Financial MNG

i
S T R A T E G I C S U C C E S S S E R I E S
Financial
Management for
Non-Financial
Managers
Clive Marsh
ii
Publisher’s note
Every possible effort has been made to ensure that the information contained
in this book is accurate at the time of going to press, and the publishers and
author cannot accept responsibility for any errors or omissions, however caused.
No responsibility for loss or damage occasioned to any person acting, or refrain
ing from action, as a result of the material in this publication can be accepted by
the editor, the publisher or the author.
First published in Great Britain and the United States in 2012 by Kogan Page Limited
Apart from any fair dealing for the purposes of research or private study, or criticism or
review, as permitted under the Copyright, Designs and Patents Act 1988, this pub
lication may only be reproduced, stored or transmitted, in any form or by any means,
with the prior permission in writing of the publishers, or in the case of reprographic
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concerning reproduction outside these terms should be sent to the publishers at the
undermentioned addresses:
120 Pentonville Road 1518 Walnut Street, Suite 1100 4737/23 Ansari Road
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© Clive Marsh, 2012
The right of Clive Marsh to be identified as the author of this work has been asserted by
him in accordance with the Copyright, Designs and Patents Act 1988.
ISBN 978 0 7494 6467 7

E-ISBN 978 0 7494 6468 4
British Library Cataloguing-in-Publication Data
A CIP record for this book is available from the British Library.
Library of Congress Cataloging-in-Publication Data
Marsh, Clive (Clive Mark Heath)

Financial management for non-financial managers / Clive Marsh.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-7494-6467-7 – ISBN 978-0-7494-6468-4 (ebook)
1. Business enterprises–Finance. 2. Corporations–Finance. I. Title.
HG4026.M3647 2012
658.15–dc23
2011043164
Typeset by Graphicraft Limited, Hong Kong

Printed and bound in India by Replika Press Pvt Ltd
iii
Contents
Online resources ix
Introduction 1
1 Types of business structure and

their finance 4
Sole proprietors 5
Partnerships: general and limited liability 6
Corporations 8
A company limited by shares 8
Limited companies 8
Public limited companies 9
Summary 9
2 The role of the accounting and

finance department 11
Financial accounting, payroll, budgeting, management
accounting, taxation, treasury 11
Accounting and finance department relationships 17
Summary 18
3 Accounting and financial statements 19

Double entry system and ledgers 19
Trial balance 24
Profit-and-loss account 25
Balance sheet 25
Classification of assets and liabilities 26
Source and application of funds statements 27
Principles: matching, accruals, deferrals, consistency,
conservatism, accounting periods, materiality, going-concern
concept, form and substance, full disclosure and clarity 29
iv CONTENTS
Accounting and the environment 33

Neuroscience and accounting 33
Summary 34
4 Analysis and financial ratios 35

Ratio analysis 36
Gross profit percentage 38
Net profit percentage 38
Current ratio 39
Liquidity ratio 40
Stock-turnover ratio 40
Debtors’ days 41
Fixed assets turnover ratio 42
Gearing ratio 43
Return on capital employed ratio 43
Return on equity: earnings per share 44
The price–earnings ratio (PER) 45
Earnings–yield 45
Dividend cover 45
Dividend yield 46
Summary 46
5 Planning and budgeting 48

The planning and budgeting process 49
Departmental budgets and variance analysis 51
Key budgets: sales, production, materials, labour, overheads,
capital 51
Some key departmental budgets 55
The direct materials budget 59
Capital budgets 64
Capital rationing 67
Summary 69
6 Product and service costing and pricing 70

Types of cost: fixed, variable, semi-variable 70
Total cost and unit costs 72
Contribution, break-even point and marginal costing 73
Absorption costing – standard costing 78
CONTENTS v
Activity-based costing (ABC) 83

Selling prices and the sales mix 84
Summary 88
7 Setting selling prices and marketing

strategies 89
Pricing strategies 92
Summary 96
8 Investment appraisal 98
Relevant cash flow 98
Pay-back period 100
Return on capital 101
Accounting rate of return (ARR) 102
Discounted-cash-flow and net present value 103
The internal rate of return (IRR) 106
Capital rationing 108
Summary 110
9 Finance, funding and working capital 111

Finance and working capital 111
Short-term funds: overdrafts, short-term loans, invoice finance,
trade credit, managing stocks 112
Leases: short term – long term 118
Term funding and long-term finance: optimal gearing, equity
funds, ordinary shares, preference shares, debentures,
bonds, convertibles, notes, subordinated debt, Eurobonds,
commercial mortgages, venture capital, derivatives 123
Export finance: bills of exchange, letters of credit, export credit
guarantees 130
Using retained earnings as a source of funds 131
Bank relationships 132
Covenants 135
Financing entrepreneurial thinking and venture capitalists 136
Interest-rate risk 138
Financial markets 140
Summary 141
vi CONTENTS
10 International transactions and

currency risk 142
Buying or selling foreign currency 142
Foreign exchange risks 144
Foreign currency accounts 146
Forward exchange contracts 147
Hedging using the money market 148
Currency futures 148
Currency options 150
Currency swaps 151
Invoicing in domestic currency 153
Advance payment 153
Matching 153
Intra-group trading 154
Export invoice finance 154
Single Euro Payments Area Direct Debit Scheme 154
Summary 155
11 Company taxation and financial

management 156
Direct and indirect taxation 157
Taxes on companies and corporations 159
VAT and GST 160
Taxes on the earnings of employees 162
Global tax planning 163
Double-taxation relief 164
Transfer pricing 164
Bringing taxation into the decision-making process 165
Taxation and the economy: future trends in tax collection 166
Summary 168
12 The value of a business 169

Building value 169
Methods of valuing a business 171
Summary 179
CONTENTS vii
13 Financial strategy 180

Elements of a financial strategy 181
Strategic financial management 182
Summary 189
14 The cost of capital 191

The weighted average cost of capital (WACC) 192
The marginal cost of capital 192
The cost of ordinary share capital 192
Dividend growth model 195
Capital-asset-pricing model (CAPM) 195
Summary 196
15 Dividend policy 197

Influences in dividend policy 198
Dividend policy theories 199
Ways of paying dividends 200
Summary 202
16 Case studies 203

Case 1 Misuse of short-term funds with disastrous
consequences 205
Case 2 Foreign exchange hedging v speculation 207
Case 3 Stock valuations and profits 209
Case 4 Bank loans and covenants 211
Case 5 Separating money transmission from a lending
bank 213
Case 6 Credit ratings and fundamental analysis 215
Case 7 Advantages and disadvantages of internal
charging 217
Case 8 Marginal costing v full absorption costing 220
Case 9 Overtrading: profits but no cash 221
Case 10 Integrating the planning and budgeting process,
leading to outsourcing 223
Case 11 Government deficits and cost cutting 227
Case 12 A 5 per cent increase in sales is generally worth more
than a 5 per cent reduction in costs 229
viii CONTENTS
Case 13 Large capital projects and cost control: critical path

analysis and integration with mainstream
accounts 231
Case 14 A mass of figures just makes life more
complicated 233
Case 15 High levels of fixed costs when income is variable
can cause failure 234
Case 16 Interest rates and inflation 236
Appendices 239
Index 241
ix
Online resources
A dditional resources to accompany the book are available on

Kogan Page’s Strategic Success website:
www.koganpage.com/strategicsuccess
Online template 1 – Departmental expenditure variance analysis

Online template 2 – Product contribution
Online template 3 – Cash forecast
Online template 4 – Planning and budgeting process
Online template 5 – Direct materials budget
Online template 6 – Direct labour budget
Online template 7 – Cost variance analysis – manufacturing
x
THIS PAGE IS INTENTIONALLY LEFT BLANK

1
Introduction
A s a manager your main task at all times is value creation and pro-
tection. You need to know where value comes from and how it is
built or eroded. This requires a strategic understanding of financial
management and managerial finance, and I hope that this little book
will help you to become more financially literate. It is written for non-
financial managers to improve their ability to evaluate the financial
consequences of their decisions. Integrating finance and corporate
strategy will help you and your finance director get a better understand-
ing of how you both contribute to value creation.
The purpose of this book

The purpose of this book is to help non-financial managers understand
finance and accounting at a managerial rather than a technical or pro-
fessional level. This will help them make better decisions and manage
their financial responsibilities more efficiently. At a strategic level it
will help managers understand how financial strategy is integrated
with business strategy. This is not a book aimed at financial experts
or academics whose task is to explore new theories. It is a book for the
practising business manager who needs practical and useful guidance
on corporate finance and accounting.
Money is the common denominator of all business transactions,
and accountancy provides a language and a method for recording the
movements of money. A successful manager needs to have a strategic
understanding of finance and accounting and also to understand how
finance supports business strategy. Too much financial information
can lead to complexity and confusion. This work will enable a manager
2 Financial Management for Non-Financial Managers
to question the validity of information received and to concentrate on

those financial performance indicators that are key to his/her business.
This work will also explain how different types of finance relate to
various business structures, the role of accounting and finance depart-
ments, the analysis of financial statements, planning, budgeting, costing,
pricing, investment appraisal, finance, taxation and international trans-
actions. You will agree that this is a broad remit for such a short book
and I must, therefore, cover the subjects at a high level only. However,
this book will enable non-financial managers to feel confident when
talking ‘finance’ with their finance directors, to manage their own finan-
cial responsibilities and to gain a better understanding of risk and
the financial consequences of their actions.
After reading this book you will have a strategic understanding of:
●● how to implement the controls required to protect financial assets;

●● how to make sound strategic financial decisions;
●● how to plan for and obtain funds;
●● how to ensure that assets are used efficiently.
Strategic financial management creates real value within an organiza-

tion, and this book will enable non-financial managers make sound
financial decisions that add value. It is intended to bring together
some of the most important financial principles and techniques in
a way that will be useful to the practising manager. A key feature of this
book is the provision of case studies in the final chapter that demon-
strate the practical use and relevance of corporate financial manage-
ment techniques.
It is expected that this book will be used by managers in different
countries with different laws. Accordingly it has been written in a broad
generic manner that outlines the general principles that are normal
to most jurisdictions and regimes. It does not provide a strict legal or
taxation framework. Any rates used are for illustrative purposes only
and do not reflect actual rates.
The author
Clive Marsh is an experienced accountant, chief finance officer, corpor
ate banker and business development director. He has worked for Shell,
IBM, Cap Gemini, Ernst & Young and several corporate banks in the UK
Introduction 3
and overseas. He has also worked with a number of small and medium-
sized businesses. His work has been published internationally.
Clive has a Masters’ degree in strategic financial management from
the Business School of Kingston University, London, is a member of the
Institute of Chartered Accountants of New Zealand (ACA NZ), a fellow of
the Chartered Bankers’ Institute (FCIBS), a chartered banker and a fellow
of the Chartered Management Institute.
4
C h apter O n e
Types of business
structure and
their finance
T he aim of this chapter is to discuss the principal types of business

entity and how they may raise initial capital.
Although there are many types of organization, for the purpose of
this book, we will consider just three groups:
●● Sole proprietorships: These are businesses that are owned by one

person. They are generally small businesses. The owner of the
business will have unlimited liability for the debts of the business
and may even have to sell his/her home to clear the business debts
if things go wrong. The capital for this type of business will be
provided by the owner and finance may also be provided by way of
loans, usually from a bank.
●● Partnerships: These are businesses that are owned by two or more
people who provide the capital. There are three principal types of
partnership:
–– General partnerships: where the partners are jointly and severally
liable for the debts of the partnership.
–– Limited partnerships: where there are one or more general
partners and one or more limited partners whose liability is
limited to a specified sum.
–– Limited liability partnerships (LLP): where the partners have
limited liability. A partner in a LLP is not liable for another
partner’s misconduct or negligence.
Partnerships may also obtain finance from banks and other lending
institutions.
Types Of Business Structure And Their Finance 5
A disadvantage of a general partnership is that a partner may have to

pay all partnerships debts if other partners or a partner are unable
to do so.
●● Corporations: These are limited liability businesses that have a
separate legal personality from their owners (shareholders). In
the event of the company winding up, the shareholders’ liability
will be limited. There are private limited companies and public
limited companies. There are also other types of corporation but
these are outside the scope of this book.
A major advantage of a limited liability company is the limit placed on a

shareholder’s liability in the event that the company folds.
There are advantages and disadvantages to each type of organization
and the type of organization will have a bearing on the methods of
finance adopted and on accounting and taxation. The advantages and
disadvantages of the three principal types of organization are dis-
cussed below.
Sole proprietors
Some advantages of being a sole trader

●● It is quick and easy to set up as a sole trader.
●● The accounting is relatively simple.
●● Simplicity. Less accountability.
Some disadvantages of being a sole trader

●● There is no limit to the liability of the proprietor. The proprietor will
be held personally liable for all debts in full and may have to use
personal assets to clear off business debts.
●● Sole traders have less ability to raise funds/capital.
As a sole trader you will be the initial provider of capital, unlike a part-
nership where partners contribute to capital or a company where the
shareholders provide capital. So it will be harder to raise additional
capital. Because a sole-trader business generally has less capital there
will also be a reduced ability to borrow money since there is less ‘equity’
in the business. However, the great advantage of being a sole trader is
that you are answerable primarily to yourself. There is no need to hold
partner or shareholder meetings and prepare so many reports. This

means that more time can be devoted to the business and direct
income-earning activities.
A sole trader should keep separate accounts and have a separate bank
account for the business so that there can be no confusion between
your personal and non-business transactions. This will also make com-
pleting your tax returns easier.
As a sole trader you also need to make sure that the tax authorities
cannot mistake you for an employee of your customer. This is especially
the case if you have few customers. To do this it is important that you
can be seen to be working for more than one customer, have your
own tools/equipment, are in control of what you do and are able to hire
others to do the work.
Banks like to see that a business has a reasonable amount of its own
capital before they will lend, and will only lend up to a limit against this
equity. This is the same as when you seek a mortgage on a house, where
the bank likes you to have some equity. For this reason sole traders are
not usually suitable business models for capital-intensive businesses
that require large sums invested in plant and equipment.
There may be taxation disadvantages in being a sole trader compared
with operating as a limited company or corporation. For example, the
rate of taxation for individuals (sole traders) might be higher than the
tax rate for corporations. Also, the timing of payments of tax may be
different. Tax rules and rates obviously very from one country to an
other and you will need to seek advice about this from an accountant
in your country of operation.
Partnerships: general and limited

liability
A partnership has been described as ‘the relationship which subsists
between persons carrying on business in common with a view to profit’.
It is brought into existence through the agreement of the parties con-
cerned to carry on business for profit. Usually there will be a partner-
ship agreement that sets out the rights, duties and responsibilities
of the partners. This will include details of the capital of the partnership
and the amount to be contributed by each of the partners. Other items
included in the agreement will include partners’ salaries (if any), interest
to be allowed or charged to partners on loans or advances, and provi-

sions for accounts, audits and so on.
Some of the principal advantages of

a partnership
●● It is usually possible to raise more capital than a sole trader can.
●● There are various types of partnerships, including limited liability
partnerships.
●● Partners may bring additional skills, contacts and knowledge.
●● The accounting and reporting might be a little simpler than for
a company.
Some of the principal disadvantages of

a partnership
●● Partners may be held jointly and severally liable for the partnership
debts. For example, if one partner fails to pay, the other partners
may have to pay the failed partner’s share.
●● The partnership has to be dissolved when a partner dies, becomes
bankrupt or leaves the partnership.
●● A partnership agreement needs careful drafting.
Some countries place restrictions on the number of partners allowed in

a partnership, although there may be exemptions for certain types of
business. If you decide that a partnership is the most appropriate type
of business structure then it is best to consult a lawyer who can advise
you of any constraints and help draft a partnership agreement. At this
stage you will also need to decide upon the type of partnership that is
best for your business.
A general partnership will only have ‘general members’, where each
partner is involved in the management and running of the partnership
and takes responsibility for the liabilities of the firm, becoming both
jointly and severally liable. This might be a real concern for some poten-
tial partners and would deter them from entering into such a partnership.
To get round this it is possible to form a limited partnership whereby
some members have their liability limited to a certain amount. This type
of partnership will have both general and limited partners. Often the
limited partners do not participate in the management of the firm.
In recent years a third category of partnership has become popular,

particularly with accounting and other professional firms. This is the
limited liability partnership (LLP), which combines characteristics of
partnerships and corporations. An LLP is different from a general or
a limited partnership. In an LLP all partners enjoy limited liability and
are not responsible for any malpractice, incompetence or mistakes of
others. They are, of course, responsible for their own acts.
Because a partnership will generally have access to more funds than
a sole trader, it will be in a stronger position to raise loan finance from
a bank.
Corporations
There are various types of corporation and for the purpose of this book
we will discuss the principal ones.
A corporation is an entity in its own right, having its own legal exist-
ence separate from that of its members (owners). This means that when
a member dies or sells his/her shares the company continues to exist
regardless. This is quite different from a partnership or sole trader,
which does not have the same separate legal existence.
A company limited by shares

A limited company is a type of corporation. The shareholders of a limited
company own the company collectively and enjoy limited liability. This
means that their liability towards the company’s debts is limited to the
amount, if any, unpaid on the shares taken up by them. Once the capital
is fully paid there is no further liability on the shareholders. A company
may be a private or a public company.
Limited companies
A private limited company is one that restricts the right to transfer
shares and may limit the number of members. Shares may not be
offered to the general public and shareholders may be bound to offer
their shares to their fellow shareholders before offering them to a third

party. Specific rules and terminology vary from country to country but
this is the general principle. A private limited company will raise capital
through the issue of shares and should be able to raise more funds
than either a sole trader or a partnership.
Public limited companies

A public limited company (PLC) has shares that are traded to the public
on a stock exchange. A PLC will have to comply with greater reporting
and regulatory requirements than a private one, and with significant
stock exchange regulations. PLCs are generally able to raise more funds
than sole traders, partnerships or private limited companies. However,
the reporting and regulatory demands on them can be burdensome for
smaller companies and for this reason some small PLCs have reverted
back to being private companies.
Summary
In this chapter we have discussed the principal types of business entity
and how they may raise initial capital. In summary these are listed
below:
●● Sole trader: unlimited liability; initial funds from proprietor; limited

ability to raise capital; simplicity; may be tax disadvantages
depending on country of operation.
●● General partnerships: may be liable for other partners’ share of debts;
initial funds from partners; relatively simple.
●● Limited partnerships: some partners have limited liability; initial
funds from partners.
●● Limited liability partnerships (LLPs): partners have limited liability;
initial funds from partners.
●● Private limited company: limited liability for members; initial funds
from members; ability to raise more funds.
●● Public limited companies (PLCs): limited liability for members;
initial funds from public members; possible to raise high levels of
funds/capital.
Choosing the correct type of business structure is a primary strategic

decision that will affect funding opportunities and the potential for
future growth. All businesses require sound governance; however, as
a general rule, the more stakeholders and more complexity in a business
structure, the more attention will need to be paid to governance issues
and processes.
11
C h apter T w o
The role of
the accounting
and finance
department
Financial accounting, payroll,

budgeting, management accounting,
taxation, treasury
The aim of this chapter is to describe the role of the accounting and
finance department and how it fits into an organization’s structure.
No business can operate without an efficient supply of finance. It is
the lifeblood of all organizations and the common denominator by which
most business performance is measured both internally and externally.
The accounting and finance department is at the centre of any organiza-
tion and is responsible for ensuring the efficient financial management
and financial controls necessary to support all business activities.
A good finance director needs to understand every aspect of a busi-
ness so that s/he can develop a financial strategy that will support
the business goals. Likewise, as a non-financial manager, it will help
you become more effective in your own role if you have an understand-
ing of the various roles of your organization’s accounting and finance
department.
The principal roles of the accounting and finance department, under
the overall control of the finance director, can be conveniently grouped
into:
●● financial accounting;
●● financial systems;
●● payroll;
●● budgeting;
●● management accounting;
●● taxation;
●● treasury and financial planning;
●● supporting the business strategy;
●● creating value.
Financial accounting
This is concerned with keeping account of all transactions, using the
double entry bookkeeping system and preparing final accounts suitable
for meeting the various regulatory requirements for statutory reporting,
the stock exchange and taxation authorities. The person responsible for
this function in most medium to large organizations is the financial
accountant, who will normally report to the finance director. Specific
responsibilities of the financial accountant include:
●● the recording of all transactions, using the double entry system;

●● the maintenance of all ledgers, including purchases, sales and
nominal ledgers;
●● maintenance of the cash book and reconciliation of bank accounts;
●● reconciliation of all accounts;
●● preparation of accruals and prepayment entries in the accounts;
●● keeping a fixed asset registers;
●● debtors’ control, debt collection and customer relations;
●● creditor relations and supplier payments;
●● stock reconciliations;
●● recording of value added tax or similar taxes such as goods and
services tax;
●● completion of tax returns;
●● extraction of a trial balance;
●● preparation of final accounts, including a profit-and-loss account,
balance sheet and funds statements;
●● liaison with auditors and with taxation authorities;
●● all external financial reporting;
●● day-to-day banking relationships.
the accounting and finance department 13
Financial systems
Medium- to large-sized organizations may employ a systems account-
ant, who will analyse the financial information needs of an organiza-
tion and review existing systems. S/he is responsible for the design
and maintenance of financial systems and for providing an interface
between the finance and technology/systems departments. Within
the accounting and finance function a systems accountant may report
to the financial accountant, management accountant or financial
director.
Systems accountants are involved in the implementation of change
processes within the finance department and may manage new finan-
cial systems projects. They may also be required to assist other users
of financial information.
Payroll
Larger organizations will have a paymaster or payroll manager. In
smaller companies this task may be performed by the financial account-
ant. The payroll department is responsible for the following functions:
●● liaison with taxation authorities to ensure that employer and

employee details are correct and that taxes deducted are paid;
●● receiving tax code notices and applying the correct tax code for
each employee;
●● completing returns to the taxation authorities;
●● receiving timesheets and clock cards;
●● ensuring basic pay, overtime and bonuses are calculated, recorded
and paid and that deductions for taxes and pensions are made;
●● ensuring employees are paid on time, using payment systems
such as BACS or other methods;
●● reconciling payroll accounts;
●● providing advice to employees and the company.
Budgeting
In a larger organization budgeting may be carried out by a budget
accountant. In a medium-sized company it may be undertaken by the
management accountant.
Budgeting is concerned with the financial evaluation of plans and

with reporting against this, normally on a monthly basis. Budgeting
may include the following activities:
●● helping managers prepare and evaluate their plans;

●● preparing departmental budgets and consolidating them into
a company budget;
●● preparing an operating budget and a capital budget;
●● obtaining approval for budgets;
●● preparing reports that compare actual expenditures against
budgets;
●● analysing variances and seeking explanations;
●● liaison with the financial accountant and the treasury manager.
Management accounting
Management accounting is concerned with the analysis and control
of financial information to assist in the day-to-day operations of
an organization. Most medium- to large-sized companies will have
a management accountant responsible for this function who will
report to the financial director. Management accounting includes, but
is not limited to, the following activities:
●● investment opportunity appraisal;

●● cost and revenue estimates;
●● budgeting as described above;
●● analysis and decision making;
●● capital investment decisions;
●● management controls over the efficient use of resources;
●● financial analysis.
Management accounting and financial accounting overlap in that

management accounting reports are often based upon information
derived from the financial accounting records. For example, the ‘actual’
expenditure figures shown in management accounts will be taken from
the financial accounting records. Sometimes financial accounting
and management accounting are integrated. An example of this would
be the fully integrated standard costing system where the financial
accounts are structured in such a way as to provide cost and manage-
ment information directly.
Taxation
Most large companies will have a taxation department dealing with all
tax affairs. In a smaller company this may be handled by the finance
director or possibly the financial accountant.
As well as day-to-day taxation management and reporting, all deci-
sions made by a company will have tax implications and these need to
be identified and built into the decision-making process and financial
plans. Not only does tax have to be accounted for but cash needs to be
made available at the right time to pay it to the authorities. Tax does,
therefore, affect cash planning and budgets.
Tax evasion is illegal and, in addition, most countries also have
anti-avoidance laws. It is the tax department’s responsibility to ensure
that all laws are complied with. A brief list of the tax manager’s duties
includes:
●● tax planning;
●● understanding the taxation implications of decisions, trade and
investments;
●● double-taxation treaties;
●● transfer pricing;
●● direct taxation;
●● company or corporation taxes;
●● profit taxes;
●● income taxes including Pay As You Earn (PAYE);
●● capital gains tax;
●● indirect taxation;
●● VAT, goods and services tax, sales taxes;
●● managing relations with taxation authorities.
There are many aspects of taxation that are open to debate and argu-
ment. This is why it is important to understand the taxation implica-
tions of business plans. Some companies adopt a more aggressive
stance than others when dealing with a taxation authority. Others,
often large multinational companies that value global relationships at
a government level, may want to be seen as responsible tax citizens
and adopt a more conciliatory approach. A large multinational com-
pany will have tax managers, some of whom are accountants and others
who are lawyers specializing in taxation. Counsel’s opinion will also
be sought on aspects of tax law that are unclear.
Treasury and financial planning

Large corporations will have a treasurer with responsibility for the
treasury function. The treasurer will normally report to the financial
director. The treasurer is responsible for the efficient provision, invest-
ment and use of funds. Treasury responsibilities will include:
●● cash management on a day-to-day basis;

●● medium- and long-term cash planning;
●● liquidity risk management to avoid running out of cash;
●● interest rate risk management;
●● foreign exchange risk management and understanding exposures;
●● foreign exchange dealing – buying and selling currency;
●● using derivatives, futures and swaps to help hedge against
exposures;
●● issuing debt;
●● share issuance and capital structure;
●● managing relationships with corporate and business bankers.
Supporting the business strategy

The finance director is a member of the executive team and is respon
sible for providing a financial environment that supports the business
strategy. The right mix of short-term and long-term finance and equity
funds needs to be available to meet the organization’s aspirations and
to provide the organizational agility needed to benefit from future
opportunities. All managers have a primary responsibility to create
value, and a primary responsibility of the finance director is to enable
them to do this. Accordingly, financial strategy must first and fore
most be integrated with the business plan.
Creating value
Within the context of the business plan the finance director has a
responsibility to create value. This can be done through, for example,
obtaining the best possible borrowing rates, cutting/controlling costs,
reducing financial risks, improving debt collection, better cash manage
ment and many other activities that are discussed later in this book.
The ‘mechanics’ of these roles will be explained in more detail in
the following chapters.
Accounting and finance department

relationships
The accounting and finance department manage a number of internal
and external relationships. These are detailed in Figure 2.1 below.
Figure 2.2 shows the organization of a typical finance department.
Figure 2 .1 Accounting and finance department relationships
Taxation
authority
Customers Executive Suppliers

team and Budget
board of holders
Auditors directors
Business-link
type
agencies
Banks
Accounting
and finance
Professional department Companies
institutions house
for Shareholders Employees
standards
Central & Import &
local export
government agencies
Trade
Lawyers FSA
associations
Internal relationships shown as shaded.

Figure 2 . 2 Organization of a typical finance department
Summary
The finance director has overall responsibility for the accounting and
finance department of an organization. He/she is a key member of
an organization’s senior management team and will be involved in all
key decisions in addition to ensuring that day-to-day financial, legal
and statutory requirements are met. The principal duties are: financial
accounting, payroll, budgeting, management accounting, taxation,
treasury and financial management. A primary responsibility is to
ensure that the financial strategy is integrated with the overall business
strategy, that there is adequate finance to support the business strategy
and that the finance department adds value to the company.
19
C h apter T h ree
Accounting
and financial
statements
T he purpose of this chapter is to provide a basic knowledge of

the double entry system and of how accounts are constructed so
as to enable you to understand financial statements and to make better
decisions.
The basis for financial accounting is the double entry system. This
system was first described in a work entitled Summa de arithmetica, geo-
metrica, proportioni et proportionali compiled by the monk Luca Pacioli.
It is a marvellous system that, if mastered, will make your understand-
ing of financial management and business a whole lot easier.
The double entry system, like many good ideas, is very simple and
it is my intention to enable you to grasp the basics that will help you
understand financial statements. As this is a text for non-financial
managers we will not be covering advanced financial accounting or
international accounting standards and regulations. We will focus on
the basics and what is generally accepted accounting practice through-
out the world.
Double entry system and ledgers

The double entry system is so named because it recognizes that every
financial transaction has two aspects: receiving and giving. So, if I were
to receive €200 of cash from a customer I would record both aspects of
the transaction in my accounts. I would show that I had received cash
into my cash account and I would also show that my customer had paid
me and record this in my customer accounts. Details of accounts are kept
in ledgers that, of course, are now computerized. As another example, if
I were to start a business with €100 I would record that the business
now had €100 cash and that it owed me (the proprietor) €100.
So far so good?
Now here comes the tricky bit – the bit where some of you readers
might think I have gone wrong!
To record the above €200 transaction I would make the following entries
in my accounting system:
Debit Cash Account €200

Credit Customer Account €200
Note that I have debited my Cash Account with the €200 received and
that I have credited my Customer Account with the €200 he has given.
This is because under the double entry system you always:
●● Debit the account that receives.

&
●● Credit the account that gives.
Now, I know what you might be thinking: this is different from what
you expected because when you view a bank statement cash received is
always shown on the statement as a credit. It is! But this is because when
the bank receives a deposit from you it will debit its cash account and
credit its customer’s account (you) – just as I have done above. When
you receive your bank statement it is a picture of the bank’s account
with you showing the credit. So, the bank operates the same system
and performs the same entries as I have outlined above. Many people
new to accounts struggle with this at first. However, you need to grasp
this fundamental point before going any further. If you can understand
and accept it the rest will be plain sailing!
Let’s now look at some further examples:
Case 1
If a farmer buys a tractor for €25,000 from a dealer, the initial entries
in the farmer’s accounts will be:
Accounting And Financial Statements 21
Debit Asset (Tractor) €25,000

Credit Dealer €25,000
When the farmer actually pays the dealer, the entries in the farmer’s
accounts will be:
Debit Dealer €25,000
Credit Cash €25,000
Note that after this transaction is posted to the accounts the balance
on the ‘Dealer’ account will be zero. This is because he has now been
paid.
Case 2
If a business sells a service for €5,000 to a customer, the entries in the
businesses accounts will be:
Debit Customer €5,000
Credit Sales €5,000
When the customer actually pays the business the €5,000, the entries
in the businesses accounts will be:
Debit Cash €5,000
Credit Customer €5,000
Note that after this entry the balance on the ‘Customer’ account is zero.
This is because the customer has now paid.
The above are basic examples showing how the double entry system
works. In the example that follows you will see that:
●● Accounts are debited with: assets, services received, expenses, losses.
●● Accounts are credited with: payments made, services rendered,
income and profit.
Example
Now work slowly through the following example showing basic
accounting entries:
Tom, a sole trader, started business on 1 January 2012 as ‘TJ Gardening’.
To start the business he opened a business bank account and paid in
€3,000 as the opening capital of the company. During the year ended
31 December 2012 the following transactions took place:
20/1/12 Purchased plants 20 plants @ €10 each cash €200
15/3/12 Sells 10 plants @ €90 each to Mr Brown €900
14/4/12 Receives cash from Mr Brown €900
16/6/12 Pays rent/rates/services €800
18/8/12 Purchases plant and equipment with cash €300
25/11/12 Charged depreciation* on plant and equipment €100
*Plant and equipment have been used and depreciated in value.
Show all of the above entries in the accounts, take out a trial balance
and prepare financial statements (profit-and-loss account and balance
sheet) as at 31/12/12.
The entries to be posted in the accounts are:
1/1/12 Debit Bank account €3,000

1/1/12 Credit Capital account €3,000
20/1/12 Debit Plants account €200

20/1/12 Credit Bank account €200
15/3/12 Debit Debtor, Mr Brown €900

15/3/12 Credit Sales €900
15/3/12 Debit Cost of sales (10×€10) €100

15/3/12 Credit Plants account €100
14/4/12 Debit Bank account €900

14/4/12 Credit Debtor, Mr Brown €900
16/6/12 Debit Rent/rates/power account €800

18/8/12 Debit Plant and equipment account €300

25/11/12 Debit Depreciation expenses account €100

25/11/12 Credit Depreciation provision account €100
When you have understood the above entries see below how they are
recorded in the accounts – debits on the left and credits on the right:
Debits Credits
Bank 1/1/12 Capital £3,000 20/1/12 Plants £200

Account: account account
14/4/12 Mr £900 16/6/12 Rent/Rates/ £800
Brown 18/8/12 Power £300
Plant and
equipment
Capital 1/1/12 Bank £3,000

Account: account
Plants 20/1/12 Cash £200 15/3/12 Cost of £100

Account: Account sales
Cost of 15/3/12 Plant £100

sales Account
account:
Sales 15/3/12 Mr £900

Account: Brown
Debtors 15/3/12 Sales £900 14/4/12 Bank £900

Account account account
(Mr Brown):
Rent/Rates/ 16/6/12 Bank £800

Power account
Expense
Account:
Plant and 18/8/12 Bank £300

equipment account
account:
Depreciation 25/11/12 Depn. £100

Expenditure provision
Account:
Depreciation 25/11/12 Depn. £100

Provision Expenditure
Account:
Follow the above entries one step at a time. Note that debit entries are
always on the left and credits are on the right. This is the standard form.
Note also that the corresponding entry is shown in each account
description of the transaction. For the sake of simplicity I have not
totalled the above accounts. There are few entries in this example and
it is easy enough to see what the balance values are. For example, the
balance of the cash account is €2,600 debit (cash in the bank).
We will now prepare a trial balance and you can see the balances
of the accounts and this will also prove the arithmetic accuracy.
Trial balance
Trial balance as at 31/12/12
Debit balances Credit balances
Cash €2,600 Capital acount €3,000

Plants acount €100 Sales acount €900
Cost of sale account €100 Depreciation €100
povision
Rent/Rates/Power Exp €800
Plant and equipment €300
account
Depreciation expenses €100
Total debits €4,000 Total credits €4,000
The above trial balance is just a list of balances of all the accounts.
It only provides proof of the arithmetical accuracy of the accounting
entries. We can now use this to prepare the final accounts – a profit-
and-loss account and a balance sheet.
Profit-and-loss account
Sales 900
Cost of sales 100
Gross profit margin 800
Rent/Rates/Power Expense 800
Depreciation expense 100
Net profit/(loss) (100)
Note that the trader has actually made a loss during the first year of
trading. He still has plenty of cash in the bank, but after all costs
including depreciation he has made a loss.
The next stage is to prepare a balance sheet to show the overall
financial position.
Balance sheet
Liabilities:
Capital account 3,000
Profit-and-loss account (100)
Proprietor’s equity 2,900
Assets:
Fixed Assets:
Plant and Equipment 300
Less Depreciation Provision (100) – 200
Current Assets:
Plant stock account 100
Cash account 2,600 – 2,700
Total Assets 2,900
Notes to the accounts:
1 The accounts show a gross profit of €800. However, after expenses

of €900 (€800+€100) the final result was a net loss of €100.
2 The proprietor’s equity has been reduced to €2,900. This is because
the initial equity/capital has been partially offset by the loss of €100
(€3,000–€100). Had the trader made a profit then his equity would
have increased.
3 Note that proprietor’s equity/capital is shown as a liability. This is

because the business unit has a liability to the proprietor for the
initial capital injected plus any retained profits or, in this case,
less any losses.
4 Note that the value of fixed assets has been reduced by the
depreciation provision.
We have shown above a simple profit-and-loss account and a balance

sheet. A third type of financial statement you might see is a funds
statement. This is simply a statement that shows where funds have
been sourced from and how they have been applied. An example is
given below.
The basic accounting equation is:
Equity = Assets less External Liabilities

(external liabilities include items such as creditors and bank loans)
In our case €2,900 = €2,900 – €0 (there being no external liabilities)
Classification of assets and liabilities

When reading financial statements you will note that assets and liabil
ities are classified into various categories. The usual classifications are
listed below.
Fixed assets
These include items such as machinery, equipment, vehicles, buildings,
furniture and other items of a permanent nature that will not be con-
sumed within the accounting period. Of course, an asset may be used
in the accounting period and may depreciate in value. This is why we
allow for depreciation and reduce the value of an asset.
Current assets
These include cash or items that can be readily converted into cash such
as debts or stock.
Assets are normally shown in the balance sheet at cost less any
depreciation. It is not prudent to show them at a higher value that
has/may not be realized. For example, stocks are normally shown at
the lower of cost or net realizable value.
Long-term liabilities
These are liabilities (amounts owing by the business) that are not due
for repayment within one year from the accounting date. Examples are
equity and term loans.
Current liabilities
These are liabilities that are repayable immediately or within one year
of the accounting date. Examples are bank overdrafts (repayable on
demand) and trade creditors.
Summary of profit-and-loss account and

balance sheet
The above example of a profit-and-loss account and balance sheet
together with their underlying accounting entries is highly simplified
and is designed to help your understanding of financial statements.
We will cover the analysis of financial statements in the next chapter.
Profit-and-loss accounts and balance sheets are the basic financial
statements. There is another statement that helps users of financial state
ments understand how funds have been sourced and applied. This is
called a Source and Application of Funds Statement and is described
briefly below.
Source and application of funds

statements
The purpose of these statements is to show where a company has
sourced its funds from and how it has applied them. Since funds
statements are only concerned with items involving the movement
of funds, depreciation is added back to net profits. This is best explained

by an example shown in the table below.
2012 2011
£m £m
Sources of funds:
Profit before tax 40.5 10.5
Depreciation (add back) 30.5 28.5
71.0 39.0
Shares issued for cash 10.0 10.0

Proceeds from sale of assets 12.0 11.0
93.0 60.0
Application of funds:
Dividends paid 5.0 5.0
Taxes paid 15.0 10.0
Movement in working capital 5.0 5.0
25.0 20.0
Movement in borrowing: 68.0 40.0
93.0 60.0
This statement shows that during 2012 the company sourced €71.0m
of funds from profits, €10.0m from a share issue and a further €12.0 mil-
lion from selling off assets. This totalled €93m and this sum was applied
to paying dividends and taxes, and to changes in working capital and
borrowing balances. Some investors find this statement useful whilst
others simply read the P&L and balance sheet. It is a useful statement
in that it shows at a glance where funds have come from and where
they have been used.
Principles: matching, accruals,

deferrals, consistency, conservatism,
accounting periods, materiality,
going-concern concept, form and
substance, full disclosure and clarity
There are some basic principles that need to be adhered to when prepar-
ing accounts. Some of the more fundamental ones are listed below.
Matching
This principle requires that expenditure of one period is matched with
income of the same period.
An invoice may be paid in one financial year that relates to services
spread over several years. For example an annual insurance premium
paid on 30 September 2011 might relate to cover for three months in
2011 and nine months in 2012. It would be entirely wrong to charge all
of the 2011 year with the total amount paid on 30 September 2011. Some
of the charge should be deferred to the following year and matched
with income of that year.
This is best explained by means of an example:
During the year ended 31 December 2013 sales were €30,000 and the
cost of those sales was €18,000.
Rent was paid annually in advance on 30 June and was €4,000 in
2012 and €6,000 in 2013. What is the net profit for the year ended
31 December 2013?
Sales €30,000
Cost of sales €18,000
Gross profit €12,000
Rent 1 January 2013 to 30 June 2013 is €4,000/2 €2,000
Rent 1 July 2013 to 31 December 2013 is €6,000/2 €3,000
Net profit €7,000

Note that the rent applicable to 2013 and charged in the accounts was
€5,000 and not the €6,000 that was actually paid. €2,000 of the rent
actually paid in 2012 related to 2013 and only €3,000 of the rent paid in
2013 actually related to 2013. This is the concept of matching income
and expenditure in the same accounting period. It is achieved through
the accounting processes of accruals and deferrals, which are explained
below.
Accruals
When a cost has been incurred but the invoice for it has not been
received it will be necessary to accrue for the cost in the accounting
period it was incurred. For example if electricity is invoiced quarterly in
arrears then it will be necessary to read the amount of electricity used
and estimate the value of this. An entry is made in the accounts to
recognize this. For example, if it is estimated that €500 of electricity
has been used but not invoiced then the accounting entry in the period
it was used would be:
Debit Electricity expenditure €500

Credit Accrued creditors €500
This entry will ensure that the cost is taken up in the correct period
and matched with income of that same period. It will also reflect an
accrued liability in the balance sheet.
In the subsequent period when the actual invoice is received (let’s
assume it was for €510) then the entry in the accounts would be:
Debit Accrued creditors €500

Debit Electricity expenditure €10
Credit Creditors €510
The accrued creditors account will now have a zero balance, electricity
expenditure for the new period will only be charged with €10 (being the
underestimate) and creditors will show a balance of €510, as the actual
amount owing to the electricity supply company.
Deferrals
Sometimes costs are paid in advance. For example, insurance premiums
are often paid annually in advance. If this is the case then the amount
paid in advance will need to be deferred to the next period in order to

ensure that costs and income are matched.
Consistency
Transactions and valuations need to be treated in a consistent way in
order to avoid confusing fluctuations in profit. A good example of this
is in the case of stock valuations, where a change in the method of
valuation such as the amount of overheads absorbed into stock/work
in progress can have a dramatic effect on the level of profitability
reported. For this reason valuation methods need to be consistently
applied from one accounting period to the next. If it is necessary to
change a method of valuation (for example) then the effect of this
change must be clearly reported.
Conservatism
This means taking a cautious approach in calculating the level of pro
fits. Bring in all costs as soon as they are incurred and recognized. Only
recognize income when it is certain.
Accounting periods
Divide the business reporting up into consistent accounting periods,
usually 12-month periods for annual accounts and six-month periods
for interim accounts. Don’t change periods so that comparisons become
confusing. If it is essential to change periods, bring together different
periods or report different periods, then full explanations need to be
given and proper comparative statements need to be prepared. This
may happen for a number of reasons such as a merger or a start up, and
as a reader of accounts you will need to be aware that you will need to
compare like with like periods.
Materiality
Don’t worry too much if accounting mistakes are so small as to have no
material effect on the overall impression that the accounts give. Of course,
all mistakes need to be rectified but as a reader of financial statements

you need to be aware of what is and is not material. A misstatement or
omission is said to be material if it influences the overall view pro-
vided in the accounts.
Going-concern concept
The value of a business will depend upon whether or not it is considered
to be a continuing going concern. A business that is folding will have
a break-up value that is different from its going-concern value. This is
an important concept in many ways. For example, the directors of a
company must not take on more debt once they are aware that the
company has ceased to be a going concern and will cease trading.
Allowing a company to take on more debt when knowing that it is
no longer a going concern is fraud.
Form and substance

This principle requires that financial statements should show the true
view and not just the strict legal view.
Full disclosure and clarity

All relevant facts need to be disclosed in a clear way. Important facts
must not be omitted and financial statements must not provide a mass
of confusing information that hides important items that need to be
disclosed.
These basic accounting principles have been applied to many types
of business transaction and have formed the basis of detailed account-
ing standards that are published internationally. A detailed analysis of
these accounting standards is beyond the scope of this book. However,
if you are interested in finding out more, simply search for ‘accounting
standards’ on your web browser and you will find that standards have
been written to cover many accounting issues. The basic accounting
principles discussed above have been incorporated into what are
known as GAAP (Generally Accepted Accounting Principles).
Accounting and the environment

Accountants are increasingly recognizing their role in helping to
provide information that enables people to understand the broader
environmental and social consequences of organizational activity.
Sustainability accounting is at varying stages of development through-
out the world and there are developing tools that attempt to incorporate
sustainability considerations into organizational decision making.
Increasingly you may notice sustainability statements within conven-
tional financial statements. These may include reports on:
●● carbon emissions;
●● social responsibility;
●● environmental impacts;
●● sustainability of operations.
The purpose of theses reports is to consider the impact of organiza-

tional activity on the broader external environment, economy and
society.
Neuroscience and accounting

When you start to think in accounting terms you might find that
business life becomes easier and more comfortable! Strange as it might
seem, some academics believe that accounting may have evolved from
the way the brain thinks about exchange opportunities. Emerging
research suggests that the evolution of accounting practice can be
traced to neuronal processes.
The assumption is that human economies are built on reciprocal
exchanges and accounting concepts such as double entry, matching
and conservatism are believed to be in harmony with the way the brain
functions. An example is the concept of conservatism where gains are
not anticipated but losses are. Neuroscience research suggests that the
brain reacts differently to gains and losses. Brain scans have shown
that areas of the brain that are related to reward and conflict resolution
are activated more by losses than by gains. The findings show that
subjects require 1.97 units of gain to compensate for 1 unit of loss.
These findings were published in the Chartered Accountants Journal
(NZ) in May 2011 in an article by Steven Cahan, FCA. The article might
help explain why accounting makes business easier. The article is

based upon work published by J de Quervain, U Fishbacher, V Treyer,
M Schellammer, U Schyder, A Buck, E Fehr, S Basu, J Dickhaut, G Hecht,
K Towry, G Waymire, M Kirk, F Castelli, F Happe, U Frith, C Frith,
K McCabe, S Toms, C Fox, C Trespel and R Poldrack.
Summary
As a non-financial manager it is unlikely that you will need a detailed
technical knowledge of accounting or of the double entry system. It is
most likely that you will be reading completed financial statements
or attending to your departmental budget statements. However, having
a basic knowledge of the double entry system and of how accounts are
constructed will enable you to understand financial statements and
to make better decisions.
In this chapter we have explained the basics of how accounts are
prepared, including accounting entries, trial balances, profit-and-loss
accounts and balance sheets. We have completed the chapter with an
overview of important accounting principles.
In the chapters that follow we will learn how to interpret financial
statements and manage finances. Underlying this will be the basics
covered in this chapter, so it is important that you have understood
it. Accountancy is, perhaps, like riding a bike in that it is easier learned
than taught! Practice makes perfect and if you are having any doubts
go through the chapter again and work through the examples.
This short chapter is based upon the Generally Accepted Accounting
Principles of the UK. To bring countries into line with each other, inter-
national financial reporting standards have been developed. Details
of these can now be searched on the web for those readers that have
an interest.
35
C h apter F o ur
Analysis and
financial ratios
I n the previous chapter we covered the basics of accounts prepara-

tion. We will now examine completed financial statements and show
how they can be used to analyse performance. In this chapter we will
cover the essential ratios that are used to provide a guide to business
performance.
Below are examples of a typical profit-and-loss account (Table 4.1)
and balance sheet (Table 4.2) for a medium-sized company. We will use
these financial statements for further analysis. Read the accounts and
become familiar with this layout. A full set of published accounts will
contain considerably more information. However, the basic principles
are the same. I have kept things simple so as not to confuse you with
too much data.
We will now use these accounts to undertake a ratio analysis and
compare the results of 2013 against 2012 in order to get a better under-
standing of how the company has performed. Shareholders, future
investors, lenders and other stakeholders will use published accounts
and ratio analysis to help make their decisions. Of course, the infor
mation in year-end accounts is largely out of date and they will also refer
to interim accounts, management accounts and other information.
Ta b le 4 .1 Profit and loss account for X Ltd
2013 2012
£m £m
Sales 650 700
Cost of sales (materials) 300 340
Gross profit 350 (54%) 360 (51%)
Expenses 100 120
Profit before interest and taxation 250 240
Interest 30 40
Profit before taxation 220 200
Taxation 66 60
Profit after taxation 154 140
Dividends paid to shareholders 40 50
Profit retained 114 90
NOTE: Gross profit is sometimes referred to as gross margin. It is also often expressed as
a percentage of sales and called the gross profit percentage or gross margin percentage.
In our example for 2013 it is 54 per cent (350 as a percentage of 650).
Ratio analysis
Ratio analysis is a way of gaining a better understanding of financial
performance. Ratios enable comparisons between periods and with
other companies. They enable us to track efficiency and profitability.
They can be used to reveal trends in profitability, efficiency, gearing,
liquidity and returns on investment. In this chapter we will explain
some of the more commonly used and, therefore, useful financial
ratios.
Analysis And Financial Ratios 37
Ta b le 4 . 2 Balance sheet on X Ltd
2013 2012
£m £m
Fixed assets:
Plant & equipment (after depreciation) 150 160
Current assets:
Stock 200 250
Debtors 150 170
Cash at bank 50 60
Current liabilities:
Trade creditors (160) (180)
Bank overdraft (100) (110)
Net current assets: 140 190
Total fixed and net current assets: 290 350
Capital & reserves:

Called up share capital 150 150
Retained profits 140 26
Term loan – 174
290 350
Note that the company has been able to repay the term loan of £174m during the year by
retaining profits of £114m and reducing total fixed and net current assets by £60m.
Gross profit percentage

This ratio is sometimes called the gross margin. It is probably the most
widely used and quoted ratio. It shows the ratio of gross profit to sales
expressed as a percentage.
In our example above for the year 2013 the gross profit was €350m
and sales were €650m.
The gross profit percentage is:
Gross profit 100

×
Sales 1
350m 100
×
650m 1
Gross profit percentage = 54%
This is an improvement on the previous year when the gross profit

percentage was 51 per cent. An analyst would compare these gross
profit percentages with those achieved in similar businesses.
The gross profit percentage is also a useful measure to compare the
contribution that individual product sales make towards a company’s
overall fixed costs.
Net profit percentage

This ratio compares net profit to sales and is calculated as follows:
Net profit 100

×
Sales 1
In the above example for X Ltd the net profit (after tax and interest)
ratio for 2013 is:
154 100
×
650 1
Net profit percentage = 24 per cent
This ratio indicates that the net profit after interest and taxation is
24 per cent of sales.
Another net profit ratio often quoted by analysts is Net Profit Before
Interest & Taxation (NBIT).
There are a number of variations used by analysts when quoting
net profit ratios and you need to be sure that you understand what
an analyst has used so that you can compare like with like.
Current ratio
This ratio measures the solvency of a business by comparing current
assets with current liabilities. It is normally shown just as a single
figure.
Current assets
Current ratio =
Current liabilities
Table 4.3 measures the ratio using figures from the balance sheet of X
Ltd for 2013. Since this is a positive number it indicates that on a going-
concern basis the company is solvent. However, the company does have
to collect its debts and convert its stock into sales and ultimately cash
in order to be able to pay its creditors. Remember also that bank over-
drafts are repayable on demand. There is a stricter test of a company’s
actual liquidity rather than just its solvency; this is called the liquidity
ratio, which is explained below.
Ta b le 4 . 3 Ratios for X Ltd
Stock and work in progress 200

Debtors 150
Cash at bank 50
Total current assets 400
Trade creditors (160)
Bank overdraft (100)
Total current liabilities (260)
Current ratio = 400
260
Current ratio = 1.54
Liquidity ratio
The liquidity ratio indicates a company’s ability to repay its debts as
they fall due. It is usually expressed as a single figure. A figure that is
greater than ‘1’ would indicate that the company is liquid. A ratio of
less than ‘1’ would indicate that the company might struggle to pay
debts when they are due.
Liquid assets
Liquidity ratio =
Current liabilities
Liquid assets are cash and debtors. Stock is not a liquid asset since it
still has to be converted into a sale.
In our example for X Ltd the liquidity ratio for 2013 is:
150 + 50
Liquidity ratio =
260
Since this liquidity ratio is less than one, it might indicate that the
company could have problems in repaying debts as they fall due. It
will certainly need to ensure that it collects cash from its own debtors
before it can pay all of its creditors. Although this company appears to
be profitable it does need to ensure that it does not ‘overtrade’ and find
itself without enough liquidity. Perhaps it needs to convert some of
its stock more quickly into sales and reduce stock levels even further.
This ratio is useful in highlighting areas for management attention.
Stock-turnover ratio
This ratio measures how fast stock moves through a business. Holding
on to stock is expensive, since there is an interest cost on funds invested
in stock and there are also holding costs such as warehousing and
storage. Also, stock may degrade if held for too long. Conversely, it might
be beneficial to buy stocks early at a time of rising prices and also to take
advantage of any quantity discounts by purchasing greater quantities
than are immediately needed by the production department. If stock
levels are kept too low then there might be a chance of not having mate-
rial required to meet production schedules or to make up customer
orders. There is an optimal level of stock that needs to be held and
this requires careful calculation.
The stock-turnover ratio is just a simple measure of how quickly

stock moves and a high stock-turnover number would generally be
considered healthy since fewer funds were being tied up in stock. Be
aware that stock-turnover ratios calculated using year-end figures can
be concealing significant movements during the accounting period.
In other words, the year-end value of stock may not reflect average
stock values. This consideration also applies to other ratios that have
been calculated using year-end values. The calculation for stock turn
over usually uses average stock values.
Cost of sales (material costs only)
Stock turnover =
Average stock values
The average stock value can be calculated in the case of X Ltd by using
the opening and closing values of stock and dividing them by 2.
200 + 250
Average stock =
2
Average stock = 225
300 (cost of sales, materials)

Stock turnover =
225 (material cost)
Stock turnover = 1.33 times p.a.
This is a slow rate of stock turnover. It may well be necessary in this

type of business. However, it is not good for liquidity, as indicated in
the liquidity ratio previously mentioned. It means that the company
will need to ensure it has sufficient funds to invest in stock and is
aware of the significant stock holding cost.
Debtors’ days
Debtors’ days is an indication of how good a company is at collecting
debts from its customers and how much trade credit it allows. The fewer
days the better.
The calculation for debtor days is:
Debtors × 365
Debtors’ days =
Sales
In the case of X Ltd for 2013:
150 × 365
Debtors’ days =
650
Debtors’ days = 84 days
Again, this would not generally be considered a good sign since 84

days is slow. Of course, it depends upon the business. For example a
car repair business may have debtors’ days of just five whilst an under-
taker may consider 90 days to be normal.
Average balances can be used to calculate debtors’ days. Also, it is
often more helpful to show the value of debtors falling into different
period categories, such as 0–30 days, 31–60 days, 61–90 days and over
90 days.
It can now be seen that the poor liquidity ratio of company X Ltd
is mainly caused by poor debt collection and a poor stock turnover as
indicated in the ratios.
Fixed assets turnover ratio

This measures the efficiency of fixed asset usage by comparing fixed
assets with sales. It is calculated as follows:
Sales turnover
Fixed assets turnover ratio =
Fixed assets
In the case of X Ltd this will be:
650
Fixed assets turnover ratio =
150
Fixed assets turnover ratio = 4 times p.a.
This is one ratio that varies enormously depending on the type of

business. For example a manufacturing company with heavy plant
and equipment may have a greater fixed asset value than a marketing
agency with a similar sales turnover. Again, it is useful to use average
fixed asset values rather than end-of-year balances.
Gearing ratio
This important ratio shows the level of a company’s external borrow-
ing compared with its equity (shareholders’ funds). A company is said
to be highly geared when it has a high level of external borrowing
compared to equity. One way of expressing gearing is as a simple
percentage as follows:
External loans
Gearing =
Internal equity
Assuming a company has bank loans outstanding of €700,000 and

shareholders’ funds (called up capital and retained earnings) of
€3,500,000 then the gearing ratio will be:
700,000
Gearing ratio =
3,500,000
Gearing ratio = 20 per cent
This result will generally be considered as healthy and as a lowly geared

company. As with other ratios it all depends on the type of business.
In our example we have shown gearing as the ratio of loans to equity.
Some analysts may show it other ways. For example, they may show
gearing as the ratio of loan capital to total capital (loans + equity). When
comparing gearing ratios, always be sure that you are comparing ratios
using the same methods/formulas. Gearing may also be calculated
using market values. For the purpose of clarity I am sticking with the
basic method that demonstrates the principle of gearing.
Return on capital employed ratio

The return on equity ratio is often referred to as ROCE. This ratio
compares profits with the capital employed to earn the profits.
Profit before interest & tax

ROCE per cent =
Capital employed
There are various definitions for capital employed. Often it is defined

as shareholders’ funds plus term loans.
Example: If a company makes a profit before interest and tax of €250,000

when shareholders’ funds were €500,000 and term loans were €100,000
then the ROCE would be:
250,000
ROCE =
500,000 + 100,000
ROCE = 42 per cent
This means that for every €1 of capital employed in the company there
is a profit (before interest and tax) of €0.42
Return on equity: earnings per share

The return on equity (ROE) ratio shows the rate of return achieved by
the equity investors in a company. It is expressed as the percentage
of profit before interest and tax (PBIT) is to equity.
PBIT
ROE =
Equity
In the case of X Ltd for the year ended 2013 this would be:
250
ROE =
290
ROE = 86 per cent
Earnings per share (EPS)

This is the amount of earnings attributable to each equity share. For
example, if a company has paid up capital of 100,000 ordinary shares
of €5 and makes a net profit after tax of €50,000 then the earnings
per share will equal 50 cents per share. Simply divide the net profit
after tax by the number of shares.
Net profit after tax

Earnings per share (EPS) =
Number of ordinary shares
€50,000
EPS =
100,000
EPS = €0.50 per share
The price–earnings ratio (PER)

The purpose of this ratio is to compare the actual earnings per share
with the market price of one ordinary share.
Market price of ordinary share

PER =
Earnings per share (EPS)
Assuming the market price of the above shares is €6 and that the earn-
ings per share are 50 cents then the price–earnings ratio would be:
6.00
PER =
0.50
PER = 12
The PER shows the relationship between return and market price and
is, therefore, of importance to investors and the market.
Earnings–yield
This is another way of expressing the price–earnings ratio (PER).
EPS 100
Earnings–yield = ×
Share price 1
Using the above figures:
0.50 100
Earnings–yield = ×
6.00 1
Earnings–yield = 8.3 per cent
Dividend cover
This shows us how many times a dividend could have been paid from
earnings. It is measured as a number and the higher the number the
better the cover.
Earnings per share

Dividend cover =
Dividend per share
If a company has earnings per share of 50 cents and pays a dividend of

10 cents on each share then the dividend cover will be five times.
50
Dividend cover =
10
Dividend cover = 5 times
Dividend yield
The dividend yield shows the dividend return against the market value
of an investment.
Dividend 100
Dividend yield = ×
Share price 1
If a dividend of 10 cents is paid when the market price of a share is €6,

the dividend yield will be:
0.10 100
Dividend yield = ×
6.00 1
Dividend yield = 1.7 per cent
Summary
Ratio analysis is a useful tool. It draws attention to areas that need fur-
ther examination and explanations. You will have noticed that in this
chapter I have used words such as ‘generally’, ‘usually’ and ‘depending’.
This is because we need to take care not to jump to conclusions when
using ratio analysis. It is a tool to guide our questioning and for further
analysis. Don’t jump in and make the wrong diagnosis!
You may also have noticed that ratios are connected to each other.
Some professional analysts like to link ratios together using a method
called the Du Pont system. The value of this is that, given only a certain
amount of information, it might be possible to obtain a fuller picture
by deduction. The detail of this method is beyond the scope of this text
but if you are interested then you can explore this initially on the web.
In this chapter we have covered the essential ratios that are used to
provide a guide to business performance. At this stage you should know:
●● how accounts are prepared using the double entry system;

●● understand the basic layout of a profit-and-loss account and
balance sheet;
●● be able to analyse accounts and ask pertinent questions using ratio
analysis as a base.
Ratio analysis can become addictive, in that once you have become
proficient you might find yourself comparing and analysing accounts
whenever they are published. This is good practice and will enable you
to make comparisons between companies and seek answers. For ex
ample, if you notice that two companies selling the same product have
very different gross margins, ask why this should be. Is there a differ-
ence in scale of operations? Do the companies operate in different
markets? Is there a difference in the quality of what appear to be similar
products? Is one company more efficient than the other? Is there a
difference in brand strength? This type of approach will enable you to
gain a better understanding of the industry sector and help you make
better executive decisions.
48
C h apter F i v e
Planning and
budgeting
I n this chapter we will explain how departmental budgets are prepared

from plans and how performance against them is monitored. A
budget should be the financial evaluation of a plan. Accordingly the
budget process follows on from an initial business plan. It is also part
of a planning process because once the financial consequences of a
plan of action are known the plan may need to be revised.
The planning and budgeting process shown in Figure 5.1 demon-
strates how budgeting needs to be integrated with the planning process.
As far as possible budgets should be zero-based. Zero-based budgets
(ZBB) assume that each year the budget holder starts from scratch and
has to justify each item of expenditure to support the operational strat-
egy, key tasks and goals. Some budgets will be dependent upon other
budgets. For example, a production budget may be dependent upon a
sales budget. A budget for new plant and equipment (a capital budget)
might be dependent upon the requirements of production. Each busi-
ness will have its own budgeting hierarchy and budget dependencies.
However, typical planning and budgeting dependencies are shown in
Figure 5.2.
Planning And Budgeting 49
The planning and budgeting process

Figure 5 .1 A planning and budgeting process
This illustration shows how certain budgets depend upon the comple-
tion of other budgets and that all budgets must support the overall
organizational goals and operational strategy. The marketing plan and
strategy will help kick off the sales budget, which in turn will form a
basis for a production budget and a debtors budget. The production
budget will help budget for creditors and stocks, and also identify
plant and equipment (capital budget). This will form the budget for
depreciation and also help identify any long-term funding. Departmental
overhead budgets to support sales and production will be completed
and budgets that affect cash flow will feed into the cash budget. Budgets
affecting the profit-and-loss and balance sheet budgets will help the
Figure 5 . 2 Budget dependencies
accountant complete a forecast financial position and this will then

be fed back into the high-level planning process to see if the evaluated
plans (budgets) are feasible. Plans and budgets are continually adjusted
by budget holders and executive teams as new information comes to
light and this is why a budgeting process will usually take some months
to complete.
Much of what we have discussed so far will not be the responsibility
of the non-financial manager but will be undertaken by the accountant
or financial director. However, having an understanding of the whole
process will enable you to get a better understanding of your company’s
planning and budgeting cycle.
Departmental budgets and variance

analysis
Possibly of more importance to you will be your own departmental
budget for operating costs and for capital equipment. Operating costs
are items such as salaries, rent, power, stationery, advertising, travel
and accommodation, whilst capital equipment costs are for fixed assets
such as plant, equipment, vehicles and furniture.
The first stage in a departmental budget is to estimate what resources
your department needs to achieve the goals and key tasks that have
been agreed as part of the overall planning process. In doing this you
might want to consider what was spent in the previous year in order
to get a feel for the cost of certain items. However, you should most
definitely not simply take last year’s actual costs and repeat them as
the current year budget because this would not reflect zero-based
budgeting! An allowance must also be made for inflation.
Key budgets: sales, production,

materials, labour, overheads, capital
A departmental work sheet for the finance department’s operating
budget could look like the one shown in Table 5.1.
Note that each item in the budget is related to a key task. Key tasks
flow from the operational strategy and are usually given numbers. For
example, Key Task Number 3 could be: ‘to meet company statutory and
legal obligations’. Some companies may call them key tasks but use some
other term. The point here is to remember that you will need to justify
your expenditure and link it back to the overall organizational plan.
Your accountant should prepare a working sheet that helps you do this.
The 2012 column is for the previous year and is used as a guide only,
to see if costs are reasonable for undertaking a similar key task. It can
also be helpful to ensure that items are not omitted.
The accountant will feed your figures into the overall consolidated
company budgets that show overall salaries, stationery costs and so
on. S/he should also consolidate the costs of undertaking key tasks.
The cost of achieving Key Task 3 (meet company statutory and legal
obligations) is €263K. The question should then be asked as to whether
Ta b le 5 .1 Finance department budget for 2013
2012 2013 Key task

Resource €000s €000s Reference Comments
Salaries 210 218 3 Inflationary pay

increase 4 per cent
National insurance 11 12 3 Budget increase
Training 20 5 2 Reduction due to

staff retention
Stationery 5 3 3 New supplier
Travel 20 5 4 Branch closure

requires fewer trips
Recruitment 30 5 3 Expected
costs staff retention
Entertainment 2 0 3 Not required
Accounting 0 8 3 New software required

software at current prices
Share of 16 17 3 Inflation increase

overheads 4 per cent
Total 314 273
this task could be outsourced to a professional firm at a lower cost. The

costs of all key tasks should be calculated and compared with typical
outsourced costs.
Some departments will require additional capital equipment. This
is prepared on a different form from operating expenditure. A capital
budget relates to the purchase of new fixed assets. Capital costs for fixed
assets are not consumed within the budget year but may span many
years. For example, a car might be used in the business for five years.
Typical items of capital expenditure are: plant and equipment, vehicles,
furniture and fittings, buildings, improvement (not repairs) to existing
assets and large main-frame-type computer installations. Smaller
computers are often assumed to be written off in the year of purchase

and are treated as operating expenditure rather then capital.
Capital budgets will have to be justified in that they must support
the overall organizational goals. It may be that new plant is required for
a new opportunity that has been identified in the plan or that there is
an opportunity to improve efficiency. The planning process should
recognize an opportunity, which will then be considered by the appro-
priate operating department. It will then be evaluated and a decision
made as to whether to proceed or not. Capital expenditure will also
have specific funding implications and additional long-term funds
will need to be found.
Capital budget process:

●● recognition of an opportunity;
●● link with overall corporate goals;
●● initial costings;
●● identification of financial benefits;
●● evaluation, net present value, payback etc;
●● identification of alternatives;
●● proposal;
●● decision.
Once the decision has been made to undertake the capital project the
department responsible should submit details to the finance depart-
ment as follows:
2013 Capital expenditure budget Production Department
Description Expected life Cost Month

of asset in years (€000s)
Cutting machine 5 50 July
Delivery van 6 30 August
From the above return the accountant will be able to arrange suitable
long-term funds and also calculate the amount of depreciation to charge
into the operating expenditure budget. S/he will also ensure that ap
propriate taxation allowances are claimed for the annual allowable
element of the capital expenditure. In some countries these are called

capital allowances. We will explore capital budgets in some detail later
in this chapter.
Reporting of actual expenditure against budget

Table 5.2 is an example of a year-to-date budget v actual expenditure
report in €000s.
Ta b le 5 . 2 Example of a year-to-date budget v actual expenditure

report in €000s
YTD YTD Total Additional

Resources Budget Actual Variance Rate Outlay Timing
Salaries 250 240 10 10
Travel 30 35 (5) (5)
Entertainment 10 5 5 5
Stationery 20 25 (5) (5)
Training 30 40 (10) (5) (5)
Allocated 70 70 0
overheads
Totals 410 415 (5) (10) 0 5
NOTES:
1 Year-to-date (YTD) figures are shown only. This is generally the most informative level at
which to report. A separate report can be prepared to show current month values can
also be prepared if required.
2 A report similar to this will be prepared for each department.
3 The total variance is reported with adverse variances shown in brackets.
4 The analysis of the total variance can be explained in three columns, rate, additional
outlay and timing. These should be completed by the budget holder.
5 Rate = a change in the rate (price) from that anticipated in the budget. For example, the
budget may have assumed a 3% increase in training fees when in fact they increased by
10%.
6 Additional outlay = purchasing more (or less if favourable) of a resource but at the same
price.
7 Timing = the expenditure is earlier or later than expected.
Example:
Budget is for 10 rolls of paper @ €5 per roll €50

Actual is 12 rolls of paper @ €4 per roll €48
Total Variance is €2 Favourable
Due to:
Additional Outlay – 2 rolls @ €5 €10 Adverse
Rate – 12 rolls @ (€4–€5) €12 Favourable
Total Variance is €2 Favourable
Most variances can be explained in the above categories of rate, addi-

tional outlay and timing. It is helpful if budget holders can use this
discipline so that a consolidated variance analysis can be prepared.
Budget holders will normally provide comments for the variances in
addition to the analysis classifications.
Some key departmental budgets

Most organizations will require the managers of each department (the
budget holders) to produce a budget. Budget holders should be respon-
sible for the expenditure that they can control. Once their budget has
been approved they will be responsible for controlling expenditure
against their budget and this will be done at the point of commitment,
assisted by periodic reporting of actual against budgeted expenditure.
Key budgets in most organizations are:
●● sales revenue budget;

●● production budget;
●● materials budget;
●● labour budget;
●● overhead budgets;
●● capital budget;
●● sales budget.
The sales budget is one of the key budgets in an organization because

most other departmental budgets depend upon and support its require-
ments. For example, the production and transportation budget will
depend on how much product is to be sold and delivered.
The sales budget will show volumes and prices for each product
to be sold. The volume forecast to be sold will depend upon demand
and the ability to compete and fulfil, and the price will depend upon
competitive factors, supply and demand.
When preparing a sales budget the sales director will take account of
the following factors:
●● the value of organizational growth required;

●● the ability of the organization to manufacture and deliver;
●● production capacity ceilings;
●● demand for products and services;
●● pricing;
●● market trends and future direction;
●● competition both existing and potential;
●● organizational limiting factors;
●● channels to market;
●● distribution and operational strategies;
●● marketing strategies;
●● sales force ability and resources;
●● advertising budget.
The price of a product is set by the market. In an efficient market it will

be set by the interaction of supply and demand. Supply will be affected
by competitors offering the same or alternative products. Demand will
be affected by the need for and ability to purchase a product in a market.
The sales director will work closely with the marketing director to deter-
mine both price and volume budgets. Setting a sales budget requires an
in-depth understanding of the market and competition.
An example of a sales budget for a company selling rigid inflatable
boats is given in Table 5.3.
Ta b le 5 . 3 Sales budget 2013
Product/ Forecast Unit price Sales revenue

model volumes (€) (€)
3 metre 500 800 400,000

4 metre 300 1,000 300,000
5 metre 100 2,000 200,000
6 metre 50 5,000 250,000
Total 1,150,000
Before a sales budget is finally agreed a reality check is essential, since

there is no room for reckless optimism. This is because so many other
things ‘hang off’ the sales budget. Production capacity, sales force
recruitment, advertising budgets and capital budgets are just a few of
the commitments that might depend on sales budget accuracy. A com-
pany could get into serious difficulty by getting the sales budget wrong.
For example, one sales manager was optimistic that sales indications
from an overseas agent were realistic! They were but they would end
up in an existing fulfilled territory, resulting in no additional sales.
A few final reality checks might include:
●● What is the basis for the volume assumptions?

●● Is there production capacity to meet the forecast sales volumes?
●● Do forecast sales fit with the company’s overall plans?
●● Is the demand real?
●● Are growth figures real?
●● Are territory/volume assumptions correct?
●● Have we correctly analysed the competition?
●● Are prices realistic?
●● Can the marketing department really provide the promotion
required?
●● How accurate has the sales director been in the past with sales
forecasts?
When the sales budget has been agreed a company can proceed to
prepare a production budget.
Production volume budget

The production volume budget will determine the production hours
required to produce the volumes of products required in the sales
budget taking into account any opening and closing stocks. An example
is shown in Table 5.4.
To meet the sales budget and the required stock level will require
the building of 980 units. We now calculate production hours and
also consider what effect this will have on plant capacity. To do this
we will prepare a plant utilization budget (Table 5.5). As the table shows,
we have identified a limiting factor. The assembly plant has a capacity
shortage of 120 hours. A decision will now be made. Either increase
plant capacity (which will have an effect on the capital budget and on
Ta b le 5 . 4 Production budget
Product/ Forecast Opening Closing Production

model volumes stock stock required
3 metre 500 0 10 510

4 metre 300 20 20 300
5 metre 100 5 15 110
6 metre 50 2 12 60
Total production 980

required
Ta b le 5 . 5 Plant utilization budget – assembly department
Product Production Assembly Assembly

model volume unit hours hours
3 metre 510 8 4,080

4 metre 300 10 3,000
5 metre 110 12 1,320
6 metre 60 12 720
Total assembly 9,120

hours
Assembly plant 9,000
capacity
Capacity shortage (120)
the cash budget) or simply do not fulfil the sale budget volumes. This is
an example of the iterative process that is part of budgeting, and also an
example of how the sales budget affects other budgets.
There will, of course, be many stages in the production of this pro
duct. We have just considered the assembly department. Other depart-
ments might include mouldings, painting and testing, each of which
will have its own limiting factors.
Now that we have worked out the number of hours required in the
assembly department we can prepare a direct labour budget and a direct
materials budget.
Direct labour budget

The direct labour budget takes the required labour hours from the
production budget and calculates the cost of labour using standard
and overtime labour rates and the number of employees required.
Direct labour budget for assembly 2013

The assembly process requires 9,120 assembly hours and this can
be performed by five men working 40 hours per week plus a little
overtime.
Assuming labour rates are €12 per hour for normal time, €18 per hour
for overtime and that a standard working week is 40 hours over 45
weeks per year, the labour cost will be:
Standard hours (5 × 40 × 45) = 9,000 hours @ €12 = €108,000
Overtime hours = 120 hours @ €18 = €2,160
Totals = 9,120 hours = €110,160
The direct labour budget for the assembly plant will, therefore, be:
Labour cost €110,160

Employee numbers 5
A labour budget will be prepared for each production process and, if

a standard costing system is used, the labour rates will become the
standard rates used. Standard costing systems will be discussed in
the chapter on costing.
Any expenditure variances against the labour budget will generally
be due either to rate, additional hours or slippage.
The direct materials budget

The direct materials budget will determine how much material or what
components are required to produce the production budget volumes.
For the assembly process it could look like Table 5.6.
Ta b le 5 . 6 Direct materials budget
Qty Qty Qty Qty Total Unit Total

Component 3m 4m 5m 6m Qty cost cost
(€) (€)
Tubes 3,060 2,400 1,100 720 7,280 5 36,400

(metres)
Soles 510 300 110 60 980 40 39,200
Thwarts 510 300 110 60 980 7 6,860
Rope 4,590 3,600 1,650 1,080 10,920 1.5 16,380

(metres)
Hulls 1,530 1,200 550 360 3,640 30 109,200

(metres)
Glue (litres) 510 400 185 120 1,215 30 36,450
Eyes 510 300 110 60 980 5 4,900
Oars 1,020 600 220 120 1,960 40 74,800
Oar 1,020 600 220 120 1,960 10 19,600

crutches
Total 343,790
The total material cost of assembling the production budget require-

ment is €343,790. The unit costs shown above will form the standard
material costs for the period.
Budgeted contribution
We have now completed the sales budget and the direct labour and
material budgets for assembly.
Assuming that there was only one other manufacturing process
and that the direct labour budget for this was €30,000 and the direct
materials budget (paint) was €10,000, then the budgeted contribution

(gross profit percentage) would be:
Sales 1,150,000
Direct labour 110,160 + 30,000 (140,160)
Direct materials 343,790 + 10,000 (353,790)
Gross profit 656,050
Gross margin per cent = 656,050/1,150,000 57 per cent
This is the gross profit before overheads. It shows the contribution a

sale makes after deducting the direct costs towards fixed overhead
expenses and profits. Note that most of the direct costs are considered
to be variable in that they vary with a level of production. Less produc-
tion should mean fewer costs.
The gross margin percentage is one of the key ‘dash board’ figures in
a company and will be carefully monitored each time a sale is made.
Overhead expenditure budgets

Many departments in a company are not directly involved in the manu-
facturing or production process but support it in some way. These may
include the human resources, finance and stock control departments.
The costs of running these departments tend not to vary with the level
of production in the way that direct costs do. Within a budget period
they are either fixed or semi-fixed.
These budgets must be prepared on a zero basis by estimating the
resources required to deliver the departmental objectives. The cost of
these departments may also be compared with the cost of using an out-
sourced service or a shared service. The previous year’s expenditure is
usually shown on the budget work sheet as a guide to costs but this
should not be used as a fundamental base for the current budget.
An example of a typical departmental overhead budget is given in
Table 5.7.
This Finance Department budget supports the following key tasks
identified in the plan:
●● meet statutory obligations to maintain proper accounts and file

annual return;
●● maintain VAT and other taxation records;
●● pay staff, run payroll, keep NI and PAYE records;
●● maintain supplier accounts and ensure payments;
Ta b le 5 .7 Finance department budget for 2013 (€000s)
Expenditure 2012 2012 2013 Comments

type budget actual budget
Salaries 50 51 53 4% increase
Bonuses 5 4 5 10% for on target
Travel 10 1 8 Audit branches
Training 3 2 3 CPE courses
Vehicle exp. 7 6 7 Lease plus

running costs
Entertainment 2 1 0 Nothing planned
Office space 7 6 6 Rent, rates, light,

heat apportioned
Stationery 4 3 3 Quoted from

supplier
Software 2 2 0 No new software

planned
IT support 5 4 5 Contracted rate

for IT support
Telephone 1 1 1 Annual usage
Temp staff 3 5 3 For possible illness
Totals 99 86 94
●● maintain debtors ledger and credit control;

●● prepare product costings;
●● prepare internal budgets and management accounts;
●● maintain cash records and bank accounts;
●● obtain audit clearance;
●● provide strategic financial advice to the board.
It may be possible to allocate the €94K resource budget across the

above 10 tasks in order to compare them with outside costs and out-
sourced services.
For example, of the €94K budget it might be estimated on a time-
apportioned basis that the costs attributable to the payroll task are €15K.
If it is possible to get payroll outsourced at a cost of only €10K then it
might be worthwhile considering this. However, as is often the case, by
outsourcing payroll the company might not lose the whole of the €15K
of internal costs apportioned because staff perform more than one
function and cannot be easily separated. However, there might be a case
for outsourcing and in any case this type of exercise does highlight
inefficiencies. Of course, outsourcing is more than a financial decision.
Quality, continuity and a whole lot more factors come into the equation.
The finance department costs tend to be fixed or semi-fixed during
the budget period. Staff can be laid off but notice periods and redun-
dancy pay may offset or partially offset any savings in the year. However,
some other departments may have costs of a more variable nature. For
example the sales department’s salaries and bonuses may vary with
sales levels because sales staff are often paid commissions.
The costs of a department are sometimes allocated to an identified
internal customer (another cost centre). The reasoning behind this is
that it shows the full costs incurred by a particular department. For
example, the finance department might allocate payroll management
costs to all other departments on the basis of personnel numbers. The
method for doing this is internal charging. Some finance directors do
not like internal charging because it can become confusing and there is
an argument that there is little point in allocating a cost out to managers
if they cannot directly control that cost. I mention it here because most
companies have some limited form of cost allocation to departments.
Research and development budget

Research costs may be considered under two major classifications:
●● pure research, where there is no specific product yet developed;

●● applied research, where the work related to the development of
a specific product offering.
For the sake of this explanation a product is something that a customer

recognizes and might buy.
Ta b le 5 . 8 Research and development budget for 2013 (€000s)
Resource Total Pure Pure Applied

budget Project 1 Project 2 Project 1
Salaries 90,000 40,000 40,000 10,000

Materials 20,000 10,000 5,000 5,000
Licenses 2,000 0 0 2,000
Lab costs 6,000 2,000 2,000 2,000
Totals 118,000 52,000 47,000 19,000
The accounting and taxation treatments of pure and applied research

are different and they need to be accounted for separately.
A research and development budget should show the costs of each
project and differentiate between pure and applied research cost as in
Table 5.8.
Capital budgets
I briefly mentioned capital budgeting earlier in this chapter. We will
now explain how the whole capital budgeting process works.
To start I will define capital expenditure, which is sometimes called
CAPEX:
Capital expenditure relates to items that are not consumed by the
business within the budget period but are used over a number of years.
They are items of a permanent nature. Examples of capital expenditure
are:
●● buildings;
●● plant and equipment;
●● vehicles;
●● improvement to existing assets (but not replacements);
●● furniture and fittings of a permanent nature;
●● large main frame type computers (generally not PCs).
Expenditure such as software, stationery and materials is not perman

ent but is consumed within the year and is called revenue expenditure.
This sort of expenditure is written off to the profit-and-loss account

each year.
Capital expenditure is not totally consumed within the budget year
and is not written off to the profit-and-loss account. Instead it is shown
in the balance sheet as an asset. A portion of capital expenditure may be
used within the year and this is the amount by which an asset depreci-
ates. Depreciation is usually calculated by dividing the asset cost by
the expected life. The resultant figure will be the figure used for depre-
ciation. This can be done on a straight-line basis or a reducing-balance
basis depending on the expected depreciation profile of the asset. For
example, an asset costing €10,000 that will last five years with a nil
residual value would be depreciated at €2,000 p.a. using the straight-line
basis. There are other methods of calculating depreciation, such as the
mileage of a vehicle. The point here is that the amount of depreciation
calculated is written off to the profit-and-loss account and the value
of the asset in the balance sheet will be reduced by the same amount.
As previously mentioned, the taxation treatment for capital expend-
iture is usually through a system of capital allowances. Therefore, to
calculate the taxable profit it is normal to add back accounting deprecia-
tion and deduct capital allowance from the accounting profit.
In addition to requiring different accounting treatment, capital
expenditure requires special approval and sanctioning because it is
an investment decision rather than an ongoing operational decision
as is the case with operating/revenue expenditure.
Different companies have different processes for capital invest
ment decisions. Probably one of the best methods was that identified
by Paul King of Queens College, Cambridge. He wrote several papers
explaining the decision process where he identified the stages involved
in capital investment decisions. These included ‘Capital investment
decisions’ (1967) and ‘Is the emphasis on capital budgeting theory
misplaced?’ (1974). I have not identified any better method so will use
his stages below.
The principal stages in capital investment decisions as identified
by Paul King are shown in Figure 5.3. Once a capital budget has been
approved by the board, the executive responsible for developing the
project will normally be required to go back for capital expenditure
approval before a final order is placed. Before making a commitment
it will be necessary to arrange suitable long-term funds. Capital projects
require long-term funds, either loan or equity capital. A capital budget
is shown in Table 5.9.
Figure 5 . 3 Principal stages in capital investment decisions
Ta b le 5 . 9 Capital budget for 2013 (€000s)
Project Q1 Q2 Q3 Q4 Total
Extension to paint shop 30 30

Additional plant capacity 10 10 10 10 40
HGV 140 140
Warehouse in Essex 240 240
Totals 10 280 150 10 450
Funding:
5-year term loan for 70
paint shop and plant
Vehicle lease for HGV 140
15-year mortgage for warehouse 240
450
Capital rationing
Because capital is often scarce it is not always possible to undertake all of
the capital projects in a budget. Choices will have to be made and, all other
things being equal, the choices made will seek to maximize overall pro
fits. Projects can be ranked in terms of their net present value (NPV). The
NPV is simply the total of the present values of the cash flow of a project.
The present value (PV) of a future value (FV) is simply:
FV × 1
PV =
(1+r)n
Where:
PV = Present value
FV = Future value
r = Compound rate of interest or discount rate
n = the period or number of years
For example, if a project would yield €5,000 in three years’ time when
the rate of inflation was 5 per cent the present value would be:
€5,000 × 1
PV =
(1+0.05)3
€5,000 × 1
PV =
1.158
PV = €5,000 × 0.864
PV = €4,318
If we have a number of projects that we can invest in but only a limited

amount of capital to invest, then we will seek to maximize our return by
investing in those that produce the highest net present value.
For example, suppose we have €1,900 to invest and there are three
project options that produce different returns as follows:
Project Outlay (€) NPV (€) Return
Project 1 500 250 50 per cent

Totals 2,100 921 44 per cent

If we assume that the projects have to be completed either in total or not

at all, we might wish to select Project 2 and Project 3 since this would
produce the highest net present value:
Project Outlay (€) NPV (€) Return

Total 1,600 671 42 per cent
By choosing to invest €1,600 of our €1,900 in Projects 2 and 3 we would

achieve a net present value of €671.
If we chose Projects 1 and 2 our net present value would only be €655
(250 + 405). However, we would only have invested €1,400 (500 + 900)
and our return as a percentage would be greater at 47 per cent (655/1400).
So we have choices:
●● Invest €1,600 in projects 2 and 3 and get a return of 42 per cent to

produce a net present value of €671;
or
●● Invest €1,400 in projects 1 and 2 and get a return of 47 per cent to

produce a net present value of €655.
Assuming that there were no other investment opportunities and that

the projects were not ‘divisible’, the company might seek to maximize
the net present value even though this produces a lower return on its
investment. However, it might decide to invest fewer funds at a greater
return percentage, thereby keeping its funds intact for potential future
opportunities.
Capital rationing decisions can get complicated in large companies
with multiple options, and the above simple example will give you
an idea of the considerations and methods that might be adopted.
However, there are often many other factors that need to be taken into
account, such as the probability of project returns that might need to be
factored in.
When an organization finds that it is rejecting profitable projects
because of limited capital it will, of course, seek to remove those
capital constraints. There are many ways of doing this, such as finding
a joint venture partner, selling and leasing back property, improving
debt collection, using invoice finance and many more. Some of these
options may reduce the return on a project.
Summary
In this chapter we have discussed how budgets are initiated and support
the planning process and how the budget cycle works. We have explained
the major types of departmental budget and how they are monitored
and controlled, together with variance analysis. An explanation of the
differences between operating expenditure budgets and capital budgets
has been provided as well as the elements of capital rationing.
You should now understand:
●● the integration of budgets with plans;

●● types of departmental operating budgets;
●● variance analysis techniques;
●● capital budgeting;
●● capital rationing issues and solutions.
Budgeting provides an important control tool for strategic financial

management. Case 10 in Chapter 16 (page 223) demonstrates some of the
practical benefits of integrating the budgeting and planning process.
70
C h apter S i x
Product and
service costing
and pricing
I n this chapter we will discuss some of the principal methods of

costing products and services, and how these may be used to deter-
mine profitability. Selling prices are, of course, determined by the
market but an understanding of costs is essential in order to ensure
that profitable sales are pursued.
We will discuss:
●● types of cost;
●● contribution, break-even point and marginal costing;
●● absorption costing/standard costing;
●● selling prices and the sales mix.
Types of cost: fixed, variable,

semi-variable
Three classifications of cost are:
●● fixed costs;
●● variable costs;
●● semi-variable costs.
Cost may also be called ‘direct’ – where they can be directly attributed to
a particular product or service – or ‘indirect’ when they do not directly
relate to a product or service. The three classifications are explained below.
Product And Service Costing And Pricing 71
Fixed costs
Fixed costs are those that do not change within the budget period, which
is usually one year. They are fixed at the start of the year and do not
change substantially or at all with levels of production or other variable
factors. Examples of fixed costs are:
●● management salaries (excluding performance bonuses);

●● rent;
●● business rates;
●● insurance premiums;
●● taxes;
●● depreciation (but see semi-variable costs below).
It is unlikely that once agreed these types of cost will change within
the year. For example, rent is usually fixed at the start of the period and
so are rates and insurance. It can be argued that, over time, all costs can
change. However, for our purposes we can assume that the above types
of cost will remain largely fixed during the year.
Variable costs
Variable costs are the types of cost that will change given different levels
of production, output or sales. For example, the total cost of vehicle fuel
used in a year will depend on the miles driven by the vehicle. Fuel,
would, therefore, be considered a variable cost. Common examples of
variables costs are:
●● direct materials;
●● direct labour;
●● machine power.
Any costs that vary with different levels of activity are variable costs.
Semi-variable costs
There is a type of cost that is difficult to classify as either fixed or vari
able. This type of cost can be called semi-variable. An example could
be storage rent, which goes up when an existing storage facility is full
and another one is hired. Depreciation, which we have classified as a
fixed cost above, may in fact be semi-variable because an item of capital
equipment may depreciate more if it is used more. Depreciation may

vary according to activity but it may also be related (and fixed) to a
period of time. It could both vary and be fixed and, therefore, a semi-
variable cost. Some costs are fixed to a certain level of activity and
then increase once that level is exceeded. This type of cost would be
semi-variable.
Total cost and unit costs

The total cost is simply the total of all costs at a given level of activity.
The unit cost is the cost attributed to a single production unit.
Given that total cost includes variable costs, we can expect it to
increase with activity levels. Unit costs should decrease when activity
increases because, within certain limits, fixed costs do not change and
will be absorbed over a greater volume of units produced.
These concepts are best explained by means of examples:
Examples
A company that manufactures filters has fixed costs (rent and rates) of
€150,000 per year. The variable costs (direct materials and labour) are
€5 per unit and it produces 60,000 units per year
Fixed costs €150,000

Variable costs (60,000 × 5) €300,000
Total cost €450,000
Unit cost of one filter (450,000/60,000) €7.50
If production is increased to 70,000 units (filters) per year we will see

that, although total costs increase, the unit cost of one filter decreases.
Fixed cost €150,000

Variable costs (70,000 × 5) €350,000
So, if we increase production we can expect a greater profit margin

when a unit is sold. This will remain true until we reach a capacity
ceiling and have to invest in greater capacity, thereby increasing the
level of fixed costs. You can see, therefore, that once a capacity ceiling
has been reached a substantial increase in production will be needed in
order to avoid increasing unit costs.
For example, if the capacity of the factory was 72,000 units and to
accommodate an increase in production to 144,000 units would require
additional fixed costs of €100,000, then it might not be worthwhile
making the investment if sales of the units could only be increased to
80,000.
New fixed costs (150,000 + 100,000) €250,000

Variable costs (80,000 × 5) €400,000
The rise in fixed costs has resulted in an increase in unit cost to €8.13
per filter produced/sold. It might not, therefore, be profitable to make
this investment unless increased levels of sales/production could be
guaranteed.
Contribution, break-even point and

marginal costing
Understanding contribution and the break-even point is one of the
most important aspects of costing and price/volume decision making.
It is a simple concept and is best explained by means of an example.
Contribution
Contribution is sometime referred to as gross margin or gross profit. It
is the contribution that sales value after the deduction of variable costs
makes towards fixed overheads and profits.
For example if a product sells for €10 per unit and its variable cost
per unit is €4 then it makes a contribution of €6 per unit. Contribution
may also be expressed as a percentage of sales. In this case it would be
60 per cent (6/10).
If sales were 100,000 units and fixed costs were €400,000 per year
the contribution and profit would be:
Volume Unit € Total €

Sales 100,000 10 1,000,000
Variable cost 100,000 4 400,000
Contribution 6 600,000
Fixed costs 400,000
Net profit 200,000
Break-even point
This is the point at which the contribution just covers fixed costs. At a
certain level of activity the volume sold/produced multiplied by the
unit contribution will cover the fixed costs. For example, in the above
case if we sold 66,667 units we would achieve a contribution of €400,000
and this is exactly equal to the level of fixed costs.
Fixed costs
Break-even volume =
Unit contribution
400,000
Break-even volume =
6
Break-even volume = 66,667 units
If we sell more than 66,667 units we will make a net profit, if we sell
exactly 66,667 units we will cover all of our fixed costs, and if we sell
fewer than 66,667 units we will not even cover our fixed costs and
we will make a net loss.
Given certain levels of expected sales, break-even analysis can also
be used to determine if a selling price will produce a net profit, a net
loss or just cover fixed costs.
Example:
A company expects to sell 100,000 units. Variable costs are €6 per unit.
Fixed costs are €400,000 per year At what price would the company
break-even?
Solution:
To break even the company needs to cover €400,000 of fixed costs. It
will need a contribution of €400,000 from the 100,000 units sold. This
is a unit contribution of €4 (€400,000/100,000). Now, since the variable

cost is €6 per unit the selling price to break even will be €10 per unit
(€4 + €6).
Fixed costs
Break-even selling price = + Variable unit cost
Volume
400,000
Break-even selling price = +6
100,000
Break-even selling price = 4 + 6

Break-even selling price = 10
Proof:
100,000 units @ €10 selling price = €1,000,000

100,000 units @ €6 variable cost = €600,000
Contribution = €400,000
Fixed costs = €400,000
Net profit = Nil
Knowing the break-even selling price is extremely useful. For example:
●● If we sell at €10 we know we will cover all costs.

●● If we sell at €11 we know we will cover all costs and make
a net profit.
●● If we sell at €9 we know that we will not cover all costs and make
a net loss.
Therefore, if the competition is selling at €10 and we cannot charge

more than this, then we must decide whether to sell for €10 and at least
cover our fixed costs. Fixed costs will not go away in the budget period
and it might be better to at least cover them. Any selling price that
covers variable costs will make a contribution towards fixed costs, and
when considering product prices there may be an argument to accept
a price that will at least make a contribution. However, a company
cannot survive on overall net losses.
Another example of a break-even point is illustrated in Figure 6.1
below:
Figure 6 .1 The break-even point
Using break-even analysis for strategic decisions

Break-even analysis can be a particularly useful aid to making strategic
decisions. It is simple to use and can provide a quick assessment of dif-
ferent strategic options, as is illustrated in the following example.
Example
A manufacturing company is considering launching a new product
into a market that already has a number of existing suppliers. The total
market value to all suppliers is about €6.5 million, which represents
500,000 units.
The company wants to evaluate two strategies. Strategy 1 is a higher-
priced higher-quality product and Strategy 2 is a lower-priced product.
The higher-priced product will produce a higher unit margin but lower
volumes, and the lower-priced product will produce a smaller margin
but should produce a higher volume.
Strategy 1 Strategy 2
Unit selling price €15 €13
Unit variable cost €8 €5
Unit contribution €7 (47 per cent) €8 (62 per cent)
Fixed costs per year €600,000 €600,000
Number of units required 85,714 75,000
to be sold to break even*
Total market size 500,000 500,000
Percentage of market required 17.1 per cent 15 per cent
to break even
* fixed costs/unit contribution
Strategy 2 requires a smaller level of market penetration to break even.

This can now be considered against market research data that indicates
the feasibility of a lower-priced lower-quality product being accepted
in the market.
The use of the break-even point and contribution analysis are the
fundamental components of marginal costing, which costs products on
a marginal basis rather than a fully cost absorbed basis. The advantages
and disadvantages of marginal costing are discussed below.
Advantages
●● Marginal costing is most useful to show the relative contribution
each product makes. It is useful for comparisons.
●● It is simple to understand and shows a very clear picture of
the relationship between cost, selling prices and volumes.
●● It is used as one of a company’s ‘dashboard indicators’ to show key
performance indicators at a glance.
●● It can be used in sales-mix-type decisions to maximize contribution
and profits.
●● There is no arbitrary allocation or spreading of fixed overheads to
products.
●● The separation of fixed and variable costs enables clearer
understanding and better business decisions.
Disadvantages
●● Marginal costing does not show the full cost of a product.
●● Marginal costing may be misunderstood and sales decisions may be
made without an understanding of a full product cost.
●● It is possible to use a mixture of both marginal and fully absorbed
costing.
Absorption costing – standard

costing
Absorption costing, as its name implies, fully absorbs all costs (both
fixed and variable) into product costs. It gives an understanding of the
total cost of a product based upon certain assumptions regarding how
costs are allocated. It can get complicated but does have certain advan-
tages if the system is operated correctly and understood. Unfortunately,
this is often not the case and many companies have made poor business
decisions based upon poor absorption costing systems. A major absorp-
tion costing system is standard costing. This type of system can be fully
integrated into the financial accounts and it is the system that we will
explain below. Most manufacturing companies use standard costing,
sometimes in conjunction with marginal costing.
The fully integrated standard costing system

This system sets standards for costs and these costs are absorbed into
product costs. Variances from standards are measured and manage-
ment actions are taken as a result of understanding variances. It is a
form of management by exception.
The cost of a product is explained in terms of materials, labour and
overheads and standards are set for these as follows:
Materials Standard prices Standard quantities

Labour Standard rates Standard times
Overheads Standard absorption rate
(see below)
The standard absorption rate is based upon the capacity of an overhead

facility and the time taken to produce a unit in that facility.
Standards are set annually (or more often) and the costs of products
are calculated using these standard costs. The amount of material
used, the labour hours and the time taken by the product in the factory
will be used in conjunction with the standard rates to calculate unit
product costs.
Of course, actual prices, quantities used, labour rates and times taken
will be different from the standard rates and variances will be measured.
The variances measured under a standard costing system are:
●● Material price variance – This is the difference between actual prices

and standard prices measured over the actual quantity used.
●● Material usage variance – This is the difference between the actual
amount of material used and the standard amount allowed all at the
standard price.
●● Labour rate variance – The difference between actual rates paid and
standard labour rates over the actual hours worked.
●● Labour efficiency variance – The difference between the actual time
taken and the standard time allowed at the standard rate of pay.
●● Overhead budget expenditure variance – A measure of buying
efficiency that is the difference between the actual and budgeted
overheads.
●● Overhead efficiency variance – This is the standard time less the
actual time at the standard overhead rate. It shows the effect of
labour efficiency on overhead absorption.
●● Overhead volume variance – This is the actual level of activity less the
standard level of activity at the standard rate. It shows whether
plant is being utilized.
The standard costing system is integrated into the financial accounting

system. An example of accounting entries is given below:
Example:
A company sets a standard of 20p for a material price.
It purchases 1,000 units at 21p each.
The material price variance will be: 1,000 (21p-20p) or €10 adverse
The standard cost was 1,000 @ 20p:€200
The actual cost was 1,000 @ 21p:€210
The total variance was: €10 adverse
Due to:
Material price: €10 adverse
Using the fully integrated standard costing system the entries in the
accounts in respect to the purchase of materials will be:
Debit materials account: €200 (with actual quantity purchased @

standard rate)
Debit material price variance account: €10 (with actual price less
standard price × actual quantity)
Credit supplier account: €210 (with the goods value on the invoice,
1,000 @ 21p)
As goods pass through the production process into work in progress

and eventually into finished stocks, entries are made in the accounts
at standard rates and allowances. There is no need for you to work
through all of these laborious entries since this is a management text
and an understanding of reports and accounts presented to you is
all that is required. However, the accounting entries are shown in
Figure 6.2 below:
Using the diagram you can trace the accounting entries. For example
the raw materials account is debited with the actual quantity of goods
purchased at the standard rate, and the variance between actual and
standard prices using the actual volume is debited or credited to the
material price variance. Materials used in production are debited to
the work in progress account, and the variance between the standard
allowance and the actual allowance is debited or credited to the material
usage variance account. Labour and overheads are absorbed into work
in progress, variances measured and as products are completed they
are transferred into the finished stock account at standard rates.
Two of the great benefits of the fully integrated standard costing
system are:
●● Integrity of information: it is integrated fully with main financial

accounting systems.
●● A dashboard approach that gives management a quick view on areas
that need attention.
The type of information produced by a standard costing system and

actions that can be taken by management are listed in Table 6.1.
Figure 6 . 2 The fully integrated standard costing system process
Raw material
Material usage
report
Purchase
invoices/goods
received notes Material price
for materials variance
Time sheets
and clock
cards Material usage
variance
Work in progress
Invoices
for
overheads Labour rate
variance
Overhead Works Labour eﬃciency

control orders variance
Overhead budget/
Finished stock expenditure variance
Overhead eﬃciency
variance
Sales Cost of sales
Overhead volume
invoices/
capacity usage variance
orders
Shaded areas represent accounts.

Ta b le 6 .1 Information produced by a standard costing system and

relevant actions
Variance Possible reasons Possible actions
Material price Changes in price Compare alternative

Inflation assumptions suppliers
wrong Review budget
estimates
Material usage Using more or less in Look for wastage,

production check controls,
review estimates
and budgets
Labour rate Paying staff more or less Revise costings

Staff mix different from and budgets
standard If adverse see if a more
favourable mix can be
achieved
Review budgets
Labour efficiency Times taken to complete Measure job times

a job different from Review budgets and
standard costs
Overhead Actuals different from Review suppliers

expenditure standard Review budgets/costs
Overhead Usage standards Measure and review

capacity use incorrect capacity
O’hd volume Times taken different Measure job time

efficiency from standard Review budgets
The theory is that if standards and assumptions set during the budget
process achieve an acceptable result then, by constantly measuring
variances from standards and taking remedial actions, management
stand a better chance of achieving their goals.
However, just a quick glance at this process will demonstrate how it

can get complicated and can confuse. Clearly, in a large manufacturing
company (a car manufacturer for example) a standard costing system
has great value. However, many smaller companies use the system with-
out the resources to ensure accuracy and without a management team
that fully appreciates how the system works. For this reason I would
suggest that it is more suitable for larger companies. As a manager you
may come across this system and I hope that the above has explained
the essential process and benefits.
Case study 8 in Chapter 16 (page 000) compares the use and mis-use
of marginal with full absorption costing (standard costing) information
in pricing decisions.
Activity-based costing (ABC)

Activity-based costing assigns costs to activities and then to products.
It is, therefore, another technique for allocating indirect costs to
products.
A traditional costing method usually assigns overhead costs to prod-
ucts on the basis of an average absorption rate. ABC first of all assigns
indirect costs to activities and then assigns the costs to products on the
basis of the products’ usage of the activities. It attempts to identify
cause-and-effect relationships in order to accurately allocate costs to
products. ABC is useful when indirect cost allocation accuracy is im
portant and when indirect costs are a large proportion of total costs.
It is commonly used in the manufacturing sector.
The four steps in the activity-based costing process are:
1 Recognize and list the activities in the value chain related to the
production process of the product.
2 Estimate a total cost for each of the activities listed above.
3 Compute a cost-driver rate for each activity on the basis of an
allocation method that has a direct link to the cost of the activity.
See example below.
4 Apply these activity costs to products using the cost-driver rate.
Example
A company classifies paint-room maintenance as an indirect cost activ-
ity for the metal lamp shades it manufactures. The company estimates
paint-room maintenance costs to be €3,000 per month and deter-
mines that batches of lamp shades sprayed in the paint room are an
appropriate cost-driver allocation base for paint-room costs. The paint
room produces 750 batches per month. Thus, the cost-driver rate would
be €3,000/750, or €3.00 per batch. Therefore, the company would apply
€3.00 of indirect cost for each batch produced by the paint room.
Activity-based costing is often used as an aid to strategic decisions
concerning processes, outsourcing and selling prices.
Selling prices and the sales mix

This chapter has been concerned with costing methods that will help
you understand the profitability of products sold. These methods will
indicate whether pricing decisions are acceptable and produce the
desired return.
Selling prices are not set from costs. They are set by the market. A
sales price, in an efficient market, is set by the interaction of supply and
demand. When setting a selling price the sales director will want to set
one that will enable volume targets to be met. S/he will do this with
an expert knowledge of the market, customers’ needs and the competi-
tion. The director will also need to know what the lowest price is that
is acceptable and in particular will need to know product contributions
in order to determine sales mixes.
When setting a selling price an organization may have a wide variety
of motives; however, pricing does have both social and legal conse-
quences that need to be taken into account. For example, price fixing is
illegal in most countries. Deceptive prices may fall foul of increasing
legislation, and predatory pricing is not allowed in many countries.
Price discrimination is also illegal in many countries. With this in mind
it is wise that price setting does at least not offend these basic rules.
A company will normally want to set an optimal price that will
maximize its profitability. However, there may be other reasons. For
example revenue maximization and cash flow may be more important
than profit. Sales growth and market penetration may be a priority. Sell
ing prices will depend to an extent on sales and marketing strategy.
The sales mix

Using marginal costing/contribution information can be very useful in
determining the optimal mix of products to be sold.
It is possible that, although overall sales values and volumes are on
target, a hidden adverse sales mix is reducing profitability. The example
in Table 6.2 illustrates how analysing a sales mix variance using gross
margin percentages can expose the effect an adverse sales mix has on
profits.
Ta b le 6 . 2 Analysis of a sales mix variance using gross margin

percentages
Product Budgeted Actual Sales Gross Gross

sales sales variance variance margin
(€) (€) (€) (%) variance
Balls 60,000 30,000 −30,000 46% −13,800

Clubs 15,000 10,000 −5,000 36% −1,800
Bags 5,000 40,000 +35,000 6% +2,100
Totals 80,000 80,000 0 –13,500
In this example overall sales were on target and there was no sales
variance. However, the company had been selling fewer of the more
profitable products. This is what is referred to as an adverse sales mix
variance, and as a consequence of it there is an adverse gross margin
variance. This is the reason why having knowledge of gross margins is
essential to management.
Generally, a company will wish to sell more of the products that
have the highest gross margin percentages. However, there may be
production or other constraints that prevent sales volumes or values
of products exceeding certain levels.
Example
A company manufactures water filters and chlorinators and wishes
to maximize the sales of chlorinators since they are more profitable
than filters.
To manufacture these products requires the processes of machining

and assembly. However, there are constraints on both of these operations
in terms of hours available. There are also limits on the maximum level
of sales for both products. A summary of the position is given below:
Filters Chlorinators
Machine time 3 hours 3 hours
Assembly time 1 hour 3 hours
Unit contribution €3 €4
Maximum sales possible 160 units 170 units
Machine room Assembly room

Maximum time available 600 hours 300 hours
We need to know what sales mix of filters and chlorinators will maxi-
mize profits subject to the production constraints and sales limits.
We can do this with some simple algebra.
Solution:
Let ‘x’ be the quantity of filters made and sold

Let ‘y’ be the quantity of chlorinators made and sold
The constraints are:
Machine room: 3x + 3y ≤ 600 hours (because machine room hours

must be less than 600)
or x + y ≤ 200 hours
Assembly room: x + 3y ≤ 300 hours (because assembly room hours
Sales of filters: x ≤ 160 units (because sales of filters must be less
than 160)
Sales of chlorinators: y ≤ 170 units (because sales of chlorinators
The object is to maximize the overall contribution within the con-

straints: Maximize the value of 3x + 4y but subject to the constraints of:
x + y ≤ 200
x + 3y ≤ 300
x ≤ 160
y ≤ 170
x≥0
y≥0
The mix that will maximize contribution can be found through the
following formulae:
x + 3y = 300
x + y = 200
2y = 100 (by subtraction)
y = 50 (100/2)
x = 150 (by subtraction 200–50)
Therefore the optimal sales mix is:
150 filters
50 chlorinators
Working out an optimal sales mix can be done by trial and error using a
spread sheet or constructing a simple linear programme chart. This is
shown in Figure 6.3 below.
Figure 6 . 3 Linear programme chart showing optimal sales mix

y x = 160
400
200
y = 170
x + y = 200
y = 50
x + 3y = 300
0
200 400 x
x = 150
The optimal point is where the lines x + y = 200 and x + 3y = 300 cross within the
constraint lines of x = 160 and y = 170.
At this point x = 150 and y = 50
The optimal sales mix is 150 filters and 50 chlorinators
Using simple linear programming techniques to determine optimal

levels of sales mix volumes is something your finance department
will advise you on, and the above is a guide to the principal methods
they will use. In real life the problem can be more complicated and
many finance specialists will use computer-simulation programs that
can run through many scenarios quickly and are ideal for carrying out
sensitivity analysis.
Summary
In this chapter we have covered the basics of product costing and have
discussed the merits of marginal costing and full absorption costing.
We have seen how marginal cost information can be used to solve sales-
volume-mix problems and how cost information can help with sales
price determination. A selling price is determined by market forces
including the value to a customer and competitive activity. Comparing
selling prices that are achievable with cost information can help a com-
pany decide whether it is likely to make the required profit from selling
a particular product. It might also give some insight into competitors’
profitability. There may be occasions where a company lacks accurate
market information regarding possible selling prices for a particular
profit. In cases like this, a company that believes its costs and opera-
tions are efficient might find cost information useful in price deter
mination and also in analysing competitor strategies.
Setting selling prices is an art that requires a combination of market
research, competitive analysis and accurate cost information. A struc-
tured approach to cost information will help a company make better
price decisions and explore alternative strategies.
89
C h apter S e v e n
Setting selling
prices and
marketing
strategies
I n the previous chapter we explored costing and some basics of

selling prices. In this chapter we will look at a price setting process
and some high-level marketing strategies. Since this is a text on
financial management we will not stray too far into the area of market-
ing but will just cover a few essentials that are related to costing
and pricing.
For the purpose of this chapter we will define cost and price as
being:
●● Cost = the costs of production and of bringing a product to market.

●● Price = the price that a customer pays for a product or service.
Cost tends to be more internally focused and price has more of an exter-
nal focus. A process for price determination showing how both internal
and external factors are related is given in Figure 7.1.
The steps normally involved in price determination are listed
below:
1 Prepare product prime cost estimates for direct materials and direct
labour used in manufacturing the product or in providing the
service.
2 Calculate the work’s cost, which will include the prime costs plus
the indirect costs of production overheads.
Figure 7.1 Price-determination process
3 Calculate the total cost of production by adding indirect costs of

administrative and office overheads to the work’s cost.
4 Calculate the cost of sales by adding selling and distribution costs to
the cost of production.
5 Decide upon the profit margin required.
Setting Selling Prices And Marketing Strategies 91
6 Calculate the ‘cost-plus’ selling price by adding the required profit

margin to the cost of sales.
7 Determine the market selling price through market research,
competitive analysis and looking at strategic options available.
Consider marketing strategies – offensive–defensive and
rationalization strategies – and factor these into the market selling
price.
8 Compare the externally and internally derived prices. Consider
the legal and social aspects of both sets of possible prices. Review
costs, production capacity and sales mix options.
9 Feed costs review information back into product costs where
appropriate.
10 Review all costs and reset internal prices if feasible.
11 Agree on final selling price.
This is an iterative process that will give the best possible chance of
getting the right price to achieve sales targets.
There are many factors that determine selling prices. These include:
●● customer inertia and reluctance to move;

●● the value a customer places upon a relationship;
●● time and urgency;
●● convenience;
●● economic climate;
●● perceived quality;
●● perceived value;
●● unique attributes;
●● brand;
●● geography;
●● competitive strategies;
●● marketing strategy – expansion, new market, leader, follower,
niches.
These are largely the province of the marketing department and I just
mention them briefly here. Marketing strategies and market analysis
are outside the scope of this financial management text. However, the
effect of marketing strategies on prices is of interest to us and we will
consider three major categories.
●● offensive;
●● defensive;
●● rationalization.
Offensive strategies
●● Expansion: Open new branches and channels. Price to win new
business.
●● Penetration: Try to win new customers in existing markets and
increase/extend existing customer purchases. Differentiation.
Price competitively.
●● Challenger: Being innovative and selling new ideas. Seize new
opportunities and outsell competitors with quality and keen prices.
Take on higher-risk business at potentially higher prices.
●● Leader: Sell at very keen/best prices. Increase distribution network.
Increased advertising.
Defensive strategies
●● Follower: Take lower risks and possibly accept lower prices.
●● Niches: Specialize and perhaps obtain better prices.
Rationalization strategies
●● Cost reduction: Cut costs. Have the ability to sell at lower prices.
We can see from the above that whichever strategy is adopted will have
an effect on selling prices.
Pricing strategies
Pricing strategies are often considered under the categories outlined
below.
Competitive pricing
This is where prices are set with consideration to competitors’ product
prices. A product may be totally distinctive, have perishable distinctive-
ness or have little distinctiveness from the competitors’ products.
Clearly if there is little that distinguishes your product from the com-
petition, then your price may have to track competitors’ prices more
closely.
Creaming or skimming
This strategy is often used to gain high profits from early adopters of
new products and technology. It involves selling a product at a high
price, maybe sacrificing some volume but obtaining high margins and
perhaps setting higher price expectations. It may be used in an attempt
to recover research and development costs.
This strategy can be used only for a limited time; to win greater
market share a seller would use other pricing tactics.
Cost-plus pricing
We have discussed at some depth various costing methods and the
need for accurate cost information to see how selling prices will con-
tribute to profits. Cost-plus pricing, where prices are set from costs, may
have some use when there is no market information but generally
has the significant disadvantage of not taking into account market
intelligence.
Loss leader
This is where a product is sold at a low price in order to encourage
the sale of other profitable products.
Limit pricing
This is a price set by a company with a monopoly in order to discourage
new entrants into a market. It is illegal in many countries. The mono
polistic company sets a low enough price to discourage a new entrant
from entering the market.
Market-researched pricing
This is where prices are set in accordance with market research data.
Penetration pricing
To help penetrate a market, a price may initially be set at a low level.
Price discrimination
This is the practice of setting different prices for the same product in
different segments of a market. Examples of this may be age-related
pricing or setting different prices at different times, as is often the prac-

tice with railways.
Predatory pricing
This is just a term for aggressive pricing to drive out competitors. It
might be illegal in some countries.
Premium pricing
Some buyers believe that a high product price equals a high quality.
Some sellers will exploit this and price at a premium accordingly.
Contribution-margin-based pricing
We have covered this already in some depth in the previous chapters.
It is pricing based on the maximization of contribution (selling price
less variable cost). It is a method of comparing the contribution that
various products make.
Psychological pricing
This is the practice of pricing to have a psychological effect on a buyer.
It is believed, for example, that goods priced at €4.99 will sell more
volume than if they were priced at €5.00.
Price leadership
The situation where a company is able to take the lead with prices and
competitors fall in line and follow.
Dynamic pricing
A mechanism that has the ability to change prices constantly in response
to market dynamics and fluctuations. This will normally be carried out
using a computer program that tracks competitors’ prices and adjusts
your own prices accordingly within pre-set parameters. This process
is more suitable to fast-moving commodities.
Target pricing
This is a method where a selling price is calculated to provide a specific
return for a specific volume of production. Target pricing may be
used most by power and utility companies, where capital investment

is high.
Absorption pricing
This is a method of cost-plus pricing that aims to recover all costs
attributed to a product on a fully absorbed cost basis plus any possible
profit.
High–low pricing
Pricing core products high, with lower promotional price offerings to
bring customers in when it is hoped they will purchase the high-priced
products.
Premium decoy pricing

Setting the price of one product high so as to make another product
seem a bargain. For example, some antique dealers may have a quality
item priced very high hoping to make low-value items seem like
bargains.
Value-based pricing
This is where a selling price is based on the value to the customer.
Marginal-cost pricing
Selling with consideration to the gross margin. For example, if a product
has a total fully absorbed cost of €3 and a variable cost of €2, a company
may decide to still sell at only €2.50 since this would still make a
contribution to the fixed pool of costs of 50p. In other words it is
better off with this sale than without it. Of course, ultimately selling
prices need to cover all costs but a contribution is better than nothing
at all.
Inertia pricing
Pricing on the basis that existing customers can’t be bothered to
change or think it is too expensive to change suppliers.
Summary
Setting selling prices is one of the most important tasks undertaken
by the executive team. It requires a deep knowledge of the external
(market) and the internal factors that affect the decision. Once decided
upon, prices need to be carefully monitored in light of sales results
and marketing strategies adopted.
In this chapter we have considered some principal pricing strategies,
their interface with marketing strategies, costs and some broad legal
issues. Whilst selling prices are driven by market forces and not internal
costs, a knowledge of product costs is essential to ensure that sales
prices produce required returns. If they do not then cost information
can provide a guide to where remedial action might be taken. However,
it is worthwhile remembering that, for example, a 10 per cent increase
in selling prices has a greater positive effect on the bottom line than a
10 per cent decrease in costs. This might seem obvious but it is often
forgotten!
Fixing a selling price is not something that a marketing director
can do in isolation. It requires close collaboration among the finance
director, the sales director and the marketing director. Understanding
the value of a product to a customer and the value of any unique selling
points or product differentiation is key, and this value information
needs to be compared with internal product cost information.
A customer will place a value on a product or services based upon
the perceived value to the business, the return that can be made from
investing/buying the service, quality, competitive prices and the avail-
ability of the product. In the case of some products or services a cus-
tomer may also place a value on an ongoing relationship with a supplier.
An experienced sales or marketing director should know how to maxi-
mize selling prices and volumes within a territory, and the conse-
quences of expected selling prices not delivering margin expectations
will be something that needs to be resolved with the finance director
and the executive team. For example, it may be decided that a higher
price can be obtained with an investment in marketing or PR.
Market conditions constantly change and the pricing policy needs
to provide the flexibility to respond to these changes. This is where
marginal cost information can be very useful in order to see what effect
a change in selling price has on the contribution to fixed costs and
profits. Failure to react quickly and respond to changing market
conditions will result in a loss of sales. A sales director needs to have

sufficient flexibility in pricing within certain parameters to be able to
close deals without having to revert back each time to the executive
team whenever s/he hits a price problem with a competitor. Sales
directors need to know the contribution at different price levels and
have the power to negotiate to some degree.
There are many factors that affect selling prices and a business needs
to be able to react quickly to market conditions. Three of the most
important are value to the customer, competition and cost.
Case 12 in Chapter 16 (page 229) gives a practical illustration of
cost and selling price decisions.
98
C h apter E ig h t
Investment
appraisal
O rganizations make investments with the expectation of gaining

future income. Investments may take the form of capital or
revenue expenditure. This chapter examines how companies decide
which investments to make and looks at the major techniques for
investment appraisal.
Relevant cash flow

Before we start any detailed analysis of investment opportunities it is
necessary to understand what cash flow is relevant in investment
appraisal. Only costs and income benefits that arise as a consequence
of the decision under evaluation are of interest to us when evaluating
an investment. Examples of relevant costs are:
●● opportunity costs (the cost of a lost opportunity resulting from

taking an alternative course);
●● incremental costs incurred as a result of undertaking the new
investment;
●● additional taxation arising from the opportunity;
●● additional working capital required to undertake the opportunity;
●● additional direct/prime costs;
●● additional selling and distribution costs;
●● new infrastructure costs;
●● additional staff costs;
●● any other expenditure arising from the proposed investment.
Investment Appraisal 99
Examples of relevant benefits are:
●● additional sales revenue;

●● savings in operating costs;
●● income from the sale of assets;
●● improved customer retention;
●● staff retention;
●● existing customers extending business;
●● any other benefits arising from the proposed investment.
Only costs and benefits that are relevant should be taken into account.
For example past costs already incurred are irrelevant.
Example
A boatyard has the opportunity to buy a new moulding for €400,000 to
replace an old moulding that originally cost €120,000 and has a scrap
value of €6,000. The new moulding would enable annual production to
be 100 boats that would sell at €3,000 each.
The production cost of each boat is:
Direct materials €600

(GRP and resins)
Direct labour €400
Fixed costs allocated €500 (Fixed costs do not change

with production levels or with
the acquisition of a new moulding)
The contribution for each boat sale is €2,000 (being €3,000 – €600 –
€400).
The new moulding has a life of five years and a scrap value after
then of €20,000. It also requires additional skilled operatives for 1,000
hours per year costing €20 per hour. The relevant cash flow is:
Year 0 Purchase price –€400,000
Years 1–5 Contribution 100 boats @ €2,000 +€200,000 per year
Years 1–5 Skilled operatives 1,000 @ €20 –€20,000 per year
Year 5 Scrap value new machine +20,000
Year 5 Scrap value old machine +€6,000
It is this relevant cash flow that will be used to appraise the investment.
The original cost of the old moulding is a past cost and is not relevant
to the decision so it is ignored. The benefit of €6,000 for scraping the
old moulding has been taken into account since the old moulding
could have continued to be used.
Pay-back period
This is the most simple method of investment appraisal and is widely
used. It simply calculates the time (normally years) that is taken for
the opportunity to pay back the initial outlay.
In the above example the initial outlay was €400,000 and there were
two relevant scrap values amounting to €26,000. This means that the
net outlay was €374,000 (€400,000 – €26,000). The net income from
the project is €180,000 per year (€200,000 – €20,000). Therefore, the
payback period will be 2.1 years (€374,000/€180,000). It will take ap
proximately two years and a month for the returns on the project to
pay back the net investment. Since the mouldings last five years this
would seem to be a good investment, if the sales volumes are actually
achieved.
Net investment
Pay back period =
Benefits
374,000
Pay back period =
180,000
Pay back period = 2.1 years

Pay-back analysis can be used to compare different projects to help

decide which one is the best.
Example of the comparative pay-backs for three projects:
Project 1 Project 2 Project 3

€000 €000 €000
Year 0 Initial investment 120 120 150

Year 1 Profits 40 30 30
Year 2 Profits 40 30 30
Year 3 Profits 40* 30 30
Year 4 Profits 5 30* 30
Year 5 Profits 0 30 30*
Project 1 pay-back period is three years.

Project 2 pay-back period is four years.
Project 3 pay-back period is five years.
Purely on the basis of pay-back, Project 1 has the advantage.
However, the pay-back period does not take account of cash flows
outside the pay-back period; this is its weakness.
Although Project 1 has the fastest pay-back, Project 2 produces the
greater profit since its income stream runs longer.
Pay-back analysis is a useful rule of thumb as long as one is mindful
of its weakness and considers also cash flows beyond the pay-back
period.
Return on capital
Also known as return on capital employed (ROCE), this method of
investment appraisal measures the percentage earned against the cost
of an investment. ROCE is often measured as the percentage average
profits are of the average investment.
Average profits
ROCE =
Average investment
Example
A company invests €90,000 in a project that has no residual or scrap
value at the end of the project. Income is €15,000 per year for Years 1 to
4 and €10,000 per year for Years 5 to 10.
(4 × €15,000) + (6 × €10,000)
Average earnings per year =
10 years
Average earnings per year = €12,000 per year
€12,000 100
ROCE = ×
€90,000 1
ROCE = 13.3% per year
ROCE can be calculated using several definitions for profits or invest-

ments, and may use different combinations of these. For example the
calculation can use average profits, total profits, average investments or
initial investments. Therefore, when comparing the ROCE of different
companies make sure you are comparing a like-with-like method.
ROCE is often used when comparing the return on mutually exclu-
sive projects. A major drawback of the ROCE method is that it does not
take account of the timing of cash flows. However, it is a simple and
easily understood method that can be used in conjunction with other
methods as long as its limitations are understood by users.
Accounting rate of return (ARR)

The ARR method compares profits after depreciation with the original
investment or average net book values. It is expressed as a percentage.
There are several different ways of calculating the ARR and it is
important to know how it has been calculated before using the infor
mation for comparative purposes. An example of the formulae is:
Average annual profit after depreciation

ARR =
Original cost of investment
A weakness of the ARR is that it does not take into account the timing
of cash flows, unlike the discounted-cash-flow method, which is
explained below.
Discounted-cash-flow and net

present value
These are the principal and most widely used methods of investment
appraisal because they take into account the timing of cash flows.
Money changes value over time and the discounted-cash-flow tech-
nique takes account of this. Two methods that use discounted-cash-
flow are the net present value and the internal rate of return. We will
explore these methods in this chapter.
Future values
The future value of a project is:
FV = PV(1+r)n
FV = Future value
PV = Present value
r = the compound rate of interest
n = the period
For example, the future value of €3,000 invested for three years at a rate
of 4 per cent per year is:
FV = €3,000 (1+0.04)3
FV = €3,000 × 1.125*
FV = €3,375
*(note: 1.125 can also be found in compound interest tables under 3YR/4 per cent
(see Appendix 2). It can also be calculated using the y x key on your financial calculator.
Therefore, if we invest €3,000 for three years @ 4 per cent per year, it will
grow to €3,375.
Present value
Using the above example, it is obvious that the present value of the
€3,375 must be €3,000. I will now show you how to calculate this.
If the future value is: FV = PV (1+r)n

FV 1
then the present value (PV) must be: PV =
(1+r)n
€3,375 × 1
PV =
(1+0.04)3
€3,375 × 1
PV =
1.125
PV = €3,375 × 0.8889*
PV = €3,000
Note: 0.8889 can also be derived from discount tables: YR3/4 per cent.
Therefore, the present value of €3,375 received in three years’ time

when interest/inflation rates are 4 per cent is €3,000.
You should now understand present value and future value and
how to calculate them. Make sure you have a firm grasp of this before
moving on to the next section.
Net present value

We have shown above how to calculate the present value. We will now
show how to calculate the net present value of a stream of cash flow
spread over a number of years. This is best explained by means of a
simple example.
Example of net-present-value calculation

A company has the opportunity to make an investment for €400,000
that would yield the following income stream:
Year 1 €150,000
Year 2 €170,000
Year 3 €155,000
If the company has a cost of capital of 5 per cent per year, should it
undertake the project? (Note: The cost of capital is explained more fully
in Chapter 14.)
To answer this question, calculate the sum of the present values using
the 5 per cent discount factors provided by the discount tables below.
Year Cash flow 5% discount factor Present value
0 –€400,000 1.000 –400,000

1 +€150,000 0.952 +142,800
2 +€170,000 0.907 +154,190
3 +€155,000 0.864 +133,920
NPV +30,910
To obtain the present value for each year we multiplied the cash-flow
value by the discount factor (obtained from the discount tables). We
then totalled the present value column to give us the net present value
(NPV). Since this is a positive figure (+€30,910), the yield provided is
greater than the company’s cost of capital. Therefore, on the basis of
NPV the project should be undertaken.
Had the NPV been a negative figure the project would not have
yielded a return greater than the cost of capital and, on the basis of
NPV criteria, it would not be undertaken.
Discount tables (used for the calculations above)
Discount rates
Years 1% 2% 3% 4% 5% 6%
1 .990 .980 .971 .962 .952 .943

2 .980 .961 .943 .925 .907 .890
3 .971 .942 .915 .889 .864 .840
4 .961 .924 .888 .855 .823 .792
For example, the discount factor in Year 2 for a 5 per cent discount rate is
0.907.
The above example assumes that the future income streams are cer
tain. If this is not the case, then allowance can be made by reducing
the income streams before discounting by their probability factor. For ex
ample, if an income stream of €400,000 was only 95 per cent certain to
be realized, then a value of €380,000 (400,000 × 95 per cent) might be used.
The internal rate of return (IRR)

The internal rate of return (IRR) is the discount rate that produces a
zero NPV. If the IRR is greater than the company’s cost of capital, the
project should be undertaken using this criterion. The IRR is an easily
understood measure but it does not demonstrate the relative size of
projects. However, it is widely used.
Calculating the IRR by simple interpolation

Example
A company has identified an opportunity costing €1,350,000 with the
following income stream:
Year Cash flow

1 +€700,000
2 +€750,000
It has a cost of capital of 3 per cent.
What is the IRR and should the company undertake the project?
Solution
Year Cash flow (€) 4% PV (€) 5% PV (€)
0 –1,350,000 1.000 –1,350,000 1.000 –1,350,000

1 +700,000 0.962 +673,400 0.952 +666,400
2 +750,000 0.925 +693,750 0.907 +680,250
NPV +17,150 NPV –3,350
Steps
1 By experimentation, find the discount rates that give a positive NPV
and a negative NPV when applied to the cash flow. In this case you
will find that these are 4 per cent and 5 per cent.
2 A 4 per cent discount rate gives a NPV of +€17,150.
3 A 5 per cent discount rate gives a NPV of –€3,350.

4 The internal rate of return must, therefore, lie between 4 per cent
and 5 per cent.
5 Using interpolation we can see that a 1 per cent move has resulted
in a –€20,500 change in NPV. The move from +€17,150 to –€3,350
is –€20,250.
6 To move from +€17,150 to zero would require the following discount
rate:
4 per cent + (5 per cent–4 per cent) × (€17,150/€20,500)
= 4 per cent + 0.837
IRR = 4.837 per cent.
Proof
Using the discount rate formulae DR = 1/(1+i)n we have:
4.8370 per cent
Year Cash flow (€) Discount factor PV (€)000s
1 –1,350,000 1.000 –1,350

2 +700,000 0.954 +668
3 +750,000 0.909 +682
NPV 0
A discount rate of 4.837 per cent will produce a zero NPV.
This means that the internal rate of return is 4.837 per cent.
Since the IRR is greater than the company’s cost of capital of 3 per cent,
the project should be undertaken on the basis of this criterion.
(Note: The IRR can also be calculated using a quadratic equation or

using a computer program. See also Figure 8.1)
Figure 8 .1 Internal rate of return graph
We can plot the range of positive and negative NPVs at different costs of capital
to determine the point of IRR.
Capital rationing
A company may have to choose which projects it can undertake within
the constraints of its capital and other factors. Projects may be capable
of being only partly completed (divisible) or they may have to be com-
pleted in total or not at all (not divisible).
When deciding which projects to complete, a company will seek
to maximize the overall return subject to the constraints of capital
rationing.
Example
A company has three project opportunities (A, B and C). They are divis-
ible and details are listed below. It has €3,000,000 to spend and requires
a minimum return of 25 per cent. How should the company prioritize
its spend?
Project A Project B Project C

€000s €000s €000s
Cost 1,000 2,000 500
NPV 400 1,000 215
NPV as % of cost 40 per cent 50 per cent 43 per cent
All projects exceed the required minimum return of 25 per cent. Clearly
Projects B and C provide the highest returns and the company will wish
to maximize these. Since the projects are divisible the solution will be:
Project Investment NPV

Priority (€000s) (€000s)
B 2,000 1,000
C 500 215
A 500 200 (400 × 500/1,000)
3,000 1,415
The company has spread its €3,000,000 across the three divisible
projects in the priority of their returns on investment with the highest
first to maximize the overall return to €1,415,000.
Had the project not been divisible then the position would be very
different.
Project Investment NPV
Priority (€000s) (€000s)
B 2,000 1,000
A 1,000 400
3,000 1,400
Were the projects not divisible the company would maximize its return
by choosing Projects B and A. This assumes that it wished to use up
all of the capital available.
Summary
In this chapter I have explained some principal methods of investment
appraisal used by organizations that wish to maximize the return on
their investments. The principal techniques include:
●● pay-back period;
●● net present value;
●● internal rate of return;
●● capital rationing analysis.
These are the techniques that are most frequently used in profit-making
organizations. However, not all organizations simply seek to maximize
returns on investments. They may be seeking to satisfy a broader range
of stakeholders’ demands.
In any analysis, each variable factor used has a set of underlying
assumptions and sensitivities. These may change and in most invest-
ment appraisal analysis it is wise to also undertake a sensitivity ana
lysis. This is simply accomplished by taking out one variable factor
value and replacing it with another value. Then running the case
through again to see what the result is. This can be done a number
of times, replacing only one variable at a time in the original appraisal.
It is then possible to see how sensitive an analysis finding is to changes
in each variable.
Socio-economic, legal, environmental and a whole load of other
factors apply to all investment decisions, as well as the financial ana
lysis I have described in this chapter. In addition the effects of taxation
should be included in project cash flows.
The methods described are those used most commonly in business
investment-decision making. For example, we can put a value on cash
flows and look at the probability/sensitivity of underlying assumptions
and will readily use this information in a ‘dashboard’ style of approach
to management. However, some may argue that this approach is a little
blunt in that management teams have options to change things at the
start and as they go along. Real option analysis attempts to apply certain
option valuation techniques to capital budgeting and, whilst this is
an area beyond the scope of this text, you might want to search for this
on the web since it is an interesting concept.
111
C h apter Ni n e
Finance, funding
and working
capital
Finance and working capital

In this chapter we will explain how to choose the correct type of finance
and working capital and why this is an important strategic decision. We
will discuss short-term funds, long-term funds, equity, gearing, capital
structures, leasing, export finance, hedging, managing bank relation-
ships, venture capital and managing interest-rate risk.
A company needs to ensure that it has sufficient finance and working
capital to achieve its strategic and operational goals. It is not enough to
just make profits. A company needs cash and funds for its short- and
long-term needs. Many profitable companies have run into trouble
because they do not have sufficient cash. The term ‘overtrading’ refers
to a situation were a company trades at a level beyond its cash and
financial resources and cannot pay its debts as they fall due.
A company will have both short-term and long-term funding require-
ments. These requirements should always be matched with the correct
type of funds as follows:
●● Use short-term funds to provide for short-term needs such as stocks

and debtors.
●● Use long-term funds for long-term financial needs such as property
purchases, vehicles, plant and equipment, and other capital needs.
●● Never use short-term funds for long-term needs. An example of
what can happen if you do this is given in Case 1 of Chapter 16
(page 205).
Short-term funds are where the provider has made no long-term (more
than one year for example) commitment to provide the funds. Long-
term funds are where the provider has agreed to provide the funds for
a term of more than one year.
Examples of short- and long-term funds are provided below:
Short-term funds: overdrafts,

short-term loans, invoice finance,
trade credit, managing stocks
These sources of funds should only be used for short-term needs such
as the purchase of stocks or providing credit.
Bank overdrafts
These are normally repayable on demand. Check the small print on the
overdraft loan agreement and you will find that they can be called back
in by the bank whenever it feels the need. This is because banks have
to comply with certain prudential and balance sheet management
ratios. Many companies incorrectly treat their overdrafts as term
finance. This can be a huge mistake. For example, one company that
was trading very profitably used its overdraft to fund the purchase of
a new branch. When its profits fell, the bank called back the overdraft
and the company was effectively insolvent. So, never use short-term
funds for long-term needs under any circumstances.
An overdraft is a short-term facility whereby a bank allows a cus-
tomer to draw down on its current account and take the account into
a deficit up to an agreed amount for an agreed period of time that is
subject to review periodically and also if certain performance criteria
have not been met. As discussed, the loan is also repayable on demand.
The amount of the overdraft limit will depend upon the credit rating
of the borrower. This type of facility is very popular because it provides
flexibility and the ability to just borrow the amount that is required.
Features of an overdraft are:
●● It is repayable on demand.
●● Its limits depend on the customer’s credit rating.
●● It is flexible in that only the amount required from time to time is
borrowed.
Finance, Funding And Working Capital 113
●● Interest is charged on the amount of the draw down (the overdrawn

balance).
●● Interest is usually expressed as a percentage over base.
●● Interest is only charged on the amount drawn down.
●● There is usually a facility/set-up/commitment fee.
●● There will be penalty fees for exceeding limits without
authorization.
●● The facility will usually run for 12 months, subject to reviews.
●● The limit set is usually based upon cash-flow analysis and needs.
●● The facility limit may be reduced by the bank if it is not
‘comfortable’ with the borrower’s performance.
●● The bank may require security.
Security may take the form of a floating charge over all the company’s
assets. Security will depend on the borrower’s credit rating, track
record and what is available. However, the bank will seek to protect
its position as tightly as it practically can. The bank may also require
guarantees.
The purpose of an overdraft must meet those required in the agree-
ment. Typically this will be to cover short-term trading deficits, seasonal
fluctuations, to provide a bridge between payments and receipts, or to
enable a borrower to take advantage of a specific short-term operational
business deal that it cannot currently pay for.
If it is clear to a bank that a customer is using an overdraft for
something other than short-term funding, then it will probably want
to discuss alternatives.
Short-term loans
These are different from overdrafts. They are loans with a fixed repay-
ment schedule usually for a period of up to two years. The principal
sum is drawn down at the start of the period and repaid along with
interest according to an agreed schedule.
The advantages of a short-term loan include:
●● It is known that the funds are available for the agreed period.
●● There is pre-defined repayment schedule.
●● The loan is not repayable on demand.
●● It is easier for the bank and the customer to monitor.
●● The bank can see if its risk is being reduced as repayments are
made.
Some disadvantages include:
●● There may be covenants/conditions that the borrower has to comply

with or risk being in default.
●● The total funds borrowed might not always be needed, whereas
under an overdraft facility only the funds needed are drawn.
●● The borrower might be paying interest on funds that are not always
required.
●● Short-term loans will usually charge interest at a percentage over
base rate. There are normally facility fees, penalty fees, covenants
and security requirements.
Invoice finance (debt finance)

This is a method of using debtor balances to provide finance. The two
main methods of invoice finance, which will be looked at below, are:
●● factoring;
●● discounting.
In debt finance there are three main parties involved. They are:
●● The client: this is the party who is owed money and wants to raise
finance on the debt.
●● The factor/invoice financier: the provider of finance to the client.
●● The debtor: the person who has received value and should pay
the client.
Debt finance does have significant benefits when managed correctly.
The benefits include:
●● An improved cash flow.

●● There may be less general administration and ledger work.
●● Because cash flow has improved there is an opportunity to obtain
better discounts from suppliers for earlier payments.
●● It is possible to also arrange insurance against bad debts.
●● The earlier realization of sales value enables growth.
●● There may be less company management time used up in chasing
slow payers.
There are, of course, certain disadvantages and these include:
●● The client needs to be fully aware of penalties and be sure that these
are manageable.
●● When factoring is used, the debtor will be aware that the supplying
company is using an invoice financier and this may, incorrectly, be
construed as a sign of ‘tight’ finance. This may be the case in some
countries more than in others where the practice of debt finance is
not so common.
The amount an invoice financier will advance will depend upon the
spread of debt and the quality of the debtors. The greater the spread, the
lower the risk. When debt is concentrated into fewer debtors the risk
will be greater. Of course, the quality of debtors makes a huge difference.
For example, a company that has a local authority as its debtor may be
viewed as a lower risk that a company whose debtors are small start-
up companies.
Some invoice financiers provide both factoring and discounting
whilst others specialize in one or the other. I will describe factoring
and discounting in detail below.
Factoring
In this system the actual book debt is sold to the factor/financier. The
steps in a factoring process are as follows:
1 The client prepares an invoice to the debtor for value provided.

2 The client sends a copy of this invoice to the financier.
3 The financier will make an advance to the client. This can be up to
90 per cent of the gross invoice value.
4 The financier collects the debt from the debtor.
5 After collecting the debt the financier pays the balance of
the invoice over to the client, less charges for the service.
The charges mentioned in 5 above will typically include interest at

the agreed rate, an administration charge, which is normally a percent-
age of the gross invoice value, an arrangement fee and fees for an
auditor/debtor survey. There will charges for late payments and bad
debts.
The reasons you might consider factoring are to:
●● improve cash flow quickly;

●● save time and effort in debt collecting;
●● use debtor balances to provide funds.
Discounting
Under this system the client retains responsibility for debt collection.
The book debts are given as security for an advance. The steps in the
discounting process are as follows:
1 The client raises an invoice to the debtor for services provided.

2 The client sends the financier the sales-day book listing.
3 The financier provides an advance to the client of typically up to
90 per cent of the value of new gross debts listed.
4 The client manages the debtor and collection process.
5 The client receives payment from the debtor.
6 This payment received is paid into a trust account.
7 The client receives from the trust account the balance of the receipt
from the debtor, less charges.
The charges mentioned in 7 above include a discount rate, a commis-

sion fee and the money transfer fee (CHAPS fee).
The reasons you might consider discounting include:
●● The client (your company) retains control of debt collection and

relationship management.
●● The client’s customers do not need to know about the invoice
discounting facility.
●● An auditor engaged by the discounter will undertake regular checks
on the sales ledger. This can be a benefit and a useful discipline.
●● The client has options as to who is responsible for collecting unpaid
invoices by way of either recourse or non-recourse discounting.
Some people consider invoice finance to be short term whereas others

view it as medium- to long-term finance. It all depends on the detail in
the contract. I have included invoice finance under short-term finance
because most of these facilities are subject to short-term (three-
monthly) reviews.
When choosing an invoice financier it is often a good idea to obtain
a reference from a known client or from your accountant.
Trade credit
The time that creditors allow between the delivery of goods or services
and when they expect payment may be a source of short-term finance.
The term is normally between 30 and 90 days and many companies

rely on it as a regular source of finance. However, the excessive use of
trade credit may have a down side. Disadvantages might include:
●● loss of discounts;
●● late payment fees;
●● damage to relationships and loss of goodwill.
Of course, it will always take time for payments to creditors to be

arranged, and trade credit is a source of short-term finance.
Managing stocks
Managing stock levels efficiently will ensure that not too much money
is tied up in stocks but that there is always enough stock to meet pro-
duction and sales needs. It is all about achieving an optimal balance.
The economic batch or order quantity (EBQ) is calculated from the
following formula:
2cd
EBQ =
ip
Where:
c = delivery cost per batch
d = annual demand
i = stock holding cost (as a percentage of value or interest)
p = cost price per item
Example
Crates cost €8 each and are ordered in batches of 400. Demand is 5,000
crates per year The ordering cost is €50 per batch. The stock carrying
costs are 11 per cent per year of the cost of a crate. What is the EBQ?
c = €50
d = 5,000
i = 11 per cent (or 0.11)
p = €8
2 × 50 × 5,000
EBQ =
0.11 × 8
EBQ = 754 crates
Figure 9.1 Economic batch quantity

Annual
cost
Total
cost
Stock
handling
cost
Delivery
cost
Batch
EBQ size
The greater the quantity ordered, the lower the ordering costs per crate
(unit). However, the greater the quantity ordered, the greater the stock
holding costs. Total costs will be minimized by ordering in quantities
of 754. This is illustrated in Figure 9.1.
Leases: short term – long term

Leases are in a class of their own and may be either short term or long
term.
A broad definition of a lease is an agreement that gives a right to
one person (called a lessee or tenant) to posses property of another
person (called a lessor or landlord). The relationship between the lessee
and the lessor is called a tenancy. A lease may be for a fixed period but
may also be subject to earlier termination. Rent is the term used to
describe consideration for the lease. The types of assets commonly
leased include vehicles, aircraft, ships, plant, buildings and large main-
frame computers.
There are many types of lease and the devil is in the detail. However,
the principal types that we will describe are operating leases, finance
leases, and sale and leaseback agreements.
Operating leases
These are generally shorter-term leases where:
●● The lessor supplies the asset to the lessee.

●● The lessor maintains the leased asset.
●● The period of the lease is shorter than the economic life of
the leased asset.
●● At the end of the lease agreement the lessor will either lease out the
asset again or sell it.
Finance leases
These are generally for a longer period. Their principal features are:
●● The agreement is for most of the asset’s expected economic life.

●● Most of the risks and rewards of ownership are with the lessee.
●● The lessee is responsible for maintenance.
●● At the end of the primary period of the asset’s useful life the asset
has little value because it is worn out or obsolete.
●● At the end of the primary (useful) period the lessee might be
allowed to continue to use the asset at a ‘peppercorn’ rent.
Sale and leaseback

A company that owns an asset might sell the asset to a financial
institution and lease it back under the terms of a sale and leaseback
agreement.
The accounting and taxation rules for the treatment of leases vary
between countries. This is a highly specialized area and will affect a
decision on which type of lease to adopt. Most large banks will have
specialist lease departments for each major class of asset, such as
aircraft and vehicles, and will offer advice on which type of lease is
an appropriate fit with your business strategy.
Advantages of leasing
There are many reasons why a company may lease. Only some of the
reasons mentioned below will apply in any specific case. The general
advantages to the lessee of leasing include:
●● There may be certain tax relief advantages depending on the

country/regime.
●● There may be ability to rent an asset that there is insufficient
cash to buy.
●● A finance lease might be less costly than a loan – a comparison
should be made.
●● A straight loan may not be available.
●● Leasing conserves other lines of credit.
●● Up to 100 per cent finance may be available.
●● Income can be matched with expenditure.
●● Leasing is often convenient.
●● It is possible to amortise (spread) the cost of lease fees into and
over the life of the lease.
Possibility of fixed-type costs

The advantages of a lease will depend upon the accounting regime and
taxation rules applicable in the country in which the company is
assessed for taxation.
In the case of an operating lease, the leased equipment might not
at the present time have to be shown on the lessee’s balance sheet. This
will depend upon the accounting regime in the country of the lessee.
There may be advantages in having an ‘off balance sheet’ asset in
terms of ratio analysis and analysts’ reports. However, international
accounting-standards boards are currently debating new rules for lease
accounting that would require companies to account on their balance
sheets all material assets they have the right to use, and also to include
depreciation for those assets. These new lease accounting rules are
at this stage in draft form. Whilst the proposed accounting disclosure
changes might affect accounting and visibility, it is not yet clear how
greatly they might or might not affect strategic financial management
decisions. You need to be aware of these proposed changes.
The lessee in a short-term operating lease may avoid having to carry
out-of-date or obsolete equipment since the lessor takes this risk.
Lease-or-buy decisions
If a company has enough cash to purchase an asset outright it might
still prefer to lease it. Or it might buy it, sell it to a finance company
and lease it back again.
The decision as to whether to lease or buy is both a strategic decision

and one of financial efficiency. The strategic decision might be con-
cerned with a company’s future intentions and the need to conserve
cash for a possible future opportunity. The financial efficiency decision
will be concerned with getting the best financial deal and making the
best use of funds.
Taxation can be a major consideration when comparing lease or buy
cash flows. This is because under some tax regimes, for example, the
annual cost of an operating lease may be written off as a fully allowable
tax expense, whereas in the case of an outright purchase only a part of
the cost of the asset may be written off as an allowable tax expense
(capital allowances in the UK for example). Therefore, to make a lease-
or-buy decision it is necessary, first of all, to compare the net present
values (NPVs) of the two alternative methods.
Example
A machine can be purchased for €30,000 or leased for €7,100 per year
for five years. Tax depreciation on the purchase price is 25 per cent
per year on a reducing balance basis. The lease rental amount can be
claimed as a tax-deductible expense each year. Tax is 30 per cent. The
after-tax cost of borrowing is 9 per cent per year. Which has the lower
net cost, leasing or buying?
Solution
The tax depreciation is shown in Table 9.1.
Ta b le 9.1 Tax depreciation
Year Tax Dep’n (€) WDV* €
1 €30,000 × 25 per cent 7,500 22,500

2 €22,500 × 25 per cent 5,625 16,875
3 €16,875 × 25 per cent 4,219 12,656
4 €12,656 × 25 per cent 3,164 9,492
5 €9,492 × 25 per cent 2,372 7,119
6 €7, 119 × 25 per cent 1,779 5,339
*Written-down value.
The tax depreciation (or capital allowance as it is called in the UK) has
been based upon a hypothetical 25 per cent per year reducing balance.
These figures will be taken into account in the discounted cash-flow
calculations as a tax benefit (Tables 9.2 and 9.3).
Ta b le 9. 2 NPV of leasing (values in €)
Year Lease 30% tax Net Discount PV

payment benefit factor
9%
1 7,100 7,100 0.917 7,100

2 7,100 2,130 4,970 0.842 4,149
3 7,100 2,130 4,970 0.772 3,837
4 7,100 2,130 4,970 0.708 3,519
5 7,100 2,130 4,970 0.650 3,231
6 2,130 –2,130 0.596 –1,269
NPV 20,567
NOTES: Lease payments run for five years.

Tax benefits run for Years 2–6.
In the sixth year there is no lease payment but there is a tax benefit.
Ta b le 9. 3 NPV of purchase (values in €)
Year Cash 30% tax Discount PV

flow benefit factor
9%
0 Cost 30,000 1.000 30,000

1 Tax allowance –7,500 –2,250 0.917 –2,063
2 Tax allowance –5,625 –1,688 0.842 –1,422
3 Tax allowance –4,219 –1,266 0.772 –977
4 Tax allowance –3,164 –949 0.708 –672
5 Tax allowance –2,372 –712 0.650 –463
6 Tax allowance –1,799 –540 0.596 –322
NPV 24,081
Comparing just the relevant costs, leasing is the lower cost option:
NPV of leasing: €20,567

NPV of buying: €24,081
Therefore on this basis the company should lease.

However, this is an oversimplified example used to illustrate how
discounted cash flows and NPVs can be used in lease-or-buy decisions.
There are, in fact, many other variables to consider and take into
account, including making an allowance for running costs (which
might be different under each scheme), making allowance for scrap
value, considering carefully the true economic life of the machine,
deciding how each scheme fits with cash-flow management and with
strategic plans.
Term funding and long-term finance:

optimal gearing, equity funds,
ordinary shares, preference shares,
debentures, bonds, convertibles,
notes, subordinated debt, Eurobonds,
commercial mortgages, venture
capital, derivatives
Long-term funds and finance are required to finance long-term needs
such as fixed assets and term investments. Long-term funds may be
equity (shareholders’ funds) or debt (term loans).
One of the first decisions to make is whether debt or equity funds
are required or whether a mixture of both is needed. The ratio of debt
to equity is called gearing and a company with a lot of external debt
compared with equity is called a highly geared company.
Optimal gearing–debt/equity ratio

Assessing how much debt and how much equity is required is a stra
tegic decision because the effect that gearing has on the return to
shareholders is considerable. When profits are high and interest rates
are low, shareholders will benefit from high gearing.
Example of the effect of high gearing on shareholders’

interests
A company has a term loan of €800,000 @ 5 per cent interest per year.
It has equity (shareholders’ funds) of €250,000. Profits before interest
and taxation in 2012 are €100,000 and in 2013 they are €200,000. Show
the profit after tax and interest that is attributable to shareholders
in 2012 and 2013.
2012 2013
£ £ Increase
Profit before tax and interest 100,000 200,000 100%

Interest (£800,000 @ 5%) 40,000 40,000
Profit before tax 60,000 160,000
Tax @ say 30% 18,000 48,000
Profit after tax available 42,000 112,000 167%
to shareholders
Pre-tax return on £250,000 24% 64%

of shareholders’ funds
Note that profits before interest and tax have increased by 100 per
cent but the final profits after interest and taxation attributable to
the shareholders have increased by 167 per cent. This is because the
company is highly geared and interest rates were relatively low. Being
highly geared, it has fewer shareholders with whom the final profits
need to be shared. The pre-tax return on shareholders’ funds has
increased from 24 per cent in 2012 to 64 per cent in 2013.
At a time of high profits and low interest rates, the owners of a busi-
ness might benefit from being highly geared. However, if interest
rates were to increase substantially they could see their profits decline.
For this reason a company’s gearing is subject to close monitoring
by the shareholders, who are concerned with their returns, and by
the banks who are concerned with their position and the strength of
the company they are lending to.
Reaching an optimal level of debt to equity (gearing) will help maxi-
mize the value of a company. Gearing decisions are determined by
balancing the benefit of the tax deductibility of loan interest (this

tends to increase the desirability of external debt and higher gearing)
and the higher financial risks associated with high gearing (this tends
to moderate the use of debt finance).
Equity funds–ordinary shares

A company issues and sells ordinary shares in order to raise equity
funds. This may either be a new issue of shares or a rights issue to
existing shareholders.
In most countries ordinary shares will have what is called a nominal
value. This is the price at which the shares were first issued and will
usually be very different from the price that they are currently trading
at on a stock exchange. The dividends that are paid on shares are
expressed as a percentage of their nominal value.
Shares are traded freely on a stock exchange at various prices and
this has no bearing on the company’s financial accounts, where the
shares issued will be shown at their nominal value. A company may
issue shares at a price that is higher that their nominal value and the
difference between the issue price and the nominal price will be
shown in a share premium account.
It is the ordinary shareholders who actually own the company, take
the risks, enjoy any final profits or suffer losses. Because shareholders
take the greatest risk they require the greatest return. Accordingly the
cost of equity should be more than the cost of debt.
A company may obtain a listing on a stock market through an initial
public offering (IPO), a placing or an introduction:
●● An IPO requires the publication of a prospectus and an invitation

to the public to buy shares. Sometimes this is referred to as
‘going public’.
●● A ‘placing’ is where shares are placed with a small number of
specific investors. A placing may cost less and be faster than an IPO.
A disadvantage might be fewer shareholders having greater control.
When a company first comes onto the market, most stock
exchanges will impose a control limit (often 75 per cent) on the
maximum number of shares that can be placed.
●● An introduction is where a quotation is made on a stock market
without the shares being made available in order to obtain
a valuation or increase marketability.
The costs of a share issue on a stock market can be substantial; they

include advertising and PR, prospectus costs, underwriting costs, listing
fees, issuing house fees, solicitors’ fees, auditors’ fee and a significant
amount of internal management time.
When pricing shares, care will need to be taken not to over-price
and become under-subscribed or under-price and raise less cash than
is possible. The market is normally efficient! When determining a
price, consider the price–earnings ratio, current market conditions,
the prices of similar companies and the future trading prospects of the
company. The time of entry to the market is paramount. Is it a bull
or a bear market?
In the case of a rights issue to existing shareholders there should be
fewer costs, and there will probably be an expectation by shareholders
that they can buy at a price that is lower than the market price at the
time of the issue.
Preference shares
These have a preferential right over the ordinary shareholders to profits
and to assets on winding-up.
Preferential shareholders, therefore, take a lower risk than ordinary
shareholders and on the whole would expect to receive a lower return.
Preferential shareholders are normally entitled to a stated level of
dividend on their shares and this must be paid before any dividend
can be paid out to ordinary shareholders.
Debentures
A debenture is a loan agreement given under the company’s seal. It
undertakes to provide the debenture holder with a fixed return when
the debenture matures. The debenture deed states the rights of the
holder. Debentures are used as a long-term debt instrument by govern-
ments and large companies.
Debentures will normally be secured over assets of the company by
a mortgage deed. A convertible debenture can, after a certain time, be
converted into ordinary shares. Different countries have slightly dif
ferent meanings for the term debenture. In the United States a deben-
ture may refer to a debt security that is not specifically protected by
assets. Since there is no universally consistent definition of a debenture
it is important to always read the details of the debenture document

and understand precisely what it is!
Debentures may carry a fixed charge, a floating charge or no charge
at all:
●● Fixed charges are over specific assets.

●● Floating charges are charges over some or all of a company’s assets
such that the company can still deal with its assets until the charge
actually ‘crystallizes’ (for example, when the company defaults on
the terms in the deed).
●● No charge simply means that there is no charge over any assets of
the company. These types of debenture are called ‘Naked
debentures’.
Debentures may be issued at par, at a premium or at a discount. In the

UK debentures can be sold and purchased once they have been issued.
Market rules vary from country to country. Debentures can be a useful
way of raising funds although the constraints imposed by charges
might cause inconvenience and a lack of strategic options.
Bonds
These are long-term debts that are issued by a company. Examples
are debentures or loan notes. A loan note is a long-term debt (either
redeemable or irredeemable) raised by a company. These may be either
floating rate, convertible or zero coupon.
Deep-discount bonds
These are bonds that are issued at a large discount against their nominal
value. They can be redeemed on maturity at a price that is above par.
They would normally, therefore, carry a low rate of interest. Since the
holder might get taxed only on the realized gain at maturity these gains
could have an advantage over the interest element, which is taxed
yearly. It all depends on the taxation regime. If there is a tax cash-flow
advantage, then this might be reflected in the rate/price.
Zero-coupon bonds
A zero-coupon bond, as its name suggests, carries a zero rate of
interest. They are issued at a discount against their redemption value.
The advantage of issuing these is the opportunity for immediate

cash-in with no repayment until redemption.
Convertible loan notes (convertibles)

A convertible loan note incorporates a right to be converted to another
form of security at a price and future date; for example, some con
vertible that may be converted to ordinary shares.
Unsecured notes
An unsecured note is one that is not backed up by any form of collateral.
Since lenders have no security they require a greater return.
Subordinated debt
Subordinated debt is subordinate to claims of other debts. This means
that lenders have a lower status, carry greater risk and require a
greater return.
Eurobonds
Eurobonds are international bonds denominated in a currency that is
not native to the country where it is issued. They are traded throughout
the world. They are named after the currency they are denominated in.
For example, Euroyens. A Eurobond is usually a bearer bond. They are
large long-term loans raised by large international companies that
have a high credit rating.
Commercial mortgages
The commercial banking arms of the major banks and specialist insti
tutions provide commercial mortgages that give them, as lender, a legal
charge over property until the full amount (principal and interest) of
a loan has been repaid. The property charged is at risk in the case of
default. A commercial mortgage provider might also impose restric-
tions on the use to which a mortgaged property can be put.
The principal features of a commercial mortgage are:
●● Advances are normally up to 75 per cent of an asset’s purchase price

or valuation, whichever is the lower.
●● Loans are normally of €25,000 or more.
●● Rates of interest may be fixed or variable.

●● Rates may be linked to LIBOR (London inter bank offered rate).
●● They are normally for between 2- to 30-year terms.
●● Repayments may be monthly or quarterly.
●● Mortgages may contain covenants.
●● They are often tailored to customer needs with the ability to take
repayment holidays.
●● They are simple to arrange compared with most other funding
methods.
Venture capital
Venture capital organizations will consider providing this type of
equity capital to high-growth companies in the expectation of a return
through an event such as a company sale of IPO. Venture capital pro
viders are naturally very selective and will require significant equity
and control. Because they tend to take on higher risks they expect
a greater return.
If you have a sound business proposition then venture capital
providers may be interested. Their main sources of new business are
start-ups, management buy-outs, exit strategies for business owners
and entry into new markets.
Each venture capitalist will have a different area of business
specialization and deal size. Deals in the market are often in the €1m
to €100m range. The requirements of venture capitalists are explained
more fully in the section on ‘Financing entrepreneurial thinking’
towards the end of this chapter.
Derivatives for hedging

Derivatives are mentioned here because they are relevant to interest-
rate risk and currency exchange management in relation to loan contracts.
A derivative is simply an instrument whose value is derived from
the value of an underlying asset, commodity, index or some other item.
Forwards/futures, options and swaps are all forms of derivative.
A forward/future is a contract to buy or sell an asset at a future date
but at a price that is specified today. A forward contract is written directly
by the parties themselves, whereas a futures contract is written by an
exchange/clearing house where the contract can be exchanged.
An option is a contract that gives the owner the right, but not the
obligation, to buy (a call option) or sell (a put option) an asset at a matu-
rity date. There are different types of option. For example under an
‘American option’ the owner can require the sales to take place at any
time up to the maturity date. A ‘European option’ owner has the right
to require the sales to take place on the maturity date but not before.
You need to read an option contract carefully to ensure you understand
it fully; there are different types.
Export finance: bills of exchange,

letters of credit, export credit
guarantees
Special types of finance are provided by banks for exporters. Export
finance includes bills of exchange, letters of credit and export
guarantees.
Bills of exchange
The best definition of a bill of exchange is that given in the Bills of
Exchange Act of 1882.
A bill of exchange is an unconditional order in writing, addressed by one

person to another, signed by the person giving it, requiring the person
to whom it is addressed to pay on demand, or at a fixed or determinable
future time, a certain sum in money to or to the order of a specified
person, or to bearer.
International trade finance may be provided by bills, and when a bank

discounts a bill it is actually buying the bill at a price that is at a discount
from the bill’s face value.
Letters of credit
These are documents addressed by a banker to a correspondent bank
or agent requesting that an advance be made to the holder and to debit
the sum paid to the banker. Various styles of letter of credit are used
in export finance.
Export credit guarantees

This is a UK form of insurance against non-payment by overseas buyers.
It is provided by the Export Credits Guarantee Department (ECGD).
Using retained earnings as a source

of funds
It is, of course, very convenient to simply retain earnings as a source of
funds by not paying out dividends. Some companies do just this to the
extreme and pay no dividends at all but simply plough profits back into
the business, an advantage being that there is no cost of raising capital.
In deciding how much dividend to pay, a company will seek to find an
optimal mix of finance that minimizes its overall cost of capital.
However, finding this optimal mix is a subject of many theories.
The traditional view is that there is an optimal capital structure that
will increase the value of the company (see Figure 9.2):
●● As gearing increases lenders would assume that a company is more

risky and will require a higher return.
●● The cost of equity may also rise as gearing increases and financial
risk increases.
●● The weighted average cost of capital initially falls as the proportion
of debt increases but then increases with the rising cost of equity
and debt.
There are other views on this subject, including those of Myers and
Mailuf and of Modigliani and Miller. There are worth researching on
the web if this is a subject that interests you, but for the purpose of
this book I just mention them here and take a more simple pragmatic
view that each company will have a way of finding what it believes to
be its optimal capital structure. It is a strategic decision that takes into
account many variables such as future profit expectations, valuations,
financial strategy and taxation.
In considering an optimal capital structure and dividend policy
a company will need to:
●● establish a target for the optimal structure taking into account all
constraints, variables and the company’s dividend policy;
●● use the optimal capital structure to determine the cost of capital;
Figure 9. 2 A traditional view of the cost of capital
As gearing increases the cost of debt (Kd) eventually increases. The cost of equity
(Ke) rises as gearing increases. The weighted average cost of capital (Ko) may
initially fall a little as the cost of debt increases, then it will increase with the rising
cost of equity and debt. The optimal point of gearing is reached at point ‘P’.
●● analyse all strategic options and prepare a sensitivity analysis;

●● appraise projects using this agreed cost of capital.
A company will be seeking to maximize shareholder wealth; retaining

profits will not necessarily achieve this. However, using retained
earnings does avoid some costs and also reduces the possibility of
a loss of control that might occur with a new issue and change of
shareholders.
Bank relationships
We have seen in this chapter that a company has many sources of
finance to match its short- and long-term needs. These include internal
and external sources.
Many of the external sources of finance are available through banks
and financial institutions. A company may need to engage a number of
such institutions in order to obtain all of the services and funds it

requires. Larger banks tend to offer most services but in many cases, and
in order to introduce competition, it may be necessary to engage more
than one bank. Also, it sometimes pays not to have ‘all your eggs in
one basket’ and it might be strategically beneficial to separate out
services with a number of institutions.
I think that many financial directors will feel that banking relation-
ships can be hard to maintain. Certainly many banks in recent years
have viewed customers more on a transactional rather than on a rela-
tionship basis. At a lower level, experienced and qualified branch
managers have been replaced with less experienced and less qualified
staff who are often sales trained and targeted whilst not being em
powered to make the sort of experienced judgement calls that a finance
director or business manager would require. At the higher end of the
corporate banking relationship ladder there has been a high staff
turnover and often lack of deep experience.
Many finance directors have different institutions handling each
type of transaction. The advantage is that there is more competition and
less leverage with any one institution. A disadvantage is that the customer
with lots of small relationships is less important to any particular bank
and may find it has a lower level of bank attention, trust and goodwill.
However, on balance most finance directors want to be in control and
do not want to rely on a relationship that may not be reciprocated.
In general I would make the following observations at this point
in time regarding bank relationship strategy:
●● Banks continue to become more transactional rather than
relationship driven. As a result of this some corporate executives
may value their bank relationships less than they used to.
●● Many customers continue to separate out their services by using
different financial providers. In particular more companies than before
separate out their money-transmission from their lending bank.
●● Many customers pay for stand-by and back-up facilities with
an institution other than their principal bank.
●● Relationship managers often change and often are not as
empowered as a finance director had assumed.
●● Depending on a single banking relationship is generally not a robust
strategy.
When deciding on which bank to engage it can be helpful to make a list
of services required and the potential institutions that can be used,
as outlined below.
Service Institution/Bank/Network
Money transmission and Bank A and Post Office Network

day-to-day banking
Current accounts Bank N
Long-term loans Bank C
Short-term loans Bank N
Overdrafts Bank N
Working capital finance Invoice discounter E
Payment services Bank N
International payments Bank N
Merchant and investment banking Bank Y
Foreign exchange dealing Banks N and C
Money market dealing Banks N and C
Term investments Bank XXX
The simple logic behind these theoretical choices is:
●● Consider keeping money transmission separate from the bank that

provides current account and overdraft so that funds can be
diverted to another bank quickly if this is required (refer to Case 5 in
Chapter 16, page 213).
●● Find the most convenient network for paying in and transmission
that is independent from your current account bank. This might be
the Post Office Network.
●● Look for a strong institution to provide all current account,
overdraft, short-term loans, payments and other day-to-day services.
●● For long-term loans introduce more competition and consider
keeping this away from your current-account provider.
●● For working capital finance consider a specialist invoice finance

company.
●● Get some competition when making foreign currency purchases by
asking two or more banks to quote.
●● In the case of term and other investments look closely at the credit
rating of the institution. Consider spreading risk.
●● Consider specialist banks for merchant and investment banking
needs.
Having the time and resource to research and build up these multiple
banking relationships may be difficult for a small company with a hard-
pressed finance director. In the case of a large multinational organiza-
tion it will be normal to have many banking relationships to obtain best
value and for strategic reasons. The balance of power may be more
weighted towards the corporates and they can demand a better response
and level of service.
Covenants
An important element to a good banking relationship is a thorough
understanding of any loan covenants since these are often a source of
frustration for businesses (as seen in Case 4 in Chapter 16 page 211).
A loan covenant is a condition that requires a borrower to fulfil
certain conditions.
Failure to comply with a covenant may result in a default, with
penalties being applied and/or the loan being called in. Covenants may
be waived and the loan agreement renegotiated by the lender. This
will normally only occur if it is in the lender’s interest.
Covenants are generally undertakings given by a borrower as a part
of a loan agreement. They require the lender to ensure that the risk to
the lender does not increase prior to maturity. They should not be
entered into lightly because failure can result in adverse consequences
for the borrower. They help increase a bank’s control and give advance
warning of potential problems.
There are many types of covenants, depending upon the type of
business. They may include:
●● loan to value ratios;

●● interest cover;
●● a requirement to keep certain insurance cover;

●● agreements to pay all taxes;
●● the submission of financial reports;
●● maintenance of financial ratios;
●● additional lending restrictions;
●● dividend payment restrictions;
●● restrictions on business ownership and mergers;
●● restrictions on changing management.
You can see from the above that a covenant in a loan agreement can
put a bank in a position of considerable strength that it may use for its
own protection and advantage. Covenants should not, therefore, be
entered into lightly.
Financing entrepreneurial thinking

and venture capitalists
It is hard to precisely define an entrepreneur but one thing they have in
common is an ability to see the future as a different place. They have
a vision, ability to innovate and the enthusiasm to make their vision
happen. They are the creators of the new ideas needed to create new
opportunities and growth.
Few of these new ideas would ever get started without sponsorship
and finance. This requires a form of judgement and risk analysis in
addition to the financial analysis applied to less ground-breaking
ideas and opportunities.
Some entrepreneurs are inventors of entirely new products whilst
others have an idea that will use existing technology to achieve a dif
ferent outcome. Of course, not all entrepreneurs are inventors but
certainly they will be promoting a new idea. Compared with an existing
product we are talking about shades of grey as far as a financier is
concerned. In terms of funding research for new ideas this is often
considered as either applied research (where a specific application has
been identified) or pure research (where the idea may have benefits that
have yet to be linked to an application). All of this ‘grey stuff’ creates
a problem for the financier who uses simple financial analysis alone
and is not the sort of risk that most banks will consider. In cases like
these the entrepreneur needs to talk with a venture capitalist.
A new idea carries a higher risk. Providers of finance for higher risks
require a higher return, and this typically requires an equity investor.
Venture capitalists own equity in the companies they invest in and
will usually require significant control.
Venture capitalists are understandably very selective in their invest-
ment decisions. Typically they will reject the vast majority of proposals
that come their way. Their interest will be in very high growth opportu-
nities with a clearly defined exit strategy within a typical time frame of
three to seven years. This will need confidence in the entrepreneur.
This is extremely important since even a good idea with a weak entre-
preneur will not succeed.
A venture capitalist will not just provide capital but will be involved
in every stage of the business opportunity from concept to their final
exit. This will include:
●● idea creation and development;

●● start-up;
●● business development;
●● exit.
The financing stages are typically:
●● seed money to help prove the new idea;

●● start-up money to fund product development and marketing;
●● round one money for manufacturing and sales;
●● round two money for finance sales until profitability is reached;
●● round three money to assist expansion of the company once it is
profitable (this is also called mezzanine finance);
●● round four money to assist going public and reaching the exit point.
When looking for a suitable venture capitalist consider their current

portfolio. It might help if they specialize and have knowledge of the
sector you are in. Also, consider their typical investment size and any
regional preferences.
Venture capitalists are rewarded for their work and risk through
a combination of management fees and interest/share of profits.
There are alternatives to venture capital, and one of these is ‘crowd
funding’. This simply means spreading the risk over large numbers of
people, each of whom makes a small donation. Online communities
make it easy to reach large groups of potential investors at a very small
cost.
Interest-rate risk
An organization that either borrows or invests money will be exposed
to an interest-rate risk. It may either pay more interest than it expected
or receive less interest income than it had hoped for. Interest-rate risk
is the sensitivity of profits to fluctuations in interest rates.
As part of its risk and sensitivity analysis an organization should
calculate what effect a change in interest rates will have on both profits
and cash flow. What effect would a 0.5 per cent change in interest rates
have on the company and how likely is this risk? Clearly a company with
more variable/floating-rate interest will be more sensitive to changes
than one with a higher proportion of fixed-rate contracts. However, as
we shall see below, even companies with fixed-rate contracts have an
element of exposure!
Interest rates are used by governments and central banks to help
control an economy. The rates may fluctuate due to changing eco-
nomic conditions, yield curves and the structure of rates. Central
banks and governments may use interest rates to help control inflation.
Case 16 in Chapter 16 (page 236) provides some insight into how
governments might use interest rates to control inflation and the risks
this creates for some businesses.
Generally, investors want more compensation for losing their
liquidity and tying up their cash for a longer term. This means that
they want a higher interest rate for investing longer term. This is one
Figure 9. 3 An interest rate/yield curve

reason why an interest-rate/yield curve might be positive. However, for

a variety of reasons a yield curve can also be negative. The shape of a
yield curve needs to be understood when selecting a hedging strategy.
Floating or variable rate interest exposure

A company that has a high level of floating-rate debt will be very vulner-
able to changes in interest rates. Floating rates change according to
general market conditions. The company might find that its customers
do not accept price increases in line with changes in interest rates. For
example, a customer might have an alternative supplier with a different
capital/debt structure that does not need to increase prices when
interest rates rise.
Fixed-rate interest
Whilst a company that has a high level of fixed-rate debt might not be
so vulnerable to the volatility of market rates it does still have an ex
posure to changes in rates. For example if the interest rate falls sharply
then a company with fixed-rate debt might find that it is not so com-
petitive as a company that has floating-rate debt and can now offer lower
prices! This is often overlooked, and the extent to which a company is
exposed will depend upon the capital/debt structure of its competitors.
It is a simple matter to determine the degree to which an organization
is exposed to interest-rate movements. One method employed is that of
‘gap analysis’. This is where assets and liabilities that are sensitive to
interest-rate changes are grouped together according to their maturity
dates. A ‘gap’ may occur and this will help identify overall exposure. When
preparing a gap analysis, be careful not to ignore ‘basis’ risk. This is the
base rate upon which floating-rate margins are based. For example, some
contracts may be based on LIBOR and others may use a different base.
Interest-rate risk management

There are a number of ways of managing interest-rate risk. An organiza-
tion can use internal methods such as matching or smoothing, or external
methods such as derivatives and forward-rate agreements.
Matching is where an organization matches its interest-bearing
assets and liabilities so that exposure is offset. Smoothing is where an
organization keeps its fixed and floating-rate exposure in balance.
Forward-rate agreements (FRAs) fix an interest rate on future borrow

ings, thereby hedging risk. FRAs are normally only available on larger
loans. The bank will fix the rate of interest for a future date. If the actual
rate on that day proves to be higher, then the bank pays the organization
the difference. If the actual rate on the day is lower, then the organiza-
tion pays the bank.
Interest-rate derivatives include futures, options, caps/collars/floors
and swaps. A borrower may sell an interest-rate future to hedge against
rate rises, and lenders may buy futures to hedge against falls in rates.
Interest-rate options grant the buyer the right but not the obligation to
deal at an agreed interest rate. ‘Caps’ set a ceiling to an interest rate, a
‘Floor’ is an option that sets a lower limit to interest rates and a collar is
the simultaneous purchase of a cap and a floor. An interest-rate swap is
where two parties agree to exchange interest-rate payments. A fixed-to-
floating-rate currency swap is both a currency and an interest-rate swap.
When using any of the external methods of matching interest-rate
exposure, your finance director will need to understand the product and
be sure that any proposed transactions are authorized by the board and
not speculative transactions (unless this is the organization’s business).
Financial markets
There are many types of institutions that make up the financial
markets. The type of institution you deal with will depend on the type
of finance or capital required.
Financial intermediaries
A financial intermediary links lenders (those with surplus funds) to
borrowers (those who need funds). The service they provide is based
upon aggregation, the economies of scale, risk sharing and maturity
transformation. Types of financial intermediary include finance
houses, commercial banks and institutional investors.
Money markets
Money markets provide short-term capital. This includes short-term
financial instruments and short-term lending/borrowing. The money
markets are operated primarily by the banks.
Capital markets
The capital markets provide long-term capital. A stock exchange is
a principal capital market and has two main purposes:
●● It is a primary market for raising new finance through the issuance

of shares or new loan notes.
●● It is a secondary market to enable existing investors to sell their
investments.
International money and capital markets

These exist for major companies to raise large amounts of finance and
include the Eurocurrency Market and Eurobonds.
Summary
Choosing the correct type of finance and working capital is an impor-
tant strategic decision. In this chapter we have discussed short-term
funds, long-term funds, equity, gearing, capital structures, leasing,
export finance, hedging, managing bank relationships, venture capital
and managing interest-rate risk. Your finance director will be trying to
ensure that there is competitive finance available to meet the strategic
and operational needs of the company. Key to this is achieving an
optimal balance between the lowest cost and the maximum flexibility
of finance to support the aspirations of the business.
Choosing the correct bank/s and maintaining a relationship can be
challenging for smaller companies, particularly if they do not warrant
an experienced and empowered banking executive. Changes in bank
ownership and internal bank re-organizations can result in a finance
director losing a long-standing relationship with a bank executive who
understood the customer’s business. Relationships can have enormous
value and are worth some investment to maintain. However, many
banks and their customers now simply operate on a transactional
basis.
Several of the case studies in Chapter 16 demonstrate how things
can go wrong between banks and customers and in managing finance
generally.
142
C h apter T e n
International
transactions
and currency
risk
B anks and other institutions provide a range of services to facilitate,

finance and insure international transactions. These include inter
national payments, documentary credits and collections, guarantees,
insurance, currency accounts, loans, foreign exchange purchase, currency
exchange risk management, hedging and derivatives.
In this chapter I will concentrate of the most common types of foreign
transactions. These are:
●● buying or selling foreign currency;

●● foreign exchange risk management;
●● foreign currency accounts;
●● export invoice finance.
Buying or selling foreign currency

If you are trading internationally you will probably need to buy or sell
foreign currency.
If you are importing you may need to purchase foreign currency
to pay for the goods you are importing. For example if you are a UK-based
company purchasing yachting equipment manufactured in New
Zealand, the manufacturer may require that you pay for the goods in
International Transactions And Currency Risk 143
NZ dollars. Therefore, you will need to purchase the NZ dollars and

probably pay for them using your local currency – Sterling.
When approaching your bank to purchase the NZ dollars you will
need a destination account. This could be the supplier’s account or
you might have your own NZ dollar account already set up. If you are
regularly trading with NZ you may well have.
The bank will offer you a rate of exchange for NZ dollars against
sterling, and there will also be payment/transaction fees. You will, par-
ticularly if the payment is a large one, want to obtain competitive
quotes. To do this you will need to have dealing lines set up with other
banks. This is so that they know who you are and can ensure they get
paid.
It is normal to have three dealing lines in place and obtain simul
taneous quotations. This may require several staff at the office working
together and in close communication.
Once you have accepted the best quote, you will provide payment
instructions and the deal is concluded.
Similarly, if you sell goods overseas, or for a variety of other reasons,
you might need to sell a foreign currency. This is a similar procedure.
Always ensure that you get a good price and obtain competitive quotes.
If you expect to have to buy or sell foreign currency at a future date
against your local or some other currency, then you have an exposure to
the risk of exchange rates moving either in your favour or against you.
We will discuss below how to hedge against such events.
When buying or selling currency it is worthwhile remembering:
●● Open dealing lines with a number of providers and read and

compare the small print in their terms and conditions.
●● When obtaining competitive quotes be sure that you compare like
with like. The market changes every second, and if you are to obtain
a fair comparison between quotes they will need to be obtained and
compared simultaneously. Work out in advance how you are going
to do this. Large companies have a treasury operation set up to do
this but a smaller company may need to make some special
arrangements.
●● It is always your responsibility to ensure that the provider of the
foreign currency is reputable because your government may not
regulate foreign currency trading. Foreign currency trading may
provide a vehicle for illegal activity such as money laundering and
you need to be sure of whom you are dealing with.
●● Obtain a good mix of providers to quote: some banks and some

independent currency providers.
●● Plan the transaction well in terms of time, staff and having the
dealing line in place.
●● Indicative rates can sometimes be used to entice a buyer. The real
rate may be not so good. Also check for hidden charges.
●● Carry out security and status checks on your providers.
●● Make sure that you understand the operating procedure for delivery
and holding of your currency. Currency you have bought that is
pending transfer should be held in a separate holding account.
●● You must insist on timely documentation and transaction
confirmations.
●● You should normally expect better rates for larger transactions.
Foreign exchange risks

A foreign exchange risk can occur whenever there is a mis-match
between the currencies in which receipts and payments are made.
For example, if a NZ-based company has NZ customers who pay in NZ
dollars but has suppliers in the United States who require settlement
for their invoices in US dollars, then there is a mis-match between the
currencies of receipts and payments. There is an exposure to foreign
exchange risk.
Unless the company is in the business of trading and speculating
in currency it should seek to either eliminate or manage currency
risks. The aim should be to make neither a loss nor a profit from an
exposure but to manage the position.
Some of the common causes of foreign exchange risk are:
●● making overseas payments for imports that are priced in a foreign

currency;
●● receiving foreign currency for exports;
●● borrowing in a foreign currency;
●● investing or depositing funds in a foreign currency;
●● having overseas subsidiaries and operations;
●● owning property overseas.
Some companies may have both overseas assets and liabilities that,
to an extent, match or partially offset each other, thereby reducing
their exposure to currency risk. However, in most cases a company

will need to develop a plan and strategy for managing its exposure and
we will discuss these techniques later in this chapter.
A currency loss/gain can occur on a specific transaction (transac-
tional risk) or on translation (translation risk). Examples of these are
given below:
Transactional risk example

A UK company imports superyachts from the United States. The board
have approved the purchase of one yacht costing US$825,000. The
UK equivalent at the time was £500,000 and this was based on the
US$/£ rate at the time of £1 = US$1.65. The approved UK budget was,
therefore, £500,000.
The US supplier agreed to hold the price at US$825,000 for six
months. When the order was due to be placed the rate of exchange
had changed to £1 = US$1.61.
UK £ Rate of US$
Sterling exchange
Approved budget 500,000 1.65 825,000

Actual at time of order 512,422 1.61 825,000
Loss on exchange 12,422
Because the rate of exchange has moved against the company, it will
require an additional £12,422 in order to place the order and complete
the transaction. This will require going back to the board and seeking
approval. There are ways of hedging against this type of occurrence
that we will discuss later.
Translation risk
When a company has overseas assets or liabilities at the year-end
balance date, it will need to convert these into its local currency for
financial reporting.
For example, a UK company has a US asset valued at US$300m. The

rate of exchange at 31/12/10 was £1/US$1.65 and the rate of exchange
at 31/12/11 was £1/US$1.69. The loss on translation will be:
Asset value at 31/12/10 US$300m. Rate £1 = US$1.65 = £181.8m

Asset value at 31/12/11 US$300m. Rate £1 = US$1.69 = £177.5m
Translation loss on 31/12/11 £4.3m
At the point in time (31/12/11) the company would record a translation

loss of £4.3m. A few days later the rate could have moved either favour-
ably or adversely.
Economic risks and hidden risks

Economic and hidden risks may occur when a rate of exchange move-
ment in a currency that is not dealt in directly affects competitiveness.
For example, a UK manufacturer sells products to a UK customer – on
the face of it there is no exchange exposure here. However, what if the
pound strengthens against the yen, making imports from a Japanese
competitor cheaper to the UK customer? This is one example of an
economic risk. There are many other hidden and economic risks, par-
ticularly through the supply chain where a local supplier might be
sourcing supplies from an overseas company.
Foreign currency accounts

A company that has regular foreign currency assets or liabilities might
find it convenient to open a foreign currency account. It can use the
account to match or partially match foreign currency receipts and pay-
ments, thereby reducing its risk to currency exchange rate exposure.
The advantages include:
●● a possible reduction in the risks associated with exchange rate

movement;
●● fewer costs associated with undertaking currency deals;
●● convenience;
●● an account where overseas customers can deposit payments;
●● foreign currency funds available at all times when needed;
●● simple to set up and to view balances;
●● overdrafts might be possible – subject to credit rating.
There are possible disadvantages, particularly in holding large bal-

ances in foreign currencies. Unless you expect to have an offsetting
transaction/balance you will increase exposure and risk to exchange
rate movements. Some countries might impose exchange controls that
could affect your ability to move funds. Then there is the possibility of
devaluation. Of course there will be fees involved in opening a foreign
currency account and you might be required to maintain a minimum
balance.
Opening a foreign currency account is a fairly simple procedure
and can be undertaken with most large international banks. Of course,
when purchasing funds to deposit in a currency account it is generally
beneficial to obtain competitive quotes.
Forward exchange contracts

Future exchange rates are very difficult to predict and if a company
has an exposure to a currency exchange risk it might choose to hedge
against this by using a forward exchange contract.
A forward contract is simply an agreement between two parties
(one of which is usually a bank) to exchange one currency for another
currency at a certain rate of exchange at a future date.
Forward contracts have the following principal features:
●● They are for the purchase or sale of an amount of a specific

currency.
●● The exchange rate is fixed at the date of the contract.
●● The delivery of the currency is at a specified future date.
●● The contract is binding.
Example of a forward contract

A US-based importer contracts to buy goods from a UK supplier for
£50,000. The invoice is payable in 30 days’ time.
The US importer takes out a forward contract with its bank to deliver
£50,000 in 30 days time at a rate of £1/US$1.63.
The US importer now knows that the cost will be US$81,500 (this is
£50,000 × 1.63). This deal has provided certainty and the US importer
may be able to back this with a US sale, knowing what its costs are. When
using the forward exchange market it is usually best to obtain several

quotations.
The forward contract has introduced certainty and has enabled the
US importer to remove the currency risk. The importer is not a currency
speculator and simply wants to remove risk and match currencies.
Of course, the actual rate on the day in 30 days time (the spot rate)
could be very different. However, this is not relevant and the company
should not be wondering if it has made a profit or loss by taking out the
forward contract compared with the spot rate on the delivery day – it has
introduced certainty in its normal business transactions and eliminated
risk. It would only be interested in taking a position with a view to gain
if the directors had authorized such speculation or if speculating on
exchanges was in the normal course of business.
Hedging using the money market

A business with a future currency exposure might decide to borrow in
its home currency on Day 1 and use the borrowed money to purchase
the required foreign currency, which will be deposited in an interest-
bearing account until needed. By doing this, the company will have
certainty of the exchange rate and be able to eliminate currency risk on
the principal amount. It will have earned interest in foreign currency
and incurred local interest on its borrowing, and there will be an
exchange exposure here. However, over a short period this will be small
compared to the exposure on the principal sum. Of course, there may
also be differences between the local and the foreign interest rates. This
is a useful alternative to buying forward, especially if the company
already has an appropriate foreign currency account. In an efficient
market there should not be an enormous difference in cost between
using this method and using the forward exchange market. It might
be worthwhile comparing the costs of this method with forward
exchange market quotations.
Currency futures
A currency future is a form of derivative and can be used to hedge
against currency risks.
Currency futures are contracts where the ‘underlying’ is a currency

exchange rate. They can be traded in the same way as any other future
on the futures exchange markets. They are different from a forward
contract, which cannot be traded. They are based on the exchange
rates of two markets and are settled in the underlying currency of the
futures market. A currency future is a futures contract to exchange one
currency for another at a specified date at a price that is fixed on the
purchase date. Accordingly these futures are used to hedge against an
exposure and, in the case of an organization authorized to do so, they
may be used to speculate.
In this book we are only interested in hedging as a tool of financial
management.
Some of the principal advantages of currency futures are:
●● Transaction costs are often lower than other forms of hedging.

●● They are fully tradable.
Some principal disadvantages are:
●● They to not allow companies to take advantage of possible future

exchange rates as do currency options (discussed later).
●● There are only a limited number of currencies available.
●● Since futures are tradable, their price may move differently from
their ‘underlying’.
Example of a futures contract

A US-based company buys wine from a French company for €200,000
payable in 30 days. The US company has decided to hedge against its
exposure by using the currency futures market.
Current rates are:
Spot rate US$0.935/€

Futures rate US$0.945/€
The rates in 30 days time are:
Spot US$0.955/€
Closing future price US$0.960/€
The contract size is €100,000.

Only three-month contracts are available.
The company will need to buy € or sell US$.
The number of contracts it will need to buy is exactly two

(€200,000/€100,000)
The ‘tick size’ (the smallest unit of movement in the contract price)
is 10.00 (€100,000 × 0.0001)
Opening futures price – buy 0.945

Closing futures price – sell 0.960
‘Tick’ movement 150
The futures profit is 150 ticks @ say US$10 per tick × 2 contracts =
US$3,000. The net payment is 30 days’ time will be:
30 days spot €200,000 @ 0.955 US$191,000

Futures profit US$3,000
Net US$188,000
This calculation is for illustrative purposes only, to demonstrate the

principle of how currency futures pricing might work. Each type of
contract needs careful examination by skilled staff experienced in
futures trading. They will need to plot out their understanding with
their adviser before committing to anything. It is exceedingly easy to
make a mistake with this type of transaction!
Currency options
A currency option gives the owner the right but not the obligation to
exchange one currency for another at a future specified date and at a
specified rate. Therefore, an option enables a company to limit its
downside without limiting its gain. Because an option allows for
unlimited gains, some people argue that this part of the deal is a form
of speculation. Because the user of an option is not obligated to buy
or sell, their potential gains are not limited.
Currency options are often traded over the counter between two
parties or on exchanges.
The ‘underlying’ of an option is the foreign exchange rate. A call
option is the right but not the obligation to buy the underlying. A
put option is the opposite in that it is the right to sell but without any
obligation. A ‘strike’ price is the guaranteed price chosen by the user/
client. This can be at the money (ATM), in the money (ITM) or out of
the money (OTM). ATM is the market rate, ITM is better than the market
and OTM is worse than the market. Options are not like futures or
forwards where the current rate in the market is pre-determined. The
client chooses a rate.
A currency option might be appropriate when the future foreign
cash flow is uncertain. If the option shows a profit on the delivery date
the holder will exercise the option and the net cost will be the cost of
the underlying plus the premium less the profit.
Example of a currency options contract

If a £/US$ currency option contract allows the owner to sell £400,000
and buy $600,000 on 31/12/11, the pre-arranged strike price is 1.5000
and the notionals are £400,000 and $600,000. The contract is a call
on US$ and a put on £ Sterling.
If on 31/12/11 the rate is 1.45, then the dollar is stronger and the £
Sterling is weaker. The option will, therefore, be exercised. The owner
of the option will sell £400,000 at the option price of 1.5 and immedi-
ately buy it back at the spot market price of 1.45, thereby making a
profit as follows:
£400,000 @ 1.50 = $600,000

$600,000 @ 1.45 = £413,793
Profit = £13,793 (£413,793 – £400,000)
Like futures, an option contract can be exceedingly complicated and a

company will seek expert advice. It is best to plot out the cash flow and
options on a chart, and to ensure they are fully understood and agreed
with the financial institution providing advice.
Currency swaps
A currency swap is where parties contract to swap equivalent amounts
of currency for a period of time by exchanging debt from one currency
to another.
Example
A UK company wishes to invest in the United States and borrows £20
million from a UK bank at 5 per cent. The £20 million will be converted
Figure 1 0.1 Currency swap
US$32m
Start US company £20m UK company
6% $ interest
Duration 5% £ interest
£20m
Maturity US company $32m UK company
into US$ at the spot rate of $1.60/£1. The US investment will yield
income in US$. The UK company agrees to swap the £20 million for
$32m with a US company that now becomes the counterparty to the
transaction. Interest is at 6 per cent on the $32m. The UK company will
invest the whole of the $32m in the United States (see Figure 10.1).
●● UK company receives interest on $32m @ 6 per cent = $1.92m per

annum.
●● The UK company gives this $1.92m to the US company so that the
US company can pay its interest.
●● The US company passes its interest to the UK company. This will be
£20m @ 5 per cent = £1m per annum.
●● The UK company pays this £1m over to the bank, its lender.
At the end of the swap period:
●● The UK company will pay back the $32m.

●● The UK company receives back the £20m.
●● The UK company pays back the £20m to its lender.
Currency swaps require an exchange of interest and principal. They may

be used to hedge against a risk.
The principal features of a currency swap are:
●● Interest rates are agreed in advance.

●● Currency exchange rates are agreed in advance.
●● The two parties exchange the principal sums at maturity.
The three types of currency swap are: fixed-to-fixed rate, fixed-to-

floating rate and floating-to-floating rate.
Currency swaps may be used to hedge against currency movements
for a longer period than is normally possible using forward contracts.
Deals are usually for seven years or less, and amounts generally exceed
£5 million.
Before a currency swap is undertaken it is necessary to consider the
implications for the company’s balance sheet. Accounting rules vary
from one country to another, but many will require the swap to be
treated like a back-to-back loan and shown in full on the balance sheet,
thereby affecting balance sheet ratios and analysis.
Invoicing in domestic currency

One very simple way to eliminate currency risk is to get foreign cus
tomers to agree to be invoiced in the seller’s currency and to settle in
this. This simply passes the problem over to the foreign customer and
may well be acceptable to them, depending on their own exposures
and trade. For example it may help them offset another position. The
same can apply to imports. It is always worth asking if a foreign cus-
tomer or supplier would accept invoice/settlement in your own local
currency. Many will!
Advance payment
To obtain an acceptable and certain rate of exchange it may be possible
to settle with the foreign party in advance. However, this will replace
an exchange risk with a delivery risk.
Matching
A company should always try to match its foreign currency receipts
with any similar currency payments to eliminate or partially eliminate
currency exposure. This is probably more easily done through the oper-
ation of a foreign currency account.
Intra-group trading
Subject to the laws, regulations, taxation implications and accounting
conventions of various countries, it might be possible to net off debit
and credit balances on intra-company trading so that only net balances
are paid. This will reduce foreign exchange exposure and transaction
costs. However, it can be a minefield of taxation and other regulations;
beware of falling foul of them.
Export invoice finance

Many banks offer a range of export invoice finance facilities. For example:
●● Up to 85 per cent of an export finance invoice can be made available

the working day after billing. This can help a company offer open
terms to an overseas customer, helping it compete with local
suppliers.
●● Many global banks provide sales ledger management services with
collections and cash allocation processes through their own
networks and through corresponding invoice finance providers
abroad. They also provide linguists.
●● Some banks also provide overseas customer credit protection.
This can be compared to the ECGD service described previously.
●● Larger global banks will also provide major customers with
a dedicated relationship manager who can advise and assist with
complex international transactions.
Single Euro Payments Area Direct

Debit Scheme
The Single Euro Payments Area Direct Debit Scheme (SEPA DD) was
launched in 2009 and may be nearing the point of mandatory imple-
mentation in a few years’ time. SEPA DD is a single and convenient way
to accept and make payments across European countries. For example,
the scheme enables a UK company to organize all euro payments from
a single domestic bank account. This will improve cash control and
money management, making business transactions throughout Europe
much simpler. SEPA DD is designed to make business throughout

Europe a lot easier and it will, no doubt, enable more companies to
consider growing their business in Europe. Your bank will advise you
further and you will be impressed with how easy and straightforward
things have become.
Summary
International trading can expose a company to considerable risk. The
purpose of this chapter has been to explain some of the more common
ways of hedging against these risks.
The methods and services provided by the banks enable companies
to choose a hedging facility appropriate to their type of risk. First, how-
ever, it is necessary to identify the direct and more obvious transac-
tional and translation type risks, whilst not forgetting the more hidden
and economic risks. Then, it is also necessary to remember that, unless
you have a mandate otherwise, you use these services to hedge and
insure against risks and not to speculate. Speculation on the currency
market is for currency dealers. Speculators are, of course, a necessary
part of the market; however, unless foreign currency is your business
why would you speculate in it? This might seem obvious but many
companies get confused between hedging and speculating: between
covering a position and taking a position. Case study 2 in Chapter 16
(page 207) demonstrates speculation and hedging.
A company should not leave itself exposed to a currency risk. It
should wherever possible try to match currencies or foreign exposure
immediately in the correct way, by using an appropriate foreign
exchange hedging service or one of the other tactics described in this
chapter.
In this chapter we have explained currency options and swaps that
are examples of a derivative. There are others. A derivative is an instru-
ment whose performance is based on the price variations of an underly-
ing asset. For example, a currency option is based on the underlying
foreign exchange market. In a derivative transaction the underlying asset
does not need to be bought or sold. It requires no movement of prin
cipal funds at maturity. The detailed study of derivative markets is
beyond the scope of this book. Recommended further reading for
those interested is Mastering Derivatives Markets by Francesca Taylor.
156
C h apter E l e v e n
Company
taxation and
financial
management
A s non-finance managers, I thought it would be useful for you to

know some of the elements of company taxation and how they
affect financial decisions. This is quite a challenge for me since taxation
is an enormous subject in its own right and each country has its own
set of rules and regulations. I must, therefore qualify this chapter at
the start as providing a basic understanding of how tax systems might
operate and not as a practical guide that can be used to calculate your tax
liabilities. Taxation affects all management decisions, and to leave this
subject out would leave a gap in your understanding of the principles
of corporate financial management.
I have worked in the UK and in New Zealand as a tax accountant and
tax manager, and have a useful knowledge of Australian taxation as well
as some limited knowledge of US taxation. I shall use this experience
to explain how taxation principles can be brought into the financial
management decision process.
The principal focus of this chapter will be on understanding the
taxation implications of decisions and how to plan for these. It is
possible, for example, that taxation will affect each project or business
opportunity differently. It must, therefore, be considered. We are not
interested in tax avoidance schemes, for which most regimes have
set up extensive anti-avoidance regulations, or in tax evasion, which
Company Taxation And Financial Management 157
is of course illegal. Neither are we concerned with ways to minimize

taxation. We are simply going to outline some basics that will help
provide an understanding of the taxation implications of financial
structures and decisions so that they can be properly considered and
planned for.
Since this text does not restrict itself to financial management in any
one taxation regime, I will provide generic examples of tax principles.
Any rates quoted are simply hypothetical and not actual rates.
Direct and indirect taxation

Most countries differentiate between direct and indirect taxation and
use a blend of both types. The principal classifications are outlined
below.
Direct taxation
Direct taxes are those that are levied directly on earnings, profits or
gains. They are charged on both companies and individuals. Examples
of direct taxation are:
●● corporation tax or company tax, UK;

●● income taxes and National Insurance, UK;
●● capital gains tax, UK;
●● inheritance tax;
●● business income tax, NZ;
●● fringe benefit tax, NZ.
Indirect taxation
Indirect taxes are levied on expenditure. Examples of indirect taxes
are:
●● Value Added Tax (VAT) in the UK;

●● Goods and Services Tax (GST) in Australia and in NZ;
●● customs duties;
●● purchase taxes;
●● sales and excise taxes, US.
In addition to the above there is a whole raft of other taxes including:
●● business rates, UK;

●● property taxes, Au;
●● petroleum revenue taxes;
●● fuel taxes, Au;
●● excise taxes, Au.
In some counties there can also be regional variations in tax rules.
Taxation authorities
The following are names of tax authorities that are mentioned in this
chapter:
●● HMRC: Her Majesty’s Revenue & Customs, UK;

●● IRD: The Inland Revenue Department, NZ;
●● ATO: Australian Tax Office;
●● CRA: Canadian Revenue Agency.
In the United States taxes are administered by very many tax author
ities. At Federal level there are the three administrations of tobacco,
alcohol and firearms taxes administered by the Alcohol and Tobacco Tax
and Trade Bureau. Other domestic taxes are administered by the IRS
(Internal Revenue Service). Import taxes are administered by the US
Customs and Border Patrol. Each state has its own tax administration,
and some states administer local taxes.
Your finance director or taxation manager will, of course, be your
first contact on tax questions. If this is not possible, then it is often
useful in the first instance to simply visit the website of the appropri
ate administration and search under the subject of your concern.
The HMRC site in the UK is excellent. It provides online answers and
also the contact numbers for each specialist area. Many topics are not
so clear-cut, and you might then seek legal advice from a tax lawyer
or the advice of a tax accountant.
Taxes on companies and corporations
Residence and the charge to corporation tax

Taxation on companies in the UK is referred to as corporation tax. In
other regimes it may be referred to as business tax. For the purpose of
this section I will make reference to the UK system of corporation tax
since the principles are similar.
UK corporation tax is a tax that is charged on the global profits and
chargeable gains of UK-resident companies. UK corporation tax is not
charged on the dividends received from companies that are resident
in the UK. A similar system applies in most other countries.
A company that is not resident in the UK but trades there through
a branch or agency may also find that its profits are chargeable to UK
corporation tax.
It is, therefore, important to understand all cross-border taxation
implications of any overseas operations or plans.
Periods of assessment
Taxation periods of assessment may be different from accounting
periods of assessment. This is an important consideration when
planning tax liabilities, payments and cash-flow forecasts.
Where the taxation period is different from the financial account-
ing period it will be necessary to allocate profits between the periods,
and it is always best to get agreement from HMRC to the method of
allocation.
Tax laws, rates and treaties between countries are forever changing
and since company residence, periods of assessment, rates and pay-
ments dates are critical to cash flow, it is important to plan taxation
carefully before starting a new operation either domestically or
overseas.
Basic calculation and payment of

corporation tax
£
Net profit per financial accounts after depreciation 3,000,000

Add back depreciation (not allowed) 30,000
Deduct capital allowances (tax depreciation) –20,000
Profit chargeable to corporation tax 3,010,000
Corporation tax at say 30 per cent 903,000
The normal due date in the UK for the payment of corporation tax is
nine months and one day after the end of the tax accounting period.
However, in the case of companies that are designated as large (with
profits of over £1.5m) corporation tax may be payable quarterly and, of
course, there are special transitional rules for companies when they
become designated as large.
Tax has to be paid on time to avoid penalties and interest. Interest
will be charged on any overdue tax and this is not an allowable expense
for taxation.
VAT and GST

Most countries have a form of indirect taxation that levies tax on goods
and services when they are sold. For example, in the UK VAT is charged
to buyers by VAT-registered sellers and in Australia there is GST (Goods
and Services Tax), which is based on similar principles.
VAT is charged in the UK on business-to-business and business-to-
end-consumer transactions and it may also be charged on goods and
services imported from places outside the EU.
The tax is charged by a VAT-registered seller to a buyer. The VAT-
registered seller is acting as a tax collector and will have to account
to HMRC for the tax collected. If the buyer, who has paid the tax on
goods purchased, is VAT registered, then s/he will call this input tax
and will use it to offset or partially offset and output tax s/he has
collected on services or products sold.
HMRC sets turnover limits for VAT registration. If a business

exceeds this limit it must register for VAT. However, it may also register
for VAT if it is below the limit. At the present time you may have to
register if your sales are over £73,000 for the last 12 months; otherwise
you may be able to register voluntarily.
Certain items are outside the scope of VAT and these are called
exempt. Examples of these are education and training (if certain con
ditions are met), subscriptions to certain membership organizations,
the provision of credit, insurance and certain fundraising events by
registered charities. Always check with HMRC or your indirect taxation
authority to determine if a product or service is exempt. Get it wrong
and you could face a huge bill for uncollected tax.
The charge to VAT

VAT is charged on most goods and services that a VAT-registered
business provides in the UK. It is also charged on goods and on some
services that are imported from countries outside the European Union
(EU), and brought into the UK from other EU countries. It is charged
when a VAT-registered business sells to either another business or to
a non-business customer.
When a VAT-registered business buys goods or services on which
VAT has been charged, it can generally reclaim the VAT paid.
There are currently three rates of VAT, depending on the goods or
services the business provides. The rates are:
●● standard: 20 per cent;

●● reduced: 5 per cent;
●● zero: 0 per cent.
Some goods and services are exempt from VAT or outside the UK VAT
system.
●● The difference between exempt and zero-rated is that:

–– Zero-rated goods or services count as taxable supplies, but they
don’t add any VAT to a selling price because the VAT rate is 0 per cent.
–– Goods or services that are exempt don’t have any VAT charge and
they’re not taxable supplies.
Generally a business can’t register for VAT or reclaim the VAT on pur-
chases if it sells only exempt goods or services. If it sells some exempt
goods or services, it may not be able to reclaim the VAT on all of its
purchases.
If a business buys and sells mainly zero-rated goods or services, it
can apply to HMRC to be exempt from registering for VAT. This might
be advantageous if it pays little or no VAT on purchases.
Indirect taxes and the economy

Indirect taxes such as VAT (UK) and GST (Au and NZ) are a simple and
largely unavoidable way of collecting taxes. They are also less expensive
to administer and provide a government with greater control over
fiscal policy. Indirect tax rates can be changed quickly in response to
economic events. They can quickly change spending patterns.
Some might argue that indirect taxes provide a better incentive in
the labour market than direct taxes because they create less of a dis
incentive to work. This is because employees believe that they retain
more of their earnings. There may be some truth in this because the
argument states that workers respond better to lower marginal rates
of direct income tax by working more hours thereby increasing
production.
Basically indirect taxes can be extremely responsive to economic
and environmental changes, enabling a government to control human
activity more readily and easily than they can through direct taxation.
Taxes on the earnings of employees

Most countries have a system of collecting income tax from the earn-
ings of employees directly from their employers. In the UK the system
is called Pay As You Earn (PAYE).
The UK PAYE is the system that HM Revenue & Customs (HMRC) uses
to collect Income Tax and National Insurance contributions (NICs) from
employees’ pay as they earn it. Employers have to deduct tax and NICs
from their employees’ pay for each pay period and pay Employer’s Class
1 NICs if they earn above a certain threshold. These amounts are paid
to HMRC monthly or quarterly. There may be penalties and interest
charges for late payment. After the end of the tax year the company
sends HMRC an Employer’s Annual Return (forms P35 and P14). Most
employers are now required to file this online.
Each employee is given a tax code by HMRC that will reflect their
personal allowance and other adjustments. This code will be given to
the employer and used in its payroll system to ensure that the correct
amount of tax is deducted.
Global tax planning

Financial planners and accountants will need to understand the impact
of different taxation regimes on the company’s global operations. Global
tax planners will need to understand different tax rules, the commercial
validity of transactions, arm’s length rules between related companies,
double-taxation treaties, transfer pricing rules and many other aspects
that can affect a strategic decision.
When considering the taxation implications of overseas activities
and investments, the following require special attention:
●● the definition of a resident – which varies from country to country;

●● the fact that non-residents may be taxed in some countries;
●● taxable income and allowable expenditure definitions – which vary
between countries;
●● variations in tax depreciation rules;
●● definitions of a taxable person;
●● different tax rates between countries;
●● the timing of tax due dates;
●● double tax treaties;
●● definition of a permanent establishment;
●● transfer pricing rules;
●● arm’s length rules;
●● the commercial validity of transactions;
●● tax avoidance definitions and tax avoidance provisions;
consequences of avoidance;
●● tax evasion and consequences;
●● what is considered as acceptable taxation behaviour in different
countries.
The above list is not exhaustive but highlights some of the areas that
need to be considered if you are planning overseas activities.
The basic position in the UK is that any UK resident company that
makes an overseas investment will be expected to pay UK taxes on
income received before the deduction of foreign taxes. Any gain on

sale of a foreign asset will also be taxed. This means that the starting
point is that in addition to incurring UK tax on overseas activities there
may also be foreign tax liabilities. However, double-taxation relief may
be available. For this reason you will need to receive advice from experts
or directly from HMRC and other taxation authorities to confirm the
precise position.
Most taxation authorities do not like companies setting up name
plates overseas to avoid taxation and controlled-foreign-company (CFC)
and motive-testing rules exist to help prevent tax avoidance.
Double-taxation relief
Relief for double taxation may be available under reciprocal treaties
with foreign countries. These allow for tax paid in one country to be
deducted from a tax liability in another. Unilateral relief in relation to
a particular tax where there is no treaty relief available may be given. If
treaty or unilateral relief is not available then it might be possible to
deduct overseas tax from overseas income before calculating local tax.
Double-taxation relief is complex and advice should be taken from the
taxation authorities or from a taxation practitioner.
Transfer pricing
World trade involves multinational enterprises (MNEs) and more than
half of world trade is through associated party transactions. The price
at which goods or services are transferred between one part of an organ-
ization and another is referred to as the transfer price. Transfer pricing
is one of the most important issues MNEs face, and tax authorities
around the world are updating their rules and regulations on interna-
tional transactions as well as increasing their audit activity.
Since the behaviour of MNEs impacts significantly on tax collec-
tions, the community expects MNEs to contribute their fair share via
the tax system, and transfer pricing is expected to have greater visibility
and commercial justification. Identifying which pricing practices
are legitimate can be a difficult task. Taxation authorities around the
world have established departments to investigate transfer prices.

Most countries will expect that a transfer price must be set at arm’s
length and reflect the market price at the time it was set.
Bringing taxation into the decision-

making process
We have discussed in this chapter how taxation might affect the activities
and cash flow of a company. Taxation must, therefore, be introduced
into the decision-making processes.
Firstly, it must be recognized that every decision a company makes
has a taxation implication and taxation will affect:
●● costs;
●● prices;
●● cost of capital;
●● cash flow;
●● domicile;
●● dividend policy;
●● project costs;
●● opportunity evaluation;
●● all financial aspects and plans of an organization.
To evaluate alternative decisions, it is necessary to understand and

bring into the equation the various taxation implications and options
available. For example, this can be done by evaluating the present
value of tax benefits associated with an investment and bringing
these into an investment appraisal calculation.
Method of bringing tax benefits into account in an investment
appraisal:
1 Calculate the present value of capital allowances (tax depreciation).

2 Multiply this by the tax rate.
3 This will give the present value of the tax benefit.
4 Deduct this present value of the tax benefit from the initial outlay
on the project to give a net after-tax cost.
Taxation and the economy:

future trends in tax collection
Annual income twenty pounds, annual expenditure
nineteen pounds nineteen and six, result happiness.
Annual income twenty pounds, annual expenditure
twenty pounds ought and six, result misery.
(Mr Micawber)
In this section we will take a look at tax collection, using the UK as

an example.
In the year ended 2010 the UK government collected £409 billion
in taxes. It collected this sum from the following sources:
Source of tax £ billions

Income Tax 145
National Insurance Contributions 96
Value Added Tax 70
Corporation Tax 36
Fuel Duties 26
Tobacco 9
Spirit, Beer & Wine Duties 9
Stamp Duties 9
Air Passenger Duty 2
Capital Gains Tax 3
All other sources 4
Total 409
In addition, £21 billion of council tax was collected in England by local

authorities and a little less than £2 billion in Scotland.
In 2010 in the UK the total central and local government spending was
£689 billion. The major categories of spend were:
Expenditure £ billions
Pensions 123
Health care/welfare 122
Education 84
Defence 46
Welfare 113
Protection 35
Transport 20
General government 24
Other 79
Interest 43
Total 689
Now, you don’t need to be Mr Micawber to realize that the above figures
will result in ‘misery’ unless the books are balanced. Of course, the UK
government is working on this and you can draw your own conclu-
sions. However, it is worth looking at more efficient and less expensive
ways of collecting taxes.
The two simplest ways of collecting tax are through VAT and through
a system of flat tax. Both of these systems reduce tax administration
costs, are unavoidable and enable a government to make quick and
easy adjustments to their tax take. We have already discussed VAT and
the similar GST methods.
Flat tax is growing in popularity around the world, with currently
around 30 countries either adopting or seriously considering it. A great
advantage to taxpayers is that they no longer need to spend large
amounts of time completing tax returns and claiming/justifying
allowances. It also makes a whole raft of tax advice and administra-
tion unnecessary, freeing up people to undertake more valuable work.
A true flat rate tax is when one tax rate is applied to all taxable income
with no exceptions or exemptions. Of course, a change such as this
would be highly contentious in a country such as the UK.
Probably the easiest way to make flat tax acceptable to most people
would be to reduce the rates of income tax to a single rate and make up
any shortfall with an increase in VAT. Looking at the above figures you
can do the sums. However some people, including some economists,
prefer the existing system. The debate will go on.
Summary
Taxation is a big-impact item. It has a huge effect on the bottom line and
just about every decision a company makes. Yet, it is often forgotten
or misunderstood by decision makers. It has been a challenge to decide
what to cover in such a short space as this that will be of use to you as
a manager or decision maker. Hopefully I have outlined some key areas
and enabled you to present some appropriate questions to your finan-
cial director.
This chapter has been concerned with explaining the taxation impli-
cations of decisions so that they can be taken into account. It has not
been concerned with aggressive tax minimization since this may be
a high-risk strategy and one that is outside a company’s core com
petence. Certainly there is always a cost for complexity and this should
not be underestimated! Most companies want to be responsible citizens
and value their relations with governments and taxation authorities.
169
C h apter T w e l v e
The value of
a business
Building value
There are many factors that affect the value of a business, some of which
are more controllable than others. In broad terms businesses would
expect to have an influence on most internal factors but little influence
over external factors. Accordingly, a business that is highly sensitive to
many external factors might find it more difficult to ensure a controlled
increase in its valuation. Some of the principal internal and external
factors that affect a business value are:
●● Internal factors:
–– financial strength;
–– quality of executive team;
–– quality of staff;
–– quality of services and products;
–– resources;
–– agility and responsiveness;
–– customer perception and loyalty;
–– efficiency and profitability;
–– dividend policy;
–– building brand awareness.
●● External factors:
–– the economy;
–– interest rates;
–– political and socio-economic environment;
–– supply chain;
–– labour supply;
–– competition;
–– industry;
–– foreign exchange rates;
–– environmental responsiveness.
Brand acceptance
A principal objective of most businesses is to increase their value. Value
is sensitive to all of the above factors. Accordingly a business must
identify which key internal factors it needs to excel in and how it can
position itself in such a way as to minimize its exposure to the largely
uncontrollable external factors. For example, developing a strong
unique selling proposition (USP) might reduce a company’s exposure
to competition for a while.
A business should determine which factors affect its value the most,
and have a plan and strategy to perform well in these. To do this it
might carry out a strategic value analysis (SVA). This is a systematic
measurement of each part of a business with a view to establishing
how it might add value to the business. This will include an examina-
tion of core strengths and a comparison with external providers of
services that might be outsourced.
Developing a target for a business valuation at a point in time in
the future can help focus business strategy. For example, is there an
intention to sell the business in the future, to float or go public, or is
it preferred to keep the company under substantially the same owner-
ship and control? Understanding how the business will be valued is
also important. Understanding who you want to value the business and
why they should value it is also a key consideration. A quoted company
will be valued by the markets with particular attention to its price–
earnings ratio. However, a company may have other value that is not
so easily measured that could greatly affect its future earnings and
valuation.
Business value is perhaps linked to the network of internal and
external relationships. This is sometimes referred to as a value chain
or value network where value is created as a result of collaboration
between parts of the network. Company controls and processes are not
the only things that create value. Understanding the value chain and
relationships is key to value creation.
The Value Of A Business 171
So far in this book we have discussed ways of measuring and

improving performance. These are all essential to business success and
value creation but so also are relationships and collaborative manage-
ment of the value chain.
Methods of valuing a business

The economic value of a business is used by buyers and sellers to
determine the price they are prepared to buy or sell a business for. It
is necessary for all mergers and acquisitions. A business valuation is
also used for estate, taxation and a number of other legal purposes.
Before a valuation can be undertaken it is necessary to understand
the reasons for the valuation. For example, a valuation of a ship for scrap
will be different from its valuation as a cargo carrier.
A value will take account of the price that a willing buyer and a will-
ing seller will agree to. This is called the fair market value (FMV). The
market conditions may, however, be far from perfect. For this reason a
business valuation will usually start with a contextual evaluation of
the economic and industry conditions surrounding the business. Is it
a buoyant market or is it in recession? An analysis of the business’s
financial performance and strength will be compared to the rest of
the industry. The valuations placed on competitors will be taken into
account.
Common approaches to an initial business valuation are:
●● income/earnings valuations as a going concern;

●● asset valuations as a going concern;
●● break up asset valuations;
●● market valuations as a going concern.
Each of the above approaches will relate to a particular reason for selling
or buying. Often a business will be valued on several bases and the dif-
ferences between the valuations explained.
Before deciding upon which is the most appropriate valuation
method the reason for a valuation will be considered. Possible reasons
include:
●● The valuation of a company to compare with the offer price of a

takeover bid. These can also be compared with the current share price.
●● A valuation may be required when a company goes into

liquidation.
●● A shareholder may require a valuation when wanting to dispose
of a significant number of shares that might give a buyer
a controlling interest.
●● A valuation may be required for bankers when requesting new or
additional finance.
●● When going public an unquoted company may need a valuation to
determine an issue price for its shares.
●● Valuations are needed when companies merge.
●● Valuations are needed for management buy-outs.
●● Loan collateral may require periodic valuations.
●● A taxation authority may require a valuation.
Some of the more common methods used for business valuations are
outlined below.
The book value

This is based on the value of an owner’s equity as recorded in the
accounts. This may be a starting point but, unfortunately, accounting
records may not reflect the true value of assets and liabilities. For
example, the generally accepted accounting practice (GAAP) requires
that stocks are valued at the lower end of cost or net realizable value.
The good reason for this is conservatism. At the point of a business
sale however, stocks may be worth a lot more or a lot less than the
value recorded in the accounts. It all depends on what value the buyer
can derive from the stocks. A buyer may have access to markets in
which the stocks could be converted into cash at a higher price than
is recorded in the accounts.
The tangible book value

This method simply values tangible assets and places no value on
goodwill or other intangibles. Book values are adjusted by removing
intangibles.
The economic book value

This method takes account of all assets including goodwill and values
them at the market rate.
Net present value of future earnings

Future earnings are discounted, using an appropriate discount rate to
give their net present value.
Income capitalization method

This method first of all establishes a capitalization rate, which is the
rate of return required for the business risk. It then divides earnings
by this rate.
Price earning multiple

This is the market price of a company’s shares divided by its earnings
per share multiplied by the net income.
Dividend capitalization
This is a company’s dividend-paying capacity based upon its net
income and cash flow.
Sales and profit valuations

Sales and profit multiples may be benchmarked in an industry and
used for a valuation.
Realizable values
This method determines the net realizable value of assets on a com-
pany break-up assumption.
Replacement values
This method estimates the replacement value of a business. For example,
how much would it cost a buyer to set up a similar business?
Who can value a business and what information

do they require?
A business valuer will need to have a thorough understanding of the
industry sector of the business and of each of the disciplines required
in the valuation methods. For this reason it is likely to be an accountant,
a lawyer or a senior banker who has been involved in the sector.
The information required will depend on the business and the

importance of that information within the sector. Essential informa-
tion will include:
●● audited financial statements for most recent and past years;

●● financial projections and the basis on which they are made;
●● current sales orders and contracts;
●● basis of cost estimates;
●● supplier contracts and listings;
●● aged debtors and creditors listings;
●● cash-flow statements and forecasts;
●● outstanding debts not yet invoiced, accruals, payments in advance,
prepayments;
●● basis of stock valuations for raw materials, work in progress and
finished goods;
●● stocktakes;
●● assessment of stock obsolescence;
●● property titles;
●● land surveys;
●● lease and rental agreements;
●● loans schedules;
●● schedules of investments and securities;
●● bank statements and statements for all financial institutions;
●● cash book;
●● bank reconciliations;
●● employment contracts;
●● payroll;
●● details of directors;
●● directors and employee interests;
●● organization chart;
●● schedule of legal charges;
●● debenture documents;
●● industry and competitor information;
●● list of shareholders, holdings and types of shares.
The precise information and depth of investigation required will

depend upon the nature of the valuation and the type of business.
The above list is not exhaustive. However, it will give you an idea of the
potential areas that need to be covered when arriving at a valuation.
Examples of valuation methods and their

appropriateness to valuation reasons
Here we will describe some of the valuation methods mentioned
above in a little more detail and discuss how appropriate they are to
different situations. Of course, real values are what is actually realized
on sale. However, valuations are made without the benefit of a realized
selling price and are at best just estimates.
Asset-based valuations
An asset-based valuation may provide a fundamental base and check
that can be used to question the results from other valuation methods.
They are sometimes referred to as floor values. However, asset-based
valuations, just like other methods, need to consider the premise or
reason for the valuation. For example, it is generally accepted account-
ing practice that stocks should be recorded in the accounts at the lower
end of cost or net realizable value. However, in a business valuation
should they be valued at replacement value, realizable value or scrap
value? The answer will depend upon the intentions of the buyer of the
business. Do they want to carry on as a going concern or is it their inten
tion to drop the stock line and sell it off? Or will stocks just be scrapped?
The value will depend upon what use the buyer can put them to.
Example
Fixed assets €400,000,000
Depreciation (€200,000,000)
Goodwill €90,000,000
Current assets – stocks at lower end of €30,000,000

cost or net realizable value
Current assets debtors and cash at bank €80,000,000
Current liabilities (€100,000,000)
Total net assets €300,000,000

Deduct goodwill included in the above €90,000,000
Total tangible assets less current liabilities €210,000,000
Term loans (€130,000,000)
Net asset value €80,000,000
Number of ordinary shares 2,000,000
Net asset value per share €40
If we deduct the intangible asset of goodwill, the net asset value per
share is €40. However, goodwill may indeed have a value to a particular
buyer or group of buyers. The basis of goodwill valuation will need to
be examined to understand its component parts. For example, how
much of this goodwill relates to the brand being purchased? Does this
have value to the buyer or will the buyer be dropping the brand for
a more powerful one? How much of the goodwill relates to customers
and suppliers and will this have value in the future?
Stocks have been valued in accordance with accounting conven-
tions. However, what is their real value to this particular buyer or to
the market the sale is aimed at? Will the stock simply be disposed of at
a low price or does it have a higher realizable value to the new buyer?
Fixed assets are in the accounts at a net book value of €200m
(€400m – €200m of depreciation). What is the realizable value of these
assets, what is their value as a going concern, what income can they
generate, what is the current replacement cost, what is their expected
life and what real value are they to the buyer? It could be a different
value from €200m.
At best an asset-based valuation provides a floor value. It can cause
confusion if not analysed but if it is properly understood in relation to
a buyer’s needs it can provide a useful base upon which to consider
the earnings-based valuations, which we will now consider.
Earnings-based valuations
An earnings or profits-based approach to business valuations enables
buyers to understand their possible future return on their investment
on the assumptions that the business is a going concern and will con-
tinue to make the profits recorded and forecast. These, of course, are
two big assumptions in many cases and this is why asset-based valu
ations are also used to bring valuations back to a more fundamental
view.
Two earnings-based valuations are the price–earnings method and
the earnings–yield method.
The price–earnings ratio and business valuation

This method uses the following formulae:
Market value = Earnings per share × Price Earning Ratio
or
MV = EPS × P/E ratio
Where:
Profit attributable to ordinary shareholders

EPS =
Weighted average number of ordinary shares
Market value
P/E Ratio =
Earnings per share
The earnings–yield method

Earnings per share
Earnings–yield = × as %
Market price per share
Earnings
Market value =
Earnings yield
Cash-flow valuations
Dividend valuation model
Annual dividend expected in perpetuity
Market value (ex div) =
Shareholder’s required rate of return
There is an assumption in this method that an equilibrium price for a

share on the market is the discounted expected future income stream.
The expected future annual income stream for a share is the expected
future dividend in perpetuity. The equilibrium price is the present value
of the future income stream.
Dividend growth model

Expected dividend in one year’s time
Market value =
Shareholder’s required rate – growth rate
Example
The dividend paid by CM plc this year was €400,000. It is expected
to grow by 4 per cent per annum. The company’s shareholders expect
and require a return of 10 per cent per annum. Calculate the value of
CM plc using the dividend growth model.
€400,000 (1.04)
MV =
0.10
MV = €4,160,000
Discounted-cash-flow (DCF) method of

valuation
This method simply discounts the expected future cash flow from an
investment using the cost of capital after tax as a discount rate. For
example, if an investor expects to receive returns of £30,000 per year
at each of the years 0 to 2 and £40,000 at year 3, when it has a cost of
capital after tax of 9 per cent during the entire period, then the value
of the investment using the DCF method would be:
Year Cash flow 9% discount Present

factor value (€)
0 €30,000 1.000 30,000

1 €30,000 0.917 27,510
2 €30,000 0.842 25,260
3 €40,000 0.772 30,880
NPV 113,650
Using the discounted-cash-flow method of valuation, the investor

would not want to pay more than €113,650 for CM plc.
The value to other investors would be different if they had a dif
ferent cost of capital.
Summary
We have worked through some of the more popular methods of busi-
ness valuation. There are other methods that are not so widely used,
but those described above are the essential methods that you need to
know. At this point, it would be a worthwhile exercise for you to go
online and obtain the financial statements and prices for a well-known
company and to prepare your own valuation using three methods:
●● the asset-based valuation method;

●● the earnings–yield method;
●● the discounted-cash-flow method.
You can choose any company. For example go to www.j-sainsbury.co.uk

and the landing page will show the share price. Then search under
Annual Report to find Financial Statements and then Balance Sheet
and other statements.
Compare the results using different valuations and consider how
each valuation might relate to different types of buyer.
In the case of bigger listed companies there will be a wealth of
market information and prices available to assist in a valuation. This
will not be the case for smaller companies where the valuation
methods will have less market data to use.
At times market sentiment may influence valuations far more
than the underlying fundamentals. At times of recession values may
become related to fundamental analysis. Most valuations will use
a mixture of income, asset and market information.
180
C h apter T h irtee n
Financial
strategy
F inancial strategy underpins a company’s mission and goals. It

ensures financial resources are available to achieve the objectives
laid out in a corporate strategy.
When an organization commits to a business strategy it will need the
capital infrastructure in place to support it. It will also need to have
enough financial resource availability to capitalize on future opportuni-
ties and to cover contingencies. In doing this it will also want to ensure
that financial resources are the correct strategic mix and are deployed
at the most efficient cost. A financial strategy should, therefore, seek to:
●● provide the capital infrastructure to support organizational

aspirations;
●● provide financial agility;
●● provide the lowest cost of finance;
●● provide the correct mix of financial resources;
●● cover financial risks.
With the correct financial structure in place an organization has a

better chance of being able to take forward its strategic vision and to
build a sustainable future.
A financial strategy may typically have the following components.
Financial environmental scan of the industry

sector
This is an analysis of the demand for and availability of finance in the
sector. What appetite do equity investors have to invest in the industry
Financial Strategy 181
sector? How is it perceived in the financial markets? Is the rest of the

sector ‘hungry’ for finance? The sector demand and supply for finance
will take account of the current and future economic conditions and
of the perceived sector risk.
Financial environment of the organization

Consider the financial strength of the organization including the past
few years’ audited results, management accounts and financial projec-
tions. What is the current cash position, what cash will be required in
future years and where will it come from? What is the ideal gearing
ratio? How does the financial environment within the organization fit
within the broader financial environment of the industry sector? How
will the markets and the banks respond to a request for additional
funds? How well will the organization respond to the expectations of
its financial providers?
Elements of a financial strategy

A financial strategy has key tasks that help underpin an organization’s
mission, strategic aims and objectives. These include:
1 The development of financial performance objectives that will:

–– deliver profits or operating surpluses;
–– provide cash when required while ensuring optimal cash
balances are achieved;
–– maintain financial viability and agility;
–– set working capital targets;
–– set target balance sheet and financial ratios;
–– set financial objectives and key performance indicators;
–– establish financial stakeholder requirements and relationship
management;
–– maintain routine cost and budgetary controls and variance
reporting;
–– require a regular review of financial objectives in light of actual
performance.
2 Maintenance of financial capacity to meet strategic objectives

including:
–– ensuring the company has the right level of financial capacity for
key resources;
–– management of financial investments, their proper availability
and bank relationships.
3 Ensuring funds are available on time for specific capital
investments.
4 Assessing the implications of strategic developments and the
evaluation and management of risks. This includes:
–– the prioritization of strategic goals;
–– the identification and management of financial risks;
–– risk and sensitivity analysis;
–– providing financial capacity;
–– providing financial agility;
–– financial contingency planning;
–– investment appraisal standards;
–– determining the cost of capital;
–– identifying strategic alliances.
5 Ensuring that the financial strategy is fully integrated and supports
every element of the corporate strategy. This includes:
–– ensuring that the financial strategy is accepted by the
organization’s executive team;
–– ensuring that budget holders accept and understand the
financial strategy;
–– holding regular reviews of the financial strategy;
–– adopting and agreeing to a new financial strategy to changes in
conditions and if circumstances require.
Strategic financial management

Strategic financial management is concerned with creating value
through financial efficiency and providing a financial environment that
supports the goals, ambitions, ethos and ethical values of a company.
It is not something that can be done in isolation but is a part of the
corporate planning and governance process.
Most companies will prepare a SWOT analysis as part of their stra
tegic plan. If, for example, during this process they identified that a lack
of agility was a weakness and that interest rate increases were a threat,
they might develop the following two high-level strategic goals:
●● increase strategic agility to take advantage of future opportunities;

●● reduce financial risks.
To help achieve these goals the following financial strategy may be

appropriate:
Financial strategy Link with overall

business strategy
To increase strategic agility:

Open credit lines with banks Increased agility and ability to
respond to new opportunities
Build additional banking Improved ability to raise new
relationships funds at short notice
Tighten working capital Improved cash balances to
management meet urgent requirements
Reduce costs Improved profitability and
cash availability
Replace some fixed costs Ability to change suppliers and
with variable ones business direction more easily
To reduce financial risks:

Take out forward contracts Reduced direct foreign
to cover FX risks exchange risk
Hedge against interest Reduced financial risk of interest
rate risks rate increases on borrowing
Consider a reduction May reduce exposure to interest
in gearing rate risks on borrowing
Consider investment strategy Reduced exposure to reductions
in interest rates on investments
The above financial strategies clearly support the overall business stra
tegy, and the finance director would seek to obtain executive agreement
to them. By supporting the organizational goals the financial strategy
will help create value within the company.
This alignment of financial strategy with overall corporate strategy

must be completed before any operational financial strategy is devel-
oped. Whilst sound financial management can create value in its own
right it must always be in alignment with overall business strategy. For
example, reducing the cost of borrowing by placing facilities with one
financial institution might also reduce a company’s financial agility,
and this might be in conflict with business strategy.
Financial strategy statements are sometimes included in reports to
shareholders and members. They vary enormously depending upon
the type of organization they relate to. An example of a simple financial
strategy statement produced by a small town council is given below.
You can see that it has addressed at least some of the elements we have
discussed above:
Example of a financial strategy set out by

a council
1 The main purpose of this finance strategy is to ensure that there
are financial resources to support the strategic objectives of the
Council. It should also support the supporting activities needed to
achieve the strategic objectives.
2 This strategy sets out how to secure efficient financial
resources needed to support the strategic objectives above,
to ensure the long-term viability of the Council and to
manage financial risks.
3 The finance strategy guides the Board to ensure that sound
financial controls exist to protect the security of the Council’s
assets.
4 The strategic plan aims to provide those services set out in
the Council’s annual statement. The financial strategy supports
this aim.
5 The systems that contribute to the achievement of the financial
strategy are:
–– financial controls;
–– financial regulatory environment;
–– cash and reserves policy;
–– treasury management policy;
–– investment policy;
–– internal and external audit programmes;
–– fixed asset register;
–– purchasing controls and regulations;
–– budgetary procedures;
–– risk management and contingency plans;
–– Board’s code of practice;
–– audit committee;
–– systems development and protection.
6 What does financial success look like?
–– Members and the public have confidence in the financial
management of the Council.
–– The Council has funds to implement its strategic objectives.
–– Members have a clear view of the cost of activities and
services.
–– All expenditure is related back to a Council meeting minute
giving approval.
–– There are clear internal and external audits.
–– Final accounts are filed on time.
–– All taxes are paid on time.
–– Budget holders understand their responsibilities.
–– The Council’s budget/precept is submitted on time.
–– Financial risks are identified and covered.
–– Funds are invested in accordance with the Council’s policy in
agreement with Borough and County Council guidelines.
7 Financial goals:
–– to provide appropriate financial support to the Council’s
objectives set out in the strategy document;
–– ensure that funds are collected on time;
–– maintain banking relationships;
–– meet statutory obligations;
–– maintain rigorous financial controls.
8 Responsibilities for the finance strategy
–– The finance committee is responsible for ensuring corporate
governance, overall internal controls and risk management.
–– The Audit Committee will report to Members on the effectiveness
of internal controls, risk management, external and internal
audit matters.
–– Day-to-day responsibility for financial management is delegated

by the Members to the Chief Executive and Finance Officer.
–– Committee heads have responsibility as budget holders.
–– The Finance Department will ensure that procedures are in place
to comply with all the financial and statutory regulations.
–– The Finance Director has overall responsibility for the Finance
function and the development and implementation of the
financial strategy.
As you would expect from a council handling public money, the empha-
sis is on risk control, accountability and strict investment guidelines.
Even so, this did not prevent many county councils investing money
with an Icelandic bank after its credit rating fell and eventually being
unable to get their investments back. More about this subject in the
chapter on case studies.
Integration of financial management with

corporate strategy
The way that aspects of financial management integrate with corporate
strategy can be seen in the summary below:
●● Value creation:
–– identify value creating activities;
–– identify critical success factors;
–– identify drivers for change;
–– identify investment opportunities;
–– identify restructuring opportunities;
–– link to business goals.
●● Financial evaluation and analysis:
–– evaluate financial implications of change;
–– link strategy to planning, budgeting and programming;
–– define strategic business units and measure their performance;
–– ensure that resources are justified from a zero base and are
aligned to business goals;
–– identify the drivers of cost;
–– use management accounting techniques to measure
performance and evaluate options;
–– use a financial performance ‘dashboard’;

–– identify opportunities for cost reduction.
●● Investment analysis and decision making:
–– decide on an appropriate cost of capital for use in investment
appraisals;
–– evaluate and prioritize investment opportunities;
–– use payback, DCF, NPV, IRR, cost–benefit and other evaluation
techniques;
–– identify links between investment opportunities and current
investments;
–– define and evaluate critical interdependencies;
–– prepare sensitivity analysis;
–– make decisions.
●● Mergers, acquisitions, MBOs and other restructuring
opportunities:
–– determine whether M&A opportunities fit with organizational
strategic objectives;
–– establish value measurement for M&A;
–– determine the effect that a merger/acquisition will have on
funding and the cost of funds;
–– evaluate the target’s and merged cost structures after
an acquisition;
–– identify risks;
–– evaluate M&A opportunities;
–– prepare risk and sensitivity analysis.
The above is not an exhaustive list but shows how financial manage-
ment supports value creation.
Strategic change programmes

When considering strategic change programmes it is helpful to classify
them into categories. For example the change may be due to transition
(as may be required following a merger), transformation (changing
products and processes) or continuous and ongoing improvements.
The value of the change can be estimated by determining the benefits
and costs:
Ta b le 1 3 .1 Benefits and costs of change
Nature of Potential financial Possible additional

change benefits costs
Product Reduced product costs Additional marketing

streamlining Higher margins Design, development,
testing
Higher sales volumes
Product Higher margins Increased product

development costs
Additional marketing
Process Lower processing Consulting,

re-engineering costs implementation
Organizational Reduced staffing Redundancy pay

streamlining costs outs
Improved margins Consulting
Increased efficiency
Quality Reduced costs Cost of change

improvement and consulting
Customer retention
Additional customers
Higher margins
Out-sourcing Reduced costs Consulting

Better organizational Transition costs
focus
Staff Fewer errors Training costs

development Staff retention Possible higher staff
turnover
Focus and productivity
Mergers and More sales Advisors’ fees

acquisitions Better margins Transitional costs
Additional opportunities
This table will be helpful when attempting to assess the key financial
benefits to strategic change programmes suggested by your executive
team. Some benefits and costs are easily identified; others are less
tangible. The above list is not exhaustive and is only a first guide. For
example, improved quality should reduce costs by reducing produc-
tion interruptions; this is easily measured. It might improve customer
retention and win additional customers, but this is not so easily estim
ated before the change.
Summary
As a manager your main task at all times is ensuring that you create
value. You will need to know where value comes from and understand
how it is built or eroded. This requires a strategic understanding of
financial management and the ability to evaluate the financial con
sequences of your decisions.
Integrating finance and corporate strategy will help you and your
finance director understand how you both contribute to value creation.
The following list has been prepared by researching best-practice
financial strategy outlined in the professional syllabuses of a number
of leading global accountancy institutions. It provides a good final
summary of the actions that need to be taken to provide a sound finan-
cial strategy.
●● Evaluate organizational objectives in financial terms.

●● Determine strategic financial objectives.
●● Evaluate the achievement of financial objectives.
●● Determine the relationships between investment decisions,
financing and dividend policy.
●● Determine the impact of internal and external constraints on
financial strategy including regulatory constraints.
●● Evaluate business performance forecasts and risks, and prepare
a sensitivity analysis.
●● Determine and evaluate alternative financial strategies.
●● Establish the short- and long-term financing requirements.
●● Consider all financing and funding alternatives.
●● Determine the most suitable method for calculating
the organization’s cost of capital.
●● Calculate interest rate and currency exposure, and determine

a hedging policy.
●● Prepare a working capital management strategy.
●● Establish the roles and parameters of the treasury function.
●● Analyse the costs and benefits of investment opportunities.
●● Make investment decisions that maximize financial objectives
subject to capital rationing.
●● Evaluate mergers, acquisitions, de-mergers and divestments.
191
C h apter F o urtee n
The cost of
capital
T he cost of capital is the cost of funds used by an organization. It is

the return that an organization gives to its providers of funds and
reflects the perceived risk of providing those funds. An organization’s
capital comes from a variety of sources that have different rights to
returns and security. Accordingly each element that makes up the cost
of capital carries a different risk and, therefore, has a different cost. We
need to consider how these components combine to make up an organ-
ization’s cost of capital. It is an important element in decision making
because the cost of capital can be used as a discount rate in investment
appraisal calculations.
This chapter will help you choose an appropriate discount rate to
use for investment appraisal using discounted-cash-flow and net-
present-value techniques. This can be a subject that occupies the time
of academics who spend a lifetime debating and arguing about the
pros and cons of each method. Certainly it is an important subject,
particularly for very large organizations making decisions that
involve billions. However, I shall try to keep this discussion at a
practical level and explain what I think will be useful to a practising
business manager.
First of all we will discuss the two concepts of the average cost of
capital and the marginal cost of capital.
The weighted average cost of capital

(WACC)
A company has the following sources of capital:
Ordinary shares €300K @ 10 per cent per annum

Long-term loans €150K @ 6 per cent per annum
Short-term loans €100K @ 8 per cent per annum
Total €550K
Its weighted average cost of capital is:
(300 × 10) + (150 × 6) + (100 × 8)

550
WACC = 8.55 per cent per annum
The marginal cost of capital

If we assume that this company wishes to borrow more money but
that the only funds currently available in the market for this level of risk
are priced at 12 per cent per annum, then the marginal cost of capital
is 12 per cent per annum.
If additional capital is taken up at this marginal cost, then the
weighted average cost of capital will increase.
The cost of ordinary share capital

We talked above about the costs of share capital and loan capital. Whilst
it is easy to determine the cost of loan capital (the agreed rate in the
contract) what is the actual cost of share capital or equity?
Whilst the directors are under no obligation to make regular divi-
dend payments to ordinary shareholders it must be remembered that
these shareholders generally carry the highest risk, own the company
and quite rightly expect the highest return. Shareholders will also
want to see the market value of their investment maintained or
increased. Therefore, the cost of equity is the rate that needs to be paid
to maintain shareholder value and to meet their expectations.
The Cost Of Capital 193
Example
A company earns 10p (after interest) per share and pays a regular
dividend of 5p per share. The other 5p is kept in the business to help
reduce gearing and will earn 5 per cent per annum. The current market
value of a share is €1.70.
Dividend
The cost of equity capital = × 100 + growth
Market value
d
or E = × 100 + g
m
E = 5p × 100 + 5%
170p
E = 7.94%
The cost of equity capital is 7.94 per cent.
I have kept this simple to illustrate the basic calculation. However, in

reality there are other costs associated with raising equity capital. A
share issue will require advertising, underwriting, financial and legal
advice and other costs. These costs can be estimated and will increase
the cost of equity.
Balancing equity and external borrowing

When finding the optimal level of financial gearing, a company will
wish to maximize the return on shareholders’ funds whilst ensuring
the financial stability of the company.
As we have discussed in previous chapters, when profits are high a
highly geared company may be able to provide a greater return to fewer
shareholders. However, when profits are low there might not be much
left to distribute to shareholders after paying interest to external
providers of finance. A highly geared company may be considered
a greater financial risk by both external and new investors, raising the
cost of capital. On the other hand, equity shareholders carry the greatest
risk and will expect the greatest return, which might increase the cost
of capital in a low-geared company.
The cost of capital may therefore relate to the cost of funds that a
company uses, bearing in mind the return that investors expect and
require. It is the minimum return that a company needs to make in
order to pay investors their expected returns. It has been described as
the opportunity cost of finance, since it is the minimum that investors
require for the level of risk they are accepting. If investors do not get
this required return they will put their funds elsewhere.
Risk and the cost of capital

The cost of capital will increase as perceived risk increases.
Risk-free rate of return

If there is no risk on an investment, as is the case with government
securities for example, then the rate of return will be the lowest in the
market. This is the risk-free rate.
The premium for a business risk

All businesses carry the risk of failure, of lower than expected results.
There is always uncertainty surrounding business results. Accordingly
an investor will require a premium over and above the risk-free rate for
making a business investment. This is called the premium for business
risk, and it will vary between businesses.
The premium for financial risk

Some companies carry a higher level of financial risk. For example a
highly geared company may be more exposed to interest rate increases.
Investors will require a higher premium for a higher financial risk.
Elements of the cost of capital

Cost of capital = Risk free rate + Premium for business risk
+ Premium for financial risk
Different companies have different capital structures and varying costs

of capital.
The Cost Of Capital 195
Dividend growth model

If we assume that the market value of a share is related to the expected
future dividends from the shares, then the cost of providing required
dividend growth can be used as a cost of capital. The method used to
calculate the cost of equity taking this into account is the ‘dividend
growth model’.
However, there is a risk in holding shares in a specific company
(unsystematic risk) and a further general market risk (systematic risk).
An investor may seek to reduce systematic risk through diversification.
However, specific unsystematic risk cannot be reduced in this way. The
‘capital-asset-pricing model’ is a method that can be used to calculate
a cost of equity and incorporate risk.
Capital-asset-pricing model (CAPM)

This pricing model is used to determine the theoretical price of a
security.
The expected return for a security is:
Es = Rf + βs(Rm – Rf )
where:
Es = the expected return for a security

Rf = t he expected risk-free return in the market (for example UK
government bonds)
βs = the sensitivity to market risk for the security
Rm = the historical rate of return on the stock market
(Rm - Rf ) = the risk-free premium of market assets over risk-free assets
Example
If the risk-free rate of return is 4 per cent when the average market
return is 6 per cent and the sensitivity to market risk is 0.9, what is the
expected return from a share?
Expected return = 4 per cent + 0.9 (6 per cent – 4 per cent)

Expected return = 5.8 per cent
Both the dividend-growth model and the CAPM methods have their
advantages and disadvantages, and the finance director will calculate
the cost of equity and the overall cost of capital using several methods
before deciding which method is appropriate. Generally, these types of
debate are more significant to a large company.
Summary
The cost of capital is the rate of return that a company has to pay to gain
and retain funds from investors, who will take into account their risk
in investing. It is the opportunity cost of investment capital or the mar-
ginal rate of return required by investors. When calculating a weighted
average cost of capital in a low-geared company, the rate for the cost
of equity that is included in the calculation might not be a factor to
which the overall rate is particularly sensitive. You need to decide
how sensitive investment appraisals are in your own organization to
estimate a precise and academically sound cost of capital.
There are arguments for and against each method of calculating
the cost of capital. This chapter has discussed some of the principal
methods and explained the elements that make up the cost of equity
and the cost of capital, and it is hoped that you can now decide which
method is relevant to your own organization. In a large multinational
organization an understanding of the true cost of capital may be con
sidered to be important, whilst in a small company it might not be
considered to be particularly material to most decisions.
197
C h apter F iftee n
Dividend policy
W hen a company finds that it has more cash than it can retain in
the businesses to provide an attractive return it may decide to
pay the shareholders a dividend. If a business is retaining cash in the
business that is not increasing the value of the business ahead of other
investment opportunities for shareholders, then the shareholders can
reasonably expect the company to pay out a dividend. It is the directors
who decide on the size of dividends, and although shareholders might
have the power to reduce a dividend they generally do not have the
power to increase it. The directors decide on dividend policy.
The questions facing directors regarding dividend payments are
around how much cash should be paid to shareholders and how much
should be retained in the business for investment and for managing
future market conditions and risks? When the directors have decided
how much to pay to shareholders, the next question is what form the
return should take.
Paying a dividend or keeping the funds

in the company?
It would be very hard for a company to always find new investment
opportunities for the surpluses and retained funds generated by its
operations. In most cases a successful and profitable company will find
that it needs to pay a dividend since this is the best option for share-
holders. It may be impossible for a company to profitably re-invest every
pound it makes. When a company pays dividends this should not be
construed by the markets as meaning that the company is running out
of new ideas, since in most cases having funds available is inevitable
with successful companies. New opportunities in a sector may not keep

pace with earnings generated.
What form should a distribution take?

A company may wish to pay a consistent and predictable dividend. If
a company cannot be sure of a consistent dividend level it might
consider alternatives such as buying back shares. A share re-purchase
has the advantage that it gives the shareholder the choice of whether
or not to participate.
Influences in dividend policy

The following are some of the main questions that influence a com
pany’s dividend policy:
●● How much of the existing retained earnings need to be retained for

future financing needs (both operational and in terms of new
investment opportunities)?
●● What new investment opportunities exist?
●● What are current interest rates?
●● What other investment opportunities exist for shareholders at this
time?
●● Will the company remain profitable?
●● Is the proposed distribution legal? For example, in the UK dividends
can only be paid out of accumulated net realized profits.
●● Do any loan agreements restrict the size of dividend payments?
●● Does the company have enough cash to pay dividends?
●● Are there any existing government constraints on dividend
payments?
●● How much profit should be retained in the business to maintain
existing operations?
●● Are any loans due for repayment? Will enough profits be retained to
make these loan repayments?
●● What will a distribution indicate to the markets? Will it be received
favourably or will it be perceived as a sign that the company has run
out of new ideas?
Dividend Policy 199
●● How will this distribution affect the company’s gearing target?

●● How easy will it be in the future to raise extra finance?
Dividend policy determination is very much a strategic decision.

Financial efficiency is only a part of the decision, which should also
consider signals to investors, future market trends, the ability to invest
profitably in new opportunities and the company’s future financial
needs.
Dividend policy theories

From the above influences on dividend payment levels have arisen
a number of theories regarding dividend payments that might help to
classify them into different categories.
The residual theory

This theory states that only when a company can no longer identify
any investment opportunities with a positive net present value should
it pay a dividend. In other words, a company should not pay dividends if
it can positively identify investments in new projects with a positive
NPV.
The traditional view

This theory assumes that a market share price depends upon the mix of
dividends expected by shareholders, and that dividend policy should
reflect this.
The irrelevancy theory

This theory concludes that the value of a company is based upon the
earning power of its assets and investments and that, in a tax-free world,
a company’s shareholders have no preference between dividends and
capital gains. Accordingly, dividend policy is irrelevant. This theory was
the view of Modigliani and Miller. There are arguments for and against
this theory and, rather than list these here I will let you form your own
opinion, which I am sure is as good as any others. The Modigliani and
Miller theory is well referenced on the web if you have an academic
interest in their work.
The optimal dividend policy theory

This theory argues that there exists an optimal dividend policy that
will strike a balance between dividend payments and growth that will
maximize a company’s share price on the market.
The dividend relevancy theory

This theory assumes that the value of a company is affected by dividend
policy and that an optimal dividend policy may be reached that will
maximize a company’s value.
There is much debate regarding the effect of dividend policy on share

valuation, and for the purpose of this text it is sufficient for you to be
aware of the various theories.
Ways of paying dividends

When a company has decided to pay a dividend the next decision is
how to pay it. Should it be by cash, a scrip issue, stock split or by a share
repurchase? I will describe these below.
Cash dividend
If the company has accumulated surplus funds and can retain adequate
levels of funding for its future needs together with adequate cash lines
in place, it might want to consider paying a cash dividend.
Scrip dividends
This is a dividend paid by the issue of additional shares. This retains
cash in the company. In certain circumstances the directors will offer
shareholders the choice between a cash dividend or a scrip dividend.
Sometimes the scrip dividends will be offered at a greater value that
the cash dividend option.
The advantages of a scrip dividend to the company are that cash is
retained and that the issue will decrease the level of gearing, which may
have a positive effect on its borrowing capacity. A disadvantage is that
Dividend Policy 201
the issue might dilute the share price, although a small scrip issue may
have no significant effect.
From the investors’ point of view there may be tax advantages in
receiving their dividend in the form of shares, and they can also increase
their holding without having to pay the costs involved in purchasing
additional shares.
Stock split
A stock split leaves reserves in place and simply splits the existing
shares into smaller denominations. For example, existing €2 shares
may be split into shares of €1 each. This may improve the market trading
in the shares and push up their price. As an example, a €2 share may be
traded on the market at €2.20 whereas, when split into €1 shares, the
new €1 denominations may trade at €1.15 thus giving existing holders
a market valuation gain of 10p over their original value (2 × €1.15 –
€2.20). There is, of course, no logical reason why this should be the
case, but perhaps investors just like trading in smaller denominations,
lose track or just assume that because the shares have been split the
company has growth plans. Whatever the underlying reasons, a split
may have a positive effect on market prices and increase existing share-
holders’ valuations, or returns if they sell.
Share repurchase
A company must check whether it is ‘legal’ to purchase its own shares
according to the laws in place in its country. In many countries, subject
to certain conditions, companies do have the right to buy back shares
from shareholders who want to sell.
Some large companies buy back their own shares in order to pull
out of the listed share market and go private. The benefits of a share
repurchase include using up surplus cash that is not generating
value, increasing gearing (when this may be seen as beneficial) and
increasing the earnings per share. Disadvantages are that a shareholder
may suffer tax disadvantages (capital gains tax v other taxes) and that
it might be difficult to determine a price. However, these aspects will
be considered by shareholders who can make their own decision as to
whether to sell.
Summary
A company’s dividend policy has a significant impact on its financial
health. For example it affects liquidity, the cost of capital, the market
value of shares and the market perception of a company. Some com
panies that can guarantee high returns on their capital have a zero
dividend policy, providing value to shareholders through the increased
market value of their shares.
It is a potentially very complex subject in a large multinational com-
pany with overseas subsidiaries, associates and investments.
This short chapter has outlined some of the more important factors
that you might want to be aware of. The main things to remember are
that retained earnings are the most important source of finance for
most companies. Generally, dividend payments are smoothed out to
avoid large fluctuations that might alarm investors and reduce their
confidence.
203
C h apter S i x tee n
Case studies
I n the previous chapters we have covered some of the basic principles

that need to be applied for sound corporate and business financial
management. It will be beneficial to see how some of the more
important principles work in practice, and so this chapter provides real
case studies that demonstrate good and bad practice. For the purpose
of confidentiality I have not named any companies or banks.
In recent years the banks have come under considerable criticism,
most of which they deserve. You will see examples in these cases.
However, you will also see cases of poor financial management by
corporates, and I am sure that you can add to this list.
It is hoped that these cases will help you recognize both good and
bad financial management behaviour within your own organizations.
Case 1. Misuse of short-term funds with disastrous consequences.

Case 2. Foreign exchange hedging v speculation.
Case 3. Stock valuations and profits.
Case 4. Bank loans and covenants.
Case 5. Separating money transmission from a lending bank.
Case 6. Credit ratings and fundamental analysis.
Case 7. Advantages and disadvantages of internal charging.
Case 8. Marginal costing v fully integrated standard costing.
Case 9. Overtrading: profits but no cash.
Case 10. Integrating the planning and budgeting process, leading
to outsourcing.
Case 11. Government deficits and cost cutting.
Case 12. A 5 per cent increase in sales is generally worth more than
a 5 per cent reduction in costs.
Case 13. Large capital projects and cost control: critical path ana
lysis and integration with mainstream accounts.
Case 14. A mass of figures just makes life more complicated.
Case 15. High levels of fixed costs when income is variable can
cause failure.
Case 16. Interest rates and inflation.
Case Studies 205
Case 1: Misuse of short-term funds

with disastrous consequences
This was one of the saddest and most unnecessary closures of an
excellent business by a bank that pulled the rug when its customer
incorrectly used short-term funds (an overdraft) for long-term needs
(purchase of a new freehold branch). I hasten to say that this was not
one of my customers or a customer of my bank.
The business had been trading in the UK for more than 40 years
under the same experienced proprietor. It had five branches, three of
which were freehold and owned without a mortgage. The business had
no significant borrowing but did have a €250k overdraft facility that
it used from time to time to help ride the seasonality of its business.
An opportunity arose to purchase a new freehold branch for €400K
and the proprietor wanted to grab what he considered to be a bargain.
To do this he used surplus cash in the business and in addition
unwisely used most of his overdraft facility to make up the balance. I
say unwisely because, as we have discussed, an overdraft is short-term
money that is repayable on demand. It should not be used for long-term
needs such as the purchase of a new branch. Appropriate funding would
have been a term loan but the proprietor did not apply for one, assuming
that he could sort things out later with the bank if need be. He thought
he had a good banking relationship.
Shortly after the new branch purchase, things started to go wrong for
the company. A recession had brought about a sharp decline in trade
and sales took a steep dive. A lot of the company’s costs were fixed
and it found itself in need of cash. It had already used up its own cash
reserves and its overdraft facility.
The proprietor went to see his bank manager to ask for an increase in
overdraft. This was a new manager with whom he had no relationship
and who had little knowledge of his customer’s business. He took the
immediate view that he would not increase the overdraft limit since
sales were in decline. He also explained that he would review existing
limits in light of current business performance. His decision was that
the limit would be reduced to €100k and that the business must achieve
this immediately. This overdraft was repayable on demand.
As the company was unable to repay this amount the receivers were
called in. The business was wound up and property was sold at the very
low prices obtainable during a recession. The bank came away with
its overdraft and the penalty charges it had loaded on. The proprietor
came away with something but this was a fraction of what the business
and property would have been valued at only a short time before. The
saddest thing, though, was that a good business closed down leaving
many people without work.
The important message here is that a business should not use short-
term funds for long-term needs. Another message is that you can expect
a bank to protect its own position first. It is not a benevolent organiza-
tion. A bank relationships can be hard to maintain and not always
worth a lot when you do. Keep your elbow room or you might find that
you have to dispose of assets when the market for them is low.
Case Studies 207
Case 2: Foreign exchange hedging v

speculation
This case involved a medium/large New Zealand company that needed
to purchase US$30 million of technical equipment from the United
States. At the time of capital budget sanction the rate of exchange was
US$1=NZ$1.28. On the actual date of purchase the rate was US$1=NZ$1.37.
The return on this investment by the New Zealand company was posi-
tive NZ$ and was based upon the rate of exchange at the time of budget
sanction as follows:
Capital budget approved (US$30m @ 1.28) NZ$38.4m

Income NZ$40.4m
Return NZ$2.00m (5.2 per cent)
(For the purpose of this illustration we will ignore the time value of
money and discounted cash flow.)
To secure the return required at the time of budget sanction the NZ
company needed to firm up (fix) the rate of exchange at US$1=NZ$1.28.
Failure to do this might result in a loss on exchange that could partially
(or more than) offset the expected return on the investment. In fact,
failure to hedge against the exposure at the time of signing the contract
for the equipment would leave the New Zealand company with an
unlimited downside risk.
Since the company was cash rich, it decided to purchase the US$
at the time of budget sanction. Dealing lines were arranged and the
US$ were purchased at a rate of US$1=NZ$1.28. The company would
earn US$ interest on the funds purchased and forgo NZ$ interest on
the NZ$ used to purchase the US$. At the time NZ and US interest rates
were similar, and since the time between budgetary sanction and equip-
ment purchase was only a few weeks, it was considered that any loss/
gain on exchange on the interest differential was small compared with
the avoidance of a loss/gain on the principal sum.
By taking this type of hedging action the company avoided (on this
occasion) the following NZ$ loss:
Actual cost of US$30m @ 1.28 NZ$38.40m
Cost on equipment purchase date, US$30m @ 1.37 NZ$41.10m
Avoided loss NZ$2.70m
Had the company not purchased the currency in advance, the loss
on exchange would have more than offset the budgeted profit on the
investment. The directors were satisfied that they had made the correct
decision by protecting the return on their investment.
The following year the company needed to make another purchase
of equipment from the United States for a similar amount. It followed
the same process and purchased the US$ in advance. On this occasion
the US$ v NZ$ rate of exchange moved in the opposite direction, and
had the company not purchased the currency in advance then it would
have made a gain on exchange on the day of equipment purchase.
However, this would have been an unauthorized gain since the directors
did not have the authority to speculate on the exchange markets. They
would have received no thanks from the shareholders had they made
a loss.
There were other alternatives to purchasing the currency in advance.
The company could have taken out a forward contract and it might
also have considered an option. An option contract would have limited
the company’s down side but not limited its potential gains. However,
there is an argument that the part of an option price relating to the
unlimited upside is a speculative investment and the directors would
need to ensure that they had authorization to enter into such a contract.
The important point to understand here is that when a mismatch
of currency results in an exposure, the duty of most finance directors
is to eliminate or hedge against the exposure. They are not authorized
to speculate unless that is the business of their organization.
Case Studies 209
Case 3: Stock valuations and profits

A small manufacturing company with 200 employees operated a fully
integrated standard costing system.
Items manufactured used materials, labour and absorbed overheads
as they travelled through the production process from raw materials
to work in progress and finally finished stock. The system provided
standards for material prices, materials used, labour rates and times,
and overhead absorption rates. Standard rates were used to value
stocks with some adjustment for variances.
At the year end a physical stock count would be taken and this
usually produced a different result from the book stock recorded in the
stock records and in the accounts. There were many reasons for this,
including errors in the physical count, record-keeping errors, wastage,
bookkeeping errors and a variety of clerical errors that occurred when
recording thousands of transactions.
Now, the problem arose as to which valuation to use in the year-
end accounts. Any difference between the stock value used and that
currently recorded in the financial accounts would have a direct impact
on the bottom line result.
Generally accepted accounting practice requires that stocks should
be valued at the lower end of cost or net realizable value. However,
which cost should be used, the actual cost of each item in stock or
the standard cost? Most auditors would like to see stocks valued at
their actual cost rather than standard costs, and they may look at the
variances recorded by the standard costing system and apportion some
of these variances back to the stock value rather than write the whole
variance off into the profit-and-loss account. Then the question of
which quantities are correct arises. Is it the physical count or the
recoded quantities/values? It is too late to re-check the physical count
after the stock-count day has passed because stocks would have moved
since then. Generally auditors will prefer the physical count as long
as it is performed properly, and this is why they should always be in
attendance and check major value items themselves.
The company regularly changed its internal accountants and stock
controllers. The auditors sought to ensure that there was consistency
in the approach to valuation because any change in method would
affect profits.
You can begin to see that amongst all these systems and processes
that there was plenty of scope for error and inconsistency. The directors
would read monthly management reports indicating profit levels based
upon the results of the fully integrated standard costing system, and get
a shock at the year end when the results had to be changed as a result
of the physical stock take and the auditor’s requirements.
Much time was spent trying to reconcile physical stock with book stock
valuations, but generally little was achieved by these reconciliations.
The principal points to be aware of here are:
●● Year-end physical stock valuations can have a dramatic effect on

profits.
●● There must be regular physical checks and reconciliations on book
stocks and their values when a fully integrated standard costing
system is used.
●● Stocks should be valued at the lower end of cost or net realizable
value.
●● The actual cost of stock can be different from its standard cost,
and it may be necessary to make adjustments to the stock values by
considering variances.
●● Consistency in valuation method is all important. The effect of any
change in method should be separately reported.
●● Stock obsolescence, wastage and loss will be discovered through
the physical stock count and the examination of stock records.
Case Studies 211
Case 4: Bank loans and covenants

I came across this appalling case of bank mismanagement and customer
naivety whilst visiting the business banking arm of a major bank oper-
ating in London. It is the sort of thing that makes banks unpopular and
was in my mind entirely unnecessary. There is an argument that the
bank’s customer was at fault here and, technically, he was. However,
I think the bank’s action, whilst protecting its interest, was avoidable.
A small family-run business operated a successful camp site. It had
plenty of spare land and decided that it would use this land to build
cabins. The proprietor went to the bank to negotiate a loan to cover
the building cost. A loan was offered for 60 per cent of the costs, with
a first charge over the land and all buildings completed or partially com-
pleted and all materials on site. The bank also required the borrower
to agree to certain covenants, which the borrower readily did, perhaps
not realizing the significance of these. The covenants were many and
varied, including things that the borrower must not do and things that
he must do.
Among the things that the covenant required were to submit regular
financial statements to the bank and to also maintain certain financial
ratios, including liquidity and profitability. These must all have seemed
easy enough to fulfil at the time.
Building works commenced in February and the proprietor expected
to have at least five cabins completed by June and have them occupied
by the time the school holidays commenced. This would have produced
valuable income to assist with the rest of the building programme.
Unfortunately, the builders (as is often the case) encountered delays
in getting materials delivered and were hit by heavy rain that caused
the whole programme to slip significantly. They would have several
cabins completed by the school holidays, but what with other comple-
tions and ground work the site would not be suitable for residents. Then
followed one of the wettest summers on record and people were just
not camping. This meant that regular income from the site was down
and that the business was running out of cash, with a delayed project
and little chance of breaking even before the end of the season. This,
you might think, must surely have been expected in such a seasonal
business as camping. Why did the proprietor not allow for this and
why did the bank not also factor it into their decision?
Of course, you can guess by now that when the borrower sent in
the accounts to the bank, they did not show the required performance
and he was in breach of covenant. The bank had headroom in its
security and might have considered allowing the borrower a season
to get things right. Perhaps it could have re-negotiated the loan and
covenants. However, it was easier for the bank to simply pull the rug,
load on penalty charges and clear its position.
So, what are the lessons learned here?
●● Don’t enter into any covenant lightly.

●● Don’t think you might not have to meet the terms of a covenant.
●● Assume the bank will enforce the covenant.
●● Understand the margin (the difference between its cost of
borrowing and what it charges you) is often small in relation to
the risk it is taking and that it will protect itself.
●● A bank’s principal responsibility is to its shareholders.
Case Studies 213
Case 5: Separating money

transmission from a lending bank
Some businesses receive large volumes of cash or paper transactions
that need to be paid into a bank. Many businesses pay these sums
directly into their principal lending bank through the bank’s branch
network. This may be costly, inefficient and not strategically useful
from a financial perspective.
A large wholesale company distributed goods throughout the UK
using a network of distribution centres and trucks. When depositing
the goods with a customer the truck driver was expected to collect
either cash or cheques. The driver was trained to complete a deposit
slip towards the end of each day and then find a bank branch and pay
the money in.
One problem with doing this was that there were few bank branches
in certain parts of the UK. This could result in time delays and security
issues. Another problem was that the bank did not like receiving cash
and imposed a cash-handling charge of 75p per cent (that is, 75p for
every €100 of cash deposited). Given the billions of turnover that
this company collected, this charge was considerable. Another issue
was that the bank had a large degree of control over the customer’s
financial arrangements and could exercise considerable control – not
good strategic financial management for a borrower!
The solution was to pay the cash and cheques into a transmission
bank using Post Office Counters. This had many advantages. For a start
the Post Office had more than five times as many branches as the
wholesaler’s bank, and they were often in locations outside a town
centre where parking was easier. The Post Office actually needed cash,
and the value of this was reflected in the overall charge to the whole-
saler, thereby reducing its bank charges. The transmission bank made
a single daily transfer by CHAPS for the total value of funds paid into
the transmission account by the wholesaler. This meant that the whole-
saler eliminated most of the fee from the principal bank and replaced
this with just the single CHAPS fee and the transmission bank’s fee,
which was much lower, having been partially offset by the cash credit
value from the Post Office.
It is always worth exploring alternative schemes to reduce bank fees.

However, another important benefit earned by this wholesaler was
independence from its principal bank. By using a transmission bank for
deposits, it could at any time issue an instruction to have the value of
the funds transferred to any other bank offering favourable facilities.
Case Studies 215
Case 6: Credit ratings and

fundamental analysis
Icelanders recently voted not to repay the £3bn owed to Britain and the
Netherlands following the crash of the country’s banking system in
2008. Britain and the Netherlands compensated their nationals who
lost savings deposited with Icesave accounts owned by Landisbanki,
which collapsed in 2008.
Deposits made to failed Icelandic banks included those from indi-
vidual citizens and also 127 English local authorities holding English
public funds. It is one thing for an individual to make a bad invest-
ment but another for a professional treasurer at a local authority to
risk public funds.
Understanding risk and whether one is authorized to take one is
a key factor worth examining here. A treasurer handling public money
has a prime responsibility to protect it. Is s/he empowered to take
anything other than the lowest-risk investment available? How many
authorities continued to make investments of public money after the
credit ratings of the collapsed Icelandic banks were reduced?
So, we have public treasurers making bad investments with public
money entrusted to them and Iceland not standing behind its debt.
One way or another the public lose out, either through their direct
investments or through their money being invested on their behalf
by public authorities.
What lessons have we learned from this and how will these affect
our future investment decisions? What this has reminded us is:
●● Don’t ignore fundamental analysis.

●● Don’t assume that a big name is a sound investment if
the fundamentals don’t stack up.
●● Don’t ignore credit ratings.
●● Don’t just follow others – they may be heading for the rocks.
●● Do understand your risks.
●● Assume that when things go wrong it may take years for you to get
some of your money back and that you might never get any of it
back in you lifetime.
A business cannot afford to ignore these basic principles – there are few
government or taxpayer hand-outs to a business. Theses principles
do not just apply to investments but also to any other judgements
regarding the financial status of organizations you are dealing with.

How reliable are they and will they pay your bill?
The market value of a company may often exceed its fundamental
value. There are many things that influence market values other than
pure asset values and earnings. Sentiment, emotion and general market
conditions to name a few. However, a wise financial manager will
understand fundamental values and know by how much these may
vary from market values. This can then be considered as part of the
risk analysis.
Case Studies 217
Case 7: Advantages and

disadvantages of internal charging
This case concerns a medium-sized, not-for-profit organization with a
turnover of around $400m per annum. It was jointly owned by a number
of institutions that enjoyed an economy of scale in sharing a resource.
It provided a good service and, compared with the alternative of each
parent company owning its own resource, the not-for-profit organiza-
tion was competitive. This was periodically checked by comparing
charge-out rates with those offered in the outsourcing market.
Although the organization was on the face of it competitive, its costs
and resources crept up each year and its owners/customers questioned
whether there was scope for efficiencies. Naturally, each departmental
head wanted to provide the best and most professional service and in
so doing often justified additional resources.
To address the concerns about increasing costs, the first step taken
was to introduce a form of ZBB (zero-based budgeting) whereby all
departmental budgets had to demonstrate how they related to corporate
goals. This helped to an extent but still additional resource was justified
across the board, and, perhaps some managers were to some extent
competing for power and influence by having the greatest resources
under their control.
In a further attempt to control costs a system of internal charging
was introduced. This system required every department to identify its
customers (these were mainly internal customers) and to charge these
customers for the service it provided. The internal customer had the
choice of using the internal provider or finding an external one. Each
internal department had to balance its books, in that the income it
received from its customers had to be at least equal to its costs.
Departments first of all needed to identify their services and the
resources used in providing them. For example, one service provided
by the HR department was recruitment. This included assisting with job
descriptions, advertising and interviewing. A charge would be advised
to potential internal customers for this service. The customer could
either accept this charge or use an external recruitment agency.
The supporters of this system argued that it would make managers
act like businessmen and run a professional service. They also argued
that it would make users aware of the costs of services they used. It
was even possible that the service provided internally could also be
provided externally if it met return on capital requirements and was

in the remit of the organization’s core business activity. This could bring
in extra income to the organization and make the core service pro
vided to the owners/customers even less expensive.
The sceptics argued that it would be too difficult to identify an inter-
nal customer. For example, who is the internal departmental customer
for the annual report and accounts and taxation return completed by
the finance department? The sceptics also argued that the system
would just introduce another layer of administration with internal
invoices and recording.
The new system was implemented, and during the budget prepara-
tion stage each budget holder would seek agreement from identified
internal customers to pay for services. A department that did not have
sufficient income would need to explain why, and a decision could be
made as to whether to continue with the service internally or to out-
source or to scrap the service altogether. The result was an overall reduc-
tion in costs. However, management attention was to some extent
diverted from pure service provision to running a mini-business
and the sceptics felt that service levels had deteriorated. A particular
problem occurred when some departments wanted to use a particular
internal service and others did not. If the costs of the internal ser
vices in question were fixed or difficult to reduce, then a decision
would need to be made as to whether the whole service should be
outsourced. Sceptics would argue that too much outsourcing would
make the organization vulnerable.
In the end it was only those services that could be readily outsourced
that were subject to internal charging; these were:
●● payroll;
●● HR;
●● accounts receivable and payable;
●● IT support services;
●● catering;
●● printing;
●● legal services;
●● security;
●● premises management.
Case Studies 219
In theory internal charging systems help management in not-for-

profit organizations to control and redistribute funds. However, many
argue that there is no evidence that it really helps make better manage-
ment decisions. It is a debate that has been ongoing for many years
and, if you work in the public sector, I am sure you will have your own
well-developed views.
Case 8: Marginal costing v full

absorption costing
A director of the business banking arm of a major bank was review
ing the profitability of a portfolio of customers. The management
accountant had produced the following statement showing the pro
fitability of the account during the year ended 2010:
Business deposits made over the counter €35,500,000

Fees at 4 cents per €100 of deposits €14,200
Variable direct counter costs €7,000
Gross margin €7,200 (51%)
Fixed overheads allocated €8,000
Net loss €800
The director requested that the fees be increased from 4 cents to

4.5 cents per €100 of deposits in order to return the account to profit
ability. The customer refused to pay the increase and the director let
the customer leave to join another bank. The director thought he had
just got rid of a loss of €800 and was rather pleased with himself. In
fact he had just lost the bank €7,200.
What he had done was to lose €14,200 of fee income and also
€7,000 of variable costs. This resulted in a loss of the gross margin
of €7,200. However, he did not lose the fixed overheads of €8,000!
He had simply lost €7,200 of contribution towards the fixed costs
of €8,000 that remained regardless of his action. So, unless he could
replace the lost business with more profitable business (which he
had not) he had reduced the bank’s bottom line.
Now, this might seem obvious to you but it is amazing how many
senior executives struggle with this simple concept and lose their
organizations’ money.
Of course, not all accounts can be run on a marginal cost basis.
Overall, fixed costs must be covered. However, consider whether you
will be worse off by losing contribution before letting an account go.
Case Studies 221
Case 9: Overtrading:
profits but no cash
A small regional advertising agency specialized for many years in
buying space in local papers and selling it to small businesses that
wanted to place advertisements. In a way it performed a service of aggre-
gation and of dealing with large volumes of enquiries. For this service
it made a small margin, employed several people and provided its
shareholders with a small return on their investment. It also added
value and income through some low-level design work and copy work.
There was little financial risk and the company had, by and large, oper-
ated on 30-days’ credit. It was allowed 30 days to pay invoices received
from the newspapers and allowed some of its own customers 30 days.
Most small customers paid as they ordered an advertisement and
accordingly the agency was generally in funds. It had a small overdraft
facility but rarely needed to use it.
The directors decided to find new income streams. Their existing
business was coming under threat as more people placed advertise-
ments directly with publishers online. They decided that the agency
needed to provide more services and increase the value of their offer-
ings. They would protect and develop their existing customer base, and
attract new customers by offering web design, copywriting, marketing
strategy, branding, PR and other services. Their ambition was to become
a full service agency.
The company had not in the past needed a finance director and had
simply used a bookkeeping service and a firm of local accountants to
prepare and file year-end accounts. A finance director was the last thing
on their minds at first and they quickly recruited very able people to
undertake the work and an experienced business developer. Things got
off to a good start and in no time at all orders for work were flowing
into the agency.
The work commanded good rates and the margins were much higher
than had previously been earned on buying space in local newspapers
and selling on. The directors produced management reports that
showed high levels of sales and profits. On the basis of this the company
took on more orders and recruited more staff. There was no shortage
of work and profits.
However, the company started to run into cash-flow problems
because, although it had a full order book and was charging out at a high
margin, there was a delay in collecting debts. Customers were slow

to pay and were taking on average between 60 and 90 days credit. This
lag did not match the agency’s outgoings, which were 30 days. The new
staff and premises were a regular monthly cash outflow.
The company was trading profitably but it was trading beyond its
cash resources. It was overtrading. It could not pay its debts as they fell
due and collapsed. It had left it too late to go to the bank and arrange
facilities. The bank now just saw a company unable to pay its staff
and rent, and was not about to jump in and save the day since it had
no assurance on the quality and ability of the agency’s customers to
pay the debts. The company sacked most of its staff and started again
in a restructured and better-financed manner.
You would have heard the saying that sales are vanity, profits are
sanity but cash is king. Well it is not a bad thing to remember. Over
trading is a common cause of collapse of profitable companies.
Case Studies 223
Case 10: Integrating the planning and

budgeting process, leading to
outsourcing
This case concerns a large service provider that enables organiza-
tions with high volumes of business transactions to outsource their
documentation handling and data-processing. The company receives
batches of prime-source documents from customers and processes
these at a number of regional centres. It also provides an outsourcing
service for the processing of electronic transactions.
The company had been operating profitably in the 20 years since it
had commenced trading with a small team supporting the founders.
It had now grown to an organization employing around 1,100 employ-
ees with all of the support functions needed. These support func-
tions had been built up by departmental heads who prepared their
annual budgets in isolation from the main corporate planning process.
The central business plan was prepared by the original executive team,
most of whom had been with the organization since inception. Their
principal concerns were the core processes surrounding the business
offerings, and with winning and retaining new customers. Specialist
support functions such as HR, payroll, buying, finance, premises
management and training had been left to functional heads.
The company now found that it was employing nearly as many sup-
port staff as it was direct processing and sales staff. Business support
costs were now more than half of the company’s total costs and it
was finding that its return on capital was being eroded. The executive
team started to examine the support departments’ budgets, which had
been prepared on a resource basis. This meant, for example, that they
could see what the money was being spent on but they could not see
how this related to the company’s overall business strategy or value-
creating activities. For example, they could see that HR was budgeting
for 25 staff and 15 weeks of staff training, but how did this relate to core
business activities and was it really all necessary? People in HR were
extremely busy. Similar questions surrounded all other support depart-
ments. They were all very professional and hard working, but were
they really all needed? Market pressures were making the retention
of customers and winning new ones extremely difficult at the prices
that would provide the margins now needed to cover indirect over-
heads. Clearly something needed to be done!
As is often the case when things get to this stage, the executive team
need a quick fix. They need to cut costs now in order to remain com-
petitive and this would be painful and difficult. What costs could be
cut without harming essential support, and what effect would all this
have on company morale? Before we consider the options that this
company considered and eventually adopted, let’s look at some of
the events that let to this situation and how the company could have
prevented it from happening in the first place.
The founding team were all experts in the field that was the com
pany’s core competence. They would be the first to admit that they had
little expertise in the other professional services they required. As a
consequence they hired professionals and let them manage their own
functions, largely in isolation. The support professionals did this and,
while it would not be fair to say that they built empires, they each
wanted their department to provide the best possible service. The
company provided an outsourced service for other organizations that
recognized its services was not their core competence. However, the
team had neglected to recognize this fundamental themselves. As a
consequence much of the company’s resource was used in areas where
they might not be as efficient as other providers, and where they
certainly did not enjoy the economy of scale that they would if they
outsourced some of their internal services.
The business plan was prepared each year showing how the com
pany’s offering would be developed, the demand, competition and
expected market share at certain price levels. This was converted into
an operations plan and sales plan. Budgets were simply prepared on
a resource basis of last year’s spend plus an allowance for inflation and
business growth. This was the root of the problem. The company should
have used a more rigorous method of budgeting to ensure that budgets
supported the business plan at each stage. They might have expected
managers to accept the business plans and goals, and then start with
a blank sheet and estimate the resources they needed to support each
item in the plan. A form of zero-based budgeting (ZBB) might have been
beneficial. The principal point here is that planning and budgeting
should be integrated. A fully integrated planning and budgeting system
will help ensure that departmental budgets are aligned with business
plans and that resources are justified in terms of the core business.
Case Studies 225
The company decided to adopt a two-stage approach to the problem.

First of all they would introduce a fully integrated planning and budget-
ing system, and then they would consider outsourcing some of their
support services. They wanted to get back to concentrating on their core
business.
The first stage in the planning and budgeting process was to consider
the business environment, including customers and competition, and
prepare objectives, goals, key tasks and an overarching strategy. This
was translated into sales and operations plans and budgets. These
master plans and budgets were then given to the support departments,
who were required to form their own plans and budgets to support
the master sales and production requirements. These were prepared
on a ZBB basis, with the requirement that each item had to be justified.
This obviously made departmental managers think a bit harder than
they had done before when simply preparing resource budgets, and
some tough questions were asked at budget review time. Overall, the
company achieved a modest reduction in support costs that, although
welcome, was not enough to ensure the company could be competitive.
However, plans and budgets were now integrated, and by relating
support department overheads to overall corporate sales and produc-
tion plans it was possible to more accurately determine product costs.
In time the company adopted a form of activity-based costing and
started to get a firmer grip on costs.
The second stage of the solution to cutting high support costs was
to consider outsourcing those services that were not areas of core
competence. Having already got costs under some control, the company
thought it had a better understanding of how to approach discussions
with various outsourcing and shared-services organizations. An initial
idea was to move a whole department into specialist-service company
that would take over all existing staff. The specialist-service company
would offer a small reduction in cost but, more importantly, offered to
hold costs for a number of years and meet service levels that were in
excess of those currently being achieved by the internal resource. The
outsourcing company would achieve this through an economy of scale
that would be achieved through natural staff departures over time. Their
current staff turnover would accommodate this, and staff being taken
on would be assured of employment on either existing work or work for
other clients. A bonus to the staff being transferred was that by working
for a company that specialized in their profession they would learn new
skills, be more marketable and have greater job security. This was all
possible and financially viable now that the company had got its sup-
port costs under control and had made some initial internal savings.
The company is now trading successfully with a much smaller core
team focusing on their area of core competence.
Shared services and outsourcing are simply an efficient business
architecture that creates sustainable business advantage through the
pooling of shared resources. The main benefits of outsourcing and
shared services are cost reduction, performance improvement and the
ability to leverage investments in new technology.
There are many types of shared service and outsourcing options,
and in this case the company decided upon full outsourcing of certain
support services to third-party suppliers once it had implemented an
integrated planning and budgeting system and reduced costs as far as
it practically could.
Case Studies 227
Case 11: Government deficits and cost

cutting
For many generations the United States has been the economic power
house of the world. Now, according to the Congressional Budget Office,
the federal government will accumulate more than $7 trillion in new
debt by 2019 unless remedial action is taken. The International Mone
tary Fund has estimated that the annual structural deficit in the United
States may reach $1 trillion by 2015 under current policies.
A fiscal imbalance of these proportions is a risk to the United States
since an accumulation of debt of this magnitude will lead to inflation
and undermine currency stability, and will also adversely affect the
private sector’s ability to create wealth and jobs. The federal government
has recognized that it needs to adopt an aggressive plan to reduce and
ultimately eliminate the deficit. The Office of Management and Budget
has, therefore, already commenced a programme to identify cost
reductions.
The situation in the UK is similar although of a smaller scale, and
cost cutting and efficiency measures are high on the government’s
agenda.
Of course the books have to balance; few would disagree with this
fundamental. Much debate, however, concerns the severity of the cuts
and how they can be spread so as to avoid doing more damage to the
economy.
In the UK benefit entitlement and the elimination of some less
essential programmes are the first to attract attention. Then all depart-
ments are expected to identify efficiencies and to cut back on spending
and recruitment. Opportunities for the amalgamation and consolida-
tion of services and departments and, in particular, for shared services
are some of the more obvious initiatives. There are, no doubt, opportu-
nities for efficiencies in energy consumption, supply chains and more
straight-through transaction processing.
Reading this case there are obvious similarities with the previous
case, Number 10. Similar actions are being taken. The question is what
planning and budgetary measures can be put in place to prevent past
mistakes happening again.
Clearly it is necessary to ensure that budgets support plans and
objectives and that there is adequate funding for public expenditure.
The problem is often the definition of the objective, since many
programmes have broad social outcomes. Unclear outcomes make the

evaluation of benefits difficult to measure.
Following the global financial crisis, many countries are strug-
gling to emerge from low economic growth and high unemployment.
Countries are in debt and also wondering how to cope with huge budget
deficits. There is a possibility of long-term pain. Many still look to
the United States to lead the world into a new period of economic
prosperity, and perhaps new technological innovation will enable this.
However, it has often been said that if companies managed their
finances the way that governments do, they would be out of business
in weeks.
How does the UK government manage its finances? Not at all well,
according to the National Audit Office! A National Audit Office report
on improving financial management in government concluded that
Whitehall departments needed to improve financial management and
accounting skills. It said that government departments were weak at
monitoring balance sheets and cash flow.
Case Studies 229
Case 12: A 5 per cent increase in sales

is generally worth more than
a 5 per cent reduction in costs
A national retail company gave its store managers a certain amount of
autonomy regarding stock, price and costs. The rationale behind this
was that local managers had a better understanding of local needs.
At one store in the South of England a new manager was appointed
who had been with the company since leaving school. She had worked
her way up the ranks from counter-assistant to supervisor and, follow-
ing a period with head office in buying, was now promoted to be manager
of a medium-sized store.
Having worked in most departments she knew most of the ‘tricks
of the trade’ and was keen to show how she could improve branch
profitability.
The results for the 12 months prior to her taking up the post were:
Sales £3,000,000
Gross profit £1,650,000 (55 per cent)
Store wages & overheads £700,000
Net profit £950,000
Her experience had made her aware of some staff inefficiencies, and
also of various practices regarding returns that might have benefited
staff but not the company’s bottom line. She resolved to increase the
net profit by 5 per cent and determined to do this through cutting local
costs and increasing efficiency.
Staff turnover was running at about 20 per cent per annum, and
an early decision was simply not to replace leaving staff and to get the
remaining workforce to cover the work by rearranging their duties.
Another move was to stop the long-established practice of staff pur-
chasing returns at concessionary rates. Generally staff practices were
tightened up and costs were cut wherever possible.
At the end of the first 12 months the new manager had reduced
local costs by the 5 per cent she had intended. Gross margins had
remained the same. Sales had dipped by just 3 per cent. She thought
this was a fair result until her regional manager called her in to explain
why her store’s net profit had fallen by 1.5 per cent.
The results were:
This year Previous year Variance (%)
Sales (£) 2,910,000 3,000,000 3% adverse

Gross profit (£) 1,600,500 1,650,000
(55%) (55 per cent)
Store wages & £665,000 700,000 5% favourable
overheads
Net profit £935,500 950,000 1.5% adverse
What is clear from these results is that a variance of sales has a greater
effect on the bottom line than a variance on costs. A 3 per cent reduc-
tion in sales more than offset a 5 per cent reduction in store costs,
resulting in an overall reduction in net profit.
For example, a 5 per cent increase in sales would have added £150,000
straight onto the bottom line, whereas a 5 per cent reduction in store
costs would only add £35,000 to the bottom line.
This is not to say that reducing costs is not worthwhile; of course it is.
However, it is a common mistake to focus too much on costs, perhaps
because they are easier to control. Finding ways to get customers to
spend more is not so controllable or easy. Many new managers, espe-
cially those who have come up though an operations’ route, perhaps
concentrate too much on cost because that is within their comfort
zone and area of knowledge.
However, in this case questions also had to be asked about why
sales had fallen by 3 per cent when elsewhere in the country sales
had increased or at least remained level. Well, not replacing staff had
meant that there were fewer sales staff to advise and promote sales. This
may have had something to do with the reduced turnover. Perhaps the
most critical factor was a palpable reduction in staff morale resulting
from extra work loads and a reduction in perks. They had worked as
a team and were not happy with the new manager’s cost cutting and
lack of encouragement of new ideas – it was all about control not new
business. Unhappy staff can have a downward effect on customer spend.
A smile can go a long way.
Case Studies 231
Case 13: Large capital projects and

cost control: critical path analysis
and integration with mainstream
accounts
This case concerns the building of an oil platform and the owning
oil company’s capital budgeting techniques.
The original capital budget was based upon contractors’ estimates
consolidated and compiled by the oil company’s consultant quantity
surveyors and cost engineers. It came to around €80 million and the
project duration was 36 months.
Half way into the project the costs had already reached nearly €200
million. Overruns were primarily due to delays in key activities that
lay on the project’s critical path. It had become exceedingly difficult
to control costs and analyse variances because there were multiple
contracts relating to multiple activities, and the task of reconciling
financial records to the critical path analysis had become almost
impossible. Costs were hopelessly out of control.
A new project manager and team were engaged and their first task
was to prepare an estimate of the total cost to completion. To do this
they first of all prepared a project network and critical path showing
each activity’s start, duration and completion date. The contracts
relating to each activity were identified and coded, to ensure that
accounts were integrated and all invoices were to be coded against
an activity. The revised cost estimate was over €500 million.
By fully integrating the mainstream financial records with the
project’s activities and contracts it was now possible to monitor and
control costs accurately. Previously the project software used, whilst
recording contract costs against activities, had not been fully inte
grated with mainstream accounts and some transactions had slipped
through the net, causing ‘surprises’ when finance produced high-level
reports of the overall project cost. A key factor in controlling large
projects is to determine just how sensitive the project costs are to
slippage of an activity on the critical path. A relatively small and low-
cost activity might, if it were delayed, cause slippage in major activities
and result in a loss of a weather window or cause some other major
disruption.
In summary, projects have activities and events. Contracts may cover

more than one event. Ensure that the mainstream finance records are
fully integrated with contract records and with the network/critical
path. Watch out for those projects that lie on the critical path, however
small they are, and see how sensitive the final outcome is to these
critical activities. Understand the risks and take measures to hedge
against them.
Case Studies 233
Case 14: A mass of figures just makes

life more complicated
In this book we have discussed many techniques and ways of looking
at business performance. The secret to good management information,
of course, is knowing which figures to look at and act upon. This will
be different for every type of business. Not knowing what is important
and relevant will lead to over-complexity, confusion and generally
missing the important point. Having too many figures will mean you
can’t see the woods for the trees.
The most successful companies concentrate on key performance
figures – a dashboard approach. Digging deeper might be necessary
but initial management attention needs to focus on key performance
indicators.
Most of the unsuccessful companies I have observed have spent
too long looking at micro-issues and as a consequence losing focus
on what is important.
John Timpson is the Chief Executive of the high-street cobbler and
key cutter Timpson. His group has over 800 shops. In an article in the
Daily Telegraph Mr Timpson commented: ‘A long time ago I learnt that
having a lot of figures doesn’t mean that you are better informed – it
just makes life more complicated.’ He went on to explain how having
detailed figures for every shop took up management time just review
ing figures, with little end influence on performance. ‘Sales never
seemed to follow our forecast – our customers clearly didn’t know
how much they were expected to spend! I scrapped the process.’ By
not wasting time on unnecessary micro-management, Mr Timpson
found that he had more time to know which shops are successful, to
actually visit branches and pass the secrets of success around.
If you find that you are receiving management information that
seems to take up much of your time but to have little effect on the
performance of your business, then there is a good chance that you are
concentrating on the wrong things. One of the biggest dangers in any
business is ‘doing the wrong thing really well’.
Case 15: High levels of fixed costs

when income is variable can cause
failure
We have discussed the difference between fixed costs (those that remain
fixed when sales or production increases) and variable costs (those that
change with sales or production activity).
A company that has a high proportion of its costs fixed during a
period of time when it cannot be sure of sales income for the same
period is extremely vulnerable. It has a ‘mis-match’ between fixed costs
and variable income, so that if sales fall it will be left with costs it
cannot afford to cover. It may go broke very quickly.
In June 2011 the case of Southern Cross in the UK demonstrated this
basic trap that organizations often fall foul of. That is having overheads
that are fixed or rising at a time when revenues are under pressure to
remain constant or fall. Southern Cross had rented property at a fixed
or increasing level at a time when its income was constrained.
Many companies assume that their sales forecasts will be achieved
but unless they have contracts in place to back up the forecasts, they
should consider what might happen if income falls. Can their costs
fall at the same rate? A company that has entered into a property rental
for a fixed period will need to be pretty sure that its income during
the same period is certain. If not then it is taking a gamble.
There is no doubt that during the next few months the causes for
the Southern Cross failure will be debated in the press, and certainly
by the time you read this book the case will be dead and buried. Blame
will have been laid in many directions and the case will have become so
confusing that only those who have followed it closely will understand
the real reasons behind the failure. However, a key risk measurement
is the ratio of fixed costs to assured income during a period and you
might consider, as I do, that this was a major contributing factor in
the failure.
As another real example, a group of independent schools has the
following simple way of keeping tabs on its fixed cost: assured income
ratio.
Case Studies 235
£ millions Years 2011–2013
Costs Income Surplus

(£) (£) (£)
Fixed/contracted 1.4 0.4

Variable/to be contracted 17.6 20.2
Totals 19.0 20.6 1.6
During the three-year period most of the schools’ income is considered

as uncommitted since parents are only required to pay one term in
advance. However, most of the schools’ costs are also variable in the
same period because staff can be reduced if student numbers fall. The
group of schools do have some real fixed costs during the three-year
period, and it tries to ensure that these are partially covered by parents
paying for fees in advance and uses the balance by cash reserves to
cover the mis-match.
If the schools did not keep adequate cash reserves, then the mis-
match between fixed costs of £1.4m and contracted income of £0.4m
would put them at risk if student numbers fell sharply. Independent
schools are regularly closing down when student numbers fall at a
time when they are saddled with a high proportion of fixed or rising
maintenance costs. For schools in this category the difference between
success and failure can amount to just a few students.
Many new start-up companies that do not have significant cash
resources will ensure that their costs are mainly variable. As a director
of a company, you have a responsibility to ensure that the company
does not incur a debt at a time when it is unable to ensure it can repay
it. You might want to consider this carefully when matching the com-
pany’s ability to cover costs with revenue during a particular period!
Case 16: Interest rates and inflation

Let’s conclude our case studies with a debate on interest rates and
inflation, with some examples of the effect of government policy on
the use of interest rates to stem inflation and how this might affect
your own business.
In the UK we have for several years experienced the lowest bank
rate in my lifetime, and that is a very long time! Inflation has also been
very low but at the time of writing it has started to creep up again.
Successive chancellors and governments have seen interest-rate
targets as a vital tool of monetary policy to fight inflation. A general
theory espoused by some chancellors is that when inflation increases
one should increase interest rates to choke it off. Nowadays the Mone
tary Policy Committee (MPC) is responsible for interest-rate setting
and has the difficult task of setting a rate that will achieve an optimal
balance between the necessary fight against inflation and very many
other economic factors. It is indeed a difficult task and not all members
will agree on the same course of action.
Sometimes a member of the MPC will speak outside the committee
at a public meeting, expressing a personal view on interest rates. This
might be simple ‘kite flying’ or just a deeply held view. It might be
an indication of future movements but then it might not! So, how do
interest rates affect inflation and how does inflation affect interest
rates? How do interest rates affect rates of currency exchange? More
importantly for your business, how will this all affect you?
Lower interest rates might create more borrowing power for con-
sumers. This might enable consumers to spend more, resulting in
economic growth and possibly creating inflation. When the MPC, the
Fed or some similar policy committee decides that the economy is
growing so fast that demand might outpace supply and increase infla-
tion, it might decide to increase interest rates as a way of slowing down
the amount of cash entering the economy. This might reduce inflation
in the longer term.
Similarly, increasing inflation might increase interest rates. This is
because real money supply is money supply divided by price level. This
means that as prices increase the money available will decrease, and
a decrease in money supply would result in higher interest rates.
Unfortunately, things do not always obey popular economic belief.
I can remember one British Chancellor announcing monthly increases
Case Studies 237
in interest rates in the belief that inflation would ‘give in’. Interest
rates reached an all-time high and this had the effect of closing down
many businesses, thereby reducing certain supplies and increasing
prices in some areas. This partially offset the effect that the increased
interest rates had on reducing consumer spending, which was expected
to bring down inflation. Interest rates are also a component of most
product costs, so that increasing rates can increase costs. Whilst inter-
est rates had reached an all-time high the pound had become a desirable
investment for many overseas investors. This created demand for
Sterling and strengthened the pound to such an extent that exporters
found it difficult to sustain overseas sales. One can go on with this debate.
The point is that setting a correct interest rate is hard and can become
very political. Interest rates can take a long time to have an effect on
inflation but can have a very quick effect on business survival, espe-
cially for new businesses and those with a high level of borrowing.
So, how will all this affect your business and what can you do about
it? Some companies like to hedge against changes in interest rates in
order to secure rates that are manageable to their business. Other com-
panies like to go with the market. All companies should have a policy
that lays down how interest rate fluctuations should be recognized and
managed. To do this, it is necessary to model for your company different
scenarios under different interest rates, inflation rates and exchange
rates. See how sensitive your results are to these variables and then
decide how you can cover this risk.
One cash-rich international oil company prepared a scenario ana
lysis for a major new capital investment. It found that interest rate
increases resulted in:
●● little immediate effect on its cost of borrowing;

●● a greater return on cash invested;
●● a reduction in the price of imported product, resulting from a
strengthening of the pound;
●● longer-term cost savings resulting from lower inflationary pressures;
●● higher return expectations from shareholders;
●● little immediate effect on the price of its product in the UK, which
was linked to global commodity prices.
At the same time a medium-sized, mainly bank-funded, manufacturing

company that exported its product found that the increases in interest
rates resulted in:
●● a large increase in its cost of borrowing;

●● reduced export sales and margins because of the stronger pound;
●● longer-term cost savings resulting from lower inflationary
pressures;
●● higher return expectations from shareholders.
The manufacturing company collapsed, thereby reducing the value of

the UK’s export sales.
The conclusion that you might draw from this is that rather than
just going with the market you should prepare a full business-risk and
scenario analysis and take advance measures to protect your business
in the short to medium term from the immediate effect of longer-term
policies of a government.
239
Appendix 1
Discounted cash flow tables
Rate of discount given to 3 decimal places

Years 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
1 990 980 971 962 952 943 935 926 917 909 901 893 885 877 870
2 980 961 943 925 907 890 873 857 842 826 812 797 783 769 756
3 971 942 915 889 864 840 816 794 772 751 731 712 693 675 658
4 961 924 888 855 823 792 763 735 708 683 659 636 613 592 572
5 951 906 863 822 784 747 713 681 650 621 593 567 543 519 497
6 942 888 837 790 746 705 667 630 596 564 535 507 480 456 432
7 933 871 813 760 711 665 623 583 547 513 482 452 425 400 376
8 923 853 789 731 677 627 582 540 502 467 434 404 376 351 327
9 914 837 766 703 645 592 544 500 460 424 391 361 333 308 284
10 905 820 744 676 614 558 508 463 422 386 352 322 295 270 247
11 896 804 722 650 585 527 475 429 388 350 317 287 261 237 215
12 887 788 701 625 557 497 444 397 356 319 286 257 231 208 187
13 879 773 681 601 530 469 415 368 326 290 258 229 204 182 163
14 870 758 661 577 505 442 388 340 299 263 232 205 181 160 141
15 861 743 642 555 481 417 362 315 275 239 209 183 160 140 123
16 853 728 623 534 458 394 339 292 252 218 188 163 141 123 107
17 844 714 605 513 436 371 317 270 231 198 170 146 125 108 93
30
Discount factors are given to 3 decimal places with the decimal point omitted.
1
Formulae: where i = rate of discount and n = number of years
(1+i)n
Use the above formulae if you need to extend the table's rows or columns
Example of use: The value of £1 in 5 years’ time using the discount factor is 3% or 86p.
240
Appendix 2
Compound interest tables
Interest rates
Years 1% 2% 3% 4% 5% 6% 7% 8%
(n)
1 1.01 1.02 1.03 1.04 1.05 1.06 1.07 1.08
2 1.02 1.04 1.061 1.082 1.102 1.124 1.145 1.166
3 1.03 1.061 1.093 1.125 1.158 1.191 1.225 1.26
4 1.041 1.082 1.126 1.167 1.216 1.262 1.311 1.36
5 1.051 1.104 1.159 1.217 1.276 1.338 1.404 1.469
6 1.061 1.126 1.194 1.265 1.34 1.419 1.501 1.587
7 1.072 1.149 1.23 1.316 1.407 1.504 1.606 1.714
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851
9 1.094 1.195 1.306 1.423 1.551 1.689 1.838 1.999
10 1.105 1.219 1.344 1.48 1.629 1.791 1.967 2.159

241
index
(italics indicate a figure or table in the text)
absorption costing 78–83, 220–21 business models 4–5

accounting/finance department 11–18 business valuation 169–79
example budget 52, 62 book value 172
functions 61–62 brand acceptance 170–71
organizational structure 18 cash-flow valuations 177–78
relationships 17 discounted-cash-flow (DCF) method
accounting periods 31 178–79
accounting principles 29–32 dividend capitalization 173
accruals 30 earnings-based valuations 176–77
activity-based costing (ABC) 83–84 earnings-yield method 177
assets 2 economic book value 172
current 26–27 external factors 169–70
fixed 26 information requirements 173–75
ATO (Australian Tax Office) 158 income capitalization method 173
GST (Goods and Services Tax) 160, 162 intangible assets 176
internal factors 169
bank overdrafts 112–13 methods 171–79
bank relationships 132–35, 141 net present value of future earnings 173
strategy 13 price earning multiple 173
bank services 134 price-earnings ratio 177
bills of exchange 130 realizable values 173
balance sheet 25–26, 27, 37 reasons for 171–72
bonds 127–29 replaceable values 173
convertible loan notes 128 sales and profit valuations 173
deep-discount 127 tangible book value 172
Eurobonds 128 see also value creation
subordinated debt 128
unsecured notes 128 Cahan, Steven 33
zero-coupon 127–28 capital 191–96
brand acceptance 170–71 elements of 194
break-even point 74–78, 76 premium for a business risk 194
strategic decisions and 76–77 premium for a financial risk 194
see also marginal costing risk-free rate of return 194
budget dependencies 50 see also loans, shares
budgeted contribution 60–61 capital-asset pricing model (CAPM)
budgeting 13–14, 48–69 195–96
capital 52–54 capital budgets 52–54, 64–66, 66
case study 223–26 case study 231–32
departmental 51 investment decisions 65–66, 66
reporting expenditure 54–55 capital rationing 67–69, 108–09
zero-based 48 CAPEX 65 see also capital budgets
242 index
case studies 203–38 currency options 150–51, 155

bank loans and covenants 211–12 call option 150
capital project 231–32 example 151
credit ratings and fundamental ‘strike price’ 150–51
analysis 215–16 ‘underlying’ 150
financial information 233 currency swaps 151–53, 152
fixed costs/variable income 234–35 example 151–52
foreign exchange hedging v features 152–53
speculation 207–08 hedging and 153
government deficits and cost cutting current ratio 40–41
227–28
interest rates and inflation 236–38 debentures 126–27
internal charging 217–19 ‘naked’ 127
marginal costing v full absorption debtors’ days 41–42
costing 220 deferrals 30–31
misuse of short-term funds 205–06 derivatives 129–30, 155
outsourcing 223–26 currency future 148–50
overtrading 221–22 interest-rate 140
separating money transmission from direct labour budget 59
a lending bank 213–14 direct materials budget 59–61, 60
stock valuations and profit 209–10 discounted cash flow tables 239
company limited by shares 8 discounting 116
compound interest tables 240 dividend cover 45–46
conservatism 31 dividend growth model 195
consistency 31 dividend policy 197–202
contribution 73–74, 220 dividend relevancy theory 200
corporate strategy 1 influences 198–99
corporation tax 159–60 irrelevancy theory 199
calculation and payment 160 optimal dividend theory 200
corporations 5, 8 residual theory 199
cost 89 traditional view 199
cost centre 63 dividend yield 46
costs 70–72 dividends 125, 195
direct 70 cash 200
fixed 70, 71, 234–35 ways of paying 200–01
indirect 70 scrip dividends 200–01
marginal 77–78, 97 share repurchase 201
sales and costs 229–30 stock split 201
semi-variable 70, 71–72 double entry bookkeeping system
support 225 12, 19–24
total 72–73 example 21–24
unit 72–73 Du Pont system 46
variable 70, 71
covenants 135–36 earnings per share (EPS) 44
CRA (Canadian Revenue Agency) 158 earnings-yield 45
credit rating 113 entrepreneurs 136
case study 215–16 environment, and accounting 33
‘crowd funding’ 137 equity funds 125–26 see also shares
currency futures 148–50 Eurobonds 141
advantages 149 Eurocurrency Market 141
disadvantages 149 exchange rate see foreign currency
example 149–50 export credit guarantees 131
index 243
export finance 130–31 forward-rate agreements (FRAs) 140

export invoice finance 154 full disclosure and clarity 32
future value (FV) 68, 103
factoring 115
finance leases 119 GAAP (General Accepted Accounting
financial accounting 12, 14 Principles) 32, 34, 172
financial controls 2 ‘gap analysis’ 139
financial evaluation 186–87 gearing 131–32, 193
financial markets 140–41 optimal 123–25
capital markets 141 shareholders’ interests and 124–25
intermediaries 140 gearing ratio 43
international 141 GST (Goods and Services Tax) 160, 162
money markets 140 going-concern concept 32
financial performance indicators 2 government deficits case study 227–28
financial ratios 35–47 gross margin see contribution, gross profit
analysis 36–37 percentage
financial strategy 16, 180–90 gross profit percentage 38
alignment with corporate strategy
184, 189 hedging 129–30, 140, 148, 153, 237
elements of 181–82 case study 207–08
environmental scan 180–81 HMRC (Her Majesty’s Revenue &
example 184–86 Customs, UK) 158, 161, 162
strategic financial management
182–89 Iceland 215–16
financial systems 13 initial public offering (IPO) 125
fixed assets turnover ratio 43 interest-rate derivatives 140
fixed charge 127 interest-rate/yield curve 138
flat tax 167 interest-rates
floating charge 113, 127 ‘caps’ 140
foreign currency 142–55 case study 236–38
advance payment 153 fixed-rate 139
buying/selling 142–44 floating or variable rate exposure 139
currency futures 148–50 ‘floor’ 140
hedging 148 forward-rate agreements (FRAs) 140
invoicing in domestic currency 153 ‘gap analysis’ 139
matching 153 hedging 237
options 150–51 risk management 139–40
swaps 151–53, 152 internal charging 63, 217–19
foreign currency accounts 146–47 internal rate of return (IRR)
advantages 146 106–08, 108
disadvantages 147 International Monetary Fund (IMF) 227
foreign-exchange risks 144–46 intra-group trading 154
causes 144 investment appraisal 98–110, 187, 196
economic risks 146 accounting rate of return (ARR) 102
hidden risks 146 capital rationing 108–09, 110
intra-group trading 154 discounted-cash-flow 103–05
transactional risk example 145 internal rate of return (IRR) 106–08,
translation risk 145–46 108, 110
form and substance 32 net present value 104–05, 110
forward exchange contracts 147–48 pay-back period 100–01, 110
example 147 real option analysis 110
forward/futures contract 129 relevant cash flow 98–100
244 index
return on capital (ROCE) 44–45, net profit percentage 38–39

101–02 neuroscience, and accounting 33–34
taxation 165
invoice finance (debt finance) 114–15 opportunity cost 196
IRD (Inland Revenue Department, option 130
New Zealand) 158 ‘American’ 130
call 130
King, Paul 65 currency 150–51
‘European’ 130
leases 118–23 put 130
decision-making 120–23 outsourcing 218, 223–26
definition 118 overhead expenditure budgets 61
finance 119 ‘overtrading’ 111, 221–22
net present value (NPV) 122
operating 119 partnerships 4–5, 6–8
sale and leaseback 119–20 advantages 7
letters of credit 130–31 disadvantages 7–8
liabilities 27 general 4, 9
current 27 limited 4, 9
long-term 27 limited liability 4, 9
limited companies 8–9 Pay As You Earn (PAYE) 162–63
limited liability partnerships payroll 13
(LLPs) 4, 8, 9 planning and budgeting process
linear programming 87, 88 49–50, 49
liquidity ratio 40 case study 223–26
loans 192 preference shares 126
covenants 135–36 premium for business risk 194
short-term 113–14, 205–06 premium for financial risk 194
present value (PV) 67, 103–04
marginal cost of capital 192 price 89
marginal costing 77–78, 220–21 price-earnings ratio (PER) 45
marginal rate of return 196 prices see selling prices
marketing strategies 91–95 pricing strategies 92–95
defensive 92 absorption pricing 94
offensive 91–92 competitive pricing 92
rationalization 92 contribution-margin-based pricing 94
matching 29–30, 139 cost-plus pricing 93
foreign currency 153 creaming/skimming 94–95
materiality 31–32 dynamic pricing 94
mergers/acquisitions (M&A) 187 high-low pricing 95
money 1 inertia pricing 95
money laundering 14 limit pricing 93
mortgages, commercial 126, 128–29 loss leader 93
multinational enterprises (MNEs) 164 market-researched pricing 93
penetration pricing 93
‘naked’ debenture 127 predatory pricing 93
National Audit Office 228 premium decoy pricing 95
Net Profit Before Interest & Taxation premium pricing 94
(NBIT) 39 price discrimination 93
net present value (NPV) 67, 104–05, 122 psychological pricing 94
index 245
target pricing 94 source and application of funds

value-based pricing 95 statements 27–28
production volume budget 57–59, 58 Southern Cross 234
profit-and-loss account 25, 27, 33, 65 speculation 155
public expenditure (UK) 167 spot rate 148
public limited companies (PLC) 9 standard costing system 78–83
benefits 80
ratios see financial ratios information produced by 82
rent 118 integrated process 81
research and development budget see also absorption costing
63–64, 64 stock exchange 125, 141
return on capital employed ratio (ROCE) stock levels, managing 117–18
43–44, 101–02 economic batch quantity (EBQ) 118
return on equity (ROE) 44 stock split 201
risk stock-turnover ratio 40–41
cost of capital 194 stock valuations and profit case study
systematic 195 209–10
unsystematic 195 strategic change programmes 187–89
risk-free rate of return 194 benefits and costs 188
strategic financial management 182–89
sales and leaseback 119–20 change programmes 187–89
sales budget 56–57, 56 integration with corporate strategy
sales mix 85–88 186–87
example 85 example 184–86
optimal 87 link to organizational goals 183
scrip dividends 200–01 SWOT analysis 182–83
selling prices 84–88, 89–96 see also financial strategy
‘cost-plus’ 90 strategic value analysis 170
determination 89, 90, 91 sustainability accounting 33
market 90
strategies and 91–95 tax manager 15
see also pricing strategies tax planning, global 163–64
share repurchase 201 taxation 15, 156–68
shareholders 192, 197 authorities 158
shares 125–26, 192 corporation tax 159–60
cost of 192–94 capital allowances 65
example 193 decisions about 165
initial public offering (IPO) 125 direct 157
introduction 125 double-taxation relief 164
‘placing’ 125 economy and 166–69
preference shares 126 employees 162
pricing 126 flat 167
Single Euro Payments Area Direct Debit indirect 157–58, 162
Scheme (SEPA DD) 154–55 periods of assessment 159
smoothing 139 UK government 166
sole proprietors 4, 5–6 VAT 160–62
advantages 5 tenancy 118
disadvantages 5–6 Timpson, John 233
sole trader see sole proprietors treasury/financial planning 16
solvency 39 trade credit 116–17
246 index
transfer pricing 164–65 venture capital 129

trial balance 24 financing stages 137
venture capitalists 136–37
unique selling point/proposition (USP)
97, 170 weighted average cost of capital (WACC)
United States of America (USA) 131, 192
taxation system 158 working capital 111–18
cost of 132
value chain/network 170 long-term 123–30
value creation 1, 16, 170, 183, 186 retained earnings 131–32
VAT (value-added tax) 160–62, 167 short-term funds 112–18
charge to 161–62
rates of 161–62 zero-based budgets (ZBB) 48, 217, 224

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© Clive Marsh, 2012

ISBN 978 0 7494 6467 7

British Library Cataloguing-in-Publication Data

Library of Congress Cataloging-in-Publication Data

Marsh, Clive (Clive Mark Heath)

Typeset by Graphicraft Limited, Hong Kong

1 Types of business structure and

2 The role of the accounting and

3 Accounting and financial statements 19

Accounting and the environment 33

4 Analysis and financial ratios 35

5 Planning and budgeting 48

6 Product and service costing and pricing 70

Activity-based costing (ABC) 83

7 Setting selling prices and marketing

9 Finance, funding and working capital 111

10 International transactions and

11 Company taxation and financial

12 The value of a business 169

13 Financial strategy 180

14 The cost of capital 191

15 Dividend policy 197

16 Case studies 203

Case 13 Large capital projects and cost control: critical path

A dditional resources to accompany the book are available on

Online template 1 – Departmental expenditure variance analysis

THIS PAGE IS INTENTIONALLY LEFT BLANK

The purpose of this book

to question the validity of information received and to concentrate on

●● how to implement the controls required to protect financial assets;

Strategic financial management creates real value within an organiza-

T he aim of this chapter is to discuss the principal types of business

●● Sole proprietorships: These are businesses that are owned by one

A disadvantage of a general partnership is that a partner may have to

A major advantage of a limited liability company is the limit placed on a

Some advantages of being a sole trader

Some disadvantages of being a sole trader

partner or shareholder meetings and prepare so many reports. This

Partnerships: general and limited

to be allowed or charged to partners on loans or advances, and provi-

Some of the principal advantages of

Some of the principal disadvantages of

Some countries place restrictions on the number of partners allowed in

In recent years a third category of partnership has become popular,

A company limited by shares

their shares to their fellow shareholders before offering them to a third

Public limited companies

●● Sole trader: unlimited liability; initial funds from proprietor; limited

Choosing the correct type of business structure is a primary strategic

Financial accounting, payroll,

●● the recording of all transactions, using the double entry system;

●● liaison with taxation authorities to ensure that employer and

Budgeting is concerned with the financial evaluation of plans and

●● helping managers prepare and evaluate their plans;

●● investment opportunity appraisal;

Management accounting and financial accounting overlap in that

Treasury and financial planning

●● cash management on a day-to-day basis;