How to Understand Business Finance, Second Edition_9 ppt

To reduce working capital we must consider reducing these buff er stocks, eliminating or combining stages in the production process, reducing the overall production cycle time, and minimi

134 How to Understand Business Finance

Raw materials

Raw materials are goods that have been delivered to our

company’s warehouse but have not yet been taken into the production area for conversion As these are part of working capital, it would seem that minimising raw material stock is ideal However, this must be off set by the economic order quantities available from suppliers

Another approach is just in time (JIT) deliveries of raw materials In this way, goods can be delivered directly to the production area, eliminating any raw material store The aim is

to get our supplier to carry the stock rather than doing this ourselves

Work in progress (WIP)

WIP involves any product once it has left the raw material store until it is declared available for sale and delivery to customers In

a multi-step process this can also involve intermediate products awaiting conversion to the next stage To reduce working capital

we must consider reducing these buff er stocks, eliminating or combining stages in the production process, reducing the overall production cycle time, and minimising raw material and fi nished goods stocks in the production area

The amount of WIP can also be badly aff ected when diff erent stages of the manufacturing process takes place on diff erent sites This is common when companies acquire an ‘upstream’ or

‘downstream’ processor In these cases the stock travelling between sites must also be taken into account

Finally, we must examine how long it takes for products to be cleared for sale by our quality control (QC) procedures Some organisations have huge stocks sitting in a pending bay awaiting clearance from QC

135 Where is all our Cash? Managing Working Capital

Finished goods

‘Finished goods’ refers to the stock sitting in the warehouse awaiting sale and delivery to our customers Some of this may have been in the warehouse for a long time, and if the goods have a shelf-life they may be unsaleable In these circumstances we must consult our technical staff to fi nd out what options we have to dispose of slow-moving items Should we repack or reprocess the stock, sell it at a discount or dispose of it altogether? Good sales and operations planning can reduce or eliminate the need for fi nished goods stocks Examples of best practice in stock management are the car manufacturers They use JIT to have components delivered directly to their production lines at the exact point where the component is fi tted to the car Then they ask their suppliers not to invoice them until a short time later when the fi nished car rolls

off the end of the production line In this way they minimise or eliminate both raw material stock and work in progress, as all their stock is now in fi nished goods

Debtors

‘Debtors’ refers to the amount of money owed to us by our

customers This is directly related to how long customers take to pay their bills The longer we give them to pay, the more we will have owed to us at any one time Inevitably customers are late in paying their bills Timely monitoring and enforcement of the terms under which you do business can help you manage your debtors better Other factors can include invoice accuracy, correct addressing of invoicing to the appropriate department/location at your customer, off ering a prompt payment discount (a small percentage discount can have a disproportionate eff ect on

payment times), and establishing maximum credit limits after which further orders cannot be accepted

Improvements can be brought about by more regular invoicing

of your customers Imagine if you only invoice once a month The

136 How to Understand Business Finance

value of a whole month’s worth of deliveries could be building up before you even invoice the customer With today’s electronic payment systems it is often possible to increase invoicing

frequency with no additional workload after the initial set-up

In all these areas the key is communicating the issues to your customers and negotiating better terms rather than simply

imposing them

How long does it take you to invoice your customers?

A private hospital with a turnover of £36 million per year was taking 15 days to collect all the information on what services and drugs patients had used in the various departments

before sending out bills With sales of £100,000 per day this was equivalent to £1.5 million that they had not yet invoiced Halving this delay in issuing their bills would release

£750,000 of cash, which could then be used to pay off

loans, buy new equipment etc – a sum defi nitely worth

working towards

Creditors

Creditors provide a mechanism for funding your business The more credit we can get from our suppliers (ie the longer we take to pay our bills), the better our cash fl ow position Once again the key

to success is to negotiate better terms and then not pay these bills until the day they are due

Asking your suppliers to invoice you monthly or quarterly rather than every time they deliver can improve your working capital This is because the amount outstanding builds up before you are billed, and therefore you end up with more credit from your supplier

137 Where is all our Cash? Managing Working Capital

It is possible to have negative working capital when you can get more credit from your suppliers than you give your customers Consider a trading company that buys from an overseas supplier with three-month terms (ie 90 days to pay the supplier’s bill) and sells to its customers on 30 days This business can receive the cash on two out of the three months’ worth of bought-in stock before having to pay its supplier anything

Supermarkets also work on this basis, eff ectively selling to consumers for cash and paying suppliers after 30–60 days This is why many retailers have started off ering fi nancial services They generate a lot of cash, which they can then use before having to pay their suppliers

Why payment terms matter

Getting extended credit terms from suppliers is worth more than any non-fi nancially aware business person ever

imagines – purchasers take note

Giving extended credit to customers is more expensive than any non-fi nancially aware business person ever

imagines – salespeople take note

Write-off s

In all the above examples, where items are carried in the books which will never realistically be realised (ie turned into cash) then

we must consider writing down their book value, or writing them

off completely

If we consider reducing the value of something on the top half

of the balance sheet, then we must reduce the value of the bottom half of the balance sheet, otherwise the books will no longer balance This is done by showing a loss for the same amount as the value we are writing off In other words, it becomes a write-off cost,

138 How to Understand Business Finance

which reduces the number carried across from the P&L account into the bottom half of the balance sheet as retained earnings Similarly, revaluing an asset by increasing its book value will result in a paper profi t to balance the bottom half of the books This will appear as an additional line in the P&L account

Both these items can sometimes appear in the accounts under various terms (eg stock adjustments) and can be found at any level between the top and bottom line of the P&L account

Cash fl ow implications of

working capital

As we have already seen, when considering the cash tied up in a business, there are two main areas: fi xed assets and working capital Because we cannot do much to aff ect the day-to-day value

of our fi xed assets, managers concentrate all their eff orts on managing working capital! Table 13.1 gives a summary of impact of each element of working capital

Table 13.1 Impact of diff erent elements of working capital

Item of working capital Cash implications

Stock (inventories) Decrease in stocks releases cash

Increase in stocks consumes cash Debtors (receivables)

– money owed by customers

Decrease in total value of debtors releases cash

Increase in total value of debtors consumes cash

Creditors (payables)

– credit from suppliers

Increase in total value of creditors releases cash

Decrease in total value of

creditors reduces cash available

139 Where is all our Cash? Managing Working Capital

Generally, managing working capital means reducing working capital to release cash This means reducing stocks, and money owed by customers, and increasing the credit from suppliers Working capital will also change as our volume of business changes Suppose we are a company with monthly sales of

£100,000 and it takes two months to get our bills paid This means

at any time we will have two months’ worth of sales, or £200,000, owed to us Now we are really successful and grow our sales to

£150,000 per month How much will we now have owed to us –

£300,000! Where does the money come from, then, to fund this

£100,000 increase in working capital? Well, it must come from somewhere Perhaps there is enough cash in the business, or perhaps we can get another loan This is one of the reasons that companies get into cash fl ow diffi culties when they expand too fast Lastly, consider what happens when closing down a business, perhaps because cash fl ow problems just got too much Inevitably there will be monies owed from customers yet to be paid In the months following the winding up of that company, cash will start

fl owing in as these invoices get paid It is at times like these that you might start to regret closing the business: you are cash rich for the fi rst time in your life! It is an irony of business that cash fl ow can be at its best when you are selling the least…

140

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Glossary of fi nancial terms

absorption costing Full costing Calculated by dividing the

total fi xed costs incurred during a period by the units sold The allocated fi xed cost is added to the variable cost to give the full cost of the product

accounting The process of measuring and summarising

fi nancial information about the activities of a business to provide information to shareholders, managers and employees about what

is happening in the business See management accounting,

fi nancial accounting

accounting conventions Principles used by accountants when

preparing accounts so that there is a degree of comparability between the accounts of diff erent companies, and between accounts for the same company in diff erent periods If any changes are made in the way that accounting conventions have been applied, these must be disclosed by the auditors in the notes to the annual accounts

accounts (UK) Financial Statements (US) Books The records

kept by a business of its fi nancial activities

141

142 How to Understand Business Finance

accounts payable (US) Creditors (UK) Money owing to

suppliers for goods and services purchased but not yet paid for

accounts receivable (US) Debtors (UK) Money owing from

customers for goods or services supplied and invoiced, but not yet paid for See also DSO

accrual accounting This recognises the occurrence of income

and expense irrespective of whether cash has moved in or out of the company at the time the transaction occurs For example, when a piece of equipment is bought, the expense will be

recorded, even though payment for it may only be made several months later If accrual accounting is not used, the system is called ‘receipts and payments’ or ‘cash accounting’

accumulated depreciation This shows the amount of

depreciation suff ered to date When subtracted from the cost of the assets, the result is the net book value

acid test (US) See quick ratio (UK).

activity ratio Asset turnover, spin Sales revenues divided by

net (or total) assets This shows the effi ciency with which the assets used by the business are being used to generate sales, regardless of the source of the capital Retailing and service industries typically have high activity ratios Manufacturing industries are typically capital-intensive, with high fi xed and current asset fi gures, and low activity ratios

allocation of costs Giving the costs to the product or division

that ‘owns’ them, eg accounting the cost of an advertising

campaign against income from the product advertised

amortisation Periodically recorded expen ses which show the

gradual reduction of value of an asset or an obligation Usually refers to goodwill, patents and other intangible assets, or issuing expenses of debt securities

143 Glossary of Financial Terms

assets The things owned by the business These may include

fi xed assets, current assets and intangible assets

asset turnover ATO; see activity ratio.

auditing The process of checking the books and accounting

systems of a company to verify that the company’s accounts give a true and fair view of its fi nancial situation

auditors’ report A limited company must by law produce a set of

accounts every year, and the auditors must report on whether the accounts provide a true and fair statement of the company’s

business The auditors have to investigate the accounts to establish this, and if they are not satisfi ed with them they produce a ‘qualifi ed report’ in which they say what they consider to be wrong or

uncertain in the accounts A qualifi ed report from the auditors can

be damaging to the public image of a company and its share price

authorised capital The amount of share capital that the

company has been authorised to issue Stamp duty is paid at the time of authorisation, and if the directors wish to issue further shares once the authorised capital is fully issued, they must get approval from the shareholders Once authorised, shares may be issued at the discretion of the company’s board of directors

bad debts Accounts receivable (US) or debtors (UK) that will

never be collected ‘Writing off ’ a bad debt means reducing the debtors fi gure by the amount written off , and putting that in the P&L account as an expense against profi ts

balance sheet A snapshot of the fi nancial position of the

business at a given time It summarises all the assets owned by the business, the equity invested, and all the liabilities; in lay terms, what the business has, and where it came from

bonds Debentures A way of borrowing.

144 How to Understand Business Finance

book value Net book value The diff erence between the

purchase cost of an asset and its accumulated depreciation

break-even point The volume of sales at which total sales equals

total costs, and the company makes neither profi t nor loss At this point the contribution exactly equals the fi xed costs Break-even volume (in unit sales) is calculated by dividing total fi xed costs by the unit contribution Break-even sales turnover is calculated by multiplying the break-even volume by the unit selling price

budget (UK) Business plan (US), a man agement plan for

fi nancial achievement over a specifi ed period This needs to be supported by an action plan that will give rise to the required

fi nancial results The budget provides a way of coordinating the activities of diff erent departments within a company, and for testing the viability of planned activities The amount of

commitment shown by employees to a budget is proportional to their involvement in creating the budget, and the amount of personal benefi t they expect to receive from achieving it

budgetary control This is a process of setting budgets, measuring

actual results, and comparing the actual against the budget to see where variances occur, and what new plans must be made

burden (US) Overhead costs, indirect expenses See also overheads.

capital Used in several diff erent senses (eg savings, cash

reserves, equity in a business), it usually means money Capital investment means the purchase of long-term assets such as machines, as opposed to goods for resale, services etc

capital employed The money used to fi nance a business

Calculated as share capital plus reserves (qv), plus long-term loans; or as total assets less current liabilities

capital expenditure The purchase of fi xed assets.