ACCOUNTING AND FINANCIAL

MANAGEMENT

Module Guide

Copyright© 2020
MANAGEMENT COLLEGE OF SOUTHERN AFRICA
All rights reserved, no part of this book may be reproduced in any form or by any means, including photocopying machines,
without the written permission of the publisher. Please report all errors and omissions to the following
email address: [email protected]
 This Module Guide,
Accounting and Financial Management(NQF level 8),
will be used across the following programmes:

 Postgraduate Diploma in Family Business Management

 Postgraduate Diploma in Business Management
 Bachelor of Business Administration Honours
 Accounting and Financial Managment

Preface .................................................................................................................................................... 3

Unit 1: Introduction to Accounting and Financial Management ............................................................. 9

Unit 2: Statement of Financial Position and Statement of Changes in Equity .................................... 20

Unit 3: Statement of Comprehensive Income ..................................................................................... 36

Unit 4: Cash Flow Statement ............................................................................................................. 50

Unit 5: Analysing Financial Statements ............................................................................................. 75

Unit 6: Financial Forecasting ........................................................................................................... 121

Unit 7: Working Capital Management .............................................................................................. 155

Unit 8: Cost-Volume-Profit Relationships......................................................................................... 194

Unit 9: Cost of Capital ..................................................................................................................... 219

Unit 10: Capital Budgeting ................................................................................................................ 247

Annexure King Code and Report on Governance for South Africa (King Iii) ........................................ 268

MANCOSA – BBA (HONS) YEAR 1 i 1

Accounting and Financial Management

List of Contents

List of Tables

Table 1: Present value of R1: PVFA .............................................................................................................. 270

Table 2 : Present value of a regular annuity of R1 per period for n periods ................................................... 271

List of Figures and Illustrations

Figure 1.1: Accounting as the link between business activities and business decisions .................................. 12

Figure 1.2: Functions of financial management ................................................................................................ 12

Figure 6.2: Projected wheel and caster sales for the first six months of 20.11 ............................................... 126

Figure 6.3: Stock of opening inventory. .......................................................................................................... 127

Figure 6.4: Production requirements (in units) ................................................................................................ 127

Figure 6.5: Unit costs ...................................................................................................................................... 128

Figure 6.6: Total production costs................................................................................................................... 128

Figure 6.7: Calculation of costs of sales and gross profit................................................................................ 128

Figure 6.8: Value of closing inventory ............................................................................................................. 129

Figure 6.9: Pro Forma Statement of Comprehensive Income for the six months ended 30 June 20.11 ......... 130

Figure 6.10: Monthly sales pattern.................................................................................................................. 131

Figure 6.11: Debtors collection schedule( Figures in Rands) ......................................................................... 131

Figure 7.1: Expanded cash cycle .................................................................................................................... 162

Figure 7.2: An ageing schedule, 31 May 20.11 .............................................................................................. 169

2 MANCOSA
 Accounting and Financial Management

Preface
A. Welcome

Dear Student
It is a great pleasure to welcome you to Accounting and Financial Management (ACF102). To make sure that
you share our passion about this area of study, we encourage you to read this overview thoroughly. Refer to it as
often as you need to since it will certainly make studying this module a lot easier. The intention of this module is to
develop both your confidence and proficiency in this module.

The field of Accounting and Financial Management is extremely dynamic and challenging. The learning content,
activities and self- study questions contained in this guide will therefore provide you with opportunities to explore
the latest developments in this field and help you to discover the field of Accounting and Financial Management
as it is practiced today.

This is a distance-learning module. Since you do not have a tutor standing next to you while you study, , you need
to apply self-discipline. You will have the opportunity to collaborate with each other via social media tools. Your
study skills will include self-direction and responsibility. However, you will gain a lot from the experience! These
study skills will contribute to your life skills, which will help you to succeed in all areas of life.

We hope you enjoy the module.

MANCOSA 3
Accounting and Financial Management

B. Module Overview
The module is a 15 credit module at NQF level 8
Aims of the module
This module aims to enable students to:

1. Interpret and use financial statements and data in allocating the enterprise’s financial resources to
maximise profit for an enterprise in the long run.

2. Seek ways to maximise wealth for the enterprise.

3. Assess the financial performance of the enterprise.

4. Determine the extent to which short-term debt should be used to finance current assets.

5. Decide on projects to fund.

C. Learning Outcomes and Associated Assessment Criteria of the Module

LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

MODULE

 Understand how Accounting and Financial  Complete the relevant module activities,
Management function within the business world. readings, examples, think points and questions.

 Interpret information presented in the Statement  Complete and pass the formative and summative
of Financial Position, Statement of Changes in assessments
Equity, Statement of Comprehensive Income, and
Cash Flow Statement.

 Use ratio analysis to evaluate a firm’s

performance.

 Construct pro forma statements.

 Implement appropriate strategies in the

management of each of the elements of working
capital.

 Calculate a firm’s cost of capital as a weighted

average of the component’s costs of each type of
capital.

 Apply and evaluate the major capital budgeting

decision techniques

4 MANCOSA
 Accounting and Financial Management

D. Learning Outcomes and the Associated Assessment Criteria of the Units

You will find the Unit Learning Outcomes and the Associated Assessment Criteria on the introductory pages of
each Unit in the Module Guide. The Unit Learning Outcomes and Associated Assessment Criteria lists an overview
of the areas you must demonstrate knowledge in and the practical skills you must be able to achieve at the end of
each Unit lesson in the Module Guide.

E How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module, by breaking
your studies into manageable parts. The Module Guide gives you extra theory and explanations where necessary,
and so enables you to get the most from your module.

The purpose of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
prescribed textbook and recommended readings. We suggest that you briefly skim read through the entire guide
to get an overview of its contents. At the beginning of each Unit, you will find a list of Learning Outcomes and
Associated Assessment Criteria. This outlines the main points that you should understand when you have
completed the Unit/s. Do not attempt to read and study everything at once. Each study session should be 90
minutes without a break

This module should be studied using the prescribed and recommended textbooks/readings and the relevant
sections of this Module Guide. You must read about the topic that you intend to study in the appropriate section
before you start reading the textbook in detail. Ensure that you make your own notes as you work through both the
textbook and this module. In the event that you do not have the prescribed and recommended textbooks/readings,
you must make use of any other source that deals with the sections in this module. If you want to do further reading,
and want to obtain publications that were used as source documents when we wrote this guide, you should look
at the reference list and the bibliography at the end of the Module Guide. In addition, at the end of each Unit there
may be link to the PowerPoint presentation and other useful reading.

F. Study Material
The study material for this module includes tutorial letters, programme handbook, this Module Guide, a list of
prescribed and recommended textbooks/readings which may be supplemented by additional readings.

MANCOSA 5
Accounting and Financial Management

G. Prescribed and Recommended Textbook/Readings

There is at least one prescribed and recommended textbooks/readings allocated for the module.
The prescribed and recommended readings/textbooks presents a tremendous amount of material in a simple,
easy-to-learn format. You should read ahead during your course. Make a point of it to re-read the learning content
in your module textbook. This will increase your retention of important concepts and skills. You may wish to read
more widely than just the Module Guide and the prescribed and recommended textbooks/readings, the
Bibliography and Reference list provides you with additional reading.

The prescribed and recommended textbooks/readings for this module is:

Financial Management in Southern Africa, Marx et al., 4th Edition, Pearson

Recommended Readings

In addition to the prescribed textbook, the following should be considered for recommended books/readings:

Atrill, P. and McLaney, E. (2008) Accounting and Finance for non-specialists. 6th Edition. London: Pearson
Education Limited.

Block, S.B., Hirt, G.A. and Danielsen, B.R. (2009) Foundations of Financial Management. 13th Edition. New York:
McGraw-Hill/Irwin.

Cornett, M.M., Adair Jr., T.A. and Nofsinger, .J. (2009) Finance : Applications and theory. 1st Edition. New York:
McGraw-Hill/Irwin.

Gitman, L.J., Smith, M.B., Hall, J., Lowies, B., Marx, J, Strydom, B. and van der Merwe, A. (2010) Principles of
Managerial Finance. 1st Edition. Cape Town: Pearson Education.

Helfert, E.A. (2003) Techniques of Financial Analysis. 11th Edition. New York: McGraw-Hill/Irwin.

Higgins, R.C. (2007) Analysis for Financial Management. 8th Edition. New York: McGraw-Hill/Irwin.
Ingram, R.W., Albright, T.L., Baldwin, B.A. and Hill, J.W. (2005) Accounting: Information for Decisions. 3rd edition.
Canada: Thomson South-Western.

Marshall, D.H., McManus, W.W. and Viele, D.F. (2011) Accounting: What the numbers mean. 9th Edition. New
York: McGraw-Hill.

6 MANCOSA
 Accounting and Financial Management

Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills for Managers. 1st Edition. North Ryde:
McDraw-Hill.www.finance.mapsoftheworld.com

H. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to help you
study. It is imperative that you work through them as they also provide guidelines for examination purposes.

Special Feature Icon Explanation

LEARNING The Learning Outcomes indicate what aspects of the particular

OUTCOMES Unit you have to master and demonstrate that you have
mastered them.

ASSOCIATED The Associated Assessment Criteria is the evaluation of student

ASSESSMENT understanding with respect to agreed-upon outcomes. The

CRITERIA Criteria set the standard for the successful demonstration of the
understanding of a concept or skill.

THINK POINT A think point asks you to stop and think about an issue.
Sometimes you are asked to apply a concept to your own
experience or to think of an example.

ACTIVITY You may come across activities that ask you to carry out specific
tasks. In most cases, there are no right or wrong answers to
these activities. The aim of the activities is to give you an
opportunity to apply what you have learned.

READINGS At this point, you should read the reference supplied. If you are
unable to acquire the suggested readings, then you are welcome
to consult any current source that deals with the subject. This
constitutes research.

PRACTICAL Real examples or cases will be discussed to enhance

APPLICATION understanding of this Module Guide.

OR EXAMPLES

MANCOSA 7
Accounting and Financial Management

SELF-TEST You may come across self-test questions at the end of each Unit
QUESTIONS that will test your knowledge. You should refer to the module for
the answers or your textbook(s).

REVISION You may come across self-assessment questions that test your
QUESTIONS understanding of what you have learned so far. These may be
attempted with the aid of your textbooks, journal articles and
Module Guide.

CASE STUDY Case studies are included in different sections in this module
guide. This activity provides students with the opportunity to
apply theory to practice.

8 MANCOSA
 Accounting and Financial Management

Unit
1: Introduction to Accounting and
Financial Management

MANCOSA 9
Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Explain the functions of accounting and  Complete relevant readings, think points and
financial management in an enterprise. activities provided.

 Identify the characteristics of the sole

proprietorships, partnerships, close
corporations, and public companies.

 Discuss the goals of financial

management.

 Describe the changing role of financial

markets

1.1 Introduction
1.2 Accounting and Financial Management
1.3 Forms of Organisation/Ownership
1.4 Goals of Financial Management
1.5 Role of Financial Markets

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:

 Marx, J., de Swardt, C., (2014) Financial Management in Southern

Africa. 4th Edition. Cape Town: Pearson Education.

Recommended Reading
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2009) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.
 Cornett, M.M., Adair Jr., T.A. and Nofsinger, .J. (2009) Finance:
Applications and theory. 1st Edition. New York: McGraw-Hill/Irwin.
 Ingram, R.W., Albright, T.L., Baldwin, B.A. and Hill, J.W. (2005)
Accounting: Information for Decisions. 3rd edition. Canada: Thomson
South-Western

10 MANCOSA
 Accounting and Financial Management

1.1 Introduction
To be an effective analyst, planner, or executive one must be both effective and confident in one’s financial skills.
In order to improve one’s performance in financial management one needs to integrate one’s knowledge from the
study of accounting. With the knowledge that you would acquire from chapters 2, 3, and 4, you would have a
better understanding of the impact of business decisions on financial statements. You will also be in a better
position to apply financial concepts.

1.2 Accounting and Financial Management

Marx et al. (2009:8) identify two key differences between accounting and financial management – one relates to
the handling of funds and the other to decision-making.

Handling of funds: The primary functions of an accountant is to develop and provide data to measure the
performance of a firm, to assess its financial position, and to see to the payment of taxes. The main concerns of
the financial manager are to maintain the firm’s liquidity and solvency by providing the cash flows necessary to
satisfy obligations and to acquire and finance the current and non-current assets needed to achieve the firm’s
goals.

Decision-making: Whilst the accountant devotes most of his or her attention to the collection and presentation of
financial data on the firm’s past, present, and future operations, the financial manager evaluates the accountant’s
statements, processes additional data, and makes decisions based on the subsequent analyses. Although
accountants also make decisions, the primary focuses of financial management and accounting are different.

Ingram et al. (2005:59) uses the following model to show how accounting forms the link between business
activities and business decisions:

MANCOSA 11
Accounting and Financial Management

Business Accounting

Activities

Measuring Business

Operating Recording Decisions

Investing Reporting

Financing Analysing

Figure 1.1: Accounting as the link between business activities and business decisions

Actions Based on Business Decisions

Block et al. (2009:7) consider the functions of financial management as the allocation of funds to current and
fixed assets, obtaining the optimum mix of financing alternatives, and developing appropriate policies in the
context of the firm’s objectives. These functions are carried out daily as well as through the occasional use of
capital markets to acquire new funds. Less routine functions include the sale of shares and bonds as well as
the establishment of capital budgeting and dividend plans. Figure 1-2 shows all these functions being carried
out while balancing the profitability and risk components of the enterprise:

Daily Occasional Profitability

Goal:
Credit management Share issue
Maximise
Bond issue Trade-off
Inventory control
shareholder
Receipt and disbursement Capital budgeting
wealth
of funds Dividend decision

Risk

Figure 1.2: Functions of financial management

12 MANCOSA
 Accounting and Financial Management

The appropriate risk-return trade-off must be determined in order to maximise the market value of the enterprise
for the shareholders.

1.3 Forms of Organisation/Ownership

The financial function may be performed within various forms of organisations. The following is a description of
sole proprietorships, partnerships, close corporations, and public companies.

1.3.1Sole proprietorship
Block et al. (2009:8) describe this form of organisation as representing a one person ownership and offers the
advantages of simplicity of decision-making and low organisational and operating costs. Cornett et al. (2009:11)
add that these businesses are so popular because they are relatively easy to establish, and subject to fewer
regulatory and paperwork burden than other forms of organisation. However, the greatest disadvantage is that
they have unlimited liability for the enterprise’s debts and actions. The owner’s personal assets may be
confiscated if the business fails. In many countries the profit of the business is added to the personal income of
the owner and taxed by the government at the applicable personal tax rate.

1.3.2 Partnership
Block et al. (2009:8) state that partnerships are similar to sole proprietorships except that there are two or more
owners. Multiple ownership enables a partnership to raise more capital and allows for sharing of responsibilities.
Partnerships, like sole proprietorships, carry the disadvantage of unlimited liability for the owners. According to
Cornett et al. (2009:12) all the partners are bound by contracts agreed to by any one of the partners. They add
that banks are more willing to lend to partnerships than sole proprietorships since all the partners are responsible
for paying all the debt. Profits are shared according to some pre-arranged agreement. Profit is usually added to
each partner’s personal income and taxed at personal income tax rates.

Think Point 1.1

Suppose three people form a partnership with a capital contribution of R20 000
each and business fails and debts payable amount to R200 000. If two of the
partners do not have sufficient personal assets, what happens to the debt?

MANCOSA 13
Accounting and Financial Management

1.3.3 Close corporations

Marx et al. (2009:5) describes a close corporation (CC) as a legal person with one or more members (with a
maximum of ten), each of whom are accorded a percentage of the “members interest”. No new close corporations
will be registered from 1st May 2011. Also, no company conversions to close corporations will be registered.
Provision has also been made for close corporations to convert to companies without any payment in terms of
the Companies Act of 2008. The liability of the members for the debts of the firm is limited. A CC does not have
to be audited. However, there are more administrative requirements dictated by law. Another drawback is that
the number of members/owners is limited to ten.

1.3.4 Public companies/Corporations

Cornett et al. (2009:12) describe public companies as legally independent entities separate from their owners.
This independence means that public companies have many rights and obligations such as owning property,
signing binding contracts, and paying taxes. Since the company assumes liability for its own debts, the
owners/shareholders have limited liability i.e. they cannot lose any more money than the amount they originally
paid for their shares. This form of organisation makes it possible to have thousands of shareholders. The profits
of the company are taxed and in some countries the shareholders also pay tax on the profits paid out to them as
dividends.

1.4 Goals of Financial Management

Block et al. (2009:11) contend that “profit maximisation as the primary goal of the enterprise” has some serious
drawbacks. Firstly, a change in profit may also be accompanied by a change in risk. Secondly, the timing of
benefits is not considered. Lastly, accurately measuring the key variable viz. “profit” is nearly impossible as there
are many different economic and accounting definitions of profit.

Block et al. (2009:12) elaborate on the following goals of financial management:

1.4.1 A valuation approach

The ultimate measure of performance is not how much profit is made, but rather how the earnings are valued by
the investor. When an investor analyses a firm, he/she will also consider the risk inherent in the firm’s operations,
the time pattern over which the firm’s earnings increase or decrease, the quality and reliability of reported
earnings, and so on.

1.4.2 Maximising shareholder wealth

The financial manager should aim to maximise the wealth of the firm’s shareholders by achieving the highest
possible value for the firm.

14 MANCOSA
 Accounting and Financial Management

1.4.3 Management and shareholder wealth

Sometimes management is more concerned with maintaining its own continuity than in maximising shareholder
wealth e.g. opposed to a merger that may be attractive to shareholders but unpleasant to the present
management. However, this is changing. Firstly, enlightened managers know that the only way to maintain their
position in the long run is to be sensitive to shareholder concerns. Secondly, management usually has sufficient
share option incentives that provide motivation to achieve market value maximisation for its own benefit. Lastly,
powerful institutional investors are making management more responsive to shareholders.

1.4.4 Social responsibility and ethical behaviour

The goal of wealth maximisation should be consistent with the concern for the social responsibility of the firm.
Firms that adopt policies that maximise values in the market can attract capital, provide employment, and offer
benefits to its community. Unethical and illegal financial practices are reported often in many countries. One of
these is insider trading that occurs when someone has information that is not available to the public and then
uses the information to profit from trading in that company’s publicly traded shares. Ethical behaviour is important
because it creates an invaluable reputation.

Cornett et al. (2009:16) add that shareholders hire managers to run the firm but managers are often tempted to
operate the firm to improve their own lifestyles instead of earning more profits for the shareholders. Sometimes
the manager’s best interest is not consistent with the shareholder goals. This situation is called the agency
problem.

Think Point 1.2

What unethical activities could managers engage in because of the agency

problem?

1.5 Role of Financial Markets

How would a financial manager know whether he or she is maximising shareholder value and how ethical or
unethical behaviour may affect the behaviour of the company? According to Block et al. (2009:15) this information
is provided daily to financial managers through price changes determined in financial markets. They describe
financial markets as the meeting place for people, companies, and institutions that either need money or have
money to lend or invest. Broadly, financial markets exist as a global network of individuals and financial
institutions that may be lenders, borrowers, or owners of public companies worldwide.

MANCOSA 15
Accounting and Financial Management

1.5.1 Money markets and capital markets

Block et al. (2009:15) define money markets as those dealing with short-term securities that have a life of a year
or less. Securities in these markets may include commercial paper sold by companies to finance their daily
operations, or certificates of deposit with maturities of less than one year sold by banks.

Capital markets are those markets where securities have a life of more than one year. Securities in the capital
market include ordinary shares, preference shares, and company and government bonds.

1.5.2 Primary market and secondary market

According to Block et al. (2009:16) when a company uses the financial markets to raise new funds, the sale of
shares is said to be made in the primary market. Once shares are sold to the public, they are traded in the
secondary market between investors. It is in the secondary market that prices are continually changing as
investors buy and sell shares based on their expectations of the company’s prospects. It is also in the secondary
market that financial managers obtain feedback on their firm’s performance.

1.5.3 Institutional pressure on public companies to restructure

Block et al. (2009:17) observe that institutional investors who seek to maximise a firm’s shareholder value may
force restructuring as a penalty for poor performance. Restructuring may result in a change in the capital structure
(equity and liabilities). Sometimes low-profit- margin divisions may be sold and the proceeds reinvested in more
profitable opportunities. There could also be a removal of the management team or reduction in the workforce.
Restructuring nowadays also include mergers and acquisitions.

1.5.4 Internationalisation of financial markets

The increase in the number of global companies has led to the growth of global fund raising as companies seek
for low-priced sources of funds. Block et al. (2009:18) advise financial managers to have the sophistication to
understand international capital flows, computerised electronic funds transfer systems, foreign currency hedging
strategies, and many other functions.

1.5.5 The Internet and changes in capital markets

Technology has had a major impact on capital markets. According to Block et al. (2009:18) the greatest impact
has been in the area of cost reduction for trading securities. Firms and exchanges that are at the front of the
technology curve have created major competitive cost pressures on those firms and exchanges that cannot
compete on a cost basis.

16 MANCOSA
 Accounting and Financial Management

Advances in computer technology led to the creation of electronic communications networks (ECNs). These
electronic markets with their speed and cost advantages over traditional markets took market share away from
stock exchanges causing some to merge with ECNs. Also, cost pressures and the need for capital caused major
markets to become for-profit publicly traded companies.

1.6 Self-Assessment Activities

1.6.1Complete the following table by filling in the applicable characteristics of the forms of organisations. The
first one has been done for you.

Sole proprietorship Partnership Public company

Ownership Single person

Control Proprietor

Ownership risk Unlimited liability

Access to capital Very limited

Taxes Paid by owner

1.6.2John founded his own fresh produce wholesale business ten years ago. After building a successful firm that
supplies fresh produce to major supermarkets, he joined with a partner who provided the capital to expand. They
changed the business to a partnership of which John owned 60% of the shares and the remaining 40% owned
by his partner. The expansion has been a huge success. Financial advisors have suggested that the partnership
converts to a public company. What issues should John and his partner consider when thinking about it?

1.6.3 Why is profit maximisation, on its own, not an appropriate goal?

1.6.4 Explain why management should be willing to maximise shareholder wealth than trying to maintain its own
tenure.

1.6.5 Explain what you understand by insider trading and what impact would it have on investors.

1.6.6 Distinguish between money markets and capital markets.

1.6.7 Differentiate between primary markets and secondary markets.

1.6.8 Explain the changes that can take place during restructuring.

MANCOSA 17
Accounting and Financial Management

1.7 Suggested Solutions

Think Point 1.3

The wealthy partner may have to bear a disproportionate share of the debt.

Think Point 1.4

Answers may vary and may include the following:

Managers may use the company’s resources to benefit themselves at the

expense of shareholders e.g. low interest loans, personal use of company
aircraft, homes, or apartments.

Sole proprietorship Partnership Public company

Ownership Single person Multiple owners Public investors who

purchase shares

Control Proprietor Shared by partners Shareholders/managers

Ownership risk Unlimited liability Unlimited liability Shareholders can only

lose their investment in the company

Access to capital Very limited Limited Easy access

Taxes Paid by owner Paid by partners Company pays tax and

in some countries shareholders pay tax on dividends.

1.7.2 Issues to consider:

More capital can be raised to enable the firm to expand nationally.

Being a larger national firm may give him the ability to buy his produce at lower costs.

The owners, including himself and his partner, could sell their shares or sell some of their shares and diversify
their wealth.

Liability for debts of the company is limited to the amount invested by shareholders.

John would have to give up some fraction of his ownership and may later lose control of the firm.

They must also consider the tax implications.

18 MANCOSA
 Accounting and Financial Management

1.7.3 Firstly, a change in profit may also be accompanied by a change in risk. Secondly, the timing of benefits
is not considered. Lastly, accurately measuring the key variable viz. “profit” is nearly impossible as there are many
different economic and accounting definitions of profit.

1.7.4 Firstly, enlightened managers know that the only way to maintain their position in the long run is to be
sensitive to shareholder concerns. Secondly, management usually have sufficient share option incentives that
provide motivation to achieve market value maximisation for its own benefit. Lastly, powerful institutional
investors are making management more responsive to shareholders.

1.7.5 Insider trading occurs when someone has information that is not available to the public and then uses the
information to profit from trading in that company’s publicly traded shares. It destroys confidence in the securities
markets by making the playing fields uneven for investors.

1.7.6Refer to paragraph 1.5.1

1.7.7Refer to paragraph 1.5.2

1.7.8Restructuring may result in a change in the capital structure (equity and liabilities). Sometimes low-profit-
margin divisions may be sold and the proceeds reinvested in more profitable opportunities. There could also be
a removal of the management team or reduction in the workforce. Restructuring nowadays also include mergers
and acquisitions.

MANCOSA 19
 Accounting and Financial Management

Unit
2: Statement of Financial Position
and Statement of Changes in Equity

20 MANCOSA
 Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Monitor a number of issues underlying items  Complete relevant readings, think points and activities
reported in a Statement of Financial Position. provided.

 Interpret each of the items in a Statement of

Financial Position.

 Prepare a Statement of Financial Position

and Statement of Changes in Equity for a sole
proprietorship, partnership, and a company.

 Prepare a Statement of Financial Position

and Statement of Changes in Equity for a sole
proprietorship, partnership, and a company.

2.1 Introduction
2.2 Interpretation of Statement of Financial Position Items
2.3 Managing the Statement of Financial Position
2.4 Statement of Changes in Equity

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:

 Marx, J., de Swardt, C., (2014) Financial Management in Southern Africa.

4th Edition. Cape Town: Pearson Education

Recommended Reading:
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.

 Cornett, M.M., Adair Jr., T.A. and Nofsinger, .J. (2009) Finance:
Applications and theory. 1st Edition. New York: McGraw-Hill/Irwin

MANCOSA 21
Accounting and Financial Management

2.1 Introduction
Marx et al. (2009:52) state that the purpose of a Statement of Financial Position (Balance Sheet) is to show the
financial position of a firm at a particular date. It is a statement that reflects what a firm owns and how these
assets are financed in the form of liabilities or ownership interest. Block et al. (2009:30) emphasise that a
Statement of Financial Position is a picture of the firm at a point in time rather than showing the result of
transactions for a specific period. It is a cumulative chronicle of all transactions that have affected the firm since
its inception.

2.2 Interpretation of Statement of Financial Position Items

Figure 2-1 reflects that Statement of Financial Position of Auto Ltd:

Figure 2-1 Statement of Financial Position

Auto Ltd

Statement of Financial Position as at 30 June 20.7

ASSETS

Non-current assets 1 169 600

Property, plant and equipment 1 121 600

Financial assets 48 000

Current assets 343 460

Inventories 96 000

Trade and other receivables 133 200

Trade debtors 128 000

Provision for bad debts (4 400)

Prepaid expenses 9 600

Cash and cash equivalents 114 260

Bank 114 260

Total assets 1 513 060

22 MANCOSA
 Accounting and Financial Management

EQUITY AND LIABILITIES

Equity 873 400

Ordinary share capital 730 000

Retained earnings 143 400

Non-current liabilities 464 000

Long-term borrowings 464 000

Current liabilities 175 660

Trade and other payables 80 260

Trade creditors 54 260

Accrued expenses 26 000

South African Revenue Services 27 400

Shareholders for dividends 68 000

Total equity and liabilities 1 513 060

From your previous studies, you should be familiar with the Statement of Financial Position. To refresh your
memories Block et al. (2009:30) provide an interpretation of the items in the Statement of Financial Position of a
company. Property, plant and equipment are shown at its carrying value i.e. the original cost minus accumulated
depreciation. Financial assets represent a longer-term commitment of funds (at least one year). They may
include shares, bonds, or investments in other companies.

Inventories may be in the form of raw material, goods in process, or finished goods. Trade debtors include a
provision for bad debts to determine their expected collection value. Prepaid expenses represent future expense
items that have already been paid. Cash and cash equivalents may also include petty cash and cash float.

The equity section is elaborated in a separate statement called “statement of changes in equity” (explained in
paragraph 2.4). The contents of this section also vary for the various forms of organisation. In the case of a sole
proprietorship, equity will reflect the balance in the capital account. For partnerships, equity will reflect the balances
in the capital accounts and current accounts of the partners. The share capital of Auto Ltd includes 600 000 ordinary
shares sold at an initial issue price R1 each (R600 000) and further 100 000 ordinary shares sold at R1.30 each
(R130 000). There is

R143 400 in retained earnings as determined in the Statement of Changes in Equity (see figure 2-2 in paragraph
2.4).

MANCOSA 23
Accounting and Financial Management

Long-term borrowings are debts that will be paid more than one year after the Statement of Financial Position
date. Trade creditors represent amounts owed on open accounts to suppliers. Accrued expenses arise when
services have been provided or obligations incurred and payment has yet to take place. South African Revenue
Services reflected the income tax owed by the company to the government tax collection agency. Shareholders
for dividends refer to the dividends that have been declared but not yet paid to the shareholders. Dividends are
payable on ordinary shares and preference shares.

Think Point 2.1

The Statement of Financial Position illustrated in figure 2-1 has been prepared in
detail. Why would companies not want to publish detailed financial statements?

2.3 Managing the Statement of Financial Position

Cornett et al. (2009:30) advise managers to monitor the following issues underlying items reported in their firms’
Statement of Financial Positions:

2.3.1 The accounting method for non-current asset depreciation

Managers can choose the accounting method used to record depreciation against their non-current assets. The
two broad categories of calculating depreciation are the accelerated depreciation methods and the straight-line
depreciation method. Accelerated depreciation methods (e.g. declining balance and sum-of-the-years’ digits)
result in a higher depreciation expense (and thus lower net profit) in the early years of the life of the asset. In the
later years, depreciation expense will be less and net profit will be higher. The straight-line method results in
lower depreciation expenses, but also higher taxes in the early years of the project’s life.

Think Point 2.2

Many surveys have shown that most companies use the straight-line method to
calculate depreciation. Why do you think that this method is preferred?

2.3.2 The level of net working capital

Net working capital is the difference between a firm’s current assets and current liabilities. Auto Ltd’s net working
capital is R167 800 and is positive since the current assets are greater. Liability holders monitor net working
capital to measure the firm’s ability to pay its short-term debts.

24 MANCOSA
 Accounting and Financial Management

2.3.3 The liquidity position of the firm

Liquidity refers not only to the ease with which a firm can convert its assets into cash but also the degree to which
such conversion can take place at fair market value. Thus a highly liquid asset is one that can be sold quickly at
its fair market value. On the other hand, an illiquid asset cannot be sold quickly unless the price is reduced far
below fair value.

Liquidity may be seen as a double-edged sword in the Statement of Financial Position. The greater the liquid
assets a firm hold, the less likely it will be for the firm to experience financial distress. However, the problem is
that liquid assets such as cash in the bank generate no return for the firm. In contrast, non-current assets are
illiquid but provide the means to generate profit. Managers have to therefore consider the trade-off between the
advantages of liquidity and the disadvantages of having money sitting idle rather than generating profit.

2.3.4 The method for financing the firm’s assets: equity or debt

The extent to which a firm chooses to finance its assets by debt is called financial leverage. The more debt a
firm uses as a percentage of its total assets, the greater is its financial leverage. When a firm does well, financial
leverage increases shareholders’ rewards, since the share of the firm’s profits due to debt holders is set and
predictable. However, the risk also increases with financial leverage. If the firm experiences a bad year and
cannot service its debt, debt holders can force the firm into bankruptcy. However, managers tend to prefer debt
to fund the firm’s activities, since they can calculate the cost of doing business without giving away too much of
the firm’s value. So managers need to be careful when deciding on the amount of debt versus equity financing
as it can determine whether the firm stays in business or goes bankrupt.

2.3.5 The difference between the book/carrying value reported on the Statement of Financial Position
and the true market value of the firm

Assets in the Statement of Financial Position are shown at their historical cost. There is therefore little relation
between the total assets value reflected in the Statement of Financial Position and the current market value of
the firm’s assets. Likewise, the shareholders’ equity listed on the Statement of Financial Position usually differs
from the true market value of the equity. Thus financial managers and investors often find that Statement of
Financial Position values are not always the most relevant amounts.

2.4 Statement of Changes in Equity

The following are usually presented in the statement of changes in equity of a company:

 The net profit (or loss) for the period.

 Transactions with the shareholders, with distribution to shareholders shown separately.

MANCOSA 25
Accounting and Financial Management

 Balance of accumulated profit (or loss) and any movements in this account.

 Reconciliation between carrying values of each class of equity, showing details of each change.

Figure 2-2 shows the statement of changes in equity for Auto Ltd:

Figure 2-2 Statement of changes in equity of a company

Auto Ltd

Statement of changes in equity for the year ended 30 June 20.7

Ordinary Retained
earnings
share capital Total

R R R

Balance on 01 July 20.6 600 000 102 000 702 000

Issue of ordinary shares 130 000 130 000

Profit for the year 125 400 125 400

Dividends:

Ordinary interim (16 000) (16 000)

Ordinary final (68 000) (68 000)

Balance on 30 June 20.7 730 000 143 400 873 400

The ordinary shares, after the initial issue price, are usually sold later at a price that is close to the market price.
Ordinary shareholders are not entitled to receive any stated dividend amount and could even not receive
dividends in some years at all. The retained earnings (retained income) account shows the cumulative profits of
the company that has been retained for use in the company rather than being distributed as dividends to the
shareholders. Marx et al. (2009:59) emphasis that the retained earnings are important because they can be
used to finance the assets of the firm. Retained earnings are necessary to replace obsolete assets, ensure the
growth of the firm, to assist in increasing the value of the firm, and to lower the cost of capital.

26 MANCOSA
 Accounting and Financial Management

The statement of changes in equity of a sole proprietorship is illustrated below:

Figure 2-3 Statement of changes in equity of a sole proprietorship

Kiara Traders

Statement of changes in equity for the year ended 28 February 20.6

Balance on 28 February 20.5 395 700

Net profit for the year 227 965

Drawings (87 000)

Balance on 28 February 20.6 536 665

The equity changed from R395 700 to R536 665 because of the effects of the net profit and
drawings. The equity can also change with a change in capital contribution.

The statement of changes in equity of a partnership is a little more complicated due to provisions
contained in the partnership agreement. The following is an illustration:

MANCOSA 27
Accounting and Financial Management

Figure 2-4 Statement of changes in equity of a partnership

Veerzara Traders

Statement of changes in equity for the year ended 28 February 20.6

Capital Accounts Veer (R) Zara (R) Total (R)

Balance at 28 February 20.5 150 000 180 000 330 000

Changes in capital 50 000 (30 000) 20 000

Balance at 28 February 20.6 200 000 150 000 350 000

Current Accounts

Balance at 28 February 20.5 3 660 (1 200) 2 460

Net profit for the year 97 835 103 635 201 470

Interest on Capital 24 000 18 000 42 000

Salaries 60 000 60 000 120 000

Bonus - 12 000 12 000

Interest on drawings (3 000) (3 200) (6 200)

Profit Share 16 835 16 835 33 670

Drawings (40 000) (64 000) (104 000)

Balance at 28 February 20.6 61 495 38 435 99 930

The capital accounts reflect an increase in capital contribution by partner Veer and a decrease in capital by
partner Zara during the year. The current accounts reflect the interest on capital, salaries, bonus, and share of
the remaining profit earned by each partner. It also reflects the drawings made by each partner and well as the
interest due to the partnership on the drawings. The current account balances reflect a significant increase for
each partner from the previous financial year.

28 MANCOSA
 Accounting and Financial Management

2.5 Self-Assessment Activities

2.5.1 How does the choice of accounting method used to record non-current asset depreciation affect
management of the Statement of Financial Position?

2.5.2 Try Ltd lists non-current assets of R50m on its Statement of Financial Position. These assets have recently
been appraised at R64m. The Statement of Financial Position also lists current assets at R20m. These current
assets were appraised at R22m. The book and market values of the current liabilities stand at R12m and the
firm’s long-term debt is R30m. Calculate the book and market values of the firm’s shareholders’ equity.

2.5.3 Explain the implications of using the First-In-First-Out (FIFO) method of valuing inventories during a
period of rising prices instead of using the Last-In-First-Out (LIF0) method.

2.5.4 You are evaluating the Statement of Financial Position of Kidman Ltd and you find the following
balances:

Cash and marketable securities 200 000

Accounts receivable 600 000

Accounts payable 400 000

Income tax payable 250 000

Inventories 1 050 000

Notes payable 300 000

Calculate the net working capital.

2.5.5 Jules Ltd has total assets of R108m. Fifty percent of these assets are financed by debt of which R34m
is current liabilities. The company has no preference shares and the balance in ordinary share capital
account is R24. Use this information to determine the balance for long-term debt and retained earnings.

MANCOSA 29
Accounting and Financial Management

2.5.6 Use the following information to calculate the dividends (paid and recommended) to ordinary
shareholders during 20.11:

R’000

Balance of retained earnings on 31 December 20.10 780

Balance of retained earnings on 31 December 20.11 820

Preference share dividends 50

Net profit for 2011 650

2.5.7 Prepare the Statement of Financial Position of Capron Ltd as at 31 December 20.11 from the
following information:

Accumulated depreciation 280 000

Retained earnings 154 000

Cash in bank 7 000

Mortgage bond 198 800

Accounts receivable 53 200

Plant and equipment at cost 1 008 000

Accounts payable 49 000

Provision for bad debts 8 400

Ordinary share capital 403 200

Inventories 92 400

Marketable securities 21 000

Shares in XYZ Limited 28 000

Notes payable 116 200

30 MANCOSA
 Accounting and Financial Management

2.5.8 Statement of Financial Position values usually do not represent the fair value of assets that have a
relatively long life. Do you agree with this statement? Why?

2.5.9 The information given below was extracted from the accounting records of Disney Traders, a
partnership business with Goofy and Donald as partners.

REQUIRED

Prepare the Statement of changes in equity for the year ended 28 February 20.11.

Information

Extract from the ledger of Disney Traders on 28 February 20.11

Capital: Goofy 450 000

Capital: Donald 320 000

Current a/c: Goofy (01 March 20.10) 27 200 DR

Current a/c: Donald (01 March 20.10) 22 400 CR

Drawings: Goofy 60 800

Drawings: Donald 104 000

The following must be taken into account:

(a) The net profit for the year, according to the Profit and loss account, amounted to R430 500.

(b) The partners are entitled to interest on capital at 15% per year. However, the rate was increased to
18% per year with effect from 01 December 20.10.

(c) The partners are entitled to the following monthly salaries for the first 6 months of the financial year:

Goofy R7 500

Donald R6 500

Partners’ salaries were increased by 10% with effect from 01 September 20.10.

(d) Interest on partners’ drawings is to be charged as follows:

Goofy R3 045

Donald R5 200

(e) The balance of the profit must be shared between Goofy and Donald equally.

MANCOSA 31
Accounting and Financial Management

2.6 Suggested Solutions

Think Point 2.4

By doing so may give their competitors information which could lead to the company
losing some of its competitive advantage.

Think Point 2.5

In the early years of an asset’s life the straight-line method results in a lower
depreciation expense and a higher net profit than accelerated depreciation. In later
years, when accelerated depreciation is less than straight-line depreciation, total
depreciation using the straight-line method will still be lower than under accelerated
method if the investment in assets has increased each year as is typical for
organisations that are growing.

2.5.1 Refer to paragraph 2.3.1

2.5.2 Book Market

value value

ASSETS

Non-current assets R50m R64m

Current assets 20m 22m

Total assets R70m R86m

EQUITY AND LIABILITIES

Shareholders’ equity R28m R44m (Assets – liabilities)

Non-current liabilities 30m 30m

Current liabilities 12m 12m

Total equity and liabilities R70m R86m

2.5.3 By taking out old, low-cost inventory and leaving in new, high-cost items, FIFO will show a higher
inventory value in the Statement of Financial Position but a lower cost of sales in the Statement of
Comprehensive Income. The reported profits will therefore be higher. The inventory valuation method
can therefore have a significant impact on financial statements.

32 MANCOSA
 Accounting and Financial Management

2.5.4 Net working capital = Current assets – Current liabilities

= (R200 000 + R600 000 + R1 050 000) – (R400 000 + R250 000 + R300 000)

= R1 850 000 – R950 000

= R900 000

2.5.5 Long term debt

(R108m X 50%) – R34m = R20m

*Retained earnings amount to R30m and is calculated as follows:

Total assets 108m

Equity (108m X 50%) 54m

Ordinary share capital 24m

Retained earnings (54m – 24m) *30m

Non-current liabilities 20m

Current liabilities 34m

Total equity and liabilities 108m

2.5.6 Extract of statement of changes in equity

Retained
earnings
R’000

Balance on 31 December 20.10 780

Net profit for year 650

Preference share dividends (50)

Ordinary share dividends (560) [780 + 650 – 50 – 820)

Balance on 31 December 20.11 820

MANCOSA 33
Accounting and Financial Management

2.5.7

Capron Ltd

Statement of Financial Position as at 31 December 20.11

R
ASSETS
Non-current assets 756 000

Property, plant and equipment (1 008 000  280 000) 728 000

Financial assets: Shares in XYZ Limited 28 000

Current assets 165 200

Inventories 92 400
Trade and other receivables 44 800

Accounts receivable 53 200

Provision for bad debts (8 400)

Cash and cash equivalents 28 000

Bank 7 000
Marketable securities 21 000

Total assets 921 200

EQUITY AND LIABILITIES

Equity 557 200

Ordinary share capital 403 200

Retained earnings 154 000

Non-current liabilities 198 800

Long-term borrowings 198 800

Current liabilities 165 200

Trade and other payables 165 200

Accounts payable 49 000

Notes payable 116 200

Total equity and liabilities 921 200

34 MANCOSA
 Accounting and Financial Management

2.5.8 Yes. Assets that have a relatively long life e.g. land and buildings are shown at their historical cost in
the Statement of Financial Position. There is therefore little relation between the asset values reflected
in the Statement of Financial Position and the current market value of the firm’s assets. Thus financial
managers and investors often find that asset values are not always the most relevant amounts.

2.5.9

Disney Traders

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 20.11

Capital Accounts Goofy (R) Donald (R) Total (R)

Balance at 28 February 20.10 450 000 320 000 770 000

Changes in capital - - -

Balance at 28 February 20.11 450 000 320 000 770 000

Current Accounts Goofy (R) Donald (R) Total (R)

Balance at 28 February 20.10 (27 200) 22 400 (4 800)

Net profit for the year 232 865 197 635 430 500

Interest on capital 70 875 50 400 121 275

Salaries 94 500 81 900 176 400

Interest on drawings (3 045) (5 200) (8 245)

Profit Share 70 535 70 535 141 070

Drawings (60 800) (104 000) (164 800)

Balance at 28 February 20.11 144 865 116 035 260 900

MANCOSA 35
Accounting and Financial Management

Unit
3: Statement of Comprehensive
Income

36 MANCOSA
 Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Understand the significance of the items in  Complete relevant readings and questions provided.
the Statement of Comprehensive Income.

 Prepare a Statement of Comprehensive

Income for a sole proprietorship, partnership
and company.

 Interpret information contained in the

Statement of Comprehensive Income

3.1 Introduction
3.2 Format of Statement of Comprehensive Income
3.3 Analysis of Items in the Statement of Comprehensive Income

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:

Marx, J., de Swardt, C., (2014) Financial Management in Southern Africa. 4th
Edition. Cape Town: Pearson Education

Recommended Reading:
Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of Financial
Management. 13th Edition. New York: McGraw-Hill/Irwin.

Marshall, D.H., McManus, W.W. and Viele, D.F. (2011) Accounting: What the
numbers mean. 9th Edition. New York: McGraw-Hill

MANCOSA 37
Accounting and Financial Management

3.1 Introduction
Block et al. (2009:27) describes a Statement of Comprehensive Income as a major device that measures the
profitability of a firm over a period of time. Overall it shows various expenses deducted from income to arrive at
the profit earned or loss incurred. Income results from economic benefits flowing to the entity because of various
transactions with third parties, other than the owners of the entity. Expenses are decreases in economic benefits
in the form of outflows or depletion of assets or the incurrence of liabilities that result in a decrease in equity

3.2 Format of Statement of Comprehensive Income

According to Marx et al. (2009:51) Statements of Comprehensive Income prepared by different
companies vary a great deal as to the amount of detail shown. Statements of Comprehensive Income
are often condensed as the public may not be interested in the details of operations and companies
may also prefer not to disclose its operations to competitors and investment analysts.

Illustrated below is an example of a format of a Statement of Comprehensive Income of a company:

Figure 3-1 Statement of Comprehensive Income of a company

Kramer Limited

Statement of Comprehensive Income for the year ended 31 December 20.11

Sales 1 672 400

Cost of sales (878 700)

Gross profit 793 700

Other operating expenses (487 900)

Income from operations/Operating profit 305 800

Interest income: 2 700

Profit before interest expense 308 500

Interest expense (11 100)

Profit before tax 297 400

Income tax (74 350)

Profit after tax 223 050

Earnings per share 37 cents

38 MANCOSA
 Accounting and Financial Management

Some Statements of Comprehensive Income would report each operating expense separately instead
of lumping them together as shown above. The Statement of Comprehensive Income of a sole
proprietorship and partnership would follow a similar format except that income tax and earnings per
share would be excluded.

3.3 Analysis of Items in the Statement of Comprehensive Income

Marshall et al. (2011:38) provide an overview of the items in the Statement of Comprehensive Income.

3.3.1 Sales

Sales reflect the amount an entity earns through selling products that it has purchased or
manufactured. If a customer returns merchandise, the customer may be given a cash refund (if sales
were for cash) or the accounts receivable may be decreased (in respect of credit sales). Sometimes
an allowance is given to a customer instead of having the goods returned. These sales returns and
allowances are recorded separately for internal control purposes but the amount is subtracted from
sales to arrive at net sales. Cash discounts to customers are also deducted from sales to arrive at
net sales.

Think Point 3.1

A customer ordered and paid for goods that have still to be manufactured, so
therefore the goods are presently not available for sale. How should this be
accounted for in the financial statements?

3.3.2 Cost of sales

Cost of sales is the cost of the merchandise sold to customers. In compliance with the matching principle cost of
sales is recognised concurrently with the income it relates to viz. sales. The determination of the cost of sales
amount depends on:

* The practices used for valuing inventory viz. FIFO, LIFO, Weighted average.

* The inventory accounting system used viz. periodic or perpetual.

3.3.3 Gross profit

Gross profit (also called gross margin) is the difference between sales revenue and cost of sales.

MANCOSA 39
Accounting and Financial Management

3.3.4 Other operating expenses

Operating expenses are the costs of resources used as part of the operating activities during a
financial period and are not directly associated with specific goods and services. Operating expenses
include selling expenses, general and administrative expenses, and research and development
expenses.

3.3.5 Income from operations / Operating profit

Income from operations is the difference between the gross profit and operating expenses. The
significance of this amount is that it is often used to measure the ability of management to utilize the
entity’s operating assets. Interest income, interest expense, gains and losses, income tax and other
non-operating transactions are excluded from income from operations. Many investors and financial
managers thus prefer to use income from operations rather than net profit to assess the profitability of
the entity.

3.3.6 Interest, gains and losses

These are non-operating items that are reported after income from operations.

Interest expense must be disclosed separately on the face of the Statement of Comprehensive
Income as finance costs. Many users of financial statements would be interested in the interest
expense as it represents an obligation that must be honoured. The greater the interest expense an
entity incurs, the greater the risk will be to shareholders on their investment.

Revenue items, with the exception of sales, are included with “other income” on the face of the
Statement of Comprehensive Income and details of revenue are presented in the notes to the financial
statements. Items that must be disclosed include interest income and dividends earned.

Gains and losses result from increases in the carrying value of assets and liabilities that do not result
from the ordinary operating activities of the entity. When the nature and amount of transactions are
important to the understanding of the entity’s financial performance and about the financial position of
that entity, gains and losses from the disposal of property, plant and equipment should be disclosed
separately from the disposal of long-term investments.

40 MANCOSA
 Accounting and Financial Management

3.3.7 Income tax

Companies are liable for the payment of income tax (e.g. public companies are taxed at 28%) on their
taxable income. The income tax expense of the entity should be disclosed on the face of the Statement
of Comprehensive Income and the taxes payable are included under current liabilities in the Statement
of Financial Position. (Note: Dividends tax is a tax at a fixed rate e.g. 15% on dividends paid in respect
of shares listed on the JSE. This tax is to be withheld by companies paying the taxable dividends.)

Think Point 3.2

Income tax is levied on a company’s “taxable income”. Why is income tax not
levied on the company’s profit before tax?

3.3.8 Net profit and Earnings per share

Arithmetically, the net profit (or loss) is the difference between revenues and gains on the one hand and expenses
and losses on the other. Since net profit is a prerequisite for dividends, shareholders and potential investors are
especially interested in the net profit. To facilitate the interpretation of the net profit (or loss), the earnings per
(ordinary) share is reported. Because of its significance, earnings per share is reported on the Statement of
Comprehensive Income just below the amount of the net profit. It is calculated by dividing the net profit after-tax
by the number of shares issued.

Think Point 3.3

Do you think that dividends paid and declared for the financial period should be
reflected in the Statement of Comprehensive Income? Explain.

3.4 Self-Assessment Activities

3.4.1 Of what significance is the Statement of Comprehensive Income to financial managers, shareholders,
potential investors, and others?

MANCOSA 41
Accounting and Financial Management

3.4.2Genkem Limited’s Statement of Comprehensive Income lists the following items:

Income from operations 910 000

Interest expense 116 000

Income tax 276 000

1 000 000 ordinary shares have been issued by the company. Calculate the earnings per share.

3.4.3 You have been provided with the following information for Jeep Inc.:

Interest income 50 000

Income from operations 2 030 000

Net profit (after tax) 1 400 000

The firm’s tax rate is 30%. Calculate the interest expense.

3.4.4 Listed below is the 20.10 Statement of Comprehensive Income for Luxor Inc.

Statement of Comprehensive Income for the year ended 31 December 20.10

Sales 8 250 000

Cost of sales (5 150 000)

Gross profit 3 100 000

Operating expenses (1 450 000)

Income from operations 1 650 000

Interest expense (475 000)

Profit before tax 1 175 000

Income tax (352 500)

Profit after tax 822 500

42 MANCOSA
 Accounting and Financial Management

The CEO of Luxor Inc wants the company to earn a net profit R1 400 000 in 20.11. Cost of sales is
expected to be 60% of sales, operating expenses would increase by 10%, interest expense would
increase to R525 000, and the firm’s tax rate will be 30%. Calculate the sales needed to produce a net
profit of R1 400 000.

3.4.5 The following information is provided for Queenstown Limited for the year 20.10:

Sales 33 375 000

Cost of sales 24 150 000

Retained earnings 1 725 000

Dividends on ordinary and preference shares 1 687 500

Interest expense 1 575 000

Tax rate is 30%

Forecast for the year 20.11:

Sales are expected to increase by R3 750 000.

Goods will be sold at cost plus 50%.

Operating expenses will remain unchanged.

Interest expense is expected to be R1 800 000.

The tax rate is expected to be 30%.

Dividends on ordinary and preference shares will not change.

Required

Calculate the retained earnings expected in 20.11.

3.4.6 Study the Statement of Comprehensive Income of Rivonia Ltd for the years ended

30 June 20.11 and 20.10 and answer the questions that follow:

MANCOSA 43
Accounting and Financial Management

Statement of Comprehensive Income for the years ended 30 June:

20.11 (R) 20.10 (R)

Net sales 800 000 680 000

Cost of sales (450 000) (432 500)

Gross profit 350 000 247 500

Selling, general and administrative expenses (125 000) (106 250)

Income from operations 225 000 141 250

Other income (expenses)

Interest expense (16 000) (14 000)

Other income 11 000 12 000

Loss on disposal of asset (5 000) -

Profit before tax 215 000 139 250

Income tax (95 000) (70 000)

Profit after tax 120 000 69 250

Earnings per share ? 14 cents

Questions

3.4.6.1 Based on the mark-up used to determine the selling price, management expected a gross profit of
R400 000 for 20.11. What are the possible reasons for the gross profit being lower than expected?

3.4.6.2 Name some specific expenses that could be included as “Selling, general and administrative
expenses”.

3.4.6.3 Could there have been any movements in the non-current liabilities? Explain.

3.4.6.4 If the carrying value of the asset sold was R13 000, calculate the selling price.

3.4.6.5 The interest rate on loans was 16% whilst the return on assets was 24%. How would shareholders
interpret this?

3.4.6.6 Has the earnings per share for the financial year ended 20.11 improved over the previous financial
year? Show the necessary calculations. How do you think shareholders will feel about this? (Note
the number of shares issued was 500 000.)

3.4.6.7 Comment on the financial result of the company for 20.11.

44 MANCOSA
 Accounting and Financial Management

3.5 Suggested Solutions

Think Point 3.4

The supplier cannot recognise the revenue of the sale until the goods have been
manufactured and delivered to the customer. Since the customer has already
paid, the amount received will be reflected as a liability (income received in
advance).

Think Point 3.5

Certain items are treated differently in terms of Generally Accepted Accounting

Practice and the Income Tax Act. As a result the net profit (before tax) will differ
from the taxable income. Examples of such differences include the following:

The company’s accounting depreciation expenses may differ from the tax
depreciation (called “wear-and-tear allowances”) allowed by the Income Tax Act.

Certain expenses may not be allowed as deductions for income tax purposes e.g.
traffic fines.

Certain kinds of income are excluded from taxable income as they are exempt e.g.
SA source dividends received.

Think Point 3.5

No. A dividend does not reflect the performance of an entity. It is distributed as a

result of the performance of an entity. The Statement of Comprehensive Income
reflects the profit of a company where profit is equal to income less expenses. The
definition of an expense excludes the result of transactions with shareholders. A
dividend results from a distribution to shareholders and is therefore not an
expense.

3.5.1 They would be interested in the financial results of the entity. In particular they may want to know
amongst other things:

 The amount of profit or loss that was made.

 Whether the profit realised is a satisfactory return on the capital invested.

MANCOSA 45
Accounting and Financial Management

 Whether sales are increasing relative to cost of sales and other operating expenses.

 Whether the entity is exercising effective control over expenses.

 The impact of the financial result on the financial position of the entity.

 How to evaluate the stewardship of the directors.

3.5.2 R

Income from operations 910 000

Interest expense (116 000)

Profit before tax 794 000

Income tax (276 000)

Profit after tax 518 000

Earnings per share = Profit after tax

No. of shares issued

=- R518 000 x 100

1 000 000

= 51.8 cents

3.5.3 Income from operations 2 030 000

Interest income: 50 000

Profit before interest expense 2 080 000

Interest expense *(80 000) *Final step: (2 080 000 – 2 000 000)

Profit before tax 2 000 000 (1 400 000  70 X 100)

Income tax (600 000) (1 400 000  70 X 30)

Profit after tax 1 400 000

70% is the amount net of tax, as the tax rate is 30%

46 MANCOSA
 Accounting and Financial Management

3.5.4 R

Sales *10 300 000 *Final step (4 120 000  40 X 100)

Cost of sales (6 180 000) (4 120 000  40 X 60)

Gross profit 4 120 000 (2 525 000 + 1 595 000)

Other operating expenses (1 595 000) (1 450 000 + 145 000)

Income from operations 2 525 000 (2 000 000 + 525 000)

Interest expense (525 000)

Profit before tax 2 000 000 (1 400 000  70 X 100)

Income tax (600 000) (1 400 000  70 X 30)

Profit after tax 1 400 000 First step

3.5.5 Calculation of operating expenses for 20.10

(20.10) R

Sales 33 375 000

Cost of sales (24 150 000)

Gross profit 9 225 000

Other operating expenses *(2 775 000) *Final step (9 225 000 – 6 450 000)

Income from operations 6 450 000 (4 875 000 + 1 575 000)

Interest expense (1 575 000)

Profit before tax 4 875 000 (3 412 500  70 X 100)

Income tax (1 462 500) (3 412 500  70 X 30)

Profit after tax 3 412 500 (1 725 000 + 1 687 500)

MANCOSA 47
Accounting and Financial Management

Calculation of retained earnings for 20.11

(20.11) R

Sales 37 125 000 (33 375 000 + 3 750 000)

Cost of sales (24 750 000) (37 125 000 X 100  150)

Gross profit 12 375 000

Other operating expenses (2 775 000) (same as 20.10; calculated above)

Income from operations 9 600 000

Interest expense (1 800 000)

Profit before tax 7 800 000

Income tax (2 340 000) (7 800 000 X 30%)

Profit after tax 5 460 000

Dividends (1 687 500)

Retained earnings 3 772 500

3.5.6.1 Some merchandise may have been sold below the normal selling price.

Monthly or seasonal sales may have been held.

Some merchandise may have been incorrectly priced.

The cost price of the goods may have increased but the selling price may have not have been
adjusted.

3.5.6.2 Salaries, advertising, depreciation, rent expense, insurance, stationery, repairs and maintenance
etc.

3.4.6.3 Yes. The increase in interest expense indicates that non-current liabilities may have increased.

3.5.6.4 Selling price = R13 000 – R 5 000 = R8 000

48 MANCOSA
 Accounting and Financial Management

3.5.6.5 Since the company borrowed money at an interest cost of 16% and was able to use to earn a return
higher than 16%, the shareholders will have a greater return on their investment than if they provided
all of the funds themselves. In other words, the use of borrowed money enhanced the return to
owners.

3.5.6.6 Earnings per share = Profit after tax

No. of shares issued

= R120 000 x 100

500 000

= 24 cents

Yes. Earnings per share increased by 10 cents per share. Shareholders should be happy with this
increase as it represents an improvement in the financial performance of the company. Higher
earnings per share mean that they can expect a greater dividend per share.

3.5.6.7 The financial result of the company, as evidenced by the net profit, has improved since 20.10. This
is further substantiated by the increase in the earnings per share. This could be largely attributed to
the 17.65% increase in net sales as well as the attainment of a higher gross profit ratio.

MANCOSA 49
Accounting and Financial Management

Unit
4:
Cash Flow Statement

50 MANCOSA
 Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Explain the purpose of a cash flow statement.  Complete relevant readings, think points and activities
provided.
 Have a proper understanding of the three
primary sections of a cash flow statement.

 Draw up a cash flow statement.

 Interpret information contained in a cash flow

statement.

4.1 Introduction
4.2 Primary Sections of a Cash Flow Statement
4.3 Preparing a Cash Flow Statement
4.4 Interpretation of a Cash Flow Statement

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:
 Marx, J., de Swardt, C., (2014) Financial Management in Southern
Africa. 4th Edition. Cape Town: Pearson Education.

Recommended Reading:
 Atrill, P. and McLaney, E. (2008) Accounting and Finance for non-
specialists. 6th Edition. London: Pearson Education Limited.
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.
 Cornett, M.M., Adair Jr., T.A. and Nofsinger, .J. (2009) Finance :
Applications and theory. 1st Edition. New York: McGraw-Hill/Irwin.
 Ingram, R.W., Albright, T.L., Baldwin, B.A. and Hill, J.W. (2005)
Accounting: Information for Decisions. 3rd edition. Canada: Thomson
South-Western

MANCOSA 51
Accounting and Financial Management

4.1 Introduction
According to Cornett et al. (2009:39) financial managers may find themselves at a loss if they only have
Statements of Comprehensive Income and Statement of Financial Positions on which to base decisions for the
present and the future. GAAP procedures require firms to recognise revenue at the time of sale, but sometimes
the cash is received before or after the sale. Likewise cash outflows incurred with production may take place at
a very different point in time. In addition to this, Statements of Comprehensive Income contain many non-cash
items, the largest of which is depreciation. Thus figures reflected in a Statement of Comprehensive Income may
not represent the actual cash inflows and outflows of a firm for a particular period. Financial managers and
investors are more interested in actual cash flows than the artificial accounting profit shown in the Statement of
Comprehensive Income. That is why the cash flow statement is prepared: to show the firm’s cash flow over a
given period of time. The statement reflects the amounts of cash that the firm generated and distributed during
a particular time period.

4.2 Primary Sections of a Cash Flow Statement

According to Marx et al. (2009:56) the three objectives of the cash flow statement are to provide information about
the:

 Cash flows from operating activities

 Cash flows from investing activities

 Cash flows from financing activities

Once these three sections are completed, the results are added together to calculate the net increase
or decrease in cash flow for the firm. This process is illustrated by Block et al. (2009:35) in figure 4-1:

52 MANCOSA
 Accounting and Financial Management

Figure 4-1 Illustration of concepts behind the cash flow statement

Cash inflows Cash outflows

Generation of funds in (1) Expenditure of funds in

normal operations normal operations
Cash flows from

operating activities

Sale of plant and equipment (2) Purchase of plant and

equipment
Liquidation of long-term Cash flows from
investment Long-term investment
investing activities

Sale of bonds, ordinary (3) Retirement or re-purchase

shares, preference shares of bonds, ordinary shares,
Cash flows from
and other securities preference shares and other
financing activities
securities

Add items 1, 2, and 3 to arrive

at net increase or decrease in
cash

MANCOSA 53
Accounting and Financial Management

4.2.1 Cash flows from operating activities

The cash flows from operating activities are derived from the main revenue-generating activities of an entity. We
start by translating the profit before interest and taxes from an accrual basis to a cash basis. According to Block
et al. (2009:34) firms may use a direct method, whereby every item in the Statement of Comprehensive Income
is adjusted from accrual accounting to cash accounting. As this is a tedious method, the indirect method is more
popular. Using this method, the profit before interest and tax (i.e. operating profit) is the starting point and then
adjustments are made to convert it to cash flows from operations. Cornett et al. (2009:40) describe cash flows
from operations as the cash inflows and outflows that result from producing and selling the firm’s products.

We then go on to deduct payments made during the accounting period for taxation, interest on borrowings and
dividends to obtain the net cash from operating activities. Any dividends and interest received are added.

Think Point 4.1

Of what significance is “cash flows from operations” to managers and investors?

4.2.2 Cash flows from investing activities

Cornett et al. (2009:40) state that these are cash flows that are associated with the purchase and sale
of fixed and other non-current assets. The most significant item is in the firm’s investment in fixed
assets. Cash flows from investing activities would typically include:

 Payments to acquire non-current assets;

 Receipts from sale of non-current assets;

 Payments to acquire other entities and other equity or debt instruments;

 Receipts from sale of interests in other entities, and sale of other equity or debt instruments;

 loans made to other parties or receipts from the repayment of such loans.

54 MANCOSA
 Accounting and Financial Management

4.2.3 Cash flows from financing activities

According to Cornett et al. (2009:40) these are cash flows that result from debt and equity financing
transactions. Examples include:
 Proceeds from the issue of shares and other equity instruments;
 Proceeds from loans, bonds and issue of debentures;
 Repayments of amounts borrowed.

4.3 Preparing a Cash Flow Statement

The following example will be used to illustrate the preparation of the cash flow statement of a company (the
same principles apply to sole proprietorships and partnerships):

Figure 4-2 Information to prepare the Cash Flow Statement of Asics Ltd

Asics Ltd

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED

31 DECEMBER 20.13
R

Sales 1 800 000

Cost of sales (1 125 000)

Gross profit 675 000

Operating expenses (474 000)

Directors’ fees 127 500

Auditor’s fees 67 500

Depreciation 81 000

Loss on sale of asset 21 000

Other non-disclosable costs 177 000

Operating profit 201 000

Other income: Investment income 24 600

Interest expense: on debentures (3 900)

Profit before tax 221 700

Income tax (77 595)

Profit after tax 144 105

MANCOSA 55
Accounting and Financial Management

Asics Ltd

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.13

Ordinary
share capital Retained
earnings Total

R R R
Balance on 01 January 20.13 525 000 263 775 788 775
Issue of ordinary shares 150 000 150 000
Profit for the year 144 105 144 105
Dividends:
Ordinary interim (18 750) (18 750)
Ordinary final (35 250) (35 250)

Balance on 31 December 20.13 675 000 353 880 1 028 880

ASIC LTD
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20.13 20.12
R R

ASSETS

Non-current assets 996 090 858 075

Property, plant and equipment (See Note 1) 790 590 699 600
Financial assets: Investment – Subsidiary company 85 500 60 000
Investment – Listed shares (at cost) 120 000 98 475
Current assets 188 925 203 505
Inventories 120 690 119 700

Trade and other receivables 67 335 82 305

Trade debtors 67 335 82 305

Cash and cash equivalents 900 1 500

Bank - -

Petty cash 900 1 500

Total assets 1 185 015 1 061 580

56 MANCOSA
 Accounting and Financial Management

EQUITY AND LIABILITIES

Equity 1 028 880 788 775

Share capital 675 000 525 000

Retained earnings 353 880 263 775
Non-current liabilities 30 000 135 000

Long-term borrowings: 13% Debentures 30 000 135 000

Current liabilities 126 135 137 805

Trade and other payables 43 185 59 805

Trade creditors 43 185 59 805

South African Revenue Services (Income tax payable) 45 000 30 000

Shareholders for dividends 35 250 39 000
Bank overdraft 2 700 9 000

Total equity and liabilities 1 185 015 1 061 580

Note 1

Property, plant and equipment

20.13 20.12

Land and Land and

buildings buildings Equipment Vehicles
Equipment Vehicles
R R R R R R

Cost 462 000 242 340 300 000 346 500 188 100 300 000

Accumulated (82 500) (131 250) (45 000) (90 000)

depreciation

Carrying value 462 000 159 840 168 750 346 500 143 100 210 000

Additional information

1. Equipment was sold for cash, R16 500. The cost price of the equipment sold was R39 750 and the
accumulated depreciation on it to the date of sale was R2 250. Equipment was also purchased for
cash.
2. Additions were made to the buildings for cash.

MANCOSA 57
Accounting and Financial Management

Solution

Asics Ltd

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20.13

Cash flows from operating activities 200 715

Profit before interest and tax (a) 201 000

Adjustments to convert to cash from operations

Non-cash flow adjustments 102 000

Add: Depreciation (b) 81 000

21 000
Loss on disposal of asset (c)

Profit before working capital changes 303 000

(2 640)
Working capital changes

Increase in inventory (d) (990)

14 970
Decrease in receivables (e) (16 620)

Decrease in payables (f)

Cash generated from operations 300 360

Interest paid (g) (3 900)

Investment income (h) 24 600

Dividends paid (i) (57 750)

Income tax paid (j) (62 595)

Cash flow from investing activities (240 015)

Investment in listed shares (k) (21 525)

(25 500)
Investment in subsidiary company (l) (209 490)
16 500
Non-current assets purchased (m)

Proceeds from sale of equipment (n)

Cash flow from financing activities 45 000

58 MANCOSA
 Accounting and Financial Management

Proceeds from issue of ordinary shares (o) 150 000

(105 000)
Long-term borrowings redeemed (p)

Net increase in cash and cash equivalents 5 700

Cash and cash equivalents at beginning of year (q) (7 500)

Cash and cash equivalents at end of year (r) (1 800)

Calculations and explanatory notes

(a) Profit before interest and tax

This amount is obtained from the Statement of Comprehensive Income (operating profit).

(b) Depreciation

The amount is obtained from the Statement of Comprehensive Income.

(c) Loss on disposal of asset

The amount is obtained from the Statement of Comprehensive Income.

(d) Increase in inventory

The increase is calculated by comparing the inventory figures for both years:

R120 690 – R119 700 = R990 (The amount is bracketed as it represents a use of cash.)

(e) Decrease in receivables

The decrease is calculated by comparing the Trade and other receivables figures for both years:

R82 305 – R67 335 = R14 970 (The amount represents a source of cash.)

MANCOSA 59
Accounting and Financial Management

(f) Decrease in payables

The decrease is calculated by comparing the Trade and other payables figures for both years:

R59 805 – R43 185 = R16 620 (The amount is bracketed as it represents a use of cash.)

(g) Interest paid

The amount is obtained from the Statement of Comprehensive Income.

(h) Investment income

The amount is obtained from the Statement of Comprehensive Income.

(i) Dividends paid

The amount paid is calculated as follows:

Dividends due on 31 December 20.12 (39 000)

Dividends for the year (54 000)

Dividends due on 31 December 20.13 35 250

(57 750)

Note:

 Dividends due on 31 December 20.12/20.13 is obtained from the item “Shareholders for dividends” in
the Statement of Financial Position.

 Dividends for the year are obtained from the Statement of Changes in Equity:

-R39 000 - 54 000 + 35 250 = (57 750)

(j) Income tax paid

The amount paid is calculated as follows:

Income tax due on 31 December 20.12 (30 000)

Income tax for the year (77 595)

Income tax due on 31 December 20.13 45 000

(62 595)

60 MANCOSA
 Accounting and Financial Management

Note:

 Income tax due on 31 December 20.12/20.13 is obtained from the item “South African Revenue
Services” in the Statement of Financial Position.

 Income tax for the year is obtained from the Statement of Comprehensive Income.

(k) Investment in listed shares

The amount is calculated by comparing the figures for “Investment – Listed shares” (in the Statement
of Financial Position) for both years:

R120 000 – R98 475= R21 525 (The amount is bracketed as it represents a use of cash.)

(l) Investment in subsidiary company

The amount is calculated by comparing the figures for “Investment – Subsidiary company” (in the
Statement of Financial Position) for both years:

R85 500 – R60 000= R25 500 (The amount is bracketed as it represents a use of cash.)

(m) Non-current assets purchased

The amount is obtained by using the figures for both years for Land and buildings and Equipment in
the Statement of Financial Position and after consideration was given to the additional information:

Land and buildings purchased: R462 000 – R346 500 = R115 500

Equipment purchase is calculated as follows:

Carrying value of equipment on 31 December 20.12 143 100

Additions (Purchase) *93 990

Disposals at carrying value (Cost R39 750 – Acc. dep. R2 250) (37 500)

Depreciation (R45 000 – R2 250) – (R82 500) (39 750)

Carrying value of equipment on 31 December 20.13 159 840

*Purchase of equipment is calculated as follows:

(R143 100 – R37 500 – R39 750) – (R159 840) = R93 990

Non-current assets purchased = R115 500 + R93 990 = R209 490

MANCOSA 61
Accounting and Financial Management

(n) Proceeds from sale of equipment

The amount is calculated by using figures from the Statement of Comprehensive Income (Loss on sale
of equipment) and after consideration was given to the additional information:

Carrying value of equipment sold is :

Cost R39 750 – Acc. dep. R2 250 = R37 500

However, the equipment was sold at a loss of R21 000. Therefore the proceeds from the sale of
equipment is R16 500 (R37 500 – R21 000).

(o) Proceeds from issue of ordinary shares

The amount is obtained from the Statement of Changes in Equity.

(p) Long-term borrowings redeemed

The amount is obtained by comparing the figures for both years for “13% Debentures” (Long-term
borrowings) in the Statement of Financial Position:

R135 000 – R30 000 = R105 000 (The amount is bracketed as it represents a use of cash.)

(q) Cash and cash equivalents at beginning of year

This is calculated by using the figures for Cash and cash equivalents and Bank overdraft as at 31
December 20.12:

Cash and cash equivalents 1 500

Bank overdraft (9 000)

Net unfavourable balance (7 500)

(r) Cash and cash equivalents at end of year

This is calculated by using the figures for Cash and cash equivalents and Bank overdraft as at

31 December 20.13:

Cash and cash equivalents 900

Bank overdraft (2 700)

Net unfavourable balance (1 800)

62 MANCOSA
 Accounting and Financial Management

Other calculations

 Profit before working capital changes

R201 000 + R102 000 = R303 000

 Cash generated from operations:

R303 000 – R2 640 = R300 360

 Cash flows from operating activities:

R300 360 – R3 900 + R24 600 – R57 750 – R62 595 = R200 715

 Net increase in cash and cash equivalents

This amount can be calculated by comparing the cash balances of 20.12 and 20.13 i.e. a net
unfavourable balance of R7 500 (20.12) turned into a net unfavourable balance of R1 800 (20.13)
resulting in a net increase in cash and cash equivalents of R5 700.

The net increase can be verified as follows:

R200 715 – R240 015 + R45 000 = R5 700

4.4 Interpretation of a Cash Flow Statement

Atrill and Mclaney (2008:171) state that since cash is regarded as the lifeblood of any business, the cash flow
statement provides very useful information. By tracking the sources and uses of cash over several years one
could observe financing trends that may help to make judgements about the likely future behaviour of the firm.

4.4.1 Interpretation of cash flow patterns

Ingram et al (2005: 190) provide a summary (figure 4-5) of common cash flow combinations together with an
indication of how well a company may be performing.

MANCOSA 63
Accounting and Financial Management

Figure 4-5 Normal interpretation of cash flow patterns

Operating Investing Financing

Cash flows Cash flows Cash flows
Normal interpretation

The company is prosperous and growing.

Financing cash flow is used to take advantage of
+ – +
growth opportunities.

The company is facing serious financial problems.

It is selling assets and using financing activities to
– + +
meet current cash needs.

The company is prosperous but may not have a lot

of good growth opportunities. It is using operating
+ + or – –
cash to pay off debt and pay shareholders.

The company may be facing a current cash flow

problem. It is selling assets to supplement current
+ or – + –
cash flows to cover its financing needs. This is
especially a problem if the company is short of cash
to repay debt.

The amount of the increase or decrease in an entity’s cash balance is usually not of major importance. Quite
often the change is small. A small increase or decrease in cash does not signify financial problems or strengths.
A net decrease in cash must not be interpreted as being a huge financial problem for an entity. The focus should
rather be on the changes in operating, investing and financing cash flows.

Think Point 4.2

Last year’s cash flow statement of Angus Limited reflected a negative cash flow
from operating activities. What could be the reasons for this, and should the
financial manager be alarmed by this?

64 MANCOSA
 Accounting and Financial Management

4.5 Self-Assessment Activities

4.5.1 What impact would changes in the Statement of Financial Position items listed below have on the
cash position of an enterprise? Place a tick () in the correct column.

Change in Statement of Financial Position items Inflow of cash Outflow of cash

Increase in current assets other than cash

Decrease in current assets other than cash

Increase in non-current assets

Decrease in non-current assets

Increase in current liabilities

Decrease in current liabilities

Increase in non-current liabilities

Decrease in non-current liabilities

4.5.2 Study the extracts of the Cash flow statement of Vuyo Limited for the year ended 30 June 20.9 and answer
the questions that follow.

Extracts of Cash Flow Statement for the year ended 30 June 20.9 R

Cash flow from operating activities 100 000

Cash flow from investing activities (300 000)

Additions to plant and equipment (300 000)

Cash flow from financing activities 250 000

Increase in Long-term borrowings 250 000

1 What do you understand by “Cash flow from operating activities R100 000”?

2 Name one transaction that improves cash flow but does not increase profit.

3 There is a combination of a positive net cash flow from operating activities

(R100 000) and a negative cash flow from investing activities (R300 000). Is this good for the
company? Explain.

4.5.3 Trojan Ltd.’s Statement of Comprehensive Income for the year ended 31 December 20.11 and
Statement of Financial Positions as at 31 December 20.10 and 20.11 are as follows:

MANCOSA 65
Accounting and Financial Management

Trojan Ltd

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20.11

Rm

Sales 1 152

Cost of sales (614)

Gross profit 538

Other operating income 42

580

Distribution expenses (130)

Administrative expenses (52)

Operating profit 398

Interest income 34

Interest expense (46)

Profit before tax 386

Income tax (92)

Profit after tax 294

Trojan Ltd

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER

20.11 20.10

Rm Rm

ASSETS

Non-current assets 1 132 1 100

Property, plant and equipment

Land and buildings 482 482

Plant and machinery 650 618

Current assets 360 330

66 MANCOSA
 Accounting and Financial Management

Inventories 82 88

Trade and other receivables 278 242

Total assets 1 492 1 430

EQUITY AND LIABILITIES

Equity 726 352

Ordinary share capital 480 300

Retained earnings 246 52

Non-current liabilities 500 800

Long-term borrowings 500 800

Current liabilities 266 278

Trade and other payables 108 110

SARS: Income tax 46 32

Bank overdraft 112 136

Total equity and liabilities 1 492 1 430

Additional information

1. During 20.11 the company spend an additional R190m on additional plant and machinery. There
were no other non-current asset acquisitions or disposals.

2. An interim dividend of R100m was paid on ordinary shares during the year.

Required

Prepare the cash flow statement for the year ended 31 December 20.11 and provide an interpretation
of your findings.

MANCOSA 67
Accounting and Financial Management

4.5.4 Study the Cash flow statement of Hydro Inc and comment on your findings.

Hydro Inc

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20.11

Rm

Cash flows from operating activities (128)

Operating profit 567.6

Adjustments to convert to cash from operations

Non-cash flow adjustments 200

Add: Depreciation (See workings below) 200

Profit before working capital changes 767.6

Working capital changes (440)

Increase in inventory (400)

Increase in receivables (120)

Increase in payables 80

Cash generated from operations 327.6

Interest paid (176)

Dividends paid (123)

Income tax paid (156.6)

Cash flow from investing activities

(460)

Non-current assets purchased (460)

Cash flow from financing activities 578

Investments redeemed 130

Long-term borrowings 448

Net increase in cash and cash equivalents (10)

Cash and cash equivalents at beginning of year 30

Cash and cash equivalents at end of year 20

68 MANCOSA
 Accounting and Financial Management

4.5.5 The cash flow statement for Tipoli Ltd is provided below:

Tipoli Ltd

Cash flow statement for the year ended 31 December 20.11

Cash flow from operating activities 385 000

Operating loss (215 000)

Adjustment

Depreciation 200 000

Profit before working capital changes (15 000)

Working capital changes 400 000

Increase in inventory (200 000)

Increase in receivables (400 000)

Increase in payables 1 000 000

Cash flow from investing activities (500 000)

Acquisition of plant and equipment (500 000)

Cash flow from financing activities 300 000

Increase in long-term loan (interest rate 30% p.a.) 300 000

Net increase in cash 185 000

Cash balance (31 December 20.10) ?

Cash balance (31 December 20.11) ?

Use the cash flow statement to answer the following questions:

1 Why was depreciation included in computing the cash flow from operating activities?

2 Calculate the cash balance on 31 December 20.10 if there was a bank overdraft of R25 000 on 31
December 20.11. State whether the balance is favourable or unfavourable.

3 Based on the cash flow information above, how does the company appear to be performing?
Explain by referring to at least 5 items on the statement.

MANCOSA 69
Accounting and Financial Management

4 The long-term loan was increased on 01 July 20.11. Was it prudent for the company to have taken
the loan? Explain.

5 Suggest two ways in which the company can improve its liquidity.

4.6 Suggested Solutions

Think Point 4.3

It shows quickly and compactly the firm’s cash flows generated by and used for
the production process. Managers and investors look for positive cash flows from
operating activities as a sign of a successful firm. Unless the firm has a stable,
healthy pattern in its cash flows from operations, it is not financially healthy no
matter what the levels of cash flows are from investing activities and financing
activities

Think Point 4.4

The first reason is that the firm may be unprofitable. This leads to more cash
being paid out to employees, suppliers, interest etc. The financial manager
should be alarmed since a major expense for most firms is depreciation. Since
depreciation is not considered in net cash flows from operating activities, the
negative operating cash flow may very well indicate a much greater trading loss.

The second reason could be that the business is expanding its activities and
spending large amounts of cash relative to the amount of cash coming in from
sales. This is because it will probably expand its assets to accommodate the
increased demand. This reason is less alarming to the financial manager.

70 MANCOSA
 Accounting and Financial Management

4.5.1

Change in Statement of Financial Position items Inflow of cash Outflow of cash

Increase in current assets other than cash 

Decrease in current assets other than cash 

Increase in non-current assets 

Decrease in non-current assets 

Increase in current liabilities 

Decrease in current liabilities 

Increase in non-current liabilities 

Decrease in non-current liabilities 

4.5.2 Vuyo Limited

1 The operations of the company yielded a positive inflow of funds of R100 000.

It has sufficient funds to finance its day-to-day activities.

2 A debtor pays an amount owed.

A bank loan is received.

Additional capital is raised.

3 Yes.

It is a sign of both good performance and growth.

The excess cash from operating activities is available for the purchase of plant and equipment.

The value of the company increases as it grows.

As the company expands by purchasing additional assets, more products are produced and
sold, which in turn improves profitability and operating cash flows.

MANCOSA 71
Accounting and Financial Management

4.5.3 Trojan Ltd

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20.6

Rm

Cash flows from operating activities 334

Profit before interest and tax / Operating profit 398

Adjustments to convert to cash from operations

Non-cash flow adjustments 158

Add: Depreciation (See workings below) 158

Profit before working capital changes 556

Working capital changes (32)

Decrease in inventory (88 – 82) 6

Increase in receivables (278 – 242) (36)

Decrease in payables (110 – 108) (2)

Cash generated from operations 524

Interest paid (46)

Investment income 34

Dividends paid (100)

Income tax paid (32 + 92 – 46) (78)

Cash flow from investing activities (190)

Non-current assets purchased (190)

Cash flow from financing activities (120)

Proceeds from issue of ordinary shares (480 – 300) 180

Long-term borrowings redeemed (800 – 500) (300)

Net increase in cash and cash equivalents 24

Cash and cash equivalents at beginning of year (136)

Cash and cash equivalents at end of year (112)

72 MANCOSA
 Accounting and Financial Management

Workings for depreciation

Carrying value of plant and equipment on 31 December 20.10 618

Additions (Purchase of plant and equipment) 190

Disposals at carrying value (0)

Depreciation *(618 + 190 – 650) *(158)

Carrying value of plant and equipment on 31 December 20.11 650

Interpretation

Atrill and Mclaney (2008:171) provide the following interpretation of the above cash flow statement:

 The cash flow from operating activities was strong, much larger than the profit after tax (R294m as per
Statement of Comprehensive Income), after taking into account the dividend paid. This would be
expected since depreciation is deducted in arriving at profit. There was a general tendency for working
capital to absorb some cash. This could have been due to the expansion of activity (sales revenue)
over the year.

 The net outflow of cash for investing activities is not unusual. Many items of property, plant and
equipment have limited lives and need replacement.

 There was a significant outflow of cash to redeem long-term borrowings, partly offset by the proceeds
of the issue of shares. This, perhaps, represents a change in the financing strategy. Together with the
ploughed-back profit from trading, there has been a significant shift in the equity/debt balance.

4.5.4 The statement of cash flows should be of worry to both managers and investors. The company
experienced a R128m cash shortfall from operating activities. The company is thus not generating any
cash to purchase additional assets, to repay debts, or invest in new products. An additional R460m
was spent on new fixed assets and it had to cover this outlay by borrowing heavily and liquidating its
investments. Obviously this situation cannot continue year after year without the company eventually
being forced into liquidation.

1 Depreciation expense does not require the payment of cash (non-cash item) and is thus added to
profit to determine cash flows.

2 R185 000 + R25 000 = R210 000 unfavourable (overdraft)

MANCOSA 73
Accounting and Financial Management

3 The company does not appear to be performing well for the following reasons:

It incurred an operating loss of R215 000 for the year.

It has R200 000 extra inventory on hand over the previous year.

R400 000 more is owing by debtors compared to the previous year.

It increased in short-term borrowings by R1 000 000 to solve its cash problems.

The increase in the long-term loan increases the financial risk.

4 No. The loan was taken to finance the purchase of plant and equipment which should have been
postponed given the poor cash situation.

The company’s adverse cash position is also evident by the absence of any payment for interest on
loan.

The interest rate is quite high.

5 - Speed up the collection of accounts receivable by offering cash discounts for early settlement of
accounts.

- Use an aggressive collection policy for outstanding debts.

- Increase inventory turnover by for example improving accuracy of demand forecasts and better
planning of purchases to coincide with these forecasts.

- Reduce administrative expenses by cutting down on overtime.

74 MANCOSA
 Accounting and Financial Management

Unit
5:
Analysing Financial Statements

MANCOSA 75
Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Explain why it is important to analyse  Complete relevant readings and activities provided.
financial statements.
 Complete relevant readings, think points and activities
 Calculate and interpret ratios from provided.
management’s point of view.

 Calculate and interpret ratios from owners’

point of view.

 Calculate and interpret ratios from the point

of view of creditors and lenders.

5.1 Introduction
5.2 Ratio Analysis
5.3 Ratio Analysis: Management’s Point Of View
5.4 Ratio Analysis: Owners’ Point Of View
5.5 Ratio Analysis: Lenders’ And Creditors’ Point Of View
5.6 Summary of The Ratios
5.7 Self-Assessment Activities
5.8 Suggested Solutions

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook
 Marx, J., de Swardt, C., (2014) Financial Management in Southern
Africa. 4th Edition. Cape Town: Pearson Education.
Recommended Reading:
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.
 Helfert, E.A. (2003) Techniques of Financial Analysis. 11th Edition. New
York: McGraw-Hill/Irwin.
 Marshall D.H., Mcmanus W.W. and Viele D.F. (2011) Accounting: What
the numbers mean, 9th Edition, McGraw-Hill: New York.

 Meredith, G. and Williams, B. (2005) Managing finance: Essential Skills

for Managers. 1st Edition. North Ryde: McGraw-Hill.

76 MANCOSA
 Accounting and Financial Management

5.1 Introduction
According to Helfert (2003:107) when one wishes to assess the performance of a business, one looks for ways to
measure the financial and economic consequences of past management decisions that shaped investments,
operations, and financing over time. One needs to know whether resources were used effectively, whether
profitability expectations were achieved or even exceeded, and whether financing choices were made prudently.

In this topic we will analyse business performance based on information contained in financial statements.
Meredith and Williams (2005:76) state that the analysis of financial statements is important in order to:

■Explain and understand the reasons for levels of performance of sales, control of expenses, profits, funds, and
investment in general.

■Identify trends in performance and owner investment over time.

■Identify the position of the enterprise in an industry in order to identify strengths, weaknesses, opportunities,
and threats.

■Understand past performance in order to plan for the future.

■Assist managers and owners to make the best use of available resources.

5.2 Ratio Analysis

A ratio may be defined as the relationship between two sets of values obtained from financial statements. Ratios
provide a means to summarise complex accounting information into a small number of key indicators. They make
figures more easily comparable. Marx et al. (2009:67) emphasise that the usefulness of ratios depends totally
on their skilful application and interpretation, as ratios on their own contain little meaningful information.

Our discussion will focus on three major viewpoints of financial performance analysis viz.:

 Managers

 Owners

 Lenders and creditors

According to Block et al. (2009:57) the users of financial statements attach different degrees of importance to the
various categories of ratios (see figure 1-1). The financial manager will, of course, look at all the ratios, but with
varying degrees of attention.

Helfert (2003:110) indicates the main performance areas of interest to management, owners, and lenders in

MANCOSA 77
Accounting and Financial Management

Figure 5-1, together with the most common ratios:

LENDERS AND

MANAGEMENT OWNERS CREDITORS

Operational analysis Profitability Liquidity

Gross margin Return on equity Current ratio

Operating margin Earnings per share Acid test ratio

Profit margin

Resource management Disposition of earnings Financial leverage

Inventory turnover Dividend per share Debt to assets

Debtors collection period Earnings retention Debt to equity

Creditors payment period

Turnover to net assets

Profitability Market indicators Debt service

Return on assets Price/Earnings ratio Interest coverage

Return on capital employed

Figure 5.1
3

We’ll now follow the sequence shown in Figure 1-1 and discuss each sub-grouping within the three broad
viewpoints. For the purposes of illustration we will use information from Figure 1-2 and Figure 1-3 adapted from
Helfert (2003:111) that represent the simplified Statement of Comprehensive Income and Statement of Financial
Position respectively of Reunion Limited. We will also follow his discussion of the ratios.

78 MANCOSA
 Accounting and Financial Management

Reunion Limited

Statements of Comprehensive Income for the year ended 31 December 20.9 and 20.8

20.9 20.8

Sales (all credit) 3 344 800 3 149 600

Cost of sales (all credit purchases) (1 757 400) (1 625 200)

Gross profit 1 587 400 1 524 400

Operating expenses: (975 800) (933 200)

Selling, general and administrative 792 600 742 400

Other expenses 183 200 190 800

Operating profit 611 600 591 200

Other income: 5 400 6 600

Interest income 5 400 6 600

Profit before interest 617 000 597 800

Interest expense (103 584) (121 216)

Profit before tax 513 416 476 584

Tax (154 026) (142 974)

Profit after tax 359 390 333 610

Figure 5.2
4

MANCOSA 79
Accounting and Financial Management

Reunion Limited

Statement of Financial Position for the year ended 31 December 20.9 and 20.8

Assets 20.9 20.8

Non-current assets 1 628 600 1 566 000

Current assets: 1 275 800 1 213 200

Inventories 462 400 406 000

Accounts receivable 578 200 555 600

Cash and cash equivalents 235 200 251 600

Total assets 2 904 400 2 779 200

20.9 20.8

Equity and liabilities

Equity 1 306 200 1 257 800

Ordinary share capital (1 200 000 shares) 1 200 000 1 200 000

Retained earnings 106 200 57 800

Non-current liabilities (16% p.a.) 647 400 757 600

Current liabilities 950 800 763 800

Accounts payable 216 200 201 600

Other current liabilities 734 600 562 200

Total Equity and liabilities 2 904 400 2 779 200

Figure 5.3

5.3 Ratio Analysis: Management’s Point Of View

Helfert (2003:109) maintains that management has a dual interest in the analysis of financial performance viz.:

 To evaluate the efficiency and profitability of operations.

 To assess how effective the resources of the enterprise are being used.

Evaluating the operations of an enterprise is largely done by an analysis of the Statement of Comprehensive
Income whilst the effectiveness of resources is usually measured by a review of both the Statement of
Comprehensive Income and Statement of Financial Position.

80 MANCOSA
 Accounting and Financial Management

5.3.1 Operational analysis

An evaluation of operational effectiveness may be performed by a percentage analysis of the Statement

of Comprehensive Income. The use of sales as a common base permits a ready comparison of key
costs and expenses from period to period, and against competitor and industry databases.

1 Gross margin

Gross margin (also called gross profit margin) is one of the most common ratios in operational
analysis. It reflects the mark-up or value added over cost. It shows operational effectiveness before
expenses are considered. It is calculated by expressing the gross profit as a percentage of sales:

Gross margin = Gross profit X 100

Sales 1

The gross margin ratio indicates the profit of the firm relative to sales after deducting the cost of sales.
Apart from measuring the efficiency of the enterprise’s operations, it also indicates how products are
priced. In the case of Reunion Limited gross margin is as follows:

20.9 20.8

Gross margin = Gross profit X 100 Gross margin = Gross profit X 100

Sales 1 Sales 1

= R1 587 400 X 100 = R1 524 400 X 100

R3 344 800 1 R3 149 600 1

= 47.46% = 48.40%

MANCOSA 81
Accounting and Financial Management

A gross margin decline of 0.94% occurred from the previous year. A lower gross margin may be the
result of a number of factors:

■ The company may have consciously reduced margins in order to increase sales.

■ Margins may have been reduced to maintain sales levels in the face of increased competition.

■ Price increases may have increased sales but the company may not have been able to pass all the
inflationary increases in the cost of sales to customers.

■ The sales mix may have been unfavourable i.e. a greater number of lower profit-bearing products
were sold.

Think Point 5.1

One should assume that a fall in gross margin means that a company is becoming
less profitable and an increase in gross margin means that a company is becoming
more profitable. “Do you agree? Explain.

2 Operating margin

This ratio shows the operational effectiveness of a company before the cost of financing (interest
expense), other miscellaneous income (e.g. interest income) and income tax.

Operating margin is calculated by expressing the operating profit as a percentage of sales:

Operating margin = Operating profit X 100

Sales 1

The operating margin of Reunion Limited is as follows:

20.9 20.8

Operating margin Operating margin

= Operating profit X 100 = Operating profit X 100

Sales 1 Sales 1

= R611 600 X 100 = R591 200 X 100

R3 344 800 1 R3 149 600 1

= 18.29% = 18.77%

82 MANCOSA
 Accounting and Financial Management

A small decline of 0.48% from 20.8 is observed. Operating expenses thus increased at a higher rate
than the increase in sales.

3 Profit margin

This ratio pertains to the relationship of Profit after taxes to sales and is indicative of management’s
ability to operate the enterprise profitably. This is the margin on sales that is potentially available for
distribution to shareholders. To be successful an enterprise must not only recover the cost of the
merchandise, the operating expenses, and the cost of borrowed funds but also there must also be
reasonable compensation to the owners for putting their capital at risk. The profit margin ratio is
important to operating managers since it reflects an enterprise’s pricing strategy and its ability to
control operating costs.

Profit margin is calculated by expressing the Profit after taxes as a percentage of sales:

Profit margin = Profit after tax X 100

Sales 1

The profit margin of Reunion Limited is as follows:

20.9 20.8

Profit margin Profit margin

= Profit after tax X 100 = Profit after tax X 100

Sales 1 Sales 1

= R359 390 X 100 = R333 610 X 100

R3 344 800 1 R3 149 600 1

= 10.74% = 10.59%

The ratio shows that the earnings available to shareholders were 10.74% of sales. A small
improvement of 0.15% from 20.8 is also noted. Net profit margin is significantly lower than the gross
margin and is probably due to the high operating expenses.

MANCOSA 83
Accounting and Financial Management

5.3.2 Resource management

Resource management concerns the effectiveness with which management has employed the assets
entrusted to it by the owners of the enterprise. We will focus on the rate at which inventory is sold, the
time taken by debtors to pay accounts, the time taken to settle creditors accounts and turnover to net
assets.

1 Inventory turnover

In evaluating the effectiveness of an enterprise’s inventory management, it is common to use the

number of times inventory has turned over during the period of analysis. The higher the turnover rate
the better, since low inventories usually suggest a minimal risk of non-saleable merchandise and also
indicates efficient use of capital. Inventory turnover is calculated as follows:

Inventory turnover = Cost of sales

Average inventory

Average inventories refer to the average of the beginning and ending inventories. The inventory
turnover of Reunion Limited is calculated as follows (Note: Inventories for 20.7 amounted to R449
360.):

20.9 20.8

Inventory turnover Inventory turnover

= Cost of sales = Cost of sales

Average inventory Average inventory

= R1 757 400 = R1 625 200

R434 200 R427 680

= 4.05 times = 3.80 times

84 MANCOSA
 Accounting and Financial Management

Note: Average inventory is calculated as follows:

20.9 20.8

= R462 400 + R406 000 = R406 000 + R449 360

2 2

= R434 200 = R427 680

The inventory turnover of Reunion Limited shows an increase from 3.80 times to 4.05 times per annum,
indicating an improvement in efficiency. The analyst must check that the improvement is not a result of
dumping inventory on dealers etc. The inventory turnover of 4.05 times for 20.9 implies that
merchandise remains in inventory for an average of 90 days (365 days ÷ 4.05 times) before being sold.

Think Point 5.2 7

What do you think are the implications for an enterprise if:

 Inventory turnover is low?

 Inventory turnover is high?

2 Debtor collection period

This ratio is useful in assessing the effectiveness of the credit administration of a company. It ratio tells us how
long, on average, trade debtors meet their obligations to pay following the sale on credit. It highlight’s the
enterprise’s management of debtors (or accounts receivable). One would want to know whether the accounts
receivable that are outstanding at the end of the period closely approximate the amount of credit sales one would
expect to remain outstanding under prevailing credit terms. This is done as follows:

Debtor collection period = Accounts receivable X 365

Credit sales

MANCOSA 85
Accounting and Financial Management

20.9 20.8

Debtor collection period Debtor collection period

= Accounts receivable X 365 = Accounts receivable X 365

Credit sales Credit sales

= R578 200 X 365 = R555 600 X 365

R3 344 800 R3 149 600

= 63.10 days = 64.39 days

The debtor collection period may be interpreted in two ways. One can say that Reunion Limited has an average
of 63.10 days’ worth of credit sales tied up in accounts receivable, or one can say that the average time lag between
sale and receipt of cash from the sale is 63.10 days. This collection period allows us to compare it with the terms
of sale. Thus if Reunion Limited sells on 30 day terms, the collection period is very unsatisfactory. It could mean
that some customers had difficulty paying, or were abusing their credit privileges, or that some sales were made
on extended terms.

An increasing ratio indicates that a company is experiencing difficulties in collecting debts. This may be an early
warning sign of large bad debts.

3 Creditor payment period

This ratio tells us how long, on average, an enterprise takes to pay for goods bought following the purchase on
credit. It is used to evaluate an enterprise’s performance with regard to the management of accounts payable
(creditors). The number of days of accounts payable (or creditor payment period) is compared to the credit terms
under which the enterprise makes purchases. Significant deviations from this norm can be detected. Optimal
management of accounts payable requires making payment within the stated terms and no earlier except taking
advantage of discounts whenever offered for early payment. The ratio could thus indicate whether the company
is taking more time than usual to pay or if it is having difficulty in paying. It will also indicate whether the company
is taking full advantage of credit facilities given to it.

Creditor payment period may be calculated as follows:

86 MANCOSA
 Accounting and Financial Management

Creditor payment period = Accounts payable X 365

Credit purchases

20.9 20.8

Creditor payment period Creditor payment period

= Accounts payable X 365 = Accounts payable X 365

Credit purchases Credit purchases

= R216 200 X 365 = R201 600 X 365

R1 813 800 R1 581 840

= 43.51 days = 46.52 days

Note: Credit purchases are calculated as follows:

20.9 20.8

Cost of sales 1 757 400 1 625 200

Add: Closing inventory 462 400 406 000

2 219 800 2 031 200

Less opening inventory (406 000) (449 360)

Purchases (all credit) 1 813 800 1 581 840

The company is paying its creditors faster than it is receiving money from its debtors. This is not a
sound credit policy.

4 Turnover to net assets

This ratio is a measure of the sales rands generated by each rand of net assets. Conversely it
indicates the size of the net asset commitment required to support a particular level of sales. Using
net assets eliminates current liabilities from the total assets. The assumption is that current liabilities
are available to the company as a matter of course. Thus the amount of assets employed in the
business is effectively reduced through these ongoing operational credit relationships. Turnover to
net assets is calculated simply as follows :

MANCOSA 87
Accounting and Financial Management

Turnover to net assets = Sales

Net assets

Turnover to net assets of Reunion Limited is calculated as follows:

20.9 20.8

Turnover to net assets Turnover to net assets

Sales Sales

Net assets Net assets

= R3 344 800 = R3 149 600

R2 904 400 – R950 800 R2 779 200 – R763 800

= R3 344 800 = R3 149 600

R1 953 600 R2 015 400

= 1.71:1 = 1.56:1

The sales generated by each rand of net assets have increased from R1.56 to R1.71. This also
indicates that the net assets required to support a level of sales have decreased. The reasons for the
improvement must be investigated.

5.3.3 Profitability
Here we examine how effectively management has employed the total assets and capital as recorded
in the Statement of Financial Position. This is evaluated by relating net profit, defined in a variety of
ways, to resources used to generate the profit. A satisfactory return is one that:

■ Exceeds the inflation rate.

■ Is higher than alternative investments e.g. fixed deposits.
■ Is higher than the cost of borrowing funds.

1 Return on assets (Operating profit on total assets)

Return on assets (ROA) measures the efficiency with which an enterprise allocates and manages
its resources i.e. whether the assets of the company are adequately and effectively used. A
company that does not have a good return on total assets cannot generate a good return on
equity. ROA is calculated as follows:

88 MANCOSA
 Accounting and Financial Management

Return = Operating X 100

on profit
assets

Total 1
assets

Return on assets of Reunion Limited is calculated as follows:

20.9 20.8

Return on assets Return on assets

= Operating profit X 100 = Operating profit X 100

Total assets 1 Total assets 1

= R611 600 X 100 = R591 200 X 100

R2 904 400 1 R2 779 200 1

= 21.06% = 21.27%

Reunion Limited experienced a slight decline in profitability. It needs to compare this return to other
similar companies, the inflation rate, return on alternative investments, and interest rate on borrowed
capital to determine whether it is satisfied with the return.

2 Return on capital employed

This ratio enables the analyst to determine whether the return earned is in excess of what could be
earned elsewhere. The return must, at the least, be greater than the prevailing rates of interest and
the weighted average cost of borrowings. This ratio is an important comparison to the cost of the
company’s capital. The calculation is as follows:

Return on capital employed = Operating profit X 100

Capital employed 1

MANCOSA 89
Accounting and Financial Management

Capital employed consists of Equity and non-current liabilities. Return on capital employed for
Reunion Limited is as follows:

20.9

Return on capital employed

= Operating profit X 100

Capital employed 1

= R611 600 X 100

R1 953 1
600

= 31.31%

20.8

Return on capital employed

= Operating profit X 100

Capital employed 1

= R591 200 X 100

R2 015 400 1

= 29.33%

The return on capital employed has improved. Since the return (31.31%) is greater than the
prevailing rate of interest (16%), the return is considered to be satisfactory.

5.4 Ratio Analysis: Owners’ Point Of View

Owners are mainly interested in the profitability of the company. In this context profitability refers to the returns
earned through the efforts of management on the funds invested by the owners. The owners would also be
interested on the disposition of earnings i.e. how much is paid out to them versus how much is reinvested in the
company. Lastly, they are concerned about the effect of the business results on the market value of their shares.

5.4.1Profitability

Financial analysts keep a close watch on the relationship between the profits earned to the shareholders’ stated
investment. Several key measures that express the company’s performance in relation to the owners’ stake may

90 MANCOSA
 Accounting and Financial Management

be used. The return on equity measures the profitability of the total ownership investment while the earnings per
share measures the proportional participation of each unit of investment in corporate earnings for the period.

1 Return on equity (ROE)

Return on equity measures the rate of return on shareholders’ investment. It enables one to check whether the
return made on an investment is better than alternatives available. It is calculated by expressing (as a
percentage) the Profit after tax on the average owners’ (shareholders’) equity:

Return on equity = Profit after tax X 100

Equity 1

Return on equity for Reunion Limited is calculated as follows:

20.9

Return on equity

= Profit after tax X 100

Equity 1

= R359 390 X 100

R1 306 200 1

= 27.51%

20.8

Return on equity

= Profit after tax X 100

Equity 1

= R333 610 X 100

R1 257 800 1

= 26.52%

MANCOSA 91
Accounting and Financial Management

The return on equity has improved slightly. If alternative investments carrying a similar risk yield a return in
excess of this (27.51%), this would indicate that the company’s profitability is low. However, it is unlikely to be
the case here.

A good return on equity fuels investment interest from prospective investors. It increases share prices and makes
it easier for the company to borrow money.

2 Earnings per share (EPS)

Earnings per share is often considered to be an indicator of profitability. It is a measure that both management
and shareholders pay a great deal of attention to. It is widely used to value ordinary shares and is often the basis
for setting specific corporate objectives and goals as part of strategic planning. The ratio simply involves dividing
Profit after tax by the number of ordinary shares in issue:

Earnings per share = Profit after tax

Number of ordinary shares issued

Earnings per share for Reunion Limited is calculated as follows:

20.9 20.8

Earnings per share Earnings per share

= Profit after tax Profit after tax

Number of ordinary shares issued Number of ordinary shares issued

= R359 390 X 100 = R333 610 X 100

1 200 000 1 200 000

= 29.95 cents = 27.80 cents

The earnings per share has increased by 2.15 cents per share.

92 MANCOSA
 Accounting and Financial Management

5.4.2 Disposition of earnings

The periodic separation of the Profit after tax (earnings) into dividends paid and earnings retained is closely
monitored by shareholders and the financial community because the retained residual builds up the Equity and
is a source of funds for management’s use. Earnings may thus be either reinvested in the company to fund
further growth or paid out in part or full as dividends.

 Dividend per share (DPS)

Dividends are usually declared on a per share basis by the company’s board of directors. The board of directors
usually has a dividend policy in place. Because the value of ordinary shares is partly influenced by dividends
paid and anticipated, the board has to deal with this periodic decision very carefully. DPS is calculated by dividing
the dividends for the year by the number of ordinary shares issued:

Dividend per share = Dividends for the year

Number of ordinary shares issued

If the dividends of Reunion Limited for 20.9 and 20.8 were R220 000 and

R200 000 respectively, then the dividend per share is calculated as follows:

20.9 20.8

Dividend per share Dividend per share

= Dividends for the year Dividends for the year

Number of ordinary shares issued Number of ordinary shares issued

= R220 000 X 100 = R200 000 X 100

1 200 000 1 200 000

= 18.33 cents = 16.67 cents

The dividend per share has risen by 1.66 cents per share, most likely due to the increase in earnings per share.

MANCOSA 93
Accounting and Financial Management

 Earnings retention

This ratio gives an indication of the amount of profit put back into the company and is a useful ratio when
determining the long-term prospects of a company. The alternative to doing this ratio is to calculate the dividend
payout ratio which is calculated by dividing the dividend per share by the earnings per share. Since most
companies have a policy of paying dividends that are a relatively constant proportion of earnings (e.g. 30 to 40%),
these ratios permit shareholders to project dividends from an assessment of the firm’s earnings prospects.
Earnings retention ratio is calculated as follows:

Earnings retention ratio = Earnings per share – Dividend per share X 100

Earnings per share

OR

Earnings retention ratio = Retained earnings for the year X 100

Profit due to ordinary shareholders

(Retained earnings = Profit due to ordinary shareholders [Profit after tax] – Ordinary dividend for the year)

The earnings retention ratio for Reunion Limited is calculated as follows:

20.9

Earnings retention ratio

= Earnings per share – Dividend per X 100

share

Earnings per share 1

= 29.95 cents – X 100

18.33 cents

29.95 cents 1

= 11.62 cents X 100

29.95 cents 1

= 38.80%

94 MANCOSA
 Accounting and Financial Management

OR

20.9

Earnings retention ratio

= Retained earnings for the year X 100

Profit due to ordinary shareholders 1

= R359 390 – R220 000 X 100

R359 390 1

= R139 390 X 100

R359 390 1

= 38.79%

20.8

Earnings retention ratio

= Earnings per share – Dividend per share X 100

Earnings per share 1

= 27.80 cents – 16.67 cents X 100

27.80 cents 1

= 11.13 cents X 100

27.80 cents 1

= 40.04%

OR

MANCOSA 95
Accounting and Financial Management

20.8

Earnings retention ratio

= Retained earnings for the year X 100

Profit due to ordinary shareholders 1

= R333 610 – R200 000 X 100

R333 610 1

= R133 610 X 100

R333 610 1

= 40.05%

It appears that the company retains about 40% of the profit. This implies that the dividend payout ratio is about
60% which is a fairly high payout and this can cause problems with liquidity in difficult years. Also, adequate funds
may not be available for expansion when the need arises.

5.4.3 Market indicators

Here we will discuss one of the common indicators of stock market values viz. price/earnings ratio.

 Price/Earnings (P/E) ratio

According to Marshall et al (2011: 421) this ratio is one of the most important measures used by investors and
managers to evaluate the market price of a company’s ordinary shares. It is also used to indicate how the stock
market is judging the company’s earnings performance and prospects. This is one reason why the EPS is reported
prominently on the face of the Statement of Comprehensive Income. Earnings multiple is another term for
price/earnings ratio. This term merely reflects the fact that the market price of a share is equal to the EPS multiplied
by the P/E ratio. Price/earnings ratio is calculated as follows:

Price/Earnings ratio = Market price per share

Earnings per share

96 MANCOSA
 Accounting and Financial Management

The Price/Earnings ratio for Reunion Limited (market price per share for 20.9 and 20.8 was 130 cents and
120 cents respectively) is calculated as follows:

20.9 20.8

Price/Earnings Price/Earnings
ratio ratio

= Market price per = Market price per

share share

Earnings per Earnings per

share share

= 130 cents = 120 cents

29.95 27.80
cents cents

= 4.34 times = 4.32 times

The ratio shows that investors are willing to pay approximately 4.34 times earnings for the shares. This ratio needs
to be compared to the average P/E ratio of similar companies. An above-average P/E ratio indicates that the
market price is high relative to the company’s current earnings, possibly because investors anticipate favourable
future developments such as increased EPS or higher DPS. Low P/E ratios usually indicate poor earnings
expectations.

5.5-Ratio Analysis: Lenders’ and Creditors’ Point Of View

Lenders and creditors are interested in funding the needs of a successful enterprise that will perform according to
expectations. However, they have to also consider the negative consequences of default and liquidation. Lenders
and creditors have to carefully assess the risk involved in recovering the funds extended. They therefore have to
look for a margin of safety in the assets held by the enterprise. Several ratios are used to evaluate this protection
by testing the liquidity of the enterprise. Another set of ratios tests the leverage of the enterprise in order to weigh
the position of lenders versus owners. Lastly, there are coverage ratios that relate to the enterprise’s ability to
provide debt service from the funds generated by operations.

MANCOSA 97
Accounting and Financial Management

5.5.1 Liquidity

Liquidity ratios measure the ability of an enterprise to meet its short-term obligations. They focus on the liquid
assets of the enterprise i.e. current assets that can readily be converted into cash on the assumption that they
form a cushion against default. The most commonly used liquidity ratios are the current ratio and acid test ratio.

 Current ratio

The current ratio shows the relationship between current assets and current liabilities and is an attempt to show
the safety of current debt holders’ claims in the case of default. Current ratio is calculated as follows:

Current ratio = Current assets

Current liabilities

The current ratio for Reunion Limited is as follows:

20.9 20.8

Current ratio Current ratio

= Current assets = Current assets

Current liabilities Current liabilities

= R1 275 800 = R1 213 200

R950 800 R763 800

= 1.34:1 = 1.59:1

A decline in the ratio (from 1.59:1 to 1.34:1) is largely due to the increase in current liabilities from the previous
year. An enterprise with a low current ratio may not be able to convert its current assets into cash to meet
maturing obligations. From a debt holder’s point of view, a higher ratio appears to provide a cushion against
losses in the event of business failure. A large excess of current assets over current liabilities seems to protect
claims. However, from a management point of view a very high current ratio may point towards slack
management practices. It may indicate idle cash, high inventory levels that may be unnecessary and poor credit
management resulting in overextended accounts receivable. The norm of 2:1 may also be used.

98 MANCOSA
 Accounting and Financial Management

 Acid test ratio

This ratio is a more stringent test of liquidity. The intention of the acid test ratio is to test the collectability of
current liabilities under distress conditions, on the assumption that inventories would have no value at all. In the
case of a real crisis creditors may realise little cash from the sale of inventory. The acid test ratio is similar to the
current ratio except that the current assets (numerator) are reduced by the value of the inventory. The calculation
is done as follows:

Acid test ratio = Current assets – Inventory

Current liabilities

Reunion Limited acid test ratio is as follows:

20.9 20.8

Acid test ratio Acid test ratio

= Current assets – Inventory = Current assets – Inventories

Current liabilities Current liabilities

= R1 275 800 – R462 400 = R1 213 200 – R406 000

R950 800 R763 800

= R813 400 = R807 200

R950 800 R763 800

= 0.86:1 = 1.06:1

It is clear that a ratio of less than 1:1 would pose liquidity problems in the event of a crisis. Reunion Limited faces
this position at the end of 20.9 as the ratio indicates there only R0.86 of liquid assets is available to settle every
R1 of current liabilities.

5.5.2 Financial leverage

An enterprise increases its financial leverage when it raises the proportion of debt relative to equity to finance the
business. The successful use of debt enhances the earnings for the owners of the enterprises since returns on
these funds, over and above the interest paid, belongs to the owners, and therefore increases the return on Equity.
However, from the point of view of the lender, when earnings are insufficient to cover the interest cost, fixed interest
and principal commitments must still be met. The positive and negative effects of leverage increase with the
proportion of debt in the enterprise. The most common measures of leverage compare the book value of an
enterprise’s liabilities to the book value of its assets or equity.

MANCOSA 99
Accounting and Financial Management

 Debt to assets

Debt to assets is used to reflect the proportion of debt to the total claims against the assets of the enterprise. The
greater the ratio, the higher the risk. Debt to asset ratio is expressed as follows:

Debt to assets = Total debt (Non-current and current debt) X 100

Total assets 1

The Debt to assets ratio of Reunion Limited is as follows:

20.9 20.8

Debt to assets Debt to assets

= Total debt X 100 = Total debt X 100

Total assets 1 Total assets 1

= R1 598 200 X 100 = R1 521 400 X 100

R2 904 400 1 R2 779 200 1

= 55.03% = 54.74%

The ratio indicates that 55.03% of Reunion Limited assets, in book value terms, come from creditors of one type
or another. Creditors normally prefer low debt ratios since the lower the ratio the greater the cushion against
creditors’ losses in the event of liquidation, a fall in demand, and low profits. Owners on the other hand, may seek
high gearing since it magnifies earnings and the sale of new shares means giving up some degree of control.

 Debt to equity

This ratio attempts to show the relative proportions of non-current claims to ownership claims, and is used as a
measure of debt exposure. Debt to equity ratio is expressed as follows:

Debt to equity = Non-current debt X 100

Equity 1

100 MANCOSA
 Accounting and Financial Management

The Debt to equity ratio of Reunion Limited is as follows:

20.9 20.8

Debt to equity Debt to equity

= Non-current debt X 100 = Non-current debt X 100

Equity 1 Equity 1

= R647 400 X 100 = R757 600 X 100

R1 306 200 1 R1 257 800 1

= 49.56% = 60.23%

The ratio indicates that the non-current creditors supply Reunion Limited with 49.65 cents for every Rand supplied
by the owners. The ratios over the two year period show a decrease in the use of non-current debt by the
company. This ratio is important because many lending agreements of companies contain covenants regarding
debt exposure expressed in terms of long-term debt to capitalisation proportions.

5.5.3 Debt service

The above ratios still don’t reveal a lot about the creditworthiness of the enterprise, which involves the ability of
the enterprise to meet its interest and principal on schedule as contractually agreed upon. Our focus will be on
interest coverage.

 Interest coverage

This ratio is based on the premise that annual operating earnings are the basic source for debt service, and that
any major change in this relationship may signal difficulties. Debt holders often stipulate the number of times the
business is expected to cover its debt service obligations. This ratio is of prime importance to a creditor. It
measures whether a company has sufficient profits to meet the interest payments on its debts. The ratio for
interest coverage is as follows:

Interest coverage = Operating profit

Interest expense

MANCOSA 101
Accounting and Financial Management

Reunion Limited interest coverage ratio is as follows:

20.9 20.8

Interest coverage Interest coverage

= Operating profit = Operating profit

Interest expense Interest expense

= R611 600 = R591 200

R103 584 R121 216

= 5.90 times = 4.88 times

Reunion Limited interest coverage of 5.90 times means that the enterprise earned its interest obligations 5.90
times over in 20.9; profit before interest and tax was 5.90 times as large as interest. The company can therefore
meet its interest obligations.

5.6 Summary of the Ratios

Management

5.6.1 Operational analysis

Gross margin = Gross profit X 100

Sales 1

Operating margin = Operating profit X 100

Sales 1

Profit margin = Profit after tax X 100

Sales 1

102 MANCOSA
 Accounting and Financial Management

5.6.2 Resource management

Inventory turnover = Cost of sales

Average inventory

Debtor collection period = Accounts receivable X 365

Credit sales

Creditor payment period = Accounts payable X 365

Credit purchases

Turnover to net assets = Sales

Net assets

5.6.3 Profitability

Return on assets = Operating profit X 100

Total assets 1

Return on capital employed = Operating profit X 100

Capital employed 1

Owners

5.6.4 Profitability

Return on equity = Profit after tax X 100

Equity 1

Earnings per share = Profit after tax

Number of ordinary shares issued

MANCOSA 103
Accounting and Financial Management

5.6.5 Disposition of earnings

Dividend per share = Dividends for the year

Number of ordinary shares issued

Earnings retention ratio = Earnings per share – Dividend per share X 100

Earnings per share

OR

Earnings retention ratio = Retained earnings for the year X 100

Profit due to ordinary shareholders

5.6.6 Market indicators

Price earnings ratio = Market price per share

Earnings per share

Lenders And Creditors

5.6.7 Liquidity

Current ratio = Current assets

Current liabilities

Acid test ratio = Current assets – Inventory

Current liabilities

5.6.8 Financial leverage

Debt to assets = Total debt (Non-current and current debt) X 100

Total assets 1

Debt to equity = Non-current debt X 100

Equity 1

104 MANCOSA
 Accounting and Financial Management

5.6.9 Debt service

Interest coverage = Operating profit

Interest expense

5.7 Self-Assessment Activities

The following information relates to Simba Limited:
Statement of Comprehensive Income for the year ended 31 December 20.9 and 20.8
20.9 20.8
Sales (all credit) 35 000 000 30 000 000
Cost of sales (all credit) (23 000 000) (20 000 000)

Gross profit 12 000 000 10 000 000

Operating expenses: (5 100 000) (4 000 000)

Distribution costs 2 000 000 1 500 000

Administrative expenses 3 100 000 2 500 000

Operating profit 6 900 000 6 000 000

Finance costs (400 000) (500 000)

Profit before tax 6 500 000 5 500 000

Income tax (1 500 000) (1 500 000)

Profit after tax 5 000 000 4 000 000

Statement of Financial Position as at 31 December 20.9 and 20.8

Assets 20.9 20.8

Non-current assets 20 000 000 18 000 000

Property, plant and equipment 20 000 000 18 000 000

Current assets: 12 000 000 12 000 000

Inventories 6 000 000 6 000 000

Accounts receivable 5 000 000 4 000 000

Cash and cash equivalents 1 000 000 2 000 000

Total assets 32 000 000 30 000 000

MANCOSA 105
Accounting and Financial Management

Equity and liabilities

Equity 20 000 000 18 000 000

Ordinary share capital 10 000 000 10 000 000

Retained earnings 10 000 000 8 000 000

Non-current liabilities 4 000 000 6 000 000

Current liabilities 8 000 000 6 000 000

Accounts payable 8 000 000 6 000 000

Total Equity and liabilities 32 000 000 30 000 000

Statement of changes in equity for the year ended 31 December 20.9 and 20.8

20.9 20.8

Balance at end of previous year 18 000 000 16 500 000

Profit for the year 5 000 000 4 000 000

Ordinary share dividends (3 000 000) (2 500 000)

Balance at end of current year 20 000 000 18 000 000

Additional information

■ Simba Limited’s issued share capital consists of 10 000 000 ordinary shares.

■ The market price of the shares was R5.60 on 31 December 20.08 and R7.50 on

31 December 20.9.

Required

Calculate the following ratios for Simba Limited for 20.8 and 20.9 and comment on your answers:

1. Gross margin

2. Operating margin

3. Profit margin

4. Inventory turnover (N.B. Inventories on 31 December 20.7 amounted to R6 000 000)

5. Debtors collection period

6. Creditors payment period

106 MANCOSA
 Accounting and Financial Management

7. Turnover to net assets

8. Return on assets

9. Return on capital employed

10. Return on equity

11. Earnings per share

12. Dividend per share

13. Earnings retention

14. Price/Earnings ratio

15. Current ratio

16. Acid test ratio

17. Debt to assets

18. Debt to equity

19. Interest coverage

5.8 Suggested Solutions

Think Point 5.3

No, one cannot assume this all the time. A fall in gross margin could be the result
of a deliberate decision to increase sales. Likewise an increase in gross margin
may be due to a price increase that may actually show a fall in sales. One should
therefore determine the reasons behind the variation in the gross margin to arrive
at a conclusion on the performance of the company.

MANCOSA 107
Accounting and Financial Management

Think Point 5.4

A low inventory turnover may mean that:

■Demand for merchandise available on sale is low.

■Items of inventory may be obsolete.

■There is too much inventory.

A high inventory turnover may mean that:

■There is a potential for inventory shortages and the resultant poor customer
service.

■Too little inventory is being carried in relation to the volume of sales.

■There is a lower dependency on capital to carry inventory.

5.7

1.

20.9 20.8

Gross margin = Gross profit X 100 Gross margin = Gross profit X 100

Sales 1 Sales 1

= R12 000 000 X 100 = R10 000 000 X 100

R35 000 000 1 R30 000 000 1

= 34.29% = 33.33%

The gross margin has improved slightly. The improvement could be due to an increase in selling
price and/or reduced cost of purchases.

108 MANCOSA
 Accounting and Financial Management

2.

20.9 20.8

Operating margin Operating margin

= Operating profit X 100 = Operating profit X 100

Sales 1 Sales 1

= R6 900 000 X 100 = R6 000 000 X 100

R35 000 000 1 R30 000 000 1

= 19.71% = 20%

Operating margin has decreased slightly. This may be due to operating expenses increasing by a
larger proportion than sales.

3.

20.9 20.8

Profit margin Profit margin

= Profit after tax X 100 = Profit after tax X 100

Sales 1 Sales 1

= R5 000 000 X 100 = R4 000 000 X 100

R35 000 000 1 R30 000 000 1

= 14.29% = 13.33%

Profit margin has improved despite the fact that operating expenses increased by a larger proportion than
sales. The increase is attributable to the decrease in finance costs (a result of loan repayment).

MANCOSA 109
Accounting and Financial Management

4.

20.9 20.8

Inventory turnover Inventory turnover

= Cost of sales = Cost of sales

Average inventory Average inventory

= R23 000 000 = R20 000 000

R6 000 000 R6 000 000

= 3.83 times = 3.33 times

Inventory levels have remained constant while sales have increased, resulting in a higher inventory turnover for
20.9.

5.

20.9 20.8

Debtor collection period Debtor collection period

= Accounts receivable X 365 = Accounts receivable X 365

Credit sales Credit sales

= R5 000 000 X 365 = R4 000 000 X 365

R35 000 000 R30 000 000

= 52.14 days = 48.67 days

It is taking the company a few days longer than the previous year to collect money from debtors. If the credit
terms are 30 days, then debtors are taking too long to pay and steps need to be taken to improve the collection
period.

110 MANCOSA
 Accounting and Financial Management

6.

20.9 20.8

Creditor payment period Creditor payment period

= Accounts payable X 365 = Accounts payable X 365

Credit purchases Credit purchases

= R8 000 000 X 365 = R6 000 000 X 365

R23 000 000 R20 000 000

= 126.96 days = 109.50 days

Note: Total purchases equal cost of sales since opening and closing inventories have not changed.
All purchases are on credit.

Creditors have increased by a larger proportion than credit purchases.

The company is taking longer to pay its creditors than the previous year
and is almost certainly exceeding the credit terms allowed by creditors
(usually between 30 and 90 days).

7.

20.9 20.8

Turnover to net assets Turnover to net assets

Sales Sales

Net assets Net assets

= R35 000 000 = R30 000 000

R32 000 000 – R8 000 R30 000 000 – R6 000

000 000

= R35 000 000 = R30 000 000

R24 000 000 R24 000 000

= 1.46:1 = 1.25:1

MANCOSA 111
Accounting and Financial Management

The sales generated by each rand of net assets have increased from
R1.25 to R1.46. There has been an improvement in the utilisation of
assets.

8.

20.9 20.8

Return on assets Return on assets

= Operating profit X 100 = Operating profit X 100

Total assets 1 Total assets 1

= R6 900 000 X 100 = R6 000 000 X 100

R32 000 000 1 R30 000 000 1

= 21.56% = 20%

Reunion Limited experienced a slight improvement in profitability. It needs to compare this return to other
similar companies, the inflation rate, return on alternative investments, and interest rate on borrowed capital to
determine whether it is satisfied with the return.

9.

20.9

Return on capital employed

= Operating profit X 100

Capital employed 1

= R6 900 000 X 100

R24 000 000 1

= 28.75%

112 MANCOSA
 Accounting and Financial Management

20.8

Return on capital employed

= Operating profit X 100

Capital employed 1

= R6 000 000 X 100

R24 000 000 1

= 25%

The return on capital employed has improved. The return appears to be greater than the prevailing rate of
interest and it is therefore considered to be satisfactory.

10.

20.9

Return on equity

= Profit after tax X 100

Equity 1

= R5 000 000 X 100

20 000 000 1

= 25%

MANCOSA 113
Accounting and Financial Management

20.8

Return on equity

= Profit after tax X 100

Equity 1

= R4 000 000 X 100

R18 000 000 1

= 22.22%

Profitability for shareholders has increased since profits have increased more than the increase in Equity.
When compared to alternative investment opportunities, shareholders should be fairly satisfied with this return.

11.

20.9 20.8

Earnings per share Earnings per share

= Profit after tax Profit after tax

Number of ordinary shares issued Number of ordinary shares issued

= R5 000 000 X 100 = R4 000 000 X 100

10 000 000 10 000 000

= 50 cents = 40 cents

The improvement in the profitability of the company is evident in the EPS which has increased by 10
cents per share.

114 MANCOSA
 Accounting and Financial Management

12.

20.9 20.8

Dividend per share Dividend per share

= Dividends for the year Dividends for the year

Number of ordinary shares issued Number of ordinary shares issued

= R3 000 000 X 100 = R2 500 000 X 100

10 000 000 10 000 000

= 30 cents = 25 cents

DPS has increased by 5 cents per share. The increase in the EPS allowed the company to declare
higher dividends during 20.9.

13.

20.9

Earnings retention ratio

= Earnings per share – Dividend X 100

per share

Earnings per share 1

= 50 cents – 30 X 100
cents

50 cents 1

= 20 cents

50 cents

= 40%

OR

MANCOSA 115
Accounting and Financial Management

20.9

Earnings retention ratio

= Retained earnings for the year X 100

Profit due to ordinary shareholders 1

= R5 000 000 – R3 000 000 X 100

R5 000 000 1

= R2 000 000 X 100

R5 000 000 1

= 40%

20.8

Earnings retention ratio

= Earnings per share – Dividend per share X 100

Earnings per share 1

= 40 cents – 25 cents X 100

40 cents 1

= 15 cents

40 cents

= 37.50%

OR

116 MANCOSA
 Accounting and Financial Management

20.8

Earnings retention ratio

= Retained earnings for the year X 100

Profit due to ordinary shareholders 1

= R4 000 000 – R2 500 000 X 100

R4 000 000 1

= R1 500 000 X 100

R4 000 000 1

= 37.50%

It appears that the company retains about 40% of the profit. This implies that the dividend payout ratio is about
60% which is a fairly high. The earnings retention has increased from 37.5% to 40%. Although dividend
increased by 5 cents per share, the earning retention increase was due to increased Profit after tax.

14.

20.9 20.8

Price earnings ratio Price

earnings
ratio

= Market price per = Market

share price per
share

Earnings per Earnings

share per share

= 750 = 560
cents cents

50 40
cents cents

= 15 times = 14 times

MANCOSA 117
Accounting and Financial Management

The market price of the shares has increased by an even greater proportion than the earnings per
share suggesting investor optimism in the company.

15.

20.9 20.8

Current ratio Current ratio

= Current assets = Current assets

Current liabilities Current liabilities

= R12 000 000 = R12 000 000

R8 000 000 R6 000 000

= 1.50:1 = 2:1

Liquidity position has deteriorated due to the increase in current liabilities. Since only R1.50 is available
for every R1 short-term debt, the company may experience difficulty in paying its short term debts as it
is not easy to convert current assets such as inventories into cash at short notice.

16.

20.9 20.8

Acid test ratio Acid test ratio

= Current assets – = Current assets –

Inventory Inventories

Current liabilities Current liabilities

= R12 000 000 – = R12 000 000 –

R6 000 000 R6 000 000

R8 000 000 R6 000 000

= R6 000 = R6 000
000 000

R8 000 R6 000
000 000

= 0.75:1 = 1:1

118 MANCOSA
 Accounting and Financial Management

Liquidity position has deteriorated. Without relying on the sale of inventories, the company would not be able to
pay its short-term debts (only R0.75 available for every R1 owed).

17.

20.9 20.8

Debt to assets Debt to assets

= Total debt X 100 = Total debt X 100

Total assets 1 Total assets 1

= R12 000 000 X 100 = R12 000 000 X 100

R32 000 000 1 R30 000 000 1

= 37.50% = 40%

The proportion of debt to assets has decreased. 37.50% of assets are financed by debt. From a
creditor’s point of view the risk in the company is lower.

18.
20.9 20.8

Debt to equity Debt to equity

= Non-current X 100 = Non- X 100

debt current
debt

Equity 1 Equity 1

= R4 000 X 100 = R6 000 X 100

000 000

R20 1 R18 1
000 000 000
000

= 20% = 33.33%

MANCOSA 119
Accounting and Financial Management

The financial risk in the company is lower. This is due to

the decrease in non-current debt as well as an increase in
Equity. The low ratio leaves the door open to take
additional loans should the need arise.

19.

20.9 20.8

Interest coverage Interest coverage

= Operating profit = Operating profit

Interest expense Interest expense

= R6 900 = R6 000
000 000

R400 R500
000 000

= 17.25 times = 12 times

Interest coverage has increased which reduces the risk for lenders. The improvement is due the reduced
borrowings, reduced interest expense and higher operating profit.

120 MANCOSA
 Accounting and Financial Management

Unit
6:
Financial Forecasting

MANCOSA 121
Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Explain why financial forecasting is  Complete relevant readings, think points and activities
important. provided.

 Interpret information contained in the pro

forma statements of a firm.

 Prepare a pro forma Statement of

Comprehensive Income, cash budget and
pro forma Statement of Financial Position.

 Prepare a pro forma Statement of Financial

Position.

 Use the percentage of sales method for

forecasting.

6.1 Introduction
6.2 Pro Forma Statements
6.3 Pro Forma Statement of Comprehensive Income
6.4 Cash Budget
6.5 Pro Forma Statement of Financial Position
6.6 Percentage-of-Sales Method

122 MANCOSA
 Accounting and Financial Management

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook

 Marx, J., de Swardt, C., (2014) Financial Management in Southern Africa.

4th Edition. Cape Town: Pearson Education:

Recommended Reading:
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.
 Gitman, L.J., Smith, M.B., Hall, J., Lowies, B., Marx, J, Strydom, B. and
van der Merwe, A. (2010) Principles of Managerial Finance. 1st Edition.
Cape Town: Pearson Education.
 Helfert, E.A. (2003) Techniques of Financial Analysis. 11th Edition. New
York: McGraw-Hill/Irwin.
 Higgins, R.C. (2007) Analysis for Financial Management. 8th Edition.
New York: McGraw-Hill/Irwin.

 Marshall, D.H., McManus, W.W. and Viele, D.F. (2011) Accounting: What
the numbers mean. 9th Edition. New York: McGraw-Hill.

MANCOSA 123
Accounting and Financial Management

6.1 Introduction
According to Gitman et al. (2010:103) financial forecasting is an important part of a firm’s operations because it
provides road maps for guiding, coordinating, and controlling the firm’s actions to achieve its objectives. The
important aspects of financial forecasting include the preparation of a pro forma Statement of Comprehensive
Income, cash budget, and a pro forma Statement of Financial Position.

6.2 Pro Forma Statements

Marx et al. (2009:97) state that pro forma statements allow management to anticipate events before they occur,
especially the need to raise funds externally. Growth may require additional sources of funding since profit is
often not enough to cover the net increase in current and non-current assets. The pro forma statements can also
be used to analyse liquidity, solvency and efficiency (see topic 5).

Block et al. (2009:95) add that projected statements enable the firm to estimate its future level of receivables,
inventory, payables, and other corporate accounts as well as its anticipated profits. The financial officer can then
track actual events against the plan in order to make the necessary adjustments. Furthermore, the statements are
usually required by banks and other lenders as a guide for the future.

Block et al. (2009:95) suggest a systems approach to develop pro forma statements. The starting point is the
pro forma Statement of Comprehensive Income that is based on sales projections and the production plan. We
then translate this material into a cash budget, and lastly assimilate all previously developed material into a pro
forma Statement of Financial Position.

Think Point 6.1

Do you think it is easier to do financial forecasting for periods of rapid economic

growth? Explain.

124 MANCOSA
 Accounting and Financial Management

Figure 6-1 depicts the process of developing pro forma statements.

Figure 6-1 Development of pro forma statements

Prior Statement of
Financial Position

1 3

Pro forma
Pro forma Statement
Statement of
Sales projection Production plan of Comprehensive
Financial
Income
Position

Cash

budget

Other supportive
budgets

Capital budget

Figure 6.1

6.3 Pro Forma Statement of Comprehensive Income

The pro forma Statement of Comprehensive Income projects the amount of profit a firm anticipates making over
the ensuing time period. Block et al. (2009:95) suggest the following four steps to develop a pro forma Statement
of Comprehensive Income:

■Establish a sales projection

■Determine a production schedule and the associated use of new material, direct labour, and overhead to arrive
at gross profit

■Compute other expenses

■Determine profit by completing the pro forma Statement of Comprehensive Income

MANCOSA 125
Accounting and Financial Management

6.3.1 Establish a sales projection

A sales projection may be described as a forecast of the number of units the enterprise expects to sell for a
predetermined period. According to Marshall et al. (2011:544) the sales forecast is the most challenging part of
the budget to develop accurately since the firm has little or no control over a number of factors that influence
revenue-producing activities. These include the state of the economy, regulatory restrictions, seasonal demand
variations, and competitors’ actions.

The reliability of the sales budget is important as all other budgets are based on it. After the number of units that
may be sold is estimated, the number of units that can be produced may be determined. Whilst the sales budget
depends a lot on previous sales figures, consideration is also to be given to sales trends, future predictions and
competitors.

Think Point 6.2

What are some possible consequences of over-estimating sales when drawing

up the sales budget?

For the purposes of our analysis we shall follow the example used by Block et al. (2009:96) of
Goldman Corporation that has two primary products. The sales forecast for the first six months of
20.11 is illustrated below:

Wheels Castors Total

Quantity 1 000 2 000

Selling price R30 R35

Sales revenue R30 000 R70 000 R100 000

Figure 6.2: Projected wheel and caster sales for the first six months of 20.11
7

126 MANCOSA
 Accounting and Financial Management

6.3.2 Determine a production schedule and the gross profit

Based on the sales projection, the production plan (or purchases plan in the case of a merchandising
enterprise) may now be determined. The number of units to be produced will depend upon the
following three factors:

■ Opening inventory

■ Sales forecast

■ Desired level of closing inventory

Assume that on 01 January 20.10 Goldman Corporation has in inventory the items shown in figure 6-3:

Wheels Castors Total

Quantity 85 180

Cost R16 20

Total value R1 360 R3 600 R4 960

Figure 6.3: Stock of opening inventory.

8

To determine the production requirements we add the projected quantity of unit sales for the next six months to
the desired closing inventory and deduct the opening inventory (in units). Figure 6-4 below shows the required
production level is 1 015 wheels and 2 020 castors:

Figure 6-4 Production requirements (in units) for six months

Wheels Castors

Sales forecast (Figure 6-2) 1 000 2 000

Desired closing inventory 100 200

Total budgeted production needs 1 100 2 200

Opening inventory (85) (180)

Units to be produced 1 015 2 020

Figure 6.4: Production requirements (in units)

9

MANCOSA 127
Accounting and Financial Management

The cost to produce these units are now determined. We now assume that the cost of materials, labour, and
overheads for the new products will increase to R18 for wheels and R22 for casters as indicated in figure 6-5:

Wheels (R) Castors (R)

Materials 10 12

Labour 5 6

Overheads 3 4

Total 18 22

Figure 6.5: Unit costs

10

The total cost of producing the required new items for the next six months is shown below:

Figure 6-6 Total production costs

Wheels Castors Total

Units to be produced (figure 6-4) 1 015 2 020

Cost per unit (figure 6-5) R18 R22

Total cost R18 270 R44 440 R62 710

Figure 6.6: Total production costs

11

Assuming that Goldman Corporation uses the first-in-first-out (FIFO) method to value inventories, we
now calculate the cost of sales and gross profit:

Figure 6-7 Calculation of cost of sales and gross profit

Wheels Casters Total

Sales 1 000 X R30 R30 000 2 000 X R35 R70 000 R100 000

Cost of sales (17 830) (43 640) (61 470)

Old inventory 85 X R16 1 360 180 X R20 3 600

New inventory 915 X R18 16 470 1 820 X R22 40 040

Gross profit 12 170 26 360 38 530

Figure 6.7: Calculation of costs of sales and gross profit

12

We may at this point also calculate the value of closing inventory for use in the pro forma Statement
of Financial Position. Figure 6-8 below indicates that value of closing inventory is R6 200:

128 MANCOSA
 Accounting and Financial Management

Value of closing inventory R

Opening inventory (Figure 6-3) 4 960

Total production cost (Figure 6-6) 62 710

Total inventory available for sale 67 670

Cost of sales (Figure 6-7) (61 470)

Closing inventory 6 200

OR

Value of closing inventory R

Wheels (100 X R18) 1 800

Casters (200 X R22) 4 400

6 200

Figure 6.8: Value of closing inventory

13

6.3.3 Other expenses

Having calculated the gross profit, we now need to subtract other expense items in order to determine
the expected net profit. The figures from the previous period are often used as a base for expense
projections. Estimates are required for selling, general, administrative, and other operating expenses.
Interest expense is then charged according to the provisions of the enterprise’s outstanding debt. The
Statement of Comprehensive Income will be complete once the income tax (not applicable to sole
proprietorships and partnerships) is estimated to determine the profit after tax.

For Goldman Corporation we shall assume that depreciation is R3 000, general and administrative
expenses are R12 000, interest expense is R1 500, and the income tax rate is 20%.

MANCOSA 129
Accounting and Financial Management

6.3.4 The Pro Forma Statement of Comprehensive Income

After considering the gross profit in figure 6-7 and the assumptions regarding expenses (in paragraph
6.3.3), we are now in a position to prepare the pro forma Statement of Comprehensive Income as
present in figure 6-9 below:

Figure 6-9 Pro Forma Statement of Comprehensive Income for the six months ended 30 June
20.11

Sales 100 000

Cost of sales (61 470)

Gross profit 38 530

Depreciation (3 000)

Other general and administrative expenses (12 000)

Operating profit 23 530

Interest expense (1 500)

Profit before tax 22 030

Income tax (4 406)

Profit after tax 17 624

Figure 6.9: Pro Forma Statement of Comprehensive Income for the six months ended 30 June 20.11
14

6.4 Cash Budget

Higgins (2007:105) describes a cash budget as a simple listing of projected cash receipts and payments over a
forecast period for the purpose of anticipating future cash shortages or surpluses. Company accounts are based
on accrual accounting while cash budgets use strictly cash accounting. This necessitates translating projections
regarding sales and purchases into their cash equivalents.

Helfert (2003:185) states that when preparing a cash budget, a time schedule of estimated receipts and payments
of cash are stated. This schedule shows, period by period, the net effect of projected activity on the cash balance.
Items that do not represent cash flows e.g. depreciation are omitted. The time intervals selected may be daily,
weekly, monthly, or even quarterly.

130 MANCOSA
 Accounting and Financial Management

6.4.1 Cash receipts

Cash generated through sales is the main receipt of a firm. In the case of Goldman Corporation we
now divide the anticipated sales of R100 000 into monthly projections, as indicated in figure 6-10:

January February March April May June

R15 000 R10 000 R15 000 R25 000 R15 000 R20 000

Figure 6.10: Monthly sales pattern

15

The analysis of collection records of the past sales of Goldman Corporation indicates that 20% of sales
is collected in the month of the sales and 80% is collected in the following month. If the sales for
December 20.10 was R12 000, the expected collections from debtors may be presented in a debtors
collection schedule:

Credit
sales
Jan Feb Mar Apr May Jun
Dec 12 000 9 600     

Jan 15 000 3 000 12 000    

Feb 10 000  2 000 8 000   

Mar 15 000   3 000 12 000  

Apr 25 000    5 000 20 000 

May 15 000     3 000 12 000

Jun 20 000      4 000

12 600 14 000 11 000 17 000 23 000 16 000

Figure 6.11: Debtors collection schedule( Figures in Rands)

16

The above schedule indicates that the cash inflows will vary between R11 000 and R23 000, with the highest
receipts expected in May. We assume that no other cash receipts are expected during the first six months of
20.11.

MANCOSA 131
Accounting and Financial Management

6.4.2 Cash payments

The main cash outflows include monthly costs related to the products manufactured (material, labour, and
overheads) and disbursements for general and administrative expenses, interest payments, taxes, and dividends.
We also need to include cash payments that do not show up in the pro forma Statement of Comprehensive
Income e.g. new plant and equipment, loans etc.

In the case of Goldman Corporation, we will firstly calculate the costs for materials, labour, and
overheads by using the information from figure 6-6 in figure 6-12 below:

Wheels Castors

Cost per Cost per

unit(R) unit(R)
Units Total Units Total Total
produced cost(R) produced cost(R) cost(R)

Materials 1 015 10 10 150 2 020 12 24 240 34 390

Labour 1 015 5 5 075 2 020 6 12 120 17 195

Overheads 1 015 3 3 045 2 020 4 8 080 11 125

62 710

Figure 6-12 Component costs of manufactured goods

We will assume that the three costs shown in figure 6-12 are incurred on an equal monthly basis over
the six month period. The average monthly costs are shown below:

Total costs Average

monthly cost
Materials R34 390 6 R5 732
Labour R17 195 6 R2 866
Overheads R11 125 6 R1 854

Figure 6-13

132 MANCOSA
 Accounting and Financial Management

Goldman Corporation pays for materials one month after the purchase is made. Labour and overheads
are direct monthly cash outlays. Cash payments are required for interest, taxes, dividends (R1 500)
and the purchases of R8 000 in new equipment in February and R10 000 in June. Previous records
indicate that R4 500 worth of materials was purchased in December and that the bank balance at the
end of December 20.10 was R5 000.

6.4.3 Actual budget

We are now in a position to put together the monthly cash receipts and payments of Goldman
Corporation into a cash budget, as illustrated in figure 6-14:

Jan (R) Feb (R) Mar (R) Apr (R) May (R) Jun (R)
Cash receipts 12 600 14 000 11 000 17 000 23 000 16 000
Receipts from debtors 12 600 14 000 11 000 17 000 23 000 16 000
Cash payments (11 220) (20 452) (12 452) (12 452) (12 452) (29 856)
Payments to creditors 4 500 5 732 5 732 5 732 5 732 *5 730
Labour 2 866 2 866 2 866 2 866 2 866 *2 865
Overheads 1 854 1 854 1 854 1 854 1 854 *1 855
General & admin exp. 2 000 2 000 2 000 2 000 2 000 2 000
Interest expense      1 500
Income tax      4 406
Cash dividend      1 500
Equipment  8 000    10 000
Cash surplus/shortfall 1 380 (6 452) (1 452) 4 548 10 548 (13 856)
Opening cash balance 5 000 6 380 (72) (1 524) 3 024 13 572
Closing cash balance 6 380 (72) (1 524) 3 024 13 572 (284)

Figure 6-14 Cash budget for the six months ended 30 June 20.11

These amounts have been adjusted so that the payments over the 6 month period correspond with the total
amounts indicated in figure 6-13.

The main purpose of a cash budget is to determine whether outside funding is required at the end of each month.
The cash budget above indicates that outside funding is required for the months of February and March. Suppose
Goldman Corporation wishes to have a minimum cash balance of R5 000 at all times. If the balance goes below

MANCOSA 133
Accounting and Financial Management

R5 000, the firm will have to borrow money from the bank. If it goes above R5 000 and the firm has a loan
outstanding, it will use the excess funds to reduce the loan. Figure 6-15 shows a fully developed cash budget with
borrowing and repayment provisions.

Jan (R) Feb (R) Mar (R) Apr (R) May (R) Jun (R)
Cash receipts 12 600 14 000 11 000 17 000 23 000 16 000
Receipts from debtors 12 600 14 000 11 000 17 000 23 000 16 000
Cash payments (11 220) (20 452) (12 452) (12 452) (12 452) (29 856)
Payments to creditors 4 500 5 732 5 732 5 732 5 732 5 730
Labour 2 866 2 866 2 866 2 866 2 866 2 865
Overheads 1 854 1 854 1 854 1 854 1 854 1 855
General & admin exp. 2 000 2 000 2 000 2 000 2 000 2 000
Interest expense      1 500
Income tax      4 406
Cash dividend      1 500
Equipment  8 000    10 000
Cash surplus/shortfall 1 380 (6 452) (1 452) 4 548 10 548 (13 856)
Opening cash balance 5 000 6 380 5 000 5 000 5 000 13 572
Cumulative cash bal. 6 380 (72) 3 548 9 548 15 548 (284)
Loan / (repayment) 0 5 072 1 452 (4 548) (1 976) 5 284
Cumulative loan bal. 0 5 072 6 524 1 976 0 5 284
Closing cash balance 6 380 5 000 5 000 5 000 13 572 5 000

Figure 6-15 Cash budget with borrowing and repayment provisions

The cash balance at the end of January is R6 380 but negative cash position by the end of February necessitates
a loan of R5 072 in order to maintain a R5 000 cash balance. The firm has a loan until May, at which time there is
a closing cash balance of R13 572. During April and May the cumulative cash balance is more than the

R5 000 minimum cash balance, enabling loan repayments of R4 548 and R1 976 to be made to retire the loans
completely in May. In June the firm needs to borrow

R5 284 to maintain the R5 000 cash balance.

134 MANCOSA
 Accounting and Financial Management

6.5 Pro Forma Statement of Financial Position

Having prepared the pro forma Statement of Comprehensive Income and cash budget, preparing the pro forma
balance is relatively simple. The Statement of Financial Position as at 31 December 20.10 (see figure 6-16) is also
required to complete this task:

Statement of Financial Position as at 31 December 20.10

R

ASSETS
Non-current assets 27 740
Plant and equipment 27 740
Current assets 22 760
Inventories 4 960
Accounts receivable 9 600
Marketable securities 3 200
Bank 5 000
Total assets 50 500

EQUITY AND LIABILITIES

Equity 31 000
Ordinary share capital 10 500
Retained earnings 20 500
Non-current liabilities 15 000
Long-term loan 15 000

Current liabilities 4 500

Accounts payable 4 500
Notes payable 0
Total equity and liabilities 50 500

Figure 6-16

In preparing the pro forma Statement of Financial Position as at 30 June 20.11, some of the accounts
from the previous Statement of Financial Position (figure 6-16) will remain unchanged, while others will
acquire new values in view of items included in the pro forma Statement of Comprehensive Income and
cash budget.

MANCOSA 135
Accounting and Financial Management

The pro forma balance of Goldman Corporation as at 30 June 20.11 is now presented in figure 6-17:

Statement of Financial Position as at 30 June 20.11

R
ASSETS Note
Non-current assets 42 740
Plant and equipment 1 42 740
Current assets 30 400
Inventories 2 6 200
Accounts receivable 3 16 000
Marketable securities 4 3 200
Bank 5 5 000
Total assets 73 140

EQUITY AND LIABILITIES

Equity 47 124
Ordinary share capital 6 10 500
Retained earnings 7 36 624
Non-current liabilities 15 000
Long-term loan 8 15 000
Current liabilities 11 016
Accounts payable 9 5 732
Notes payable 10 5 284
Total equity and liabilities 73 140

Figure 6-17

Each item in figure 6-16 is now explained on the basis of prior calculations or assumptions.
1. Plant and equipment:
Carrying value on 31 December 20.10 (figure 6-16) R27 740
Purchases (figure 6-15) 18 000

136 MANCOSA
 Accounting and Financial Management

Depreciation (figure 6-9) (3 000)

Carrying value on 30 June 20.11 R42 740
2. Inventories: As indicated in figure 6-8, the value is R6 200.
3. Accounts receivable: 80% of the sales for June (R20 000) is outstanding:
R20 000 X 80% = R16 000
4. Marketable securities: remains unchanged.
5. Bank: The minimum cash balance of R5 000 as per figure 6-15 is reflected.
6. Ordinary share capital: remains unchanged.
7. Retained earnings: are calculated as follows:
Balance on 31 December 20.10 (figure 6-16) 20 500
Net profit (figure 6-9) 17 624
Dividends (figure 6-15) (1 500)
Balance on 30 June 20.11 36 624
8. Long-term loan: remains unchanged.
9. Accounts payable: The material purchases for June (R5 732) will only be paid in July.
10. Notes payable: is the amount that must be borrowed to maintain the minimum cash balance of
R5 000 (see figure 6-15)

6.6 Percentage-of-Sales Method

According to Higgins (2007:88) a straightforward yet effective way to forecast is to tie many of the Statement of
Comprehensive Income and Statement of Financial Position figures to future sales. The rationale for this approach
is the tendency for variable costs and most current assets and current liabilities to vary directly with sales.
Obviously, this will not hold true for all items in the financial statements, and certainly some independent estimates
of individual items will be required.

Percentage-of-sales forecast may be done using the following three steps:

Step 1

Examine historical data to determine which financial statement items varied in proportion to sales in the
past. This enables the forecaster to determine which items can be safely estimated as a percentage
of sales and which must be forecast using other information.

Step 2

A forecast of sales must now be done. Since many items are linked to the sales forecast, it is important
to estimate sales as accurately as possible.

MANCOSA 137
Accounting and Financial Management

Step 3

The last step is to extrapolate the historical patterns to the newly estimated sales e.g. if inventories
have historically been about 15% of sales and next year’s sales are forecast to be R1 000 000, then
one would expect inventories to be R150 000.

Consider the Statement of Comprehensive Income of Dino Ltd for 20.8:

Statement of Comprehensive Income for 20.8

R
Sales 240 000
Cost of sales (160 000)
Gross profit 80 000
Operating expenses (36 000)
Income from operations 44 000
Interest expense (4 000)
Profit before tax 40 000
Income tax (25%) (10 000)
Profit after tax 30 000

Figure 6-18

If Dino Ltd identified cost of sales, operating expenses and interest expense as varying in proportion
to sales in the past, then the following percentages would be obtained:

Expenses expressed as a percentage of sales

Cost of sales = R160 000 = 66.667%

Sales R240 000

Operating expenses = R36 000 = 15%

Sales R240 000

Interest expense = R4 000 = 1.667%

Sales R240 000

Figure 6-19

138 MANCOSA
 Accounting and Financial Management

If the sales forecast of Dino Ltd for 20.9 is R300 000, then the pro forma Statement of Comprehensive
Income for 20.9 will appear as follows:

Pro Forma Statement of Comprehensive Income

for 20.9
R
Sales 300 000
Cost of sales (66.667% of R300 000) (200 000)
Gross profit 100 000
Operating expenses (15% of R300 000) (45 000)
Income from operations 55 000
Interest expense (1.667% of R300 000) (5 000)

Profit before tax 50 000

Income tax (25% of profit before tax) (12 500)
Net profit 37 500

Consider the Statement of Financial Position of Dino Ltd for 20.8:

Figure 6-20

Statement of Financial Position for 20.8 Percentage

of sales of
R300 000

ASSETS

Non-current assets

Equipment 80 000 26.667%

Current assets 140 000 46.667%

Inventories 50 000 16.667%

Accounts receivable 80 000 26.667%

Cash and cash equivalents 10 000 3.333%

Total assets 220 000 73.333%

MANCOSA 139
Accounting and Financial Management

EQUITY AND LIABILITIES

Equity 160 000 53.333%

Non-current liabilities

- 0

Current liabilities

Accounts payable 60 000 20%

Total equity and liabilities 220 000 73.333%

Figure 6-21

From the above one observes that the equipment represents 26.667% of sales, inventories of R50
000 is 16.667% of sales and so on. Total assets represent 73.333% of sales.

Let us assume that the sales of Dino Ltd is expected to increase from R300 000 to R450 000 for 20.9.
We further assume that the after tax return on sales is 20% and 50% of profits is paid out in dividends.
Based on these figures, expected profit is R60 000 (20% of R300 000) of which R30 000 will be paid
out as dividends. The pro forma Statement of Financial Position for 20.9 is expected to be as follows:

Pro Forma Statement of Financial Position

for 20.9

ASSETS

Non-current assets

Equipment 120 000

Current assets 210 000

Inventories 75 000

Accounts receivable 120 000

Cash and cash equivalents 15 000

Total assets 330 000

140 MANCOSA
 Accounting and Financial Management

EQUITY AND LIABILITIES

Equity 190 000 (160 000 + 30 000 Retained

profit)

Non-current liabilities

External funding required ?

Current liabilities

Accounts payable 90 000

Total equity and liabilities ?

Figure 6-22

The percentages obtained from figure 2-11 were used to calculate the amounts for 20.9 with the exception
of equity. For example, the equipment figure of R120 000 is 26.667% of the expected sales of R450 000
for 20.9. Equity increases by the portion of the net profit that is not expected to be given as dividends i.e.
the portion retained by the company.

Total equity and liabilities add up to R280 000 which is R50 000 less than the total assets of R330 000.
The R50 000 represents the external funding required. This may be represented as follows:

External funding required = Total assets – (Liabilities + Equity)

= R330 000 – (90 000 + 190 000)

= R330 000 – R280 000

= R50 000

Another way of looking at the external funding required is as follows:

If sales increases by R150 000 (from R300 000 to R450 000) then 20% will be financed by accounts
payable, necessitating R80 000 (53.333%) in additional financing. Since R30 000 is available from the
retained profit, only R50 000 is required from external funding.

MANCOSA 141
Accounting and Financial Management

6.7 Self-Assessment Activities

6.7.1 The following information has been obtained from Aliwal Traders:

1. Total sales figures (actual and budgeted) are:

Actual Budgeted

January February March April May June

R R R R R R

Total sales 320 000 260 000 400 000 420 000 380 000 360 000

2. The abridged Statement of Financial Position on 31 March 20.6 is as follows:

Statement of Financial Position as at 31 March 20.6

ASSETS
Non-current assets 200 000
Property, plant and equipment 200 000
Current assets 605 600
Inventories 240 000
Debtors 361 600
Bank 4 000
Total assets 805 600

EQUITY AND LIABILITIES

Equity
Capital 693 600
Current liabilities 112 000
Creditors 112 000
Total equity and liabilities 805 600

142 MANCOSA
 Accounting and Financial Management

3. Rent amounts to R240 000 per annum and is payable monthly.

4. Selling and administration expenses are estimated to be 25% of sales and are payable in the same
month as the sale.

5. The gross profit percentage on sales is 60%.

6. Depreciation on fixed assets for the year amount to R28 000.

7. Cash sales account for 20% of total sales. Credit sales (80%) are usually collected as follows:

80% 1 month after the sale

20% 2 months after the sale.

8. The inventory balance will remain constant. Thirty percent (30%) of all purchases are for cash. The
total purchases are as follows:

March April May June

R160 000 R168 000 R152 000 R144 000

9. Creditors are paid in full in the month after the purchase.

10. All other expenses are paid monthly and are expected to amount to R22 000 per month.

Required

6.7.1.1 Prepare a budgeted Statement of Comprehensive Income for the 3 months ended 30 June 20.6.

Prepare a monthly cash budget for April, May and June 20.6.

6.7.1.2 Prepare a budgeted Statement of Financial Position on 30 June 20.6.

6.7.1.3

6.7.2 PC Solutions makes and sells computers. On 31 March 20.6, the entity had 60 computers in inventory.
The company’s policy is to maintain a computer inventory of 5% of the following month’s sales. The
sales forecast of the entity for second quarter of the year is:

April 1 200 computers

May 1 000 computers

June 900 computers

MANCOSA 143
Accounting and Financial Management

Required

Draw up a production budget/schedule for April and May 20.6.

6.7.3 Computek Ltd sells computers. At the beginning of May 20.9 the business had an overdraft of R70
000 and the bank had asked that it be settled by the end of October 20.9. As a result, the directors
decided to review their plans for the next 6 months and the following is the cash budget that was
subsequently drawn up for the 6 months ending 31 October 20.9.

Computek Ltd

Cash Budget for the 6 months ended 31 October 20.9

May Jun Jul Aug Sep Oct

R’000 R’000 R’000 R’000 R’000 R’000

Cash receipts 454 630 492 276 236 216

Cash sales 454 630 492 276 236 216

Cash payments 404 528 506 328 264 240

Cash purchase of merchandise 270 360 284 188 150 132

Administration expenses 80 82 76 66 62 60

Loan repayments 10 10 10 10 10 10

Selling expenses 44 48 56 52 42 38

Shop refurbishment 28 36 12

Tax payment 44

Cash surplus (shortfall) 50 102 (14) (52) (28) (24)

Opening cash balance (70) (20) 82 68 16 (12)

Closing cash balance (20) 82 68 16 (12) (36)

Additional information

(a) The business maintains a minimum monthly inventory level of R80 000 of merchandise.

(b) The gross profit margin is 40%.

144 MANCOSA
 Accounting and Financial Management

Question

What problems are likely to be faced by Computek Ltd during the 6 month period May to October
20.9? Suggest ways in which the business may deal with these problems.

6.7.4 Cobalt Ltd, a manufacturing concern, is making financial plans for the 12 months commencing 01
November 20.10. Projected sales value is R8 700 000 as compared to the estimated R7 350 000 for the financial
year ended 31 October 20.10. The best estimates of the operating results for the current year are shown in the
projected Statement of Comprehensive Income below. All values are reflected as a percentage of sales e.g. labour
at R1 838 000 is 25% of sales.

Cobalt Ltd

Projected Statement of Comprehensive Income for the year ended 31 October 20.10

R %

Sales 7 350 000 100

Cost of sales (4 634 000) 63

Labour 1 838 000 25

Materials 1 044 000 14.2

Overheads 1 486 000 20.2

Depreciation 266 000 3.6

Gross profit 2 716 000 37

Operating expenses (1 256 000) 17.1

Selling expenses

General and administrative expenses 610 000

646 000 8.3

8.8

Operating profit 1 460 000 19.9

Interest expense 0

Profit before tax 1 460 000 19.9

Income tax (46%) (672 000) 9.1

Profit after tax 788 000 10.7

MANCOSA 145
Accounting and Financial Management

Assumptions for the financial year ending 31 October 20.11

■ Manufacturing labour will drop to 24% of direct sales.

■ The cost of materials will increase to 14.5% of sales.

■ Overhead costs will rise above the present level by 6% of the 20.10 Rand amount, reflecting higher
costs and additional variable costs will be encountered at a rate of 11% of the incremental sales
volume.

■ Depreciation will increase by R20 000, reflecting the addition of some production machinery.

■ Selling expenses will rise more than proportionately, by R250 000, since additional effort will be
required to increase sales volume.

■ Income taxes are estimated at 46% of pre-tax profits.

Required

Prepare a Pro Forma Statement of Comprehensive Income for Cobalt Ltd for the year ending 31
October 20.11 and discuss your findings.

Adapted from Marx et al. 2009.

6.7.5 A financial manager at Emerald Inc has gathered financial data needed to prepare a pro forma
Statement of Financial Position for cash and profit planning purposes for the coming year ending 31
December 20.11. Use the percentage-of-sales method and the following financial data to prepare the
pro forma Statement of Financial Position as at 31 December 20.11:

■ Sales for 20.11 is estimated to be R2 000 000.

■ The business maintains a cash balance of R50 000.

■ Trade and other receivables represent 15% of sales.

■ Inventory represents 35% of sales.

■ A new piece of mining equipment costing R300 000 will be purchased in 20.11. Total depreciation for
20.11 will be R150 000.

■ Trade and other payables represent 10% of sales.

■ There will be no change in notes payable and share capital.

■ Dividends of R90 000 will be paid in 20.11.

■ The business predicts a 4% net profit margin.

■ Long-term debt is estimated to be 15% of sales.

146 MANCOSA
 Accounting and Financial Management

Emerald Inc.

Statement of Financial Position as at 30 June 20.11

ASSETS

Non-current assets 1 000 000

Fixed/Tangible assets 1 000 000

Current assets 890 000

Inventories 600 000

Trade and other receivables 240 000

Cash and cash equivalents 50 000

Total assets 1 890 000

EQUITY AND LIABILITIES

Shareholders’ equity 630 000

Ordinary share capital 360 000

Retained earnings 270 000

Non-current liabilities 300 000

Long-term loan 300 000

Current liabilities 960 000

Trade and other payables 160 000

Notes payable 800 000

Total equity and liabilities 1 890 000

Adapted from Marx et al. 2009.

MANCOSA 147
Accounting and Financial Management

6.8 Suggested Solutions

Think Point 3.4

It is easier to plan because of reduced risk and greater certainty about growth
prospects. However, businesses may also face difficulties in managing growth.
The business may, at times, have inadequate capacity, lack of funds, not enough
inventory, or too little staff to deal with marketing enquiries, thus losing sales.

Think Point 3.5

Over-estimating sales may result in serious financial consequences. The firm may
have to hold stock that is not selling, experience idle capacity, and staff may be
demoralised about the prospect of losing their jobs. The firm may be forced into
cash flow problems and face eventual bankruptcy.

6.7.1.1

Aliwal Traders

Budgeted Statement of Comprehensive Income for the 3 months ended 30 June 20.6

Sales (R420 000 + R380 000 + R360 000) 1 160 000

Cost of sales (40% of sales) (464 000)

Gross profit (60% of sales) 696 000

Expenses (423 000)

Rent expense (R20 000 X 3) 60 000

Selling and distribution (R1 160 000 X 25%) 290 000

Depreciation (R28 000 ÷4) 7 000

Other expenses (R22 000 X 3) 66 000

Net profit 273 000

148 MANCOSA
 Accounting and Financial Management

REMARKS

 Sales: reflects the total sales for April, May and June.

 Cost of sales: is 40% of sales since the gross profit percentage on sales is 60%.

 Rent expense: is R2 000 per month and includes rent for April, May and June.

 Selling and distribution: is 25% of the total sales (R1 160 000).

 Depreciation: is R28 000 per annum and this translates to R7 000 every 3 months.

 Other expenses: are R22 000 per month for 3 months.

6.7.1.2

Aliwal Traders

Cash budget for the period 01 April to 30 June 20.6

April May June

Cash receipts 381 600 408 800 382 400

Cash sales 84 000 76 000 72 000

Receipts from debtors 297 600 332 800 310 400

Cash payments (309 400) (300 200) (281 600)

Cash purchases 50 400 45 600 43 200

Payments to creditors 112 000 117 600 106 400

Rent 20 000 20 000 20 000

Selling and administrative costs 105 000 95 000 90 000

Other expenses 22 000 22 000 22 000

Cash surplus (shortfall) 72 200 108 600 100 800

Opening cash balance 4 000 76 200 184 800

Closing cash balance 76 200 184 800 285 600

MANCOSA 149
Accounting and Financial Management

REMARKS

 Cash sales: are 20% of total sales.

 Receipts from debtors: are calculated as follows:

Credit

Month sales April May June

R R R R

February (April R208 000 X 20%) 208 000 41 600 - -

March (April R320 000 X 80%) 320 000 256 000 64 000 -

(May R320 000 X 20%)

April (May R336 000 X 80%) 336 000 - 268 800 67 200

(June R336 000 X 20%)

May (June R304 000 X 80%) 304 000 - - 243 200

297 600 332 800 310 400

 Cash purchases and payments to creditors: The following calculations reflect the cash purchases
and payments to creditors:

March April May June

R R R R

Total purchases 160 000 168 000 152 000 144 000

Cash purchases (30% of purchases) 48 000 50 400 45 600 43 200

Credit purchases (70% of purchases) 112 000 117 600 106 400 100 800

Payments to creditors (1 month after) 112 000 117 600 106 400

 Rent: is paid monthly (R240 000 ÷12 = R20 000)

 Selling and administrative expenses: are 25% of sales.

 Other expenses: are paid monthly.

 Opening cash balance: for April is obtained from the Statement of Financial Position as at 31 March
20.6.

150 MANCOSA
 Accounting and Financial Management

6.7.1.3

Aliwal Traders

Budgeted Statement of Financial Position as at 30 June 20.6 R

ASSETS

Fixed assets 193 000

Property, plant and equipment (200 000 – 7 000) 193 000

Current assets 874 400

Inventories 240 000

Debtors (60 800 + 288 000) 348 800

Bank 285 600

Total assets 1 067 400

EQUITY AND LIABILITIES

Equity

Capital (693 600 + 273 000) 966 600

Current liabilities 100 800

Creditors 100 800

Total equity and liabilities 1 067 400

REMARKS

 Plant, property and equipment: was subject to an annual depreciation of R28 000. For 3 months it
would amount to R7 000 and this is the amount by which property, plant and equipment decreases.

 Inventory balance will remain the same.

 Debtors: The amount owing by debtors includes 20% of the credit sales for May (R60 800) and the
entire credit sales for June (R288 000).

 Bank: The expected bank balance at the end of June is obtained from the cash budget.

 Capital: increases by the expected profit as calculated in the Statement of Comprehensive Income.

 Creditors: The amount owing to creditors will be the credit purchases for June

MANCOSA 151
Accounting and Financial Management

(R100 800).

6.7.2

Production budget/schedule April May

Sales forecast (in units) 1 200 1 000

Desired closing inventory of finished goods (1000 x 5% 50 45

-April); (900 x 5% -May)

Total budgeted production needs 1 250 1 045

Opening inventory of finished goods (60) (50)

Required production 1 190 995

6.7.3 Problems:

The company will not be able to achieve the requirement of settling the overdraft by the end of
October.

Although the initial overdraft is expected to be eliminated in June, a study of the closing cash balance
each month thereafter suggests that the cash balance is expected to get worse each month.

Except for the first 2 months, a cash shortfall is expected for the rest of the budgeted period.

The company expects a decline in sales each month from July to October.

Dealing with the problems:

The shop refurbishment could be postponed.

The company could obtain funds from the shareholders or other investors.

It may try to stimulate sales in some way.

Ways could be found to reduce overhead expenses.

Sales were declining, yet selling expenses are high – investigate this.

152 MANCOSA
 Accounting and Financial Management

6.7.4

Cobalt Ltd

Projected Statement of Comprehensive Income for the year ended 31 October 20.10

R %

Sales 8 700 000

Cost of sales (5 359 160)

Labour 2 088 000 24.0

Materials 1 261 500 14.5

Overheads (1 486 000 + 89 160 + 148 5000) 1 723 660

Depreciation (266 000 + 20 000) 286 000

Gross profit 3 340 840

Operating expenses (1 625 600)

Selling expenses (610 000 + 250 000) 860 000

General and administrative expenses 765 600 8.8

Operating profit 1 715 240

Interest expense 0

Profit before tax 1 715 240

Income tax (46%) (789 010)

Profit after tax 926 230 10.6

Net profit as a percentage of sales decreases slightly from 10.7% to 10.6% despite drop in labour
cost as a percent of sales. The decrease is mainly due to the percentage increase in the cost of
materials and variable costs.

MANCOSA 153
Accounting and Financial Management

6.7.5
Emerald Inc
Statement of Financial Position as at 30 June 20.11
R
ASSETS
Non-current assets 1 150 000
Fixed/Tangible assets (R1 000 000 + R300 000 – R150 000) 1 150 000
Current assets 1 050 000
Inventories (35% of R2 000 000) 700 000
Trade and other receivables (15% of R2 000 000) 300 000
Cash and cash equivalents 50 000
Total assets 2 200 000

EQUITY AND LIABILITIES

Shareholders’ equity 620 000
Ordinary share capital 360 000
Retained earnings (R270 000 + R80 000 [4% of sales] – R90 000) 260 000
Non-current liabilities 580 000
Long-term loan (15% of R2 000 000) 300 000
External funding required
*280 000
(2 200 000 – 620 000 – 300 000 – 1 000 000 final step)
Current liabilities 1 000 000
Trade and other payables (10% of R2 000 000) 200 000
Notes payable 800 000
Total equity and liabilities 2 200 000

* The Statement of Financial Position does not balance until the business obtains external funding of
R280 000 (the difference between the total assets and the equity plus liabilities). So, in order for the
Statement of Financial Position to balance, the non-current liabilities need to increase by R280 000 to
R580 000.

154 MANCOSA
 Accounting and Financial Management

Unit
7:
Working Capital Management

MANCOSA 155
Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Explain the motives for holding cash.  Complete relevant readings, think points and
 Calculate the cash conversion cycle. activities provided.
 Provide strategies for the efficient
management of the cash conversion cycle.
 Explain the cash flow cycle.
 Determine the effect of credit terms on
profitability.
 Discuss the three primary policy variables
with regard to the extension of credit viz.
credit standards, credit terms, and collection
policy.
 Explain and apply the four common methods
to value inventory.
 Perform the relevant calculations with regard
to the costs of inventory.
 Explain the various sources of financing.

7.1 Introduction
7.2 Cash Management
7.3 Management of Accounts Receivable
7.4 Inventory Management
7.5 Sources of Short-Term Financing

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:
 Marx, J., de Swardt, C., (2014) Financial Management in Southern
Africa. 4th Edition. Cape Town: Pearson Education.

Recommended Reading:

 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of

Financial Management. 13th Edition. New York: McGraw-Hill/Irwin

156 MANCOSA
 Accounting and Financial Management

7.1 Introduction
According to Block et al. (2009:157) working capital management involves the financing and management of a
firm’s current assets. The financial executive is likely to devote more time to working capital management than
to any other activity. Current assets change daily and managerial decisions are required. Unlike long-term
decisions, action cannot be deferred. While long-term decisions related to non-current assets or market strategy
may be important for the success of the firm, it is the short-term decisions on working capital that determines
whether the firm gets to the long term.

We begin with an overview of current asset management involving cash, accounts receivables, and inventory
management followed by a look at the sources of short-term financing.

7.2 Cash Management

Block et al. (2009:190) observe that the management of cash is becoming ever more sophisticated in the global
and electronic age as financial managers try to squeeze the last rand of profit out of their cash management
strategies. Contrary to popular belief, the less cash a firm has the better off it is, but at the same time it must not
be caught without cash when it is needed. Corporate financial managers thus try to keep this non-earning asset
to a minimum.

7.2.1 Motives for holding cash

Marx et al. (2009:203) concur that cash is a non-earning asset of a firm but is held to reduce the risk of technical
insolvency by providing a pool of funds that are used to pay bills as they fall due and to meet unexpected outlays.
Despite being considered as the most unproductive asset, there are strong motives for holding cash. These
include the following:

■The transaction motive: is the need for cash to make payments in the ordinary course of business.

■Compensating balances: Banks that provide loans to firms may require them to keep a minimum amount on
deposit to help offset the cost of services provided to them.

■The speculative motive: relates to keeping cash to take advantage of unexpected profitable opportunities that
may arise.

■The precautionary motive: has to do with keeping cash for unexpected contingencies.

7.2.2 The efficient management of cash

According to Marx et al. (2009:204) the efficient management of cash depends largely on how well a firm manages
its operating and cash conversion cycles. The objective of the financial manager is to efficiently manage the cash
conversion cycle in order to maintain low levels of cash investment, thus contributing to maximising the firm’s
value.

MANCOSA 157
Accounting and Financial Management

7.2.2.1 The operating cycle

This refers to the period of time that elapses between the building up of inventory and when the cash is
collected from the sale of that inventory. The operating cycle is calculated as follows:

Operating cycle = Inventory period + Debtor collection period

= Inventory X 365 + Accounts receivable X 365

Cost of sales 1 Credit sales 1

Example 1

Suppose GHT Manufacturers has annual sales of R2 000 0000, cost of sales of

R1 300 000, inventory of R232 000 and accounts receivable of R300 000. If all the sales are on
credit, calculate the firm’s operating cycle.

Solution

Operating cycle = Inventory period + Debtor collection period

= Inventory X 365 + Accounts receivable X 365

Cost of sales 1 Credit sales 1

= R232 000 X 365 + R300 000 X 365

R1 300 000 1 R2 000 000 1

= 65.14 days + 54.75 days

= 119.89 days

It will take GHT Manufacturers approximately 120 days from the time they receive raw materials to
produce, market, sell, and collect the cash from the sales of the finished goods.

158 MANCOSA
 Accounting and Financial Management

7.2.2.2 The cash conversion cycle / The cash cycle

Firms usually purchase inventory on credit from producers or suppliers. The cash conversion cycle
represents the number of days in the operating cycle of the firm minus the creditor payment period:

Cash conversion cycle = Operating cycle – Creditor payment period

= Operating cycle – Accounts payable X 365

Credit purchases 1

Example 2

Extending example 1, assume that GHT Manufacturers accounts payable balance is R240 000 and
that the credit purchases amount to R1 300 000. Calculate the cash conversion cycle.

Cash conversion cycle = Operating cycle – Creditor payment period

= Operating cycle – Accounts payable X 365

Credit purchases 1

= 119.89 days – R240 000 X 365

R1 300 000 1

= 119.89 days – 67.38 days

= 52.51 days

The firm’s money is tied up for about 53 days. In other words, the period between the cash outflow
to pay the accounts payable (67.38 days) and the cash inflow from the collection of accounts
receivable (119.89 days) is about 53 days. This is referred to as a positive cash conversion cycle,
indicating that payment is made 53 days before the cash is received from the sale of the goods.
The longer the operating and cash cycles, the more financing is required, hence the importance of
monitoring both these cycles.

MANCOSA 159
Accounting and Financial Management

Think Point 7.1

What can a firm such as GHT Manufacturers do to manage a positive cash

conversion cycle?

7.2.2.3 Strategies for the efficient management of the cash conversion cycle

Ideally, firms should strive towards a negative cash conversion cycle i.e. a situation where the average
payment period exceeds the operating cycle. Firms with positive cash conversion cycles may pursue
certain strategies minimise the cash conversion cycle. Marx et al. (2009:206) elaborate on three
strategies:

■ Stretching accounts payable: This involves stretching the payment period to creditors as late as
possible but without affecting credit ratings negatively. However, if a creditor offers a discount for
prompt settlement of account, the enterprise must compare the benefit of early payment with the cost
of forgoing the cash discount. The calculation for the cost of forgoing a cash discount is shown below:

Cost of not accepting

a discount = % rebate X 365 X 100

100% – % rebate Payment period – discount 1

period

Example 3

Labtec Distributors’ normal credit terms to Interstat Stores are 30 days but is prepared to allow a
2% rebate if Interstat Stores pays the account within 10 days. Calculate the cost to Interstat Stores
of not accepting the discount.

Solution

Cost of not accepting a discount = 2% X 365 X 100

100% – 2% 30 – 10 1

= 37.24%

160 MANCOSA
 Accounting and Financial Management

■ Efficient purchasing and inventory management: Another way of improving liquidity is to increase
inventory turnover. This may be achieved in the following ways:

* Improving the accuracy of demand forecasts and better planning of purchases to coincide with these
forecasts.

* Through better purchasing planning, scheduling, and control techniques, an enterprise can reduce the
length of the purchasing cycle. This should increase inventory turnover.

■ Speeding up the collection of accounts receivable: One way of achieving this is to offer a cash
discount for early settlement of account. Changes in credit terms and policies, and collection policies
may also be used to reduce the average collection period while maintaining or increasing overall profits.

7.2.3 The cash flow cycle

A firm’s cash conversion cycle stems from its cash flow cycle. This cycle is the pattern in which cash
moves in and out of a firm. According to Block et al. (2009:190) the main consideration in managing a
cash flow cycle is to ensure that inflows and outflows are properly synchronised for transaction
purposes. In figure 7-1 below they illustrate a cash flow cycle that expands the detail and activities that
influence cash.

Cash inflows are driven by sales and influenced by the type of customers, their geographical location,
the product being sold, as well as the industry. Sales may be made for cash or on credit. Credit terms
vary from 30 days to 120 days. When a debt is collected or the credit card company advances payment,
the firm’s cash balance increases and the firm uses the cash to pay interest to lenders, dividends to
shareholders, taxes to the government, accounts payable to suppliers, wages to employees, and to
replenish inventory. Excess cash may be invested in marketable securities and if cash is needed for
current assets, the firm will either sell marketable securities or borrow funds from short-term lenders.

MANCOSA 161
Accounting and Financial Management

Customers

Sales

Geographical area

Product/ division

Customer type

Inventory Accounts receivable

Finished goods 0-30 days

Goods-in-process 31-60 days

Raw materials 61-90 days

91-120 days

CASH

Materials & services Marketable securities

Suppliers: accounts payable

Labour: wages payable Interest and dividends

Other: expenses

Government taxes Short-term lenders

Income taxes Commercial banks

Value added tax Non-bank lenders

Other taxes Foreign banks & lenders

Figure 7.1: Expanded cash cycle

17

162 MANCOSA
 Accounting and Financial Management

7.3 Management of Accounts Receivable

Block et al. (2009:202) observe that an increasing portion of investment of corporate assets is in accounts
receivable as sales expand and the effects of inflation and recessions require firms to carry larger balances for
their customers. Accounts receivable as a percentage of total assets have increased relative to inventory, and
this is a cause for concern for some firms in their management of current assets.

7.3.1 Credit policy administration

In considering the extension of credit, Block et al. (2009:202) identify three primary policy variables to consider
in conjunction with the profit objective:

■Credit standards

■Terms of trade / Credit terms

■Collection policy

7.3.1.1 Credit standards

Credit standards may be viewed as the minimum requirements for extending credit to customers.
Firms need to determine the nature of the credit risk through an examination of past records of
payment, financial stability, current net worth, and other factors. Bankers sometimes refer to the 5 C’s
of credit as an indicator that the loan will be repaid on time, late, or not at all:

■ Character – the moral and ethical quality of the applicant to pay.

■ Capacity – the availability and sustainability of the firm’s cash flow to pay off the loan.

■ Capital – the financial resources of the applicant that includes an analysis of debt to equity and the
firm’s capital structure.

■ Conditions – the sensitivity of the operating income and cash flows to current economic or business
conditions prevailing.

■ Collateral – assets that can be pledged by the applicant in the event of non-payment of the loan.

The assessment of credit risk and the setting of reasonable credit standards that permit marketing and
finance to set goals and objectives together depend on the ability to get information and analyse it.
An extensive electronic network of credit information is available from credit agencies that help to
facilitate credit decisions.

MANCOSA 163
Accounting and Financial Management

Think Point 7.2

What effects do you think the relaxing of the existing credit standards will have on a
firm that allows the credit?

7.3.1.2 Terms of trade / Credit terms

The stated credit terms will impact greatly on the eventual size of the accounts receivable balance. A
firm that averages R10 000 in daily credit sales and allows 30-day terms will have an accounts
receivable balance of R300 000. If customers are carried for 60 days, R600 000 in receivables must
be maintained and much additional funding will be needed.

According to Marx et al. (2009:234) setting credit terms involves the determination of three parameters,
namely:

■ the cash discount (the percentage discount allowed if the debt is settled within a specified period of
time)

■ the period of time for which this discount is to be allowed

■ the net date (the due date for payment if the discount is not taken)

Credit terms are often indicated as follows:

2/10 net 30 days

This means that the customer will receive a discount of 2% if the account is settled within 10 days from
the start of the credit period. The account must be settled within 30 days if the customer does not take
advantage of the discount.

Marx et al. (2009:235) explore the influence of credit terms on profitability. When a firm sells on credit,
a cost is incurred that involves the value of the investment in the sale (cost of the goods sold) during
the period until the payment is received.

164 MANCOSA
 Accounting and Financial Management

Consider the following example:

Example 4

PC Suppliers is considering selling a laptop to Mrs G. Smith on credit. The cost of the laptop is R6 000
and the selling price is R10 000. A credit term of “net 60 days” has been agreed upon. The cost of
capital to PC Suppliers is 10%. Determine the effect of the sale on the profit of PC Suppliers.

Solution

Added credit cost to the business = R6 000 X 10% X 60 days

365 days

= R98.63

Total cost of sale of the laptop

Cost price R6 000.00

Add: Credit cost 98.63

Total cost R6 098.63

Effect on profit

Sales R10 000.00

Less: Cost of sales (R6 098.63)

Profit R3 901.37

If the laptop was sold for cash, the gross profit would have been R4 000.

The analysis of the credit decision is complicated by the possibility of a cash discount. Consider the
following example:

MANCOSA 165
Accounting and Financial Management

Example 5

PC Suppliers offers Mrs G. Smith the terms 2/30 net 60. Determine the effect of the sale on the profit
of PC Suppliers.

Solution

Firstly, there is a reduction of R200 (2% of R10 000) on the sales price if the account is paid within 30
days.

Added credit cost to the business = R6 000 X 10% X 30 days

365 days

= R49.32

Total cost of sale of the laptop

Cost price R6 000.00

Add: Credit cost 49.32

Total cost R6 049.32

Effect on profit

30-day 60-day
payment payment

Effective price R9 800.00 R10 000.00

Less: Cost of sales (6 000) (6 000.00)

Less: Credit cost (R49.32) (98.63)

Profit R3 750.68 R3 901.37

The cash discount more than offsets the difference in the credit cost resulting in a greater profit if Mrs
G. Smith settles her debt on day 60.

If the customer fails to pay the amount due, the loss to the firm will be the cost price plus the credit
cost up to the point that the account is written off as a bad debt.

166 MANCOSA
 Accounting and Financial Management

Example 6

Suppose PC Suppliers writes off all accounts after 180 days. Calculate the loss to the firm if Mrs G.
Smith fails to pay her account.

Solution

R6 000 + (R6 000 X 10% X 180/365)

= R6 000 + R295.89

= R6 295.89

7.3.1.2 Collection policy

According to Marx et al. (2009:241) the collection policy of a firm refers to the various procedures it
follows to collect accounts receivable once they become due. The collection of accounts receivable
starts with the correct and timeous mailing of invoices. This is followed by the sending of statements
of accounts before the end of each month.

The following methods may be used to collect overdue accounts:

■ Letters: Firms usually send two standard letters to customers before sending a final letter of
warning.

■ Telephone calls, emails, sms : are effective ways of collecting outstanding debts but one must
consider the costs associated with making telephone calls.

■ Legal action: is usually taken when all reasonable procedures have failed.

■ Collection agencies: may be used to attempt to recover the amount owing.

■ Personal visits: may be effective in certain instances.

Think Point 7.3

What advice would you offer a firm in drafting a final letter of warning for an
outstanding debt?

Block et al. (2009:206) suggest three quantitative measures that may be used to assess a firm’s
collection policy:

MANCOSA 167
Accounting and Financial Management

■ Ratios can be useful in management of debtors. The most widely used ratio is the debtor collection
period. The formula is as follows:

Debtor collection period = Accounts receivable X 365

Credit sales

This ratio tells us how long trade debtors take to meet their obligations to pay following the sale on
credit. If the collection period exceeds what is specified in the policy, then steps need to be taken to
remedy matters. The calculation and interpretation of this ratio is discussed in topic 5 (paragraph
5.3.2.2).

■ Ratio of bad debts to credit sales (bad debt ratio) is used to monitor bad debts and is calculated
as follows:

Bad debt ratio = Bad debts X 100

Credit sales

According to Marx et al. (2009:249) a firm determines certain confidence limits based on the expected
value of this ratio e.g. a bad debt ratio of 5% is generally expected for businesses. Block et al. (2009:206)
state that an increasing ratio may indicate too many weak accounts or an aggressive market expansion
policy.

■ An ageing schedule is one way of finding out if customers are paying their accounts within the time
prescribed in the credit terms. A build-up of receivables beyond the normal credit terms will result in poor
cash inflows and would require more stringent credit terms and collection procedures. The following is
an example of an ageing schedule:

168 MANCOSA
 Accounting and Financial Management

Month of Age of account Percent of

(days) account due
sales Amounts

May 0-30 R120 000 60%

April 31-60 50 000 25%

March 61-90 10 000 5%

February 91-120 20 000 10%

Total receivables R200 000 100%

Figure 7.2: An ageing schedule, 31 May 20.11

18

If the normal credit terms are 30 days, then the firm has a problem collecting debts since 40% are
overdue with 10% over 90 days outstanding.

7.3.2 An actual credit decision

We now examine a credit decision that brings together all the elements of accounts receivable
management. Suppose a firm is considering selling to a group of customers that will bring R100 000 in
new annual sales, of which 10% is expected to be bad debts. With this high rate of non-payment, the
critical consideration is the contribution to profitability.

Suppose the collection cost on these accounts is 5% and the cost of producing and selling the product
is 75% of the sales rand. If the tax rate is 30%, then the profit on the new sales is as follows:

Additional sales 100 000

Bad debts (10% of sales) (10 000)

Annual incremental revenue 90 000

Collection costs (5% of new sales) (5 000)

Production and selling costs (75% of new sales) (75 000)

Annual profit before tax 10 000

MANCOSA 169
Accounting and Financial Management

Income tax (30%) (3 000)

Annual incremental profit after tax 7 000

Although the return on sales is only 7% (R7 000/R100 000 X 100), the return on invested rands may be
much higher. Suppose the only new investment in this case is a build-up in accounts receivable.
Assume that the turnover ratio is 6 to 1 between sales and accounts receivable. The new accounts
receivable balance will average R16 667 (R100 000/6). This means that an average investment of only
R16 667 will provide an after tax return of R7 000, so that the yield is a very attractive 42% (7 000/16
667). If the firm had a minimum required after-tax return of 10%, then this is obviously an acceptable
investment.

7.4 Inventory Management

Block et al. (2009:208) state that in a manufacturing firm inventory consists of three basic categories: raw
materials used to make the product; work in progress, which reflects partially completed goods; and finished
goods, which are ready for sale. Since all these forms of inventory need to be financed, they need to be carefully
managed in order to contribute towards the maximisation of wealth of the firm. The objective of the financial
manager should be to keep inventory levels as low as possible in order to lower investment and costs and provide
an opportunity for more profitable investments.

7.4.1 Inventory valuation

Of great concern for every firm is determining the actual value of its inventory on hand. The method that is used
to establish the value of inventory has a significant influence on gross profit reflected in the Statement of
Comprehensive Income and the value of inventory in the Statement of Financial Position. Marx et al. (2009:258)
elaborate on the four most common methods used to value inventory:

■First-in-first-out (FIFO)

■Last-in-first-out (LIFO)

■Weighted average cost

■Specific identification

170 MANCOSA
 Accounting and Financial Management

7.4.1.1 First-in-first-out (FIFO)

Using the FIFO method to value inventory, the units sold will be based on the cost of the units first
purchased. The following example illustrates this method:

Example 7

PC Distributors, a seller of computers, has the following inventory of laptops on hand on 01 March
20.11 (the start of the financial year):

2 units @ R5 000 each purchased on 01 Jul 20.10 10 000

3 units @ R6 000 each purchased on 01 Aug 20.10 18 000

4 units @ R6 400 each purchased on 02 Jan 20.11 25 600

53 600

On 01 March 20.11 the firm purchased another four laptops at R7 600 each. During the year six laptops
were sold at R10 000 each. This left the firm with seven laptops as closing inventory.

Gross profit and closing inventory, based on the FIFO method, are reflected in the following extract
from the Statement of Comprehensive Income:

PC Distributors

Statement of Comprehensive Income for the year ended 28 February 20.11

Sales 60 000

Cost of sales (34 400)

Opening inventory 53 600

Purchases 30 400 (R7 600 X 4)

84 000

Closing inventory (49 600) (R6 400 X 3) + (R7 600 X 4)

Gross profit 25 600

MANCOSA 171
Accounting and Financial Management

7.4.1.2 Last-in-first-out (FIFO)

Using this method the cost of goods sold is based on the last units placed in inventory, while the
remaining inventory value consists of the first goods placed in inventory. In terms of tax legislation,
this method of valuing inventory is no longer allowed in South Africa. The main reason for this is the
tax advantages gained during periods of inflation.

Example 8

Using the same set of details used in example 4 we now calculate the gross profit and closing
inventory.

PC Distributors

Statement of Comprehensive Income for the year ended 28 February 20.11

Sales 60 000

Cost of sales (43 200)

Opening inventory 53 600

Purchases 30 400 (R7 600 X 4)

84 000

Closing inventory (40 800) (R6 400 X 2) + (R6 000 X 3) + (5 000 X 2)

Gross profit 16 800

Think Point 7.4

What is the impact of the carrying value of inventory (in the Statement of Financial
Position) and the cost of goods sold when LIFO rather than FIFO is used during
periods of inflation?

172 MANCOSA
 Accounting and Financial Management

7.4.1.3 Weighted average cost

This method results in the cost of goods sold and closing inventory falling somewhere between the
values obtained using FIFO and LIFO. The average cost per unit is determined by dividing the total
cost of similar items by the number of items purchased.

Example 9

Using the same set of details used in example 4 we now calculate the gross profit and closing
inventory. The weighted average cost per unit is R6 461.54 (R84 000 ÷ 13).

PC Distributors

Statement of Comprehensive Income for the year ended 28 February 20.11

Sales 60 000.00

Cost of sales (38 769.22)

Opening inventory 53 600.00

Purchases 30 400.00 (R7 600 X 4)

84 000.00

Closing inventory (45 230.78) (R6 461.54 X 7)

Gross profit 21 230.78

7.4.1.4 Specific identification

Using this method a unique cost is attached to each item in the inventory. This valuation method is
usually used for high cost, slow-moving stock e.g. motor cars and jewellery.

Example 10

Regal Motors, a dealer in second-hand vehicles, purchased the following vehicles during the
financial year ending 28 February 20.11:

Red Toyota Yaris Reg. no. NJ 33433 @ R64 000

Blue Nissan Sentra Reg. no. ND 56782 @ R50 000

MANCOSA 173
Accounting and Financial Management

White VW Jetta Reg. no. NT 42491 @ R56 000

Green Toyota Camry Reg. no. NP 97466 @ R70 000

Black Opel Corsa Reg. no. ND 75623 @ R64 000

R304 000

The firm has no opening inventory. During the year, the business sold the Red Toyota Yaris for R90
000, the White VW Jetta for R66 000 and the Green Toyota Camry for R80 000.

The gross profit for Regal Motors for the financial year, using the specific identification method of
inventory valuation, is reflected below:

Regal Motors

Statement of Comprehensive Income for the year ended 28 February 20.11

Sales 236 000 (R90 000 + R66 000 + R80 000)

Cost of sales (190 000) (R64 000 + R56 000 + R70 000)

Opening inventory 0

Purchases 304 000

304 000

Closing inventory (114 000) (50 000 + 64 000)

Gross profit 46 000

7.4.2 The cost of inventory

According to Block et al. (2009:209) there are two important costs associated with inventory:

■ Carrying or storage costs

■ Ordering costs

Through an analysis of these two variables, we can determine the optimum order size that minimises
costs.

174 MANCOSA
 Accounting and Financial Management

7.4.2.1 Carrying or storage costs

Carrying costs include interest on funds tied up in inventory and the costs of warehouse space,
insurance premiums, and material handling expenses. Marx et al. (2009:262) point out that carrying
costs usually increase in direct proportion to the average amount of inventory on hand. In turn,
inventory on hand depends upon the frequency with which orders are placed. Example 11 below
shows how the total cost of carrying inventory is calculated.

Example 11

RNA Stationers sells 40 000 pens per year and orders inventory 4 times a year. The pens are
purchased at R5 each. The cost of capital is 10%. The firm incurs storage costs of R600, inventory
insurance costs of R800, and depreciation and obsolescence costs of R400 per year. No safety stocks
are carried. Calculate total cost of carrying the inventory.

Solution

We start by calculating the average inventory on hand. Since no safety stocks are carried, the average
inventory may be calculated as follows (where S is the number of units sold per year and N is the
number of equal-sized orders placed per year):

Average inventory on hand = SN

= 40 000  4

= 5 000

The value of the inventory on hand will amount to R25 000 (5 000 X R5).

Opportunity cost to carry the inventory is R2 500 (R25 000 X 10% cost of capital).

The total cost of carrying the average inventory of R25 000 is calculated as follows:

Opportunity cost R2 500

Storage cost 600

Inventory insurance cost 800

MANCOSA 175
Accounting and Financial Management

Depreciation and obsolescence cost 400

Total carrying costs R4 300

The cost of carrying inventory in this firm is R4 300/R25 000 X 100 = 17.2% of the investment in
inventory.

Total carrying costs (TCC) may also be calculated as follows:

= Percentage carrying cost (C) X Price per unit (P) X Average number of units (A)

= 17.2% X R5 X 5000

= R4 300

7.4.2.2 Ordering costs

Marx et al. (2009:264) define ordering costs as costs associated with placing the order and receiving
the inventory. They include the cost of completing order forms and other documents as well as the
cost of locating, preparing, and transporting the requested goods. The cost for each order is normally
fixed. Total ordering costs may be calculated using the following formula:

TOC = F S

2A

Where:

F is the fixed cost associated with placing each order

S is the number of units sold each year

A is the average number of units on hand

Example 12

RNA Stationers sells 40 000 pens per year and carries an average inventory of 5 000 units. The fixed
ordering costs for placing and receiving orders of these pens amounts to R50 per order. Calculate
the total annual ordering cost for the pens.

176 MANCOSA
 Accounting and Financial Management

Solution

TOC = F S

2A

= R50 X 40 000

2 X 5 000

= R50 X 4

= R200

7.4.2.3 Economic order quantity (EOQ)

Marx et al. (2009:265) point out that the average investment in inventory depends on the number of times
an order is placed, as well as the size of each order. The firm’s carrying costs increase in direct proportion
to the size of the order. On the other hand, ordering costs will decrease if orders are placed less
frequently and larger quantities of inventories are held.

The aim of inventory management is to maintain a balance between the rising and falling costs that will
result in the lowest total cost of inventory for a firm. This may be achieved by determining the economic
order quantity (EOQ).

Block et al. (2009:210) refers to EOQ as the most advantageous quantity for a firm to order each time.
EOQ may be calculated using the following formula:

2SO

Where:

S is the total Sales in units

O is the Ordering cost for each order

C is the Carrying cost per unit

MANCOSA 177
Accounting and Financial Management

Example 13
Assume that BM Retailers anticipate selling 2 000 units during the year 20.11. It will cost R16 to place each
order; the price per unit is R2, with a 20% carrying cost to maintain inventory (resulting in a carrying charge per
unit of R0.40). Calculate the EOQ and subsequently the total costs of the order size and average inventory
determined.

Solution

= 2 X 2 000 X R16
√
R0.40
=
R160 000

400 units

Total costs = Ordering costs + Carrying costs

Ordering costs:

Number of orders for the year = 2 000 units  400 units = 5 orders

Ordering costs = 5 orders X R16 per order = R80

Carrying costs

Average inventory on hand= SN = 2 000  5 = 200 units

2 2

Carrying costs = 200 units X R0.40 = R80

Total cost = Ordering costs + Carrying costs = R80 + R80 = R160

7.4.2.4 Safety stock and Stock-outs

Thus far we have assumed that inventory would be used at a constant rate and that new inventory
would be received when the old level of inventory reached zero. The problem of being out of stock
was not considered. Block et al. (2009:212) defines a stock-out as a situation that arises when a firm
is out of a specific inventory item and is unable to sell or deliver the product. This risk of losing sales
to competitors often forces firms to hold a safety stock to reduce this risk. Safety stock will provide
protection against late deliveries, production delays, equipment breakdowns, and anything else that
could go wrong between the time of placing an order and receiving the goods.

178 MANCOSA
 Accounting and Financial Management

Holding safety stock will increase the cost of inventory due to the increase in carrying costs.

Example 14

Using the information from example 13, suppose a safety stock of 50 units is maintained.

The average inventory figure would now increase to 250 units (200 + 50). The inventory carrying costs
will now increase to R100:

Carrying costs = 250 units X R0.40 per unit = R100

7.5 Sources of Short-Term Financing

According to Marx et al. (2009:188) the purpose of short-term financing is to meet seasonal or temporary financing
needs of less than one year’s duration and may take the form of:

■Spontaneous financing

■unsecured loans

■secured loans

7.5.1 Spontaneous sources of short-term financing

This type of financing arises from a firm’s normal operating cycle and the two main sources are
accounts payable and accruals. Both sources are created spontaneously relative to the level of sales;
they increase or decrease in direct proportion to sales. These sources of financing have no explicit
costs attached to them but accounts payable may have an implicit cost if a cash discount is offered.
(Refer to paragraph 7.2.2.3 to determine the cost to a firm of forfeiting a cash discount allowed by a
supplier.)

MANCOSA 179
Accounting and Financial Management

7.5.1.1 Accounts payable (Trade credit)

Trade credit differs from other forms of short-term credit in that it is not associated with a financial
institution. Credit is granted without security and usually extended for 30 days to 60 days. Trade
credit is an advantageous and important source of credit. It is convenient and flexible. The financial
manager should use it wisely since the trade credit that is received influences the trade credit given.

7.5.1.2 Accruals

Since employees are paid weekly or monthly, some accrued wages/salaries are shown in the
Statement of Financial Position. Accruals for taxes such as income tax and value added tax are also
shown as taxes in the Statement of Financial Position as there are specific dates for payment.

7.5.2 Unsecured sources of short-term financing

The main sources of unsecured short-term financing are bank loans and commercial paper. These
have to be negotiated and applied for.

7.5.2.1 Bank loans (Bank credit)

Commercial banks are the traditional providers of unsecured short-term loans. These short-term loans
are provided by means of:

■ single-payment notes

■ lines of credit

■ compensating balances

■ revolving credit agreements

Before discussing these types of bank loans, let us consider the costs attached to these forms of
financing. Interest rates on bank loans are usually based on the prime rate and may be either a fixed
rate or a floating rate. Prime rate is the lowest rate of interest charged by banks to their most valued
and reliable borrowers. Interest rates on fixed rate loans are set at the date the loan is negotiated
and remain the same for the entire duration of the loan. For floating rate loans, interest rates are
determined at a set increment above prime rate at the negotiation of the loan, but are allowed to vary
above prime as the prime rate varies until maturity.

180 MANCOSA
 Accounting and Financial Management

The cost of bank loans is best evaluated in terms of the effective interest rates which depend on
whether interest is paid in advance or when the loan matures. When interest is paid in advance, the
amount of the interest is subtracted from the face value of the loan when the loan is negotiated. These
loans are referred to as discount loans. The effective interest rate for a discount loan with a one-year
maturity is calculated as follows:

Effective interest rate = Interest X 100

Face value of the loan – Interest 1

Example 15

XYZ Limited wants to borrow R400 000 at a rate of 12% for one year. Interest is payable in advance.
Calculate the effective interest rate.

Solution

Interest amounts to R48 000 (R400 000 X 12%). The amount received from the bank will be R352
000 (R400 000 – R48 000).

Effective interest rate = Interest X 100

Face value of the loan – Interest 1

= R48 000 X 100

R400 000 – R48 000 1

= 13.64%

If interest is payable at maturity, the effective interest rate is determined as follows:

Effective interest rate = Interest X 100

Face value of the loan 1

Example 16

XYZ Limited wants to borrow R400 000 at a rate of 12% for one year. Interest is payable at maturity.
Calculate the effective interest rate.

MANCOSA 181
Accounting and Financial Management

Solution

Interest amounts to R48 000. The amount received from the bank will be R400 000.

Effective interest rate = Interest X 100

Face value of the loan 1

= R48 000 X 100

R400 000 1

= 12%

When interest is paid in advance, the effective interest rate increases.

■ Single-payment notes

Borrowers who require funds for a short period of time can obtain a single payment note from a
commercial bank. The note, which has to be signed by the borrower, specifies the amount borrowed,
the interest rate, the repayment schedule, any collateral required, and any other terms and conditions.
The notes usually have a maturity of 30 to 90 days. The interest charged may be fixed or floating.

■ Line of credit

In this form of credit the bank agrees on a specified maximum amount of credit for a designated period.
It is normally extended for a period up to a year. At the end of the period the line may be extended if
the customer’s creditworthiness has not deteriorated. Interest is usually charged on a floating rate
above prime.

■ Compensating balances

In order to minimise credit risks, banks that offer unsecured loans may require that the borrower
maintain a compensating balance in a demand deposit account equal to a certain percentage of the
amount borrowed. Compensating balances increases the interest cost to the borrower. This is
demonstrated in example 14 below:

Example 17

Jeron Enterprises borrowed R500 000 under a line of credit agreement. The interest rate is 10%. A
compensating balance of 20% of the amount borrowed is required. Calculate the effective interest rate.

182 MANCOSA
 Accounting and Financial Management

Solution

The firm in effect has the use of only R400 000 (80% of R500 000).

The cost of this R400 000 amounts to R50 000 (10% of R500 000).

Effective interest rate = R50 000 X 100

R400 000 1

= 12.5%

However, if the firm usually maintains a balance of R100 000 in its cheque account, the effective interest
rate will be the same as the stated interest rate. The borrower will have full use of the R500 000 as
none is needed to maintain a compensating balance.

■ Revolving credit agreement

This is a formal, committed line of credit often used by large businesses. Suppose a company
negotiates a revolving line of credit of R5 000 000 if it requires funds. The bank commits to lend the
company for a certain period up to R5 000 000 if it requires the funds. In return the company has to
pay an annual commitment fee of a certain percentage on the unused balance. Interest is also charged
for the actual amount taken up as loan.

7.5.2.2 Commercial paper

Commercial paper is an unsecured, short-term promissory note issued by large, financially stable firms
to raise funds. Maturity dates vary from one to nine months. The interest rate varies with supply and
demand conditions. The rates are usually lower than prime rate.

7.5.3 Secured sources of short-term loans

Secured short-term financing requires the borrower to pledge specific assets as collateral. For short-
term borrowing it normally takes the form of current assets such as accounts receivable or inventory.
Firms usually make use of secured loans if unsecured sources of short-term funding are exhausted.

7.5.3.1 Accounts receivable as collateral

Short-term financing may be obtained on a secured basis in one of two ways:

■ Pledging of accounts receivable: Accounts receivable are considered as security for short-term
financing because of the high level of liquidity of this asset. The stated cost of a pledge of accounts
receivable is usually two to five percent above prime rate. The lender may also charge a service fee
to compensate it for its administrative costs.

MANCOSA 183
Accounting and Financial Management

■ Factoring: involves the sale of accounts receivable at a discount to a factor or other financial institution
to acquire funds. The financing institution purchases the firm’s accounts receivable as they occur,
assumes the risk of bad debts, and is responsible for collection. A factor is a financial institution that
specialises in the purchase of accounts receivable from firms. The factoring costs include
commissions and interest.

7.5.3.2 Inventory as collateral

Inventory is considered an attractive security for short-term financing as it usually has a market value
that is greater than its book value and it is the book value of inventory that is used to establish its
value as collateral. Perishable and specialised goods are usually considered less desirable for
security purposes compared to items with stable market prices and ready markets.

Think Point 3.5

Do you think that banks consider secured loans as lower risks than unsecured
loans? Explain.

7.6 Self-Assessment Activities

7.6.1

Would it be possible to have a negative cash conversion cycle? Explain.

7.6.2

In the management of cash, why should the primary concern be for safety and liquidity rather than profitability?

7.6.3 Suppose Intraflora has annual sales of R460 000, cost of sales of R330 000, inventories of R9 000,
accounts receivable of R50 000, and accounts payable balance of R14 000. If all the sales are on
credit and credit purchases are R330 000, what will be the firm’s cash conversion cycle?

7.6.4 Discuss the three quantitative measures that can be applied to the collection policy of a firm.

7.6.5 What are the five Cs of credit that are sometime used by bankers and others to determine whether a
potential loan will be repaid?

184 MANCOSA
 Accounting and Financial Management

7.6.6 GH Furnishers is considering extending credit to some customers who were previously considered
to be poor risks. Sales will increase by R200 000 if credit is granted to these customers. From the
new accounts receivable generated, 10% is expected to be uncollectible. Additional collection costs
will be 3% of sales, and the production and selling costs will be 80% of sales. The firm is in the 30%
tax bracket.

7.6.6.1 Calculate the incremental profit after tax.

7.6.6.2 Calculate the incremental return on sales if these new credit customers are accepted.

7.6.6.3 If the receivable turnover ratio is 6 to 1, and no other asset build-up is required to serve these
customers, what will the incremental return on average investment be?

7.6.7 Beenie Appliances is considering selling a dishwasher to Mrs L. Kuene on credit. The cost of the
dishwasher is R2 500 and the selling price is R4 000. A credit term of 2/15 net 60 was agreed upon.
The cost of capital to Beenie Appliances is 12%.

7.6.7.1 Calculate the profit that Beenie Appliances would make if the account is settled within 15 days.

7.6.7.2 Should the customer fail to pay the amount due and the account is written off after 90 days, what
would be the loss to the firm?

7.6.8 Should a firm always turn over long-overdue debts from customers to a collection agency or even sue
the customers? Why or why not?

7.6.9 The annual sales of EMI Limited is 1 200 000 units. The purchase price is R4 per unit. The carrying
cost of inventory amounts to 25% of the purchase price. The ordering cost is R40 per order.

7.6.9.1 Calculate the EOQ.

7.6.9.2 Calculate the number of orders that need to be placed each year.

7.6.9.3 Calculate the total cost of the order size and average inventory determined.

7.6.10 Regeant Cosmetics, a seller of perfumes, had the following inventory of perfume gift sets on
hand on 01 January 20.11, the start of the financial year.

20 units at R100 each purchased on 30 August 20.10

MANCOSA 185
Accounting and Financial Management

30 units at R110 each purchased on 15 December 20.11

During 20.11 the following purchases were made:

40 units at R120 each were purchased on 30 April 20.11

35 units at R130 were purchased on 30 September 20.11

During the year 60 perfume gift sets were sold at R160 each.

Calculate the gross profit and closing inventory using the FIFO, LIFO, and Weighted average
cost methods.

7.6.11 What is prime interest rate? How does the average bank customer fare with regard to the prime
interest rate?

7.6.12 What are the benefits of commercial paper in comparison to bank borrowing?

7.6.13 What is the difference between pledging accounts receivable and factoring accounts
receivable?

7.6.14 RICA Limited plans to borrow R4 000 000 for one year. The stated interest rate is 12%.
Calculate the effective interest rate if:

7.6.14.1 The interest is discounted.

7.6.14.2 There is a 20% compensating balance requirement.

7.7 Suggested Solutions

Think Point 7.6

It may have to use negotiated forms of financing such as unsecured short-term

loans to support the cash conversion cycle. This is necessary because of the
difference between the number of days the resources are tied up in the
operating cycle and the number of days the business can use trade credit
before payment has to be made.

186 MANCOSA
 Accounting and Financial Management

Think Point 7.7

It will have a direct effect on its sales volume, level of accounts receivable, and
bad debts expenses. A relaxation of credit standards will:

■Increase the number of credit customers and consequently sales.

■Lead to an increase in the investment in accounts receivable due to the

increase in sales.

■Increase the possibility of bad debts since credit may be granted to customers
with lower credit ratings.

Think Point 7.8

Marx et al. (2009:244) offers the following advice:

■Send only one final warning letter.

■Do not make empty threats.

■Be polite but business-like.

■State the exact deadline for payment and the amount payable.

■State what would happen if no reply is received.

■Send the letter by registered mail where possible.

Think Point 7.9

During periods of inflation (when costs are rising), LIFO results in a lower closing
inventory and a higher cost of goods sold than FIFO. This is because the LIFO
assumption results in the most recent, higher, costs being transferred to cost of
goods sold (cost of sales).

Think Point 7.10

No Securing a loan does not change the risk of default and the use of collateral has
no impact on reducing default. It only ensures that possible recovery of part or the
entire loan if there is default.

MANCOSA 187
Accounting and Financial Management

7.6.1 Yes. A negative cash conversion cycle arises where the average payment period exceeds the
operating cycle.

7.6.2 The survival of a firm is ultimately directly linked to its cash than to an intangible value called
profitability. A firm may be profitable from an accounting point of view but without adequate cash
flows to meet its obligations, it will not survive.

7.6.3

Operating cycle = Inventory period + Debtor collection period

= Inventory X 365 + Accounts receivable X 365

Cost of sales 1 Credit sales 1

= R9 000 X 365 + R50 000 X 365

R330 000 1 R460 000 1

= 9.95 days + 39.67 days

= 49.62 days

Cash conversion cycle = Operating cycle – Creditor payment period

= Operating cycle – Accounts payable X 365

Credit purchases 1

= 49.62 days – R14 000 X 365

R330 000 1

= 49.62 days – 15.48 days

= 34.14 days

7.6.4 Three quantitative measures that may be used to assess a firm’s collection policy:

The debtor collection period tells us how long trade debtors meet their obligations to pay following
the sale on credit. If the collection period exceeds what is specified in the policy, then steps need to
be taken to remedy matters

188 MANCOSA
 Accounting and Financial Management

■ Ratio of bad debts to credit sales (bad debt ratio) is used to monitor bad debts.

A firm determines certain confidence limits based on the expected value of this ratio e.g. a bad debt
ratio of 5% is generally expected for businesses

■ An ageing schedule is one way of finding out if customers are paying their accounts within the time
prescribed in the credit terms. A build-up of receivables beyond the normal credit terms will result in
poor cash inflows and would require more stringent credit terms and collection procedures.

7.6.5 Refer to paragraph 7.3.1.1

7.6.6.1

Additional sales 200 000

Bad debts (10% of sales) (20 000)

Annual incremental revenue 180 000

Collection costs (3% of new sales) (6 000)

Production and selling costs (80% of new sales) (160 000)

Annual profit before tax 14 000

Income tax (30%) (4 200)

Annual incremental profit after tax 9 800

7.6.6.2 Return on sales is 4.9% (R9 800/R200 000 X 100).

7.6.6.3 The new accounts receivable balance will average R33 333 (R200 000/6).

The Incremental return on average investment is 29.4%.

(R9 800/R33 333 X 100).

MANCOSA 189
Accounting and Financial Management

7.6.7.1 Firstly, there is a reduction of R80 (2% of R4 000) on the selling price if the account is paid within
15 days.

Added credit cost to the business = R2 500 X 12% X 15 days

365 days

= R12.33

Profit:

Effective price (R4 000 – R80) 3 920.00

Less: Cost of sales (2 500.00)

Less: Credit cost (12.33)

Profit 1 407.67

7.6.7.2 R2 500 + (R2 500 X 12% X 90/365)

= R2 500 + R73.97

= R2 573.97

7.6.8 Not always. If the amount owing is small enough, it may not be worth pursuing the overdue debt.
However, if a collection agency is willing to work for a percentage of the amount recovered, the firm
may as well turn the collection over to the agency no matter what the size involved since there is no
cost to the firm.

7.6.9.1 EOQ =

= √ 2 X 1 200 000 X R40

= 4 (0.25) R1

R96 000 000

9 798 units

7.6.9.2 Number of orders for the year = 1 200 000 units  9 798 units = 123 orders

190 MANCOSA
 Accounting and Financial Management

7.6.9.3 Ordering costs = 123 orders X R40 per order = R4 920

Carrying costs

Average inventory on hand= SN = 1 200 000  123 = 4 878 units

2 2

Carrying costs = 4 878 units X (25% of R4) = R4 878

Total cost = Ordering costs + Carrying costs = R4 920 + R4 878 = R9 798

7.6.10 FIFO

Statement of Comprehensive Income for the year ended 31 December 20.11

Sales 9 600 (R160 X 60)

Cost of sales (6 500)

Opening inventory 5 300 (R100 X 20) + (110 X R30)

Purchases 9 350 (R120 X 40) + (R130 X 35)

14 650

Closing inventory (8 150) (R130 X 35) + (R120 X 30)

Gross profit 3 100

MANCOSA 191
Accounting and Financial Management

LIFO

Statement of Comprehensive Income for the year ended 31 December 20.11

Sales 9 600 (R160 X 60)

Cost of sales (7 550)

Opening inventory 5 300 (R100 X 20) + (110 X R30)

Purchases 9 350 (R120 X 40) + (R130 X 35)

14 650

Closing inventory (7 100) (R100 X 20) + (R110 X 30) + (R120 X 15)

Gross profit 2 050

WEIGHTED AVERAGE (R14 650  125 units (20+30+40+35) = R117.20 per unit)

Statement of Comprehensive Income for the year ended 31 December 20.11

Sales 9 600 (R160 X 60)

Cost of sales (7 032) (60 X R117.20)

Opening inventory 5 300 (R100 X 20) + (110 X R30)

Purchases 9 350 (R120 X 40) + (R130 X 35)

14 650

Closing inventory (7 618) (65 X R117.20)

Gross profit 2 568

7.6.11 Prime interest rate is the lowest rate of interest charged by banks to their most valued and reliable
borrowers. The average bank customer can expect to pay one or two percentage points above prime.

7.6.12 Commercial paper may be issued at below the prime interest rate. Secondly, no compensating balance
requirements are associated with the issue. Lastly, a number of firms enjoy the prestige associated
with being able to float their commercial paper in what is regarded as a “snobbish market” for funds.

192 MANCOSA
 Accounting and Financial Management

7.6.13 Refer to paragraph 7.5.3.1

7.6.14.1

Effective interest rate = Interest X 100

Face value of the loan – Interest 1

= R480 000 X 100

R4 000 000 – R480 000 1

= 13.64%

7.6.14.2

The firm in effect has the use of only R3 200 000 (80% of R4 000 000).

The cost of this R3 200 000 amounts to R480 000 (12% of R4 000 000).

Effective interest rate = R480 000 X 100

R3 200 000 1

= 15%

MANCOSA 193
 Accounting and Financial Management

Unit
8: Cost-Volume-Profit
Relationships

194 MANCOSA
 Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Describe what is meant by cost-volume-profit  Complete relevant readings and activities provided.
(CVP) analysis.

 Understand the fundamentals of CVP

analysis

 Use the CVP relation to plan profit.

 Make short-term decisions using CVP

analysis.

 Classify cost by their behaviour as fixed

costs, variable costs, or mixed costs.

8.1 Introduction
8.2 Cost Classifications
8.3 Cost-Volume-Profit Relationships
8.4. Self-Assessment Activities
8.5 Suggested Solutions

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:

 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of

Financial Management. 13th Edition. New York: McGraw-Hill/Irwin

Recommended Reading:
 Drury C. (2008) Management and Cost Accounting. 7th edition.
Hampshire: South-Western Cengage Learning.

 Marshall, D.H., McManus, W.W. and Viele, D.F. (2011) Accounting: What
the numbers mean. 9th Edition. New York: McGraw-Hill

MANCOSA 195
Accounting and Financial Management

8.1 Introduction
Knowledge of how costs behave is important to management for a number of reasons. Amongst other things it
allows management to predict profits as sales, costs and production volume change. It is also useful for
estimating costs. Estimated costs themselves affect a number of management decisions e.g. whether to use
excess capacity to produce and sell a product at a lower price.

8.2 Cost Classifications

Cost behaviour refers to the way in which a cost changes as a related activity changes. Marshall et al (2011:
455) state that the most common classification of cost behaviour is variable costs, fixed costs and semi-variable
(mixed) costs. Variable costs are costs that change in proportion to changes in the volume of activity e.g. raw
material cost to produce a product has a variable cost behaviour pattern because an increase in the number of
units produced will increase the total raw materials cost. Fixed costs are costs that remain the same in total
Rand amount as the level of activity varies. For example rent expense is a fixed cost because rent expense will
not change irrespective of the level of production.

Think Point 8.1

Will you consider wages paid to employees in a factory to be a fixed cost or a variable
cost? Why?

Not all costs can be classified as either fixed or variable. Some are a combination of fixed costs and variable costs
and are called semi-variable or mixed costs. For example the total electricity consumption at a factory changes
with production levels as the number of machine hours changes. However, if production drops to zero, electricity
would still be used for lighting and heating or cooling of plant facilities.

8.3 Cost-Volume-Profit Relationships

According to Drury (2008: 166) Cost-Volume-Profit (CVP) analysis is an examination of the relationships between
changes in activity (i.e. output) and changes in production volume, costs and profits. In particular it examines the
effect on profits when there are changes in factors such as selling price, variable costs, fixed costs, volume and
the number of products marketed. CVP analysis puts management in a better position to cope with various short-
term planning decisions.

196 MANCOSA
 Accounting and Financial Management

Using CVP analysis, managers would be able to get information to use in decision-making relating to the
following:

 How profits are affected by a change in costs.

 What effect a change in sales volume will have on profit.

 The profit that is expected from a certain sales volume.

 How many units need to be sold to achieve a targeted profit.

 At what output of production will the income and costs be the same.

 Setting selling prices.

 Selecting the mix of products to sell.

In today’s competitive business environment, management must make such decisions quickly and correctly.

8.3.1 Contribution margin concept

One relationship among cost, volume and profit is the contribution margin. Marshall et al (2011: 455)
define contribution margin as the difference between sales revenues and variable costs. The
contribution margin concept is useful as it gives insight into the profit potential of an entity.

8.3.2 The traditional Statement of Comprehensive Income format and the Contribution Margin
Statement of Comprehensive Income format

Marshall et al (2011: 455) illustrate the difference between an Statement of Comprehensive Income
prepared according to the traditional format and an Statement of Comprehensive Income prepared
according to a contribution margin format as follows:

MANCOSA 197
Accounting and Financial Management

STATEMENTS OF COMPREHENSIVE INCOME

Traditional format Contribution margin format

Sales R600 000 Sales R600 000

Cost of sales (400 000) Variable costs (480 000)

Gross profit 200 000 Contribution margin 120 000

Operating expenses (120 000) Fixed costs (40 000)

Operating profit R80 000 Operating profit R80 000

Figure 8.119

Contribution margin (as reflected in Figure 9-1) means that this amount is the contribution to fixed
expenses and operating profit.

When the traditional Statement of Comprehensive Income is used, incorrect conclusions may be drawn
when changes in activity levels are being considered because it is assumed that all expenses change
in proportion to changes in activity. This error is avoided when the contribution model is used correctly.

8.3.3 An expanded contribution margin model

Marshall et al (2011: 463) recommend an expanded version of the contribution model for analytical
purposes. Its benefits are best understood when applying it to a single product. The expanded
model is:

Per unit x Volume = Total %

Sales R

Variable costs

Contribution margin R x = R %

Fixed costs

Operating profit R

Figure 8.220

198 MANCOSA
 Accounting and Financial Management

The following steps are recommended when using the model:

 Express sales, variable costs and contribution margin on a per unit basis.

 Multiply contribution margin per unit by volume to obtain total contribution margin.

 Subtract fixed costs from total contribution margin to obtain operating profit.

 Express contribution margin as a percentage of sales.

The above expanded model demonstrates the effect on operating profit of changes in selling price,
variable costs, fixed costs, or the volume of activity. In the examples that follow, you will observe the
following four relationships constantly interacting with one another:

 Sales – Variable costs = Contribution margin

 Contribution margin ÷ Sales = Contribution margin ratio

 Total contribution margin depends on the volume of activity

 Contribution must cover fixed costs before an operating profit is earned.

Example 1 – Calculation of operating profit

Suppose management needs to know the operating profit from a product with the following sales,
cost and volume figures:

Selling price per crate R30

Variable costs per crate R18

Fixed costs in respect of the product R80 000

Sales volume in crates 8 000 crates

Figure 8.3
21

MANCOSA 199
Accounting and Financial Management

Applying the figures in the model results in the following operating profit:

Per unit x Volume = Total %

Sales R30

Variable costs R18

Contribution margin R12 x 8 000 = R96 000 40%

Fixed costs (80 000)

Operating profit R16 000

Figure 8.4
22

Example 2 – Drop in selling price and increase in sales volume

Suppose that management wants to know what would happen to operating profit if a R6 per unit drop
in selling price were to result in a sales volume increase of 4 000 units, to a total of 12 000 units.

The operating profit will be:

Figure 8.5
23

Per unit x Volume = Total %

Sales R24

Variable costs 18

Contribution margin R6 x 12 000 = R72 000 25%

Fixed costs (80 000)

Operating loss (R8 000)

The calculations above clearly demonstrates to management not to implement the drop in selling price by
R6 as the result will be an operating loss of R8 000.

200 MANCOSA
 Accounting and Financial Management

Example 3 – Decrease in selling price accompanied by an increase in advertising expense and an

expected increase in sales volume

Suppose management wants to implement the same R6 drop in (as per example 2) the selling price per unit
accompanied by a R6 000 increase in advertising expense, with the prediction that sales volume will
increase to 19 000 crates.

Operating profit is expected to be:

Per unit x Volume = Total %

Sales R24

Variable costs 18

Contribution margin R6 x 19 000 = R114 000 25%

Fixed costs (86 000)

Operating profit R28 000

Figure 8.6
24

The calculations suggest that if the sales volume increase is possible from the price cut and increased
advertising (fixed cost), then operating profit will increase from its current level. However, the relevant
range assumption must be considered here as a large increase in sales volume is likely to have an
impact on fixed costs.

Example 4 – Calculating the volume of sales required to achieve a target level of operating
profit

Using the original data from Example 1, suppose management wants to know the sales volume
required to achieve an operating profit of R46 000. The solution entails recording the known data in
the model and working to the middle to obtain the required sales volume:

MANCOSA 201
Accounting and Financial Management

Per unit x Volume = Total %

Sales R30

Variable costs R18

Contribution margin R12 x ? = R126 000 40%

Fixed costs (80 000)

Operating profit R46 000

Figure 8.7
25

The required sales volume is 10 500 units (R126 000 ÷ R12).

Example 5 – Effect on contribution margin and operating profit when a change in operations
is expressed in terms of total sales.

Suppose the contribution margin is 40% and total sales are predicted to increase by

R24 000.

Using the marginal income ratio, it is expected that contribution margin and operating profit will
increase by R9 600 (R24 000 X 40%) provided that fixed costs did not change.

Example 6 – Increase in sales and sales volume required to cover an increase in fixed costs

Suppose fixed costs were to increase by R18 000, selling price is R15 per unit and the contribution
margin ratio is 40%.

The contribution margin has to increase by the same amount if operating profit was to remain the
same. Sales will have to increase by R45 000 (R18 000 ÷ 40%) to earn a

R18 000 increase in contribution margin. The sales volume increase that is required to generate the
additional sales is calculated by dividing R45 000 by the selling price per unit, which is R15. The
volume increase is 3 000 units (which can also be calculated by dividing the increased contribution
margin required R18 000 by the margin contribution of R6 per unit).

202 MANCOSA
 Accounting and Financial Management

Example 7 – Determining sales and contribution margin changes when per unit data is not
available or applicable

The contribution margin model is often used to analyse the impact of an entire product line (e.g. a
chocolate bar brand) that is sold in a variety of package or size configurations (with each configuration
having virtually the same contribution margin ratio). Suppose a product line had a contribution margin
of 40%, would an advertising programme costing R36 000 be effective if it generated an additional
R100 000 of sales?

The increase in contribution margin would be R40 000 (R100 000 X 40%) which is R4 000 more than
the cost of the advertising. Thus the program would be cost effective.

8.3.4 Sales mix considerations

The sales mix issue must be considered when applying the contribution margin model using data for
more than one product. Sales mix is the relative distribution of sales among the various products sold
by an entity. Since different products often have different contribution margin ratios, the average
contribution margin ratio for a given mix of products will vary if the sales mix of the products varies.

Table 9-8 illustrates the effect of a change in the sales mix. You will notice that though sales volume
remained the same (6 000 units), total sales increased (from R135 000 to R138 000) and operating
profit decreased (from R16 000 to R14 800). This can be attributed to the sale of more units of product
X (with a lower contribution margin ratio) than product Y (which had a higher contribution margin ratio).
Consequently the company’s average contribution margin ratio also dropped (from 35,6% to 33,9%).

When an entity markets products of varying degrees of quality, products of a higher quality usually have higher
contribution margin ratios and marketing efforts are usually concentrated on those products. Entities that market
products with similar contribution margin ratios do not have to be concerned about changes in the sales mix.
Marketing efforts can be more evenly spread.

MANCOSA 203
 Accounting and Financial Management

(1). Assume that a company market 2 products. Shown below are per unit sales, variable costs and product volumes for current operations:

Product X Product Y Total for company

Per Per
unit unit
x Volume = Total % x Volume = Total % Total %
Sales R25 3 000 R75 000 Sales R20 3 000 R60 000 135 000 100%
Variable costs R18 Variable costs R11
Contribution margin R7 x 3 000 = R21 000 28% Contribution margin R9 x 3 000 = R27 000 45% R48 000 35,6%
Fixed costs Fixed costs (32 000)
Operating profit Operating profit R16 000

(2). Now assume a change in the sales mix: Sales volume of product X increases to 3 600 units and sales volume of product Y drops to 2 400.

Product X Product Y Total for company

Per Per
unit unit
X Volume = Total % x Volume = Total % Total %
Sales R25 3 600 R90 000 Sales R20 2 400 R48 000 138 000 100%
Variable costs R18 Variable costs R11
Contribution margin R7 X 3 600 = R25 200 28% Contribution margin R9 x 2 400 = R21 600 45% R46 800 33,9%
Fixed costs Fixed costs (32 000)
Operating profit Operating profit R14 800

Figure 8.826

204 MANCOSA
 Accounting and Financial Management

8.3.5 Break-even point

The break-even point is the level of operations at which the revenues of an entity are equal to its
total costs. In other words, the entity has neither a profit nor a loss from operations. Expressed in
another way it is the point at which operating profit is equal to zero.

Think Point 8.2

Of what significance is the break-even point to management?

There are various ways of calculating the break-even point. We will use the contribution margin model
to determine the break-even point. The break-even point can be calculated in terms of units and
revenues (Rand value). The following figure will be used to illustrate this:

Per unit x Volume = Total %

Sales R30

Variable costs R18

Contribution margin R12 x ? = ? 40%

Fixed costs (96 000)

Operating profit 0

Figure 8.9
27

In terms of the model, contribution margin must be equal to the fixed costs in order to break-even.
Therefore:

MANCOSA 205
Accounting and Financial Management

Break-even quantity = Fixed costs

Contribution margin per unit

= R96 000

R12

= 8 000 units

Total revenues at break-even = Fixed costs OR

Contribution margin ratio No. of units X Revenue

per unit

= 8 000 X R30
= R96 000

40%

= R240 000
= R240 000

Figure 8.10
28

8.3.6 Target-profit analysis

A target profit is the operating profit that an entity wants to achieve over a stated period. CVP analysis
can also be used to determine the sales (in units or Rand value) needed to achieve a target profit.
This can be done by modifying the break-even formula stated above. Using the information from
Figure 9-9 and a target profit of R24 000:

MANCOSA 206
 Accounting and Financial Management

Target sales volume = Fixed costs + Target profit

Contribution margin per unit

= R96 000 + R24 000

R12

= 10 000 units

Target sales value = Fixed costs + Target profit

Contribution margin ratio

= R96 000 + R24 000

40%

= R300 000

Figure 8.11
29

8.3.7 Margin of safety

The margin of safety is the amount by which the actual level of sales exceeds the break-even point.
It is the amount by which the sales volume may drop before losses are incurred. If the margin of
safety is low, even a small decrease in sales revenue may result in an operating loss. The margin of
safety may be expressed as a percentage and is calculated as follows:

Margin of safety = Sales – Break-even sales X 100

Sales

Figure 8.12
30

If sales are R125 000 (10 000 units), the unit selling price is R12,50, and the sales at break-even
point are R100 000 (8 000 units), the margin of safety is 20%, calculated as follows:

207 MANCOSA
Accounting and Financial Management

Margin of safety = Sales – Break-even sales X 100

Sales

= R125 000 – R100 000 X 100

R125 000

= 20%

Figure 8.13
31

The margin of safety may be expressed in terms of value or Rand sales:

R125 000 – R100 000 = R25 000 or R125 000 X 20% = R25 000.

The margin of safety can also be expressed in units. In this case it would be 2 000 units:

10 000 units – 8 000 units = 2 000 units or R25 000 ÷ R12,50 = 2 000 units.

This means that present sales may decrease by R25 000 or 2 000 units before an operating loss
results.

8.4. Self-Assessment Activities

8.4.1 Classify the following costs as fixed or variable in terms of the level of output. Place a tick in the
appropriate column.

No. Cost Fixed cost Variable cost

1. Rent expense

2. Direct materials

3. Property rates and taxes

4. Commission of salesperson

5. Depreciation using straight-line method

6. Direct labour

7. Insurance

8. Salary of factory manager

MANCOSA 208
 Accounting and Financial Management

8.4.2 AIM Ltd supplies component J to furniture manufacturers. The marketing manager is of the opinion
that if the selling price of component J is reduced, sales could increase by 25%. The following
information is available:

Present Proposed

Selling price per unit R6 R5

Sales volume 100 000 units 25% more

Variable cost per unit R4 R4

Fixed costs R140 000 R140 000

Operating profit R60 000 ?

Required
8.4.2.1
Calculate the expected profit or loss on the marketing manager’s proposal.
8.4.2.2
Calculate the number of sales units required under the proposed price to make a profit of R60 000.

Calculate the sales value required under the proposed price to make a profit of
8.4.2.3
R60 000.

8.4.3 Yashik CC manufactures one product. The following details relating to the product applies:

Variable costs per unit R72

Total fixed cost R36 000

Selling price per unit R82

Number of units sold 6 000

Required

8.4.3.1 Calculate the break-even quantity and break-even value.

8.4.3.2 Calculate the margin of safety in terms of units and value.

209 MANCOSA
Accounting and Financial Management

8.4.4 Kivi Ltd manufactures and sells only one product. The budgeted details for 20.7 are as follows:

Sales (units) 150 000 per month

Selling price per unit R3

Variable cost per unit R1,40

Total fixed cost R1 350 000

Required

8.4.4.1 Calculate the budgeted profit for 20.7.

8.4.4.2 Calculate the break-even quantity and value.

8.4.4.3 Suppose Kivi (Pty) Ltd wants to make provision for a 10% increase in fixed costs and an increase
in variable costs by R0,20 per unit. Taking these increases into account, calculate the following:

New break-even quantity and value

Safety margin (in terms of value)

8.4.4.3.1
The number of units that need to be sold to earn an operating profit of R400 000
8.4.4.3.2

8.4.4.3.3

8.4.5 HJK Limited sells two products viz. product A and product B. The fixed costs are

R300 000 and the sales mix is 60% product A and 40% product B. The unit selling price and unit
variable cost for each product are as follows:

Products Unit selling price Unit variable cost

Product A R2,80 R1,10

Product B R2,00 R0,80

MANCOSA 210
 Accounting and Financial Management

Required:

8.4.5.1 Calculate the total break-even quantity.

8.4.5.2 How many units of each product would be sold at break-even point?

8.4.6 FMB Enterprises sales for March 20.7 was R200 000. Operating profit was R20 000. Variable costs
are usually 60% of sales. Suppose sales dropped by 15% in April to

R170 000. Would it be correct to say that operating profit will decline by 15% to R17 000? Motivate
your answer.

8.5 Suggested Solutions

Think Point 8.5

Wages appears to be a variable cost since total wage costs vary according to the
number of hours worked. However, when a factory is producing below expected
volume, in many cases the employees are not asked to go home but remain at
work. In other words, each employee still works for the normal working week
duration (e.g. 45 hours). In this case the wages of the hourly paid employees is
considered to be a fixed cost as the total hours worked does not vary with
production

Think Point 8.6

Provides the minimum sales target that must be achieved before an entity can start
showing a profit. Expressed another way, it is the sales level that must be reached
before an entity ceases to be unprofitable. Many managers find it simpler to think
in terms of sales rather than fixed and variable costs. Break-even point is a useful
planning tool, especially when decisions have to be made whether to increase or
decrease operations.

211 MANCOSA
Accounting and Financial Management

8.4.1

No. Cost Fixed cost Variable cost

1. Rent expense 

2. Direct materials 

3. Property rates and taxes 

4. Commission of salesperson 

5. Depreciation using straight-line method 

6. Direct labour 

7. Insurance 

8. Salary of factory manager 

8.4.2.1 Expected profit or loss Per unit x Volume = Total %

Sales R5

Variable costs R4

Contribution margin R1 x 125 000 = 125 000 20%

Fixed costs (140 000)

Operating loss (15 000)

8.4.2.2 Target sales volume = Fixed costs + Target profit

Contribution margin per unit

= R140 000 + R60 000

R1

= 200 000 units

MANCOSA 212
 Accounting and Financial Management

8.4.2.3 Target sales value = 200 000 X R5 = R1 000 000

This amount can also be calculated as follows:

Target sales value = Fixed costs + Target profit

Contribution margin ratio

= R140 000 + R60 000

20%

= R1 000 000

8.4.3 Per unit x Volume = Total %

Sales R82 6 000 492 000

Variable costs R72 6 000 (432 000)

Contribution margin R10 x 6 000 = 60 000 12,195%

Fixed costs (36 000)

Operating profit 24 000

8.4.3.1 Break-even quantity = Fixed costs

Contribution margin per unit

= R36 000

R10

= 3 600 units

213 MANCOSA
Accounting and Financial Management

8.4.3.1 Total revenues at break-even = Fixed costs

Contribution margin ratio

= R36 000

12,195%

= R295 200 (rounded off) (OR 3 600 X R82)

8.4.3.2 Margin of safety = Sales units – Break-even sales units

(in terms of units)

= 6 000 – 3 600

= 2 400 units

8.4.3.2 Margin of safety = Sales – Break-even sales

(in terms of value)

= R492 000 – R295 200

= R196 800

8.4.4.1 Per unit x Volume = Total %

Sales R3

Variable costs R1,40

Contribution margin R1,60 x 1 800 000 = 2 880 000 53,333%

Fixed costs (1 350 000)

Operating profit 1 530 000

MANCOSA 214
 Accounting and Financial Management

Note: Sales volume = 150 000 X 12 months = 1 800 000

8.4.4.2 Break even quantity = Fixed costs

Contribution margin per unit

= R1350 000
R1,60

= 843 750 units

8.4.4.2 Total revenues at break-even = Fixed costs

Contribution margin ratio

= R1 350 000
53,333%

= R2 531 250 (rounded off)

(OR 843 750 X R3)

8.4.4.3
Per unit x Volume = Total %

Sales (Volume:150 000 X 12) R3 1 800 000 5 400 000

Variable costs (R1,40 + R0,20) R1,60

Contribution margin R1,40 x 1 800 000 = 2 520 000 46,667%

Fixed costs (R1 350 000 +R135 000) 1 485 000

Operating profit 1 035 000

215 MANCOSA
Accounting and Financial Management

8.4.4.3.1 Break even quantity = Fixed costs

Contribution margin per unit

= R1 485 000
R1,40

= 1 060 714 units

Total revenues at break-even = Fixed costs

Contribution margin ratio

= R1 485 000

46,667%

= R3 182 120 (rounded off)

(OR 1 060 714 X R3)

8.4.4.3.2 Margin of safety = Budgeted sales – Break-even sales

(in terms of value)

= R5 400 000 – R3 182 120

= R2 217 880

8.4.4.3.3 Target sales volume = Fixed costs + Target profit

Contribution margin per unit

= R1 485 000 + R400 000

R1,40

= 1 346 429 units

MANCOSA 216
 Accounting and Financial Management

8.4.5

Product A + Product B = Total

Selling price R2,80 R2,00

Variable cost per unit R1,10 R0,80

Contribution margin per unit (R1,70 X 60%) + (R1,20 X 40%) = R1,50

8.4.5.1 Break even quantity = Fixed costs

Contribution margin per unit

= R300 000

R1,50

= 200 000 units

8.4.5.2 Break-even quantity of product A = 200 000 X 60% = 120 000 units

Break-even quantity of product B = 200 000 X 40% = 80 000 units

8.4.6 STATEMENTS OF COMPREHENSIVE INCOME

May 20.7 April 20.7

Sales 200 000 Sales 170 000

Variable costs (60%) (120 000) Variable costs (60%) (102 000)

Contribution margin 80 000 Contribution margin 68 000

Fixed costs (60 000) Fixed costs (60 000)

Operating profit 20 000 Operating profit 8 000

217 MANCOSA
Accounting and Financial Management

The answer is no. From the calculations above it is clear that operating profit will drop by R12 000 to R8 000
(and not drop to R17 000). Since fixed costs remained unchanged, the R12 000 decrease in contribution margin
(resulting from the 15% decrease in sales) reduced the operating profit by the same amount. This illustrates the
point that fixed costs behave differently from variable costs.

MANCOSA 218
 Accounting and Financial Management

Unit
9:
Cost of Capital

219 MANCOSA
Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 define cost of capital and its Importance  Complete relevant readings, think points and
activities provided.
 calculate and interpret the weighted average
cost of capital (WACC) of a company

 describe how taxes affect the cost of capital

from different capital sources

 describe the use of target capital structure in

estimating WACC and how target capital
structure weights may be determined

 calculate and interpret the cost of debt

capital using the yield-to-maturity approach

 calculate and interpret the cost of

noncallable, nonconvertible preferred stock

 calculate and interpret the cost of equity

capital using the capital asset pricing model
(CAPM) approach and the dividend discount
model (DDM) approach

 explain and demonstrate the correct

treatment of flotation costs

MANCOSA 220
 Accounting and Financial Management

9.1 Introduction
9.2 Cost of Capital
9.3 Cost of Common Equity
9.4 Cost of Debt and Preferred Stock
9.5 Flotation Costs
9.6 Weighted Average Cost of Capital (WACC)
9.7 Weighted Marginal Cost of Capital (WMCC)

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:

 2014) Financial Management in Southern Africa. 4th Edition. Cape Town:

Pearson Education

Recommended Reading:
 Atrill, P. and McLaney, E. (2008) Accounting and Finance for non-
specialists. 6th Edition. London: Pearson Education Limited.
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.
 Gitman, L.J., Smith, M.B., Hall, J., Lowies, B., Marx, J, Strydom, B. and
van der Merwe, A. (2010) Principles of Managerial Finance. 1st Edition.
Cape Town: Pearson Education

221 MANCOSA
Accounting and Financial Management

9.1 Introduction

Businesses need to earn a return before they generate revenue. Before a business can turn a profit, it must at
least generate sufficient income to cover the cost of the capital it uses to fund its operations. Cost of capital consists
of both the cost of debt and the cost of equity used for financing a business. A company’s cost of capital depends
to a large extent on the type of financing the company chooses to rely on. The company may rely solely on equity
or debt, or use a combination of the two. The choice of financing makes the cost of capital a crucial variable for
every company, as it will determine the company’s capital structure. Companies look for the optimal mix of financing
that provides adequate funding and that minimizes the cost of capital.

9.2 Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value. It
represents the investors` opportunity cost of taking on the risk of putting money into a company. For this reason,
the cost of capital maybe referred to as required return or an appropriate discount rate.

It is important to correctly compute an organization’s cost of capital since the cost of capital affects a number of
important decisions that will be made by the organization’s management. It is worth noting that the cost of capital
associated with an investment depends on the risk of that investment. In other words, that there is no income a
firm can generate without incurring an element of risk otherwise arbitrage opportunity exists which may cause
ruckus in the market. Given that the capital structure (mixture of debt and equity) of a firm is a managerial variable,
the cost of capital will reflect both its cost of debt and cost equity. We will discuss these costs separately in the
sections that follow.

9.3 What is Cost of Equity (kE)?

Cost of Equity (ke) is the rate of return a shareholder requires for Investing equity into a business. The rate of return an
investor requires is based on the level of risk associated with the investment, which is measured as the historical volatility of
returns. A firm uses cost of equity to assess the relative attractiveness of investments, including both internal projects and
external acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity capital
being more expensive. The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model), The dividend
discount model approach and Bond yield plus risk premium approach

9.3.1 CAPM (Capital Asset Pricing Model)

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the
estimates made in the calculation (because it uses historical information)

MANCOSA 222
 Accounting and Financial Management

CAPM Formula:
E(RI) = Rf + βi * [E(Rm) – Rf]
Where:

E(Ri) = Expected return on asset i

Rf = Risk-free rate of return

βi = Beta of asset i

E(Rm) = Expected market return

Step 1: Estimate the risk-free rate, Rf. Yields on default risk-free debt such as government Treasury
notes are usually used. The most appropriate maturity to choose is one that is close to the useful life of the project.
Step 2: Estimate the stock’s beta, β. This is the stock’s risk measure.
Step 3: Estimate the expected rate of return on the market, E(Rm).
Step 4: Use the capital asset pricing model (CAPM) equation to estimate the required rate of Return

Example: Using CAPM to estimate cost of equity (Ke)

Suppose a hypothetical company, Dexter has a beta of 1.1, Risk free rate =6%, Return on the market =11%. Estimate
Dexter’s cost of equity.
Answer
The required rate of return for Dexter’s stock is
Ke = 6% + 1.1(11% - 6%) = 11.5%

The market risk premium of 5% (11% - 6%), when adjusted for the asset’s index of risk (beta) of 1.1, results in a risk premium
of 5.5% (1.1 X 5%). That risk premium, when added to the 6% risk-free rate, results in a 11.5% required return.

Beta Coefficient
βi < 1: Asset i is less volatile (relative to the market)
βi = 1: Asset i’s volatility is the same rate as the market
βi > 1: Asset i is more volatile (relative to the market)
Other things being equal, the higher the beta, the higher the required return, and the lower the beta, the lower the required
return.

9.3.2 The Dividend Discount Model approach

In much of the finance literature, you will see this model referred to as the constant growth model, DDM, or the Gordon growth
model. Whatever you call it, the concept remains the same. The Gordon growth model, developed by Gordon and Shapiro
(1956) and Gordon (1962), assumes that dividends grow indefinitely at a constant rate. In other words, the only cash flow you
receive from a firm when you buy publicly traded stock is the dividend. This is the simplest model for valuing equity -- the value
of a stock is the present value of expected dividends on it.

223 MANCOSA
Accounting and Financial Management

When an investor buys stock, s/he generally expects to get two types of cash flows - dividends during the period s/he holds
the stock and an expected price at the end of the holding period. Since this expected price is itself determined by future
dividends, the value of a stock is the present value of dividends through infinity.

The assumptions of the Gordon growth model are:

 Dividends are the appropriate measure of shareholder wealth
 The constant dividend growth rate, g and required return on stock, ke, are never expected to change.
 Ke must be greater than g. If not, the maths will not work

where D0 is the dividend just paid and D1 is the next period’s projected dividend, RE is required return and PO is the
current price of the stock. We can rearrange this to solve for RE as follows:
𝐷1
𝑅𝐸 = 𝑃0
+g

Example: Gordon growth model valuation

Suppose Greater States Public Service, a large public utility, paid a dividend of R6 per share last year. The stock
currently sells for R80 per share. You estimate that the dividend will grow steadily at a rate of 9 percent per year
into the indefinite future. What is the cost of equity capital for Greater States?
Answer
D1 = D0 x (1 + g) = R6 x 1.09 = R6.54
Given this, the cost of equity, RE is: RE = D1 / P0 + g = (R6.54/R80) + 0.09 = 17.18%
Thus the cost of equity is 17.18%

In order to use the Gordon growth rate model, you have to estimate the expected growth rate, g. This can be done
by:
 Using the growth rate as projected by security analysts.
 Using historical growth rate
 Using the following equation to estimate a firm’s sustainable growth rate:
g = (retention rate) (return on equity) = (1 – payout rate) (ROE)

Example: Estimating growth rate to determine Cost of Equity

Suppose Community broadcasting company issued the following dividends over a period of 5 years. If the shares
sell for R172 per share, Using the DDM, what is your best estimate of the company’s cost of capital?
Year 2013 2014 2015 2016 2017
Dividend R11.00 12.00 13.50 14.00 15.50

MANCOSA 224
 Accounting and Financial Management

Answer
To answer this question, we need to first estimate the growth rates. This can be done by calculating the year-to-
year growth rates, and average them. Or simply using the time value of money concept.
Using the time value concept:
PV = -R11 FV = 15.5 N = 4 Years I = to be Computed

Using the financial calculator, I = 8.95%

D1 = D0 x (1 + g) = 15.50 x 1.0895 = R16.89
RE = D1 /P0 + g
= (R16.89/R172) + 0.0895
= 18.77%

Thus best estimate of the company’s cost of capital is 18.77%

Example: Sustainable growth rate and Cost of Equity
Suppose Jumbo Burger Ltd.’s stock sells for R210, next year’s dividend is expected to be $10, Jumbo Burger’s
expected ROE is 12%, and Jumbo Burger Ltd is expected to pay out 40% of its earnings. What is Jumbo Burger’s
cost of equity?

Answer
g = (1 – payout rate) (ROE)
= (1 – 0.4) (0.12)
= 0.6 x 0.12
= 7.2%
Using Gordon growth model, RE is:

RE = (R10/R210) + 0.072 = 11.96%

Thus, Jumbo Burger Ltd.’s cost of capital is 11.96%

Comparing the Constant-Growth and CAPM Approaches

 both approaches are easy to understand and easy to use
 The CAPM approach differs from the constant-growth valuation model in that it directly considers the
firm’s risk, as reflected by beta, in determining the required return or cost of equity.
 The constant-growth model does not look at risk; it uses the market price, P0, as a reflection of the
expected risk–return preference of investors in the marketplace.

225 MANCOSA
Accounting and Financial Management

 The constant Growth model can easily be adjusted for flotation costs to find the cost of new common
stock the CAPM does not provide a simple adjustment mechanism
 Constant growth approach is applicable only to companies that pay dividends otherwise the approach is
useless in many cases
 The CAPM approach requires estimates of the market risk premium and beta coefficient: poor estimating
these two and result in inaccurate cost of equity.
 If two approaches result in similar answers, then analysts have some confidence in their estimates.

9.3.3 Bond Yield Plus risk premium approach

Analysts often use an ad hoc approach to estimate the required rate of return. They add a risk premium (three to
five percentage points) to the market yield on the firm’s long-term debt.

RE = bond yield + risk premium

 the yield on a bond is the rate of return received from the investment
 The equity risk premium is essentially the return that stocks are expected to receive in excess of the
risk-free interest rate

Example Estimating RE with bond yields plus a risk premium

Dexter’s interest rate on long-term debt is 8%. Suppose the risk premium is estimated to be 5%. Estimate
Dexter’s cost of equity.

Answer:

Dexter’s estimated cost of equity is:

RE = 8% + 5% = 13%

This approach does not produce accurate estimate of RE as compared to CAPM and DDM.

MANCOSA 226
 Accounting and Financial Management

Think Point 9.1

1. What do we mean when we say that a firm cost of equity capital is 13
percent?
2. What are three approaches to estimating the cost of equity capital?

9.4 The Cost of Debt and Preference shares

In addition to common equity, firms use debt and, to a lesser extent, preferred stock to finance their investments.
As we shall see in the following sub-sections, determining the costs of capital associated with these sources of
financing is much easier than determining the cost of equity.

9.4.1 Cost of debt

Investors who subscribe to debentures anticipate future interest payments. This means that the present value of a
debenture is equal to the investor’s future expected receipts discounted at the investors required rate of return.
Thus cost of debt is the return the firm’s creditors demand on new borrowing. In other words, cost of debt is the
simply the interest rate the firm must pay its creditors. The interest rate can be observed in the financial market.
To be precise cost of debt is the after-tax cost today of raising long-term funds through borrowing.

 Before cost of Debt

The starting point of calculating the cost of debt is to establish the before-tax cost of debt (KD) and then provide
the tax adjustment since interest payment is tax deductible. This can be done in three ways:

Methods of obtaining before tax cost on debt (KD)

Quotations: A common method is to quote the coupon interest rate on the bond as the before tax cost of debt if
the bond is selling at par on a net basis. In other words, if the net proceeds from sale of a bond equal its par value,
then the before-tax cost debt is equal to the coupon interest rate. A variation would be to quote YTM on similar risk
bonds as before tax cost on debt.

For example, a bond with a 10 percent coupon interest rate with net proceeds equal to the bond’s R1000 par
value would have a before-tax cost, KD of 10 percent.

Calculating the Cost This approach finds the before-tax cost of debt by calculating the internal rate of return
(IRR) on the bond cash flows. This can be done by trial and error, excel or a financial calculator.

Calculating the Before cost of Debt

For example, the net proceeds of a R1 000, 9% coupon interest rate, 20-year bond were found to be R960. The
coupon is paid annually. What is the before cost of debt (KD).

227 MANCOSA
Accounting and Financial Management

The calculation of the annual cost is quite simple using a financial calculator

FV = 1000
PV = -960
PMT = 90
N = 20
I = Compute to get 9.452%
Thus the before cost of debt is 9.452% which can also be called the IRR

Approximating the cost of debt using YTM

This approach relies on the use of the approximate yield to maturity on similar risk bonds. This approximate YTM
will then be used as the before tax cost of debt (K). For a bond with a R1 000 par value the approximate YTM (KD)
is obtained by the following equation:

KD = [ 𝐼+
(𝑅1 000−𝑁)
𝑛
𝑁+𝑅1 000
2
]
where
I = annual interest in dollars
N = net proceeds from the sale of debt (bond)
n =number of years to the bond’s maturity

Using the same example above: the approximate value is:

(1 000−960)
90+ 90+2
KD = 20
960+1 000 = = 9.4%
980
2
This approximate before-tax cost of debt is close to the 9.452% value calculated precisely in the preceding example

 After-Tax Cost of Debt (KI)

Since interest on debt is tax deductible a tax adjustment is required because the real cost of debt should be lower.
The after-tax cost of debt, KI, can be found by multiplying the before-tax cost, KD, by 1 minus the tax rate, T, as
stated in the following equation:

KI = KD (1 – t)

Where KD = before tax cost of debt

t = tax rate

MANCOSA 228
 Accounting and Financial Management

Example: Calculating after tax cost of debt

Company XYZ issued debentures maturing in three years’ time at a discount of 5%. Similar debentures are trading
at 12%. The tax rate is 35%.

Required:

Calculate the after tax cost of debt (KI)

Solution

KD = 12% x (1 -35%) = 7.8%

9.4.2 Cost of Preference Shares (KP)

Preferred stock have features of both common stock and debt. As with common stock, preferred stock dividends
are not a contractual obligation, the shares usually do not mature, and the shares can have put or call features.
Like debt, preferred shares typically make fixed periodic payments to investors and do not usually have voting
rights.

As with debentures or bonds, the cost of preference shares is calculated on the assumption that the market value
of the share is equal to all expected future receipts (dividends) discounted at the investor’s required rate of return.

𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝐷𝑝

Cost of preference shares (KP) = =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑒𝑥 𝑑𝑖𝑣 𝑃

 If floatation costs are incurred these have to be incorporated in the calculation of cost of preference
shares.
 No tax adjustment to before tax cost of preference shares is necessary since preferred share dividends
are paid out from the firm’s after tax cash flows

Example: Cost of preferred stock

DT Ltd. is considering issuing 10% preference shares that are expected to sell for R87 per share par value.
Floatation costs are expected to be R5.00 per share. Calculate KP

Solution
𝐷
KP = 𝑃−𝑓𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛
𝑃
𝑐𝑜𝑠𝑡

0.1 𝑥 87
= 87−5

8.7
= 82

= 0.1061

Thus the cost of preferred stock is 10.61%

229 MANCOSA
Accounting and Financial Management

9.5 Flotation costs

Flotation cost are the fees charged by investment bankers when a company raises external equity
capital. Flotation costs can be substantial and often amount to between 2% and 7% of the total
amount of equity capital raised, depending on the type of offering.

9.5.1 Incorrect Treatment of Flotation Costs

Because the learning outcome asks for the “correct treatment of flotation costs,” that implies that there is an
incorrect treatment. Many financial textbooks incorporate flotation costs directly into the cost of capital by
increasing the cost of external equity. For example, if a company has a dividend of R1.50 per share, a current price
of R30 per share, and an expected growth rate of 6%, the cost of equity without flotation costs would be:

1.50 (1+0.06)
KE = 30
+ 0.06 = 0.1130 = 11.30%

Here we’re using the constant growth model, rather than the CAPM, to estimate the cost of equity. If we incorporate
flotation costs of 4.5% directly into the cost of equity computation, the cost of equity increases

1.50 (1+0.06)
KE = 30 (1−0.045)
+ 0.06 = 0.1155 = 11.55%

9.5.2 Correct Treatment of Flotation Costs

In the incorrect treatment we have just seen, flotation costs effectively increase the WACC by a fixed percentage
and will be a factor for the duration of the project because future project cash flows are discounted at this higher
WACC to determine project NPV. The problem with this approach is that flotation costs are not an ongoing expense
for the firm. Flotation costs are a cash outflow that occurs at the initiation of a project and affect the project NPV
by increasing the initial cash outflow. Therefore, the correct way to account for flotation costs is to adjust the initial
project cost. An analyst should calculate the dollar amount of the flotation cost attributable to the project and
increase the initial cash outflow for the project by this amount.

9.6 The Weighted Average Cost of Capital (WACC)

Now that we are familiar with the cost of specific sources of financing, we can determine the overall cost of capital
to the firm. This overall cost of capital is popularly known as the weighted average cost of capital (WACC). It reflects
the expected average future cost of funds over the long run. It is found by weighting the cost of each specific type
of capital by its proportion in the firm’s capital structure.

MANCOSA 230
 Accounting and Financial Management

9.6.1 Importance of WACC

It is important to correctly compute an organization’s WACC since the weighted average cost of capital affects a
number of important decisions that will be made by the organization’s management.

Weighted average cost of capital and security valuation

Security analysts employ the weighted average cost of capital when valuing financial securities. In the valuation of
financial securities, the weighted average cost of capital is used as a discount rate, which is applied to future cash
flows to be generated by the financial instrument being valued. In this case the weighted average cost of capital
will be used as a hurdle rate. If the weighted average cost of capital is wrongly calculated, then the intrinsic value
of the financial instrument as calculated will be wrong.

Weighted average cost of capital and the investment decision

Organizations also use the weighted average cost of capital when evaluating capital projects. The weighted
average cost of capital is used as a hurdle rate when evaluating project cash flows using the net present value
analysis. If the weighted average cost of capital is wrongly calculated, then capital projects will either be wrongly
accepted or rejected.

Weighted average cost of capital and economic value added (EVA)

In financial management economic value added (EVA) is the determination of value created for the shareholders
of the company. The approach used is as follows
EVA = NPAT – (NOA * WACC)
Where NPAT = Net profit after taxes
NOA = Net operating assets
WACC = Weighted average cost of capital
Shareholders will receive a positive value added when the return from the equity employed in the business
operations is greater than the cost of capital.

Weighted average cost of capital and the individual investor

WACC serves as a useful reality check for investors. The average investor may not bother to calculate WACC
because it is a complicated measure that requires much detailed information but it helps investors to know the
meaning of weighted average cost of capital when they encounter it in brokerage analysts` reports.

9.6.2 Assumptions underlying the computation of weighted average cost of capital

I. Business risk is assumed to remain constant.

II. Financial risk is also assumed to remain constant
III. Component costs used in the computation of weighted average cost of capital are after tax costs. This
assumption is consistent with the framework of making capital decisions.

231 MANCOSA
Accounting and Financial Management

9.6.3 Weighting schemes

Weights can be calculated as book value, market value or target weights
Book value weights

Accounting book values are used to measure the proportion of each type of capital in the financial structure when
calculating the weighted average cost of capital.

The advantage of this approach is that the accounting information is readily available. The disadvantage is that
book values do not usually indicate the approximate value that could be realized on the sale of the assets.

Market value weights

The market values of each type of capital in the firm’s capital structure are used to establish the weights to use
when calculating the weighted average cost of capital.

The advantage of using market values is that the market values closely approximate actual dollar amounts to be
realized should assets be sold. The problem, however, is the fact that market values are generally not readily
available. Both book value and market value weights can be referred to as historical weights because they base
their weighting on actual capital structure proportions.

Target weights

The target weights can either be book values or market values based on desired capital structure proportions.
These will then be used when calculating weighted average cost of capital. The preferred weighting scheme is to
use target market values.

9.6.4 Calculating the weighted average cost of capital

Once the component cost is established and the appropriate weighting scheme chosen, the weighted average cost
of capital can then be calculated using the following equation:

WACC = (WI * KI) + (WP * KP) + (WE * KE)

Where WI = proportion of long-term debt in the capital structure

KI = after tax component cost of debt,

WP = proportion of preference shares in the capital structure

KP = component cost of preference shares,

WE = proportion of ordinary shares in the capital structure,

KE = component cost of ordinary shares

MANCOSA 232
 Accounting and Financial Management

 WI + WP + WE = 1
 If a firm does not have preferred stock in its capital structure, then only debt and equity are used in
computing the WACC
 For computational convenience, it is best to convert the weights into decimal form and leave the specific
costs in percentage terms.

Example: Calculating the WACC

The B.B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells for R20 per share. The
firm’s debt is publicly traded and was recently quoted at 93 percent of face value. It has a total face value of 5
million, and it is currently priced to yield 11 percent. The risk-free rate is 8 percent, and the market risk premium is
7 percent. You’ve estimated that Lean has a beta of 0.74. If the corporate tax rate is 34 percent, what is the WACC
of Lean Co.?

Solution
First we can determine the cost of equity using the CAPM
KE = RF + β (RM – RM)
= 8% + 0.74(7%) = 13.18%
cost of debt (KI) = KD (1 –t)
= 11% (1 – 0.34) = 7.26%
Market Value of Equity = 1. 4 million shares x R20 = R28 million
Market value of debt = 0.93 x R5 million = R4.65 million
Total market value of financing = R28m + R4.65m = R32.65
28 4.65
Weights (WE) = = 85.76% WI = = 14.24%
32.65 32.65

WACC = (WI * KI) + (WE * KE)

= 0.142 * 7.26% + 0.8576 * 13.18%
= 12.34%
B.B. Lean thus has an overall weighted average cost of capital of 12.34%

Think Point 9.2

a) What is the weighted average cost of capital (WACC), and how is it

calculated?
b) Why do we multiply the cost of debt by (1 -t) when we compute the
WACC?

233 MANCOSA
Accounting and Financial Management

9.7 Weighted Marginal Cost of Capital (WMCC)

This is the firm’s weighted average cost of capital associated with its next dollar of total financing. WMCC is an
increasing function of the level of total new financing. As new financing increases, risk increases, increasing the
cost associated with the new financing. This ultimately increases weighted average cost of capital. Computing
weighted marginal cost of capital will require knowledge of the breaking point for each type of financing. This is the
point at which the component cost of a particular type of financing increases.

9.7.1 Breaking point

This is the level of total new financing at which the cost of the financing component increases creating an upward
shift in the weighted marginal cost of capital. The breaking point is obtained by using the following equation:

Amount of financing available from a given financing source

Breaking point = Capital structure weight stated in decimal form

Once the breaking points are established, the different weighted average cost of capital at given levels of financing
can be calculated. From this, the marginal increments, which define the weighted marginal cost of capital, can be
deduced. It is also necessary to have knowledge of the investment opportunities schedule. This can then be used
in conjunction with the weighted marginal cost of capital to indicate the various investments that will be acceptable.

9.7.2 The investment opportunities schedule

This is the ranking of investment possibilities from the one with the highest returns (best) to the one with the lowest
returns (worst). As the cumulative amount of money invested in a firm’s investment projects increases, the returns
from the projects as measured by IRR decreases. The return on investments decreases as the firm accepts
additional projects.

EXAMPLE

Nice Time Ltd is a leading company with an optimal capital structure made up of 30% debt, 20% preference shares
and 50% equity. The cost of debt is 20%, cost of preference shares is 18% and cost of equity is 24%. The company
can borrow up to R2.4 million in debentures and R3 million in preference shares without a change in the cost of
debt and preference shares respectively. The expected retained earnings for the firm are R5 million after which
the cost of equity would increase because of floatation costs. If additional debt finance over R2.4 million is required,
the cost will increase by 15%, additional preference shares over R3 million will increase the cost of preference
shares to 24% and a new issue of ordinary shares will increase the cost of equity to 28%.
a) What is the breaking point for each source of financing?
b) What is the marginal cost of capital for each range of capital raised?
c) Suppose that the firm had the following capital projects under consideration

MANCOSA 234
 Accounting and Financial Management

Project IRR Initial Investment (R)

A 22% 2 000 000

B 25% 4 000 000

C 23% 6 000 000

D 24% 5 000 000

E 20% 7 000 000

F 18% 4 000 000

Construct a graph showing the marginal cost of capital and the investment opportunity schedule and show which
projects will be implemented.

Solutions

a) Breaking points
5 000 000
I. Equity = 0.5
= R10 000 000

𝑅2 400 000
II. Debt = 0.3
= R8 000 000

𝑅3 000 000
III. Preference shares = 0.2
= R15 000 000

b) The best way to calculate the WMCC is to tackle it using a table:

Amount raised Source of capital Weight Cost Weighted Cost

Ordinary shares 0.5 24 12
Debt 0.3 20 6
0 - <R8 000 000 Preference shares 0.2 18 3.6
WACC 21.6

Ordinary shares 0.5 24% 12

Debt 0.3 35% 10.50%
R8m – <R10 000000 Preference shares 0.2 18% 3.6
WACC 26.1%

Ordinary shares 0.5 28% 14%

Debt 0.3 35% 10.5
R10m - <R15 000 000 Preference shares 0.2 18% 3.6
WACC 28.10%

Ordinary shares 0.5 28% 14%

Debt 0.3 35% 10.5
R15m + Preference shares 0.2 24% 4.8%
WACC 29.3%

235 MANCOSA
Accounting and Financial Management

The weighted marginal cost of capital schedule can now be prepared from the results obtained in the table above.
This schedule will, however be, presented in conjunction with the investment opportunity schedule. It is therefore
necessary to illustrate the preliminary requirements before one can prepare the investment opportunity schedule.

The first step is to prepare a table of cumulative investments. The schedule shows the ranking of the available
opportunities starting with the most preferred in terms of the internal rate of return to the lest preferred. The
schedule also shows the cumulative amount of investment financing needed as each successive project is
considered. The investment opportunity schedule now follows.

Investment opportunity IRR Initial Investment (R) Cumulative Investment (R)

B 25% 4 000 000 4 000 000
D 24% 5 000 000 9 000 000
C 23% 6 000 000 15 000 000
A 22% 2 000 000 17 000 000
E 20% 7 000 000 24 000 000
F 18% 4 000 000 28 000 000

From the above schedule it can be noted that the graph to be prepared should be able to accommodate on one
axis a 25% return and on the other axis total new financing amounting to R28m. From the weighted marginal cost
of capital table, it can also be noted that the graph to be prepared should be able to accommodate on one axis a
maximum of 29.30% cost while on the other axis the ceiling is not defined but it should be above R15m. Since the
vertical axis will record both weighted average cost of capital and the internal rate of return this axis should be able
to accommodate a highest rate of 29.30%, which is the highest weighted average cost of capital. The horizontal
axis will record new financing and investment so provision should be made to accommodate a cumulative
investment of R28m

The WMCC and the investment opportunities schedule can now be presented on a single graph to show which
investment opportunities are acceptable and those that are not acceptable

MANCOSA 236
 Accounting and Financial Management

(R
Only those projects whose internal rate of return is above the weighted marginal costmillion)
of capital are acceptable as
they generate a positive return for the shareholders. From the previous graph it can be noted that project B is
acceptable. Project D can be problematic as part of it lies below the cost function. If it is a divisible project, then a
substantial part of it can be implemented. If it is not divisible then the whole project should not be considered at all.

9.8 Summary
The cost of equity capital, KE, is the required rate of return on the firm’s common stock.
There are three approaches to estimating KE:
CAPM approach: KE = E(RI) = Rf + βi * [E(Rm) – Rf]
𝐷
Dividend discount model approach: RE = 𝑃1 + g
0
a. Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm’s
long-term debt
 The cost of debt is calculated at after tax cost of debt, KI and offers tax shield benefit.
 Before tax of debt, KD can be obtained from quotation, approximation using YTM or a financial calculator.
 It is cheaper to raise funds using debt financing than equity
 If floatation costs exist, they have to be incorporated in the calculation of cost of preference shares and
cost of equity
 The correct method to account for flotation costs of raising new equity capital is to increase a project’s
initial cash outflow by the flotation cost attributable to the project when calculating the project’s NPV.

237 MANCOSA
Accounting and Financial Management

 The weighted average cost of capital, or WACC, is calculated using weights based on the market values
of each component of a firm’s capital structure and is the correct discount rate to use to discount the cash
flows of projects with risk equal to the average risk of a firm’s projects.
WACC = (WI * KI) + (WP * KP) + (WE * KE)
 Interest expense on a firm’s debt is tax deductible, so the pre-tax cost of debt must be reduced by the
firm’s marginal tax rate to get an after-tax cost of debt capital:
after-tax cost of debt (KI = KD (1 – firm’s marginal tax rate)
 The pre-tax and after-tax capital costs are equal for both preferred stock and common equity because
dividends paid by the firm are not tax deductible.
 WACC should be calculated based on a firm’s target capital structure weights.
If information on a firm’s target capital structure is not available, you can use the firm’s current capital
structure, based on market values, or the average capital structure in the firm’s industry as estimates of
the target capital structure
 A firm’s marginal cost of capital (WACC at each level of capital investment) increases as it needs to raise
larger amounts of capital. This is shown by an upward-sloping marginal cost of capital curve.
 An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial
investment amounts for, a firm’s potential projects. The intersection of a firm’s investment opportunity
schedule with its marginal cost of capital curve indicates the optimal amount of capital expenditure, the
amount of investment required to undertake all positive NPV projects.

9.9 Self-Assessment activities

1. A company has R5 million in debt outstanding with a coupon rate of 12%. Currently, the
yield to maturity (YTM) on these bonds is 14%. If the firm’s tax rate is 40%, what is the
company’s after-tax cost of debt?

2. A company’s $100, 8% preferred is currently selling for R85. What is the company’s cost of preferred
equity?

3. The expected dividend is R2.50 for a share of stock priced at R25. What is the cost of equity if the long-
term growth in dividends is projected to be 8%?

4. An analyst gathered the following data about a company:

Capital structure Required rate of return

30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

MANCOSA 238
 Accounting and Financial Management

Assuming a 40% tax rate, what after-tax rate of return must the company earn on its
investments?

5. A company is planning a R50 million expansion. The expansion is to be financed by selling R20 million in
new debt and R30 million in new common stock. The before-tax required return on debt is 9% and 14%
for equity. Given that the company is in the 40% tax bracket, calculate the company’s marginal cost of
capital.

6. Use the following data to answer the questions that follow

 A company has a target capital structure of 40% debt and 60% equity.
 The company’s bonds with face value of R1,000 pay a 10% coupon (semi-annual), mature in 20
years, and sell for R849.54 with a yield to maturity of 12%.
 The company stock beta is 1.2.
 Risk-free rate is 10%, and market risk premium is 5%.
 The company is a constant-growth firm that just paid a dividend of R2, sells for R27 per share,
and has a growth rate of 8%.
 The company’s marginal tax rate is 40%.

I. Calculate the company’s after tax cost of debt

II. What is the company’s cost of equity using the capital asset pricing model (CAPM) approach?
III. What is the company’s cost of equity using the dividend discount model?
IV. Calculate the company’s weighted average cost of capital (using the cost of equity from CAPM)

7. TMK is considering a project that requires a R180,000 cash outlay and is expected to produce cash flows
of R50,000 per year for the next five years. Black Pearl’s tax rate is 25%, and the before-tax cost of debt
is 8%. The current share price for Black Pearl’s stock is R56 and the expected dividend next year is R2.80
per share. TMK expected growth rate is 5%. Assume that TMK finances the project with 60% equity and
40% debt, and the flotation cost for equity is 4.0%. The appropriate discount rate is the weighted average
cost of capital (WACC). Calculate the rand amount of the flotation costs and the NPV for the project,
assuming that flotation costs are accounted for properly?

8. What role does the cost of capital play in the firm’s long term investment decisions? How does it relate
to the firm’s ability to maximize shareholder wealth?

9. What are flotation costs, and how do they affect net proceeds of preferred stock

239 MANCOSA
Accounting and Financial Management

10. Moroka Investments has compiled the following data relating to the current costs of its sources of capital
for various ranges of financing. It is interested in measuring its overall cost of capital. The firm is in the
40% tax bracket. Current investigation has gathered the following data

Debt: The firm can raise an unlimited amount of debt by selling R1 000 par value, 10% coupon interest rate, 10-
year bonds on which annual interest payments will be made. To sell the issue, an average discount of R30 per
bond must be given. The firm must also pay flotation costs of R20 per bond.

Preferred stock: The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value. The cost
of issuing and selling the preferred stock is expected to be $4 per share. An unlimited amount of preferred stock
can be sold under these terms.

Common stock: The firm’s common stock is currently selling for R80 per share. The firm expects to pay cash
dividends of R6 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this rate
is expected to continue in the future. The stock will have to be under-priced by R4 per share, and flotation costs
are expected to amount to R4 per share. The firm can sell an
unlimited amount of new common stock under these terms.

Retained earnings: The firm expects to have R225 000 of retained earnings available in the coming year. Once
these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity
financing.

Required
a) Calculate the specific cost of each source of financing. (Round to the nearest 0.1%.)
b) The firm uses the weights shown in the following table, which are based on target capital structure
proportions, to calculate its weighted average cost of capital. (Round to the nearest 0.1%.)

Source of Capital Weights (%)

Long-term debt 40
Preferred stock 15
Common stock equity 45
Total 100

i. Calculate the single break point associated with the firm’s financial situation. (Hint: This point
results from the exhaustion of the firm’s retained earnings)
ii. Calculate the weighted average cost of capital associated with total new financing below the break
point calculated in part (i).

MANCOSA 240
 Accounting and Financial Management

iii. Calculate the weighted average cost of capital associated with total new financing above the break
point calculated in part (i).

c) Using the results of part (b) along with the information shown in the following table on the available
investment opportunities, draw the firm’s weighted marginal cost of capital (WMCC) schedule and
investment opportunities schedule (IOS) on the same set of axes (total new financing or investment on
the x axis and weighted average cost of capital and IRR on the y axis).

Investment Opportunity IRR Initial Investment (R)

A 11.2% 100 000

B 9.7 500 000

C 12.9 150 000

D 16.5 200 000

E 11.8 450 000

F 10.1 600 000

G 10.5 300 000

d) Which, if any, of the available investments do you recommend that the firm accept? Explain your
answer. How much total new financing is required?

9.10 Suggested solutions

1. After tax cost of capital

KD 1 – t) = (0.14) (1 – 0.4)
= 8.4%

2. Cost of preferred stock

𝐷𝑝
KP = , KP = R100 × 8% = R8, KP = 8 / 85 = 9.4%
𝑃

3. Using the dividend yield plus growth rate approach:

KE = (D1 / P0) + g = (2.50 / 25.00) + 8%
= 18%

4. WACC = (WI * KI) + (WP * KP) + (WE * KE)

= (0.3) (0.1) (1 – 0.4) + (0.2) (0.11) + (0.5) (0.18)
= 13%

241 MANCOSA
Accounting and Financial Management

5. WI = 20 / (20 + 30) = 0.4, WE= 30 / (20 + 30) = 0.6

WACC = (WI * KI) + (WE * KE)
= (0.4) (9) (1 – 0.4) + (0.6) (14)
= 10.56% = MCC
6.
i. KD (1 – t) = 12(1 – 0.4)
= 7.2%
ii. Using the CAPM formula, KE= RF + β[E(RM) – RF]
= 10 + 1.2(5)
= 16%
iii. D1= D0 (1 + g)
= 2(1.08) = 2.16;
KE= (D1 / P0) + g = (2.16 / 27) + 0.08
= 16%
iv. WACC = (WI)(KD) (1 – t) + (WE)(KE)
= (0.4) (7.2) + (0.6) (16)
= 12.48%

7. Because the project is financed with 60% equity, the amount of equity capital raised is
0.60 × R180 000 = R108 000.
Flotation costs are 4.0%, which equates to a rand value of R108 000 × 0.04 = R4 320.
After-tax cost of debt = 8.0% (1 – 0.25) = 6.0%

𝑅2.80
Cost of equity = 𝑅56.00 + 0.05 = 0.1 =10%

WACC = 0.60(0.10) + 0.40(0.06) = 8.4%

To determine the NPV
Total cash outflow (180 000 + 4320 = 184 320
Annual cash flow = 50 000 for 5 years
Using the present value of an annuity
Year Cash flow Discount factor PV
0 (R184 320) 1 (R184 320)
1-5 R50 000 3.951 R197 550
NPV R13 230

MANCOSA 242
 Accounting and Financial Management

Alternatively, use a financial calculator

CFO = -184 320
CFJ = 50 000
NJ = 5
I = 8.4
Press f and then NPV to get R13 228 which is approximately R13 230
Please note the concept of NPV is covered in detail in the Capital Budgeting topic.

8. In the firm’s long term investment decisions, the cost of capital play a very important role as it is the
minimum rate of return that a firm must earn on a particular project or an investment to increase the value
of the stock. They relate because the wealth of firm’s owners of determined by the market value of their
shares. So firm should invest in those particular projects which provides return more than the cost of
capital resulting in maximization of shareholder wealth.

9. Flotation cost are the costs of issuing and selling a bond or security preferred and common stock. It
included underwriting cost and administrative costs. Companies use investment bankers when they issue
new common stock. This banker’s fee is a flotation cost. Flotation costs reduce the bonds net proceeds
because these costs are paid out from the funds available with a security

10. Calculate the before cost of debt (KD) using the approximation formula

(𝑅1 000−𝑁)
𝐼+
KD = [ 𝑛
𝑁+𝑅1 000 ]
2

I = 0.01 x R1000 = R100

N = R1 000 – R30 discount – R20 flotation cost = R950

n = 10 years

(𝑅1 000−950)
100 + (100 + 5)⁄
KD = [ 10
950 +𝑅1 000 ]= 975 = 10.8%
2

Or Use calculator
PV = -950 FV = 1 000 PMT = 100 I= Compute =10.8

KI = KD (1 –T)
= 10.8 (1 – 0.4)
= 6.5%

243 MANCOSA
Accounting and Financial Management

Cost of preferred stock, KP

𝐷
KP = 𝑃⁄𝑃
DP = 0.11 x R100 = R11
P = R100 – R4 flotation cost = R96
KP = 𝑅11⁄𝑅96 = 11.5%

Cost of Retained earnings, KR

𝐷
KR = 𝑃1 + g

6
= 80 + 6.% = 7.5% + 6.0% = 13.5%

Cost of new common equity, KE

𝐷
KE = 𝑁1 + g Nn = Net proceeds
𝑛

D1 = R6 g = 6.0%
Nn = R80 – R4 underpricing – R4 flotation cost = R72
𝑅6
KE = + 6.0% = 8.3% + 6.0% = 14.3%
𝑅72

b) (i) Break Point, BP

𝐴𝐹𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
𝐵𝑃𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝑊𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦

𝐴𝐹𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = R225 000

𝑊𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = 45%
𝑅225 000
𝐵𝑃𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = 0.45
= R500 000

(ii) WACC for total new financing < R500 000

Weighted cost
Source of capital Weight (1) Cost (2) (1) X (2) = 3
Long term debt 0.40 6.5% 2.6%
Preferred stock 0.15 11.5 1.7
Common stock equity 0.45 13.5 6.1
Totals 1.00 10.4%
WACC = 10.4%

MANCOSA 244
 Accounting and Financial Management

(iii) WACC for total new financing > R500 000

Weighted cost
Source of capital Weight (1) Cost (2) (1) X (2) = 3
Long term debt 0.40 6.5% 2.6%
Preferred stock 0.15 11.5 1.7
Common stock equity 0.45 14.3 6.4
Totals 1.00 10.7%
WACC = 10.7%

c) Investment opportunity schedule (IOS) data for graph

Investment Opportunity IRR(%) Initial Investment (R) Cumulative Investment (R)
D 16.5 200 000 200 000
C 12.9 150 000 350 000
E 11.8 450 000 800 000
A 11.2 100 000 900 000
G 10.5 300 000 1 200 000
F 10.1 600 000 1 800 000
B 9.7 500 000 2 300 000

245 MANCOSA
Accounting and Financial Management

17
D
16

15

14
WACC and IRR (%)

13 C

12 E
A
11 10.7%
10.4% WMCC
10 G
F IOS
9 B

(R900 total new financing required)

0 200 600 1 000 1 400 1 800 2 200

Total New financing or Investment (R'000')

d) Projects D, C, E, and A should be accepted because their respective IRRs exceed the WMCC. They will
require R900 000 of total new financing.

MANCOSA 246
 Accounting and Financial Management

Unit
10:
Capital Budgeting

247 MANCOSA
Accounting and Financial Management

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Understand the key motives of Capital  Complete relevant readings, think points and
Budgeting activities provided.

 Describe the steps to be followed in the

capital budgeting process.

 Distinguish between independent and

mutually exclusive projects.

 Calculate the relevant cash flows required

to evaluate a capital investment.

 Calculate Initial Investment associated with

a proposed capital expenditure

 Finding terminal cash flow

 Use and interpret payback period, net
present value, and internal rate of return as
capital budgeting techniques.

10.1 Introduction
10.2 The Capital Budgeting Process
10.3 Types of Projects
10.4 Cash Flows
10.5 Capital Budgeting Techniques

MANCOSA 248
 Accounting and Financial Management

Prescribed and Recommended Textbooks/Readings

Prescribed Textbook:

 2014 Financial Management in Southern Africa. 4th Edition. Cape Town:

Pearson Education

Recommended Reading:
 Atrill, P. and McLaney, E. (2008) Accounting and Finance for non-
specialists. 6th Edition. London: Pearson Education Limited.
 Block, S.B., Hirt, G.A. and Danielsen, B.R. (2007) Foundations of
Financial Management. 13th Edition. New York: McGraw-Hill/Irwin.

 Gitman, L.J., Smith, M.B., Hall, J., Lowies, B., Marx, J, Strydom, B. and
van der Merwe, A. (2010) Principles of Managerial Finance. 1st Edition.
Cape Town: Pearson Education

249 MANCOSA
Accounting and Financial Management

10.1 Introduction
Marx et al. (2009:283) define capital budgeting (also called capital investment analysis) as the process of
evaluating and selecting long-term investments that would contribute towards the goal of increasing the firm’s
value. A capital expenditure is an investment made by a firm that is expected to produce benefits for a period of
more than one year. The main motives for capital expenditure are expansion, replacement, and renewal. Block
et al. (2009:256) adds that the decision to purchase new plant and equipment or introduce a new product requires
the use of capital budgeting techniques. Of primary concern is whether the future benefits are large enough to
justify the current outlay.

10.2 The Capital Budgeting Process

Marx et al. (2009:285) identify five distinct but interrelated steps in the capital budgeting process:

■Proposal generation: Many firms permit employees at all levels within the organisation to make proposals for
capital expenditure.

■Review and analysis: Capital expenditure proposals are formally reviewed so that their consistency with the
firm’s overall objectives and plans may be assessed and their economic viability determined.

■Decision-making: A summary report, indicating whether or not an investment decision should be made, is
submitted to management.

■Implementation: Once the proposal is approved, funding is made available and the implementation phase
commences.

■Control: Controlling the costs during implementation is important as well as the monitoring of results during the
operating phase. Actual outcomes must be compared to those projected and if necessary action may be required
to improve the benefits or maybe even terminate the project.

10.3 Types of Projects

Marx et al. (2009:286) distinguish between the two most common project types:

■ Independent projects: are those projects whereby the acceptance of one does not preclude others
from being considered (so long as the firm has funds available and the minimum investment criteria are
met).

■ Mutually exclusive projects: are projects that serve the same function. The acceptance of one project
in a group of mutually exclusive projects prevents all the other projects from the group from being
chosen.\

MANCOSA 250
 Accounting and Financial Management

10.4 Cash Flows

Block et al. (2009:372) highlight the fact that in most capital budgeting decisions the emphasis is on
cash flow rather than on accounting profit. Capital budgeting thus requires the calculation of all the
relevant cash flows that are expected to be associated with the project during its lifespan.

Since depreciation is not an actual expenditure of funds in calculating profit, it must be added back to
profit to determine the amount of cash flow generated. Suppose Petro Ltd has R100 000 new
equipment that depreciated over five years using the straight-line method. The firm has R40 000 in
profit before depreciation and taxes and pays 30% in taxes. The information in figure 8-1 illustrates the
main points involved:

Figure 8-1 Converting net profit to cash flow

Profit before depreciation and taxes R40 000 (cash inflow)

Depreciation (R100 000  5) (20 000) (non-cash expense)

Profit before tax 20 000

Income tax (30%) (6 000) (cash outflow)

Profit after tax 14 000

Depreciation 20 000

Cash flow 34 000

10.5 CAPITAL BUDGETING TECHNIQUES

Block et al. (2009:375) elaborate on some of the widely used methods to evaluate capital
expenditures:

■ Payback period

■ Accounting rate of return

■ Net present value

■ Internal rate of return

251 MANCOSA
Accounting and Financial Management

10.5.1 Payback period

Using this method, we calculate the time needed to recoup the original investment. Payback period
is calculated as follows if the net cash inflow is the same each year:

Payback period = Initial investment

Net annual cash inflow

Example 1

Margate Ltd obtained information in respect of two projects, one of which it intends choosing. The
following details are available:

Project M Project N

Cash outlay R600 000 R600 000

Economic lifetime 6 years 4 years

Average annual net cash inflow over the economic lifetime

Depreciation (straight-line method) R200 000 R280 000

100 000 150 000

Required

Calculate the payback period of each project and recommend the project that should be chosen
based on the payback period.

Solution

Payback period:

Project M Project N

Initial investment = R600 000 R600 000

Net annual cash inflow R200 000 R280 000

3 years 2.14 years or

= 2 years 1 month 26 days

Note:

0.14 X 12 mths = 1.86 months

0.86 X 30 days = 26 days

MANCOSA 252
 Accounting and Financial Management

According to the calculation above Margate Ltd should choose project N since it can recover the cash
outlay in a shorter time (2 years 1 month and 26 days) than project M (3 years).

When the cash inflows are not even, the payback formula stated above will not work. Instead, the cash
flows must be accumulated on a year-to-year basis until the accumulated amount equals the initial
investment. Consider the following example:

Example 2

Consider two projects whose cash inflows are not even. Assume that the project costs

R200 000. The net cash inflows for each year is as follows:

Year Project B Project C

1 R20 000 R100 000

2 R40 000 R80 000

3 R60 000 R60 000

4 R80 000 R20 000

5 R100 000 -

6 R100 200 -

Required

Calculate the payback period of each project and recommend the project that should be selected
based on the payback period.

253 MANCOSA
Accounting and Financial Management

Solution

Project B Project C

Investment (200 000) (200 000)

Year 1 Cash flow 20 000 100 000

(180 000) (100 000)

Year 2 Cash flow 40 000 80 000

(140 000) (20 000)

Year 3 Cash flow 60 000 60 000

(80 000)

Year 4 Cash flow 80 000

The payback period is 4 years 2 years 4 months

Note:

20 000 X 12 mths

60 000

= 4 months

Project C should be chosen since the payback period (2 years and 4 months) is less than that of project
B (4 years).

The rationale behind payback period as a capital investment technique is that projects that can recoup
the investment quickly are economically more attractive than those with longer payback periods.
Gitman et al. (2010:383) adds that the longer a firm must wait to recover its invested funds, the greater
the possibility of a calamity. A short payback period lowers the firm’s exposure to such a risk. Its
popularity stems from its computational simplicity and the fact that it considers cash flows rather than
accounting profit. A rapid payback may be important for firms in industries characterised by rapid
technological developments.

MANCOSA 254
 Accounting and Financial Management

Marx et al. (2009:303) highlight three primary disadvantages of using the payback period:

■ In view of the goal of wealth maximisation, one cannot determine the appropriate payback period using
this technique.

■ It fails to take into account the time value of money.

■ It also fails to take into account the cash flows that occur after the payback period.

10.5.2 Accounting Rate of Return (Arr)

According to Correia et al. (2008: 1050) the focus of the accounting rate of return is on the incremental
profit that results from a project. Accounting profit is based on the accrual accounting procedures.
Revenue is thus recognised during the period of sale and not necessarily when cash is received;
likewise expenses are recognised during the period in which they are incurred and not necessarily
when they are paid in cash.

The accounting rate of return (ARR) on an investment project is calculated as follows:

Accounting rate of return = Average annual profit X 100

Initial investment 1

Using the ARR method, the project that is expected to realise a higher rate of return is chosen.

Example 3

Use the figures from example 1 to calculate the accounting rate of return for each project.

255 MANCOSA
Accounting and Financial Management

Solution

Project M Project N

ARR = Average annual profit X 100 Average annual profit X 100

Initial investment 1 Initial investment 1

= R100 000 X 100 R130 000 X 100

R600 000 1 R600 000 1

= 16,67% 21,67%

In calculating the average annual profit depreciation is deducted from the average annual net cash
inflow (Project M: R200 000 – R100 000 = R100 000). Using ARR, project N gives a higher rate of
return and appears to be a better investment.

The advantage of the ARR method is that it is easy to calculate and it recognises profitability. Unlike the
payback method, it considers the entire life of the project. However, it does not take into account the time
value of money. Furthermore it uses accounting data instead of cash flow data.

10.5.3 Net present value (NPV)

Net present value is calculated by discounting back the inflows at a specified rate over the life of the investment to
determine whether they equal or exceed the required investment. The rate, according to Gitman et al. (2020:386),
is the minimum return that must be earned on a project to leave the firm’s market value unchanged. The rate is
also called the discount rate, required return, cost of capital, or opportunity cost. When NPV is used, both inflows
and outflows are measured in terms of present rands. NPV thus gives consideration to the time value of money.
If the NPV is greater than zero (R0), the firm will earn a return greater than the cost of capital and the project should
be accepted. If the NPV is less than zero (R0), the project should be rejected.

Present value tables that appear at the end of this topic may be used. Table 1 shows the present value of R1 at
various interest rates receivable after n years (n can represent any number). Table 2 shows the present value of
R1 at various interest rates receivable annually for n years.

MANCOSA 256
 Accounting and Financial Management

Example 3

Jameson Ltd has a choice of investing in one of two projects. The following details relate to these
projects:

Project A Project B

Investment required R75 000 R75 000

Expected economic lifetime 6 years 6 years

Minimum required rate of return 12% 12%

Net annual cash inflows

1st year R20 000 R22 000

2nd year R22 000 R22 000

3rd year R24 000 R22 000

4th year R26 000 R22 000

5th year R23 000 R22 000

6th year R21 000 R22 000

Required

Use the net present value method to determine which project Jameson Ltd should choose.

Solution

Project A

Year Cash Discount Present

inflow Factor for 12% value

(see Table 1)

1 R20 000 0.8929 R17 858

2 R22 000 0.7972 R17 538

3 R24 000 0.7118 R17 083

4 R26 000 0.6355 R16 523

5 R23 000 0.5674 R13 050

6 R21 000 0.5066 R10 639

257 MANCOSA
Accounting and Financial Management

Total PV R92 691

Investment (R75 000)

NPV (positive) R17 691

Project B

Net inflow per year R22 000

Discount factor (see Table 2-equal X 4.1114

cash flow, use annuity table)

Total Present value R90 451

Investment (R75 000)

NPV (positive) R15 451

Decision: Project A should be chosen since it has a higher net present value.

10.5.4 Internal rate of return (IRR)

IRR is described by Gitman et al. (2010:387) as the discount rate that equates the NPV of an investment
opportunity with R0 (since the present value of cash inflows equals the initial investment). It is the rate of return
that a firm will earn if it invests in the project and receives the given cash flows. If the IRR is greater than the cost
of capital, the project is accepted as the outcome should increase the market value of the firm and thus the wealth
of the owners. If the IRR is less than the cost of capital, the project must be rejected.

Think Point 10.1

If a project has an IRR of 17.5% and the cost of capital is 17%, would you still
recommend that the investment be made? Explain.

MANCOSA 258
 Accounting and Financial Management

A trial-and-error method is required for calculating IRR and may be summarised as follows:

 Calculate the NPV at the cost of capital rate.

 Check if the NPV is positive or negative.

 If the NPV is positive, then pick another rate higher than the cost of capital rate. (If the NPV is
negative, pick a smaller rate.) The correct IRR is the one at which the NPV = 0 and lies somewhere
between two rates, with one rate indicating a positive NPV and the other rate showing a negative
NPV.

 Use interpolation to calculate the exact rate. (by making use of the table)

Example 4

Use the information in example 3 and determine which project should be selected using the internal rate
of return.

Solution

Project A

Step 1

We notice that the NPV is positive, and is far away from zero.

Step 2

We now pick a higher rate e.g. 18%. (Trial-and-error is used to obtain the higher rate.)

259 MANCOSA
Accounting and Financial Management

Project A

Cash Discount Discount Discount Present Present Present

inflow factor factor factor value value value
Year
18% 19% 20% 18% 19% 20%

1 R20 000 0.8475 0.8403 0.8333 16 950 16 806 R16 666

2 R22 000 0.7182 0.7062 0.6944 15 800 15 536 R15 277

3 R24 000 0.6086 0.5934 0.5787 14 606 14 242 R13 889

4 R26 000 0.5158 0.4987 0.4823 13 411 12 966 R12 540

5 R23 000 0.4371 0.4190 0.4019 10 053 9 637 R9 244

6 R21 000 0.3704 0.3521 0.3349 7 778 7 394 R7 033

Total PV 78 598 76 581 74 649

Investment (75 000) (75 000) (75 000)

NPV R3 598 R1 581 (R351)

Step 3

Interpolation:

The IRR is between 19% and 20%.

IRR= 19 + 1 581

1 581 + 351

= 19 + 1 581

1 932

= 19.82%

Project B

Step 1

We notice that the NPV is positive, and also far from zero.

Step 2

We now pick a higher rate e.g. 16%. (Trial-and-error is used to obtain the higher rate.)

MANCOSA 260
 Accounting and Financial Management

Project B

Cash inflow Discount Discount Present Present

Year p.a. Factor Factor value value

16% 17% 16% 17%

PV 1-6 R22 000 3.6847 3.5892 81 063 78 962

Investment (80 000) (80 000)

NPV R1 063 (R1 038)

Step 3

Interpolation:

The IRR is between 16% and 17%.

IRR= 16 + 1 063

1 063 + 1 038

= 16 + 1 063

2 101

= 16.51%

Decision: Project A should be chosen since the IRR is greater.

Think Point 10.2

In paragraph 8.5.1 we discussed the limitations of the payback period method. How
do you explain the fact that it still seems to be a popular method of investment
appraisal among businesses?

261 MANCOSA
Accounting and Financial Management

10.6 Self-Assessment Activities

10.6.1 Why are cash flows rather than profit flows used in determining the payback period, NPV, and IRR?

10.6.2 As a financial manager of Humphry Enterprises, you are required to analyse two proposed capital
investments, Projects A and B. Each has a cost of R100 000, and the cost of capital for each project
is 12%. Depreciation on each project is estimated at R25 000 per year. The projects’ expected profit
are as follows:

Year Project A Project B

1 R40 000 R10 000

2 R5 000 R10 000

3 R5 000 R10 000

4 (R15 000) R10 000

Required

10.6.2.1 Calculate the payback period, NPV, and IRR for each project.

10.6.2.2 Which project or projects should be accepted if they are independent?

10.6.2.3 Which project should be accepted if they are mutually exclusive?

10.6.2.4 Calculate the ARR for each project.

10.7 Suggested Solutions

Think Point 10.3

Technically one may say yes as the IRR exceeds the cost of capital. However,
the smallest error with the calculation of the initial investment, or deviation from
the forecasted figure for the initial investment as a result of inflation, or any mistake
with the projected cash inflows may render the project unviable.

Think Point 10.4

Payback period is easy to use. Problems of forecasting far into the future are
avoided. Emphasis is given to the early cash flows when there is greater certainty
concerning the accuracy of their predicted value. It emphasises the importance
of liquidity. When a firm experiences liquidity problems, a short payback period
would be preferred.

MANCOSA 262
 Accounting and Financial Management

10.6.1

Cash flows are preferred because cash is the ultimate measure of economic wealth (Atrill and McLaney, 2008:516).
Cash is used to obtain resources and for distribution to shareholders. When cash is invested in a project, an
opportunity cost is incurred, as the cash cannot be used in other projects. Similarly, when a project generates
positive cash flows, the cash can re-invested in other projects.

Profit, on the other hand, reports on the productive effort for a period. This measure of effort may only have a
tenuous relationship to cash flows for a period. Accounting conventions may lead to the recognition of gains and
losses in one period and the relevant cash inflows and outflows occurring in another period.

10.6.2.1 To do the calculations required, we first need to convert the net profit to cash flow:

Project A

Year Net profit Depreciation Cash flow

1 R40 000 R25 000 R65 000

2 R5 000 R25 000 R30 000

3 R5 000 R25 000 R30 000

4 (R15 000) R25 000 R10 000

Project B

Year Net profit Depreciation Cash flow

1 R10 000 R25 000 R35 000

2 R10 000 R25 000 R35 000

3 R10 000 R25 000 R35 000

4 R10 000 R25 000 R35 000

263 MANCOSA
Accounting and Financial Management

Payback period: Project A

Investment (R100 000)

Year 1 Cash flow 65 000

(35 000)

Year 2 Cash flow 30 000

(5 000)

Year 3 Cash flow 30 000

The payback period is 2 years 2 months

Note:

5 000_ X 12 mths

30 000

= 2 months

Payback period: Project B

Initial investment = R100 000

Net annual cash inflow R35 000

2.86 years or

= 2 years 10 months 10 days

Note:

0.86 X 12 months = 10.32 months

0.32 X 30 days = 9.6 days

MANCOSA 264
 Accounting and Financial Management

NPV: Project A

Cash Discount Present

Year inflow Factor (12%) value

1 R65 000 0.8929 R58 039

2 R30 000 0.7972 23 916

3 R30 000 0.7118 21 354

4 R10 000 0.6355 6 355

Total PV 109 664

Investment (100 000)

NPV (positive) R9 664

NPV: Project B

Net inflow per year R35 000

Discount factor (12%, annuity X 3.0373

table)

Total Present value 106 306

Investment (100 000)

NPV (positive) R6 306

IRR: Project A

265 MANCOSA
Accounting and Financial Management

Year Cash Discount Discount Present Present

inflow factor factor value value

18% 19% 18% 19%

1 R65 000 0.8475 0.8403 R55 088 54 620

2 R30 000 0.7182 0.7062 21 546 21 186

3 R30 000 0.6086 0.5934 18 258 17 802

4 R10 000 0.5158 0.4987 5 158 4 987

Total PV 100 050 98 595

Investment (100 000) (100 000)

NPV R50 (R1 405)

The IRR is between 18% and 19%.

IRR= 18 + 50

50 + 1 405

= 18 + 50

1 455

= 18.03%

IRR: Project B

Year Cash inflow Discount Discount Present Present

p.a. Factor Factor value value

14% 15% 14% 15%

PV 1-4 R35 000 2.9137 2.8550 R101 980 R99 925

Investment (100 000) (100 000)

NPV R1 980 (R75)

MANCOSA 266
 Accounting and Financial Management

The IRR is between 14% and 15%.

IRR= 14 + 1 980

1 980 + 75

= 14 + 1 980

2 055

= 14.96%

10.6.2.2 Since both projects are acceptable under the NPV (positive) and IRR (greater than the cost of
capital) criteria, both should be chosen.

10.6.2.3 Project A, with a higher NPV and IRR, should be chosen.

10.6.2.4 Project M Project N

ARR = Average annual profit X 100 Average annual profit X 100

Initial investment 1 Initial investment 1

= R8 750 X 100 R10 000 X 100

R50 000 1 R50 000 1

= 17,50% 20%

267 MANCOSA
Accounting and Financial Management

Annexure
King Code and Report on Governance
for South Africa (King Iii)

KING CODE AND REPORT ON GOVERNANCE FOR SOUTH AFRICA (KING III)
The revised King Code and Report on Governance for South Africa (King III) was launched on 01 September 2009.
It came into effect and replaced the King II Code and Report on Corporate Governance (King II) on 01 March 2010.

In a change of approach, King III moves from a “comply or explain” approach to an “apply or explain” approach.
The “apply and explain” approach requires a greater consideration of how a principle or a recommended practice
in King III could be applied.

Set out below are the important highlights and main changes introduced by King III:
 the chairman of the board should be an independent non-executive director (NED) who is free from
conflicts of interest on appointment and is not the chief executive officer (CEO);
 the majority of board members should be NEDs, of which the majority must be independent;

 the independence and performance of a non-executive director who has been on a board for more than
nine consecutive years should be assessed, also a retired CEO should not become chairman of the board until
three full years have elapsed since the end of his tenure as an executive director;
 the duties of directors to act in good faith and to exercise the required degree of care, skill and diligence
in the best interests of the company;

 all companies should have standing risk, remuneration and nomination committees, unless legislated
otherwise;
 King III reflects the 2008 Companies Act’s requirements that public companies and state-owned
companies must appoint an audit committee comprising at least three non-executive independent
members;
■
 a risk-based approach to the internal audit function is adopted with the emphasis being on its strategic
importance to the company and its independence from management;
 IT governance is tackled for the first time in King III. Boards should be responsible for IT governance and
should appoint a “Chief Information Officer” (CIO) who is responsible for the management of IT;

MANCOSA 268
 Accounting and Financial Management

■
 King III stresses the importance of building a sustainable business having regard to the economic, social and
environmental impact of the company.

Conclusion

Corporate governance has become an issue of global significance. King III is forward-looking and represents a
significant advance in good corporate governance. Companies will find King III more user-friendly, in particular
the new format of the Code which briefly sets out the recommended best practices against the applicable principles,
should constitute a handy quick reference guide (www.polity.org.za).

269 MANCOSA
 Accounting and Finance

1Table 1: Present value of R1: PVFA (k,n) =

Number
of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 25%
Periods
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 0.8000
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 0.6400
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 0.5120
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 0.4096
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 0.3277

6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349 0.2621
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791 0.2097
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326 0.1678
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938 0.1342
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615 0.1074

11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346 0.0859
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122 0.0687
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935 0.0550
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779 0.0440
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649 0.0352

16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069 0.0930 0.0811 0.0708 0.0618 0.0541 0.0281
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929 0.0802 0.0693 0.0600 0.0520 0.0451 0.0225
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808 0.0691 0.0592 0.0508 0.0437 0.0376 0.0180
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703 0.0596 0.0506 0.0431 0.0367 0.0313 0.0144
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611 0.0514 0.0433 0.0365 0.0308 0.0261 0.0115

25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304 0.0245 0.0197 0.0160 0.0129 0.0105 0.0038
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151 0.0116 0.0090 0.0070 0.0054 0.0042 0.0012
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037 0.0026 0.0019 0.0013 0.0010 0.0007 0.0001
50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001 *
60 0.5504 0.3048 0.1697 0.0951 0.0535 0.0303 0.0173 0.0099 0.0057 0.0033 0.0019 0.0011 0.0007 0.0004 0.0002 0.0001 0.0001 * * * *

270 MANCOSA
 Accounting and Financial Management

n
2Table 2 : Present value of a regular annuity of R1 per period for n periods : PVFA (k,n) = ∑ =
i=1

Number
of 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
Periods
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6052 1.5852 1.5656 1.5465 1.5278
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832 2.2459 2.2096 2.1743 2.1399 2.1065
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550 2.7982 2.7432 2.6901 2.6386 2.5887
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522 3.2743 3.1993 3.1272 3.0576 2.9906

6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845 3.6847 3.5892 3.4976 3.4098 3.3255
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604 4.0386 3.9224 3.8115 3.7057 3.6046
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873 4.3436 4.2072 4.0776 3.9544 3.8372
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716 4.6065 4.4506 4.3038 4.1633 4.0310
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188 4.8332 4.6586 4.4941 4.3389 4.1925

11 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337 5.0286 4.8364 4.6560 4.4865 4.3271
12 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206 5.1971 4.9884 4.7932 4.6105 4.4392
13 12.1337 11.3484 10.6350 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831 5.3423 5.1183 4.9095 4.7147 4.5327
14 13.0037 12.1062 11.2961 10.5631 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245 5.4675 5.2293 5.0081 4.8023 4.6106
15 13.8651 12.8493 11.9379 11.1184 10.3797 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474 5.5755 5.3242 5.0916 4.8759 4.6755

16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542 5.6685 5.4053 5.1624 4.9377 4.7296
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472 5.7487 5.4746 5.2223 4.9897 4.7746
18 16.3983 14.9920 13.7535 12.6593 11.6896 10.8276 10.0591 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280 5.8178 5.5339 5.2732 5.0333 4.8122
19 17.2260 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982 5.8775 5.5845 5.3162 5.0700 4.8435
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 10.5940 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593 5.9288 5.6278 5.3527 5.1009 4.8696

25 22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641 6.0971 5.7662 5.4669 5.1951 4.9476
30 25.8077 22.3965 19.6004 17.2920 15.3725 13.7648 12.4090 11.2578 10.2737 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660 6.1772 5.8294 5.5168 5.2347 4.9789
40 32.8347 27.3555 23.1148 19.7928 17.1591 15.0463 13.3317 11.9246 10.7574 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418 6.2335 5.8713 5.5482 5.2582 4.9966
50 39.1961 31.4236 25.7298 21.4822 18.2559 15.7619 13.8007 12.2335 10.9617 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605 6.2463 5.8801 5.5541 5.2623 4.9995
60 44.9550 34.7609 27.6756 22.6235 18.9293 16.1614 14.0392 12.3766 11.0480 9.9672 9.0736 8.3240 7.6873 7.1401 6.6651 6.2402 5.8819 5.5553 5.2630 4.9999

271 MANCOSA
Accounting and Finance

272
MANCOSA