A basic understanding of the principles of costing is important in business management.

Most non-financial managers instinctively know that costing is important.

Unfortunately, it is probably also true that most non-financial managers do not know very much about it.

This is a pity because it affects so many business decisions.

For example, the fixed costs of running a cruise ship do not vary (or realistically only vary slightly) according to the number of passengers is the reason that large last-minute price reductions are often available. (Think of that when you book your holiday.)

A basic understanding of the principles of costing is important in business management.

The Working Capital Management: Success in managing debtors, stock and creditors affect cash.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.



Debtors

Many local businesses are plaqued by slow payment of invoices and it is a problem in many other countries too.

A statutory right to interest has been in place for a number of years but nothing seems to make much difference.

An improvement can significantly affect working capital.

It is a great problem for managers, who sometimes are frightened of upsetting customers and feel that there is little that they can do.

This is  completely the wrong attitude.

Customer relations must always be considered, but a great deal can be done.

Some practical steps for credit control are summarized below:

• Have the right attitude; ask early and ask often.
• Make sure that payment terms are agreed in advance.
• Do not underestimate the strength of your position.
• Give credit control realistic status and priority.
• Have well-thought out credit policies.
• Concentrate on the biggest and most worrying debts first.
• Be efficient; send out invoices and statements promptly.
• Deal with queries quickly and efficiently.
• Make full use of the telephone, your best aid.
• Use legal action if necessary.

This may sound obvious but it usually works.

Be efficient, ask and be tough if necessary.

Stock

The aim should be 

• to keep stock as low as is realistically feasible and 
• to achieve as high a rate of stock turnover as is realistically feasible.

In practice, it is usually necessary to compromise between 

• the wish to have stock as low as possible, and 
• the need to keep production and sales going with a reasonable margin of safety.

Exactly how the compromise is struck will vary from case to case.  

Purchasing and production control are highly skilled functions and great effort may be expended on getting it right.

"Just in time deliveries" is the technique of arranging deliveries of supplies frequently and in small quantities.  In fact, just in time to keep production going.

It is particularly successful in japan where, for example, car manufacturers keep some parts for production measured only in hours.

It is not easy to achieve and suppliers would probably like to make large deliveries at irregular intervals.  

It may pay to approach the problem with an attitude of partnership with key suppliers, and to reward them with fair prices and continuity of business.

Finished goods should be sold, delivered and invoiced as quickly as possible.

Creditors

It is not ethical advice, but there is an obvious advantage in paying suppliers slowly.

This is why slow payment is such a problem and, as has already been stated, the control of debtors is so important.

Slow payment is often imposed by large and strong companies on small and weak suppliers.

Slow payment does not affect the net balance of working capital,but it does mean that both cash and creditors are higher than would otherwise be the case.

Apart from moral considerations, there are some definite disadvantages in a policy of slow payment:

• Suppliers will try to compensate with higher prices or lower service.
• Best long-term results are often obtained by fostering mutual loyalty with key suppliers; it pays to consider their interests.
• If payments are already slow, there will be less scope for taking longer to pay in response to a crisis.

For these reasons it is probably not wise to adopt a consistent policy of slow payment, at least with important suppliers.

It is better to be hard but fair and to ensure that this fair play is rewarded with 

• keen prices, 
• good service and 
• perhaps prompt payment discounts.

There may be scope for timing deliveries to take advantage of payment terms.  

For example, if the terms are 'net monthly account', a 30 June delivery will be due for payment on 31 July.  At 1 July delivery will be due for payment on 31 August.

The Management of Working Capital. Is it important?

The effective management of working capital can be critical to the survival of the business and it is hard to think of anything more important then that.

Many businesses that fail are profitable at the time of their failure and failure often comes as a surprise to the managers.

The reason for the failure is a shortage of working capital.

Furthermore, effective management of working capital is likely to improve profitability significantly.

The percentage return on capital employed increases as capital employed is reduced.

Effective management of working capital can reduce the capital employed.

It increases profits as well as enabling mangers to sleep soundly without worries.

The four largest elements affecting working capital are usually

• debtors, 
• stock, 
• creditors and 
• cash.

Success in managing the first three affect cash, which can be reinvested in the business or distributed.

The Cash-Flow Forecast

It is extremely important that cash receipts and payments are effectively planned and anticipated.

This has not been done in nearly all businesses that fail.

A good manager will plan that sufficient resources are available but that not too many resources are tied up.

This can be done in isolation but it is better done as part of the overall budgeting process.



Cash-Flow Forecast will yield many benefits

The preparation of a detailed Cash-Flow Forecast will yield many benefits.

Calculating and writing down the figures may suggest ideas as to how they can be improved.

For example,

• the figures for cash payments from trade debtors will be based on the estimate of the average number of days' credit that will be taken.
• This will pose the question of whether or not payments can be sped up.

Are the Cash-Flow Forecast results acceptable?

When the Cash-Flow Forecast is finished it will be necessary to consider if the results are acceptable.

• Even if resources are available the results might not be satisfactory, and improvements will have to be worked out.
• If sufficient resources are not available, either changes must be made or extra resources arranged.  Perhaps, an additional bank overdraft can be negotiated.

Either way, a well-planned document will help managers to take action in good time.


Best illustrated in a table format

The principles of a Cash-Flow Forecast are best illustrated with an example in a table format.

Variations in the layout are possible but a constant feature should be the running cash or overdraft balance.

Do not overlook contingencies and do not overlook the possibility of a peak figure within a period.

What is cash?

Cash includes the notes and coins in the petty cash box.

It also includes money in the bank current accounts, and money in various short-term investment accounts that can be quickly be turned into available cash.

It is common for a Balance Sheet to show only a tiny amount for cash.  This is because the business has an overdraft and only such things as the petty cash are included.

Practical management usage of the term cash includes a negative figure for an overdraft.

A Cash-Flow Forecast can often result in a series of forecast overdrafts.

The distinction between Profit and Cash. A business can be profitable but short of cash.

Cash is completely different from profit, a fact that is not always properly appreciated.

It is possible, and indeed quite common, for a business to be profitable but short of cash.

Among the differences are the following:

1. Money may be collected from customers more slowly (or more quickly) than money is paid to suppliers.
2. Capital expenditure (unless financed by hire purchase or similar means) has an immediate impact on cash.  The effect on profit, by means of depreciation, is spread over a number of years.
3. Taxation, dividends and other payments to owners are an appropriation of profit.  Cash is taken out of the business which may be more or less than the profit.
4. An expanding business will have to spend money on materials, items for sale, wages, etc. before it completes the extra sales and gets paid.  Purchases and expenses come first.  Sales and profit come later.

Four Key Questions when using Financial Information and Interpreting Accounting Ratios

There are many traps in using financial information and interpreting accounting ratios.

You are advised to approach the job with caution and always keep in mind four key questions:

1. Am I comparing like with like?
2. Is there an explanation?
3. What am I comparing it with?
4. Do I believe the figures?

1.  Am I comparing like with like?

Financial analysts pay great attention to the notes in accounts and to the stated accounting policies.

One of the reasons for this is that changes in accounting policies can affect the figures and hence the comparisons.

For example:

• Consider a company that writes off research and development costs as overheads as soon as they are incurred.
• Then suppose that it changes policy and decides to capitalize the research and development, holding it in the Balance Sheet as having a long-term value.
• A case can be made for either treatment but the change makes it difficult to compare ratios for different years.

2.  Is there an explanation?

Do not forget that there may be a special reason for an odd-looking ratio.

For example:

• Greetings card manufacturers commonly deliver Christmas cards  in August with an arrangement that payment is due on 1 January.
• The 30 June Balance Sheet may show that customers are taking an average of 55 days' credit.
• The 31 December Balance Sheet may show that customers are taking an average of 120 days' credit.
• This does not mean that the position has deteriorated dreadfully and the company is in trouble
• The change in the period of credit is an accepted feature of the trade and happens every year.
• It is of course important, particularly as extra working capital has to be found at the end of each year.

3.  What am I comparing it with?

A ratio by itself has only limited value.

It needs to be compared with something.

Useful comparisons may be with the company budget, last year's ratio, or competitors' ratios.

4.  Do I believe the figures?

You may be working with audited and published figures.

On the other hand, you may only have unchecked data rushed from the accountant's desk.

This sort of information may be more valuable because it is up to date.

But beware of errors.

Even if you are not a financial expert, if it feels wrong, perhaps it is wrong.

Accounting Ratios - these are among the most important

There are many useful ratios that can be taken from accounts.

The following are among the most important but there are many others.

• Profit turnover
• Return on Capital Employed 
• Stock turn
• Number of Days' Credit Granted
• Number of Days' Credit Taken
• Dividend per Share
• Price/earnings ratio

When going through a set of accounts, it is a good idea to pick out relevant figures, work out the ratios and try to draw conclusions.

For all the ratios, if you have access to frequently produced management accounts, the ratios will be more useful.




Questions to ask yourself regarding Accounting Ratios:

1. What was the ratio of Profit to Turnover?
2. What was the Return on Capital Employed?
3. What was the Stock Turn?
4. What was the number of days' credit granted?  (Ignore possible GST or VAT implications)
5. What is the working capital?  Does this give cause for concern?

Dividend per share

For example;

Total dividends  $2 million
Number of issued shares  10 million
Dividend per share  20 sen.

This is the total dividends for the year divided by the number of shares in issue.

Any preference shares are normally disregarded.

Price/earnings ratio

For example:

Profit after tax  $5 million
Number of issued shares 10 million
Earnings per share 50 sen
Current share price $7.50
Price/earnings ratio 15

This is one of the most helpful of the investment ratios and it can be used to compare different companies.

The higher the number the more expensive the shares.

It is often useful to do the calculation based on anticipated future earnings rather than declared historic earnings, although of course you can never be certain what future earnings will be.

The calculation is the current quoted price per share divided by earnings per share.

Gearing

For example:

Loans  $6 million

Shareholders' funds $3 million

Gearing 200%

The purpose of this ratio is to compare the finance provided by the banks and other borrowing with the finance invested by shareholders.

It is a ratio much used by banks, who may not like to see a ratio of 1 to 1 (or some other such proportion) exceeded.

The ratio is sometimes expressed as a proportion as in 1 to 1.

Sometimes it is expressed as a percentage:  1 to 1 is 50% because borrowing is 50% of the total.

Gearing is said to be high when borrowing is high in relation to shareholders' funds.

This can be dangerous but shareholders' returns will be high if the company does well  

This is what is meant by being highly geared.

Number of days' credit taken

In this case the figure for closing trade creditors is compared with that for the annual purchases.  

Annual costs of sales  $6 million
Trade creditors  $1.0 million
Number of days' credit taken

The calculation is (1.0 / 6.0) x 365 = 61 days

Number of days' credit granted

For example:

Annual turnover including GST  $10 million
Trade debtors $1.5 million
Number of days' credit  55

The calculation is:  (1.5 / 10) x 365 = 55 days

Obviously, the lower the number of days the more efficiently the business is being run.

The figure for trade debtors normally comes from the closing Balance Sheet and care should be taken that it is a figure typical of the whole year.

If $1.5 million of the $10 million turnover came in the final month, the number of days' credit is really 31 instead of 55.

The calculation is:  (1.5 / 1.5 ) x 31 = 31 days

Care should also be taken that the GST-inclusive debtors figure is compared with the GST-inclusive turnover figure.

GST is normally excluded from the Profit and Loss Account.



GST = General Sales Tax
In other countries, it is the VAT or Value Added Tax.

Stock Turn or Inventory Turn

For example:

Annual turnover  $10 million
Annual cost of sales (60%)  $6 million
Stock value $1.5 million
Stock turn 4


This measures the number of times that total stock is used (turned over) in the course of a year.

The higher the stock turn the more efficiently the business is being run, though adequate safety margins must of course be maintained.

It is important that the terms are completely understood and that there are no abnormal factors.

Normally the definition of stock includes all finished goods, work in progress and raw materials.

The stock value will usually be taken from the closing Balance Sheet but you need to consider if it is a typical figure.

If the business is seasonal, such as a manufacturing of fireworks, it may not be.  

A better result may be obtained if the average of several stock figures throughout the year can be used.

Profit Turnover

For example:

Annual turnover $10 million
Annual profit before tax $1 million
Profit before tax to turnover 10%


This uses Profit before tax but it may be more useful to use Profit after tax.

Perhaps you want to define profit as excluding the charge for bank interest (EBIT or Earnings before Interest and Tax).

You should select the definition most relevant to your circumstances.

Return on Capital Employed

For example:

Capital employed $5 million
Annual profit after tax $1 million
Return on capital employed 20%

The profit may be expressed before or after tax.

Capital employed is the net amount invested in the business by the owners and is taken from the Balance Sheet.

Many people (including Warren Buffett) consider this the most important ratio of all.

It is useful to compare the result with a return that can be obtained outside the business.

If a bank is paying a higher rate, perhaps the business should be closed down and the money put in the bank.

Note that there are 2 ways of improving the return.  In the example above:

• the return on capital employed would be 25% if the profit was increased to $1.25 million.
• it would also be 25% if the capital employed was reduced to $4 million.

Reading the content of the Annual Report

The content of the Annual Report and Accounts is governed by the law and accounting standards, though directors do still have some discretion.

Listed companies are required to use international accounting standards.

If you are looking at the Report and Accounts of a listed company you will see the following:

• Independent Auditor's Report
• Balance Sheet (it might be called Statement of Financial Position)
• Statement of Comprehensive Income or it might be called Income Statement (this corresponds with the Profit and Loss Account)
• Statement of Changes in Equity
• Statement of Cash Flows
• Notes to the financial statements
• Chairman's Statement
• Directors' Report
• Business Review
• Directors' Remuneration Report

There is so much detail that there is really no substitute for diving in and having a look at the Report and Accounts of your chosen company.

Try not to get bogged down.  Best of luck.



Additional Notes:

Can you locate the following in the Report and Accounts of the company you are interested?

• the pre-tax profit (Profit and Loss Account)
• details of the fixed assets (Balance Sheet and supporting notes)
• the amount of any exports (the notes)
• is it an unqualified audit report? (the Audit Report)
• details of any political or charitable donation (the Directors' Report)
• was there a cash outflow in the period? (the Cash Flow Statement)
• details of the share capital (Balance Sheet and supporting notes)
• the amount of the capital employed (the Balance Sheet).

Consolidated Accounts

A large group may have a hundred or more companies.

It would obviously give an incomplete picture if each of these companies gave information just about its own activities.

This is especially true when companies in a group trade with each other.

This is why the holding company must include consolidated accounts as well as its own figures.

The effect of inter-group trading is eliminated and the Consolidated Balance Sheet gives the group's position in relation to the outside world.

This does not remove the obligation for every group company to prepare and file its own accounts.

Such accounts must include the name, in the opinion of the directors, of the ultimate holding company.

Cash Flow Statement

There are sometimes disputes about the figures in the Profit and Loss Account and Balance Sheet.

This is one reason why cash is so important.  

Cash is much more a matter of fact rather than of opinion.

It is either there or it is not there.

Whether the cash came from (banks, shareholders, customers) is also a matter of fact.

So too is where the cash went to (dividends, wages, suppliers, etc.).

The Cash Flow Statement gives all this information.

Late filing of financial accounts

Unfortunately, a small minority of companies file their accounts late or even not at all.

This is an offence for which the directors can be punished and the company incur a penalty, but it does happen.

It is often companies with problems that file late.