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Budgeting

Budgeting is the process of preparing a financial plan for a business by preparing reports that estimate or predict the financial consequences of likely future transactions.

Budgets

Actual (historical)

Report future events

Report historical events

Use estimates or predictions

Uses actual verifiable data (for most)

Budget process must be continuous and flexible. They are not perfect, as they are only predictions of future events.

Importance of Sales Budget

1)

Main revenue item and cash flow

- Cash sales

Budgeted Cash Flow Statement

- Receipts from Debtors

Budgeted Cash Flow Statement

- Sales Revenue

Budgeted Profit and Loss Statement

2)

Estimating expenses which vary with number of units sold

- Cost of Goods Sold

Budgeted Profit and Loss Statement

- Wages

Budgeted Profit and Loss Statement

- Corresponding cash outflows

Budgeted Cash Flow Statement

3)

Estimating number of stock purchases

- Stock Control

- Creditors Control

- Payments to Creditors

- Cash Purchases of Stock

Role of Budgeting

Budgeted Balance Sheet Budgeted Balance Sheet Budgeted Cash Flow Statement Budgeted Cash Flow Statement

1)

Assists planning by predicting what is likely to occur in the future. This allows the owner to prepare for what is

2)

likely to occur so that possible problems may be managed and possible opportunities may be taken Aids decision making by providing a benchmark/yardstick/standard against which actual performance can be measured. This allows the owner to identify areas in which performance is unsatisfactory, so that remedial action can be taken (this can include budgeted ratios and other indicators of performance).

Budgeting process

Budgeting process Decisions made to improve performance for the next period Budgeted reports predicts what is
Decisions made to improve performance for the next period
Decisions
made to improve
performance for
the next period
Budgeted reports predicts what is likely to occur
Budgeted reports
predicts what is likely
to occur
Variance reports prepared to highlight differences/problem areas
Variance reports
prepared to highlight
differences/problem
areas

Budgeted reports

to highlight differences/problem areas Budgeted reports Actual reports prepared to detail what has happened in
Actual reports prepared to detail what has happened in the current period
Actual reports
prepared to detail
what has happened
in the current
period

Budgeted Cash Flow Statement

Budgeted Cash Flow Statement is an accounting report that shows estimates of cash receipts and cash payments, and an estimated bank balance, at a particular point in time in the future.

Cash flow is the lifeline of a small business as they cannot function without it. It shows the business’s ability to meet debt obligations over the budget period. It is crucial to know the expected cash situation of the business in the forthcoming months, as many businesses purchase stock on credit over 30 or 60 day terms.

Many forecasts are quite straight-forward but the most difficult is the cash proceeds from sales. To make forecasts, management ensures that all relevant information is available before sales estimates are finalised. An informed decision is more likely to result in an accurate budget than one based on guesswork because of a lack of information. Such information include:

Likelihood to continue trading as successfully

Plan to sell same stock lines or experimenting

Any general or local competitors in the market (any new)

External factors (government decisions, state of economy, environmental factors)

Population changes (demographics, e.g. more aging)

Technology (new ones), keeping up with new trends

Ability to cope with expected demand

Not all credit sales are excluded from the Budgeted Cash Flow Statement. Schedule of collections is a table used by businesses (that sell stock on credit to help predict cash inflows from debtors by identifying how much percentage pay in the first month, second, and so on. Similarly, schedule of payments is a table used by businesses (that purchase stock on credit) to help predict cash outflows to creditors. In both tables, you must deduct discounts from amounts.

For a Budgeted Cash Flow Statement of a quarter, the format of showing all three months separately is preferable to simply adding up all receipts and payments for the quarter and resenting them as one figure, as this allows management to calculate an estimated cash balance at the end of each month.

Operating activities, ideally, must be positive. This area shows the movements of cash in and out of the business that result from the provision of goods and services in the day-to-day operations of the business. This area shows the ability to meet ongoing obligations. When budgeted as negative, users can use this forewarning to address the problem before it hits. This can be done in two ways:

1)

Strategies to increase expected inflows

- Increasing sales: promotions, greater advertising, discounting prices

- Increasing receipts from debtors: offering discounts, contacting slow payers, reminder notices

2)

Strategies to decrease expected outflows

- Deferring payments to creditors

- Cutting back cash paid for expenses: must be careful as some expenses are vital for earning sales (hence the generation of cash inflows), and cutting theses may actually worsen the cash situation rather than improving it

Consecutive budgets allow identification of monthly and seasonal trends, which can help in deciding when to undertake a particular cash activity (such as cash purchase of non-current assets or repayment of a loan).

Planning

This report allows the users to predict a cash surplus or deficit. The may react to either by following:

1)

In case of budgeted overall cash deficit:

- Defer the purchase of non-current assets, or use credit facilities or a loan for their purchase

- Leasing non-current assets rather than purchasing it

- Defer loan repayments

- Make a cash capital contribution

- Organise (or extend) an overdraft facility

- Cut back on personal cash drawings

2)

Reducing/postponing the payment of expenses In case of budgeted overall cash surplus:

-

- Purchase more/newer non-current assets [expansion]

- Purchase stock on cash for discounts

- Increase loan repayments

- Increase cash drawings

- Expand trading activities by increasing advertising, employees and etc.

- if started with an overdraft, do nothing and let the cash budget bring balance to positive

Decision making

This report provides a benchmark (target/goal to motivate staff and management) for the assessment of the business’s actual cash performance. By comparing it to actual cash flows, the users can identify problem areas, and then act to correct the situation. They could assess:

Debtor collection procedures

Creditor payment policies

Level of cash drawings

Budgeted Profit and Loss Statement

Budgeted Profit and Loss Statement is an accounting report that shows estimates of revenues, expenses and thus profit over a specific period of time in the future.

Budgeted net profit equals revenue expected to be earned during the budget period minus expenses expected to be incurred in that period.

Planning

This report assist planning because it indicates the future requirements of the firm relating to issues like staffing (hiring/firing/wages), stock levels, or advertising campaigns.

If the result predicted by the budget fit in with managements overall objectives, the budget should be adopted and put into action. If it is seen as unsatisfactory, it should be reviewed and changes introduced until management is happy with the goals contained in the budget. This is possible as a budget is a workable document that is based on attainable goals.

Decision making

This report provides a benchmark for measuring actual performance. The users can assess:

The level of sales (and the effectiveness of advertising)

The mark-up achieved

The level of stock loss (to assess stock management procedures)

Expense control

Staff performance

Vertical analysis of Profit and Loss Statement

Vertical analysis is a report that expresses every item as a percentage of a base figure (in this case, Sales revenue). Such analysis helps with expenses control, as the users can identify and highlight increases in expenses, not just in amounts, but also as a percentage of sales. Such reports that use percentages rather than dollar values to allow easier comparison of results are called common size statements.

Budgeted Balance Sheet

Budgeted Balance Sheet is an accounting report that shows estimates of assets, liabilities and owners equity at a specific date in the future.

Planning

It is used for:

Reporting the future situation of non-current assets [capital spending]

Examining the future liquidity position of the business

Evaluating the gearing in the future [reliance on borrowed funds]

Shows future details about owners equity, including future net profits and drawings

The expected carrying value of non-current assets helps preparation of their replacement

When used in conjunction with Budgeted Cash Flow Statement, it can be used to control loan repayments and cash drawings.

Decision making

This report provides a benchmark for indicators that assess liquidity and stability [beyond VCE course]. It can also be used to calculate the budgeted Working Capital ratio, which can then be used to assess liquidity. Comparison of Budgeted Balance Sheet and historical Balance Sheet allows management to identify the key changes that are expected to occur in the budget period.

Performance evaluation

Analysing is the examination of the financial reports in detail to identify changes or differences in performance

Interpreting is the examination of the relationships between the items in the financial reports in order to explain the cause and effect of changes or differences in performance.

Trend analysis

Trend analysis is measuring the change in a financial item or a ratio over several reporting periods. Trend is the pattern formed by changes in an item over a number of periods. This information is often presented as line or bar graphs to satisfy Understandability.

Horizontal analysis

Horizontal analysis is the comparison of reports from one reporting period to the next, and identifying the increase or decrease in specific items in the report.

Variance

Variance is the difference between an actual figure and a budgeted figure. It is expressed in dollar terms or in percentages. There are two types of variances:

1) Favourable variance (a.k.a. positive variance) is a situation in which the actual result is better than the result predicted in the budget 2) Unfavourable variance (a.k.a. negative variance) is a situation in which the actual result is worse than the result predicted in the budget

If a budget contains too many variances, management should attempt to find explanations for these and make adjustments in its future planning. For example, an unexpected event (e.g. bad debts) should be noted for future budgets.

Actions are often necessary to ensure budgets can be met. Therefore, even when a budget is prepared for a quarterly period, it should be reviewed after each month. If results are not as expected, decisions must be made to get the plan back in line with that outlined in the budget.

If reports are prepared quarterly, ideally, at the end of each month, a budget variance report should be prepared an then a new quarterly budgeted report should be prepared. This achieves the goal of budgeting as an ongoing process that involves future planning which is continuously updated.

Variance report (a.k.a. performance report) is an accounting report that is used to compare a businesss budget predictions with the actual results achieved. It is prepared to show variances between a budgeted report and the actual report. These reports are invaluable tools for assessing profitability because they draw attention to areas in which performance has been below expectation.

Benchmark

Benchmark is an acceptable standard against which the firm’s actual performance can be assessed. These may include:

Performance in previous periods allows for the preparation of a horizontal analysis and identification of trends. Using this benchmark enables an assessment of whether profitability has improved or deteriorated from one period to the next.

Budgeted performance for the current period allows for the preparation of a variance report, and enables an assessment of whether profitability was satisfactory or unsatisfactory in terms of meeting the firm’s goals and expectations.

Performance of other similar firms is sometimes expressed as an ‘industry average’. It allows the firm’s performance to be compared against other firms operating under similar conditions (this is sometimes known as an ‘inter-firm comparison’)

Profitability

Profitability is the ability of the business to earn profit, as measured by comparing against such as sales, assets or owner’s equity.

A business’s ability to earn profit is dependent on its ability to earn revenue and control expenses. Consequentially, any assessment of profitability must examine the firm’s performance in these two areas, with an analysis of the Profit and Loss Statement a logical starting point. This assessment must not be based on the dollar terms only, as there are many factors affecting the ability to earn revenue and control expenses, and these factors’ significance must be considered when assessing profitability. Profitability is a relative measure, as it does not just consider the level of profit, but its comparison with another base (e.g. assets and owner’s equity).

Strategies to improve profitability

Earn Revenue Earning revenue is heavily dependent on the firm’s efficiency as shown in the efficiency ratios. To improve this, a business may change its:

1)

Selling price

2)

Decreased selling price could generate greater sales revenue, while increased selling price could generate greater revenue and gross profit per sale. Selling price

3)

Increased, or targeted more accurately at prospective customers (market niche) Stock mix

4)

Slow-moving stock must be replaced with fat-moving ones Non-current assets

5)

More, or more efficient non-current assets may enable the firm to generate more revenue Customer service Customer-friendly, staff training, after service, extra services, etc.

Controlling Expenses A firm must have the ability to manage its expenses so that they either decrease, or in the case of variable expenses, increase no faster than sales revenue. It must be acknowledged that an increase in revenue will rarely happen without an increase in expense. However, if theses expense increases overtake the increases in revenue, we will in fact experience a decrease in net profit. Thus, we need to evaluate expenses control, and this is achieved through the three profitability indicators: Net Profit Rate, Gross Profit Rate, and Adjusted Gross Profit Rate.

To improve this, a business may change its:

1)

Management of stock

2)

Alternative supplier may provide cheaper and/or better quality stock, while different ordering procedures could reduce storage costs and stock losses, or generate price discount Management of staff

3)

Different rostering systems, appropriate incentives, and extra training may improve staff productivity and performance. Management of non-current assets Inefficient, under-utilised or unreliable assets are ultimately expensive, and should be replaced or removed.

Advices that may be right for a similar business may not be for another. Therefore, there is no “must” but “recommendations”.

Analytical ratios

Analytical ratio is a comparison of two items that are somehow related in order to analyze an aspect of business performance.

Ratios are usually compared to benchmarks, or tools used to measure performance by comparing financial results in some established criteria. This is to measure how the business performed compared to:

Previous reporting periods (for trend)

Industry averages, or similar businesses

Budget estimates, or predicted results (level of performance defined by budgets)

Alternative investments

Profitability

Return on Owner’s Investment

Net Profit

Average Owner s Equity

Measurement: percentages

Definition Return on Owner’s Investment is a profitability indicator that measures how effectively a business has used Owner’s Equity to earn profit by calculating the net profit as a percentage of average owner’s equity during the reporting period.

Notes Return on Owner’s Equity is from an investor’s point of view. Given the risk that comes with running a business, the owner will expect a higher ROI than alternative investments. For this reason, the ROI must be comparable with interest on term deposit, dividends on shares and etc.

Limitations An increase in Return on Owner’s Investments does not always mean a favourable outcome. It may simply mean that the owner is investing less in the business and not mean that net profit has increased.

Changes

Increased by:

 

Increase in

Achieved through:

Net Profit

Increase in sales

Decrease expenses

Others as outlined under “Strategies to improve profitability

Decrease in Average Owner’s Equity

Achieved through:

Cut down of capital contribution

 

More drawings

In such cases of reduction in OE increasing the ROI, this will lead to higher gearing (percentage of a firm’s assets that are financed by its liabilities). This means there is a higher risk of the business becoming unable to repay its debts and meet the interest payments

An optimal condition would have a gearing high enough to maximise the ROI, without sending the business into difficulties in relation to its debt burden.

Return on Assets

Net Profit

Average Total Assets

Measurement: percentages

Definition Return on Assets is a profitability indicator that measures how effectively a business has used Owner’s Equity to earn profit by calculating the net profit as a percentage of average total assets during the reporting period.

Notes It is always lower than the Return on Owner’s Investment, because the average owner’s equity is always lower than average total assets, except in extreme cases where they are equal. The difference between the two is dependent on the firm’s gearing.

Average Total Assets do not change significantly unless unexpected events occur. Therefore, an increase in Return on Assets is most likely to be caused by an increase in Net Profit.

Changes

Increased by:

 

Increase in

Achieved through:

Net Profit

Increase in sales

Decrease expenses

Others as outlined under “Strategies to improve profitability

Decrease in Average Total Assets

Achieved through:

Selling of high-value assets (eg. Premises) and withdrawing the amount or repaying debts

 

Rent instead of purchasing NCAs

Big repayment of large loans

Liquidation of the business by external equities

Net Profit Rate

Net Profit

Sales

Measurement: percentages

Definition Net Profit Rate is a profitability indicator that measures the firm’s control over expenses by calculating the percentage of sales revenue that is retained as net profit.

Notes

Limitations Net Profit Ratio may be increased by a cut down in expenses which may decrease Sales (but not as much as the decrease in expenses). This may appear favourable, but in dollar terms, the business may be earning less net profit than previously.

Changes

Increased by:

 

Increase in

Achieved through:

 

Net Profit

Decreasing expenses

 

Others

as

outlined

under

“Controlling

Expenses”

in

Strategies

to

improve

profitability

 

Decrease in

Does not work, as a decrease in sales would decrease the net profit

 

Sales

 

Gross Profit Rate

Gross Profit

Sales

Measurement: percentages

Definition Gross Profit Rate is a profitability indicator that measures the average mark-up by calculating the percentage of sales revenue that is retained as Gross Profit.

Notes It allows users to assess the adequacy of the mark-up to see if it is large enough to cover other expenses, and thus shows whether the mark-up is to blame for a lower Net Profit Rate.

Limitations Higher GPR always indicates a higher average mark-up on sales. Increase in GPR does not always mean a good thing. An increase in GPR can occur with a decrease in Sales:

Increased selling prices may lower demand

Buying from a cheaper supplier may result in poorer quality goods and thus higher Sales Returns, which reduce sales and customer satisfaction, also affecting future sales

In both cases gross profit per item increases but gross profit as a whole (in dollar terms) decreases.

Changes

Increased by:

 

Increase in

Achieved through:

Mark-up

Increasing the selling price

Decreasing the cost of goods sold

o

Buying from a cheaper supplier with similar quality

o

Taking advantage of bulk pricing (if possible)

Decrease in

Does not work, as a decrease in sales would decrease the net profit

Sales

Liquidity

Working Capital Ratio

Current Assets

Current Liabilities

Measurement: ratio of x:1

Definition Working Capital Ratio is a liquidity indicator that measures the ratio of current assets to current liabilities, to assess the business’s ability to meet its short-term debt obligations.

Notes A satisfactory liquidity would exist if the Working Capital Ratio was at least 1:1. This would indicate that there is at least $1 of Current Assets to repay every $1 of Current Liabilities. However, a WCR of 1:1 is still not very satisfactory, as it leaves no margin for error.

There is a problem with liquidity if:

WCR is lower than 1:1 The business will have difficulties meeting its debts as they fall due. This may for them to go through liquidation (selling of its assets for immediate cash). In order to survive, the owner may need to:

- Make a (cash) capital contribution

- Seek additional finance by entering into (or extending) an overdraft facility

- Take out a long-term loan

WCR is much greater than 1:1 Although this may mean that there is little liquidity problems, it is still a problem. Such high WCR may be the cause of idle assets. Problems in having idle assets are:

- Cash at Bank:

-

little interest is paid out in business accounts

- Stock Control:

-

additional storage costs

-

greater chance of stock loss, damage, obsolescence and thus stock write downs.

- Debtors Control:

-

debtors may be “ageing”, meaning they are likely to be written off as bad debts later on

Possible solutions to such issues are:

- Using excess cash to repay debts, purchasing NCAs or drawings

- Allowing stock to run down before re-ordering (adopt Just-In-Time ordering method)

- Contact debtors to collect amounts outstanding

Changes

Increased by:

 

Increase in

Achieved through:

Current Assets

Taking out long-term loans

Capital contributions of current assets, mainly cash

Selling of non-current assets for cash

Decrease in Current Liabilities

Achieved through:

Taking out long-term loans to repay short-term debts

 

Using capital contributions to repay short-term debts

Sell non-current assets to repay short-term debts

Quick Asset Ratio

Current Assets (Stock Control + Prepaid Expenses)

Current Liabilities (Bank overdraft)

Measurement: ratio of x:1

Definition Quick Asset Ratio is a liquidity indicator that measures the ratio of quick assets to short-term liabilities, to assess the firm’s ability to meet its immediate debts.

Notes This ratio shows the firm’s immediate liquidity as Current Assets that cannot be quickly turned into cash and Current Liabilities that do not require immediate cash obligations have been excluded from calculation.

Changes

Increased by:

 

Increase in

Achieved through:

“Quick Assets”

Taking out long-term loans

Capital contributions of current assets, mainly cash, and not stock

Selling of non-current assets for cash

Decrease in “Quick Liabilities”

Achieved through:

Taking out long-term loans to repay short-term debts

 

Using capital contributions to repay short-term debts

Sell non-current assets to repay short-term debts

Using overdraft facility to repay short-term debts

Cash Flow Ratio

Net Cash Flow from Operating Activities

Average Current Liabilities

Measurement: times per period

Definition Cash Flow Ratio is a liquidity indicator that measures the number of times net cash flows from the provision of goods and services in the day-to-day operations of the business (operating activities) is able to cover average Current Liabilities.

Notes There is no certain point/where CFR is satisfactory, unlike WCR and QAR. CFR becomes higher when the reporting period is longer.

Changes

Increased by:

 

Increase in Net Cash Flow from Operating Activities

Achieved through:

Increasing inflows:

o

More cash sales

 

o

Improve collections from debtors and more credit sales

Decreasing outflows

o

Reduce rent expense (get cheaper lease)

o

Reduce interest expense (repay long-term debt)

Decrease in Current Liabilities

Achieved through:

Pay off short-term debts using capital contribution

 

Reduce bank overdraft

Interest Cover

Net Cash Flow from Operating Activities (before interest)

Interest

Measurement: times per period

Definition Interest Cover is a liquidity indicator that measures the number of times net cash flows from the provision of goods and services in the day-to-day operations of the business (operating activities) is able to cover interest.

Changes

Increased by:

 

Increase in Net Cash Flow from Operating Activities

Achieved through:

Increasing inflows:

o

More cash sales

 

o

Improve collections from debtors and more credit sales

Decreasing outflows

o

Reduce rent expense (get cheaper lease)

Decrease in

Achieved through:

Interest expense

Repay debts

Efficiency

Asset Turnover

Sales

Average Total Assets

Measurement: times per period

Definition Asset Turnover is an efficiency indicator which measures how productively a business has used its assets to earn revenue.

Notes Relationship between Asset Turnover and Return on Assets These two indicators both assess the firm’s ability to use its assets, the only difference being that ROA relates to net profit and ATO to Sales.

This means that an increase in ATO does not guarantee an increase in ROA. However, if an increase in ATO is much higher than the increase in ROA, it indicates a change (unfavourable) in expense control.

Relationship between Net Profit Ratio, Asset Turnover and Return on Assets ATO ability to use assets to earn sales NPR ability to retain that sales revenue as net profit. Thus, ROA would depend on both.

=

Alas, ATO x NPR

Sales

Average

Total Assets

x Net Profit Sales

=

Net Profit

Average

Total Assets

= ROA

Changes

Increased by:

 

Increase in Net Cash Flow from Operating Activities

Achieved through:

 

Increasing inflows:

 

o

More cash sales

 

o

Improve collections from debtors and more credit sales

Decreasing outflows

 

o

Reduce rent expense (get cheaper lease)

Decrease in

Achieved through:

 

Interest expense

Repay debts

Speed of Liquidity

Liquidity as shown in liquidity ratios of WCR and QAR give a static view of a firm’s liquidity. In actual fact, a business can survive with a low WCR and QAR with a fast enough trading cycle. This can be calculated by using efficiency indicators.

Stock Turnover

Average Stock x 365

Cost of Goods Sold

Measurement: days

Definition Stock turnover is the average number of days it takes for a business to convert its stock into sales. This ratio evaluates the success or otherwise of management’s investment in its stock.

Notes Assessment Stock Turnover should take into account the nature of goods sold. Perishable and obsolescence-prone goods must have a lower STO than others.

With most stock, there can be a problem if:

STO is too slow High number of days mean the firm will be less able to generate sales, and thus less able to generate cash inflows (cash sales and receipts from debtors) in time to meet debt obligations as the fall due. Possible solutions may be:

- Increasing sales through advertising, lowering selling prices, changing stock mix

- Decreasing the level of stock on hand by ordering less, ordering small amounts more frequently (Just-In-Time ordering), replacing slow-moving stock lines.

STO is too fast Low number of days may mean that the selling prices are too low, and this would mean a loss in potential revenue and profit. It could also be because the business is holding too little stock. This would lead to higher delivery costs (more frequent) and the loss of possibility of bulk purchase discounts.

As the STO only shows the average time taken to sell stock, decisions must not be made on STO alone. Individual stock cards need to also be analysed, so that the user has detailed information about the speed at which specific lines of stock are selling.

Factors Factors affecting stock turnover are;

Range of products being sold

The length of time business have been operating

Size of the business

Competition in the local area

Management Stock is the bloodline of any trading business. It is easily the most valuable asset apart from the premises. Some procedures used to control stock are:

1)

Determine an appropriate level of stock on hand by setting minimum and maximum levels of inventory

2)

This can be used to adopt Just-In-Time ordering which is a method of purchasing inventory whereby the new order of goods arrive just before the business runs out of stock Physically rotate stock to avoid NRV issues

3)

Older units should be on prominent display so that the customers are encouraged to first purchase those units closer to expiry date. This avoids NRV issues through damage and obsolescence. Maintain an appropriate stock mix by identifying and removing slow-moving lines

4)

Clearance sale look for better alternatives or stop altogether n.b. Some “slow-moving” lines can compose of highly profitable items, and these are not considered slow- moving Monitoring seasonal products

5)

Stock that are subject to seasonal demands must be run down to a very low level or cleared out altogether at the end of the season to avoid becoming dead stock. Monitoring products subject to technological obsolescence

6)

It would be unwise to stock up technological goods just because the supplier is offering a very good price. Theses can become superseded by newer models. Therefore, the business must take care to not over-commit to purchases. Changing with the times to ensure stock is up-to-date

7)

Business must change to adapt to changing markets, competitors, and customers, so stock should reflect this change. introducing complementary goods

8)

Increased range of stock may attract customers e.g. menswear seatbelts, ties, shirts, trousers mobile phone batteries, hands-free kits Monitoring selling prices

9)

Cost price should be monitored to ensure mark-up remains profitable. An increase in cost price should lead to increase in selling price but it is often difficult to do so, due to competition. Ensuring that adequate stock security is in place Stock is the second most theft-targeted asset after cash. Some strategies to tackle this issue are:

- Security guards

- Undercover security personnel

- Video surveillance

- Security tags on products

- Two-way mirrors

- Dye bombs

- Electronic security gates at all exits

- Random checks on staff

10) Avoiding stock losses There are also other causes to stock losses, and this can be dealt by:

- Checking all deliveries of stock against invoices received

- Filing documents in an organised fashion to avoid ‘double invoicing’ by suppliers

- Securely placing cash in registers in all cash sales (avoid staff pocketing cash from cash sales by not recording the sale later identified as stock loss) 11) Reducing selling price of slow-moving lines 12) Relocating stock within store to highlight particular goods 13) Running special promotions of targeted stock lines 14) Combining items to promote particular products (e.g. ice cream + drink combo)

Limitations An increase in Cost of Goods Sold is not always a favourable indicator. Although at most times it represents an increase in volume of stock sold, it may simply represent a rise in cost prices. Therefore, it is necessary that Sales Revenue is assessed alongside STO.

Debtors Turnover

Average Debtors x 365

Credit Sales

Measurement: days

Definition Debtors turnover is the average number of days it takes for a business to collect cash from its debtors.

Notes Assessment Debtors Turnover can be compared with the benchmarks outlined before, and also with the credit terms.

Debtors ageing analysis is a listing of the amount and proportion of debtors according to the length of time they are owing. Age analysis of debtors is a table that classifies debtors’ accounts according to the age of their debt.

 

Total Debtors

0 30 days

31 60 days

61 90 days

Amount

$14000

$10500

$2000

$1500

Percentage

100.0%

75.0%

14.3%

10.7%

   

An ideal situation would have 100.0% here

 

*this assumes 30-day credit terms

This table should be prepared regularly (preferably, monthly) and compared with previous analyses so that management can see any trends emerging.

Management Stock is the bloodline of any trading business. It is easily the most valuable asset apart from the premises. Some procedures used to control stock are:

Extensive credit checks Selling on credit is a legitimate tactic to increase stock turnover, as new clients may be attracted to the

business if a credit facility is available. However, it is useless if they are not eventually turned to cash. Credit checks should be conducted on prospective customers, checking:

1)

- Banking history

- Loans and/or credit card history

- References from other businesses

- References from financial institutions

- Cash forecasts and/or budgets

- Profit and Loss Statements

- Balance Sheets

- Using agencies

2)

Offering discounts for prompt payment

3)

Charging interest on overdue amounts (need to be stated on original contract)

4)

Sending reminders via fax or email

5)

Sending monthly statements regularly

6)

Threatening not to provide credit in the future

7)

Making personal visits to the customer’s place of business

8)

Threatening clients with legal action

9)

Employing a debt collection agency

10) Taking legal action to recover the debt

The business must be able to coax credit customers into paying overdue amount without undue embarrassment. This is to avoid losing slow-paying but large customers. This is why italic options are the last resort.

Creditors Turnover

Average Creditors x 365

Credit Purchases

Measurement: days

Definition Creditors turnover is the average number of days it takes for a business to pay its creditors.

Notes Why credit purchases

Credit purchases are preferred, because:

1)

It gives the business time to try to sell its stock and turn it into cash

2)

Trade credit is basically interest-free finance.

Payments to Creditors Payments should be made at a time so that the business has time to generate cash from the stock it purchased on credit. However, late payments can lead to disadvantages, such as:

- Interest charges on late accounts

- Removal of credit facilities

- Reduction in credit rating

The ability to repay creditors may simply reflect the current state of the liquidity of the business; that is, its ability to meet its debt obligations as they fall due.

Limitations of ratio analysis

Ratio analysis is limited in its nature as they can only be as accurate as the information on which they are based. It is also questionable, because:

Ratios are based on historical data Past results do not correspond to future events

Historical cost accounting Inflation can distort real meaning, depreciation may not be accurate, and turnover rates may be distorted

Changes in accounting methods

If management changes methods, details will be made available regarding the change (Relevance) but ratios are still difficult to compare

Inter-firm comparisons

Every business is unique in financial structure (assets, revenues, expenses, etc.). Even with industry averages, it

is not accurate and only a suspect at its best.

Frequency of reporting Ratios are only very useful with frequent, detailed reporting

Limited information Many owners with limited accounting knowledge do not undertake a comprehensive reporting system, leading to limited analysis.

Non-financial information

Non-financial information is any information that cannot be fond in the financial statements, and is not expressed in dollars and cents, or not reliant on dollars and cents for its calculation.

Financial reports are limited, because:

They use historical data, and do not guarantee future events

Many indicators rely on averages, and this may conceal details about individual items

Different accounting methods used by different firms undermine comparability of reports and indicators

Non-financial information provides information about:

1)

Firm’s relationship with its customers

It is difficult to attract customers, so it is crucial to keep them by assessing customer satisfaction. This includes:

- Customer satisfaction surveys

o Feedback forms

2)

- Number of repeat sales

- Number/amount of sales returns

o Sales returns ratio %

=

Sales Returns

Total Sales

100

- Number of customer complaints

- Number of sales enquiries/catalogue requests

- Degree of brand recognition (based on market research) Suitability of stock

Businesses must continuously assess the suitability of their stock to make sure they are meeting the demands of customers:

- Number of customer satisfaction

- Number of sales returns

- Quality reassurance

3)

o Purchases returns ratio % Quality of management

A good owner needs to have:

=

Pur chases Returns

Total Pu rch ases

100

- Good communication skills (deal with customers, staff, etc.)

- Adequate management skills (controlling stock, debtors, creditors, etc.)

- Ability to adapt to change (keep up with current trends, visions of future, changing bad methods)

- Ability to develop/stock new product (be aware of market changes)

- Flexibility in responding to customersneeds (treat on individual basis)

- Ability to recognise ones own weaknesses

4)

Profit compared to hours worked

Profit per hour =

There is no definite answer for acceptable profit per hour, because of:

Net Profit

Hours worked

- Potential for growth in the business

- Potential for salary increases

- Risks of unemployment if employer goes out of the business

- Excitement of running a business

- Security of employment as a salary earner

- Risk of having insufficient cash to pay drawings (profit does not equal cash)

- Security in having a salary deposited into a bank account every week or every month

5)

- Alternative investments Firm’s relationship with its employees

- Structured performance appraisals

- Number of days lost due to sick leave/industrial action

6)

- Staff turnover/average length of employment State of the economy

A shrinking economy will affect even a strong firm. This includes:

- Interest rates

- Unemployment rate

- Number of competitors

- Level of inflation

- Consumer confidence

- Actions of big businesses

- Government decision-making (e.g. introduction of GST)

- Wage demands by unions

- Taxation changes

- Technological change

- Market trends

Cash cycle

Cash cycle is the process of turning stock into sales, and then turning theses sales into cash. It is calculated as STO + DTO.

Purchase stock on cash/credit

It is calculated as STO + DTO. Purchase stock on cash/credit Stock Turnover Pay cash to
It is calculated as STO + DTO. Purchase stock on cash/credit Stock Turnover Pay cash to

Stock Turnover

Pay cash to creditors

*not part of cash cycle

Sell stock on cash/credit

This is not always the case. Some creditors demand payment earlier than debtors turnover

Some creditors demand payment earlier than debtors turnover Collect cash from debtors Debtors Turnover Faster cash
Some creditors demand payment earlier than debtors turnover Collect cash from debtors Debtors Turnover Faster cash

Collect cash from debtors

Debtors Turnover

Faster cash cycle is highly advantageous as the cash is available at n earlier date and can therefore be used by management as it sees fit.

Ideally, STO + DTO should be as fast as possible, and CTO should be as slow as possible. This may be achieved by buying stock on credit and selling them in cash.