CIMA P1 Performance Operations Study Text 2013

8/17/2019 CIMA P1 Performance Operations Study Text 2013

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CIMA

S

T

U

D

Y

T

EX

T

OPERATIONAL

PAPER PPERFORMANCE OPERATIONS

SUITABLE FOR EXAMS UP TO SEPTEMBER 2014

Our text is designed to help you study effectively and efficiently.

In this edition we:

• Highlight the most important elements in the syllabus and the key skills you will need

• Signpost how each chapter links to the syllabus and the learning outcomes

• Provide lots of exam alerts explaining how what you're learning may be tested

• Include examples and questions to help you apply what you've learnt

• Emphasise key points in section summaries

• Test your knowledge of what you've studied in quick quizzes

• Examine your understanding in our exam question bank

• Reference all the important topics in the full index


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ii

First edition 2009

Fifth edition June 2013

ISBN 9781 4453 7132 0

(Previous ISBN 9781 4453 9608 8)

e-ISBN 9781 4453 7177 1

British Library Cataloguing-in-Publication Data

A catalogue record for this book

is available from the British Library

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suggested solutions in the exam answer bank havebeen prepared by BPP Learning Media Ltd.

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2013

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ContentsPage

IntroductionHow our Study Text can help you pass iv

Features in our Study Text v

Streamlined studying vi

Syllabus and learning outcomes vii

Studying P1 xiii

The exam paper xvii

Part A Managing short-term finance

1 Working capital and the operating cycle 3

2 Cash flow forecasts 23

3 Cash management 53

4 Receivables and payables 83

5 Managing inventory 119

Part B Cost accounting systems

6a Basic management accounting techniques 133

6b Absorption and marginal costing 159

7a Standard costing 173

7b Variance analysis 193

7c Interpretation of variances 217

8 Further variance analysis 239

9 The modern business environment 279

10 Modern costing techniques – throughput and backflush accounting 307

11 Modern costing techniques – activity based costing 323

12 Environmental costing 341

Part C Forecasting and budgeting techniques

13 Budgeting 355

14 Preparing forecasts 391

Part D Project appraisal

15 Investment decision making 425

16 DCF techniques of investment appraisal 439

17 Taking account of taxation and inflation 471

18 Further aspects of investment decision making 487

Part E Dealing with uncertainty in analysis19 Risk and uncertainty in decision making 519

Objective test question bank 567

Objective test answer bank 571

Exam question bank 579

Exam answer bank 595

Appendix: Mathematical tables and exam formulae 639

Index 645

Review form


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How our Study Text can help you pass

Streamlined

studying

• We show you the best ways to study efficiently

• Our Text has been designed to ensure you can easily and quickly navigate

through it

• The different features in our Text emphasise important knowledge and

techniques

Exam expertise Studying P1 on page xiii introduces the key themes of the syllabus and

summarises how to pass

• We highlight throughout our Text how topics may be tested and what you’ll have

to do in the exam

• We help you see the complete picture of the syllabus, so that you can answer

questions that range across the whole syllabus

• Our Text covers the syllabus content – no more, no less

Regular review • We frequently summarise the key knowledge you need

• We test what you’ve learnt by providing questions and quizzes throughout our

Text

Our other products

BPP Learning Media also offers these products for the P1 exam:

Practice and

Revision Kit

Providing lots more question practice and helpful guidance on how to pass the exam

Passcards Summarising what you should know in visual, easy to remember, form

Success CDs Covering the vital elements of the P1 syllabus in less than 90 minutes and alsocontaining exam hints to help you fine tune your strategy

i-Pass Providing computer-based testing in a variety of formats, ideal for self-assessment

Interactive

Passcards

Allowing you to learn actively with a clear visual format summarising what you must

know

Strategic case

study kit

Providing question practice with specially written questions, based on the preseen

issued by CIMA

You can purchase these products by visiting www.bpp.com/cimamaterials

CIMA Distance Learning

BPP's distance learning packages provide flexibility and convenience, allowing you to study effectively, at

a pace that suits you, where and when you choose. There are four great distance learning packages

available.

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live

Through live interactive online sessions it provides you with the traditional

structure and support of classroom learning, but with the convenience of

attending classes wherever you are

Online classroom Through pre-recorded online lectures it provides you with the classroom

experience via the web with the tutor guidance and support you’d expect from

a face to face classroom

Basics Plus A guided self study package containing a wealth of rich e-learning and physical

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INTRO U TION

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Features in our Study Text

Section Introductions explain how the section fits into the chapter

Key Terms are the core vocabulary you need to learn

Key Points are points that you have to know, ideas or calculations that will be the

foundations of your answers

Exam Alerts show you how subjects are likely to be tested

Exam Skills are the key skills you will need to demonstrate in the exam, linked to

question requirements

Formulae To Learn are formulae you must remember in the exam

Exam Formulae are formulae you will be given in the exam

Examples show how theory is put into practice

Questions give you the practice you need to test your understanding of what you’velearnt

Case Studies link what you’ve learnt with the real-world business environment

Links show how the syllabus overlaps with other parts of the qualification, including

Knowledge Brought Forward that you need to remember from previous exams

Website References link to material that will enhance your understanding of what

you’re studying

Further Reading will give you a wider perspective on the subjects you’re covering

Section Summaries allow you to review each section

KEY POINT

CASE STUDY

KEY TERM


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Streamlined studying

What you should do In order to

Read the Chapter and Section Introductions See why topics need to be studied and map your

way through the chapter

Go quickly through the explanations Gain the depth of knowledge and understanding

that you'll need

Highlight the Key Points, Key Terms and Formulae

To Learn

Make sure you know the basics that you can't do

without in the exam

Focus on the Exam Skills and Exam Alerts Know how you'll be tested and what you'll have to

do

Work through the Examples and Case Studies See how what you've learnt applies in practice

Prepare Answers to the Questions See if you can apply what you've learnt in

practice

Revisit the Section Summaries in the Chapter

Roundup

Remind you of, and reinforce, what you've learnt

Answer the Quick Quiz Find out if there are any gaps in your knowledge

Answer the Question(s) in the Exam Question Bank Practise what you've learnt in depth

Should I take notes?

Brief notes may help you remember what you’re learning. You should use the notes format that’s most

helpful to you (lists, diagrams, mindmaps).

Further help

BPP Learning Media’s Learning to Learn Accountancy provides lots more helpful guidance on studying. It

is designed to be used both at the outset of your CIMA studies and throughout the process of learning

accountancy. It can help you focus your studies on the subject and exam, enabling you to acquire

knowledge, practise and revise efficiently and effectively.


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Syllabus and learning outcomes

Paper P1 Performance Operations

The syllabus comprises:

Topic and Study Weighting

%

A Cost Accounting Systems 30

B Forecasting and Budgeting Techniques 10

C Project Appraisal 25

D Dealing with Uncertainty in Analysis 15

E Managing Short-Term Finance 20

Learning Outcomes

Lead Component Syllabus content

A Cost accounting systems

1 Discuss

costing

methods and

their results

(a) compare and contrast

marginal (or variable),

throughput and absorption

accounting methods in

respect of profit reporting

and stock valuation;

(b) discuss a report which

reconciles budget and

actual profit using

absorption and/or marginal

costing principles;

(c) discuss activity-based

costing as compared with

traditional marginal and

absorption costing

methods, including its

relative advantages and

disadvantages as a system

of cost accounting;

(d) apply standard costing

methods, within costing

systems, including the

reconciliation of budgeted

and actual profit margins;

(e) explain why and how

standards are set in

manufacturing and in

service industries with

particular reference to the

maximisation of efficiency

and minimisation of waste;

(f) interpret material, labour,variable overhead, fixed

overhead and sales

• Marginal (or variable), throughput

and absorption accounting systems

of profit reporting and stock

valuation.

• Activity-based costing as a system

of profit reporting and stock

valuation.

• Criticisms of standard costing in

general and in advanced

manufacturing environments in

particular.

• Integration of standard costing with

marginal cost accounting,

absorption cost accounting and

throughput accounting.

• Manufacturing standards for

material, labour, variable overhead

and fixed overhead.

• Price/rate and usage/efficiency

variances for materials, labour and

variable overhead.• Further subdivision of total

usage/efficiency variances into mix

and yield components.

(Note: The calculation of mix

variances on both individual and

average valuation bases is required.)

• Fixed overhead expenditure and

volume variances. (Note: the

subdivision of fixed overhead

volume variance into capacity and

efficiency elements will not beexamined.)


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Learning Outcomes


variances, distinguishing

between planning and

operational variances;

(g) prepare reports using a

range of internal and

external benchmarks and

interpret the results;

(h) explain the impact of just-

in-time manufacturing

methods on cost

accounting and the use of

‘back-flush accounting’

when work in progress

stock is minimal.

• Planning and operational

variances.

• Standards and variances in serviceindustries (including the

phenomenon of

‘McDonaldization’), public services

(eg Health), (including the use of

‘diagnostic related’ or ‘reference’

groups), and the professions (eg

labour mix variances in audit

work).

• Sales price and sales

revenue/margin volume variances

(calculation of the latter on a unitbasis related to revenue, gross

margin and contribution margin).

Application of these variances to

all sectors, including professional

services and retail analysis.

• Interpretation of variances:

interrelationship, significance.

• Benchmarking.

• Back-flush accounting in just-in-

time production environments. The

benefits of just-in-time production,

total quality management and

theory of constraints and the

possible impacts of these methods

on cost accounting and

performance measurement.

2 Explain the

role of MRP

and ERP

systems

(a) explain the role of MRP

and ERP systems in

supporting standard

costing systems,

calculating variances andfacilitating the posting of

ledger entries.

• MRP and ERP systems for

resource planning and the

integration of accounting functions

with other systems, such as

purchase ordering and productionplanning.

3 Apply

principles of

environmental

costing

(a) apply principles of

environmental costing in

identifying relevant

internalised costs and

externalised environmental

impacts of the

organisation’s activities.

• Types of internalised costs relating

to the environment (eg emissions

permits, taxes, waste disposal

costs) and key externalised

environmental impacts, especially

carbon, energy and water usage.

Principles for associating such

costs and impacts with activities

and output.


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Learning Outcomes


B Forecasting and budgeting techniques

1 Explain the

purposes offorecasts,

plans and

budgets.

(a) explain why organisations

prepare forecasts andplans;

(b) explain the purposes of

budgets, including

planning, communication,

co-ordination, motivation,

authorisation, control and

evaluation, and how these

may conflict.

• The role of forecasts and plans in

resource allocation, performanceevaluation and control.

• The purposes of budgets and the

budgeting process, and conflicts

that can arise (eg between budgets

for realistic planning and budgets

based on ‘hard to achieve’ targets

for motivation).

2 Prepare

forecasts of

financial

results.

(a) calculate projected

product/service volumes

employing appropriate

forecasting techniques;

(b) calculate projected

revenues and costs based

on product/service

volumes, pricing strategies

and cost structures.

• Time series analysis including

moving totals and averages,treatment of seasonality, trend

analysis using regression analysis

and the application of these

techniques in forecasting product

and service volumes.

• Fixed, variable, semi-variable and

activity based categorisations of

cost and their application in

projecting financial results.

3 Prepare

budgets basedon forecasts.

(a) prepare a budget for any

account in the masterbudget, based on

projections/forecasts and

managerial targets;

(b) apply alternative

approaches to budgeting.

• Mechanics of budget construction:

limiting factors, componentbudgets and the master budget,

and their interaction.

• Alternative approaches to budget

creation, including incremental

approaches, zero-based budgeting

and activity-based budgets.

C Project appraisal

1 Prepare

information to

support project

appraisal

(a) explain the processes

involved in making long-

term decisions;

(b) apply the principles of

relevant cash flow analysis

to long-run projects that

continue for several years;

(c) calculate project cash

flows, accounting for tax

and inflation, and apply

perpetuities to derive ‘end

of project’ value where

appropriate;

• The process of investment decision

making, including origination of

proposals, creation of capital

budgets, go/no go decisions on

individual projects (where

judgements on qualitative issues

interact with financial analysis),

and post audit of completed

projects.

• Identification and calculation of

relevant project cash flows taking

account of inflation, tax, and ‘final’

project value where appropriate.


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Learning Outcomes


(d) apply activity-based

costing techniques to

derive approximate ‘long-

run’ product or service

costs appropriate for use in

strategic decision making;

(e) explain the financial

consequences of dealing

with long-run projects, in

particular the importance

of accounting for the ‘time

value of money’;

(f) apply sensitivity analysis to

cash flow parameters toidentify those to which net

present value is

particularly sensitive;

(g) prepare decision support

information for

management, integrating

financial and non-financial

considerations.

• Activity-based costing to derive

approximate ‘long-run’ costs

appropriate for use in strategicdecision making.

• Need for and method of

discounting.

• Sensitivity analysis to identify the

input variables that most affect the

chosen measure of project worth

(payback, ARR, NPV or IRR).

• Identifying and integrating non-

financial factors in long-term

decisions.

• Methods of dealing with particular

problems: the use of annuities in

comparing projects with unequal

lives and the profitability index in

capital rationing situations.

2 Evaluate

project

proposals

(a) evaluate project proposals

using the techniques of

investment appraisal;

(b) compare and contrast the

alternative techniques of

investment appraisal;

(c) prioritise projects that are

mutually exclusive, involve

unequal lives and/or are

subject to capital rationing.

• The techniques of investment

appraisal: payback, discounted

payback, accounting rate of return,

net present value and internal rate

of return.

• Application of the techniques of

investment appraisal to project

cash flows and evaluation of the

strengths and weaknesses of the

techniques.

D Dealing with uncertainty in analysis

1 Analyse

information to

assess the

impact on

decisions of

variables with

uncertain

values

(a) analyse the impact of

uncertainty and risk on

decision models that may

be based on relevant cash

flows, learning curves,

discounting techniques

etc;

(b) apply sensitivity analysis to

both short and long-run

decision models to identify

variables that might have

significant impacts on

project outcomes;

• The nature of risk and uncertainty.

• Sensitivity analysis in decision

modelling and the use of computer

software for “what if” analysis.

• Assignment of probabilities to key

variables in decision models.

• Analysis of probabilistic models

and interpretation of distributions

of project outcomes.

• Expected value tables and the

value of information.

• Decision trees for multi-stage

decision problems.


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Learning Outcomes


(c) analyse risk and

uncertainty by calculating

expected values and

standard deviations

together with probability

tables and histograms;

(d) prepare expected value

tables;

(e) calculate the value of

information;

(f) apply decision trees.

E Managing short-term finance

1 Analyse theworking capital

position and

identify areas

for

improvement

(a) explain the importance ofcash flow and working

capital management;

(b) interpret working capital

ratios for business sectors;

(c) analyse cash-flow

forecasts over a twelve-

month period;

(d) discuss measures to

improve a cash forecast

situation;

(e) analyse trade debtor and

creditor information;

(f) analyse the impacts of

alternative debtor and

creditor policies;

(g) analyse the impacts of

alternative policies for

stock management

• The link between cash, profit andthe balance sheet.

• The credit cycle from receipt of

customer order to cash receipt and

the payment cycle from agreeing

the order to making payment.

• Working capital ratios (eg debtor

days, stock days, creditor days,

current ratio, quick ratio) and the

working capital cycle.

•

Working capital characteristics ofdifferent businesses (eg

supermarkets being heavily funded

by creditors) and the importance of

industry comparisons.

• Cash-flow forecasts, use of

spreadsheets to assist in this in

terms of changing variables (eg

interest rates, inflation) and in

consolidating forecasts.

• Variables that are most easily

changed, delayed or broughtforward in a forecast.

• Methods for evaluating payment

terms and settlement discounts.

• Preparation and interpretation of

age analyses of debtors and

creditors.

• Establishing collection targets on

an appropriate basis (eg

motivational issues in managing

credit control).• Centralised versus decentralised

purchasing.


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Learning Outcomes


• The relationship between

purchasing and stock control.

• Principles of the economic orderquantity (EOQ) model and

criticisms thereof.

2 Identify short-

term funding

and

investment

opportunities

(a) identify sources of short-

term funding;

(b) identify alternatives for

investment of short-term

cash surpluses;

(c) identify appropriate

methods of finance for

trading internationally.(d) illustrate numerically the

financial impact of short-

term funding and

investment methods.

• Use and abuse of trade creditors as

a source of finance.

• Types and features of short-term

finance: trade creditors, overdrafts,

short-term loans and debt

factoring.

• The principles of investing short

term (ie maturity, return, security,liquidity and diversification).

• Types of investments (eg interest-

bearing bank accounts, negotiable

instruments including certificates

of deposit, short-term treasury

bills, and securities).

• The difference between the coupon

on debt and the yield to maturity.

• Export finance (eg documentary

credits, bills of exchange, export

factoring, forfeiting).


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Studying P1

1 What's P1 about?

1.1 Current performance evaluation and future projectionsP1 looks at how information is obtained, evaluated and used to control and predict business performance.

For example, budgets are used along side cost accounting systems to evaluate business performance.

Cash projections are used to evaluate individual projects and predict their performance. Cash flow

forecasts are used to control working capital. All of these examples use estimated (and therefore

uncertain) information and P1 looks at measuring the risk associated with this uncertainty.

There is assumed prior knowledge of Certificate level papers, particularly C1 Fundamentals of

Management Accounting and C3 Fundamentals of Business Maths.

1.2 Managing short-term finance

This element of the syllabus concentrates on what’s required for the business’s day-to-day operations and

short-term financing requirements including its working capital of inventory, receivables, payables and

cash. P1 covers how working capital is measured and managed, how an organisation determines its

short-term financing requirements and where it can invest surplus cash.

1.3 Cost accounting systems

There are different ways of carrying out costing. These include traditional management accounting

techniques and new alternatives which may be more appropriate for the modern business environment.

The various costing methods impact upon the business’s inventory valuation and profitability.

1.4 Standard costing

A standard cost is the planned unit of cost of a product or service. Without this, producing a budget

would be very difficult. Standard costing and variance analysis act as a control mechanism by

establishing standards and highlighting activities that do not conform to plan.

1.5 Forecasting and budgeting

A budget is a plan of what the organisation is aiming to achieve and what it has set as a target. There are

several different techniques used to produce a budget but they are all produced to ensure that objectives

are achieved. It is important that results are measured regularly and compared to budget so that

management can try to take corrective action if areas of the business are not performing well.

1.6 Project appraisal

You are expected to understand and apply techniques for evaluating long-term proposals. This includes

identifying relevant cash flows, using investment appraisal techniques (including DCF and ARR) and

factoring in inflation and taxation, ranking the projects and applying sensitivity analysis.

1.7 Dealing with uncertainty in analysis

This part of the syllabus looks at techniques for measuring risk and evaluating uncertainty. These

techniques include expected values, sensitivity analysis and decision trees. You need to be familiar withthe techniques and their application across a variety of decision making tools such as relevant cash flows,

DCF and CVP analysis.


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2 What's required

2.1 Explanation

As well as testing your knowledge and understanding, you are asked to demonstrate the skill of explaining

key ideas, techniques or approaches. Explaining means providing simple definitions and covering thereasons why these approaches have been developed. You’ll gain higher marks if your explanations are

clearly focused on the question and you can supplement your explanations with examples. You could try

using the PEA approach. Point, Explain, Apply. Make your point in a sentence. Explain that point in

another sentence by answering the reader's 'so what?' or 'why?'. Then apply it to the scenario so that your

point relates to the organisation or specific situation in the question.

2.2 Interpretation and recommendation

You will probably have to interpret the results of any calculations that you carry out. You must understand that

interpretation isn’t just saying figures have increased or decreased. It means explaining why figures have

changed and also the consequences of the changes. You will also have to provide recommendations. For

example, you may be given some details or working capital ratios and then asked to explain how thatparticular business could improve its day-to-day working capital management and what sources of short-term

finance it will need.

2.3 What the examiner means

The table below has been prepared by CIMA to help you interpret the syllabus and learning outcomes and

the meaning of exam questions.

You will see that there are 5 levels of Learning objective, ranging from Knowledge to Evaluation, reflecting

the level of skill you will be expected to demonstrate. CIMA Certificate subjects were constrained to levels

1 to 3, but in CIMA’s Professional qualification the entire hierarchy will be used.

At the start of each chapter in your study text is a topic list relating the coverage in the chapter to the

level of skill you may be called on to demonstrate in the exam.

Learning objectives Verbs used Definition

1 Knowledge

What are you expected to

know

• List

• State

• Define

• Make a list of

• Express, fully or clearly, the details of/facts of

• Give the exact meaning of

2 Comprehension

What you are expected tounderstand

•

Describe• Distinguish

• Explain

• Identify

• Illustrate

•

Communicate the key features of• Highlight the differences between

• Make clear or intelligible/state the meaning of

• Recognise, establish or select after

consideration

• Use an example to describe or explain

something


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Learning objectives Verbs used Definition

3 Application

How you are expected to

apply your knowledge

• Apply

• Calculate/

compute

• Demonstrate

• Prepare

• Reconcile

• Solve

• Tabulate

• Put to practical use

• Ascertain or reckon mathematically

• Prove with certainty or to exhibit by practical

means

• Make or get ready for use

• Make or prove consistent/compatible

• Find an answer to

• Arrange in a table

4 Analysis

How you are expected to

analyse the detail of what

you have learned

• Analyse

• Categorise

• Compare and

contrast

• Construct

• Discuss

• Interpret

• Prioritise

• Produce

• Examine in detail the structure of

• Place into a defined class or division

• Show the similarities and/or differences

between

• Build up or compile

• Examine in detail by argument

• Translate into intelligible or familiar terms

• Place in order of priority or sequence for action

• Create or bring into existence

5 Evaluation

How you are expected to useyour learning to evaluate,

make decisions or

recommendations

•

Advise• Evaluate

• Recommend

•

Counsel, inform or notify• Appraise or assess the value of

• Propose a course of action

3 How to pass

3.1 Study the whole syllabus

You need to be comfortable with all areas of the syllabus, as questions, particularly the objective testing

questions in Section A, will often span a number of syllabus areas. Remember that all questions in paper

P1 are compulsory.

3.2 Lots of question practice

You can develop application skills by attempting questions in the Exam Question Bank and later on

questions in the BPP Practice and Revision Kit.


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3.3 Exam technique

The following points of exam technique are particularly relevant to this paper.

• You should consider in advance how you are going to use the 20 minutes' reading time. It gives

you a great opportunity to read through the paper and consider your answers. You can use it to

analyse the Section B question, or read carefully through the Section C questions.

• Read the question carefully. You must make sure that you answer the actual question set rather

than what you would like the question to say! It is easy to write all that you know about a topic

but you must remember to stick to the actual requirement of the question.

• Make sure that you develop time management skills. You have 1.8 minutes per mark so Section

A, for example, must be completed in 36 minutes. You should not go over on time on any

question. If you have not finished the question, move on and come back to it if you have time at

the end.

• Practise your writing skills. You need to be able to write short paragraphs which answer the

question.

4 Brought forward knowledge

You may be tested on knowledge or techniques you've learnt at lower levels. CIMA C1 Fundamentals of

Management Accounting and C3 Fundamentals of Business Maths are particularly important for this

paper.

5 Links with other exams

Some of the topics in the P1 paper will be covered in more detail in later exams so it is important to keep

your books and notes. For example, knowledge of budgeting, relevant costing, sensitivity analysis andmodern philosophies such as JIT and TQM will all be needed for the P2 exam. Knowledge of project

appraisal will be required for the F3 exam.


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INTRO U TION

xvii

The exam paper

Format of the paper

Number of

marks Section A: A variety of multiple choice and other objective test questions, 2-4

marks each

20

Section B: 6 compulsory questions, 5 marks each 30 Section C: 2 questions, 25 marks each 50

100

Time allowed: 3 hours, plus 20 minutes reading time

Numerical content

The paper is likely to have a mixture of numerical and written parts and the percentage of numerical

questions is likely to vary with each exam sitting. You are probably unlikely to get a Section B or Section

C question which is entirely numerical or entirely written. Section A questions will probably contain somemultiple choice questions which refer to the meanings of terms. So, you cannot expect Section A to be

entirely numerical either.

Breadth of question coverage

Questions may cover more than one syllabus area.

May 2013 exam paper

Section A1 Eight objective test questions

Section B

2 (a) Aggressive working capital policy

(b) Economic order quantity and just-in-time

(c) Probability and expected values

(d) Absorption costing and marginal costing profit reconciliation

(e) Yield to maturity calculation

(f) Activity based budgeting vs incremental budgeting

Section C

3 Operating statement, planning and operational variances, variance investigation

4 NPV, sensitivity analysis


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xviii INTRO U TION

March 2013 resit exam paper

Section A

1 Eight objective test questions

Section B

2 (a) Treasury bills and bank deposit accounts

(b) Sensitivity of cost of capital

(c) Material mix and yield variance

(d) Recovering overdue debts

(e) Expected values

(f) Zero-based budgeting

Section C

3 Absorption costing and activity-based costing

4 NPV, probability analysis, sensitivity analysis, optimum replacement cycle

November 2012 exam paper

Section A


Section B

2 (a) Aged debt analysis

(b) Certificates of deposit and bills of exchange

(c) Sales mix and quantity variances

(d) Zero-based budgeting

(e) Decision tree

(f) Expected value and its limitations

Section C

3 Absorption costing and activity-based costing

4 NPV, payback and environmental issues

September 2012 resit exam paper

Section A



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xx INTRO U TION


Section A


Section B

2 (a) Cash budget preparation

(b) Decision tree and value of perfect information

(c) Credit limits for customers

(d) Benefits of environmental costing

(e) Probability and expected value

(f) Benefits of budgetary planning and control systems

Section C

3 Operating statement, planning and operational variances, JIT purchasing

4 Annualised equivalent calculation, sensitivity analysis, tax depreciation


Section A


Section B

2 (a) Budgets and management participation

(b) Advantages and disadvantages of overdrafts

(c) Decision tree

(d) Annualised equivalent calculation

(e) Default risk and interest rate risk

(f) Throughput accounting

Section C

3 Sales mix and quantity variance, operating statement, investigating variances

4 NPV, sensitivity analysis, payback period

May 2011 exam paper

Section A



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INTRO U TION

xxi

Section B

2 (a) Budgets as performance targets

(b) Perfect information

(c) Optimum replacement cycle

(d) Factoring(e) Export finance

(f) Yield to maturity

Section C

3 Budgeting and variances

4 NPV, IRR, discounted payback, post completion audit

March 2011 resit exam paper

Section A


Section B

2 (a) Zero-based budgeting

(b) Perfect information

(c) Attitudes to risk

(d) Factoring

(e) Investments

(f) Coupon rate and yield to maturity

Section C

3 Activity-based costing

4 NPV, IRR and sensitivity analysis


Section A


Section B

2 (a) Zero-based budgeting

(b) Maximin, maximax and minimax regret criteria

(c) Attitudes to risk

(d) Expected receipts and bad debts

(e) Investments

(f) Working capital cycle length


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xxii INTRO U TION

Section C

3 Activity-based costing

4 Relevant cash flows, NPV and IRR calculation and comparison


Section A


Section B

2 (a) Trade receivables

(b) EOQ

(c) Backflush accounting

(d) ZBB

(e) ABC, ABB

(f) Decision tree

Section C

3 Operating statement, planning and operational variances

4 NPV, IRR

May 2010 exam paper

Section A


Section B

2 (a) Preparation of age analysis of trade receivables

(b) EOQ and cost of holding and ordering inventory

(c) Manufacturing resource planning

(d) Benefits of an activity based budgeting system

(e) Production budget preparation

(f) Decision tree preparation

Section C

3 Operating statement, variances and standard costing

4 NPV calculation, interpretation of expected value, IRR and standard deviation


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INTRO U TION

xxiii

Specimen exam paper

Section A

1 Seven objective test questions

Section B

2 (a) Debtor days and debt factoring

(b) Non-financial factors of debt factoring

(c) Decision tree

(d) Regression analysis and forecasting

(e) Budgets – motivation vs control

(f) Environmental failure costs

Section C

3 NPV and ARR

4 Variance analysis


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xxiv INTRO U TION


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1

Part A

MANAGING SHORT-TERM

FINANCE


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2


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3

1

topic list learning outcomes syllabus references ability required

1 Working capital E1(a) E1(ii) comprehension

2 Working capital ratios E1(b), (e) E1(iii) analysis

3 Working capital requirements E1(a) E1(ii) comprehension

WORKING CAPITAL AND THE

OPERATING CYCLE

In this chapter we consider functions of the

management accountant relating to the

management of working capital in general

terms, including how much working capital the business

requires and the impact on working capital of changes in

the business.


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PART A MANAGING SHORT TERM FINANCE

1: Working capital and the operating cycle 5

A business pursuing a conservative policy will hold large levels of ready cash and safety inventory and

use long-term funding for both non-current and most current assets. This is the least risky option but

results in the lowest expected return.

An excessively conservative approach to working capital management resulting in high levels of cash

holdings will harm profits because the opportunity to make a return on the assets tied up as cash will

have been missed.

A moderate policy will match short-term finance to fluctuating current assets and non-fluctuating current

(and non-current) assets will be matched by long-term funding.

1.5 The working capital cycle 5/10, 11/10

WORKING CAPITAL CYCLE is the period of time which elapses between the point at which cash begins to

be expended on the production of a product and the collection of cash from a purchaser.

(CIMA Official Terminology)

The connection between investment in working capital and cash flow may be illustrated by means of the

working capital cycle (also called the cash cycle, operating cycle or trading cycle).The working capital cycle in a manufacturing business equals:

The average time that raw materials remain in inventory XLess the period of credit taken from suppliers (X)Plus the time taken to produce the goods XPlus the time finished goods remain in inventory after production is completed XPlus the time taken by customers to pay for the goods X

X

If the turnover periods for inventories and receivables lengthen, or the payment period to payables

shortens, then the operating cycle will lengthen and the investment in working capital will increase.

Wines Co buys raw materials from suppliers that allow Wines 2.5 months credit. The raw materials

remain in inventory for 1 month, and it takes Wines 2 months to produce the goods. The goods are sold

within a couple of days of production being completed and customers take on average 1.5 months to pay.

Required

Calculate Wines's working capital cycle.

We can ignore the time finished goods are in inventory as it is no more than a couple of days.

Months

The average time that raw materials remain in inventory 1.0 Less: The time taken to pay suppliers (2.5) The time taken to produce the goods 2.0 The time taken by customers to pay for the goods 1.5

2.0

Solution

Example: working capital cycle

KEY TERM


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6 1: Working capital and the operating cycle PART A MANAGING SHORT TERM FINANCE

The company's working capital cycle is 2 months. This can be illustrated diagrammatically as follows.

0 2.5 3 4.5

Goods Goods

purchased sold to customers

Suppliers Cash received

paid from customers

Working capital cycle

2 months

The working capital cycle is the period between the suppliers being paid and the cash being received fromthe customers.

1.6 Managing the cycle

A longer working capital cycle requires more financial resource, so management will seek whenever

possible to reduce the length of the cycle. Their possible options are as follows.

(a) Reduce levels of raw materials inventory. This may be done by the introduction of some type of

just-in-time system, which will necessitate more efficient links with suppliers. Production delays

due to running out of inventory must be avoided.(b) Reduce work in progress by reducing production volume or improving techniques and efficiency.

(c) Reduce finished goods inventory, perhaps by improving distribution. This may lead to delays in

fulfilling customer orders.

(d) Delay payments to suppliers. This can lead to loss of discounts and of supplier goodwill.

(e) Reduce period of credit given to customers. This may mean offering discounts and more

aggressive credit control may lead to loss of customers.

1.7 Cash flow planning

Since a company must have adequate cash inflows to survive, management should plan and control cash

flows as well as profitability. Cash budgeting is an important element in short-term cash flow planning.

The purpose of cash budgets is to make sure that the organisation will have enough cash inflows to meet

its cash outflows. If a budget reveals that a short-term cash shortage can be expected, steps will be taken

to meet the problem and avoid the cash crisis (perhaps by arranging a bigger bank overdraft facility).

Cash budgets and cash flow forecasts on their own do not give full protection against a cash shortage and

enforced liquidation of the business. There may be unexpected changes in cash flow patterns. When

unforeseen events have an adverse effect on cash inflows, a company will only survive if it can maintain

adequate cash inflows despite the setbacks.


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Learning outcome E1(a)

Give examples of unforeseen changes which may affect cash flow patterns.

Section summary

The amount tied up in working capital is equal to the value of all inventory and receivables less payables.

This amount directly affects the liquidity of the organisation.

Working capital cycle is the period of time which elapses between the point at which cash begins to be

expended on the production of a product and the collection of cash from a purchaser.

(CIMA Official Terminology)

2 Working capital ratios

Introduction

Working capital ratios may help to indicate whether a company has too much working capital (over-

capitalised) or too little (overtrading).

2.1 The current ratio and the quick ratio

The standard test of liquidity is the current ratio. It can be obtained from the statement of financialposition.

CURRENT RATIO =sliabilitieCurrent

assetsCurrent

A company should have enough current assets that give a promise of 'cash to come' to meet its

commitments to pay its current liabilities. Obviously, a ratio in excess of 1 should be expected; an ideal

is probably about 2. Otherwise, there would be the prospect that the company might be unable to pay its

debts on time. In practice, a ratio comfortably in excess of 1 should be expected, but what is 'comfortable'

varies between different types of businesses.

Some manufacturing companies might hold large quantities of raw material inventories, which must be

used in production to create finished goods. Finished goods might be warehoused for a long time, or soldon lengthy credit. In such businesses, where inventory turnover is slow, most inventories are not very

easy to turn into liquid assets, because the cash cycle is so long. For these reasons, we calculate an

additional liquidity ratio, known as the quick ratio or acid test ratio.

QUICK RATIO, or ACID TEST RATIO=sliabilitieCurrent

sinventorielessassetsCurrent

This ratio should ideally be at least 1 for companies with a slow inventory turnover. For companies with a

fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company is in cash

flow difficulties.

The current ratio and the quick ratio are known as liquidity ratios.

Question 1.1 Cash flow patterns

KEY TERM

KEY TERM


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2.2 The receivables collection period 9/11

A rough measure of the average length of time it takes for a company's customers to pay is the 'receivable

days' ratio.

RECEIVABLE DAYS RATIO =

termscreditonsalesdailyAverage

sreceivabletradeAverage (CIMA Official Terminology)

An equivalent measure is the receivables turnover period.

RECEIVABLES TURNOVER PERIOD =yeartheforsalesCredit

sreceivabletradeAverage × 365 days

The trade receivables are not the total figure for receivables in the statement of financial position, which

includes prepayments and non-trade receivables. The trade receivables figure will be itemised in an

analysis of the total receivables, in a note to the accounts.

The estimate of receivables days is only approximate.

(a) The statement of financial position value might be used instead of the average. However, don't

forget that the statement of financial position value of receivables might be abnormally high or low

compared with the 'normal' level the company usually has.

(b) Sales revenue in the income statement excludes sales tax, but the receivables figure in the

statement of financial position includes sales tax. We are not strictly comparing like with like. If the

figures are too distorted by sales tax, adjustment will be needed.

(c) Average receivables may not be representative of year-end sales if sales are growing rapidly.

2.3 The payables payment period

Similar measures can be used for payables.

The payables payment period indicates the average time taken, in calendar days, to pay for supplies

received on credit.

PAYABLES DAYS RATIO =termscreditonpurchasesdailyAverage

payablestradeAverage (CIMA Official Terminology)

PAYABLES PAYMENT PERIOD, or PAYABLES TURNOVER PERIOD =

yearfortermscreditonPurchases

payablestradeAverage × 365 days

If the credit purchases information is not readily available, cost of sales can be used instead. Don't forget

however that some elements of cost of sales (for example, labour costs) are not relevant to trade

payables. Note also that credit purchases in the income statement do not include sales tax.

2.4 The inventory turnover period

The inventory turnover period shows how long goods are being kept in inventory.

Another ratio worth calculating is the inventory turnover period. This is another estimated figure,

obtainable from published accounts, which indicates the average number of days that items of inventory

are held for. As with the average receivable collection period, it is only an approximate figure; there may

be distortions caused by seasonal variations in inventory levels. However it should be reliable enough forfinding changes over time.

KEY TERMS

KEY TERMS


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INVENTORY TURNOVER =periodinsalesofcostdailyAverage

Inventory or

salesofCost

inventoryAverage

The inventory turnover period can also be calculated:

INVENTORY TURNOVER PERIOD =

salesofCost

Inventory × 365 days

A lengthening inventory turnover period indicates:

(a) A slowdown in trading, or

(b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is becoming

excessive

Where a business is manufacturing goods for resale, inventory turnover will have three components:

Raw materials:materialsrawofpurchases

inventorymaterialsaverage × 365

WIP:costingmanufactur

progressinworkaverage× 365

Finished goods:salesofcost

goodsfinishedaverage × 365

Where average values are not available, closing values can be used.

Where no breakdown of inventories is supplied, just use the overall ratio:salesofcost

inventoryaverage

If we add together the inventory days and the receivable days, this should give us an indication of how

soon inventory is convertible into cash, thereby giving a further indication of the company's liquidity.

All the ratios calculated above will vary industry by industry; hence comparisons of ratios calculated with

other similar companies in the same industry are important. There are organisations which specialise in

inter-firm comparison. A company submits its figures to one of these organisations and receives an

analysis of the average ratios for its industry. It can then compare its own performance to that of the

industry as a whole.

The receivables turnover period, payables turnover period and inventory turnover period are known as

efficiency ratios.

The working capital cycle (covered in Section 1) can be calculated using the following formulae.

Days

purchasesmaterialsRaw

inventorymaterialsRaw × 365 =

X

costingManufactur

progressinWork× 365 =

X

salesofCost

goodsFinished × 365 =

X

Sales

sreceivableTrade × 365 =

X

Purchases

payablesTrade

× 365 = (X)

__X

KEY TERMS


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Note that if you are provided with the statement of financial position figures for the start and end of a year

(top line in each formula), you should calculate the average for the year. You add the two figures together

and divide by two.

Exam skills

Remember that exam questions will probably ask you to discuss the results of any ratios that youcalculate.

Another term you may come across is capital employed. This usually means non-current assets + current

assets – current liabilities.

Section summary

Working capital ratios may help to indicate whether a company has too much working capital (over-

capitalised) or too little (overtrading).

Current ratio = sliabilitieCurrent

assetsCurrent

Quick ratio =sliabilitieCurrent

sinventorielessassetsCurrent

Receivable days ratio =termscreditonsalesdailyAverage

sreceivabletradeAverage (CIMA Official Terminology)

Receivables turnover period =Average trade receivables

Credit sales for the year × 365 days

Payables days ratio =

Average trade payables

Average daily purchases on credit terms (CIMA Official Terminology)

Payables payment period, or payables turnover period =Average trade payables

Purchases on credit

terms for year

× 365 days

Inventory turnover =Inventory

Average daily cost of sales inperiod or

Average inventory

Cost of sales

3 Working capital requirements

Introduction

Current assets may be financed either by long-term funds or by current liabilities.

Liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds

that it is unable to renew its short-term liabilities (for example, if the bank suspends its overdraft facilities,

or suppliers start to demand earlier payment), there will be a danger of insolvency unless the company is

able to turn enough of its current assets into cash quickly.


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3.1 The need for funds for investment in current assets

Current liabilities are often a cheap method of finance (trade payables do not usually carry an interest

cost) and companies may therefore consider that, in the interest of higher profits, it is worth accepting

some risk of insolvency by increasing current liabilities, taking the maximum credit possible from

suppliers.

3.2 The volume of current assets required

The volume of current assets required will depend on the nature of the company's business. For example,

a manufacturing company may require more inventories than a company in a service industry. As the

volume of output by a company increases, the volume of current assets required will also increase.

Even assuming efficient inventory holding, receivable collection procedures and cash management, there

is still a certain degree of choice in the total volume of current assets required to meet output

requirements. Policies of low inventory-holding levels, tight credit and minimum cash holdings may be

contrasted with policies of high inventories (to allow for safety or buffer inventories) easier credit and

sizeable cash holdings (for precautionary reasons).

3.3 Over-capitalisation and working capital

If there are excessive inventories, receivables and cash, and very few payables, there will be an over-

investment by the company in current assets. Working capital will be excessive and the company will be

in this respect over-capitalised. The return on investment will be lower than it should be, and long-term

funds will be unnecessarily tied up when they could be invested elsewhere to earn profits.

Over-capitalisation with respect to working capital should not exist if there is good management, but the

warning signs of excessive working capital would be unfavourable accounting ratios, including the following.

(a) Sales/working capital

The volume of sales as a multiple of the working capital investment should indicate whether, incomparison with previous years or with similar companies, the total volume of working capital is

too high.

(b) Liquidity ratios

A current ratio greatly in excess of 2:1 or a quick ratio much in excess of 1:1 may indicate over-

investment in working capital.

(c) Turnover periods

Excessive turnover periods for inventories and receivables, or a short period of credit taken from

suppliers, might indicate that the volume of inventories or receivables is unnecessarily high, or the

volume of payables too low.

Calculate liquidity and working capital ratios from the following accounts of a manufacturer of products

for the construction industry, and comment on the ratios.

20X8 20X7 $m $m

Sales revenue 2,065.0 1,788.7 Cost of sales 1,478.6 1,304.0 Gross profit 586.4 484.7

Example: working capital ratios


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20X8 20X7 $m $m

Current assets

Inventories 119.0 109.0 Receivables (note 1) 400.9 347.4 Short-term investments

4.2

18.8

Cash at bank and in hand 48.2 48.0 572.3 523.2

Payables: amounts falling due within one year

Loans and overdrafts 49.1 35.3 Income taxes 62.0 46.7 Dividend 19.2 14.3 Payables (note 2) 370.7 324.0

501.0 420.3

Net current assets 71.3 102.9

Notes

20X8 20X7 $m $m

1 Trade receivables 329.8 285.4

2 Trade payables 236.2 210.8

3 We are not given a breakdown of inventories

20X8 20X7

Current ratio 572.3

501.0 = 1.14

523.2

420.3 = 1.24

Quick ratio 453.3501.0

= 0.90420.3414.2 = 0.99

Receivables' turnover period 329.8

2,065.0 × 365 = 58 days

1,788.7

285.4 × 365 = 58 days

Inventory turnover period 119.0

1,478.6 × 365 = 29 days

109.0

1,304.0 × 365 = 31 days

Payables turnover period 236.2

1,478.6 × 365 = 58 days

210.8

1,304.0 × 365 = 59 days

The company is a manufacturing group serving the construction industry, and so would be expected to

have a comparatively lengthy receivables turnover period, because of the relatively poor cash flow in the

construction industry. It is clear that the company compensates for this by ensuring that they do not pay

for raw materials and other costs before they have sold their inventories of finished goods (hence thesimilarity of receivables and payables turnover periods).

The company's current ratio is a little lower than average but its quick ratio is better than average and

very little less than the current ratio. This suggests that inventory levels are strictly controlled, which is

reinforced by the low inventory turnover period. It would seem that working capital is tightly managed, to

avoid the poor liquidity which could be caused by a high receivables turnover period and comparatively

high payables.

Solution


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3.4 Overtrading 5/10

OVERTRADING is the condition of a business which enters into commitments in excess of its available

short-term resources. This can arise even if the company is trading profitably, and is typically caused by

financing strains imposed by a lengthy operating cycle or production cycle. (CIMA Official Terminology)

In contrast with over-capitalisation, overtrading happens when a business tries to do too much tooquickly with too little long-term capital, so that it is trying to support too large a volume of trade with the

capital resources at its disposal.

Even if an overtrading business operates at a profit, it could easily run into serious trouble because it is

short of money. Such liquidity troubles stem from the fact that it does not have enough capital to provide

the cash to pay its debts as they fall due.

Great Ambition appoints a new managing director who has great plans to expand the company. He wants

to increase revenue by 100% within two years, and to do this he employs extra sales staff. He recognises

that customers do not want to have to wait for deliveries, and so he decides that the company must buildup its inventory levels. There is a substantial increase in the company's inventories. These are held in

additional warehouse space which is now rented. The company also buys new cars for its extra sales

representatives.

The managing director's policies are immediately successful in boosting sales, which double in just over

one year. Inventory levels are now much higher, but the company takes longer credit from its suppliers,

even though some suppliers have expressed their annoyance at the length of time they must wait for

payment. Credit terms for receivables are unchanged, and so the volume of receivables, like the volume of

sales, rises by 100%.

In spite of taking longer credit, the company still needs to increase its overdraft facilities with the bank,

which are raised from a limit of $40,000 to one of $80,000. The company is profitable, and retainssome profits in the business, but profit margins have fallen. Gross profit margins are lower because some

prices have been reduced to obtain extra sales. Net profit margins are lower because overhead costs are

higher. These include sales representatives' wages, car expenses and depreciation on cars, warehouse

rent and additional losses from having to write off out-of-date and slow-moving inventory items.

The statement of financial position of the company changed over time from (A) to (B).

Statement of Statement of financial position (A) financial position (B)

$ $ $ $

Non-current assets 160,000 210,000Current assets

Inventory 60,000 150,000 Receivables 64,000 135,000 Cash 1,000 –

125,000 285,000

Total assets 285,000 495,000Current liabilities Bank 25,000 80,000 Payables 50,000 200,000

75,000 280,000Share capital 10,000 10,000 Retained earnings 200,000 205,000

210,000 215,000

Total equity/liabilities 285,000 495,000

Example: overtrading

KEY TERM


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3.6 The working capital requirement

Computing the working capital requirement is a matter of calculating the value of current assets less

current liabilities, perhaps by taking averages over a one year period.

The following data relate to Corn Co, a manufacturing company.

Sales for the year $1,500,000

Costs as percentages of sales

%

Direct materials 30

Direct labour 25

Variable overheads 10

Fixed overheads 15

Selling and distribution 5

On average:

(a) Receivables take 2.5 months before payment.

(b) Raw materials are in inventory for three months.

(c) Work-in-progress represents two months’ worth of half produced goods.

(d) Finished goods represents one month's production.

(e) Credit is taken as follows.

(i) Direct materials 2 months

(ii) Direct labour 1 week

(iii) Variable overheads 1 month

(iv) Fixed overheads 1 month

(v) Selling and distribution 0.5 months

Work-in-progress and finished goods are valued at material, labour and variable expense cost.

Compute the working capital requirement of Corn assuming the labour force is paid for 50 working weeks

a year.

(a) The annual costs incurred will be as follows.

$

Direct materials 30% of $1,500,000 450,000Direct labour 25% of $1,500,000 375,000Variable overheads 10% of $1,500,000 150,000Fixed overheads 15% of $1,500,000 225,000Selling and distribution 5% of $1,500,000 75,000

Solution

Example: working capital requirements


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$ Current liabilities Overdraft 30,000 Dividend 40,000 Trade payables 80,000 Other payables 10,000

160,000 Net current assets 30,000

What is the quick ratio?

A 0.69

B 0.72

C 0.82

D 1.19

Section summaryOver-capitalisation means that the organisation has an excess of working capital.

Overtrading means that the organisation has too little working capital.


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3 Fill in the blanks with the following:

Current liabilities; current assets; inventories; 1.

Quick ratio =less

(This should be at least ………….………..)

4 Which of the following describes overcapitalisation and which describes overtrading?

A A company with excessive investment in working capital

B A company trying to support too large a volume of trade with the capital resources at its disposal

5 Which of the following statements best defines the current ratio?

A The ratio of current assets to current liabilities.

For the majority of businesses it should ideally be about 2.

B The ratio of current assets to current liabilities.


C The ratio of current assets excluding inventory to current liabilities.


D The ratio of current assets excluding inventory to current liabilities.


6 The receivables payment period is a calculation of the time taken to pay by all receivables.

True

False

7 What is the working capital requirement of a company with the following average figures over a year?

$

Inventory 3,750Trade receivables 1,500Cash and bank balances 500Trade payables 1,800

8 WHB Co has the following year end balances.

$ $Sales 879,000 Raw material inventory 123,000Cost of production 690,000 WIP inventory 90,600Cost of sales 771,000 Finished goods 101,400Purchases of raw materials 533,400 Receivables 187,800

Payables 102,000

Using efficiency ratios, calculate the length of the working capital cycle to the nearest day.


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1 D Rapid increase in sales

2 A The time raw materials remain in inventoryB The time period of credit taken from suppliers

C The time taken to produce goods

D The time finished goods remain in inventory after production is completed

E The time taken by customers to pay for goods

3 Quick ratio =sliabilitieCurrent

sinventorielessassetsCurrent (This should be at least 1)

4 A Overcapitalisation

B Overtrading

5 A The ratio of current assets to current liabilities: 2

6 False. The calculation normally only includes trade receivables.

7 Working capital requirement = current assets less current liabilities = 3,750 + 1,500 + 500 – 1,800

= $3,950

8 188 days

Days

purchasesmaterialsRaw

inventorymaterialsRaw × 365 =

123,000

533,400 × 365 = 84

costingManufactur

progressinWork× 365 =

90,600

690,000

× 365 = 48

salesofCost

goodsFinished × 365 =

101,400

771,000 × 365 = 48

Sales

sreceivableTrade × 365 =

187,800

879,000 × 365 = 78

Purchases

payablesTrade × 365 =

102,000

533,400 × 365 = (70)

188

Answers to Quick Quiz


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1.1 Cash flow patterns

Your list probably included some of the following.

(a) A change in the general economic environment. An economic recession will cause a slump in trade.

(b) A new product, launched by a competitor, which takes business away from a company's traditional and

established product lines.

(c) New cost-saving product technology, which forces the company to invest in the new technology to

remain competitive.

(d) Moves by competitors which have to be countered (for example a price reduction or a sales promotion).

(e) Changes in consumer preferences, resulting in a fall in demand.

(f) Government action against certain trade practices or against trade with a country that a company has

dealings with.

(g) Strikes or other industrial action.

(h) Natural disasters, such as floods or fire damage, which curtail an organisation's activities.

1.2 Overtrading

'Overtrading' refers to the situation where a company is over-reliant on short-term finance to support its

operations. This is risky because short-term finance may be withdrawn relatively quickly if suppliers lose

confidence in the business, or if there is a general tightening of credit in the economy. This may result in a

liquidity crisis and even bankruptcy, even though the firm is profitable. The fundamental solution to overtrading

is to replace short term finance with longer term finance such as term loans or equity funds.

The term overtrading is used because the condition commonly arises when a company is expanding rapidly. In this

situation, because of increasing volumes, more cash is needed to pay input costs such as wages or purchases than

is currently being collected from customers. The result is that the company runs up its overdraft to the limit and

sometimes there is insufficient time to arrange an increase in facilities to pay other payables on the due dates.

These problems are often compounded by a general lack of attention to cost control and working capital

management, such as receivables collection, because most management time is spent organising selling or

production. The result is an unnecessary drop in profit margins.

When the overdraft limit is reached the company frequently raises funds from other expensive short term

sources, such as receivables factoring or receivables prompt payment discounts, and delays payment to

suppliers, instead of underpinning its financial position with equity funds or a longer term loan. The consequent

under-capitalisation delays investment in non-current assets and staff and can further harm the quality of the

firm'

s operations.

1.3 Quick ratio

B The quick ratio is the ratio of current assets excluding inventories to current liabilities.

In this case:160,000

75,000190,000 −= 0.72

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topic list learning outcomes syllabus references ability required

1 Cash flows and profit E1(c) E1(i) analysis

2 The purpose of cash forecasts E1(c), (d) E1(v) analysis

3 Cash budgets in receipts and payments format E1(c), (d) E1(v) analysis

4 Cleared funds cash forecasts E1(c) E1(v) analysis

5 Cash forecasts based on financial statements E1(c) E1(vi) analysis

6 The need for cash management E1(c) E1(vi) analysis

7 Cash management services E1(c) E1(vi) analysis

CASH FLOW FORECASTS

Survival in business depends on the ability to

generate cash. Cash flow information directs

attention towards this critical issue. Cash flow

is a more comprehensive concept than 'profit' which is

dependent on accounting conventions and concepts.

The cash budget is an extremely important mechanism

for monitoring cash flows. Various complications about

timing of cash flows or lack of particular figures may be

included in cash budget exam questions.

At the heart of this chapter is the method for

systematically preparing a cash budget. You must be able

to set out a budget clearly, supported by appropriate

workings.

Section 6 looks at why cash flow problems arise and

methods for easing cash shortages.

Section 7 concentrates on float. Float is the time

difference between when a payment is first initiated and

when the funds become available for use.


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24 2: Cash flow forecasts PART A MANAGING SHORT TERM FINANCE

1 Cash flows and profit

1.1 Types of cash transaction

IntroductionThere are many types of cash transaction. They can be distinguished by their purpose (ie what they are

for), their form (how they are implemented), and their frequency.

Sometimes the following distinctions are made.

(a) Capital and revenue items

(i) Capital items relate to the long-term functioning of the business, such as raising money

from shareholders, or acquiring non-current assets.

(ii) Revenue items relate to day-to-day operations, as in the operating cycle, including other

matters such as overdraft interest.

(b) Exceptional and unexceptional items

(i) Exceptional items are unusual. An example would be the costs of closing down part of a

business.

(ii) Unexceptional items include everything else. You have to be careful using this distinction,

as the phrase 'exceptional item' has a precise meaning in the preparation of a company's

financial statements.

(c) Regular and irregular items

(i) Regular items occur at predictable intervals. Such intervals might be frequent such as the

payment of wages every week or month, or relatively infrequent, such as the disbursement

of interim and final dividends twice a year. A capital item might be the regular repayment of

principal and interest on leased property. Annual disbursements are sums of money paid at

yearly intervals.

(ii) Irregular items do not occur at regular intervals.

1.2 Cash flows and profit

Trading profits and cash flows are different. A company can make losses but still have a net cash income

from trading. A company can also make profits but have a net cash deficit on its trading operations.

(a) Cash may be obtained from a transaction which has nothing to do with profit or loss. For example,

an issue of shares or loan stock for cash has no immediate effect on profit but is obviously a sourceof cash. Similarly, an increase in bank overdraft provides a source of cash for payments, but it is

not reported in the income statement.

(b) Cash may be paid for the purchase of non-current assets, but the charge in the income statement

is depreciation, which is only a part of an asset's cost.

(c) When a non-current asset is sold there is a profit or loss on sale equal to the difference between

the sale proceeds and the 'net book value' of the asset in the statement of financial position at the

time it is sold.

(d) Cash flows also differ from trading profits due to changes in the amount of the company's

inventories, receivables and payables.

(i) Profit is sales minus the cost of sales.

(ii) Operational cash flow is the difference between cash received and cash paid from trading.


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2: Cash flow forecasts 25

(iii) Cash received differs from sales because of changes in the amount of receivables.

$ Customers owing money at the start of the year X Sales during the year XTotal money due from customers X Less customers owing money at the end of the year (X) Cash receipts from customers during the year X

(iv) Cash paid differs from the cost of sales because of changes in the amount of inventories

and payables.$

Closing inventories at the end of the year X Add cost of sales during the year X

X Less opening inventories at the start of the year (X) Equals purchases Y

$ Payments owing to suppliers at the start of the year X Add purchases

Y X

Less payments still owing to suppliers at the end of the year (X) Equals cash payments to suppliers during the year X

(v) Operational cash flow therefore differs from profit because of changes in the amount of

receivables, inventories and payables between the start and end of a period.

Learning outcome E1(c)

Assume that Beta achieved sales revenue in a particular year of $200,000 and the cost of sales was

$170,000. Inventories were $12,000, payables $11,000 and receivables $15,000 at the start of the

year. At the end of the year, inventories were $21,000, payables were $14,000 and receivables

$24,000.

Required

Calculate the profits and the operational cash flow resulting from the year's trading.

The difference between profit and cash flow has important implications.

(a) If a company is profitable but short of cash, one reason could be an increase in the other elements

of working capital. Instead of seeking credit from a bank to finance the growth in working capital,

management may consider whether operational cash flows could be improved by squeezing

working capital, and:

(i) Reducing receivables

(ii) Reducing inventories

(iii) Taking more trade credit from suppliers

Better control over working capital could remove the need to borrow.

(b) If a company is making losses, it could try to maintain a positive operational cash flow by taking

more credit (ie by increasing its payables and so reducing working capital). (Supplier companies

would then consider whether to give the extra credit required, or whether to refuse because the

risk would be too great.)

Question 2.1 Profits and cash flow


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26 2: Cash flow forecasts PART A MANAGING SHORT TERM FINANCE

Learning outcome E1(c)

Write brief notes on why the reported profit figure of a business for a period does not normally represent

the amount of cash generated in that period.

1.3 Benefits of holding cash

(a) Transactions motive. Cash is needed for every-day expenses such as wages and payments to

suppliers.

(b) Precautionary motive. This is cash held ‘just in case’ to co

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CIMA P1 Performance Operations Study Text 2013