies produces a single product. The previous year's statement of financial perfor-
mance (income statement) is provided below:
Sales (30000 units) 1260 000
Less: variable costs 840000
Contribution margin 420000
Less: fixed costs 300000
Operating income 120000
Required:
1. Calculate the breakeven point in units.
2. Calculate the breakeven point measured in rand.
3. Calculate the margin of safety ratio.

1. BE point (units) Total fixed cost
=---------
Marginal income per unit
300 000
= (42-28)
= 21 428,57 units
= 21 429 units (rounded off to the nearest unit)
2. BE point (value) = BE point units x selling price per unit
= (21 429 x R42)
= R900018
. f c ty t· Expected sales volumes - breakeven volume 100
3. M argm o sa1e ra 10 = ~--------=-----=-----=------ x - -
expected sales volume 1
30 000 - 21429 100
= 30 000
X
1
= 28,57%
Self-test question 4: Cash budget

80 J&G Ltd expects to receive cash from sales of R45000, R50000 and R47 000 in March,
April and May respectively. In addition, J&G Ltd expects to sell property worth R35 000
in March. Payments for materials and supplies are expected to total RIO 000 in March,
Rl 1 000 in April and R1 2 000 in May. Direct labour payroll will be fixed at R12 500 for
4
each of the three months. Other expenditures are budgeted at Rl 4 600 per month. In
addition, the company purchased a machine in February for RlS 000 that is no longer
in use. On March 1, the cash account balance is Rl 230.
Required:
1. Prepare a cash budget for J&G Ltd for the month of March.
2. Assume that J&G Ltd wanted a minimum cash balance of RS0 000 and that it could
borrow from the bank in multiples of Rl 000 at an interest rate of 9% per year.
What would the adjusted ending balance be for March?
3. Calculate the amount of interest that J&G would owe for the month of April,
assuming that the entire amount borrowed in March would be paid pack.

1. J&G Ltd
Cash budget for the month of March
R
Beginning cash balance 1230
Cash sales 45000
Sales of property 35000
Total cash available 81230
Less: disbursements
Materials and supplies 10000
Direct labour payroll 12500
Other expenditures 14600
Total disbursements 37100
Ending cash balance 44130

N ote: The amount of RIS000 is regarded as a sunk cost and can thus be ignored as the cost has already been incurred .
2. Unadjusted ending balance 44130

Plus: borrowing 6000
Adjusted ending balance 50130
3. In April, interest owed would be:
1
R6000 x 9% x 12 = R45
81
CHAPTER FIVE
THE TIME VALUE

OF MONEY
What's the problem?

Lizre Gericke has joined the University of South Africa (Unisa) as a health and safety officer
from I May 2014. She completed her BCur degree in Nursing Sciences and graduated in
December 20 12 from the University of Pretoria. Owing to limited office space on the main
campus, her office is in the Solomon Mahlangu (SM) building in the central business district,
some 3.4 kilometres away from the main campus.
Unisa has its main campus on Muckleneuk Ridge in Tshwane, where some 3800 staff mem-
bers perform their duties. It also has a Science campus in Florida, Johannesburg, for students
studying Science, Engineering and Technology, as well as Agricultural and Environmental Sci-
ences. Furthermore, there are the rented offices in Hazelwood (for the School of Economic
Sciences) and Brooklyn (for a section of the College of Law). The university has a total of 24
regional and service centres in all the provinces of South Africa, and a centre in Ethiopia.
Approximately 1200 staff members are not located on the main campus, but in the various
regions. With 284 000 students, it is the biggest university in the southern hemisphere.
Lizre realises she will have to travel from time to time to all the various regional centres.
However, what strikes her during her first week of duty is that transport between the SM
building and the main campus for her health and wellness unit is problematic.
"I shall have to submit a proposal as soon as possible for dealing with the matter," she
informs the vice-principal responsible for HR. She will need management committee approval
and the support from the chief financial officer (CFO). Although there are some pool vehicles
available, they are needed by other staff members on a daily basis. She needs a dedicated
vehicle for her unit in order to perform their duties effectively and in order to attend meetings
at the main campus.
But just how much will the monthly instalments and insurance cost? And then there are the
operating costs and maintenance to be taken into consideration.
She will have to prepare and submit the request as soon as possible. She has been advised
that this may be regarded as capital expenditure and may have to be budgeted for during
the current year and procured during the following year. She has to provide very compelling
arguments and calculations in order to convince management. 83
Question: How do you suggest Lizre substantiate her proposal to the m anagement
committee?
CHAPTER 5 THE TIME VALUE OF MONEY
S.I INTRODUCTION
The purpose of financial management is to increase the value of the firm.
The value of the firm may be increased by investing in non-current assets (such as land,
buildings, production plants, machinery) and current assets (such as accounts receivable
and inventory) which will earn returns greater than the cost of capital. Firms should not
invest in these assets unless they increase the value of the firm.
The investment of funds in assets (cash outflow) needs to occur first, after which the
firm has to earn a return (cash inflow) as soon as possible on the investment. In order
to evaluate any financial decision involving differences in the timing of cash inflows and
outflows we use a concept known as the time value of money.
According to the time value of money concept, an amount of money today is worth
more than it will be at some point in time in the future. A rand that is available today
can be invested to earn a return (in the form of interest, dividends or capital gains) and
be worth more than if it were received, say, a year from now, and invested only then. In a
similar vein, if you are expecting to receive an amount of money in the future, there is an
opportunity cost involved in waiting to receive the amount. Ifyou had the amount at your
disposal now, you could either invest it and earn a return or, alternatively, you could avoid
interest charges on financing (such as an overdraft or loan).
The time value of money should not be confused with a decrease in purchasing power
as a result of inflation. Inflation refers to a continuous rise in the general level of prices
of goods and services. Inflation causes a decrease in the purchasing power of a monetary
unit, such as the South African rand, and is taken into account when the nominal interest
rates are determined. If, for example, the expected rate of inflation is at 5% and the real rate
of return is 3%, then the nominal interest rate is 8, 15%. 1 Inflation certainly compounds the
problem of the time value of money, but it is not the central issue in this chapter. The time
value of money is a matter of interest that may be earned if money is available today and
invested, or the opportunity cost if an amount will only b e received at some future date
instead of immediately.
In this chapter you will learn how to account for differences in the timing of inflows or
outflows of cash by mastering the basic interest and discounting calculations.
An interest calculation involves calculating the end value, called the future value (FV) ,
of an amount which is invested in the present. Discounting calculations are the opposite of
interest calculations. Discounting calculations involve the calculation of the present values
(PV) of amounts that will only be received at some time in the future. These calculations
will now be explained, starting with the calculation of future value (interest calculations).
Time value of money calculations may be done with an ordinary calculator using inter-
est and discounting factors, or by simply using a financial calculator. Interest and dis-
counting tables provide either an interest factor which can be used to determine the future
value of an amount, or a discounting factor to determine the present value of an amount
to be received at some future date. The use of these tables is explained in the examples of
84
the various calculations in this chapter. The tables are included in the appendices on pages
180- 183.
1. Nominal interest rate = (1.05)(1.03) - 1 = 1.0815 - 1 = 0.0815 or 8.1 5%

THE TIME VALUE OF MONEY
5
S.2 FUTURE VALUE
The concept of future value involves the calculation of interest on a present amount to
result in some future amount.
The amount on which interest is paid is known as the principal. Future value is the
amount to which the principal (be it a lump sum or a series of cash flows) will grow
by a given future date when compounded at a certain interest rate. The interest rate
may be expressed as x% interest compounded either annually, semi-annually, quarterly,
monthly, weekly or daily. The compound rate is the rate applicable when interest is
earned not only on the original principal, but also on the accumulated interest from
previous periods (also called earning interest on interest).
The principles of future value are quite simple, regardless of the period of time
involved. In this chapter we discuss three types of compounding: annual compounding,
intra-year compounding, and finding the future value of an annuity.
5.2.1 Annual compounding

Interest is compounded when the amount earned on the initial principal becomes part
of the principal at the end of the first compounding period.
The calculation offuture value

The actual method by which future value is determined with annual compounding can
be illustrated by a simple example.
Example
If an investor places RIO 000 in a savings account paying 10% interest compounded
annually, then at the end of the first year he or she will have earned RI 000 in
interest. The value of his or her investment will be RI I 000; RIO 000 representing the
initial principal and RI 000 in interest. The future value at the end of the first year is
Future value at the end of year I = RIO 000 ( I + 0, I 0)

= RI I 000
The calculation can also be done using a financial calculator (HP I 0B11):
Key in: Press: Calculator Notes:

display:
- IOOOO PV - IOOOO • PV stands for present value
10 I/YR 10 • I /YR indicates the interest rate
N I • N indicates the number of periods
FV 11 000 • determines FV (the future value)
85
The above example may be illustrated using a timeline, such as the one in Figure 5. I .
FV = R11 000
, - - - - - -- 1
PV = R10000
0 ears
Figure 5.1 Timeline illustrating future value at the end of year I
If the investor leaves his or her money in this investment for another year and capitalises
the interest, he or she would be paid interest at the rate of I 0% on the new principal of
RI I 000. At the end of year 2 the investment would be worth R 12 I 00:
Future value at the end of year 2 = RI I 000 ( I + 0.10) = RI 2 100
Alternatively, the calculation could be done as follows:
Future value at the end of year 2 = RIO 000 ( I + 0. I 0)( I + 0. I 0)
= RI O 000 ( I. I 0)2
=
RIO 000 x 1.21
= Rl2 100
Using a financial calculator:
Key in: Press: Calculator display:
- 10 000 PV - 10 000
10 I/YR 10
2 N 2
FV 12 100
FV = R12.100
- - -- 1
PV=- Rl1000
PV"' R1QOOO
86
a 2
Erld of year
Figure 5.2 Timeline illustrat ing future value at the end of year 2
5
The general formula which can be used to calculate the future value of an amount is
FVn = PV(l + i) 0
where FV 0 = the future value of the amount at the end of n periods

PV = the initial principal
= the annual rate of interest paid
n = the number of periods of the investment.
Whether you use a financial calculator or the tables, a fundamental relationship will
always exist between interest rates, time periods and future value factors. If you look at
Table A on page 180, the future value interest factors for one rand (FVIFi,n), you should
note the following:
1. The factors in the table are those for determining the future value of one rand at the
end of the given period.
2. The future value interest factor for a single amount is always greater than 1.
3. As the interest rate increases for any given period, the future value interest factor
also increases. Thus the higher the interest rate, the greater the future value.
4. For a given interest rate, the future value of a rand increases with the passage of time.
Thus, the longer the period of time, the greater the future value.
5.2.2 Intra-year compounding

Intra-year compounding of interest refers to the situation where interest is compounded
more often than once a year. Savings institutions compound interest semi-annually,
quarterly, monthly, weekly or daily. Intra-year compounding changes the frequency
with which the interest is calculated, and this requires adjustments to the number of
periods (n) and the interest payable (i), as indicated in Table 5.1.
Table 5.1 Intra-year compounding
Compounding Adjustment Adjustment Explanation

during a one- to number to interest
year period of periods rate
Semi-annual N X 2 i + 2 Instead of the nominal interest

rate being paid once a year, one-
half of the interest rate is paid
twice a year.
Quarterly N X 4 i + 4 Instead of the nominal interest

quarter of the interest rate is paid 87
four t imes a year.
Monthly N X 12 i+ 12 Instead of the nominal interest

twelfth of the interest rate is paid
twelve times a year.
Weekly N X 52 i + 52 Instead of the nominal interest rate

being paid once a year, one fifty-
second part of the interest rate is
paid fifty-two times per year.
Daily N X 365 i + 365 Instead of the nominal interest rate

being paid once a year, one three-
hundred-and-sixty-fifth part of the
interest rate is paid three hundred
and sixty-five times per year.
Example
Assume a firm invests RIO 000 for a period of two years at 12% interest per annum,
calculated monthly. This means the interest rate becomes 1% (i =
I) payable 24 times (n
= 12 X 2 = 24). The future value at the end of year 2 may be calculated as follows:
Using the future value interest factor (FVIF) table:
Future value at the end of year 2 = RIO 000 X FVIF 1%, 24

= RIO 000 X 1.270
= Rl2 700

- 10 000 PV - 10 000
12 + 12 =
I I/YR I
24 N 24
FV 12 697.35
The slight difference in answers may be ascribed to the fact that the FVIF table only takes
three digits into account, whereas the financial calculator t akes ten digits into account.
5.2.3 The future value of an annuity

An annuity is a series of equal cash flows for each of a specified number of periods.
88 These cash flows may be received or deposited. An annuity typically consists of cash
flows similar to the following:
5
Year Cash flow
I Rl2 000
2 Rl2 000
3 Rl2 000
Two types of annuity exist, namely an ordinary annuity and an annuity due. If an annu-
ity consists of amounts received or deposited at the end of each period it is known as
an ordinary annuity. If an annuity consists of amounts deposited or received at the
beginning of each period it is known as an annuity due.
Future value ofan ordinary annuity

The calculation of the future value of an ordinary annuity may be simplified using Table
B (the FVIFA table) on page 181. The values in the FVIFA table assume that deposits
are made at the end of each period. The calculation of the factors contained in Table B
may be explained using the following example.
Example
To determine the FVIFA 16%,s the FVIFA is found by adding together the FVIF 16% for
four periods (n) plus one (I). This involves the following:
n FVIF1 6%
4 1.811
3 +
1.561
2 +
1.346
I _±__l.160
= 5.878
0 _±__l.000
= 6.878
The following formula can be used to calculate the future value of an ordinary annuity
by means of the interest factors in Table B.
FVAn = PMT X FVIFAi,n
where FVA = the future value of an annuity at the end of n periods
0
PMT = the amount invested periodically (e.g. annually)

FVIFA = the future value interest factor for an annuity
i = the annual interest rate
n = the number of periods of the investment. 89
Example
To determine the future value of R 12 000 invested annually (at the end of each year) for
five years in succession earning 15% annual interest, the calculation is as follows:
Future value at the end of year 5 = RI 2 000 X FVIFA 1s%.s

= RI 2 000 x 6.742
FV of PMTn = R80 904

-12 000 PMT -12 000
15 I/YR IS
5 N 5
FV 80 908.58
Once again, the difference is the result of the number of digits that are used by the FVIFA
table versus the ten digits of the financial calculator.
The above calculation can also be illustrated by means of a timeline such as the one in
Figure 5.3.
R20 988,08
. - - - - - - - - - - - - - - -- - R18 250,50
. - - - - - - - - - --
. - - - - - -•
R15 870.00
R13 800,00
l
~
~
g
a:
R12000,00
R1 2 000 R1 2 000 R1 2 000 R1 2 000 R1 2 000
0 0 3 5
Years
Figure 5.3 Timeline illustrating the future value of an ordinary annuity
Future value ofan annuity due

If an amount of R1 2 000 (PMT = R1 2 000) is invested at the beginning of each year
at an interest rate of 15% (i = 15%) over the same period, the value of the investment
would be R93 044.86 at the end of a five-year period. This calculation can be illustrated
90 by the following timeline:
5
~ - - - - - - - - - - - - - - - - - --R24 132
~ - - - - - - - - - - - --R20988
~ - - - - - - - --R18252
. - - - - - --R15864
r
I
R13800
R93036
R12000 R12000 R12000 R12000 Rl 2000
0 7 2 3 4 5
Years
Figure 5.4 Timeline illustrating the future value of an annuity due
Using the FVIF table:

Beginning of Amount deposited Number of years Future values Future value at
year (PMT) compounded interest factors end of year
(FVIF}
I Rl2 000 5 2.0 11 R24 132
2 Rl2 000 4 1.749 R20 988
3 Rl2 000 3 1.521 Rl8 252
4 Rl2 000 2 1.322 RIS 864
5 Rl2 000 I I.ISO RI 3 800
Total future value at the end of five years = R93 036

First set the calculator to BEG (depending on the type of calculator) so that it
assumes the cash flows occur at the beginning of each period.

-12 000 PMT -12 000
15 I/YR 15
5 N 5
FY 93 044.86
(Yes, you've guessed it! The difference between the amounts obtained by means of the
FVIF table and the financial calculator is the result of differences in the number of
decimals used.)
Using the figures provided through the use of the tables and assuming that the
same amount is invested (PMT = Rl2 000 in our example) at the same rate of interest
(i = 15%), the difference in future value between an ordinary annuity and an annuity
due amounts to Rl2 132 (using the tables) or Rl2 136,28 (using a financial calculator). 91
This difference between R93 044,86 (of the annuity due) and R80 908,58 (of the ordi-
nary annuity) is the result of the differences in the timing of the investments (at the
beginning versus the end of periods). In the case of the ordinary annuity, the amount
invested (PMT = Rl2 000 in our example) in the last period (n = 5 in our example) is
merely added to the investment at the end of period 5 without any time elapsing for it
to earn interest. The number of periods for which compounding took place were four
periods. However, in the case of the annuity due, interest is earned also on the final
deposit because it occurred at the beginning of the fifth period.
S.3 COMPARING FUTURE VALUE AND PRESENT VALUE

Future value and present value are simply the inverse of each other. Mathematically, the
future value of a single amount is found by
FVn = PV X (1 + i)n
whereas present value of a single amount is found by
PVn = FVn X 1
(1 + i)n
In terms of future value versus present value factors, the PV is the reciprocal of the FV
for the same discount rate and time period, so that
PVn = l
FVn
This observation can be confirmed by dividing a present value interest factor for i% and
n periods, PVIFi,n into 1, and comparing the resulting value to the future value interest
factor given in Table A for i% and n periods, FVIFi,n• The two values should be equiva-
lent. Because of the relationship between present value interest factors and future value
interest factors, we can find the present value interest factors given a table of future
value interest factors. From Table A we see that the future value interest factor for 10%
and five periods is 1.611. Dividing 1 by this value yields 0.621 , which is the present
value interest factor given in Table C on page 182 for 10% and five periods.
Having established this relationship between future and present value, we now pro-
ceed to present value calculations.
S.4 PRESENT VALUE

It is often useful to determine the present value of a future sum of money. The concept
of present value, like the concept of future value, is based on the belief that the value of
money is affected by the timing of its receipt. The axiom underlying this belief is that a
rand today is worth more than a rand that will be received at some future date. In other
words, the present value of a rand that will be received in the future is less than the
value of a rand in hand today.
92 The actual present value of a rand depends largely on the earning opportunities
of the recipient and the point in time at which the money is expected. This section
explores the present value of a single amount, a mixed stream, and an annuity.
5
5.4.1 The present value of a single amount
The process of finding present values or discounting cash flows is actually the inverse
of compounding. It is concerned with answering the question, "If I can earn i% on
my money, what is the most I would be willing to pay for an opportunity to receive R x
n periods from today?" Instead of finding the future value of present rands invested
at a given rate, discounting determines the present value of a future amount, assum-
ing that the decision maker has an opportunity to earn a certain return, i, on the money.
This return is often referred to as the discount rate, required return, cost of capital or
opportunity cost. The discounting process can be illustrated by means of a simple example.
Example
You have the opportunity to receive RI 000 one year from now. If you can earn 16%
by investing the amount, the present value of the RI 000 is
PY = RI 000 = R862.07
1.16
To simplify the present value calculation, tables of present value interest factors can be
used. The table for the present value interest factor, PVIFi,n, gives values for the expres-
sion 1 --;- (1 + i)n where i is the discount rate and n is the number of periods involved.
Table C on page 182 presents present value interest factors for various discount rates
and periods.
Using the present value interest table, the general formula for determining present
values (PVn) can be expressed as follows:
PV n = FV n X PVIFi,n
where FV n = the amount at the end of the n periods

PVn = the present value
PVIF = present value interest factor
= the interest rate
This expression indicates that to find the present value, PV n, of an amount to be received
in a future period, n, we have merely to multiply the future amount, FV, by the appro-
priate present value interest factor from Table C. An example should help clarify how
this formula is used.
93
Example
You have the opportunity to receive RI 000 one year from now. If you can earn 16% by
investing the amount, the present value of the RI 000 may be calculated as follows.
Using tables:
Present value of a FY of RI 000 = RI 000 x PVIF 16%, I

= RI 000 X 0.862
= R862

I 000 FY I 000
16 I/YR 16
N
PY - 862.07
5.4.2 The present value of a mixed stream

Quite often in financial management there is a need to find the present value of cash
flows to be received in various future periods. Two basic types of cash flow streams are
possible: the mixed stream and the annuity. A mixed stream of cash flows reflects no
particular pattern, while an annuity is a pattern of equal annual cash flows (the cash
flows are the same each year). Since certain shortcuts are possible in finding the present
value of an annuity, it will be discussed separately from mixed streams.
To find the present value of a mixed stream of cash flows, determine the present
value of each future amount in the manner described in the preceding section, then
add all the individual present values to find the present value of the stream. An example
should clarify this process.
Example
It is expected that the following cash inflows will be received over the next five years:
Year Cash inflow

I RI 000
2 RI 200
3 RI 300
94
4 RI 100
5 RI 400
5
Example
If a minimum return of 12% can be earned, the present value of the aforementioned
cash flows can be illustrated by the timeline in Figure 5.5 and the calculations that
follow.
End of year
R1000 R1 200 R1300 R1 100 R1 400
0 1 2 3 4 5
R 893.00
R 956,40
R 925 60
R 699,60
R 793,80
R4 268,40
Figure 5.5 Timeline illustrating the present value of a mixed stream

Period Cash Present value interest Present value
inflow (I) factors(l) (I) X (2)
I RI 000 .893 R893 .00

2 RI 200 .797 R956.40
3 RI 300 .712 R925.60
4 RI 100 .636 R699.60
5 RI 400 .567 R793.80
Total present value of mixed stream = R4 268.40
5.4.3 The present value of an annuity

The present value of an annuity can be found in a manner similar to that used for a
mixed stream, but a shortcut is possible. The following is an example of how the present
value of an annuity can be determined.
95
Example
It is expected that an annuity will provide a cash flow of RI 000 per year. If a return of
12% can be earned, the present value of the annuity may be determined as indicated in
Figure 5.6. Using a financial calculator:
I 000 PMT I 000

12 I/YR 12
5 N 5
PV - 3604.78
End of year
R1 000 R1 000 R1000 R1000 R1000
0 2 3 4 s
R 893 -+-- - ~
R 797 ••- - - - - - - ~ I
I
R 712 ••- - - - - - - - - - _ _ _ _ ,
R 636 ••- - - - - - - - - - - - - - ~ I
R 567 - -----------------~
R3605
Figure 5.6 Timeline illustrating the present value of an annuity
The calculations used in the preceding example can be simplified by recognising that
each of the five multiplications made to get the individual present values involved multi-
plying the annual amount (Rl 000) by the appropriate present value interest factor. This
method of finding the present value of the annuity can also be written as an equation:
PVn = PMT X PVIFAi,n
where PMT = the amount of the annuity at the end of each period
PV = the present value
O
PVIFA = present value interest factor for an annuity

i = the discount rate
Thus the present value of an annuity can be found by multiplying the annual amount
received by the sum of the present value interest factors for each year of the annuity's life.
Using interest factors for an annuity

Table D on page 183 is a table of present value interest factors for an annuity for
specified rates and periods. It simplifies even further the calculations required to
96 find the present value of any annuity. The interest factors in the table are derived by
summing the PVIFs used to determine the present value of the annuity using the
lori[µnirohmlst factors in Table D actually represent the sum of the first n present value
interest factors in Table C for a given discount rate. The formula for the present value
5
interest factor for an n-year annuity with end-of-year cash flows that are discounted at
i percent, is PVIFAi,n'
The problem presented earlier involving the calculation of the present value of a
five-year annuity of Rl 000 assuming a 12% opportunity cost can easily be worked out
with the aid of Table D. The present value interest factor for a one rand annuity in Table
D for 12% and five periods, PVIFA 12%,sy' is 3.605. Multiplying this factor by the Rl 000
annuity gives a present value for the annuity of R3 605.
Period Present value interest factor

I .893
2 .797
3 .712
4 .636
5 .567
Total = 3.605
S.S VARIATIONS OF FUTURE AND PRESENT VALUE

TECHNIQUES
Future value and present value techniques have a number of variations. Three of these
variations are presented in this section:
• The calculation of the deposits needed to accumulate a future sum
• The amortisation of loans
• The determination of interest or growth rates
5.5.1 Deposits to accumulate a future sum

You may wish to determine the annual deposit necessary to accumulate a certain
amount of money many periods hence. The solution to this problem is closely related
to the process of finding the future value of an annuity.
In an earlier section of this chapter, the future value of an n -year annuity, FVn, was
found by multiplying the annual deposit, PMT, by the appropriate interest factor from
Table B, FVIFAi,n•
The relationship of the three variables was defined and is repeated here:
FVn = PMT X FVIFAi,n
We can find the annual deposit required to accumulate FVAn rand, given a specified
interest rate, i, and a certain number of periods, n, by solving the above formula for
PMT. Isolating PMT on the left side of the formula gives us:
97
PMT = FVn
FVIFAi,n
Once this is done, we have only to substitute the known values of FVAn and FVIFA1,n
into the right side of the formula to find the annual deposit required.
Example
Suppose you wish to replace equipment five periods from now and recognise that a
payment of RI 00 000 will be required at that time. If you wish to make equal annual
end-of-year deposits into an account paying annual interest of 12%, you must determine
what size annuity will result in a sum equal to RI 00 000 at the end of year 5.
Using tables:
PMT = FY RI00 000 = RI 5 740 ' 60

FVIFA12%,S 6.353
100 000 FY 100 000
12 I/YR 12
5 N 5
PMT 15 740.97
5.5.2 Loan amortisation

The expression "loan amortisation" refers to the determination of the equal annual loan
payments necessary to provide a lender with a specified interest return and repay the
loan principal over a specified term. The loan amortisation process involves finding the
future payments (over the term of the loan) so that their present value just equals the
amount of initial principal borrowed (given the loan interest rate). Lenders use loan
amortisation tables to find these payment amounts. In the case of a home mortgage,
these tables are used to find the equal monthly payments necessary to amortise or pay
off the loan at a specified interest rate over a 20- to 30-year period.
The discussion here will deal only with the amortisation ofloans on which end-of-
year payments are made, since the tables in this text are based on end-of-year amounts.
Amortising a loan actually involves creating an annuity out of a present amount.
Earlier in this chapter, the present value, PVm of an n-period annuity of an amount
was found by multiplying the annual amount, PMT, by the present value interest
factor for an annuity from Table D, PVIFAi,n:
PV n = PMT X PVIFAi,n
98 To find the equal annual payment, PMT, required to pay off or amortise the loan,
ju -<:~ PVn, over a certain number of periods at a specified interest rate, we need to solve the
ii formula for PMT. Isolating PMT on the left side of the formula gives us:
@
CHAPTER 5 THE TI M E VALUE OF MONE Y TH E TIME VALUE OF MONE Y
5
PVn
PMT
PVIFAi,n
Once this is done, we have only to substitute the known values of PVnand PVIFAi,ninto
the right side of the formula to find the annual payment required.
Example
A firm may borrow R6 000 000 at 14% and agree to make equal annual end-of- year
payments over IO periods. To determine t he size of the payments, the I 0-year annuity
discounted at 14% that has a present value of R6 000 000 must be determined. This
process is actually the inverse of finding the present value of an annuity.
= R6 000 000 = RI 150 281

5.2161168
A loan amortisation schedule can be drawn up to show the interest and principal
repayments:
End Loan Beginning Interest Principal End of

of payment of year year
vear DrinciDal DrinciDal
. 14 X (2) ( 1) - (3)
( I) (2) (3) (4) (2) - (4)
I RI 150 281 R6 000 000 R840 000 R3 IO 28 1 RS 689 719
2 RI 150 281 RS 689 719 R796 561 R353 72 1 RS 335 998
3 RI ISO 281 RS 335 998 R747 040 R403 242 R4 932 757
4 RI 150 281 R4 932 757 R690 586 R459 695 R4 473 06 1
5 RI ISO 281 R4 473 061 R626 229 R524 053 R3 949 009
6 RI 150 281 R3 949 009 RS52 861 R597 420 R3 35 I 589
7 RI ISO 281 R3 35 I 589 R469 222 R68 I 059 R2 670 530
8 RI 150 281 R2 670 530 R373 874 R776 407 RI 894 123
9 RI 150 281 RI 894 123 R265 177 R885 104 RI 009 019
10 RI ISO 281 RI 009 019 Rl41 263 RI 009 0 19 RO
Using a financial calculat o r:

6 000 000 PV 6 000 000
14 I/YR 14
10 N 10
PMT -I 150 281.25 99
Note
If the amount was payable in monthly instalments, we would have calculated it in the
following manner, using a financial calculator:
Key in: Press: Calculator display: Explanation:

6 000 000 PY 6 000 000
14+ 12 1.1667 Monthly interest rate
1.1667 I/YR 1.1667
120 N 120 IO years x 12 months = 120 periods
PMT 93 161.30 Monthly instalments
5.5.3 Determining growth rates

It is often necessary to calculate the compound annual growth rate associated with a
stream of cash flows. In doing this, either future value or present value interest tables
are used, as described in this section. The simplest situation is where you wish to find
the growth rate of a cash flow stream. This can be illustrated by the following example.
Example
You wish to determine the growth rate of the following stream of dividends received.
Using tables:
Year Cash flow (cents)

2014 160
2013 ISO
2012 145
2011 135
2010 IOI
Growth occurred for four years. To find the rate at which this has occurred, the amount
received in the earliest year is divided by the amount received in the last year. This gives
us the present value interest factor (PVIF) for four years, which is 0.6313 (RI.O I +
RI .60). The interest rate in Table C associated with the factor closest to 0.63 I 3 for four
years is the rate of interest or growth rate associated with the cash flows. Looking across
year 4 of Table C shows that the factor for 12% is 0.636. This is the growth rate to the
nearest integer.
100 L
TH E TIME VALUE OF MONEY
5

-IOI PV - IOI
160 FV 160
4 N 4
I/YR 12.1 888
S.6 THE ROLE OF TIME VALUE OF MONEY IN FINANCIAL

MANAGEMENT
Time value of money plays a role in several areas of financial decision making. Time
value of money is applied in the areas of financial decision making discussed below.
5.6. 1 Financing decisions

A firm has to finance its assets by means of the owners' contribution (called equity)
and, if necessary, borrowing money. From a financing point of view, a firm should keep
its cost of capital as low as possible. No one wants to use the most expensive financing,
and a firm would be equally reluctant to do so. As is explained in Chapters 6 and 7, the
lower the cost of capital, the easier it is to add value to a firm.
5.6.2 Investment decisions

Investment decisions involve long-term investments, which require considerable out-
lays that commit a firm to a course of action. A great deal of attention should be given
to the initial outlay and subsequent cash flows associated with long-term or fixed-asset
investments. Investment decisions are made by means of capital budgeting techniques.
The payback period is the number of years required to recover the initial invest-
ment. The payback period gives some consideration to the timing of cash flows and
therefore to the time value of money in the sense that, ideally, the payback period
should be as short as possible.
Sophisticated capital budgeting techniques give explicit consideration to the time
value of money. These techniques discount the firm's cash flows at a specified rate. The
firm's cost of capital or opportunity cost serves as the discount rate.
Net present value is calculated by subtracting the initial investment from the pres-
ent value of the future net cash inflows discounted at a rate equal to the firm's cost
of capital. Only if all cash flows, both inflows and outflows, are measured in present 101
rand, can valid comparisons be made. If some of the investment (cash outflow) occurs
beyond the initial period (t = 0), then the net present value of a project is determined
by subtracting the present value of outflows from the present value of inflows.
The profitability index is calculated by dividing the present value of cash inflows by the
initial investment. This index measures the present value of the return per rand invested.
The internal rate of return is defined as the discount rate that equates the present
value of cash inflows with the initial investment associated with a project.
5.6.3 Working capital management

Working capital consists primarily of cash, inventory and accounts receivable. The firm
holds working capital for the same purpose as any other asset, namely to maximise
the value of ordinary shares and therefore the value of the firm. The firm should hold
neither idle current assets nor idle fixed assets.
The investment of excess cash, minimising of inventories or stocking faster-moving
inventories, the speedy collection of receivables and the elimination of unnecessary or
costly short-term financing, all contribute to maximising the value of the firm by taking
the time value of money into consideration.
Ideally, cash outflow should be postponed for as long as possible. Creditors should
be paid as late as possible without damaging the firm's credit rating. This is known
as "stretching accounts payable': Similarly, the payment of cash dividends could be
delayed to the firm's advantage.
5.6.4 Valuation
The basic valuation model calculates the present value of the sum of all net cash inflows
expected for the duration of an investment.
The value of a bond is the present value of the contractual payments the issuer is
obliged to make from the present time until it matures. The appropriate discount rate
would be the required return, which depends on the prevailing interest rates and risk.
Interest is paid at a fixed rate on nominal value, that is, the coupon rate.
If the bond value differs from par, the yield to maturity will differ from the coupon
interest rate. The yield to maturity of a bond can be calculated in such cases by using
present value interest factors for an annuity (PVIFA) and present value interest factors
(PVIF), as follows:
Value = (interest paid x PVIFAi,n) + (principal x PVIFi,n)
The value of a share, like that of a bond, is equal to the present value of all future divi-
dends it is expected to provide over a period. Although a shareholder can earn capital
gains by selling the shares at a price above that originally paid, what is really sold is
the right to all future dividends. From a valuation point of view only dividends are
therefore relevant.
The intrinsic value of ordinary shares can be calculated by means of the zero growth
model, the constant growth model or the variable growth model. Preference shares can
102 be valued by using the zero growth model. Each of these models is based on the time
value of money principle since future cash flows (expected dividends) are discounted
back to present value.
5
S.7 SUMMARY
The key concepts related to the time value of money are future value and present value.
Future value relies on compound interest to measure the value of future amounts.
When interest is compounded, the initial principal or deposit in one period, along with
the interest earned on it, becomes the beginning principal of the following period; this
is also known as capitalising interest or earning interest on interest.
Present value is the inverse of future value.
By manipulating the formulae for the future and present value of single amounts
and annuities in certain ways, the deposits needed to accumulate a future sum, loan
amortisation and growth rates can be calculated.
The present value calculations are used in various aspects of financial management,
which are covered in greater detail in the following chapters.
REFERENCES
Marx, J., & De Swardt, C.J. 2013. Financial management in Southern Africa, 3rd ed. Cape Town: Pearson.
Self-test questions
1 RIO 000 is invested in a savings account at 20% p.a. compound interest for 10
years. Calculate the end value of the investment.
a. R61 740
b. R61 920
C. R62 290
d. R62 470
2. You invest R3 600 per year for 10 successive years (at the end of each year) in a
savings account at 15% p.a. compound interest. What will be the end value in the
savings account?
a. R73 094,40
b. R74 390,60
C. R83 094,40
d. R93 940,60
3. RIO 000 is invested in a savings account for 10 years at 20% p.a. compound inter-
est, but the interest is calculated semi-annually. What is the end value of the invest-
ment?
a. R27 670
b. R47 860
c. R67 270
d. R87 410
103
4. Calculate the difference between the investment proposals below:

• RI 000 is invested annually for five successive years at 10% p.a.
• R2 051,85 is invested for five years at 20% p.a. compound interest.
a. RO
b. RIOS
c. R550
d. RI 000
5. You will receive an amount of RI 700 eight years from now. However, if you
received the amount right now and invested it, you would earn 8% interest p.a. on
the amount. What would the amount be worth if you received it now instead of
waiting eight years?
a. R819
b. R918
c. RI 564
d. RI 700
6. Calculate the present value of R25 000 received annually for 10 successive years
using a discount rate of 17%.
a. R29 250
b. R207 500
c. R116 475
d. R292 500
7. What amount must be invested annually (at the end of each year) for five successive
years at 12% p.a. compounded interest in order to yield R25 000?
a. R3 935,15
b. R4 199,72
C. R4 167,58
d. R4 400,00
8. Calculate the growth rate of the following stream of cash flows:
2003: RI 517
2002: RI 312
2001: RI 210
2000: RI 080
a. 6%
b. 8%
C. 10%
d. 12%
9. A bank has granted you a loan of R20 000. It has to be repaid at the end of each
year over a period of 10 years. The bank charges 14% interest per year on the loan.
104
5
What is the amount payable at the end of each year in order to pay back the loan?
a. R2 280,00
b. R3 834,36
C. R4 847,22
d. R7 414,44
10. What is the difference between RI 000 invested at 10% p.a. compounded interest
for five years if
• interest is calculated annually
• interest is calculated semi-annually?
a. RO
b. R18
c. R315
d. R611
Solutions to self-test questions

1. b. RIO 000 x 6.192 = R61 920 (using Table A).
2. a. R3 600 x 20.304 = R73 094,40 (using Table B).
3. c. RIO 000 x 6.727 = R67 270 (using Table A).
4. d. RI 000,00 x 6.105 = R6 105
R2 051,85 x 2.488 = RS 105
RI 000
5. b. RI 700 x 0.540 = R918 (using Table C).
6. c. R25 000 x 4.659 = R116 475 (using Table D).
7. a. R25 000 = R3 935,15
6.353
8. d. RI 080 = PVIF
RI 517
= 0.7119 or 0.712 if rounded off
See Table C: 12% (approximated to the nearest 1%).
9. b. R20 000 = R3 834,36
5.216
10. b. RI 000 x 1.629 = RI 629 (semi-annually)
RI 000 x 1.611 = RI 611 (annually)
Difference = R 18
105
CHAPTER SIX
CAPITAL
BUDGETING
What's the problem?

Attacq Ltd listed on the main board of the JSE on 14 October 20 I 3. Attacq Ltd develops and
manages landmark properties such as Lynnwood Bridge, Glenfair Boulevard and Brooklyn
Bridge (opposite Brooklyn Mall) in Pretoria; Woodmead North Office Park in Johannes-
burg; and Garden Route Mall in George. Attacq follows a policy of investing approximately
65% of its capital directly into property, and uses 35% for property development. Attacq
had to decide how to develop four properties in Hazelwood, Pretoria.
Four buildings were possible, known as The Club, Club I , Club 2 and Club 3 (these
properties are adjacent to the Pretoria Country Club).
Club I comprises almost 5000 m2 of prime office space in a building consisting of three
floors of inspirational workspace covering some 4200 m2 gross lettable area. Trendy
ground-floor retail spans some 800 m2, and hosts chic retail stores and a restaurant.
The second phase involved The Club. Construction of The Club retail centre com-
menced in January 2013, and the centre opened its doors by late April 2014. Woolworths
is the anchor tenant. The Club consists of 4400 m 2 of retail space and 1869 m 2 of office
space.
Attacq's balance sheet at the time indicated that 53% of the capital structure consisted
of equity, and 47% consisted of debt (non-current liabilities). The firm's cost of capital was
indicated as 13.75% in their prospectus.
If they could find interested tenants, they could proceed with either C lub 2 or Club 3.
However, they have to seriously consider developing Club 2 as a residential building, and
Club 3 as another office block.
Question: How will Attacq determine which would be the best investment - should they
construct Club 2 next, or rather Club 3?
6.1 INTRODUCTION
107
Capital budgeting refers to the process of identifying and evaluating potential invest-
ments in long-lived assets to determine whether they will add value to the firm, and the
implementation and monitoring of such investments.
CHAPTER 6 CAPITAL BUDGETING
Capital budgeting places the emphasis on cash flows associated with the invest-
ments, rather than on accounting profit figures. The differences in the timing of the
cash inflows and cash outflows necessitate the use of the time value of money calcula-
tions. In order to take investment decisions that will contribute to the accomplishment
of the goal of the financial manager, we have to compare the costs (cash outflows) to the
benefits (cash inflows) of each investment.
The goal of the financial manager is to maximise shareholders' wealth. This may be
accomplished by investing in assets that will add value to the firm. An investment in
assets can only add value if its return is greater than the required rate of return. The
return may best be measured in terms of the net present value (NPV) and the internal
rate of return (IRR).
In the case of the NPV, the net cash flows have to be discounted back to present value
using the cost of capital as the required rate of return. An investment will only add
value if the sum of the present values of the cash flows exceeds the initial investment, in
other words, if the NPV is greater than nought.
In the case of the IRR, the investment will only add value if the IRR exceeds the
required rate of return as measured by the weighted average cost of capital (WACC).
This chapter explains approaches and techniques that may be used for capital
budgeting decisions.
6.2 APPROACHES TO DECISION MAKING

There are two basic approaches to making capital budgeting decisions. These approaches
are somewhat dependent on whether or not the firm is subject to capital rationing, and
the effect (if any) of the type of project involved. The two are the accept-reject approach
and the ranking approach.
6.2.1 The accept-rejed approach

The accept-reject approach involves evaluating capital expenditure proposals to deter-
mine whether they are acceptable. This is a simple approach because it merely requires
that predetermined criteria be applied to a proposal and that the resulting return be
compared with the firm's minimum acceptable return. This approach can be used if the
firm has unlimited funds at its disposal. An accept-reject decision is also a preliminary
step in evaluating mutually exclusive projects or in a situation in which capital must be
rationed. If a mutually exclusive project does not meet the basic acceptance criterion, it
should be eliminated from consideration. If the firm is evaluating projects with a view
to capital rationing, only acceptable projects should be considered.
6.2.2 The ranking approach

108
A second approach involves ranking projects on the basis of some predetermined cri-
terion, such as the rate of return. The project with the highest return is ranked first and
the project with the lowest acceptable return, last. Only acceptable projects should be
CAPITAL BUDGETING
6
ranked. Ranking is useful in selecting the best of a group of mutually exclusive projects
and in evaluating projects with a view to capital rationing.
6.3 CAPITAL BUDGETING TECHNIQUES

A distinction can be made between capital budgeting techniques that do not discount
cash flows, in other words, that do not involve the time value of money, and those that
do discount cash flows.
6.3.1 Non-discounted cash flow methods

There are various non-discounted cash flow methods for determining the acceptabil-
ity of capital expenditure alternatives. One of these techniques is the payback period.
The same figures will be used to illustrate the application of all the techniques
described in this section. The illustration concerns a firm which is currently contem-
plating the capital expenditure described in the following example.
Example
The marketing manager proposes the introduction of a new product as part of the
firm's differentiation strategy. The operations manager has indicated that the cost of
procurement and installation of the assets required to manufacture the product will
require an initial investment of RI 200 000. The annual net cash flow may be
determined by calculating the expected net operating profit (after tax) NOPAT and
adding back depreciation. A marketing and finance task team estimates that the
project will create the following net cash flows over the next five years:
Year Net cash flow (CF)

I R350 000
2 R650 000
3 R400 000
4 R300 000
5 R201 025
The treasury department has indicated that the firm has a weighted average cost of
capital 011/ACC) of 12%. The financial manager has recommended that only projects
with payback periods of less than five years should be considered for analysis by
means of the NPV, profitability index (Pl) and IRR.
109
Each of the following techniques will now be applied to the afore-mentioned data:
• Payback period
• Net present value (NPV)
• Profitability index (PI)
• Internal rate of return (IRR)
Payback period
The payback period is the number of years required to recover the initial investment. It
is determined by calculating exactly how long it takes to recover the initial investment
from net cash inflows.
Since the project in our example generates a mixed net cash flow stream, the calcula-
tion of the payback period has to be determined in the following manner. In year 1, the
firm will recover R350 000 of its initial investment of RI 200 000. At the end of year 2,
RI 000 000 (R350 000 from year 1 plus R650 000 from year 2) will have been recovered.
By the end of year 3, RI 400 000 (RI 000 000 from years 1 and 2 plus the R400 000 from
year 3) will have been recovered. Since the amount received by the end of year 3 exceeds
the initial investment of RI 200 000, the payback period ends somewhere between two
and three years. While only R200 000 (R400 000 - R200 000) must be recovered during
year 3 to make up the initial investment of RI 200 000, R400 000 is actually recovered.
Thus only 50% (R200 000 --;- R400 000) of the net cash flow in year 3 is needed to complete
the payback of the initial RI 200 000. The payback period for the project is therefore 2,5
years (2 years plus 50% of year 3). Often firms establish a maximum payback period so
that projects with longer paybacks are rejected, while other projects are accepted or fur-
ther evaluated by means of a discounted cash flow technique. In other words, the payback
period is commonly used as an initial screening device for projects.
The payback period gives some consideration to the timing of cash flows and there-
fore to the time value of money. A final reason why many firms use the payback period
as a decision criterion or as a supplement to discounted cash flow criteria (such as
NPV or IRR) is that it is a measure of risk. The payback period reflects the liquidity of
a project and therefore the risk of recovering the initial investment. The more liquid
an investment, the less risky it is assumed to be, and vice versa. Companies making
international investments in countries with high inflation rates, unstable governments
or other problems use the payback period as a primary decision criterion because of
their inability to forecast or measure such risks in any other way.
The payback period has three primary disadvantages, the major one being that, like
the average rate of return, one cannot determine the appropriate payback period in light
of the wealth maximising goal. A second weakness is that this approach fails to take the
time factor in the value of money fully into account; by measuring how quickly the firm
recovers its initial investment, it only takes the timing of cash flows into consideration
by implication. A third weakness is the failure to recognise cash flows that occur after
110
the payback period. This weakness can be illustrated using the data from the example
box on page 109. The project will generate cash flows of R300 000 during year 4 and
R201 025 during year 5, which are not considered by the payback period technique.
CAPITAL BUDGETING
6
Payback periods are commonly used to determine whether it would be worth devoting
further time and effort to the analysis of a project. Companies may also decide that proj-
ects with payback periods oflonger than, say, five years may pose too many uncertainties,
because the further into the future we try to make projections, the greater the risk
6.3.2 Discounted cash flow techniques

Discounted cash flow techniques give explicit consideration to the time value of
money. It is for this reason that these methods are referred to as discounted cash flow
(DCF) techniques. In one way or another, they all discount the net cash flows of a proj-
ect to a present value at a specified rate. The concept of present value is based on the
belief that the value of money is affected by the time at which it is received. The axiom
underlying this is that a rand today is worth more than a rand that will be received at
some future date because of interest that could be earned in the meantime.
Thus far, the rate used has been referred to as the discount rate or opportunity cost.
The rate used to discount cash flows is also referred to as the firm's cost of capital. The
terms discount rate, opportunity cost and cost of capital will be used interchangeably
to refer to the minimum return that must be earned on a project in order to leave the
firm's market value unchanged. A second assumption will be that the projects being
evaluated are equally risky.
The calculation of the three basic discounted cash flow techniques - net present
value, the profitability index and internal rate of return - will now be described and
illustrated.
Net present value

The net present value (NPV) is calculated by subtracting the initial investment (II)
from the present value of the net cash inflows (CF) discounted at a rate equal to the
firm's cost of capital (WACC):
NPV = sum of the present values of the net cash flows - initial investment.
Expressed in mathematical terms, the NPV may be calculated as follows:
n CF
NPV = t~l (1 + k)t - II
The sign l simply means calculate the sum of the calculation(s) that directly follows it.
In this case, from the first instance (period t = 1) to the last case (n) calculate the pres-
ent value of each of the net cash flows (CF) for every period (t) by discounting it by the
required rate of return (k), total all these PVsand subtract the initial investment (II).
Only if all cash flows - thus both inflows and outflows - are measured in terms of
present rand value can valid comparisons be made. Since we are dealing with conven- 111
tional investments, the initial investment is automatically stated in terms of today's
rand value. If this is not the case, the present value of a project could be determined by
subtracting the present value of outflows from the present value of inflows.
The following decision criterion is used when the net present value approach is used
to make accept-reject decisions: if NPV is greater than or equal to zero, accept the proj-
ect; otherwise reject the project. If the NPV is greater than or equal to zero, the firm will
earn a return greater than or equal to its required return or cost of capital. Acceptance
of the project will thus enhance or maintain the wealth of the firm's owners.
The NPV of the project in the example may be determined as follows:
Using the PVIF table (Table C on page 182):
Year Net cash flow PVIF 12.000% PVof net CF
R350 000 0.893 R 312 550,00

2 R650 000 0.797 R518 050,00
3 R400 000 0.712 R284 800,00
4 R300 000 0.636 Rl90 800,00
5 R201 025 0.567 RI 13 981, 18
Total PV of CF RI 420 18 1, 18
- Initial investment RI 200 000,00
NPV= R220 18 1, 18

Before starting on the calculator, first press the second function (2nd F) and C ALL.
This will clear all (CALL) data still in the memory of the calculator.

I 200 000 +/- CF - I 200 000.00
350 000 CF 350 000.00
650 000 CF 650 000.00
400 000 CF 400 000.00
300 000 CF 300 000.00
201 025 CF 201 025.00
12 I/YR 12.00
NPV 220 110.53
Interpretation
The project is acceptable, since the net present values exceed zero. This suggests that the
project will add value worth R220 110 to the firm.
Profitability index
The PI is sometimes called a benefit-cost ratio. The only difference between the PI
approach to capital budgeting and the NPV approach is that the PI measures the pres-
ent value return per rand invested, while the NPV approach gives the difference in rand
112 between the present value of returns and the initial investment. The PI is calculated by
j ~ dividing the present value of cash inflows by the initial investment:
u -<:
(/) ~
~~
@
CAPITAL BUDGETING
6
PI = total present values of the net cash flows
initial investment
The decision criterion when PI is used to make accept-reject decisions is as follows: if

PI is greater than or equal to one, accept the project; otherwise reject the project.
When the PI is greater than or equal to one, the NPV is greater than or equal to zero.
The PI and NPV approaches give the same solution to accept-reject decisions. In a
fashion similar to that described for NPV, the acceptance of projects having a PI greater
than or equal to one will, respectively, enhance or maintain the value of the firm.
Example
The present value of the net cash flows (calculated earlier) amounts to RI 420 181 , 18.
The II = RI 200 000. The Pl equals 1.183, calculated as follows:
Pl= PVofCF = RI 420 181,18 = 1.183

II RI 200 000
Interpretation
Since the PI is greater than one, the project will add value to the firm. The project
should be accepted.
Internal rate ofreturn

The IRR is the technique propably used most often to evaluate investment alternatives,
but it is considerably more difficult to calculate than NPV and PI. The IRR is defined as
the discount rate that equates the present value of cash inflows with the initial invest-
ment associated with the project. The IRR is, in other words, the discount rate that
equates the NPV of an investment opportunity with zero (since the present value of
cash inflows equals the initial investment).
l CF1 _ II
t=l (1 + IRR)!
or
i
t= I
CF1
(1 + IRR)t
- II = 0
The decision criterion when the IRR is used in making accept-reject decisions is as fol-
lows: ifIRR is greater than or equal to the cost of capital (k), accept the project; other-
wise reject it. For a project to be acceptable, the IRR must thus exceed or at least equal 113
the firm's cost of capital or opportunity cost. This guarantees that the firm is earning at
least its required return and ensures that the market value of the firm will increase or
at least remain unchanged.
The steps involved in calculating the IRR are described below on the basis of the data
provided earlier on.
Using the PVIF table (Table C on page 182):
Year Net cash flow PVIF PVof net CF
20%
R350 000 0.833333 R 291 667
2 R650 000 0.694444 R 451 389
3 R400 000 0.578704 R 231 481
4 R300 000 0.482253 R 144 676
5 R201 025 0.401878 R 80 787
Total PV of CF RI 200 000
- Initial investment RI 200 000
NPV = B. Q

Once again, before starting on the calculator, press the second function (2nd F) and
C ALL. This will clear all (C ALL) data in the memory of the calculator.

I 200 000 +/- CF - I 200 000.00
350 000 CF 350 000.00
650 000 CF 650 000.00
400 000 CF 400 000.00
300 000 CF 300 000.00
201 025 CF 201 025.00
12 I/YR 12.00
NPV 220 110.53
IRR 20
Interpretation
The IRR is 20%. The cost of capital is 12%. The project will add value to the firm because
the IRR exceeds the cost of capital.
6.4 COMPARISON OF TECHNIQUES

Of the three discounted cash flow techniques, NPV and IRR will receive the greatest
attention here, since they represent completely different approaches to assessing project
acceptability. Both techniques will generate the same accept-reject decisions for a given
project, but differences in their underlying assumptions can cause them to rank groups
of projects differently. The latter can be ascribed to differences in the magnitude and
114
timing of cash inflows of projects.
The question arises: Which approach is better? On a purely theoretical basis, NPV
is best. The reason that IRR is preferred in practice may be attributed to the general
disposition of business people towards rates of return rather than pure rand returns.
CAPITAL BUDGETING
6
Because interest rates, profitability measures and so on are measured as annual rates of
return (percentages), corporate decision-makers thus prefer to use IRR.
6.S SUMMARY
Techniques for capital budgeting are used to compare the benefits that can be
derived from planned projects, given their associated costs, in order to select capital
expenditures that are consistent with the achievement of the firm's goal.
In non-discounted cash flow methods the payback period is used to evaluate the
attractiveness of capital projects.
In discounted cash flow techniques for capital budgeting, the time value of money
is taken into consideration. The NPV, PI and IRR are regarded as discounted cash flow
techniques.
With the NPV approach, the difference between the present value of inflows and the
initial investment or present value of outflows is measured to determine the desirability
of a project.
The PI is similar to NPV, except that it is used to measure the ratio of the present
value of inflows to the initial investment, which indicates the present value return per
rand invested.
The IRR, the discount rate in which the NPV of a project is equated with zero, is also
used as a basis for capital budget decision making.
REFERENCES
Self-test question
Evaluate the following capital budgeting decision using the NPV, the PI and IRR tech-
niques, given a cost of capital (required rate of return) of 12%.
The firm estimates that the initial investment will amount to Rl 800 062 and that the
net cash inflows during the five-year life span of the project will be as follows:
Year Net cash inflows

I RS00 000
2 R650 000
3 R480 000
4 R400 000
5 R200 000
115
Solution to self-test question

The question required the calculation and interpretation of the NPV, PI and IRR of a
project. The following is an illustration of these capital budgeting techniques.
The NPV of the project is as follows:
Year Net cash flow PVIF PVof net CF
12.000%
I R500 000 0.892857 14 R 446 428,57
2 R650 000 0.79719388 R 518 176,02
3 R480 000 0.71178024 R 341 654,52
4 R400 000 0.63551807 R 254 207,23
5 R200 000 0.56742686 R 113 485,37
Total PV of CF RI 673 95 1,7 1
- Initial investment RI 800 062,00
NPV = - R 126 110,29
Interpretation
Since the NPV is negative (NPV < 0), the firm should not invest in the project. The
NPV suggests that the project will not add value to the firm, which is not in the interest
of the shareholders, who want to see their wealth maximised.
The PI is 0.93, calculated as follows:
PI = 1 673 951,71 = 0.93

1800062,00
Interpretation
Since the PI is less than one (PI < 1), the project will not contribute to the shareholders'
wealth.
The IRR is 8.75%. Remember, the IRR is that rate of return that will cause the NPV
to be precisely zero (0).
I 800 062 +/- CF - I 800 062.00
500 000 CF 500 000.00
650 000 CF 650 000.00
480 000 CF 480 000.00
400 000 CF 400 000.00
200 000 CF 200 000.00
12 I/yr 12.00
NPV -126 110.29
IRR 8.75
Interpretation
116
Since the IRR is less than the required rate of return of 12%, the project is not accept-
able and should not be invested in. In line with the interpretations of the NPV and PI,
the IRR confirms that the project will not add value to the firm.
CHAPTER SEVEN
FINANCING
What's the problem?

Patrice Motsepe won South Africa's Best Entrepreneur Award in 2002. Despite being
raised in a poor rural area, he became South Africa's first black billionaire. His mining
conglomerate, African Rainbow Minerals (ARM), has interests in platinum, nickel, chrome,
iron, manganese, coal, copper and gold. However, the South African mining industry is
facing major challenges. Not only has the dollar price of gold declined significantly, but
labour unions have also staged some of the longest strikes in history. Some politicians
are clearly in favour of nationalisation, and the investment community is disinvesting from
mining companies as a result of the increased risk.
Motsepe studied law, which enabled him to become the first black partner (specialising
in mining law) at Bowman Gilfillan, a law firm in Johannesburg. He bought low-producing
gold-mine shafts and made them profitable by paying workers a reasonable salary and a
profit-sharing bonus as an incentive.
He also serves on several boards of directors, including being the non-executive chair-
man of Harmony Gold, the I 2th-largest gold mining company in the world. He is the
deputy chairman of Sanlam and a non-executive director of ABSA. In 2012, Motsepe w as
named South Africa's richest man, topping the Sunday Times' annual Rich List with an esti-
mated fortune of R20.07 billion ($2.4 billion).
In 2003, he also became the owner of the football club, Mamelodi Sundowns. According
to Forbes magazine, Motsepe is Africa's eighth-richest person, with a fortune of $2.65bn
(€ I .96bn). In January 2012, he became the first African to sign Bill Gates and Warren Buf-
fet's Giving Pledge, and a year later he announced that 50% of all profits earned from his
assets would be donated to the Motsepe Trust, which will be used to assist the needy.
Given the challenges in the mining industry, Motsepe has set up Ubuntu-Botho Financial
Services, a concern that will sell insurance, provide asset management and private equity
services. Ubuntu-Botho already has a 14% interest in Sanlam. (Source: Forbes n.d.)
Question: What would be the best way offinancing Ubuntu-Botho?

117
CHAPTER 7 FINANCING
7.1 INTRODUCTION
It is often said that it takes money to make money. In other words, a firm can only
acquire assets if it has adequate capital (finances) available.
However, financing is not just about raising an adequate amount of capital from
shareholders and lenders. A firm cannot be financed from debt exclusively. No finan-
cial institution would be interested in running the risk of financing a business by means
of debt only. Normally the owners (shareholders) are expected to finance the largest
part of the assets of the firm.
The goal of a firm should be to maximise its wealth. This can be achieved by earning
the maximum return from the assets of the firm (without assuming undue risk) and by
keeping its cost of capital as low as possible.
The period for which the financing is required is also important. The firm can finance
its short-term needs, for example, by means of trade credit or bank overdraft. Trade
credit involves buying raw materials or goods on credit and paying the creditor after 30
or 60 days. Normally, trade credit does not involve interest charges (unless the account
is not settled promptly). Bank overdraft involves an arrangement with a bank to have a
debit balance on the firm's cheque account up to a certain amount. Interest payable on
the overdraft is calculated on the outstanding amount of the cheque account.
The firm's non-current assets and a portion of the firm's net working capital have to
be financed by means oflong-term financing.
7.2 LONG-TERM FINANCING

Essentially, a firm can only finance its fixed assets by means of equity or long-term debt.
The equity of a company listed on a securities exchange consists of the ordinary
share capital. Preference shares which are not redeemable or which cannot be con-
verted into loans may also be regarded as equity.
Long-term debt could take various forms: it could be debentures or bonds sold
which only pay interest every six months and repay the principal back at maturity.
Bonds normally involve the financing of specific assets, which also serve as collateral.
Debentures could be used to finance any assets or activities of the firm. Long-term
debt could also consist of a mortgage loan which could be used to finance land and
buildings. A mortgage loan requires monthly instalments over a 20 or 25-year period.
Each instalment on a mortgage loan consists of two components: interest and an
amortisation of a part of the principal.
The mixture of debt and equity finance in the capital structure is also called gearing.
A firm is said to be highly geared when it obtains a substantial proportion of its finance
from debt, be it short-term, medium-term or long-term debt.
Debt and equity have specific characteristics, as will now be explained.
118
FINANCING
7
7.2. 1 Characteristics of debt versus equity
When a firm borrows money, it usually gives first claim on the firm's cash flow to credi-
tors. Equity holders are entitled only to the residual value, that is, the portion left after
the creditors have been paid. The value of this residual portion is the owners' equity in
the firm, which is the value of the firm's assets less the firm's liabilities (debt):
Owners' equity = total assets - liabilities
This is true in an accounting sense, because we define owners' equity as this residual
portion. More importantly, it is true in an economic sense: if the firm sells its assets and
pays its debts, whatever cash is left belongs to the owners.
Several factors distinguish debt from equity: maturity, claims on income, claims on
assets, the right to a voice in management and the tax benefit of paying interest. Each
of these factors will now be explained.
Maturity
Maturity refers to debt falling due. A debt must be repaid at some time specified in
the agreement between the firm and its creditors. The distinction between short-term,
medium-term and long-term debts lies in the period for which contracts are written.
Short-term debt is scheduled to mature within one year, medium-term debt from one
to ten years, and long-term debt in a period exceeding ten years. If the debt is not paid
when it falls due, the creditors may seize assets or even force the liquidation of the firm,
depending upon the terms of the agreement with the firm.
Equity has no date of maturity. When owners invest in a firm, there is no agreement
that they will have their initial investment returned. If an owner wishes to regain his
investment, he must either find another buyer for his share in the firm, or liquidate the
firm. Whether or not he regains his original investment depends upon the fortunes of
the firm and his bargaining ability.
Claims on income
There are three aspects of claims on income that distinguish debt from equity - the
priority of the claim, the certainty of the claim and the amount of the claim.
Priority ofthe claim

The claims of creditors come before the claims of owners. The firm must meet all obli-
gations to creditors first, and, in some instances, owners may not withdraw income if
these withdrawals jeopardise the prior claims of the creditors.
While the claims of the creditors on the firm's income come before those of the
owners, the claims of the holders of preference capital on income usually precede those
of the residual owners. In this regard, two types of preference capital are noted. In 119
some partnerships there may be limited partners, and in companies there may be pref-
erence shareholders. The residual owners in a partnership are the general partners,
while in a company they are the ordinary shareholders. A company must pay dividends
CHAPTER 7 FINANCING
(not interest) on preference shares in line with the agreement before it can make any
distribution to the ordinary shareholders.
Certainty of the claim

If the firm has promised to pay interest on debt, it must pay the interest (whatever the
level of earnings) or face legal action. The interest payments are a fixed charge. Pay-
ments to owners are called "withdrawals" for proprietorships and partnerships, and
"dividends" for companies. In the first instance, the payment is at the discretion of
the owner or partners; and for a company, at the discretion of the board of directors
(which the ordinary shareholders elect). Whether the claims on income are preferred
or residual, there is no promise by the company to pay, although the owners always
hope for the best.
Amount of the claim

Interest payments on debt are limited to a certain fixed amount. For example, the bank
receives 9,5% interest per annum, and no more, on its loan to the firm. The interest
payments have to take place, no matter how profitable (or unprofitable) the firm may
be. In return for their prior claim on income, preference shareholders generally agree to
limit the amount of their annual claim. Once firms have paid the preference sharehold-
ers their claim, they can pay any remaining earnings to the ordinary shareholders. The
amount of income will vary from year to year, so that residual owners have no reason
to expect regular withdrawals/dividends.
Claims on assets
Creditors and owners seldom invest in a firm with the expectation that they will par-
ticipate in its ultimate liquidation. Nonetheless, their relative fates in times of trouble
are necessarily of some concern. Whereas claims on income are significant in the case
of a going concern, claims on assets are usually important when a firm gets into dif-
ficulty, especially when its assets are being liquidated. The claims of creditors on assets
always come before those of the owners, and claims of preference shareholders are
usually superior to those of residual owners. In return for this prior position, the credi-
tors agree to seek no more than the principal amount they have lent, and any unpaid
interest. Limited partners and preference shareholders are generally restricted to cov-
ering an amount approximately equal to their original investment. Last in line are the
ordinary shareholders. They may have whatever is left, although the bones have usu-
ally been picked clean by the time they arrive on the scene. Unfortunately for residual
owners, the value of assets in liquidation is seldom as high as those of a going concern.
The right to a voice in management

120
Creditors have no direct voice in the management of a firm, although they may place
certain restrictions in the loan agreement on management's activities. Even without
written agreements, creditors have a certain degree of control because firms know they
FINANC ING
7
cannot count on their continued support if the affairs of the firm are managed badly.
Nonetheless, if a proprietor or some of the partners are incompetent, creditors cannot
vote them out; they can only withhold their credit. Similarly, creditors do not vote
when the board of directors of a company is elected.
Preference shareholders may or may not have any voting control. Limited partners
are specifically prohibited from having any say in management. Generally, preference
shareholders do not have the right to vote for members of the board of directors.
As a rule, the power to choose the management rests with the residual owners. In
a company, they exercise this power by voting for the board of directors, who in turn
appoint the management. In a proprietorship or partnership, the owners and members
are usually the managers. It seems reasonable that the residual owners should have con-
trol. Since they have the last claim on income and assets, their risk is greater than that
of the creditors and preference shareholders; they can hardly be expected to invest their
money in a business under these terms unless they have the power to control its affairs.
The tax benefit ofpaying interest

Interest paid is an expense item in a firm's statement of financial performance. It reduces
the earnings before tax (EBT) used in calculating the firm's tax liability. The firm must
adjust the interest rate paid on its loan as follows:
After tax cost of debt = interest rate X (1 - tax rate)
Example
A firm uses a loan to finance part of its assets. The interest rate payable on the loan
is 13.54% and the firm is subject to a tax rate of 28%. The after tax cost of debt is
9.75%, calculated as follows:
After tax cost of debt = 13.54% ( I - 0 .28)

= 13.54 X 0.72
= 9.75%
The dividends paid on ordinary shares come from the net income (earnings after tax).
As such, a firm will not enjoy the same tax benefit on dividends paid to ordinary share-
holders as it does on interest paid on loans.
7.3 THE COST OF CAPITAL

The cost of capital is also referred to as the firm's required rate of return. The cost of
capital depends on the proportion that each form of financing contributes to the total 121
financing of a firm and the required rate of return on each form of financing. The cost
of capital is a weighted average cost.
CHAPTER 7 FINANCING
Example
A firm finances I0% of its assets by means of debt at an interest rate of 13.54%. The
firm is subject to a tax rate of 28%. It finances the other 90% of its assets by means of
equity. The required rate of return on equity is 18%. The firm's cost of capital may be
determined as follows:
Component Weight X Cost = Weighted cost

Debt 0.10 X 9.75% = 0.98%
Ordinary shares 0.90 X 18.00% 16.20%
WACC= 17. 18%
In the case of the above-mentioned example the firm can reduce its cost of capital
(WACC) by using financial leverage.
7.4 FINANCIAL LEVERAGE
Financial leverage (or gearing, as it is sometimes called) involves the use of debt financ-
ing in order to increase the EPS (earnings per share) and the value of the firm. The
value of the firm can be increased by lowering the firm's cost of capital.
Example
A firm has decided to finance 40% of its assets by means of debt at an interest rate of
13.54%. The firm is subject to a tax rate of 28%. The firm has an after tax cost of debt
of 9.75%. It finances the other 60% of its assets by means of equity. It has therefore
increased its debt-equity ratio from I0% to 40%. The required rate of return on equity
is 18%. The firm's cost of capital is now 14.7%, calculated as follows:
Component Weight X Cost = Weighted cost

Debt 0.40 X 9.75% 3.90%
Ordinary shares 0.60 X 18.00% 10.80%
WACC = 14.70%
Financial leverage also reduces the number of ordinary shares a firm needs to issue. A
reduction in the supply of ordinary shares could lead to an increase in the price of the
shares on a securities exchange, provided the firm maintains good profitability and is a
122 sought after investment.
FINANC ING
7
Example
A firm needs to have financing of RS 000 000. If it issues shares at RIO each, the
influence of various debt-equity ratios on the number of ordinary shares would be
as follows:
Debt- No. of Par Amount of Amount of Total

equity ordinary value ordinary debt financing
ratio shares shares
0% 500 000 RIO RS 000 000 + RO = RS 000 000
10% 450 000 RIO R4 500 000 + RSOO 000 = RS 000 000
20% 400 000 RIO R4 000 000 + RI 000 000 = RS 000 000
30% 350 000 RIO R3 500 000 + RI 500 000 = RS 000 000
40% 300 000 RIO R3 000 000 + R2 000 000 = RS 000 000
By reducing the number of ordinary shares, the firm can improve its earnings per
share (EPS) and dividends per share (DPS) figures.
Example
Assume a firm has achieved a net income of RI 000 000 during the past financial
year. The firm pays out 20% of its net income as dividends to ordinary shareholders.
Using the above-mentioned debt-equity ratios would yield the following EPS and
DPS figures:
Debt- Net income Dividends Number of EPS DPS

equity shares
ratio
(2) + (4) (3) + (4)
(I) (2) (3) (4) (5) (6)
0% RI 000 000 R200 000 500 000 R2,00 40 cents
10% RI 000 000 R200 000 450 000 R2,22 44 cents
20% RI 000 000 R200 000 400 000 R2,50 50 cents
30% RI 000 000 R200 000 350 000 R2,86 57 cents
40% RI 000 000 R200 000 300 000 R3,33 67 cents
7.S IMPORTANT CONSIDERATIONS IN FINANCING ASSETS 123
Certain common and conflicting elements or criteria are often involved in the methods
used to finance assets. Because each firm's situation is different, the weight given to
CHAPTER 7 FINANCING
these elements in making the decision varies according to conditions in the economy,
the industry and the firm. However, the availability of the various types of funds limits
the freedom of management to adjust the mix of debt and equity according to the crite-
ria of funds sought. Although management may decide to borrow more, the suppliers
of funds may conclude that this would involve too much risk. Consequently, the plans
management ultimately makes in the light of these factors often involve a comparison
between its desires and the conditions imposed by the suppliers of funds.
7.5. 1 Suitability
Suitability refers to the compatibility of the types of funds used in relation to the nature
of the assets financed: the types of funds obtained must be consistent or in harmony
with the kind of operating assets employed.
As a rule, firms finance their permanent assets, including the initial investment in
current assets, with permanent funds. The reason for financing non-current assets with
long-term funds relates to the cash flows obtained from the assets. A non-current asset
provides services over several years. Through these services and the sale of their prod-
ucts or the services they render, firms obtain a cash inflow that includes a recovery of
part of their investment in the non-current assets (depreciation). By the very nature of
the assets involved, the recovery of the investment in non-current assets is usually a
slow process. Consequently, it would be unwise to promise to repay a creditor who has
financed non-current assets at a rate faster than the rate at which firms can obtain cash
inflows from these assets. Of course, in practice, firms do not segregate non-current
assets and say that the flows from certain non-current assets go to certain creditors.
Firms consider assets as a group. However, the fact remains that firms with proportion-
ately large amounts of non-current assets customarily rely on similarly large amounts
of permanent funds in long-term debt and equity.
The higher the proportion of temporary current assets, the greater the need for
short -term debt. Thus, the large proportion of current assets in the retail industry
explains the heavy reliance on short-term debt. When accounts receivable and inven-
tory decrease, firms would like to be able to use their excess cash to repay debt. It would
be most unprofitable to pay interest on a loan when the borrowed funds are lying idle
in the bank. If firms finance temporary current assets with owners' funds or long-term
debt, the idle cash balances would represent a very unprofitable investment of their
money. Therefore an objective of the financial manager would be to finance temporary
current assets with flexible short-term debt that may expand or contract with corre-
sponding fluctuations in the assets.
7.5.2 Control
Another consideration in planning the types of funds to use is the desire of the residual
124 owners to maintain control of the firm. As explained earlier in this chapter, creditors
have no voice in the selection of management, and the holders of preference shares
have very little (if any). If firms obtain funds from creditors or by means of preference
shares, they sacrifice little or no share of control of management.
FINANCING
7
There is no doubt about who controls a proprietorship. The owner is the manager,
and her freedom of control is unquestioned. In fact, this is probably one of the reasons
that she has her own business. Her unwillingness to bring any outsiders to share control
may also hamper the ability to raise additional funds.
Legally, partners have an equal say in management, although minor decisions in
specific areas may be delegated to various partners.
In a company, each ordinary shareholder is entitled to vote in proportion to the
number of shares he or she owns. Usually the majority rules, although it may take more
than a majority to approve certain specified decisions.
If the main object of the owners is to maintain control, it may be advisable to raise
any necessary additional funds from creditors or preference owners. This is not always
viable. As explained earlier, if a firm borrows more than it can service or repay, the
creditors may seize the assets of the firm to satisfy their claims. In these circumstances,
firms lose all control. Sacrificing a measure of control by some additional equity financ-
ing may be better than running the risk oflosing all the control to creditors by employ-
ing too much debt. Similarly, firms can probably issue additional preference shares only
with the promise that, if they fail to pay their dividends, they will allow the preference
shareholders to elect most of the board of directors.
7.5.3 Flexibility
Flexibility is the ability to adjust sources of funds upwards (expansion) or downwards
(contraction) in response to major changes in needs for funds, that is, in terms of the
type of funds. Short-term debt allows adjustments in sources of funds to seasonal
swings in current assets. However, the overall needs for funds may undergo drastic
shifts over a period of years.
Firms seek flexibility so that they have as many options as possible when they need
to expand or contract the total funds employed. Not only does this enable them to use
the type of funds that are most readily available at any given time, it also enhances their
bargaining power when dealing with a prospective supplier of funds.
While firms need flexibility to expand, they also need it on the downside - to con-
tract. For example, let us say that a firm wants to dispose of certain assets and use the
proceeds from the sale to reduce its liabilities. In terms of flexibility, the firm should try
to incorporate in the agreement with the suppliers of these funds a provision that it can
redeem the debt before its maturity date. This simply means that, with adequate notice,
firms can repay the creditor before the debt falls due.
7.5.4 Timing
Closely related to flexibility in determining the types of funds used, is timing. An impor-
tant consequence of flexibility is that it presents an opportunity to allow the reduction
125
of total cost of debt and equity funds. Consider timing as the sole criterion in the selec-
tion of sources of funds over the business cycle. Firms seek to shift from short-term to
long-term debt in the early stages of recovery from a recession. At this point, long-term
CHAPTER 7 FINANCING
rates are likely to be low, and firms will need these funds later to finance additions
to permanent fixed and current assets. It is preferable to make this switch early and
freeze the low-cost, long-term debt into the capital structure. However, a proper bal-
ance between debt and equity should be maintained, and it may be necessary to forego
adding low-cost debt to the capital structure if a firm is already top-heavy with debt.
7.5.5 Charaderistics of the economy

When firms set a financial plan, they have to live with it for some time. Consequently,
any financial plan involves certain predictions of the economic outlook. Making these
forecasts consciously as part of the process of financial planning is preferable to assum-
ing that today's economic situation will persist tomorrow.
Level ofbusiness activity

If it is expected that the level of business activity will increase, it may mean that the
need for assets and the funds with which to finance their acquisition will also grow.
Flexibility in the financial plan is therefore essential.
Money and capita/2 markets

The outlook for the cost and availability of different types of funds is of great signifi-
cance. It is of vital importance to the income factor when the types of funds to be
employed are selected. If it is felt that borrowed funds will become costly or scarce, the
enterprise may wish immediately to lower its degree of financial leverage. An expected
decline in interest rates may encourage borrowing, to enable the firm to take advantage
of cheaper money.
Taxes
Since the interest cost on borrowed funds is a tax deductible expense, increases in the
applicable tax rates raise the desirability of debt in relation to other types of funds from
the point of view of income.
7.5.6 Charaderistics of the industry

Competitive forces
The nature of the competition within the industry will also affect the weight given to the
various factors that influence the sources of funds used. For example, in the clothing
industry much of the competition is based on style. Because styles are unpredictable
and transitory, profits are equally so. Firms in this industry commonly emphasise
equity over debt because of the excessive risk of not being able to meet payments on
126
borrowed funds and payments for retail space (rent payable).
1. The money market is the place where the supply and demand for short-term funds meet.
2. The capital market is the place where the supply and demand for long-term funds meet.
FINANCING
7
Seasonal variations
Industries with wide seasonal movements are likely to need large proportions of flex-
ible short-term borrowing. Firms in such an industry should also be wary of the fact
that seasonal variations in sales, together with operating and financial leverage, could
affect the earnings available to owners.
Cyclical variations
The sales of some products are immune to changes in the national income. In economic
terminology we could say that these goods have a low income elasticity. Industries deal-
ing with non-durable consumer goods (food), with inexpensive items or with items in
habitual use (cigarettes) are likely to find that the variations in their sales are fewer than
the movements in national income. Sales of products with a high income elasticity are
subject to wider variations than the national income. This would be true of such items
as refrigerators, machine tools and most capital equipment.
Flexibility and risk become major factors to consider in planning the types of funds
to use if an industry's sales vary widely over a business cycle. Room should be left for
easy and rapid expansion or contraction of funds.
Stages in the life cycle

Industries are born, they grow, they mature and, finally, many of them decline. If the
industry is in its infancy, the rate of failure of firms within the industry will be high and
the main source of funds will be risk capital. Such a firm would do well to avoid seeking
funds that require fixed payments. In these cases, the risk outweighs the attractions of
financial leverage. During rapid growth, a firm may pay special attention to flexibil-
ity to assure that as it grows it can obtain funds when needed and under acceptable
terms. When the industry has reached maturity, the firm must be prepared to meet the
financial impacts of wider seasonal and cyclical swings in sales. If the outlook is for
long-term decline in business, the enterprise should build a financial structure that will
allow for easy contraction in the sources of funds.
7.5. 7 Characteristics of the company

Form of the business firm
Companies usually find it easier to find equity capital than do proprietorships, close
corporations and partnerships. The acquisition of additional equity in a proprietorship
or partnership will usually result in greater sacrifice of control than for a company.
Size
Management's freedom of choice regarding the types of funds is especially limited for 127
very small and very large firms. Firms that are very small rely heavily upon owners'
funds for their financing. Furthermore, because small firms do not have ready access
CHAPTER 7 FINANCING
to different types of funds from various sources, they are in a poor bargaining position
when they seek funds.
In contrast, very large firms are forced to employ different types of funds. Because
they need so much money, they will find it difficult to satisfy their total needs at area-
sonable cost if they restrict their demands to only one type of financing.
Creditworthiness (rating)
The higher the firm's creditworthiness, the greater its flexibility will be. If the firm's
credit rating is poor, its financial planning should aim to improve its credit rating and
its flexibility. A firm's credit rating is mainly a product of its liquidity, earnings potential
and record of having met previous obligations. The value and character of the assets
that a firm has to pledge as security are of secondary importance.
7.6 SUMMARY
In financing assets, firms can choose between various methods of financing. To
simplify the matter, we have considered only the basic features of debt and equity as
related to maturity, claims on income, claims on assets, say (voice) in management and
the tax benefit of paying interest.
The mixture of debt and equity that a firm will ultimately use is a compromise
between the combination it would like to employ and the ability and willingness of the
market to supply such funds.
Ideally, a firm should keep its WACC as low as possible.
Considerations of suitability, risk, income, control, flexibility and timing affect
the determination of the most desirable mix of debt and equity. The relative weights
assigned to each of these factors will vary widely from firm to firm, depending on
the general economic conditions, the characteristics of the industry and the particular
situation of each firm.
REFERENCES
Forbes, n.d. 747 Patrice Motsepe. Available at: http://www.forbes. com/proftle/patrice-motsepe/(accessed
on 20 September 2014).
Self-test question
A company has determined its optimal capital structure, which comprises the
following:
128
FINANC IN G
7
Form of capital Weight After-tax cost
Long-term debt 40% 6%
Preference shares 10% 11%

Ordinary shares 50% 15%
Determine the firm's weighted average cost of capital.

Form of capital Weight After-tax cost Weighted cost
Long-term debt 40% 6% 2.4%
Preference shares 10% 11% 1.1%
Ordinary shares 50% 15% 7.5%
WACC = 11.0%
129
CHAPTER EIGHT
THE MANAGEMENT
OF WORKING
CAPITAL
What's the problem?

It was on 7 July 2008 that Moody's Investor Services warned that South Africa could slip
into a recession by the end of that year. A recession represents two consecutive quarters
of negative growth in the gross domestic product (GDP). Economists agreed that this was
due to electricity shortages, a lack of consumer confidence, rising interest rates as inflation
increased, and a decline in property transactions and housing projects. A recession has
major consequences for the retail sector.
The South African clothing, footwear and textile (CFT) retail industry consists of firms
such as Edcon, Truworths, Foschini, Mr Price Group and Woolworths. These firms jointly
serve 90% of the CFT market in South Africa. Others include Ackermans and PEP, and the
clothing sections of Pick n Pay and Makro (Makro is part of Massmart).
Edcon is regarded as the market leader in the CFT industry. It has a market share of
approximately 3 I% and operates stores such as Edgars, Boardmans, CNA, Prato, Red
Square and Temptations for the middle- and upper-income groups, as well as Jet, Jet Mart,
Jet Shoes, Legit, Discom and Blacksnow for the lower- to middle-income groups. It pro-
vides credit facilities and financial service products to more than four million customers,
and has 1200 merchandise suppliers.
The business of Edcon is seasonal, with 34% of its sales occurring during the Easter
(April) and Christmas (November and December) seasons. A survey among South African
customers found Woolworths, Ackermans and PEP to be the three most satisfying clothing
retailers, with Edgars and Truworths on a par with the industry average. Edcon was the
first to introduce a customer loyalty card called the Thank U rewards programme. Online
sales have been increasing, which is encouraging.
Edcon has approximately 43 300 employees of which 57% are temporary employees. It
operates approximately 186 stores. T he cost of operating these stores is rising as a result
of increases in rentals, electricity and salaries.
Edcon's inventory increased from R2 402 million in 20 IO to R3 170 million in 2012;
accounts receivable increased from R8 983 million in 20 IO to RI 0426 million by 2012; and
cash decreased from RI 125 million in 20 IO to RI 083 million by 2012. The firm imports 131
most of its merchandise, and has to pay in euros and dollars. However, the South African
rand is w eakening against these currencies.
CHAPTER 8 THE MANAGEMENT OF WORKING CAPITAL
Before a board meeting starts, two directors are discussing the situation. "Consumer
spending is on the decline and, judging by our financial statements, we are losing millions -
we went from a loss of RI 029 million in 20 IO to RI 691 million in 20 I I, and now we are
looking at a loss of R2 124 million."
Question: What could retail firms do in order to survive recessions?
8.1 INTRODUCTION
Working capital refers to the management of a firm's current assets and current liabili-
ties. The current assets consist mainly of inventory, accounts receivable and cash. The
current liabilities consist mainly of accounts payable, but might also include short-
term financing such as a bank overdraft.
Net working capital is the difference between a firm's current assets and current
liabilities. If the current assets exceed the current liabilities, then the firm is said to
have a positive net working capital. A positive net working capital suggests that the
firm has adequate current assets available, which could be used to pay its creditors. A
positive net working capital also suggests that the firm has not financed all of its current
assets by means of current liabilities. The amount of the net working capital indicates
the extent to which the current assets had to be financed from long-term financing
such as equity and/or long-term loans.
Working capital is one of the most crucial managerial aspects of any firm due to the
impact it has on liquidity. Liquidity refers to the ability to pay accounts as they fall due.
To this end, management must ensure turnover, in other words, that inventory is sold,
preferably for cash. However, in most industries, sales are made on credit. Making sales
on credit means that goods and services are sold to clients, but the clients (called debt-
ors or accounts receivable) will only pay for the goods at a later date, say 30 days later.
In terms of the statement of financial position of a firm, this means that inventory is
converted to accounts receivable. During the period where the amounts are outstand-
ing, there is a risk that the goods or services might not be paid for, in which case the
supplying firm will suffer a loss. Continuous losses of this nature could cause the firm
to go bankrupt, which ultimately results in job losses and hardship for all the employees
of the firm. In the ideal situation, where the debtors pay their accounts promptly, the
firm has cash available which can be used to continue operations. Some refer to this as
the firm's "money merry-go-round': because of the continuous cash inflow and outflow.
The cash flow of a firm is illustrated in Figure 8.1 .
We need to comment briefly on Figure 8.1.
132
THE MANAGEMENT OF WORKING CAPITAL
8
Dividends
Figure 8. I The cash flow of a firm
• The firm is continuously involved in a cycle of cash inflows and outflows. A firm
has to make a cash outflow for purchasing, inter alia, goods or raw materials (in
the case of a manufacturing firm). It is through sound marketing that goods which
have been manufactured or purchased are sold in order to generate cash inflows.
• The cycle should be as short as possible because of the time value of money.
• The firm would like to see the cycle occur as frequently as possible in order to
generate profit and cash flow.
8.2 THE CASH CONVERSION CYCLE

The objective of the financial manager is to manage the cash conversion cycle (CCC)
efficiently in order to maintain adequate levels of cash, thereby contributing to the
maximisation of the firm's value.
8.2. 1 The operating cycle

The operating cycle (OC) may be described as the period of time that elapses between
the building up of inventory and cash being collected from the sale of that inventory.
The cycle comprises two components, namely:
• The average age of inventory (AAI)
• The average collection period (ACP) of sales
133
Example
Assume a firm sells all its products on credit. The firm has determined that it takes an
average of IO days from stocking a final product to selling it - the AAI is thus IO days.
On average, accounts receivable are collected after 90 days.
OC = AAI + ACP
= 10 + 90
= 100 days
8.2.2 Managing the CCC

In most cases, firms buy inventory on credit from producers or suppliers.
The time period that elapses between buying the products and actual payment is
referred to as the average payment period (APP). The CCC represents the total number
of days in the operating cycle of the firm less the APP.
Example
A firm has an AAI of IO days, an ACP of 90 days and an APP of 30 days.

CCC = AAI + ACP - APP
= 10 + 90 - 30
= 70 days
The firm's money is tied up for 70 days - the period between the cash outflow to pay
accounts payable (on day 30) and the cash inflow from the collection of accounts
receivable (on day I 00).
Firms experiencing positive CCCs have to use negotiated forms of financing, such as
unsecured short-term loans, to support the CCC. This is obvious since the CCC is
the difference between the number of days the resources are tied up in the OC and
the number of days the firm can use spontaneous financing before payment has to be
made. Spontaneous financing arises from the normal operations of the firm, that is
buying goods and services from creditors and paying their accounts later.
The management of each type of current asset will now be explained, starting with
the management of inventory.
8.3 MANAGING INVENTORY

Inventory ties up valuable cash resources of the firm, thereby foregoing other earning
134 opportunities. Of all the current assets, inventory is the least liquid and consequently
ju -<:~ needs to be managed carefully in order to contribute to the wealth maximisation of the
ii firm. Higher inventory levels require greater investment and costs, while lower inven-
@ tory levels require lower investment and costs.
THE MANAGEMENT OF WORKING CAPITA L
8
The financial manager's objective is to keep inventory levels as low as possible,
thereby saving costs and providing an opportunity to undertake more profitable invest-
ments. However, the management of inventory is not that simple. Production, market-
ing and procurement managers each view inventory levels differently from the way the
financial manager views them.
• Production managers will tend to keep inventory levels as high as possible in order
to fulfil production requirements. Production managers cannot afford to have
stoppages in the production process and have to ensure that enough inventory of
raw materials, goods-in-process and finished goods are available.
• Marketing managers will also want inventory levels as high as possible in order to
fulfil sales orders and to prevent the loss of clients due to out-of-stock situations.
• The procurement manager is responsible for the provision of correct quantity and
quality of goods to the production and marketing departments. Without proper
control, the procurement manager may purchase larger than required quantities
of merchandise to qualify for quantity discounts or in anticipation of rising prices
or shortages. The procurement manager must consult with the marketing and
production managers to also ensure that appropriate goods, which meet certain
minimum quality specifications, are bought. Failure to do so results in losses that
cannot be afforded.
In this chapter, we will concentrate on the methods that management can use to manage
inventory in order to help achieve wealth maximisation for the owners of the firm.
8.3.1 Managing inventory as an investment

A firm must make funds available for the purchase and maintenance of inventory,
including investment in warehouses and storage facilities. There is an opportunity cost
attached to the holding of inventory which refers to the rate of return that could have
been earned by investing the funds in other assets with more or less the same risk.
The nature of inventory management will depend on the type of firm. Service firms
normally carry lower inventory levels than manufacturing and retail firms. Inventory
management will therefore be less critical to service firms as long as they have suppliers
who are able to deliver on a daily or just-in-time basis.
The types and levels of inventories depend on the marketing strategies and the
expected level of sales. Inventory must be acquired ahead of the date of sale. The target
inventory level established is based on expected sales levels. Any errors in estimating
inventory levels may lead to one or more of the following problems:
• Overstocking, which may lead to
- opportunity cost of money tied up in stock
- storage costs
- problems of obsolescence 135
- danger of fire and theft
- price fluctuations.
• Understocking, which may lead to

- loss of sales because of out-of-stock situations
- loss of customers to competitors who stock the same products.
Inventory may be classified into three basic classes, namely raw materials, work-in-
process and finished goods. A manufacturing firm has to manage all three types of inven-
tory. A retail firm normally manages finished goods only. The different classes of inven-
tory are discussed in the following section.
8.3.2 Classification of inventory

Raw materials
Raw material inventories include products to be changed through the production process
into work-in-process and finished goods, such as the iron ore to produce steel. A firm
carries inventories of raw materials for the following reasons:
• To make the scheduling of production easier. A firm may schedule its production
without having to worry about the arrival of material because it is available in the
warehouse.
• To hedge against price changes. A firm that stocks raw materials is in a position to
purchase products when prices are low and can decline to purchase during times of
price increases. This would normally result in lower costs and would also reduce the
variability of costs.
• To hedge against shortages of supply. In times of an anticipated shortage of supply, a
firm may take raw material into stock in order to continue production.
• To make use of quantity discounts. Larger orders usually qualify for quantity dis-
counts, that is, a reduction in price per unit.
Work-in-process
These inventories include products in various stages of the production process. Firms usu-
ally stock work-in-process products to buffer production, in other words, to prevent any
stoppages in the production process.
Finished goods
Finished goods are stocked in order to provide an immediate service to the customer
or to provide for the immediate demand for a specific product, for example in the retail
industry. Uncertainty about demand is one of the reasons for keeping finished goods in
stock. If the demand for and the supply of goods were certain, there would be no need to
stock inventories - goods could be ordered as the customer needed them.
Finished goods are also stocked in order to stabilise production. In cases where various
products are manufactured, using the same equipment and facilities, certain costs and
136
delays, referred to as set-up costs, are incurred every time the production changes from
one product to another. These set-up costs normally decrease in proportion to the period
of time the production runs and the amount of products manufactured. This leads to
increased inventories of finished and work-in-process items.
8
8.3.3 Ordering economic quantities of inventory
The cost of inventory is a trade-off between the cost of placing orders regularly (called
ordering cost) versus the cost of carrying inventory (called carrying cost). We can
determine total inventory costs (TIC) by adding together the ordering costs and the
carrying costs:
TIC = total carrying cost+ total ordering cost
The carrying costs of the firm will rise in direct proportion to the size of the order.
Ordering costs, on the other hand, will decline if orders are placed infrequently and
larger quantities of inventories are kept. The objective of inventory management is to
maintain a balance between the rising and falling costs that will result in the lowest
total cost of inventory for a firm (which is an example of a risk-return trade-off deci-
sion). This can be achieved by determining the economic ordering quantity (EOQ) .
The EOQ can be determined numerically by means of the following equation:
2X(FxS)
EOQ=
CxP
where EOQ = economic ordering quantity or the optimum quantity to be ordered
with each order placed
F = fixed costs of placing and receiving an order
S = annual sales in units
C = carrying costs expressed as a percentage of inventory value
P = purchase price per unit.
The EOQ is based on the following assumptions:
• Sales can be forecast exactly.
• Sales are evenly distributed throughout the year.
• Orders are received without delays.
Graphically, the EOQ is that point where the total cost of ordering and carrying inven-
tory will be at its lowest or optimum level, as illustrated in Figure 8.2.
Costs Total costs

.-· Carrying costs
f .,.,,...,--✓
1 000 !i _.,.,-_....,,.,-·-
/
\ ___.,,,.,_.....,
\ /
-✓-✓-✓-✓-✓-
\ .?
500 \ • j
~- j /.,...
·:1<_ Ordering costs
_.- _.,..... .--!' ---------------------------------------------------
137
0 EOO 500 1 000 1 500 2000
Order size (Q)
Figure 8.2 The economic
ordering quantity
Example
Consider the following data of a company:
Annual sales (S) = 121 000 units

Carrying costs as a percentage of inventory value (C) = 18% of inventory value
Purchase price per unit (P) = R520 per unit
Fixed costs of placing and receiving an order (F) = RS0 per order
Substituting this data into the EOQ equation, the EOQ can be determined:
EOQ = 2 x (RS0 x 121 000) = IRI 2 100 000 = I129 274 = 360 units
0.18XR520 ~ 93 .6 '-1
If the firm orders quantities of 360 units, it will minimise its total inventory cost.
Average inventories on hand depend directly on the EOQ. Once an order has been
received, 360 units are in stock. Assuming a 52-week year, the average sales rate is 2 327
units per week ( 121 000 + 52). Inventory thus decreases by 2 327 units every week.
Inventory on hand will thus vary from 2 327 units just after the order has been received
to zero just before the new order arrives. With a uniform sales rate, average inventory on
hand will be equal to half of the EOQ:
Average inventory on hand = inventory at beginning of period + inventory at end

2
Average inventory on hand = 2 327 + 0 = I 164 units
2
At a cost of R520 per unit, the value of the average inventory on hand during the year w ill
be R605 280. If inventories are financed by, say, bank loans, the average amount
outstanding during the year will be R605 280.
The EOQ and average inventory on hand are influenced by an increase or decrease in
sales. Let us consider the following example.
Example
Assume the sales of the above-mentioned firm are expected to increase by I 0% to
I 33 I 00 units per year. T he effect of this increase on the EOQ and the average inventory
on hand is as follows:
EOQ = 2x (RS0 x l33 I00) = IR13310000 = 377 units

0.18 X R520 ~ 93 .6
The EOQ therefore increases by 4.7%:
138 377 - 360 = 17 and (17 + 360) x 100 = 4.7%

~ ~
;: ~
~~ T he average inventory will increase by t he same perce ntage.
~~
@
8
The EOQ of a firm should be viewed as a range rather than as a fixed value. The reason
for this is the minor effect small deviations from the EOQ have on total inventory costs.
Once a firm has determined its EOQ, it must determine when orders should be
placed to avoid out-of-stock situations - in other words, the firm must determine at
what point inventory should be reordered to forestall being out of stock.
8.3.4 Setting the reorder point

Assuming a constant sales rate for inventory, the reorder point for a firm can be deter-
mined by means of the following equation:
Reorder point = lead time in days x daily requirement
Example
A mining firm uses 924 litres of diesel per day for its earth-moving equipment. It
takes three days from placing the order until delivery is received . The reorder point
is 924 x 3 days = 2 772 litres. The firm's tanks must be filled up before, or no later
than when the level reaches 2 772 litres.
If the estimates for lead times and daily sales rates are correct, the new orders should
reach the firm more or less when the inventory approaches zero. However, sometimes
deliveries are delayed. For this reason most firms carry additional stock, referred to as
safety stocks.
Firms maintain safety stocks for the following reasons:
• To provide for a sudden increase in the demand for a specific item in stock
• To guard against delays in receiving orders
Maintaining safety stocks will thus enable a firm to sustain sales should production or
delivery delays occur. Carrying safety stock does, however, involve additional costs for
the firm.
8.3.5 Inventory control systems

Reliable inventory control provides firms with information to enable them to meet
competition and regulate the amount of stock. Chain stores that rely on reserve stock
in a warehouse and keep less stock on their premises need careful inventory control to
make sure that they do not run out of stock. Inventory control systems vary from very
simple to complex, depending on the size of the firm and the nature of its inventories.
The following are examples of inventory control systems used in firms.
139
Simple control systems

• The red line method requires inventory items to be stocked in a bin. A red line is
drawn around the inside of the bin at the level of the reorder point, and the inven-
tory clerk places an order when the red line shows.
• In the two-bin method, inventory items are stocked in two bins. When the work-
ing bin is empty, an order is placed and inventory is drawn from the second bin.
Computerised systems
Taking a physical inventory is a tedious, time-consuming and costly job. A computer-
ised system facilitates stocktaking and can provide information on the following:
• Items currently in stock
• Sales trends over a period
• High and low sales months
• Wholesale costs and retail prices
• Delivery information (what is in, what has been ordered, etc.)
• Minimum quantities
• Ordering quantities
The system usually starts with an inventory count in memory. As sales are made, the
inventory balance is revised. When the reorder point is reached, the computer indicates
that an order should be placed. Barcoding may be useful here; as an item is checked out,
the code is read, a signal is sent to the computer, and the inventory balance is adjusted.
At the same time, the price is fed into the cash register tape.
Controlling inventory also involves monitoring and adjusting products that com-
prise the inventory of the firm. The determination of inventory turnover provides a
measurement of the effectiveness of inventory planning and control in a firm.
Carrying inventory entails certain risks and steps have to be taken to ensure protec-
tion. Various measures that firms can take to prevent losses of inventory are discussed
in the next section.
8.3.6 Preventing losses of inventory

Losses may occur as a result of damage and theft of inventory. The theft of items of
inventory by both employees and clients has to be prevented. Losses of this nature
should be kept to a minimum. This can be done by means of the following.
Proper control
The key aspect of proper control is to make specific employees responsible for the man-
agement of the various types of inventories. The following are some of the measures
140
which m ay be implemented to ensure proper control.
8
Checking deliveries for quantities and quality
Every delivery should be logged in a receiving record and assigned a receiving number.
The goods received should be checked to determine whether the supplier has delivered
what the firm has ordered and whether the goods arrived in good condition.
Regular stocktaking
Information on inventory is provided through the inventory system of the firm. Inven-
tory systems vary in terms of how and when the inventory is taken. Based on these two
factors, the following two inventory systems may be applied.
A perpetual inventory system refers to a system of continuous stocktaking and
information gathering by using accounting records to compute inventory on hand at
any given time. Inventory levels are adjusted as soon as stock is sold, and new stock is
purchased shortly thereafter. The advantage of this system is that the firm can deter-
mine inventory on hand at any time without actually having to physically take stock.
The disadvantage of this system is that it is not possible to detect obsolete stock or theft
of stock. For this reason a firm should consider taking physical stock at least once or
twice a year.
A periodic physical inventory system involves gathering information by means of
an actual physical count of inventory items. The main disadvantage of this system is
that it is time consuming. It is, however, necessary to determine shortages of inventory
(shortages of inventory as indicated by the difference between the books of the firm and
the actual inventory in the warehouse or on display in the shop. Adjustments are then
made in the books of the firm).
Searching employees before their departure from the store

Theft by employees may account for a substantial part of inventory losses. Periodic
searching of employees might be necessary to prevent such losses.
Preventive measures
The following measures can be taken to prevent inventory losses:
• Adequate and secure storage facilities can be provided.
• Surveillance equipment, such as closed-circuit TV, mirrors and electronic detec-
tion equipment, can be installed.
• Items of stock can be tagged or labelled with plastic devices that have to be deac-
tivated or removed from the article by a salesperson. If this is not done, an alarm
will sound when a customer passes through a detecting device at the exit to the
premises.
• An effective store layout is another option. Small, high-priced items should be kept
out of reach of clients, or at counters where salespeople are in attendance. 141
• Security officers can be in attendance at each exit to compare the invoice to the
goods purchased by the client.
• A system can be put in place whereby so-called whistle-blowers are rewarded (i.e.
employees provide evidence of dishonest fellow employees).
• Fire detection and fire-fighting equipment should be provided.
Reduction of eventual losses through insurance

Provision can be made for eventual losses of inventory by insuring against these risks.
The financial consequence of the risk of inventory losses is transferred to an insurance
company in return for the payment of a predetermined premium.
As indicated earlier, inventory is converted into accounts receivable, and then back
into cash. Because of this close relationship between these assets, inventory manage-
ment and accounts receivable management should not be viewed as independent.
8.4 THE MANAGEMENT OF ACCOUNTS RECEIVABLE

The decision to extend credit to customers normally results in increased sales levels, but
not necessarily in increased profitability. Increased sales levels can only be supported
by higher levels of inventory and accounts receivable. The principles underlying the
management of accounts receivable discussed in this chapter apply to both consumer
credit, which involves sales by firms to individuals, and trade or commercial credit,
which involves credit granted by one firm to another.
In managing accounts receivable, decisions should be made on
• credit selection
• credit standards
• credit limits
• credit terms
• collection policy
• monitoring accounts receivable
• collecting outstanding debt.
The following aspects of credit policy are also worth mentioning:
• A system of forms, paperwork and overall flow of information should be developed
in the credit department.
• A contract, stating the conditions of sale and the buyer- seller relationship, should
be drawn up and should accompany a credit transaction.
• Credit insurance on major credit customers may be considered.
• A decision should be made about the possible factoring 1 of debtors' accounts.
8.4. 1 Credit selection

Credit selection involves decisions about whether credit should be extended to a customer
142
and, if so, how much.
~ ~~
;:
ell ] 1. Factoring, or selling accounts receivable, involves selling a firm's accounts receivable to a finan cial
j~ intermediary (the factor) . The credit-granting function of the firm is taken over by the factor who buys
@ the resulting assets.
8
The credit selection process (application for credit)
The credit selection process normally starts with the development of a well-designed
and neatly printed "application for credit" form. This form is an important document
because it is the basis of the credit contract and as such is a vital document in litigation.
The following minimum information should be supplied by the applicant:
• Full name
• Home address and telephone number
• Employer's name and address, telephone number and employee reference number
• Bank particulars, particularly credit card information (if applicable) 2
• Trade and personal references (if no credit card is held)
If the applicant is a business firm, the following details should be acquired:
• The registered and the trade name of the entity
• Particulars of the auditors of the entity
• Registration number of the firm
• Registered address
• Full particulars of the owners, directors, shareholders, members or partners
If the applicant is unknown to the firm, personal suretyship should be obtained from the
owners or shareholders for the due and punctual fulfilment of the applicant's obligations.
The next step is to verify the information furnished by the applicant on the applica-
tion form by making use of one or more of the following sources of information.
Trade references
Providing trade references is an unproductive chore for management. A firm wishing
to obtain trade references should make it as easy as possible for the addressed party to
comply. A good idea is for a reply-paid envelope to be sent, enclosing a letter that can
be marked and returned quickly. It is best to ask specific questions and mention specific
sums that are under consideration; a firm that has granted credit to a customer in the
range of Rl 000 may provide a good reference, but such a reference is not necessarily
meaningful if a credit reference is being sought in the range of R20 000.
Negative responses or no responses at all should not be ignored. Additional sources
of information should be accessed before a final decision is taken. Circumstances will
dictate the number of sources to be used. For larger amounts of credit, more than two
sources of information should be considered.
Bank references
Bank references of potential customers may be obtained. The information obtained
will normally be rather vague unless the applicant assists the firm in obtaining it. A
banker normally gives a subj ective opinion on an account and will comment on the
143
2. The possession of a credit card indicates that the applicant's bank has done a credit screening. The
amount of credit extended on the card is indicative of the person's character, capacity and collateral.
No further trade or personal references should be required if the applicant has a credit card. The bank
should be able to provide sufficient information on the applicant's creditworthiness.
safety of dealing with the customer and not necessarily on the speed with which bills are
paid. A banker who feels loyal towards his or her customer may put forward an opinion that
is consistent with the truth but casts it in the most favourable light.
When using this source of information, it is important to consider the following:
• The size of the order placed should be checked against the balance of the account of the
customer as reported by the bank. If the money in the bank account is insufficient to
cover the size of the order, a banker may have to wait for payment until the customer sells
the goods or is paid by his or her debtors.
• Even if the bank balances reported are favourable, the banker should check the loan
position of the customer. The customer may have borrowed large sums and the bank
may have a call on receivables and inventory as security for those loans. In the event of a
business failing, the customer may be unable to pay the debt, with the bank taking over
the business of the customer and thus leaving little for other creditors.
Trade sources and competitors

This is one of the most valuable sources of information available. The main advantage is that
the firms are in the same type or a related type of business and you may know some of the
contact persons personally. Many trades form associations with firms of a similar grouping,
which provides a basis for exchanging information. In many cases, a customer is likely to
trade with one or more of the competitors in the market, and the chances of obtaining useful
information from them are good. This pooling of information is very valuable when the pay-
ment performance of an established customer is deteriorating. A combined approach to the
customer may be the best alternative to follow.
The following are valuable points to consider in using this source of information:
• A customer should not be told of the exchange of information.
• A firm should not abuse this source of information by asking for it too often.
• Firms should cooperate when approached for information by other firms.
Credit bureaux
Credit bureaux are professional businesses registered with the National Credit Regulator
(NCR) that provide services to firms seeking information on potential customers' credit rat-
ings, for a predetermined fee. Any money spent on these bureaux is recouped in the form
of prompt collections and fewer bad debts. Information supplied by these bureaux may be
purely factual, that is information on the directors, trading addresses and key details from
published statements and reports of the firm under review. Trade and bankers' references
may also be provided by these bureaux together with an opinion about the credit rating of
the potential customer. The aforementioned information is extremely useful but one should
ensure that it is not outdated or incomplete.
Credit insurance
144 It is possible for a firm to insure some or all of its debts against the risk of insol-
j~ vency. Note that it is not possible to insure against slow payments. Credit insurers are
J:: ] experienced in assessing risk and making sound judgements. A firm should think twice
~~
@ before granting credit to a customer who has been refused insurance or for whom high rates
have been quoted.
8
In-house opinion
Members of the firm's sales force may provide useful information on customers. They
might have met the customer or been given a lead from another source and their com-
ments should be heeded.
Own records
Useful information may be obtained from in-house accounts. It can be determined
whether a customer pays on time and whether he or she makes use of worthwhile dis-
counts offered. This will indicate whether the payment pattern of a customer is improv-
ing, stable or deteriorating. Watch out for so-called long firm fraud. This involves cus-
tomers building up a good payment record and then greatly increasing the volume of
his or her orders. He or she then suddenly closes down with a resultant disappearance
of stock and eventual bad debt for the selling firm.
Civil judgements
It is worthwhile to subscribe to a firm that provides information on all civil judgements
granted against members of the public for bad debts. It would normally not be a good
idea to extend credit to such a customer.
Credit analysis
The final step in the credit selection process is the evaluation of the applicant - also
referred to as credit analysis. The purpose of this step is to determine the creditworthi-
ness of the customer, as well as to estimate the maximum amount of credit he or she is
capable of supporting. Various methods are available to assist a credit manager in the
evaluation.
Traditional approach to credit analysis

In the traditional approach to credit granting, all the information gathered is synthe-
sised and a verdict reached on the creditworthiness of the customer. The information
collected is organised by classifying the applicant according to five dimensions, the so-
called Five Cs of credit, namely capital, collateral, character, capacity and conditions.
Each of these will be briefly discussed.
• Capital: This refers to the financial position of the customer. Data obtained from the
financial statements of the customer are analysed using liquidity and solvency ratios.
• Collateral: Collateral is the security provided by the customer to obtain credit.
In the event of the liquidation of a customer, the recovery to trade creditors will
depend on
- the recoveries on assets sold
- the amount of debt of the customer
- the extent to which these debts are secured.
145
The debt of secured creditors will be settled first. Since it is extremely difficult for trade
creditors to obtain secured positions, recoveries are much lower than when the cus-
tomer is financed by using secured borrowing.
• Character: Character refers to the willingness of the customer to pay and is

measured by the payment history of the customer and defaults to other traders.
• Capacity: Capacity refers to the ability to pay by a stipulated due date. Evidence of
capacity is obtained mainly from the income statement of the customer. Capacity
may also refer to both the value and technology of a customer's plant and facilities,
as well as the management competency of the particular customer, where such
customer is a commercial customer.
• Conditions: Conditions refer to the economic and competitive environment in
which the applicant operates. During periods of rising interest rates and recessions,
as well as tough competition, the probability of encountering bad debts increases.
Problems with the traditional approach

The traditional judgemental approach is extremely flexible. However, this flexibility
does create a few problems, which may be summarised as follows:
• The analyst is required to make a judgement, with only vague guidelines on what
the appropriate criteria for the judgement should be.
• The traditional analysis method, in contrast to most other financial decision meth-
ods, is not explicitly linked to the creation of owners' wealth. There is thus no guar-
antee that decisions based on this technique will contribute to the owners' wealth
maximisation.
• Because of the judgemental nature of the method, the results may be inconsistent.
This may lead to the impression that credit decisions are made in an arbitrary fash-
ion, which again may cause friction between the credit and other departments in
the firm.
• Experience in assessing the strengths and weaknesses of applicants is gained over
time. The more experience an analyst has of the traditional approach, the larger
the sample of applicants analysed will be and the less likelihood there will be of
biased decisions. Inexperienced analysts may have great difficulty in applying the
traditional approach and may make costly mistakes.
In attempting to overcome some of these problems, firms have developed judgemental
scoring systems for the evaluation of potential customers.
judgemental scoring systems

The two versions of this evaluation method are the checklist system and the weighted
scoring system.
• Checklist system: This method involves asking a series of questions, such as, "Is
the current ratio of the customer above 2,0?" or "Is the total debt to total asset
ratio above 0,5?" Positive responses to a predetermined portion of questions are
required before credit is granted to a customer.
146 • Weighted scoring system: Weights reflecting the importance of questions are
~~ assigned to the questions in the checklist. The sum of points scored is compared to
U pre-set points when making a credit-granting decision.
~~
@
THE M ANAGE ME NT OF WORKI N G CAPITAL
8
The following is an example of credit scoring.
Characteristic Score Predetermined Weighted
(0-100) weight score
Credit references 80 0.25 20.0

Home ownership 100 0.20 20.0
Income range 60 0. 15 9.0
Payment history 90 0. 15 13.5
Years at address 70 0. 10 7.0
Years on job 70 0. 15 10.5
Total l....00 filLQ
The firm's credit standard defines the minimum criteria for the extension of credit to a
customer. The following is an illustration of a decision to extend credit:
Credit score Action
Greater than 75 • Extend standard credit terms.
60 to 74 • Extend limited credit; if account is properly maintained it
can be converted to standard credit terms after one year.
Less than 60 • Reject application.
The methods discussed above are developed by consultation between experienced credit
analysts. They are referred to as "expert systems" in that they simulate the decision an
expert would make when evaluating a credit applicant. These methods are preferred to
traditional methods because they provide an analytical framework for analysis, they yield
consistent results and can be used by inexperienced credit analysts in decision making.
8.4.2 Credit standards

Credit standards reflect the minimum requirements for extending credit to a customer.
The tightening or relaxing of the existing credit standards of a firm will have a direct
effect on its sales volume, level of accounts receivable and bad debt expenses. The effect
of a change in the credit standards on these variables is summarised below.
Relaxation of credit standards:
Variable Direction of change Effect on net income
Sales volume Increase Positive
Investment in accounts Increase Negative
receivable
Bad debts cost s Increase N egative
Tightening of credit standards:
Variable Direction of change Effect on net income
Sales volume Decrease Negative 147
Invest ment in account s D ecrease Positive ~~
receivable ~~
C -Cl
Bad debt costs Decrease Positive ~ ct
@
8.4.3 Credit limits

After all checks have been completed and the firm has decided to extend credit to a
client, it is important to place a credit limit on the account in order to limit risks for the
firm. Trading at credit limits may be done for two main reasons, namely:
• It is sensible to limit the amount and effort spent on credit checks in proportion
to the amount of credit needed for a specific period of time. A credit check on a
customer requiring credit of RS 000 will be limited to, say, one source of informa-
tion. However, should the customer wish to increase his or her credit to R20 000 it
would be wise to do additional checks. Placing a limit of about RS 000 on the credit
granted to the customer protects the firm against credit risks. Credit limits provide
a realistic compromise for limited credit checking.
• It is best to inform a customer of the limit placed on the account so that he or she is
aware of the concomitant restriction of supplies. Credit limits should be regularly
reviewed.
8.4.4 Credit terms

The credit terms of a business firm specify the repayment terms required of all its credit
customers. It is important for the firm, as the seller, to ensure that credit terms legally
govern the contract of sale. A contract is governed by the position at the time it is
drawn up, for example a contract of sale is formed when an order is accepted and not
when an invoice is issued with the delivery of the goods. It is also a good idea to put
the terms of sale on all orders, invoices, statements and delivery notes, and to have the
customer sign these as proof of his or her acceptance of the terms.
Setting credit terms involves determining three parameters, namely:
• The cash discount (the percentage discount allowed if payment is received within a
specified period of time)
• The period of time for which this discount is to be allowed
• The net date (the due date for payment if the discount is not taken)
Typically, credit terms may be indicated as follows in the condition of sale:
2/10 net 30 days
The above credit terms mean that the client receives a discount of 2% if the account is
paid within 10 days from the beginning of the credit period. Should the discount not be
taken up, the account must be settled within 30 days from the beginning of the credit
period.
148 8.4.5 Colledion policy

The collection policy of a business firm refers to the different procedures it uses to collect
accounts receivable once they become due. In this section we discuss some ofthe methods
and procedures available to businesses in the collection of accounts receivable.
8
Invoices, statements and accounts receivable
The collection of accounts receivable starts with the correct and timeous mailing of
invoices. An invoice provides both managers and clients with information on the trans-
actions that have taken place. An invoice provides a customer with information on the
amount due and the date on which the debt due must be paid. It is best to indicate the
conditions of sale at the back of invoices and statements. It is, however, advisable to
put the period of credit on the front of the document. A customer must have no doubt
about the amount demanded for payment and the date on which the payment is due.
Timing ofinvoices
Invoices should be sent out to customers promptly. Large invoices may even be sent by
e-mail or faxed to the customer, with the original copy following in the mail. Sending
out invoices early may result in early payments.
Size and frequency ofinvoices

It is better to send small invoices regularly rather than one invoice at the end of a series
of deliveries of goods. The advantages of this are as follows:
• Earlier invoices will become due for payment more quickly.
• Smaller rather than large invoices may be paid in cases where customers are short
of money.
• A dispute about an invoice may delay payment. If the amount causing the dispute is
included with other amounts on one invoice, the payment of the total amount due
on the invoice may be delayed.
• Larger invoices normally require more approval signatures and may take longer to
be settled.
8.4.6 Monitoring and controlling accounts receivable

The effectiveness of the credit and collection policy of a firm can be monitored by
evaluating the payment patterns of debtors and the bad debt costs of the business firm.
Monitoring payment patterns

It is essential to keep adequate and accurate records for each debtor. These records
should preferably be computerised to ensure the instant availability of information on
the credit position of the firm. Accounts receivable can first be examined as a whole.
Individual accounts may be checked if necessary.
An effective indicator of the effectiveness of credit policy and collection is the aver-
age collection period. This is a ratio that expresses the total amount of receivables out-
standing in terms of an equivalent number of average daily credit sales. 149
An ageing schedule may be used to disentangle sales trends and payment behaviour.
An ageing schedule indicates how long accounts receivable have been outstanding at
a given point in time. Ageing accounts receivable involves dividing each customer's
account into amounts that are Oto 30 days old, 31 to 60 days old, 61 to 90 days old, and
so on. An example of an ageing schedule is provided in Table 8.1.
Table 8.1 Ageing schedule
Interval 1st quarter 2nd quarter 3rd quarter 4th quarter

0-30 days R30 000 R45 000 RS0 000 R65 000
31--60 days R21 000 R25 000 R30 000 R42 000
61-90 days R6 000 R6 000 RIS 000 Rl2 000
91-120 days 0 0 0 0
Total R57 000 R76 000 R95 000 RI 19 000
Converting rand values to percentages of the total for each interval helps to remove
the influences of changes in sales levels. Probably the best way to determine changes in
customer behaviour is to draw up a schedule of the percentage portion of each month's
credit sales that are still outstanding at the end of successive months, as illustrated in
Table 8.2.
Table 8.2 Percentage of credit sales outstanding at the end of the month for six months
% of Credit sales Jan Feb Mar Apr May Jun

outstanding after:
Current month 100% 100% 100% 100% 100% 100%
I month 70% 72% 70% 75% 76% 70%
2 months 20% 20% 21% 30% 32% 21%
3 months 5% 4% 5% 6% 8% 4%
4 months 0% 0% 0% 0% 0% 0%
Comparing the relative percentage at the end of the month over the six-month period,
we can see that no accounts were paid during the month of sale. All unpaid accounts
were written off at the end of four months. During April and May, payment of accounts
receivable took place at a slower rate but returned to normal in June. An additional
advantage ofthis monitoring technique is that it provides an historical record of payment
percentages that may be used in projecting monthly collections that are needed to draw
up the cash budget of the firm.
Monitoring bad debts

Bad debts are measured by means of the following ratio:
Bad debts X
100
Credit sales 1
150
1j
(/) ~
A firm determines certain confidence limits based on the expected value of this ratio.
~~
@
8
Example
A bad debt ratio of 5% of credit sales is generally expected. The firm determines
the historic random variation in this ratio, for example historical variations of I%
have occurred. If the actual ratio of bad debts to credit sales of the firm falls
outside these limits, an investigation needs to be conducted . A bad debt ratio of 5
to 6% or 4 to 5% of credit sales might therefore be considered normal. However,
should the bad debt ratio increase to 7% of credit sales or drop to 3%, an
investigation should be conducted to determine the cause of th is larger than
expected variation .
Both positive and negative variations should be investigated. A positive variation (i.e. a
drop in the bad debt ratio) may point to positive measures that were undertaken by the
firm and which need further exploitation. Negative deviations need to be investigated
and corrective measures introduced to prevent the ratio from increasing even more.
However, certain difficulties are inherent in this comparison process, such as the
following:
• Bad debts are recognised in a period after the occurrence of the sale. Bad debts
should be compared with sales in the month in which the sales occurred.
• Most of the bad debts of a firm are the result of only a few defaulters. Firms with
proper credit policies experience very few defaults by debtors, but the defaults that
do occur are normally for large sums of money.
8.4. 7 Follow-up of delinquent accounts

The longer an account remains outstanding, the lower the probability of collecting it.
Prompt follow-up is necessary to prevent losses. Various methods may be used to collect
overdue accounts, such as
• letters or e-mail
• telephone calls
• personal visits
• collection agencies
• legal action .
8.S THE MANAGEMENT OF CASH

The management of cash flow is a vital activity in a firm and involves not only the finan-
cial manager or accountant, but also the cooperation of all the managers or decision
makers in the main functional areas. 151
Although cash is considered to be the most liquid asset of a firm, firms n ormally
carry other assets that are also high in liquidity. The ability of an asset to be converted
readily into cash at short notice, without the possibility oflosses attached to its conver-
sion, is referred to as the "liquidity of an asset': These assets are referred to as near-cash
assets, an example of which is a marketable security such as a treasury bill.
8.5.1 Motives for holding cash and marketable security balances

Cash is considered to be a non-earning asset. Interest earned on marketable securities
is also normally much lower than returns on other assets held by the firm. However,
even though the rate of return on these assets is low, there are strong motives for hold-
ing them.
Transaction motive
The transaction motive is the need for cash to meet payments arising in the ordinary
course of business. A firm needs cash to pay for finished goods, services, labour inputs,
taxes, etc. With cash in the bank a firm can obtain more favourable conditions of pur-
chase. When a firm buys on credit, it normally has to accept the credit conditions of
the creditor.
Compensating balances
Banks providing loans to firms may require that a certain minimum amount be held on
deposit to help offset the cost of services provided. Recent developments in the banking
sector have, however, resulted in a move towards fee-based systems of bank compen-
sation which do not require the holding of cash for the purposes of compensating
balances.
Speculative motive
The speculative motive relates to holding cash in order to take advantage of unex -
pected profitable opportunities, such as bargain purchases and, in the case of multi-
national firms, exchange rate fluctuations. However, these days most firms rely on
reserve borrowing power and on marketable securities portfolios rather than actual
cash holdings for speculative purposes.
Precautionary motive
The precautionary motive for holding cash has to do with maintaining a cushion or
buffer to meet unexpected contingencies. A firm with easy access to borrowed funds
will require less precautionary cash. Firms with large needs for precautionary balances
tend to keep highly marketable securities that can be converted into cash in a very short
period, and that at the same time provide income in the form of interest.
152
A firm thus requires cash to take advantage of trade and quantity discounts in pur-
chasing, to achieve and maintain a credit standing, to take advantage of favourable
business opportunities and to meet unexpected contingencies. The maintenance of
cash balances does, however, entail certain costs.
8
8.5.2 The cost of cash
The cost of maintaining cash holdings comprises the following:
• An opportunity cost of foregoing other lucrative investment opportunities is
incurred. For example, cash could be used to purchase securities, expand accounts
receivable or obtain other assets.
• Excessive reliance on internally generated liquidity may also isolate the firm from
the short -term financial market, making it difficult to obtain short -term financing
quickly and at reasonable rates.
• There is also a cost attached to the holding of cash that could otherwise be used to
offset the cost and financial risk derived from the firm's short-term debt.
The objective of cash management is to minimise the amount of cash held by the firm,
lowering the costs attached thereto and consequently maximising wealth. The cash bal-
ances and safety stocks of cash are influenced by production and sales techniques, pro-
cedures for collecting outstanding accounts and payment for purchases. These factors
can be better understood by an analysis of the operating and cash conversion cycles of
the firm. They are dealt with in the next section.
8.5.3 Strategies for cash flow management

Firms with positive cash conversion cycles may pursue certain strategies to minimise
the cash conversion cycle. Care should be taken not to use these strategies to the detri-
ment of the firm, to cause more harm than good. The three main strategies available to
firms are discussed in the sections below.
Stretching accounts payable

One strategy available to firms is to stretch accounts payable - to pay their bills as late
as possible without damaging their credit rating. Although this is a financially attrac-
tive strategy, it raises an important ethical issue since it may cause the firm to violate an
agreement with a supplier. Clearly, a supplier would not look kindly upon a customer
who deliberately postpones paying for merchandise or equipment. The firm may lose
its credibility and may be refused credit in future.
A firm may settle its account earlier if the creditor offers a cash discount. Sometimes
a firm prefers to settle its account after the discount period in order to preserve cash
flow. In such cases, you would have to calculate the cost of foregoing a cash discount
as follows:
CD X 365
(1 - CD) N
153
where CD = the cash discount (expressed as a proportion)
N = the number of days foregone
365 = days per year
Example
Assume that a firm is offered 2/ IO net 30. The cost of foregoing the cash discount may be
Cost of foregoing cash discount = 0.02 X 365 = 37.24%

(I - 0.02) 20 days
If the firm's short-term borrowing (e.g. a bank overdraft) rate is 18%, then it would be
more profitable to borrow the money to settle its account with the creditor. The firm will
effectively earn 19.24% (37.24% saving - 18% cost of overdraft) by taking advantage of
the cash discount.
Efficient purchasing and inventory management

Another way of minimising required cash is to increase inventory turnover. This can be
achieved in either of the following ways:
• The firm can increase its inventory turnover through better forecasting of demand
and better planning of purchasing to coincide with these forecasts. More efficient
control of inventory will contribute to a faster inventory turnover.
• With better purchasing planning, scheduling and control techniques, the firm can
reduce the length of the purchasing cycle. This will result in an increase in the firm's
inventory turnover.
Regardless of which aspects of the firm's overall inventory turnover are adjusted, the
result will be a reduction in the amount of operating cash required.
Speeding up the collection ofaccounts receivable

Yet another way of reducing the operating cash requirement is to speed up the collection
of accounts receivable. Accounts receivable, like inventory, tie up rands that could be
more profitably invested in other assets. Accounts receivable are a necessary cost to
the firm, since the extension of credit to customers normally allows the firm to achieve
higher levels of sales than would be the case if it operated on a cash basis. The actual
credit terms extended are generally dictated by the industry in which the firm operates
and are normally related to the nature of the product sold (i.e. the way in which it is
transported and used). In industries where virtually undifferentiated products are sold,
credit terms may be a critical factor in sales. In these industries, the firms generally all
match the best credit terms extended in order to maintain their competitive position.
In industries where relatively differentiated types of products are sold, there may be
greater variance in credit terms.
154 The above strategies all have favourable effects on the overall operating cycle of the
j ~ firm. Firms should therefore not attempt to implement only one of these strategies, but
J:: ] should rather use a combination to reduce their operating cash requirements. In this
~~
@ respect, the execution of the firm's marketing plan should contribute to the efficient
8
flow of funds to ensure that the profitability, liquidity and solvency of the firm can be
maintained.
8.5.4 The cash budget

The cash budget or cash forecast allows the firm to plan its cash needs. Typically, atten-
tion is given to planning for surplus cash and cash shortages. A firm expecting a cash
surplus can plan short-term investments, whereas a firm expecting shortages in cash
must arrange for short-term financing. The cash budget gives the manager a clear view
of the timing of the cash inflows and outflows expected during a given period. Allow-
ances should also be made for contingencies.
The cash budget is generally designed to cover a one-year period, although any time
p eriod is acceptable. The period covered is normally divided into intervals, the number
and type of which depend on the nature of the company. The more seasonal and uncer-
tain a firm's cash flows, the greater the number of intervals, and in such cases a monthly
basis is often preferred, while firms with stable cash-flow patterns may use quarterly or
annual intervals. If a cash budget is developed for a period exceeding one year, the less
frequent intervals may be warranted by the difficulty and uncertainty of forecasting
sales and associated cash items.
Format of the cash budget

The general format of the cash budget is presented below. Each of the following
components of a cash budget will be discussed individually.
Cash inflow
less: cash outflow
equals: net cash flow
add: beginning cash balance
less: interest on short-term borrowing (if any)
equals: ending cash balance (before borrowing)
Cash inflow includes the total of all items that result in cash inflows in any given period.
The most common components of cash inflow are cash sales, collections of accounts
receivable, and interest earned.
Cash outflow includes all outlays of cash during the relevant periods. It is important
to recognise that depreciation and other non-cash charges are not included in the cash
budget, because they merely represent a sch eduled write-off of an earlier cash outflow.
A firm's net cash flow is calculated by subtracting the cash outflow from the cash
inflow each month.
The ending cash for each month is determined by adding beginning cash to the 155
firm's net cash flow. If the ending cash is less than zero, the firm would have to arrange
financing, such as an overdraft. If the ending cash exceeds zero, the firm has excess cash
available.
Example
"I
A firm sells al I its goods on credit. Based on the firm's ageing schedule of accounts
receivable, the credit manager has indicated that the firm (on average) collects 70%
of the sales in the month following the sales transaction, 20% during the second
month and S<¾o during the third month. 5% of all sales prove to be uncollectable. The
firm has made the following sales during May, June and July, and the marketing
manager has iorecast the following sales for August, September and October:
Actual Forecast
May June July August September October
R2 100 000 R2 400 000 R2 000 000 RI 600 000 RI 200 000 RI 000 000
Other income expected is the following: R 12 456 during August, RIO 600 during
September an d R 14 500 during October.
The procurement manager has indicated that payment for purchases will take
place as follows:
August September October

Payment for purchases R500 000 RS50 000 R690 000
The human r esources manager has indicated that payment of salaries (including
bonuses) will amount to:

Salaries R800 500 R820 000 R800 100
She has also indicated that the retrenchment of two employees during September
will cost the fi rm RI 50 000.
The financia I manager has prepared the following estimates of cash outflows
during August, September and October:

Rent payable 24 000 24 000 24 000
Dividends 0 0 42 800
Equipment 74 356 0 0
Tax 418 130 360 200 279 426
The firm expects to have a beginning balance of R60 000 on I August. Interest
payable is expected to amount to RS 16 during October.
156
-
THE M ANAGE ME NT OF WORKI N G CAPITAL
8
In order to determine the expected cash inflow and cash outflow for t he respective
months, schedules of projected cash inflow and outflow need to be compiled based
on forecast sales and purchases, together with other information on expected cash
inflows and outflows.
The projected cash inflows are as follows:

Cash receipts I 985 000 I 640 000 I 260 000
Other income 12 456 10 600 14 500
Total cash inflow I 997 456 I 650 600 I 274 500
The cash receipts from accounts receivable are calculated as follows:

.70 Xprevious month 's credit sales
.20xtwo months prior's credit sales
.05 Xthree months prior's credit sales
Note
The firm has determined that 5% of sales prove to be uncollectable; thus the above
figures do not add up to I or I00%.
The cash receipts for August would be calculated as:
.70 Xcredit sales of July = .70 x R2 000 000 = RI 400 000
.20xcredit sales of June = .20 x R2 400 000 = R 480 000
.OS x credit sales of May = .OS x R2 I00 000 = R I05 000
Cash receipts for August = RI 985 000
The projected cash outflows are as follows:

Payment for 500 000 550 000 690 000
purchases
Salaries 800 500 820 000 800 100
Retre nchme nt 0 150 000 0
Rent paid 24 000 24 000 24 000
Tax 418 130 360 200 279 426
Total cash outflow I 816 986 I 904 200 I 836 326
The projected total cash outflows are carried over to t he cash budget. Cash inflow
and cash outflow as calculated for t he respective mont hs appear at the top of t he
cash budget. 157

Other income 12456 10 600 14 500
Cash outflow:
Payment for purchases 500 000 550 000 690 000
Salaries 800 500 820 000 800 100
Retrenchment 0 150 000 0
Rent paid 24 000 24 000 24 000
Tax 418 130 360 200 279 426
Total cash outflow I 816 986 I 904 200 I 836 326
Net monthly change 180 470 -253 600 -561 826
plus beginning balance 60000 / 240470 / -13130
less interest paid 0 0 516
= Balance (before borrowing) 240 470 -13 130 -575 472
The net monthly change is determined by subtracting cash outflow from cash inflow for
every month. To this is added the beginning cash balance, which is estimated to be
R60 000 on I August.
The ending balance of one month is the beginning balance of the following month. The
ending cash balance at 3 I August is the beginning cash balance on I September, which
amounts to R240 470.
Interpreting the cash budget

The cash budget provides the firm with figures indicating the expected ending cash bal-
ance, which can be analysed to determine whether a cash deficit or surplus is expected
to result in each of the months covered by the forecast.
In the above example, the firm can expect a cash deficit during September and
October. It will have to either obtain short-term finance or apply the cash management
strategies of accelerating cash inflows, delaying cash outflows and managing inventory
better. If short-term financing is chosen, then at least Rl 3 130 would have to be arranged
for September and R575 472 for October.
Coping with uncertainty in the cash budget

Apart from care in the preparation of sales forecasts and other estimates included in the
cash budget, there are various ways of coping with the uncertainty of the cash budget.
One is by preparing several cash budgets, namely one based on a pessimistic forecast,
158 one based on the most likely forecast and a third based on an optimistic forecast. An
~~
;: ~
evaluation of these different scenarios of cash flow will allow the financial manager to
J:: ] determine the amount of finance necessary to cover the most adverse situation. The
~~
@ use of a computer spreadsheet program (such as MS Excel) is strongly recommended
8
for this purpose. The use of a number of cash budgets, each based on differing assump-
tions, should also indicate to the financial manager how risky each alternative is, thus
enabling him or her to make more intelligent short-term financial decisions. The sensi-
tivity analysis approach is commonly used to analyse cash flows in a variety of possible
circumstances.
8.5.5 Preventing cash losses

Cash is more susceptible to theft than any other asset. Furthermore, a large portion of
the total transactions of a firm involves the receipt or disbursement of cash. For both
these reasons, internal control over cash is of vital importance to management and the
employees of a firm. If a cash shortage arises in a firm in which internal controls are
weak or non-existent, every employee is under suspicion. Perhaps no one employee
can be proved to be guilty of the theft, but neither can any employee prove his or her
innocence.
On the other hand, if internal controls over cash are adequate, theft without detection
is virtually impossible except through the collusion of two or more employees. The first
requirement for ensuring internal control over cash or any other group of assets is that
the custody of assets should be clearly separated from the recording of transactions.
Secondly, the recording function should be divided between several employees, so that
the work of one person is verified by that of another. This division of duties discourages
fraud, because collusion among a number of employees would be necessary to conceal
an irregularity. Internal control is more easily achieved in large than in small firms,
because extensive subdivision of duties is more feasible in large firms.
The major steps in establishing internal controls over cash include the following:
• Separate the function of handling cash from the maintenance of accounting
records. The cashier should not maintain the accounting records and should not
have access to the records. Accounting personnel should not have access to cash.
• Separate the function of receiving cash from that of disbursing cash. The person
who handles cash receipts should not also make cash disbursements.
• All cash receipts should be deposited in the bank on a daily basis and all cash pay-
ments should be made by cheque or electronic fund transfer (EFT). Keep cash on
hand under lock and key.
The application of these principles in building an adequate system of internal control
over cash can best be illustrated by considering separately the topics of cash receipts
and cash disbursements.
Control over cash receipts

Cash receipts consist of two major types, namely cash received over the counter at the
time of a sale, and cash received through the mail as collections on accounts receivable. 159
Measures to be used for the control of cash receipts are discussed below.
• Use of cash registers. Cash received over the counter at the time of a sale should
be rung up on a cash register, positioned in such a way that the customer is able to
see the amount recorded. If store operations can be arranged so that two employees
must participate in each sales transaction, stronger internal control will be achieved
than when one employee is permitted to handle a transaction in its entirety. In
some stores, this objective is accomplished by employing a central cashier who
rings up the sales made by all clerks on a cash register. At the end of the day, the
store manager or a supervisor should compare the cash register tape, showing the
total sales for the day, with the total cash collected.
• Use of pre-numbered receipts. Internal control may be further strengthened by
printing a pre-numbered receipt in duplicate at the time of each sale. The original
is given to the customer and the copy retained. At the end of the day an employee
computes a total sales figure from these duplicate receipts, and also makes sure that
no receipts are missing from the series. The total amount of sales computed from the
duplicate receipts is then compared with the total sales recorded on the cash register.
• Cash received through the mail. The procedures for handling cheques and cur-
rency received through the mail are also based on the internal control principle
that two or more employees should participate in every transaction. The employee
who opens the mail should prepare a list of the cheques received. If this list is
to represent the total receipts of the day, the totals recorded on the cash registers
should be added to the list. One copy of the list is forwarded with the cash (cur-
rency and cheques) to the cashier, who deposits all the cash received for the day
in the bank. Another copy of the list is sent to the accounting department, which
records the amount of cash received. The total cash receipts recorded each day in
the accounting records should agree with the amount of the cashier's deposit, and
also with the list of total cash receipts for the day.
Cash over and short. In handling over-the-counter cash receipts, a few errors will inevi-
tably occur in giving change. These errors will cause a cash shortage or surplus at the
end of the day when the cash is counted and compared with the reading on the cash
register.
Control over cash disbursements

An adequate system of internal control requires that each day's cash receipts should
be deposited intact in the bank and that all disbursements should be made by cheque.
Cheques should be pre-numbered. Any spoiled cheques should be marked "Void" and
filed in sequence so that all numbers in the series can be accounted for.
The official(s) authorised to sign cheques should not have the authority to approve
invoices for payment or to make entries in the accounting records. When a cheque is
presented to the official(s) for signature, it should be accompanied by the approved
invoice and voucher showing that the transaction has been fully verified and that
payment is justified. When the cheque is signed, the supporting invoices and vouchers
should be perforated or stamped "Paid" to eliminate any possibility of their being
160
presented again for payment. If these procedural rules are followed, it is almost
impossible for a fraudulent cash disbursement to be concealed without the collusion of
two or more persons.
8
8.6 SUMMARY
Efficient management of working capital is important for the achievement of the overall
objective in a firm, namely wealth maximisation for the owners. A firm has to manage
its inventory, accounts receivable and cash prudently. Too much liquidity in a firm may
lower profitability, while poor liquidity may lead to technical insolvency.
This chapter explained the efficient management of cash inflows and outflows in a firm.
The importance of cash balances was indicated with reference to the different motives
for holding cash balances. Also briefly referred to were the various costs attached to
cash holdings in a firm. Strategies and techniques for the efficient management of cash
resources were addressed. The compilation of the cash budget was illustrated by means
of a practical example, and methods for the prevention of cash losses were discussed.
REFERENCES
Self-test question
Prepare a cash budget for October, November and December from the following
information.
Based on a firm's ageing schedule of accounts receivable, the credit manager has
indicated that the firm (on average) sells 20% of its goods for cash, while it collects 60%
of the sales in the month following the sales transaction, and the remaining 20% during
the second month.
The marketing manager has prepared the following data for the planning period:
Actual Forecast
August September October November December
R700 000 RI 000 000 RI 400 000 RI 900 000 R2 200 000
Other income expected is the following: R7 500 during October, R9 000 during Novem -
ber and Rl8 000 during December.
The procurement manager has indicated that payment for purchases will take place
as follows:
October November December

Payment for purchases R320 000 R558 560 R280 000
The human resources manager h as indicated that payment of salaries (including

bonuses) will take place as follows:
October November December 161

Salaries R400 000 RS00 000 RSS0 000
He has also indicated that training will cost the firm R60 000 during October and
R72 000 during November.
The marketing manager has budgeted for advertising as follows:

Advertising Rl20 000 R240 000 R2 10 000
The financial manager has received the following budgets from various managers for
October, November and December:
Rent payable (Property manager) IS 000 IS 000 IS 000
Maintenance (Maintenance section) 24 000 32 000 21 000
Computer equipment (IT section) 92 000 6 000 0
Tax (Accounting section) 32 456 35 664 375 184
The firm expects to have a beginning balance of Rl 0 000 on 1 October. Interest payable
is expected to amount to Rl 800 during November and R2 400 during December.
Solution to self-test question

Cash budget
Other income 7 500 9 000 18 000
Cash outflows:
Payment for merchandise 320 000 558 560 280 000

Salaries 400 000 500 000 550 000
Training 60 000 72 000 0
Advertising 120 000 240 000 210 000
Rent IS 000 IS 000 IS 000
Maintenance 24 000 32 000 21 000
Computer equipment 92 000 6 000 0
Tax 32 456 35 664 375 184
Total cash outflows I 063 456 I 459 224 I 451 184
Net monthly change - 35 956 - 30 224 426 816

plus beginning balance 10 000 - 25 956 - 57 980
162
~ ~ less interest paid 0 I 800 2 400
;: ~
u -<:
(/) ~
C -Cl = Balance (before borrowing) - 25 956 - 57 980 366 436
~~
@
Glossary
Accept-reject approach: an approach in financial decision making that involves
evaluating capital expenditure proposals to determine whether they are acceptable.
It can be used if the firm has unlimited funds at its disposal. If the firm is evaluat-
ing projects with a view to capital rationing, only acceptable projects should be
considered.
Account payable: an account due for payment that, in contrast to a note payable,
does not involve the issuing of a formal written promise to the creditor (the two
types of liabilities are shown separately in the statement of financial position (bal-
ance sheet)).
Accountability: (in the budgeting process) where a manager is obliged to give a
reckoning, explanation or account of his or her actions and decisions regarding the
use of money entrusted to his or her care. Managers must be made accountable for
their actions, but should also be given responsibility and be empowered to achieve
the goals that have been set.
Accounting: the development and provision of data for measuring the perfor-
mance of the firm, to assess its financial position and see to the payment of taxes.
(Accounting differs from financial management in the way in which the firm's funds
are viewed.) Accounting data does not fully describe the circumstances of the firm.
Accounting period: the period of time covered by a statement of financial perfor-
mance (income statement). It may be a month, a quarter of a year, half a year or a
year.
Accounts receivable: debtors to the firm (part of current assets) .
Accrual principle: a principle whereby revenues are recognised at the point of sale
and expenses when they are incurred (i.e. when transactions have occurred). In
calculating the profit for a specific period, only income earned during that period
(regardless of when it was received) may be brought into account, and only value
consumed during that period can be brought into account as expenses (regardless
of when payment was made).
Acid-test ratio: see Quick (acid-test) ratio.
Activity ratios: measurements of the speed with which various accounts are con-
verted into sales or cash. Measures of overall liquidity are generally inadequate
because differences in the composition of a firm's current assets and liabilities may
significantly affect the firm's "true" liquidity.
Adaptability of budgets: necessary because circumstances change as budgets are
implemented during a financial year and budgets should not be so rigid that no
changes can be made, although changes must be justifiable. 163
Agency problem: a conflict of interest between principals (the owners) and agents
(managers), whereby managers do not necessarily act in the best interests of the
GLOSSARY
shareholders - in larger firms such as public companies, ownership is spread over a

huge number of shareholders, and the dispersion of ownership means that managers
have to act on behalf of owners.
Amortisation: repayment of the loan principal over a specified term. See Loan
amortisation and Long-term debt.
Annual compounding: when the amount earned (i.e. the interest) on the initial
principal becomes part of the principal at the end of each compounding period.
Annuity: a series of equal cash flows (which may be received or deposited) for each
of a specified number of periods. There are two types of annuity: an ordinary annu-
ity and an annuity due. If an annuity consists of amounts received or deposited at
the end of each period, it is known as an ordinary annuity. If it consists of amounts
deposited or received at the beginning of each period, it is known as an annuity due.
Annuity due: see Annuity.
Auditors' report: a statement that the auditors have audited the annual financial
statements and that these statements fairly represent the financial position of the
firm at the financial year-end date.
Average age of accounts receivable: see Average collection period (ACP).
Average age of inventory (AAI): see Operating cycle (OC).
Average collection period (ACP): a useful means for evaluating credit and col-
lection policies. It is determined by dividing the average daily credit sales into the
accounts receivable balance.
Average payment period (APP) : the time period that elapses between buying the
products and actual payment when firms buy inventory on credit from producers or
suppliers. The APP is determined by dividing the average daily credit purchases into
the accounts payable balance.
Bank overdraft: the arrangement with the bank to have a debit balance on the firm's
cheque account up to a certain limited amount. Interest payable on the overdraft is
calculated on the outstanding amount of the cheque account.
Benefit-cost ratio: see Profitability index (PI).
Bonds: fixed interest securities (loans with fixed interest rates) issued by compa-
nies in order to finance plant, equipment or working capital. Bonds are legal agree-
ments that list the obligations of the issuer to the bondholder, including the payment
schedule, collateral and restrictive covenants. Only interest is paid (normally every
six months) over the life of the bond and the principal is paid back at maturity.
164 Break.even analysis: a framework for understanding the interrelationships between
variable costs, fixed costs, sales volume and selling prices. Formulae used are those
for marginal income, marginal income per unit, profit, breakeven point (measured in
units), breakeven point value (measured in rand), and margin of safety ratio.
GLOSSARY
Breakeven point: the activity level at which total costs = total revenues. The firm's
operating breakeven point is the level of sales necessary to cover all operating costs.
At this point, the earnings before interest and taxes (EBIT) = zero.
Capital budget: an indicator of the expected (budgeted) future capital investment in
physical facilities (buildings, equipment, etc.) to maintain present or expand future
productive capacity.
Capital budgeting: the process of identifying and evaluating potential investments
in long-lived assets to determine if they will add value to the firm, and the implemen-
tation and monitoring of such investments. Capital budgeting places the emphasis on
cash flows associated with the investments, rather than on accounting profit figures.
Capital budgeting techniques: methods that do not discount cash flows (they do
not involve the time value of money), and other methods that do discount cash flows.
(See Non-discounted cash flow methods and Payback period.)
Capital market: a key financial market that deals in long-term funds, from three
years and longer. In practice, funds flow back and forth between the money market
and the capital market. The following financial institutions may be regarded as the
primary source of funds for the capital market: short - and long-term insurers; pen-
sion and provident funds; unit trusts; public investment commissioners; and the JSE,
which is a significant feature of the South African capital market.
Carrying cost: the cost of carrying inventory. Carrying costs of the firm rise in direct
proportion to the size of the order. (Also see Ordering cost, Total inventory cost (TIC)
and Economic ordering quantity (EOQ).)
Cash budget: indicator of the extent, time and sources of expected cash inflows; the
extent, time and purposes of expected cash outflows; and the expected availability of
cash in comparison with the expected need for it.
Cash conversion cycle (CCC): the total number of days in the operating cycle of the
firm, less the average payment period. The maintenance of adequate levels of cash
contributes to the maximisation of the value of the firm.
Cash flow statement: part of the financial statements of a firm, it indicates what cash
flows were generated from operating activities, from financing and from investment
activities.
Cash receipts: cash received over the counter at the time of a sale, and cash received
through the mail as collections on accounts receivable.
Claims on assets: actioned when a firm gets into difficulty, especially when its assets
are being liquidated. Claims of creditors precede those of the owners; claims of pref-
erence shareholders are usually superior to those of residual owners; ordinary share-
165
holders are last in line.
Claims on income: aspects of these distinguish debt from equity - priority of the
claim, the certainty of the claim and the amount of the claim are aspects of claims
GLOSSARY
on income that distinguish debt from equity.

Collateral: the security provided by the customer to obtain credit (e.g. an insur-
ance policy or specific assets such as buildings or equipment).
Commercial credit: see Trade (or commercial) credit.
Common costs: see Indirect costs (also called common costs).
Company equity: ordinary share capital of a company. Preference shares that are
not redeemable or that cannot be converted into loans may also be regarded as
equity. (Also see Equity.)
Compensating balances: a certain minimum amount to be held on deposit at the
bank to help offset the cost of services provided. (There is now a move in the bank-
ing sector towards fee-based systems of bank compensation that do not require the
holding of cash for these purposes.)
Conservatism: the use of the most conservative approach of profit determination.
Consistency concept: consistency of accounting treatment of like items within
each accounting period and from one period to another.
Consumer credit: sales by firms to individuals (management of accounts
receivable).
Core business: the crucial operations a business must perform, for example the
excavation of metals and minerals (in the case of mining firms), the manufacturing
of goods (in the case of manufacturing firms) and buying and selling (in the case
of retail firms).
Cost-benefit principle: sound financial decision making requires making an anal-
ysis of the total cost and the total benefits. Decision making, which is based on the
cost of resources only, will not necessarily lead to the most economic utilisation
of resources. As far as possible, the benefits should be greater than the cost of any
decision.
Cost leadership: the sustainable mass production and marketing of standardised
items at a cost below that of competitors.
Cost of capital: the rate used to discount cash flows (the required rate of return).
The terms "discount rate': "opportunity cost" and "weighted average cost of capital"
are used interchangeably to refer to the minimum return that must be earned on a
project in order to leave the firm's market value unchanged.
Coupon rate: interest paid at a fixed rate on nominal value.
Credit analysis: evaluation of an applicant as the final step in the credit selection
166 process to determine creditworthiness and to estimate the maximum amount of
credit the applicant is capable of supporting. (Various methods are available to
assist a credit manager in the evaluation - in the traditional approach, information
is organised by classification according to five dimensions, or "five Cs of credit":
GLOSSARY
capital, collateral, capacity, character and conditions.) (Also see Judgemental

scoring systems.)
Creditor: the person or company to whom an account payable is owed.
Creditworthiness (rating): a firm's credit rating is mainly a product of its liquid-
ity, earnings potential and record of having met previous obligations. (The value
and character of the assets that a firm has to pledge as security are of secondary
importance.)
Current assets: those that change with the transactions that take place as business
is conducted - inventory (stock), accounts receivable (debtors) and cash deposited
or on hand. In a trading business, inventory would be merchandise for resale; a
manufacturing firm would hold inventory of raw material, work-in-process and
finished goods.
Current liabilities: consist mainly of accounts payable, but might also include
short -term financing, such as a bank overdraft.
Current ratio: one of the most commonly cited financial ratios (used to measure
liquidity) expressed as: current assets + current liabilities.
Debentures: loans made to a firm, usually for a predetermined period and interest
rate - used to finance any assets or activities of the firm without pledging any assets
as collateral.
Debt: money borrowed by the firm - a firm usually gives first claim on the firm's
cash flow to creditors. Equity holders are entitled only to the residual value (the
portion left after the creditors have been paid). The value of this residual portion is
the owners' equity in the firm, which is the value of the firm's assets less the firm's
liabilities (debt): owners' equity = total assets - liabilities. (Maturity (debt falls due),
claims on income, claims on assets, the right to a voice in management and the tax
benefit of paying interest distinguish debt from equity.)
Debt-equity ratio: an indicator of the relationship between the long-term funds
provided by creditors and those provided by the firm's owners. It is commonly used
to measure the degree of financial leverage of the firm and is defined as: long-term
debt + shareholders' equity x 100 over 1.
Debt financing: liabilities that need to be paid back by a certain date.
Debtors: accounts receivable (a current asset) - customers that owe money to the
firm.
Debt ratio: measurement of the proportion of total assets provided by the firm's
creditors. The higher this ratio, the greater the amount of other people's money
being used in the attempt to generate profits. The formula for calculation is: total 167
liabilities + total assets x 100 over 1.
Depreciation: a reduction in the value of a fixed asset as it is used up or worn out
over time; its original cost is reduced in order to reflect this usage. When depre-
GLOSSARY
ciation is applicable, the asset will be shown in the statement of financial position
(balance sheet) at the depreciated value.
Differentiation: the supply of products or services that are unique, and which
provide good value to customers. In order to sustain differentiation, the product
or service must be able to continue offering high perceived value to buyers, and
competitors must not be able to imitate such differentiation.
Direct labour: salaries paid to employees who work directly on the transformation
of raw materials into a finished product, as well as payments to quality inspectors.
Direct material: the cost of all materials directly traceable to a finished product
that are necessary to produce it.
Directors' report: an overview of the firm and its state of affairs for the benefit
of the users of the financial statements. It deals with the firm's nature of business
(including the mission statement, the influence of the state of the economy, and
prevailing conditions in the industry), profit or loss, and state of affairs, and it
will contain information on additional financing raised, any major changes in the
nature of the firm's fixed assets, and dividends paid and/ or declared.
Discount rate: see Cost of capital, Opportunity cost, Required return and Weighted
average cost of capital (WACC).
Discounted cash flow (DCF) techniques: capital budgeting methods that give
explicit consideration to the time value of money. Net cash flows of a project are
discounted to a present value at a specified rate. (The concept of present value is
based on the time value of money.)
Discounting cash flows: the process of finding present values (PV); it is the inverse
of compounding. Instead of finding the future value (FV) (interest value) of a pres-
ent amount invested at a given rate, discounting determines the present value of a
future amount, assuming that the decision maker has an opportunity to earn acer-
tain return on the money. (This return is also referred to as discount rate, required
return, cost of capital or opportunity cost.)
Diversification: not placing all money into a single investment, but rather spread-
ing it over various investments. An investor may combine various kinds of assets in
order to achieve a diversified portfolio. The investor has a choice between various
asset classes.
Dividend per share (DPS): share earnings calculated as: dividends for ordinary
shareholders + the number of ordinary shares issued.
Dividend yield: calculated as: dividends per share + current market price x 100
over 1. The earnings per share are not all paid out to shareholders; but rather the
168
dividends per share is the actual cash flow shareholders receive.
Double-entry system: for every debit entry, there must be a credit entry of the
same amount of money (and vice versa).
GLOSSARY
Earning statement: see Statement offinancial performance (income statement).

Earnings before interest and taxes (EBIT): the level of operations necessary to
cover all operating costs, and also to evaluate the profitability associated with vari-
ous levels of sales.
Earnings per share (EPS): measurement of the return earned on behalf of each
ordinary share issued; monitored by investment analysts and portfolio managers.
EPS is calculated as: earnings after tax - preference dividend+ the number of ordi-
nary shares issued.
Earnings yield: an indicator of the current income-producing power per ordinary
share at the current market price. (This is the opposite of the price-earnings ratio.)
Earnings yield is calculated as: earnings per share + current market price x 100
over 1.
Economic ordering quantity (EOQ): the point where the total cost of ordering
and carrying inventory will be at its lowest or optimum level. The EOQ is a range
rather than a fixed value; small deviations from the EOQ have a minor effect on
total inventory costs. Once the EOQ is ascertained, it must be determined at what
point inventory should be reordered to forestall being out of stock. (Also see Car-
rying cost, Ordering cost and Total inventory costs (TIC) .)
Equity: capital provided by the owners of the firm for an indefinite period. Equity
holders are entitled only to the residual value (i.e. the portion left after the creditors
have been paid). The value of this residual portion is the owners' equity in the firm,
which is the value of the firm's assets less the firm's liabilities (debt): owners' equity
= total assets - liabilities. (Also see Company equity and Debt.)
Financial analysis (or ratio analysis): evaluation of the financial performance
and the financial position of the firm during the previous accounting period, or
the evaluation of the future plans of the firm based on the budgeted (pro forma)
statement of financial performance (income statement) and statement of financial
position (balance sheet).
Financial budgets: used by financial management in carrying out the financial
planning and control task, they consist of the capital budget, cash budget, proforma
statement of financial performance (income statement) and pro forma statement
of financial position (balance sheet). These budgets (prepared from information
contained in the operating budgets) integrate the financial planning of the business
with its operational planning. Financial budgets serve three purposes: to verify the
viability of the operational planning (operating budgets); to reveal the financial
actions that the business must take to make execution of its operating budgets pos-
sible; and to indicate how the operating plans of the business will affect its future
financial performance and position. 169
Financial goal of the firm: the short-term financial goal should be to ensure the
profitability, liquidity and solvency of the firm. The long-term financial goal should
GLOSSARY
be to increase the value of the firm, thereby increasing the wealth of the owners.
This may be accomplished by investing in assets that will add value to the firm, and
keeping the firm's cost of capital as low as possible.
Financial institution: intermediaries or agents such as banks, insurance compa-
nies, pension funds and investment trusts which participate in the financial mar-
kets on behalf of lenders and borrowers. Funds are channelled from the savings of
investors to investment in either financial assets (such as shares or bonds) or real
assets (such as office blocks or industrial parks).
Financial leverage: the extent to which debt is used to finance the firm. The greater
the extent to which a firm makes use of debt, the greater its financial leverage.
"Financial leverage" is a term used to describe the magnification of risk and return
introduced through the use of fixed-cost financing such as debt and preference
shares. The more debt or financial leverage a firm uses, the greater its risk and
required return will be. (Also see Leverage (or gearing).)
Financial management: the acquisition and employment of capital aimed at
increasing the value of the firm over the long term and maintaining the profit-
ability, liquidity and solvency of the firm over the short term.
Financial markets: the involvement of various role players (most significantly the
financial institutions) as buyers and sellers who contact one another in order to do
business. Financial markets influence the required and actual rates of return in an
economy and provide a forum in which suppliers and borrowers of funds negotiate
and transact their business. The financial market is not necessarily a physical place.
Finished goods: inventory (stock) held in order to provide an immediate service
to the customer or to provide for the immediate demand for a specific product.
Uncertainty about demand is one of the reasons for keeping finished goods in
stock; they are also held in order to stabilise production.
Fixed assets (non-current assets): assets that will be retained for a longer period
than the accounting period of the business, which is usually a year. They include
land and buildings, plant and equipment, and motor vehicles.
Fixed costs: costs which remain constant during a given period for a given poten-
tial capacity, irrespective of the degree to which the capacity is utilised during the
period.
Focus strategy: concentrating on serving a narrowly defined market called a
market niche. Focus enables a relatively small firm to respond more rapidly to the
needs of customers than larger, diversified competitors can. Focus may involve the
use of cost leadership or differentiation in serving the chosen market niche.
170 Future value (FV): the calculation of interest on a present amount to result in some
future amount. The amount on which interest is paid is known as the principal.
Future value is the amount to which the principal (be it a lump sum or series of cash
flows) will grow by a given future date when compounded at a certain interest rate.
GLOSSARY
GAAP: generally accepted accounting principles.

Gearing: see Leverage (or gearing).
Going concern: a concept that gives the users of financial statements the assur-
ance of the continuity of the firm - the business entity will continue in operational
existence for the foreseeable future.
Gross profit margin: the indicator of the contribution from the firm's core business
towards covering the firm's operating expenses. Gross profit + sales x 100.
High income elasticity: economic terminology for the sales of goods/products
that are subject to wider variations than the national income - items such as refrig-
erators, machine tools and most capital equipment. (See Low income elasticity.)
Historic cost: the phenomenon that assets are initially brought into account in the
accounting process at the cost that the entity incurred in acquiring those assets.
Income statement: see Statement of financial performance.
Indirect costs (also called common costs): costs that consist mainly of manufac-
turing overheads, which comprise all costs that are not classified as direct material
or direct labour, for example machine lubricants (indirect material); factory clean-
ing staff (indirect labour); and depreciation of machinery; and other factory costs,
such as electricity, heating and telephones used in the factory.
Industry comparative analysis: the comparison of the financial ratios of different
firms in the same industry at the same point in time.
Inflation: a continuous rise in the general level of prices of goods and services. It
causes a decrease in the purchasing power of a monetary unit.
Integer: a whole number - the nearest whole number to a decimal amount.
Internal rate of return (IRR): the discount rate that equates the present value of
cash inflows with the initial investment associated with a project; thus IRR is the
discount rate that equates the NPV of an investment opportunity with zero (since
the present value of cash inflows = the initial investment).
Intra-year compounding: the situation where interest is compounded more often
than once a year. Savings institutions compound interest semi-annually, quarterly,
monthly, weekly or daily. Intra-year compounding changes the frequency with
which the interest is calculated, and this requires adjustments to the number of
periods and the interest payable.
Inventory (stock levels): that which represents an investment (a current asset) of a
portion of the firm's available funds. In the case of a manufacturing firm, it consists
of raw materials, work-in-process and finished goods. 171
Inventory turnover: measured by cost of goods sold + average inventory (average

inventory is: beginning inventory + ending inventory + 2). The activity, or liquidity,
of a firm's inventory is commonly measured by its turnover.
GLOSSARY
JSE: a securities exchange whose basic functions include raising finance for public
companies listed, or wishing to list, by facilitating the trading of the company's
shares; providing a market for listed securities; and affording protection to inves-
tors by enforcing the rules and regulations of the Stock Exchange Control Act. In
both the money and capital markets there is a primary and a secondary sector. The
primary sector deals only in new securities (such as shares and bonds issued for the
first time). The secondary market trades only existing securities (e.g. the shares of
companies that have been listed on the JSE for some time).
Judgemental scoring systems: a refined evaluation method of credit analysis
embodying a checklist and weighted scoring system. The checklist requires posi-
tive responses to a predetermined portion of questions; the weighted scoring system
assigns weights (reflecting the importance of questions) to the questions in the
checklist. The sum of points scored is compared to pre-set points when making the
credit-granting decision.
Leverage (or gearing): the extent to which fixed cost assets or fixed cost financing
are used to magnify the returns of the firm. Operating leverage involves the use of
fixed cost assets such as plant and equipment to lower the cost per unit, thereby
increasing the profitability of the firm. Financial leverage refers to the use of fixed
cost financing (such as debt and preference shares) to reduce the amount of equity
used, thereby increasing the return on equity and earnings per share.
Liabilities: debts, which can generally be divided into two basic categories: long-term
debt in the form of loans with a maturity exceeding one year; and current liabilities,
which are debts with a maturity of less than a year.
Liquidity: the firm's ability to satisfy its short-term obligations as they become due.
Liquidity can be measured by calculating net working capital, current ratio and the
quick (acid-test) ratio. Liquidity may be achieved by accelerating cash flows from
debtors; delaying cash flows by paying creditors as late as possible; not over-investing
in inventory (stock); and stocking a range that will turn over rapidly.
Liquidity ratio: measurement of a firm's ability to satisfy its short-term obligations
as they become due.
Loan amortisation: the determination of the equal annual loan payments necessary
to provide a lender with a specified interest return and repay the loan principal over
a specified term. The loan amortisation process involves finding the future payments
(over the term of the loan) so that its present value just equals the amount of initial
principal borrowed (given the loan interest rate). (Also see Long-term debt.)
Long firm fraud: a term used to describe a deteriorating payment pattern whereby
customers build up a good payment record, greatly increase the volume of their
172 orders and suddenly close down - the result is the disappearance of stock and even-
tual bad debt for the firm.
Long-term debt: debt that matures in a period exceeding ten years, usually deben-
tures or bonds sold, which only pay interest every six months and repay the principal
GLOSSARY
back at maturity. It could also consist of a mortgage loan used to finance land and
buildings (requiring monthly instalments over a 20- or 25-year period with each
instalment consisting of interest and an amortisation of a part of the principal).
Low income elasticity: economic terminology for the sales of goods/products that
are immune to changes in the national income - that is, variations in the sales of
non-durable consumer goods (e.g. food), inexpensive items, or items in habitual use
(e.g. cigarettes) are less than the movements in national income.
Manufacturing overheads: all costs that are not classified as direct material or direct
labour.
Margin of safety ratio: an indicator of the extent to which sales volume may decrease
before profits reach nil (the breakeven point). From a profitability and risk perspec-
tive, a high margin of safety is preferable to a low one.
Marketable securities: short-term funds (see Money market).
Matching principle: income and expenses incurred in generating income must be
brought into account during the same accounting period (e.g. the same financial
year). Revenue and costs are accrued (i.e. recognised as they are earned or incurred,
not as money is received or paid), matched with each other insofar as their relation-
ship can be established or justifiably assumed, and dealt with in the statement of
financial performance (income statement) for the period to which they relate.
Materiality: an accounting requirement that transactions and events which are not
material in relation to the nature and scope of an entity's activities need not be taken
into account if the cost and difficulty in recording them are not justified by the result-
ing benefit.
Medium-term debt: debt that matures from one to ten years.
Mixed stream: cash flows that reflect no particular pattern, unlike an annuity pattern
of equal annual cash flows (i.e. the cash flows are the same each year).
Money market: a key financial market that deals only in short -term funds, also
referred to as marketable securities, with a maturity or lifespan of three years or less.
While the banking sector may be regarded as the primary source of funds for the
money market, the South African Reserve Bank acts as the lender of last resort.
Money measurement: a universal accounting denominator used to express the
assets, liabilities and owners' equity to accurately describe the financial position of a
firm.
Mortgage loan (bond): a loan backed by liens on land and buildings. The assets
serve as collateral, and the instalments consist of interest and principal amounts to
amortise the loan by the time maturity is reached. 173
Near-cash assets: assets that can be converted readily into cash at short notice with-
out the possibility of losses attached to their conversion (liquidity of assets), for
example a marketable security such as a treasury bill. While cash is considered
GLOSSARY
to be the most liquid asset of a firm, other assets that are high in liquidity are also
carried.
Net current assets: see Net working capital.
Net income: earnings after tax.
Net present value (NPV): an approach to capital budgeting where the net cash
flows have to be discounted back to present value using the cost of capital as the
required rate of return. The NPV is calculated by subtracting the initial investment
(II) from the present value of the net cash inflows (CF) discounted at a rate equal
to the firm's cost of capital (WACC). (An investment will only add value if the sum
of the present values of the cash flows exceeds the initial investment, i.e. if the NPV
is greater than zero.)
Net profit margin: the measurement of the percentage of each sales rand remain-
ing after all expenses, including taxes, have been deducted. The net profit margin
is a commonly cited measure of a firm's success with respect to earnings on sales.
Net working capital: the difference between current assets and current liabilities
(also referred to as net current assets). If the current assets exceed the current lia-
bilities, the firm is said to have a positive net working capital.
Non-current assets: see Fixed assets (non -current assets).
Non-discounted cash flow methods: various methods for determining the accept-
ability of capital expenditure alternatives. See Payback period.
Note payable: the document for liability when money is borrowed - a formal writ-
ten promise to pay a certain amount of money, plus interest, at a definite future date
during the next 12 months.
Objectivity principle: an approach used by accountants to ensure asset valuations
are factual and easy to verify.
Operating budgets: operational planning - the correlation of three of the respon-
sibility centres: cost, income and profit. Financial budgets are prepared from infor-
mation contained in the operating budgets. It excludes any capital expenditure.
Operating cycle (OC): the period of time that elapses between the building up
of inventory and cash being collected from the sale of that inventory. The cycle
comprises two components: the average age of inventory (AAI), and the average
collection period (ACP) of sales. The formula for calculation is: OC = AAI + ACP.
Operating expenses: examples are advertising, salaries, interest paid, maintenance,
depreciation, insurance and taxes. The gross profit must be sufficient to enable the
firm to pay its operating expenses - the greater the gross profit margin, the better
174
the firm's ability to cover its operating expenses.
Opportunity cost: a concept invoked in the time value of money principle - if
the receipt of an amount of money is expected in the future, an opportunity cost
GLOSSARY
is involved in waiting to receive the amount. If the amount was at the investor's
disposal, it might either have been invested and a return earned, or interest charges
on financing (such as an overdraft or loan) might have been avoided. (Also see
Weighted average cost of capital (WACC) and Discount rate.)
Ordering cost: the cost of inventory ordered. Ordering costs decline if orders are
placed infrequently and larger quantities of inventories are kept (also see Carrying
cost, Total inventory costs (TIC) and Economic ordering quantity (EOQ)).
Ordinary annuity: see Annuity.
Owners' equity: the resources invested by the owners; it is equal to the total assets
minus the liabilities.
Payback period: the number of years required to recover an initial investment. It
gives some consideration to the timing of cash flows and therefore the time value of
money, in that the payback period should be as short as possible.
Periodic physical inventory system: a system of gathering information by means
of an actual physical count of inventory items. Although time consuming, it deter-
mines shortages of inventory (indicated by the difference between the books of the
firm and the actual inventory- adjustments are made in the books of the firm).
Perpetual inventory system: a system of continuous stocktaking and information
gathering by using accounting records to compute inventory on hand at any given
time. Inventory levels are adjusted as soon as stock is sold and new stock is pur-
chased shortly thereafter. (Although inventory on hand can be determined at any
time without having physically to take stock, it is not possible to detect obsolete
stock or theft. For this reason, actual physical stocktaking should be done once or
twice a year.)
Precautionary motive: holding cash to maintain a cushion or buffer to meet unex-
pected contingencies. A firm with easy access to borrowed funds requires less pre-
cautionary cash. Firms with large needs for precautionary balances tend to keep
highly marketable securities that can be converted into cash in a very short period,
and at the same time provide income in the form of interest.
Present value (PV): a concept (like that of future value) based on the belief that the
value of money is affected by the timing of its receipt. The present value of one rand
that will be received in the future can be determined by means of discounting. See
Discounting cash flows .
Price-earnings (PIE) ratio: current market price per ordinary share + earnings per
share. (This is the opposite of the earnings yield.) Investors can multiply the PIE by
the EPS to find a rough approximation of the value of an ordinary share.
175
Prime rate: the interest rate quoted by the bank for its customers with the lowest
risk of default.
Principal amount: the amount on which interest is paid.
GLOSSARY
Profit and loss statement: see Statement of financial performance (income

statement).
Profitability: the firm's ability to generate revenues that will exceed total costs by
using the firm's assets for productive purposes. Profitability may be achieved by
marketing products or services to include a sufficient profit margin with the sup-
port of promotion at competitive prices, to appropriate target markets through
appropriate distribution channels.
Profitability index (PI): (sometimes called benefit-cost ratio) an approach to capi-
tal budgeting calculated by dividing the present value of cash inflows by the initial
investment. It measures the present value return per rand invested.
Profitability ratios: measures of profitability that relate the returns of the firm to
its sales, to assets or to equity, to allow the analyst to evaluate the effectiveness and
efficiency of the firm's management and employees in generating profit by means
of sales, the productive use of assets and the productive use of the capital of the
owners. Typical measures are gross profit margin; net profit margin; return on
investment (ROI); and return on equity (ROE) or return on net assets (RONA).
Pro forma statement of financial position (balance sheet): drawn up to bring
together all the other budgets to project how the financial position of the firm will
look at the end of the budget period if actual results conform to planned ones.
Pro forma statement of financial performance (income statement): developed to
evaluate the budgeted income relative to expenses in the short term and to evaluate
plans which could improve profitability.
Quick (acid-test) ratio: used to measure liquidity, it is similar to the current ratio
except that it excludes inventory (as the least liquid current asset) from current
assets. Quick ratio is calculated as: current assets - inventory + current liabilities.
Ranking projects: an approach in financial decision making that involves ranking
projects on the basis of some predetermined criterion, such as the rate of return.
Ranking is useful in selecting the best of a group of mutually exclusive projects and
in evaluating projects with a view to capital rationing.
Ratio analysis (financial analysis): the application of a formula to financial data
in order to calculate a given ratio and, more importantly, the interpretation of the
ratio. (See Industry comparative analysis and Time-series analysis.)
Raw material: inventories that include products to be changed through the pro-
duction process into work-in-process and finished goods (e.g. iron ore to produce
steel).
Realisation principle: two conditions of recognising income - income is earned
176
when obligations are met towards the party receiving value; income is realised by
being measurable and recoverable.
Red line method: an inventory control system that requires inventory items to be
GLOSSARY
stocked in a bin in which a red line is drawn around the inside at the level of the
reorder point; an order is placed when the red line shows.
Required return: the appropriate discount rate (for a bond) which depends on the
prevailing interest rates and risk. Interest is paid at a fixed rate on nominal value
(i.e. the coupon rate). (Also see Discount rate, Cost of capital, Opportunity cost.)
Residual owners: in a partnership, these are the general partners; in a company
they are the ordinary shareholders.
Responsibility centre: any organisational or functional unit in a business that is
headed by a manager responsible for the activities of that unit. All responsibility
centres use resources (inputs or costs) to produce something (outputs or income).
Typically, responsibility is assigned to income, cost (expense), profit and/or invest-
ment centres.
Return on assets (ROA): see Return on investment (ROI).
Return on equity (ROE): a measure of the return earned on the owners' investment.
ROE is determined by three variables - profitability (the net profit margin), activity
(asset turnover) and leverage (also called gearing).
Return on investment (ROI): a measure (sometimes also called return on assets
or ROA) of the overall effectiveness of management in generating profits with the
available assets.
Return on net assets (RONA): net income+ net assets. Net assets= total assets -
liabilities.
Risk-return principle: a trade-off between risk and return - the greater the
risk, the greater the required rate of return. As far as possible, the return should
exceed the risk involved in any business decision; risk should also be minimised or
managed.
Safety stocks: additional stock (inventory) maintained to provide for a sudden
increase in the demand for a specific item, and to guard against delays in receiving
orders. Maintaining safety stocks enables a firm to maintain sales should produc-
tion or delivery delays occur, but it involves additional costs.
Short-term debt: debt that is scheduled to mature within one year.
Solvency: the extent to which the firm's assets exceed its liabilities. Solvency differs
from liquidity in that liquidity pertains to the settlement of short-term liabilities,
while solvency pertains to the excess of total assets over total liabilities.
Speculative motive: holding cash in order to take advantage of unexpected prof-
itable opportunities, such as bargain purchases and, in the case of multinational
177
firms, exchange rate fluctuations - nowadays, firms rely more on reserve borrowing
power and marketable securities portfolios rather than actual cash holdings for
speculative purposes.
GLOSSARY
Spread: the difference between the rate charged and the rate paid - financial insti-
tutions need to invest or lend out their available funds at a rate that exceeds the rate
they are paying to their depositors.
Statement of financial performance (income statement): part of the financial
statements of a firm, it measures the financial performance during a certain period
- that is, whether a profit or a loss was recorded. The statement of financial perfor-
mance (income statement) is also referred to as the earnings statement, statement
of comprehensive income, and profit and loss statement.
Statement of financial position (balance sheet): part of the financial statements of
a firm, it indicates the financial position at a specific point in time - that is, what the
assets of the firm are worth (at book value) and how they were financed by means
of equity and debt financing.
Statement of operations: see Statement of financial performance (income
statement).
SWOT analysis: a technique of strategic management that determines the firm's
strengths, weaknesses and opportunities, and any threats to the firm.
Time-series analysis: a financial analyst's evaluation of the performance of a firm
over time. Comparison of current with past performance utilising ratio analysis
allows the firm to determine whether it is progressing as planned.
Time value of money principle: a concept used to evaluate any financial decision
involving differences in the timing of cash inflows and outflows. The time value of
money is a matter of interest that may be earned if money is available today and
invested, or the opportunity cost if an amount will only be received at some future
date - an amount of money today is worth more than it will be at some point in
the future.
Total inventory costs (TIC): determined by adding together the ordering costs and
the carrying costs: total inventory cost = total carrying cost + total ordering cost.
Trade (or commercial) credit: credit granted by one firm to another - buying raw
materials or goods on credit and paying the creditor after 30 or 60 days. Trade
credit does not involve interest charges, unless the account is not settled promptly.
Transaction motive: the need for cash to meet payments arising in the ordinary
course of business. A firm needs cash to pay for finished goods, services, labour
inputs, taxes, etc.; cash in the bank allows for more favourable conditions of pur-
chase. (When a firm buys on credit, there are normally credit conditions involved.)
Turnover: sales of inventory for cash or on credit.
178 Two-bin method: an inventory control system whereby inventory items are stocked
in two bins. When the working bin is empty, an order is placed and inventory is
drawn from the second bin.
GLOSSARY
Valuation model: calculation of the present value of the sum of all net cash inflows
expected for the duration of an investment.
Variable costs: unlike fixed costs, these change with fluctuations in the number of
units produced and sold, for example packaging material for a product such as a
cellular phone, and instruction pamphlets and a battery to accompany each unit
sold.
Weighted average cost of capital (WACC): a measurement of the required rate
of return. It is calculated by multiplying the weight (proportion) of each form of
financing by its associated cost. WACC is the total of the weighted costs.
Working capital: the management of a firm's current assets and current liabili-
ties. Current assets are primarily cash, inventory and accounts receivable; current
liabilities consist mainly of accounts payable, but might also include short-term
financing such as a bank overdraft.
Work-in-process (inventories): products stocked in various stages of the produc-
tion process to buffer production (i.e. to prevent any stoppages in the production
process).
179
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(./)
-+-
11 10,37 9,787 9,253 8,760 8,306 7,887 7,499 7,139 6,805 6,495 6,207 5,938 5,687 5,453 5,234 5,029 4,327 3,656 3 ,147 3 'Tl
DJ
'<
0
12 11 ,26 10,58 9,954 9 ,385 8,863 8,384 7,943 7,536 7,161 6,814 6,492 6 ,194 5,91 8 5,660 5 ,421 5,1 97 4,439 3 ,725 3 ,190 0
O'" -+-
13 12, 13 11,35 10,63 9 ,986 9,394 8,853 8,358 7,904 7,487 7,103 6,750 6,424 6,122 5,842 5 ,583 5,342 4,533 3,780 3,223 (D 0
14
15
13,00
13,87
12,11
12,85
11 ,30
11,94
10,56
11, 12
9 ,899
10,38
9,295
9,712
8,745
9,108
8 ,244
8,559
7,786
8,061
7,367
7,606
6,982
7, 191
6,628
6,811
6,302
6,462
6,002
6,142
5,724
5,847
5,468
5,575
4,611
4,675
3,824
3,859
3,249
3,268
()
DJ
0
C
-
en
Q
16
17
14,72
15,56
13,58
14,29
12,56
13,17
11 ,65
12,17
10,84
11 ,27
10, 11
10,48
9,447
9,763
8,851
9,122
8,313
8,544
7,824
8 ,022
7,379
7,549
6,974
7,120
6,604
6,729
6,265
6,373
5,954
6,047
5,668
5,749
4,730
4,775
3,887
3,910
3,283
3,295
-
OJ
(D
Q.
O'"
0
;:;J
~
0
18 16,40 14,99 13,75 12,66 11 ,69 10,83 10,06 9,372 8,756 8 ,201 7,702 7,250 6,840 6,467 6,128 5,818 4,812 3,928 3,304 '< ::J
3(D ::J
C
19 17,23 15,68 14,32 13,13 12,09 11 , 16 10,34 9,604 8,950 8,365 7,839 7,366 6,938 6,550 6,198 5,877 4,843 3,942 3,311
DJ
:::J
~
20 18,05 16,35 14,88 13,59 12,46 11 ,47 10,59 9 ,818 9,129 8,514 7,963 7 ,469 7,025 6,623 6,259 5,929 4,870 3,954 3 ,316 (/) Q_
u=;·
-
21 18,86 17,01 15,42 14,03 12,82 11 ,76 10,84 10,02 9,292 8,649 8,075 7,562 7,102 6,687 6 ,312 5,973 4,891 3 ,963 3,320 0--+,
0 -I
0 I
22 19,66 17,66 15,94 14,45 13,16 12,04 11 ,06 10,20 9,442 8,772 8,176 7,645 7, 170 6,743 6,359 6,011 4,909 3,970 3,323 ::r m
(D C
::J
--I
--+,
23 20,46 18,29 16,44 14,86 13,49 12,30 11,27 10,37 9,580 8,883 8,266 7,718 7,230 6,792 6,399 6,044 4,925 3,976 3,325 -+-
Q. (D
:s:
24 21,24 18,91 16,94 15,25 13,80 12,55 11,47 10,53 9,707 8,985 8,348 7,784 7,283 6,835 6,434 6,073 4,937 3,981 3,327 0 Q_ m
25 22,02 19,52 17,41 15,62 14,09 12,78 11,65 10,67 9,823 9,077 8,422 7,843 7,330 6,873 6,464 6,097 4,948 3,985 3,329 ~- 0-+- <
:::J )>
(Cl 7'
25,81 19,60 17,29 13,76 12,41 11,26 10,27 9 ,427 8,694 7,496 4,979 r
30 22,40 15,37 8,055 7,003 6,566 6,177 3 ,995 3,332 (D C
.a D
m m
-a·
35 29,41 25,00 21,49 18,66 16,37 14,50 12,95 11 ,65 10,57 9 ,644 8,855 8, 176 7,586 7,070 6,617 6,21 5 4,992 3,998 3,333 C
DJ 0
40 32,83 27,36 23,11 19,79 17, 16 15,05 13,33 11 ,92 10,76 9,779 8,951 8,244 7,634 7,105 6,642 6,233 4,997 3,999 3,333 0 "TI
(D
45 36,09 29,49 24,52 20,72 17,77 15,46 13,61 12,1 1 10,88 9,863 9 ,008 8,283 7,661 7,123 6,654 6,242 4,999 4,000 3,333
:::J ::J
-+- :s:
0
50 39,20 31,42 25,73 21,48 18,26 15,76 13,80 12,23 10,96 9,915 9,042 8,304 7,675 7,133 6,661 6,246 4,999 4,000 3 ,333 z
~
m
-<
l© Van Schaikj
C Publishers
Cl
uJ u,
Index
A carrying cost 13 7
accept-reject approach 108 cash 151
accounting entity 21 cash budget 155
accounting equation 24 cash inflow 155
accounting period 22, 27 cash ouflow 155
accounts receivable 132, 142, 154 net cash flow 155
accrual principle 23 cash conversion cycle (CCC) 133
activity ratios 41, 49 cash flow of a firm 133
agency problem 14 cash registers 159
amortisation 118 certainty of the claim 120
amount of the claim 120 claims on assets 120
annual compounding 85 claims on income 119
annuity due 90 classification of inventory 136
application for credit 143 finished goods 136
bank references 143 raw materials 136
civil judgements 145 work-in-process 136
competitors 144 collection policy 148
credit analysis 145 commercial credit 142
credit bureaux 144 competitive environment 2
credit insurance 144 compliance 14
in-house opinion 145 conservatism 21
own records 145 consistency concept 22
trade references 143 consumer credit 142
trade sources 144 cost leadership 3
asset classes 4 cost of capital 121
cash 4 cost of capital (WACC) 122
dividend-gathering assets 4 cost of cash 153
interest-generating assets 4 credit limits 148
rent-generating assets 4 credit scoring 147
assets 30 credit selection 142
current 30 credit standards 147
non-current 30 credit terms 148
auditors' report 34 current ratio 47
average age of inventory (AAI) 133
average collection period 50 D
average collection period (ACP) 133 debt (or solvency) ratios 41
average payment period (APP) 51, 134 debt ratio 53
debt-equity ratio 54
B debtors 132
bank overdraft 118 deposits 97
breakeven point 68, 69 differentiation 3
budget 61 direct cost 64
185
direct labour 65
C direct materials 65
capital budgeting 107 directors' report 35
capital market 126 discounted cash flow techniques 111
IN DEX
discounting cash flows 93 sole proprietorship 3

diversification 4 fundam ental principles 8
dividend per share (DPS) 55 cost-benefit principle 9
dividend yield (DY) 57 risk-return principle 9
double-entry system 22 time value of money 9
future value (FV) 84, 85
E future value of an annuity 88
earnings per share (EPS) 55
earnings yield 57 G
economic cycles 10 gearing ll8, 122
contraction 10 Generally Accepted Accounting Principles 20
growth 10 going-concern concept 22
recession 10 gross profit margin 43
economic environment 10 growth rates 100
economic ordering quantity (EOQ) 137
efficient purchasing 154 H
equity 118 historic cost 22
F
financial accounting 62 indirect cost 64, 65
financial analysis (ratio analysis) 40 inflation 84
industry comparative analysis 40 insurance 142
time-series an alysis 40 interest rates 85
financial assets 13 internal rate of return 102, 108, 113
financial budgets 71, 73 International Financial Reporting Standards
capital budget 73 (IFRS) 20
pro forma balance sheet 73 intra-year compounding 87
pro forma income statement 73 inventory control systems 139
financial goal 4 computerised systems 140
financial institution 13 simple control systems 140
financial leverage 122 inventory management 154
financial markets 12 inventory turnover 49
capital market 12 investing activities 32, 33
money market 12 investment decisions 8, 101
Financial Reporting Standards Council
(FRSC) 20 J
financial statements 20 journal 26
financing 8 judgemental scoring systems 146
financing activities 32, 33 checklist system 146
financing decisions 101 weighted scoring system 146
fixed costs 66
focus strategy 3 L
follow-up of delinquent accounts 151 lagging economic indicators 11
186 forms of business organisation 3 balance of trade 12
partnership 3 consumer price index ( CDI) 11
private company 3 employment and unemployment
public company 3 statistics 11
INDEX
exchange rate 11 net working capital 46, 132

financial performance 12 non-discounted cash flow methods 109
growth in the GDP 11
interest rates 11 0
production pr ice index (PPI) 11 operating activities 32, 33
leading indicators 10 operating budgets 71, 72
building plans approved 11 cost budgets 72
business start-ups 11 income budgets 72
increases in stock levels 10 profit budget 72
indices of the stock exch ange 10 profit plan 72
manufacturing statistics 10 operating cycle (OC) 133
new company registrations 11 opportunity cost 10, 65, 84
statistics about retail sales 11 ordinary annuity 89
statistics about the housing market 11 overstocking 135
liabilities 31 owner's equity 31, 119
liquidity 5, 132
liquidity ratios 41, 46 p
loan amortisation 98 payback period 101, 109, 110
long-term debt 118 present value of a mixed stream 94
bonds 118 present value of an annuity 95
debentures 118 present values (PV) 84, 92
mortgage loan 118 preventing cash losses 159
losses of inventory 140 preventive m easures 141
price-earnings ratio (PIE ratio) 56
M principal 85
management accounting 62 principles of budgeting 75
m argin of safety ratio 69 accountability according to
m arginal income 69 respon sibility 75
marginal income per unit 69 acknowledgement 76
m ateriality 22 adaptability 75
maturity 119 effective communication 76
mission statement 2 follow-up and feedback 76
money m arket 126 m anagement involvement 75
money measurement 21 realistic expectation s 76
monitoring bad debts 150 priority of the claim 119
monitoring payment patterns 149 profit 69
motives for holding cash 152 profit m aximisation 6
compensating balances 152 profit planning and control 61
precautionary motive 152 profitability 5
speculative motive 152 profitability index 102, 112
transaction motive 152 profitability ratios 41, 42
gross profit margin 42
N net profit margin 42
n eeds 2 return on equity (ROE) 42 187
n et operating profit (after tax) NOPAT 109 return on investment (ROI) 42
net present value (NPV) 108, 101, 111 return on net assets (RONA) 42
n et profit margin 44
INDEX
Q stocktaking 141
quick (acid test) ratio 48 periodic physical inventory system 141
perpetual inventory system 141
R stretching accounts payable 153
ranking projects 108 sunkcost 65
real assets 13 sustainable competitive advantage 3
realisation principle 22
reorder point 139
T
residual owners 119 tax benefit 121
responsibility centres 73 time value of money 84
cost centre 74 total inventory costs (TIC) 137
income centre 74 trade credit 118
investment centre 74 traditional approach 145
profit centre 74 capacity 145, 146
return on equity (ROE) 45 capital 145
return on investment (ROI) 44 character 145, 146
return on net assets (RONA) 46 collateral 145
risk and return 6 conditions 145, 146
rules of debit and credit 25 transaction 24
turnover 132
s
securities m arket ratios 41, 54
u
dividend per share (DPS) 54 understocking 136
dividend yield (DY) 54 users of financial statements 21
earnings per share (EPS) 54
price-earnings ratio (P /E ratio) 54
V
semi-variable costs 68 valuation 102
solvency 5 variable costs 67
speeding up 154 voice in management 120
statement of cash flows 20, 32
statement of financial performance 20, 27
w
statement of financial position 20, 29 weighted average cost of capital (WACC) 108
statement of shareholders' changes in equity 20 working capital 102, 132
188
Table A Future-Value Interest Factors for Rl com pounded at k per cent for n Period s
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11 % 12% 13% 14% 15 % 16 % 20% 25% 30%
1 1,010 1,020 1,030 1,040 1,050 1,060 1,070 1,080 1,090 1,100 1,110 1,120 1,130 1,140 1,150 1,160 1,200 1,250 1,300
2 1,020 1,040 1,061 1,082 1,103 1,124 1,145 1,166 1,1 88 1,210 1,232 1,254 1,277 1,300 1,323 1,346 1,440 1,563 1,690
3 1,030 1,061 1,093 1,125 1,158 1,1 9 1 1,225 1,260 1,295 1,331 1,368 1,405 1,443 1,482 1,521 1,561 1,728 1,953 2,197
4 1,041 1,082 1,126 1,170 1,216 1,262 1,311 1,360 1,41 2 1,464 1,518 1,574 1,630 1,689 1,749 1,811 2,074 2,441 2,856
5 1,051 1,104 1,159 1,217 1,276 1,338 1,403 1,469 1,539 1,611 1,685 1,762 1,842 1,925 2,011 2,100 2,488 3,052 3,713
6 1,062 1,126 1,194 1,265 1,340 1,419 1,501 1,587 1,677 1,772 1,870 1,974 2,082 2, 195 2,313 2,436 2,986 3,815 4,827
7 1,072 1,149 1,230 1,31 6 1,407 1,504 1,606 1,714 1,828 1,949 2,076 2,211 2,353 2,502 2,660 2,826 3,583 4,768 6,275
0 1 ni:t-:i 1 17? 1 ')l':7 1 'l!:;Q 1 ,1 77 1 ,::;0 11 1 7 1Q 1 i:i,::;1 1 QQ'l ? 1 11 11 ? -:1:n,::; ? 1171': ')J::;i:;J:I ? i:l.<;'l 'l n,:;a 'l 'J7J:I ,1 -:inn ,::; ai::n J:I 1 ,::;7
Table B Future-Value Interest Factors for a Rl annuity compounded at k per cent for n Periods
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30%
1 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
2 2,010 2,020 2,030 2,040 2,050 2 ,060 2,070 2,080 2,090 2,100 2,1 10 2,120 2,130 2,140 2,150 2,160 2 ,200 2,250 2,300
3 3,030 3,060 3,091 3,122 3,153 3,184 3,215 3,246 3,278 3,310 3,342 3,374 3,407 3,440 3,473 3,506 3,640 3,813 3,990
4 4,060 4,1 22 4,184 4,246 4,310 4,375 4,440 4 ,506 4,573 4,641 4,710 4,779 4,850 4,921 4 ,993 5,066 5,368 5,766 6,187
5 5,101 5,204 5,309 5,416 5,526 5,637 5,751 5 ,867 5,985 6 ,105 6,228 6,353 6,480 6 ,610 6,742 6,877 7 ,442 8,207 9,043
6 6,152 6,308 6 ,468 6,633 6,802 6 ,975 7,153 7 ,336 7,523 7,716 7,913 8 ,115 8,323 8 ,536 8,754 8,977 9,930 11 ,259 12,756
7 7,214 7,434 7,662 7,898 8,142 8,394 8 ,654 8 ,923 9,200 9,487 9 ,783 10,089 10,405 10,730 11,067 11 ,414 12,916 15,073 17,583
8 8,286 8,583 8,892 9 ,2 14 9,549 9,897 10,26 10 ,64 11,03 11 ,44 11,86 12,30 12 ,76 13,23 13,73 14 ,24 16,50 19 ,84 23,86
9 9 ,369 9,755 10,16 10,58 11 ,03 11 ,49 11 ,98 12,49 13,02 13,58 14 ,16 14,78 15,42 16 ,09 16,79 17,52 20,80 25,80 32,01
Table C Present-Value Interest Factors for Rl Discounted a t k per cent fo r n Periods
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30%
1 0,990 0,980 0,971 0,962 0,952 0,943 0,935 0,926 0,917 0,909 0,901 0,893 0,885 0,877 0,870 0,862 0,833 0,800 0,769
2 0,980 0,961 0,943 0,925 0,907 0,890 0,873 0,857 0,842 0,826 0,812 0,797 0,783 0,769 0,756 0,743 0,694 0,640 0,592
3 0,971 0,942 0,915 0,889 0,864 0,840 0,816 0 ,794 0,772 0,751 0,731 0 ,712 0,693 0 ,675 0,658 0,641 0,579 0,512 0 ,455
4 0 ,961 0 ,924 0 ,888 0 ,855 0 ,823 0 ,792 0 ,763 0 ,735 0 ,708 0 ,683 0,659 0 ,636 0,613 0 ,592 0,572 0 ,552 0,482 0,410 0 ,350
5 0,951 0,906 0,863 0,822 0,784 0 ,747 0,713 0,681 0,650 0,621 0,593 0,567 0,543 0,519 0 ,497 0,476 0,402 0,328 0,269
6 0,942 0,888 0,837 0,790 0,746 0,705 0,666 0,630 0,596 0,564 0,535 0,507 0,480 0,456 0,432 0 ,410 0,335 0,262 0,207
.
7 0,933
n O ')'l
0,871
n1:u:;-:i
0,813
n 7J:ia
0,760
n 7':1 1
0,711
n ,:::77
0,665
n i::'J7
0,623
n -=;i:t')
0,583
n ~An
0,547
n ,:;n,,
0,513
n J1 R7
0,482
n A'lA
0,452
n ,1n,1
0,425
n 'l7R
0,400
n-:i.c:;1
0,376
n 'l')7
0,354
n -:in.c;
0,279
n ')'l'l
0,210
n 1 RJ:l
0,1 59
n 1 ')'l
Table D Present-Va lue Interest Factors for a Rl annui1v disc ounted at k per c ent for n Periods
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 20% 25% 30%
1 0 ,990 0 ,980 0 ,971 0 ,962 0 ,952 0 ,943 0,935 0 ,926 0,917 0 ,909 0,901 0 ,893 0,885 0 ,877 0,870 0 ,862 0,833 0 ,800 0,769
2 1,970 1,942 1,91 3 1,886 1,859 1,833 1,808 1,783 1,759 1,736 1,713 1,690 1,668 1,647 1,626 1,605 1,528 1,440 1,361
3 2,941 2,884 2,829 2,775 2,723 2,6 73 2,624 2,577 2,531 2,487 2 ,444 2,402 2,361 2,322 2,283 2,246 2,106 1,952 1,816
4 3,902 3,808 3,717 3,630 3,546 3,465 3,387 3,312 3,240 3,170 3,102 3,037 2 ,974 2,914 2,855 2,798 2,589 2,362 2,1 66
5 4 ,853 4 ,713 4 ,580 4,452 4 ,329 4 ,212 4 ,100 3,993 3 ,890 3,791 3,696 3,605 3,517 3,433 3,352 3,274 2,991 2,689 2,436
6 5,795 5,601 5,417 5,242 5,076 4 ,917 4,767 4,623 4,486 4,3 55 4,231 4 ,111 3,998 3,889 3,784 3,685 3,326 2,951 2,643
7 6,728 6,472 6,230 6,002 5,786 5,582 5,389 5,206 5,033 4,868 4,712 4,564 4,423 4,288 4,160 4,039 3,605 3,161 2,802
8 7,652 7,325 7,020 6,733 6,463 6,2 10 5,971 5,747 5,535 5,335 5,146 4,968 4,799 4 ,639 4,48 7 4,344 3,837 3,329 2,925
Q R .l':,RR R 1R? 7 7 RR 7 .d..~ _
,::; 7 1nR R Rn ? i; _,::;1 _,::; R ?.d.7 ,::; qq_
,::; ,::; 7 _
,::;q ,::; _1':,'.U "i .~ ?R "i H? .d. Q.d.R .d. 77? .d. Rn7 .:1 n.~ 1 ~.d.ft~ ~ n1 q

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AC 0

NON• INA CIAL

No part of this publication may be reproduced, stored in a retrieval system, or trans-

First edition 2004 by New Africa Books

Print ISBN 978 0 627 03138 0

Commissioning editors Rosem ary Lerungoana and Julia Read

Website addresses and links were correct at time of publication.

About the authors ...................................................................................................... . X

Chapter 1 The financial goal of a firm .................................................................. . 1

Chapter 2 Understanding financial statements ................................................. . 19

2.3.11 The accrual principle .............................................................................. . 23 u-<:

2.4 The classification of financial information ...................................................... 23 "'~

Chapter 3 The analysis of financial statements ................................................... 39

Chapter 5 The time value of money ...................................................................... . 83

Chapter 6 Capital budgeting................................................................................... 107

6. 1 Introduction ......................................................................................................... 107

Chapter 7 Financing................................................................................................. 117

Sam Ngwenya is an Associate Professor in the Department of Finance, Risk Man-

Gerhard Grebe is a lecturer at Unisa. He is currently working within the Depart-

What's the problem?

Question: What are the dilemmas one faces in business?

Threat of new entrants

Figure I . I Competitive forces

1.2 FORMS OF BUSINESS ORGANISATION

There are different types of companies:

a public company is seven shareholders, and there is no maximum. Furthermore, a

1.3 THE FINANCIAL GOAL OF A FIRM

A firm wishing to maximise profits could use inferior-quality materials in products

2. Profit maximisation is a short-term approach, while wealth maximisation is based

1.4 FINANCIAL MANAGEMENT AND ACCOUNTING

1.4. 1 Handling of funds

1.4.2 Decision making

I.S THE FUNCTIONS OF A FINANCIAL MANAGER 7

• Making investment decisions

1.6 FINANCIAL MANAGEMENT AND THE NON-FINANCIAL

1.7 THE FUNDAMENTAL PRINCIPLES OF FINANCIAL

1. 7. 1 The cost-benefit principle

1. 7.2 The risk-return principle

1. 7.3 The time value of money principle

1.8 FINANCIAL MANAGEMENT AND THE OPERATING

1.8.1 The economic environment

• The financial performance (profitability) of corporate firms. An increase in the

SARB Leading Business Cycle Indicator

--- m/m % change (Right Axls)

Figure 1.2 Economic cycles 2006-2013

1.8.2 The regulatory and political environment

1.8.3 The natural environment

1.9 THE AGENCY PROBLEM

Solutions to self-test questions

What's the problem?

2.3 KEY GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

2.3. 1 Accounting entity

2.3.2 Money measurement

2.3.4 The consistency concept

2.3.6 Historic cost

2.3. 7 The double-entry system

2.3.8 The going-concern concept

2.3.9 The accounting period

2.3.10 The realisation principle

2.4 THE CLASSIFICATION OF FINANCIAL INFORMATION

Total or control accounts for raw materials inventory, manufacturing overheads,

2.S RECORDING CHANGES IN THE FINANCIAL POSITION

Preparation of business document