Strategies for managing working capital include:
Leasing represents an agreement between the owner of an item
and the potential user of an item in return of payment of a
periodic charge. The owner of the item is the lessor and the
business using it is the lessee.
Leasing is very much an
instrument of the finance companies, which are the largest
source of leasing arrangement, followed by the banks, with
merchant banks and life assurance companies active in a minor
way.
Where a finance company agrees to enter into a lease with a
client, it could just as well have lent the client the money.
The main difference is that, in a lease, the finance company
owns the equipment. The payments the lessee must every month
meet, among other things, the interest costs of the funds used
by the finance company to purchase the leased asset.
There are two types of lease:
1.
Financial leases, which are often indistinguishable from debt
finance, provide the required item to the user, with the
eventual purchase terms clearly written into the lease, it
differs from time payment in its many guises by requiring no
initial deposit, other than one periodic payment, usually
monthly, and instead of an on-going lump sum there is usually a
residual value. This figure is that at which the lessee may, but
need not, offer to purchase the leased asset at the termination
of the lease. No agreement to actually purchase may be written
into the lease. If it is, or is even implied, the Australian
Taxation Office (ATO) is likely to disallow the agreement as a
lease, and deem it a purchase agreement, namely, that the lessee
owns the equipment and has borrowed funds to acquire it. The
residual value is the result of a complex calculation which
includes:
- The written down value of the item at the end of the lease.
- The opportunity cost of the funds employed.
- The interest earned from the lease payments.
- The probable market value of the item at the end of the lease.
There are certain conditions to a financial lease, namely:
- The pre-arranged agreement on the terms of the lease is
usually firm, and may only be abrogated by the lessee at a
substantial penalty. The term of the lease will usually cover
the leased asset's expected working life.
- The lessee is responsible for maintenance, insurance,
operating costs, and any legal government charged incurred by
operating the item which is the subject of the lease, for
example, paying registration and compulsory third party
insurance on a motor vehicle. The leased item, and the lease
agreement, both appear in the accounts of the lessee, in the
non-current assets and deferred liabilities sections of the
Balance Sheet.
- The lease agreement will specify a series of monthly payments
and a residual value. Both must be commercially acceptable to
the Australian Taxation Office.
- The transaction that brings the monthly lease payments to
account is usually generated by a bank standing order. It may be
paid by cheque.
- From the financier's standpoint, the item is purchased
specifically for the lessee, at the lessee's choice
specification, and the first term of the lease amortises the
cost of the item completely. Amortisation means paying of
interest bearing liability by gradual reduction through a series
of installments comprising of both principal and interest
components, as opposed to paying it off by a single lump-sum
payment.
Thus, the lesse has all the obligations of ownership, without
actually owning the item. The main advantages are the taxation
relief from the payments, and the conservation of initial
capital.
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2. Operating leases, of which a sub-type is the rental lease.
Operating leases differ from financial leases in not providing,
as a right, an opportunity to purchase the item being leased
when the lease agreement comes to an end. Here the emphasis is
on rental, rather than what is effectively deferred purchase.
The general conditions of these eases are:
- The term of the lease generally has no relation to the leased
asset's working life.
- The leased asset was probably not acquired specifically for
the lessee by the lessor.
- Usually no penalty attends early termination of the lease by
the lessee.
- No residual value is written into the lease, and the lessee
has no vehicle by which he/she may offer to purchase the leased
asset.
- In the case of operating leases, the lessee may be responsible
for paying all or any of the maintenance, insurance, operating
costs, and any legal or government charges related to the
operating of the equipment which is the subject of the lease,
for example, paying registration on a motor vehicle.
- In a rental lease it is usual for the periodic payments of the
lease to cover all of these costs, except possible operating
costs such as fuel and oil in the motor vehicle, although even
these may be included, particularly in fleet management leases.
Neither of these leases appears in the Balance Sheet, being
regarded as an ongoing current overhead expense of business.
Thus, to the extent that they are used totally in the business,
as opposed to the potential private use of a motor vehicle, the
payments are totally tax deductible.
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Factoring is the selling of accounts receivable or debtors'
ledgers to a third party for less than the book value. The
factor advances the business the value of the invoices and takes
over the collection of accounts from the customers. The balance,
less the factoring fee, is paid to the business when the factor
receives the customer's remittance. In factoring, the debtors'
ledger itself is usually sold to a finance company, which will
purchase it as a considerable discount from the face value of
the balances, often 20 per cent of sixty days prior balances.
For example, if the company has $1 million of debtor accounts to
sell over sixty days, the factor will accept and then discount
them to provide immediate working funds to the seller. The funds
are expensive, compared to bank overdrafts, but are available
immediately. The factor's (finance company's) calculations are:
$1 000 000
1 + 0.20
(60) = $968 170
(365)
The factor therefore discounts the ledger by $31 830. This is
the factor's fee for taking the risk of collecting, or not
collecting, the debtor balances. There are two types of
factoring:
- Non-resource factoring is one we see everyday. This is the
bankcard, VisaCard and MasterCard system, in which the factors,
in this case the banks, takes the total risk of the debts. The
banks typically charge traders' 2-5 per cent month of all
current charges negotiated for the non-recourse debtors' ledgers
they accept and they make funds available on a daily basis.
Despite some traders' critical comments about the allegedly
greedy banks, this service provides great security for the
trader.
- Recourse factoring in which the factor will return bad or
doubtful debts to the original seller of the ledger. The
factor's discount reflects the amount of risk taken, and the
higher the risk, the greater is the discount.
- The term factoring is sometimes applied to loans offered by
banks and finance companies, secured against the balances in the
debtors' ledger. This only becomes actual factoring if the
borrower defaults, and the lender takes up his/her security.
Sale and leaseback refers to a transaction in which the seller
retains the use of an asset, such as occupancy of a building, by
simultaneously signing a lease (usually of long duration) with
the purchaser of the asset at the time of sale. In this way the
seller receives cash for the transaction, while the buyer is
assured a lease, and thus a fixed return on his/her investment.
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The Cash Flow Statement shows what was actually received and
paid by the company in a particular year, not what was owed or
recorded.
The Cash Flow Statement takes the Balance Sheet of the business
entity, and proves it by detailing the sources of cash used to
fund various accounts in the Balance Sheet. For example, in
current liabilities, a decrease in the trade creditors' ledger
from one period to another has to be funded, and this may be
done by increasing the bank overdraft (or reducing the bank
balance) or reducing trade debtors' (given that sales have at
least held even). The proof of the Statement lies in the
equality of the two totals, that is:
Source of funds = application (use) of funds.
Sources include:
- Injection of new capital
- Raising new loans
- Profits earned (after adding back depreciation)
- Reduction in stock
- Increases in creditors
- Proceeds of sales of fixed assets, for example plant and
equipment.
Applications include:
- Pay-out of business loans
- Payments of dividends
- Taxation paid
- Increases in stock and debtors
- Reduction of creditors
- Purchase of fixed assets
- Losses incurred by the business
A typical cash flow statement is divided into three parts:
1. Cash flows from operating activities. These are mainly
receipts from customers, payments to suppliers, wages, dividend
and interest payments, and receipts and taxes. Generally,
operating activities is negative. However, an established
company should maintain regular positive cash flows, unless it
is in the process of major expansion.
2. Cash flows from investing activities. These are such things
as research and development expenditure, exploration and
evaluation costs, payments for plant and equipment, loans to
associated companies, new investments and the proceeds from the
sale of property and investments.
3. Cash flows from financing activities. These are largely cash
flows related to borrowing or from the issue of new shares.
An overall positive cash flow could result from borrowing, while
a negative cash flow could mean that the company is paying off
loans. Thus, it is important to consider what is behind the
figures.
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- Shortening the operating cycle. Increasing the inventory
turnover or reducing the days debtors, while maintaining the
same level of sales, will release cash. This requires more
aggressive collection of trade debtors and tighter control of
inventories. It may even pay to offer discounts for early
payments.
- Increase net profit margin. This can be achieved by increasing
price, reducing costs of sales, or reducing operating expenses.
- Reduce sales volume. This reduces the investment required in
the components that make up the operating cycle. It is often
preferable to show growth than to have a cash crisis. It is
possible to increase profit margin and cash flow while reducing
sales volume by selectively increasing prices.
- Increase trade payables. To slow down cash disbursements, the
business may rely more heavily on available credit. Credit terms
may be extended. Otherwise, it may be possible to acquire goods
on consignment, which means that the business does not pay until
the goods are sold.
- Borrow money. This can be used to solve both short-term and
long-term cash flow problems.
Short-term borrowing is used to finance temporary increases in
working capital, such as a seasonal build-up of stock financed
by an overdraft. It should be self-liquidating, so that when the
operating cycle returns to normal it produces the cash flow
necessary to repay the loan. Long-term borrowing can be used for
permanent increases in working capital or for the acquisition of
fixed assets. It is repaid over a longer period to give assets
enough time to generate the cash flow necessary for repayment.
- Look for equity capital. This can be done by either the owner
putting more of his/her own money into the business, or taking
in new owners in the form of partners or shareholders. It is
long-term capital and should be used for long-term purposes.
- Maintain a minimum cash reserve. While cash is an idle asset,
it is sometimes prudent to have minimum cash reserve. The size
of a cash reserve will depend upon the extent of owner can count
on collections from debtors, the flexibility of business's
disbursements and the availability of external finance.
Cash flow shows cash in and cash out. It does not show non-cash
items. There are two key risks not covered by cash flows
statements, namely:
- Liabilities, which are amounts owing and yet to be paid.
- Assets losing value which, if acquired by paying cash for
them, appear in the Cash Flows Statement when paid for.
Over-valuation of assets is often difficult to detect.
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Profitability is concerned with managing the flow of sales
revenue into, and operating expenses out of, the business.
Profitability management is concerned with maintaining or
increasing a business's earnings through attention to:
- Cost control
- Pricing policy
- Sales volume
- Stock management
- Capital expenditure.
Gross profit is obtained by subtracting costs from revenue. The
greater the 'gap', the greater the profit.
There are two types of controls that improve profit levels:
1. Cost controls, such as:
- Fixed and variable costs. Fixed, or overhead costs, are those
whose amount is not influenced by the plant's production level.
They exist even if the plant is idle, for example, council rates
and fire insurance. Variable costs are those that vary with the
level of production, such as wages and salaries, raw materials
and electricity. Total costs for a business for various levels
output are the summation of total fixed costs and the total
variable costs for those outputs. From knowing the business's
costs, the break-even point can be ascertained. Break-even
occurs where S = FC + VC, where S is the break-even level of
sales in dollars, FC is fixed costs, and VC is variable costs in
dollars. If, for example, variable costs divided by sales,
expressed as percentage, resulted in a figure of 75 per cent,
this means that 75 cents of every dollar of sales, is required
to cover the variable cost. The remainder, 25 cents of every
dollar of sales, is available to make a contribution towards
paying the fixed costs and eventually to make a profit. This 25
cents is called the contribution margin, and it represents the
percentage of each dollar of sales available to pay for the
fixed costs and to make a profit. The margin of safety is the
difference between the break-even point and the current level of
sales. It indicates the extent to which sales may decline before
the firm begins to operate at a loss.
- Cost centres. Particularly in large diversified companies,
separate departments may be designated cost centres for
accounting and cash flow monitoring by a central finance
department. They enable managers to quickly and easily see when
one department's costs are growing too fast.
- Expense minimisation. There is a saying: "The business that
watches its cost, does not get lost". This means that while it
is necessary to sell goods to generate inward cash and gross
profits, it is even more necessary to guard against waste of the
asset that the business has worked so hard to gain, namely,
cash. Thus, most businesses aim to minimise expenses.
2. Revenue controls, which include:
Sales analysis. A sales analysis would be conducted to compare
sales objectives with actual results. However, a study of total
sales is not enough to give an accurate picture of performance.
A consideration of the sales mix, or a sales volume analysis of
different market segments, is required to show what happened
where, and to assist in explaining revenue collection. More
detailed analysis would be provided by considering:
- Sales by product lines
- Marketing segments
- Territories
- Individual sales representatives.
Pricing policy. Pricing can be a critical decision. Factors such
as cost, customer reaction, competitor pricing policies,
marketing strategies, types of products or services being
offered, impact of Government legislation, and the price
elasticity of demand can all affect a business's pricing policy.
Price elasticity of demand refers to the degree of
responsiveness of demand for a good, as a result of a price
change. In the case of basic necessities as price change has
little effect on the demand. Necessities have a relatively
inelastic demand and a price rise will result in increased sales
revenue and rising profits. On the other hand, if the demand for
product is relatively elastic, the business that increases its
price will be faced with falling sales revenue and profits. The
pricing of products may follow one of several methods:
- Full cost pricing (which reflects the business's costs)
- Gross margin pricing (which takes operating costs and
marketing factors into account)
- Pricing to achieve a certain rate of return on
investment
- Pricing that follows current market prices.
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your cash flow.
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