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11/20/2009 The cash cycle Payables Cash and cash flows Raw materials Cash Work in progress Receivables Examples of cash outflows Finished goods Examples of cash inflows • Payments to suppliers • Cash from cash customers • Wages and salaries • Cash from credit customers • Dividends • Proceeds from new share issues • Interest on loan notes and bank overdrafts • Loan advances • Purchases of new assets • Sales of assets Profits and cash flows are different • Cash is received from non-trading transactions • eg loan advances Forecasting cash flows • Cash is paid for non-trading items • eg purchases of assets • Income statements include non-cash items • eg depreciation • Income statements are based on accruals concept 1 11/20/2009 Forecasts estimate Why is cash forecasting necessary? • To forecast cash shortages (to borrow) • How much is required • To forecast cash surpluses (to invest) • When it will be required • For control purposes (actual v budget comparison) • How long it will be required for • Whether it will be available from anticipated sources Cash budget guidelines Cash budget – Receipts and payments format • Cash receipts • • • • Establish sales volume/price Calculate credit/cash sales Adjust for early payment discount Add one-off or irregular cash receipts • Cash payments • • • • • Establish purchases volume/price Calculate credit/cash purchases Adjust for early payment discount Add other regular payments, eg wages Add one-off or irregular cash payments Cash receipts Sales receipts Issue of shares X Cash payments Purchase payments X X Wages X Purchase of non-current assets Dividends Cash surplus/(deficit) Cash balance, beginning Cash balance, ending X X X Jan Feb Mar X X X X X X X X X (X) X (X) X X X X X (X) X X Tools for forecasting cash flows • Index = Value in year Value in base year X 100% Cash forecasting techniques • Sensitivity analysis • Time series analysis • Seasonally adjusted data • Additive model Y=T+S+I • Multiplicative model Y = T x S x I 2 11/20/2009 The focus of cash management Cash and treasury management Profitability Liquidity Safety The role of the treasurer Corporate objectives Liquidity management Others, eg tax Investing surplus funds The Treasurer Corporate finance Funding management Currency management Where to invest surplus funds? • Bank and building society accounts • Gilts – shorts, mediums, longs, undated, indexlinked • Local authority stocks • Certificates of deposit • Bills of exchange • Shares • Loan notes • Bonds • Commercial paper Risk and exposure • Risk may affect an investment’s income, capital or both • Most risky Ordinary shares • Least risky Government backed investments 3 11/20/2009 Working capital Current assets Working capital management • Cash • Inventory, WIP and finished goods • Trade receivables Current liabilities • Trade payables • Short-term loans • Taxation Liquidity ratios • • • • • Current ratio Quick ratio Accounts receivable payment period Inventory turnover period Accounts payable period Over-capitalisation • Definition – Excessive investment in working capital Lose out on investment income Overtrading Increasing Managing payables and inventory revenue Falling current Increasing & quick assets ratios SYMPTOMS Current liabs Inventory & > receivables Current assets > Sales Assets financed by debt 4 11/20/2009 Methods of paying suppliers • • • • • • • Managing inventory • • • • Cash Cheque Standing order Direct debit Telegraphic Transfer (TT) BACS CHAPS Holding costs Procuring costs Shortage costs Cost of goods and supplier discounts Economic order quantity model EOQ = 2C0D CH Co = ordering cost for units Safety inventory D = demand Q Q Average inventory Average inventory = = S + Q/2 Q/2 Ch = holding costs S = the optimal ordering quantity for an item of inventory which minimises costs 0 time time Just in time (JIT) Managing receivables Inventory suppliers staff quality lead times 0 5 11/20/2009 Credit control Overall policy Credit control policies Overall policy Procedures for offering credit Overall policy Credit control Not to offer credit Procedures for offering credit Review account information Total credit is limited to x% of sales Credit control Procedures for offering credit Obtain references Offer credit to specific customers only Credit control Customer visits Formal agreement Complies with legislation Probationary period Settlement terms Receivables ageing reports Settlement discounts • Worthwhile if the benefit from offering the discount exceeds its cost • Benefit = profit from investing the amount collected early • Cost = percentage discount on amount owed Chasing slow payers Elements of a contract Offer Acceptance Agreement Intention Consideration Contract 6 11/20/2009 Assessing creditworthiness Aim = Minimise bad debts but maximise sales Assessing credit worthiness • Only sell to reliable customers • Process credit sales efficiently • Ensure cash is collected promptly Sources of credit information External sources • External sources Bank references – Generated by third parties Company accounts • Internal sources – Generated by the company County court records Trade references External sources Companies registry Credit ratings Credit bureaux Newspapers Internal sources – Ratio analysis • • • • • • Profit margin Asset turnover ROCE EPS/PE Working capital ratios Gearing, interest cover, debt ratio Monitoring and collecting debts 7 11/20/2009 Managing receivables Insolvency • Liquidation • Factoring =>3 Services – Compulsory or voluntary winding up of the company. – Outsource credit control – Bad debt protection – Advance payment Charge % turnover • Receivership Charge fee – Creditors call in the receiver to run the business. Charge interest • Administration Sell a selection of invoices: INVOICE DISCOUNTING – Protection from liquidation while an insolvency practitioner seeks a good resolution for all. Any combination of 3 services Financial institutions The banking system and financial markets Financial intermediaries Investors Financial markets Increasing risk Financial intermediary Company Money markets disintermediation Investors Merchant banks Pension funds Insurance companies • Bills of exchange • Commercial paper • Certificates of deposit • Treasury bills Company 8 11/20/2009 Euromarkets Economic influences Eurocurrency = a deposit of funds with a bank outside of the currency’s country of issue Economic influences • Interest rates – Nominal vs real rates Short and medium-term finance • Inflation – Redistribution of wealth – Effect on prices • Government control over money supply – Monetary policy Short-term finance •Matching approach • Types – Trade credit – Overdraft – Loans – Leasing Leasing • Lessor • Lessee end start Operating lease Finance lease 9 11/20/2009 Operating and finance leases Operating lease • Lessor supplies the equipment Finance lease • Lessee responsible for maintenance • Lessor responsible for maintenance Banks’ criteria for lending • • • • • • • Character of the customer Ability to borrow and repay Margin of profit Purpose of the borrowing Amount of the borrowing Repayment terms Insurance against possible non-payment Long-term finance Long-term finance • Used for major investments • Usually more expensive and less flexible • Types – Retained earnings – Debt – Equity – Venture capital – Government aid Equity finance Access to wider pool of finance Higher public profile Better position to make a takeover bid Why seek a stock market listing? Higher investor confidence due to greater scrutiny Allows owners to realise some of their investment Debt finance Bank loans Bonds / loan notes • Many types • Sold to investors • Often secured • Secured / covenants • Loan covenants • Types – Redeemable – Irredeemable – Floating rate – Deep discount – Convertible – Zero coupon 10 11/20/2009 Small & medium-sized enterprises Financing of small and mediumsized enterprises • Strong competition for investment capital • Lack of track record • Perceived as high risk • Few assets for security • Robust business plan required Sources of finance for SMEs • • • • • • • • Owner finance Overdraft/bank loans Trade credit/debt factoring Equity Leasing Government aid Venture capital Business angels Decision making Relevant Costs Relevant cost - materials • What is a relevant cost? FUTURE INCREMENTAL CASHFLOW Only cash Only future costs are affected by our decision i.e. incurred as a direct result of our decision Not in inventory In inventory In continual use No other use Scarce If taken from inventory it will have to be replaced If taken from inventory it won’t have to be replaced If taken from inventory it can’t be replaced Relevant cost = current purchase price Relevant cost = scrap value foregone Relevant cost = opportunity cost Just have to buy it Relevant cost = current purchase price 11 11/20/2009 Relevant cost - labour Shutdown decisions Labour Could hire more Spare capacity Relevant cost = current rate of pay Relevant cost = nil The only fixed costs which are relevant are avoidable fixed costs Full capacity Relevant cost = opportunity cost Sales15,000 Variable cost Cont’n Fixed cost Profit A 10,000 8,000 7,000 (4,000) 3,000 B 8,000 6,000 4,000 (3,000) 1,000 C 5,000 3,000 (4,000) (1,000) Introduction CVP analysis So we will break even when… Contribution = Fixed costs Cont’n/unit x Q = Fixed costs Fixed costs Q = __________ Cont’n/unit Breakeven Revenue – C/S Ratio Margin of safety (in units) = B/E Revenue = BEP x SP/unit B/E Revenue = Fixed costs __________ x SP/unit Fixed costs Budgeted sales volume – breakeven sales volume OR Cont’n/unit B/E Revenue = Margin of safety ÷ Cont’n/unit _________ Margin of safety (as %) = SP/unit Budgeted sales volume – Break even sales volume B/E Revenue = costs _Fixed _________ X 100 Budgeted sales volume C/S ratio 12 11/20/2009 Required profit level Breakeven chart $ TR $40,000 Sales volume to reach required profit level = Fixed costs + required profit ______________________ Profit TC $38,200 $30,400 Contribution/unit Fixed cost 3,800 5,000 Q Margin of safety Profit volume chart Profit $1,800 Capital expenditure budgeting $0 3,800 5,000 Q Margin of safety ($5,700) Capital expenditure • Capital expenditure acquires non-current assets or improves their earning capacity • Non-current assets include: Car; machinery; property…. Revenue expenditure • Revenue expenditure is incurred for the purposes of the trade – Raw materials – Marketing costs – Administration expenses – Finance charges – Maintaining the earning capacity of non-current assets 13 11/20/2009 Steps in project appraisal Investigation Methods of project appraisal Detailed evaluation Authorisation and implementation Monitoring and post-completion audit ARR / ROI Payback Est average profits Est average investment X 100%   Advantages? Advantages? Disadvantages? The time it takes the cash inflows from a project to equal the cash outflows   Advantages? Disadvantages? Time value of money Cash received in one year’s time is not worth the same as cash received today Future cash flows need to be discounted Net Present Value If the discounted future cash flows > cost of setting up the project today The project has a + net present value (NPV) Annuity: Cost of capital: A constant cash flow for a number of years • Cost of funds • Minimum return 14 11/20/2009 Internal rate of return Disadvantages of IRR • Multiple IRRs • Mutually exclusive projects • Unfamiliar/confusing • Reinvestment assumption = The % return given by a project 1. NPVA (+ve) of the project at a% 2. NPVB (-ve) of the project at b% 3. Use the formula IRR = a + NPVA x (b - a) NPVA - NPVB 15
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