CHAPTER

11
WORKING CAPITAL
MANAGEMENT
 WORKING CAPITAL
MANAGEMENT
• Working Capital, Definition
• Float
Payment and Collection Instruments
• Short-Term Investing
• Short-Term Borrowing
Working Capital
• Working Capital – All the items in the short term part of the balance sheet e.g. cash, short
term debt, investments, inventory, debtors (receivables), payables (creditors) etc
• Net Working Capital is the difference between Current Assets and Current Liabilities
• Cash Management, Liquidity Management Interconnected terms.
CORPORATE DEFINITION OF CASH MANAGEMENT
The effective planning, monitoring and management of liquid / near liquid resources including:
• Day-to-day cash control
• Money at the bank
• Receipts
• Payments
• S-T investments and borrowings
 WORKING CAPITAL
DEFINITION OF LIQUIDITY
Having sufficient funds available to meet all foreseen and unforeseen obligations
• Liquidity has costs
• Cash is unproductive
• Spread between borrowing and deposit rates and between long and short term rates
NEED FOR LIQUIDITY
• Day to day transactions
• Precautionary balances
• Compensating balances
• Obtaining discounts
• Acid tests
• Favourable opportunities
• Overall avoiding bankruptcy!
Operating Cycle
Purchase Resources Pay Sell on Credit Receive Cash

Inventory Conversion Receivables Conversion

Payables Period Cash Conversion Cycle

Operating Cycle
From: Fundamentals of Contemporary Financial Management, 2nd ed, by Moyer, McGuigan and
Rao
The Various Cycles
• Inventory Conversion
Inventory x 365
Cost of Goods Sold
• Payables Conversion
Payables/Creditors x 365
Cost of Goods Sold
• Receivables Conversion

Receivables/Debtors x 365
Turnover
Balance Sheet Short Term Items
Current assets
Inventories 1,910 1,903
Trade and other receivables 1,713 1,625
Current tax assets 13 -
Other financial assets 43 78
Cash and short term assets 733 917
4,412 4,523
Current liabilities
Short term borrowings 355 555
Trade and other payables 1,690 1,735
Current tax liabilities 121 44
Other financial liabilities 119 13
Short term provisions 82 130
1,367 2,477
Turnover 9,577
Cost of goods sold 8,943
Operating Cycle
Purchase Resources Pay Sell on Credit Receive Cash

Inventory Conversion 78 days Receivables Conversion

65 days
Payables Period Cash Conversion Cycle
69 days 74 days
Operating Cycle
143
Cash Conversion
• We need to consider control in all areas of working capital to maximise return, reduce cost.
• Some areas are not controlled by the Finance Function – Stock/inventory
• Some areas have shared control – payables and receivables
• Some areas are controlled by the Finance Function – short term borrowing and
investment
Float
• Any delay in the process of converting materials and labour to receipt of payment involves
cost, float cost.
• Similarly, any delay in making payments will also give rise to float but this time to our
advantage
• What is float?
The time lost between a payer making a payment and a beneficiary receiving value
• Cost of Float
principle amount due x no of days x cost of funds
360 or 365
WHY DOES FLOAT OCCUR?
• Deliberately
• Inefficiency
• Logistical situations
• Compensation mechanism
Controlling Float
We need to look at controlling / influencing float in three areas
* Ourselves
* Our Customers
* Our Banks
HOW TO REDUCE/CONTROL FLOAT
• Your Own Actions
• Change own systems
• Educate customers
• Include costs in prices
• Negotiate with bank
RECEIVABLES AND PAYABLES MANAGEMENT
• Good receivables and payables management aids in:
• Cash flow forecasting
• Long-term funding and investment decisions
• Reduced risk of bad debts
• Stronger liquidity
• Stronger balance sheet ratios
RECEIVABLES IMPACT
Important because of costs arising from
• Float
• Bad debts
• Management time
• Legal fees
• Impact on analysts and creditors
RECEIVABLES MANAGEMENT
• Clear instructions
• Method of payment
• Documentation
• Account structures
• Terms of Trade
Controlling Float
• Payment Methods
Payment methods are important because of
- Cost
- Risk
- Value Dating
- Finality
RECEIVABLES MANAGEMENT
• Penalties
• Post dated cheques
• Legal process
• Internal process
• Stop supply
But do not forget Relationship
PAYABLES
Critical questions:
• What is due?
• When is it due?
• Where the payment should be sent?
• How should the payment be sent?
• Are there funds to cover the payment?
• Is the payment properly authorized?
PAYABLES MANAGEMENT
The flip side of the coin
So
• Hang on to it
• Consider float versus control
• Account structures
• Discounts
But do not forget Relationship
SHORT-TERM INVESTING
The Decision Process
• How much do I have to invest per currency?
• How long do I have to invest it?
• Where are the funds located?
• What is my appetite for risk?
INVESTMENT GUIDELINES
What are the company’s policies regarding?
• Currency exposure and hedging
• Banks used and limits
• Investment instruments and limits
• Use of automated sweep accounts
• Bank / investment ratings
FACTORS IN CHOOSING INVESTMENTS
• The need to make an adequate return
• The need to take into account areas of risk
 Credit risk
 Interest rate risk
 Capital risk
 Market risk
• The need to consider liquidity
HOW RATES ARE QUOTED
• At a discount: Instrument issued at less than 100%
• Coupon: Specific interest payments made at specific times
• Yield to redemption: Interest payments over the lifetime of the instrument and principal
repaid may be greater or less than 100%
SHORT-TERM INVESTMENTS
• Commercial paper (CP)
• Banker’s acceptances (BAs)
• Repurchase agreements
• Certificates of deposit (CDs)
• Money market funds
 • Treasury instruments (bills, notes, bonds)
SHORT-TERM BORROWING
The Decision Process
• How much needs to be financed and in what currency?
• How long does the deficit need to be financed?
• Where does it need it be financed?
• What is the maximum level of funding needed?
FACTORS AFFECTING BORROWING
These factors affect both amounts available and cost
• Financial strength of the company
• Key covenants
• Industry
• Available guarantee or security
• Company’s ability to repay on time from bank’s perspective
SHORT-TERM FUNDING INSTRUMENTS
Internal short-term funding
• Least expensive source of funding
• Cross-border and cross-currency intra-group financing can be difficult
External short-term funding
• Can act as a built-in hedge if sourced in the same currency
• Can be inexpensive to borrow local currency in the currency center
FACTORS IN CHOOSING FUNDING INSTRUMENTS
• All-in borrowing cost
• Security required
• Terms & conditions
• Tax & balance sheet aspects
FACTORS IN CHOOSING FUNDING
• Are all-in borrowing costs being offered?
• Does the bank require security?
• What are the terms and conditions?
• Is interest able to be offset on tax returns?
OTHER SOURCES OF FUNDING
• Factoring
• Invoice discounting
• Trade bills
• Acceptance credits
Financing Of Working Capital
The financing of the components working capital is not always undertaken on a completely
maturity matched basis. That is, whilst working capital is regarded as net current assets that
arguably should be funded by short term source of finance, this is not always the case for two
reasons. First, by construction, net current assets are funded by long term sources of finance to
the extent that all short-term sources of finance have been exhausted. This can be demonstrated
from a characterization of a typical balance sheet:
Fixed Assets + Net Current Assets - Long-Term Loans = Capital and Reserves
By simply re-arranging, we see that:
Net Current Assets = Capital and Reserves + Long-Term Loans – Fixed Assets
That is, net current assets are funded by long-term sources of finance not otherwise tied-up in
fixed assets. These amounts will vary-day to day because the components of working capital vary
from day to day. However, to the extent that there exists positive net current assets, then
adequate long-term financing needs have to be considered.
Second, the liabilities component of working capital (trade creditors and bank overdrafts)
represent sources of' finance. As such, they are normally regarded as short term sources of
finance. ln reality, for many business there is likely to be a core of current assets that will always
need funding whilst the components of current assets will change on a day to day basis, their level
– to an extent ñ will remain predictable. It is this predictable component that enables managers to
utilize longer term sources of finance in the knowledge that the finance will always be required.
The distinction is often made between fluctuating current assets and permanent current assets.
To the extent that current assets are permanent, then they are more efficiently financed by
longer-term sources. This will help avoid the higher interest cost (implicit or explicit) in
shorter-term sources of finance. The distinction between fluctuating and permanent current
assets is illustrated in the following diagram that indicates the relationship between asset
variability and funding maturity.
Question: 1
All Weather Windows Co manufactures and fits windows for domestic customer. The company
needs to forecast its working capital requirement for the year ahead. The following figures are
available:

Sales revenue $7,600,000

Cost as percentage of sales revenue
Raw materials 22%
Direct labour 18%
Variable production overheads 7%
Apportioned fixed production overheads 12%
Other costs 5%
Working capital statistics
Average raw material holding period 6 weeks
Average work-in-progress (WIP) holding period 3 weeks
Average finished goods holding period 5 weeks
Average trade receivable’s collection period 2.5 weeks
Average trade payables’ payment period on:
Raw materials 8 weeks
Direct labour 2 weeks
Variable production overheads 4 weeks
Fixed production overheads 6 weeks
Other costs 3 weeks

Other relevant information

1. All finished goods inventory and WIP values include raw materials, direct labour, variable
production overheads and apportioned fixed production overhead costs.
2. Assume WIP is 80% complete as to materials; 75% complete as to direct labour; 50%
complete as to variable production overheads and fixed production overheads.
3. Assume there are 52 weeks in one year.
4. Assume that production and sales volume are the same.
5. All working should be in $’000, to the nearest $’000.
Required:
Calculate the estimated average working capital required by All Weather Windows Co for the
year, showing all necessary workings.
Answer: 1
All Weather Windows
(a) Working capital requirements
$’000
Sales revenue for the year: 7,600
Raw material costs
$7,600,000 x 22% 1,672
Direct labour costs
$7,600,000 x 18% 1,368
Variable production overheads
$7,600,000 x 7% 532
Variable production overheads
$7,600,000 x 12% 912
Other costs
$7,600,000 x 5% 380
4,864
Current Assets:
Inventory $’000 $’000
Raw materials 6/52 x $1.672m 193
W-I-P
Materials 3/52 x $1.672m x 80% 77
Direct labor 3/52 x $1.368m x 75% 59
Variable and fixed production 3/52 x ($532k + 912k) x 50% 42
overheads
178
Finished good
Materials and direct labor 5/52 x ($1.672m + $1.368m) 292
Variable and fixed production 5/52 x ($532k + $912k) 139
overheads
432
Total inventory value 802
Trade receivables 2.5/52 x$7,600,000 365
Total value of current assets 1,167
Current Liabilities
Accounts payable $’000 $’000
Materials 8/52 x $1.672m (257)
Labor 2/52 x $1.368m (53)
Variable production overheads 4/52 x $532k (41)
Fixed production overhead 6/52 x $912k (105)
Other costs 3/52 x $380k (22)
Total value of current liabilities (478)
Working Capital required 689
Question: 2
Extracts of recent accounts for Best plc, a manufacturer of sportswear, are given below.
£’000
Year ended 31/12 2011 2012
Sales 5,000 6,000
Cost of sales 2,000 3,000
Purchase 1,000 1,300
Stocks:
Raw materials 164 205
Work in progress 88 118
Finished goods 170 280
Debtors 1,233 1,740
Creditors 122 110
Notes
1. Work in progress is estimated to be 40% complete.
2. Figures for stocks, debtors and creditors represent average balance
3. Sales and production are spread evenly over the year.

Required:
(a) Calculate the length (in days) of the cash operating cycle (sometimes known as the
working capital cycle) for Best plc for the years 2011 and 2012.
(b) Explain what the length of the cash operating cycle means and comment on the
implications of any changes in the length of the operating cycle between 2001 and 2002
for Best plc.
(c) In an attempt to reduce the length of time customers take to settle bills Best is considering
introducing a settlement discount of 2% for payment made within 30 days.
assuming that customers who will take discount currently pay on average in 100 days,
estimate the annual percentage
(d) Suggest five other methods Best may use to prompt earlier settlement from
overdue debtors.
Answers: 2. (a): Cash Operating Cycle
Days
2011 2012
Raw material holding period 59.86 57.56
Production period 40.15 35.89
Finished goods holding 31.03 34.07
period
Debtor days 90.01 105.85
Creditor days (40.88) (30.88)
Cash operating cycle 180.17 202.49
180 days 202 days
Workings
2011 2012
Raw material holding period 164/1,000 x 365 = 59.86 205/1,.00 x 365 = 57.56
Production period 88/(2,000 x 0.4) x 365=40.15 118/(3,000 x 0.4) x 365=35.89

Finished goods holding 170/2,000 x 365 = 31.03 280/3,000 x 365 = 34.07

period
Debtor days 1,233/5,000 x 365 = 90.01 1,740/6,000 x 365 = 105.85
Creditor days 112/1,000 x 365 = 40.88 110/1,300 x 365 = 30.88

(b) Explanation and Comment

Length of the cash measures the interval between a company paying cash at the start of its
operations (normally for raw materials in a manufacturing business) and receiving cash from
customers.
Implications of any changes
For Best plc the cycle appears to have lengthened. This has several implications:
 The amount of money tied up in working capital will increase; this will be detrimental to
Best’s cash flow.
 The finance cost of working capital will increase.
Longer stock holding periods for finished goods may result I more stock losses due to damage,
deterioration, obsolescence,
 theft etc
 Longer credit given to customers may result in more bad debts as long credit periods give
more time for things to go wrong.
On the other hand there could be some good new associated with the longer cycle.
  Higher stock levels and longer credit periods may attract ore customers and increase
sales and profits
 Quicker settlement of creditors may gain settlement discounts, or better service from
suppliers.
(c) In simple interest terms the discount costs
2/98 x 365/70 = 10.6%
in compound (APR) terms it costs
(1 + 2/98)365/70 – 1 = 11.1%
Question: 3
On 1st July 2012, the CFO of Decent Fabrics Ltd., wishes to know the working capital requirement
for the current year to arrange the short-term financing. The following information is available:
i. Issued and paid-up capital Rs. 4,000,000.
ii. 10% TFCs Rs. 1,000,000.
iii. Fixed assets valued at RS.2, 500,000 on 30th June 2012. The depreciation for the current
year is Rs. 250,000.
iv. Production during the previous year was 4,000 units. It is planned that this level of activity
should be increased by 50% during the current year.
v. The expected ratios of cost to selling price are - raw materials 60%, direct wages 10%, and
overheads 20%.
vi. Raw materials are expected to remain in stores for an average of two months before these
are issued for production.
vii. Each unit of production is expected to be in process for one month
viii. Finished goods will stay in warehouse for approximately three months
ix. The suppliers grant credit for two months from the date of delivery of raw materials
Required:
a. Calculate the working capital requirement for the current year.
b. Prepare the forecast income statement and balance sheet for 2012- 13.
Answer 3.(a):

Decent Fabrics Ltd.

Forecast Working Capital
Current Assets Rs. Rs.
Cash in hand 100,000
Raw Material 600,000
Work-in-progress 450,000
Finished Goods 1,350,000 Alternatively
Accounts receivable 1,350,000 1,500,000
3,850,000 4,000,000
Less: current Liabilities: Accounts Payable 600,000 600,000
Net Working Capital 3,250,000 3,400,000
Workings:
Rupees
Raw Materials:
2 Months consumption (3,600,000 x 2/12) 600,000
Work in Process (1 month’s production):
Raw Material (Rs. 3,600,000/12) 300,000
Direct Wages (600,000/12) 50,000
Overheads (1,200,000 /12) 100,000
450,000
Finished goods 5,400,000 x 3/12) 1,350,000
Alternatively
Accounts receivable (3 months cost of sale) 1,350,000 1,500,000
(5,400,000 x 3/12)
(6,000,000 x 3/12
Accounts payable (2 months consumptions of raw 600,000
material) (3,600,000 x 2/12)
Answer 3.(b) i:
Decent Fabrics Ltd.
Forecast Income Statement
For the year ended 30th June 2013
Sales 6,000 units @ Rs. 1,000 1,200,000
Less: Cost of Sales:
Raw Material (6,000 x 600) 3,600,000
Direct Wages (6,000 x 100) 600,000
Overheads (6,000 x 200) 1,200,000 5,400,000
Gross Profit 600,000
Selling and administrative expenses 300,000
EBIT 300,000
Less: Interest on TFCs 100,000
Net Profit 200,000
Answer 3 (b) ii:
Decent Fabrics Ltd.
Forecast Balance Sheet
As on 30th June , 2013
Liabilities and owners Equity Rs. Rs. Assets Rs. Rs.

Accounts payable 600,000 Current Assets

10% TFC 1,000,000 Cash in hand 100,000
Accounts 1,500,000
Owners equity
Receivable
Share Capital 4,000,000 Raw Material 600,000
Work-in-process 450,000
Retained earnings (Balance
450,000
figure)
Profit for the year 200,000 4,650,000 Finished goods 1,350,000
Fixed assets 2,500,000
Less: depreciation 250,000 2,225,000

Total 6,250,000 Total 6,250,000

Question: 4
A Ltd is a retailer of real wood flooring. It buys and sells 20,000 packs of flooring each year from its
supplier B Ltd.
The real wood flooring from Strong Ltd costs £35 per pack. There is an order processing charge of
£150 per order irrespective of the quantity of packs ordered, and B Ltd takes 10 days to deliver
the wood flooring. The average cost of holding one pack of real wood flooring for one year is
£9.
A new supplier of real wood flooring C Ltd, has offered A Ltd wood flooring on slightly different
term. C Ltd guarantees that its wood will never arrive damaged since it uses special packaging
designed for maximum protection. It charges £34.95 per pack for the flooring . There is an
order processing charge of £160 per order irrespective of the quantity of packs ordered, and
CLtd takes 7 days to deliver the goods. The average cot of holding one pack of C Ltd’s real
wood flooring for one year is £12. this is because the special packaging takes additional
storage space.
The economic order quantity, which will minimize costs, is:

Where Co = the cost of placing one order

D = the annual demand in unit
Ch = the cost of holding one unit per annum
Required:
(a) Calculate and conclude whether it is worth accepting the offer by ordering 2,000
packs at a time from Fake Ltd.
(b) Outline three non-financial factors that should be taken into account when deciding
whether to change suppliers from Strong Ltd to Fake Ltd.
Answer: 4
(a) Current supplier
EOQ

Where: Co = the cost of placing one order

D = the annual demand in unit
Ch = the cost of holding one unit per annum
 = 816
(i) Total cost:
Holding cost: average stock x unit holding cost
= (816 ÷ 2) x £9 = £3,672
Ordering cost = number of order x £150
Number of order = annual demand ÷ EOQ
= 20,000 ÷ 816
= 24.5
Therefore ordering cost = £3,675 per annum
Purchase cost = 20,000 x £35
= 700,000
Total cost for one year = £3,672 + £3,675 + £700,000
= £707,347
b. New supplier
i. EOQ

= 730
ii. Total cost
Holding cost: average stock x unit holding cost
= (730 ÷ 2) x £12 = £4,380
Ordering cost = number of orders x £160
Number of orders = annual demand ÷ EOQ
= 20,000 ÷ 730
= 27.4
Therefore ordering cost = £ 4,384 per annum
Purchase cost = 20,000 x £34.95 = £699,000
Total cost for one year = £4,380 + £4,384 + £699,000
= £707,764
(c) Discount
Holding cost = (2,000 ÷ 2) x £12 = £12,000
Ordering cost = (2,000 ÷ 2,000) x £160
= £1,600
Purchase cost = £699,000 x 99%
= £692,010
Total cost for one year = £12,000 + £1,6000 + £692,010
= £705,610
The discount means that it is worth changing suppliers.
(d) Non-financial factors
 Quality of C Ltd’s wood. This may not be as good as B Ltd’s wood, although it should be as
there is very difference in price. The new wood should be closely inspected to ensure that
it is of the same thickness as the current wood.
 Reliability of C Ltd. appears to have a shorter lead time for orders (seven days instead of
10 days) both they are not able to send stock consistently on time, A Ltd may end up
running out of stock. This could mean customers go elsewhere, leading to lost revenue for
the company.
 Packaging of C Ltd’s wood. C Ltd’s packaging needs to look attractive; otherwise
customers will not buy if the addition, it needs to protect the wood well, as the guarantee
claims.
 Range. There are many different types of wood, e.g. beech, maple and oak. A Ltd needs
to ensure that all currently stocked types of wood are on offer from the new supplier.
 Returns policy. C Ltd appears to offer a guarantee that the wood will arrive undamaged
but A Ltd may still need make returns. C Ltd’s policy would need to be understood and the
extent to which they are contactable to deal problems would be relevant.
Question: 5
Tostao plc is a manufacturer and distributor of a popular child’s toy, the Rivelino.
It sells 66,000 Rivelinos per year but demand is very seasonal with 50% of annual sales occurring
in December and the remainder being spread evenly over the rest of the year. At present Tostao
plc manufactures a constant 5,500 toys per month and builds up stocks of finished goods which
are used to meet the high demand in December. By the end of December finished goods stocks
are zero.
The major raw material for the Rivelino is plastic which Tostao plc buys from a local supplier. Each
Rivelino uses 1 kilogram of plastic costing £2 per kilogram. A material order is placed once a year
for delivery of 66,000 kilograms of plastic at the beginning of January.
There is a delivery charge of £2,000 per order and Tostao plc estimates that it costs £0.50 to store
a kilogram of plastic for a year.
Tostao plc is currently looking for ways to reduce its overdraft and the bank manager has
suggested that it reviews its stock management policies.
Required:
(a) Calculate the total annual holding, ordering and purchase cost for plastic under Tostao
plc’s current raw material stock policy.
(b) Calculate the economic order quantity for plastic assuming Tostao plc continues to
manufacture 5,500 Rivelinos per month.
The economic order quantity equation may be defined as:
EOQ =

Where Co = the cost of placing an order

D = annual demand
Ch = the cost of holding one unit for one year
(c) The supplier of plastic finds it very convenient to deliver once per year and has indicated that
it would be prepared to offer Tostao plc a bulk order discount if it continued to buy in lots of
66,000 kilograms.
Calculate the minimum discount (to the nearest percentage point) required to persuade Tostao
plc to continue to order once per year.
(d) Explain the just-in-time approach to stock control and discuss the advantages and
disadvantages to Tostao plc of adopting a just-in-time approach to its production of Rivelinos
and raw material purchasing.
 Answer:5
£
Current annual costs
Ordering cost
Number of order x cost per order 2,000
1 x £2,000
Holding cost
Average stock x holding cost per annum 16,500
66,000 kg/2 x £0.50
Purchase cost
Kg purchased x price per kg 132,000
66,000 kg x £2 per kg £150,00

(b) Economic order quantity

Co = £2,000
Ch = £0.50
D = 66,000 kg

(c) £
Minimum discount
Revised annual costs
Ordering cost
Number of order x cost per order 5,745
66,000/22,978 x £2,000
Holding cost
Average stock x holding cost per annum
22,978 kg/2 x £0.50 5,745
Purchase cost
Kg purchased x price per kg 132,000
143,490
Current annual cost {from (a)} 150,500
Saving from new policy £7,010
Using EOQ would generate saving of £7,010 per annum. To persuade Tostao plc to remain with
its existing policy the supplier would need to offer a discount of £7,010/£132,000 = 5.0%
(d) Just – in - (JIT) approach to stock to control
JIT approach to control involves manufacturing the finished product at the last possible moment
before it is required by customers and arranging delivery of raw materials at the possible moment
when they are required to the production line.
Advantages or disadvantages of adopting (JIT) approach
 (JIT) approach to the production Rivelinos would substantially reduce finished goods
stock holding costs. At present Tosta pick is stockpiling finished products from January
onwards. Under the (JIT) the toys required for December sales would be made in
December , substantially reducing holding costs.
 (JIT) would also lead to low raw material stocks, again giving substantial saving in holding
costs.
Disadvantages:
 Adaption
Of a (JIT) system would mean that production levels in December would need to be much
higher then other months. This would involved an increase in the work force and possibly
and extension to factory capacity for this one month. This may be not be possible or costs
affective.
 (JIT) would involve more frequent deliveries of raw material and a close working
relationship with suppliers. The supplier has already indicated reluctance to deliver more
frequently and raw material cost may rise.
 Quality of raw material and manufacturing becomes absolutely vital under a (JIT) system
as there are no safety-stock to fall back on. Any failures could lead to delayed delivery to
customer and the potential for lost business.
d. Many possibilities exist including
 Interest charges for late settlement
 Reminder letters
 Telephone calls
 Debt collection agencies
 Visits to the customer by credit control staff
 Legal action on overdue accounts
Question: 6
In your organization uses 1,000 packets of paper each year of 48 working weeks. The variable
costs of placing an order; progressing delivery and payment have been estimated at RS.12 per
order.
Storage and interest costs have been estimated at RS.O.50 per packet per annum based on the
average annual stock.
The price from the usual supplier is Rs. 7.50 per packet for any quantity
The usual supplier requires four weeks between order and delivery.
A potential supplier has offered the following schedule of prices and quantities:
Rs. 7.25 per packet for a minimum quantity of 500 at any one time.
Rs. 7.00 per packet for a minimum quantity of 750 at any one time.
Rs. 6.94 per packet for a minimum quantity of 1,000 at any one time.
If more than 450 packets are received at the same time an additional fixed storage cost of Rs. 250
will be payable for the use of additional space for the year. Assume certainty. of demand, lead
time and costs.
You are required to:
(a) Calculate and state the EQO from the existing supplier.
(b) Calculate and state the stock level at which the orders will be placed;
(c) Calculate and state the total minimum cost for the year from the existing supplier;
(d) Calculate and state the total minimum cost if you change to the new supplier.

Answer: 6

(a)

(b) Re-order level = Usage during lead time + Safety Stock

= Weekly usage x lead time in weeks + Safety Stock = 1000/48 x 4 + 0

Re-order level = 83 Packets.

Assuming certainty of delivery within four weeks i.e. Zero Safety Stock

(c) No. of orders = 1000/219 = 4.567 i.e. 5 orders

Purchase Price Rs. 1000 x Rs. 7.50 = 7,500

Carrying Cost = Average Inv. X per unit C.C. = 219/2 x 0.50 = Rs. 54.75
Ordering Cost = No. of order x per order cost = 4.56 x Rs. 12 = 54.80

Total Cost of existing supplier = Rs. 7,609.55

(d)
Option-I Purchase Price = Rs. 7.25 per packet
EOQ = 500 Packets
Cost of Packet (1000 x Rs. 7.25) = Rs. 7,250
Carrying Cost (500/2 x Rs. 0.50) = 375
Ordering Cost (1000/500 x Rs. 12) = 24
Total Cost = Rs. 7,649

Option-III Purchase Price = Rs. 6.94 per packet

EOQ = 1,000 Packets.

No. of Orders = 1000/1000 = 1 order.

Cost of Packet (1000 x Rs. 6.94) = Rs. 6,940

Carrying Cost (1,000/2 x 0.50) + Rs. 250 500
Ordering Cost (1000/1000 x Rs. 12) 12
Total Cost = Rs. 7,452

Thus, the minimum total annual cost is Rs. 7,452 with an order quantity of 1,000 Packet.
Question 7:
Waset Co is a waste management company, with one sole shareholder / director, Mr. Trusty. It
collects two types of waste from business – recyclable waste and confidential waste. Since
companies have increasingly become aware of both the need for recycling and the need to
protect confidential information, Waste co’s client base has expanded rapidly over the last two
years.

As the business has expanded Mr. Trusty has had less time available to focus on credit control.
This ahs resulted in a steady deterioration in accounts receivable collection and a rapid increase
in Mr. Trusty’s overdraft, despite high profits. Mr. Trusty’s bank has now refused to extend his
overdraft any further and has suggested that he either employ a credit controller or factor his
accounts receivable.

The following information is available:

1. Credit sales for the year ending 30 November 2007 were $ 2,550,000 and average
accounts receivable days were 60. Sales are expected to increase by 25% over the next
year.
2. If Mr. Trusty employs a good credit controller, the cost to the business will be $47,000. it is
anticipated that the accounts receivable days can then be reduced to 40 days.
3. A local factoring organization has offer a facto the company's accounts receivable on the
following terms.
i. An advance of 80% of the value sales invoices (which Mr. Trusty would fully
utilize.
ii. An estimated reduction in accounts receivable days to 35 days.
iii. An annual administration fee of 1.3% of turnover.
iv. Interest charge on advances of 12% per annum.
4. Current overdraft rates are 10% per annum.
5. Assume there are 365 days in a year.
Required:
a. Explain the meaning of ‘debt factoring’ (accounts receivable factoring) to Mr. Trusty,
distinguishing between ‘with recourse’ and ‘without recourse’ agreements.
b. Explain how debt factoring is different form ‘invoice discounting’.
c. Calculate whether it is financially beneficial for Waste Co to factor its accounts receivables
for the next year, as compared to employing a credit controller.
d. State four roles that a credit controller may plan.
Answer 7:
a. Debt factoring:
'Debt factoring' is a service provided by factors whereby the factor collects accounts receivable on
behalf of their client and
often invoices their client's customers as well. The factor also advances, to its client, a proportion
of the money it is due to
collect (typically about 80% is advanced.)
Mr. Trusty would find the service useful because he could both receive cash early and also
delegate the administration of his invoicing, accounting and accounts receivable collection work.
There are two types of factoring agreements: 'with recourse' and 'without recourse' agreements.
With the first of these agreements, although the factor advances monies, the risk of non-payment
of accounts receivable balances stays with the client. If a balance is not recovered, the factor has
'recourse' to their client for the money. If the agreement is 'without recourse' the factor bears the
risk of non-payment.
Debt factoring has to be paid for, usually as a percentage of the amounts advanced and as a
percentage of turnovers. Agreements without recourse to the client obviously cost more. Mr.
Trusty would have to compare the cost to those of employing an individual to do his invoicing
and obtaining insurance against unpaid accounts receivable balances. In addition, there may
be some stigma attached to debt factoring as clients sometimes assume that a business using
a factor must be in financial difficulty.
b. Difference from Invoice discounting
Invoice discounting is a service whereby a provider (often a factoring company) purchases
invoices from a client at a discount. In this case, they are merely advancing cash, rather than
providing an accounts receivable collection service. For this reason,
there is no administration fee payable (like there is for factoring), making invoice discounting a
cheaper option.
c. Whether to factor accounts receivables
Cost of factoring
New sales level = $2,550,000 x 125% $3,187,500
Accounts receivable reduced to 35 days:

$3,187,500 x 35/365 $305,651

$
80% advanced by factor at 12%:
$305,651 x 80% x 12% 29,342
$20% still financed by overdraft:
$305,651 x 20% x 10% 6,113
Admin fee: $ 3m187m500 x 1.3% 41,438
 76,893

Cost of not factoring but employing, staff accounts receivable

reduced to 40 days:

$3,187,500 x 40/365 $349,315

$
Overdraft cost
$349,315 x 10% 34,932
Credit controller costs 47,000
81,932
b. Roles of a credit controller
May include some/all of the following:
- Updating the sales ledger
- Dealing with customers’ queries
- Assessing creditworthiness of new customers
- Establishing / updating payment terms for customers
- Regular review of the sales ledger
- Pursuing overdue accounts receivable balances
- Providing references for customers
Question: 8
(a) XYZ Ltd. requires advice on its debt collection policy. Should the current policy be discarded in
favour of option 1 or option 2?
Current Policy Option 1
Option 2
Expenditure on debt collection per annum Rs. 240,000 Rs.300, 000 Rs.400, 000
Bad debts losses (% of sales) 3% 2% 1%
Average collection period 2 months 1 ½ months 1 month

Current sales are Rs. 4.8 million per annum and the variable cost of sales is 90% of sales value.
The company requires a 15% return on its investment.
(b) XYZ ltd. is considering a change of credit policy which will result in a slowing down in the
average collection period from one month to two months. The relaxation in credit standards is
expected to produce an increase in sales in each year amounting ton 25% of the current sales
volume.
• Sales price per unit Rs.10, variable cost per unit Rs.8.50, current sales per annum Rs.2.4
million. The required rate of return on investment is 20%.
• Assuming that the 25% increase in sales would result in additional stocks of Rs.100, 000 and
additional creditors of Rs.20, 000.
• Required: advise the company on whether or not to extend the credit period to customers if :
• All customers take the longer period 0f 2 months.
• Existing customers do not change their payment habits, only new customers take a full 2
months credit.
Answer: 8 (a)
Recommendation:
The company should discard the current policy in favour of option I

Current Policy Option I Option II

Rs.000 Rs.000 Rs.000
Current sales 4,800 4,800 4,800
Less variable cost of sales 90% 4,320 4,320 4,320
Contribution 480 480 480
Less:
Debt collection expenditure 240 300 400
Bad debts 3% 144
2% 96
1% 48
Carrying Costs
Rs. 4,800 x (2/12) x 0.15 120
Rs. 4,800 x (1.5/12) x 0.15 90
Rs. 4,800 x (1/12) x 0.15 60
504 486 508
Profit (loss) before taxes (24) (6) (28)

Answer: 8(b)
XYZ Ltd.
Current Rs.’000
Situation
Situation Situation
Rs. A Rs. B Rs.
Sales (Rs. 1.25 x 2400,000) 2,400 3,000 3,000
Less: Variable cost 85% 2,080 2,550 2,550
Contribution 360 450 450
Carrying costs 40 100 60
Cost of addition working capital
Rs. (80,000 x 20%) 16 16
Total Cost 40 116 76
Profit before taxes 320 334 374

Carrying Cost (i) Rs. 2400 x (1 /12) x 20% = 40

(ii) Rs. 3000 x (2/12) x 20% = 100
(iii) Rs. 2400 x (1 /12) x 20% = 40
 (3,000 - 2,400) = 600 x (2 / 12) x 20% = 20
60
Plan B has an advantage of Rs. 19,440 over plan A which is very nominal compared with period of
credit 45 days to 60 days. Before we decide to relax credit policy a detail study is required of all
other factors relevant to credit policy, reliability of estimates etc.
Note:
Credit cost can be calculated by using cost rather Sales.
Question: 9
ABC Company is attempting to evaluate whether it should ease collection efforts, the firm sells
72,000 units per year at an average price of Rs.32 each. Bad debt expenses are 1 percent of
sales and collection expenditures are Rs. 60,000. The average collection period is 40 days, and
the variable cost per unit is Rs. 28.
By easing the collection efforts, ABC Company expects to save Rs. 40,000 per year in collection
expenses. Bad debts will increase to 2% of sales, and the average collection period will increase
to 58 days. Sales will increase by 1000 units per year. If the firm has a required rate of return on
equal risk investments of 24 percent, what recommendation would you give the firm?
Use your analysis to justify you answer.
Answer: 9 Current Relax
Situation Policy
Rs. Rs. Rs. Rs.
Sales 32 32
Variable cost 28 28
Contribution (a) 4 4
Total contribution (a x sales) 288,00 292,000
Bad debts (W -1 ) 23,040 46,720
Collection charges 60,000 20,000
Credit cost:
72,000 x Rs. 32 = Rs. 2,304,000 x
40/360 x 24% 61,440 144,480
73,000 x Rs. 32 x 58/360 x 24% 90,325 157,045
Profit 143,520 134,955

'(W-1) Current situation - 72,000 x Rs. 32 = Rs. 2,304,000 x 1% = Rs. 23,040

Relax policy - 73,000 x Rs. 32 = Rs. 2,336,000 x 2% = Rs. 46,720
Recommendation:
The credit policy should not be relaxed as it increase the cost of Bad Debts as well as credit cost,
although there is saving of Rs. 40,000 in collection expenditure. an overall decrease of Rs. 8,565
in profit does not justify the relaxation in the credit policy.
Question: 10
Noor Ltd., is considering to raise working capital of Rs. 400,000 either by a commercial bank loan,
secured by accounts receivable, or factoring accounts receivable. Noor Ltd: s bank has agreed to
lend the firm 80% of its average monthly accounts receivable of RS.500,000 at an annual interest
rate of 12%. The bank loan is in the form of a series of 30-day loans. The loan would be
discounted, and a 15% compensating balance would also be required. Noor Ltd., can arrange
from another commercial bank any shortfall in working capital up to RS.75,000 @ 15% annual
interest payable in arrear.
A factor has agreed to purchase Noor Ltd.s 84% accounts receivable. The 16% of receivables
would be held in a reserve account. The factor would charge Rs. 1,500 processing fee and 3%
factoring commission on the invoice amount each month. The factor would also charge interest @
10% on accounts receivable purchased. The factoring commission, processing fee and monthly
interest payment would be deducted from the accounts receivable purchased on monthly basis. If
Noor Ltd., chooses the factoring arrangement, it can eliminate its credit department and reduce
operating expenses by Rs. 8,000 per month. In addition, bad debt losses of 2% of the monthly
receivables will also be avoided.
Required:
i. Compute the annual cost associated with each financing arrangement.
ii. Discuss some considerations other than cost that may influence management’s decision
between factoring and bank loan.
Answer: 10
Annual Cost of financing:
Shortfall of working capital in case of commercial bank loan:
Rupees
Amount of loan (0.80) (500,000) 400,000
Interest (0.12/12)(400,000) (4,000)
Compensating balance (0.15) (400,000) (60,000)
Amount received 336,000
Working capital required 400,000
Shortfall in working capital 64,000
Annual cost of commercial bank loan:
Rupees
Interest expense (0.12)(400,000) 48,000
Credit department (8,000)(12) 96,000
Bad debts (0.02)(500,000)(12) 120,000
Interest on short fall in working capital Rs. 64,000 x 0.15 9,600
Total annuals costs 273,600
The cost of the credit department and bad debts expenses will be incurred if a bank loan is used,
but these costs will be avoided if the company accepts the factoring arrangement.
 Amount received form factor:
Rupees
Amount loaned (0.84) (500,000) 420,000
Commission (0.03)(500,000) (15,000)
Prepaid interest (0.10/12) (420,000) (3,500)
Process fee (1,500)
Amount received 400,000
Annual cost of factoring:
Rupees
Annual commission (15,000)(12) 180,000
Annual interest (0.10)(420,000) 42,000
Processing fee (1,500)(12) 18,000
Total annual costs 240,000

The factoring costs are slightly lower by Rs. 33,600 (Rs. 273,600 – Rs. 240,000) than the cost of
the bank loan, and the factor is willing to advance a significantly greater amount. On the other
hand, the elimination of the credit department could reduce the firm’s options in the future.
Question: 11
Special Gift Supplies pIc is a wholesale distributor of a variety of imported goods to a range of
retail outlets. The company specializes in supplying ornaments, small works of art, high value
furnishings (rugs. etc.) and other items that the chief buyer for the 'company feels would have a
market in the UK. In seeking to improve working capital management, the financial controller has
gathered the following information:

Months
Average period for which items held stock 3.5
Average debtors’ collection period 2.5
Average creditors payment period 2.0

Required:
(a) Calculate Special Gift Supplies’ funding requirement for working capital measured in
terms of months.
(b) In looking to reduce the working capital funding;
(c) Requirement, the financial controller of special Gift Supplies is considering factoring credit
sales. The company's annual turnover is £2·5m of which 90% are credit sales. Bad debts
are typically 3% of credit sales. The offer from the factor is conditional on the following:
1. The factor will take over the sales ledger of Special Gift Supplies completely.
2. 80% of the value of credit sales will be advanced immediately (as soon as sales are made
to the customer) to Special Gift Supplies, the remaining 20% will be paid to the company
one month later. The factor charges 15% per annum on credit sales for advancing funds in
the manner suggested. The factor is normally able to reduce the debtor's collection period
to one month.
3. The factor offers a 'no recourse’ facility whereby they take on the responsibility for dealing
with bad debts. The factor is normally able to reduce bad debts to 2% of credit sales.
4. A charge for factoring services of 4% of credit sales will be made.
5. A one-off payment of £25,000 is payable to the factor.
The salary of the Sales Ledger Administrator (£12,500) would be saved under the proposals and
overhead costs of the credit control department, amounting to £2,000 per annum, would have to
be reallocated. Special Gift Supplies' cost of overdraft finance is 12% per annum. Special Gift
Supplies pays its sales force on a commission only basis. The cost of this is 5% of credit sales and
is payable immediately the sales are made. There is no intention to alter this arrangement under
the factoring proposals.
Required:
Evaluate tile proposal to factor the sales ledger by comparing Special Gift Supplies’ existing
debtor collection cost with those that would result from using the factor (assuming that the factor
can reduce the debtor's collection period to one month).
Answer: 11
(a) The funding requirement for working capital is the sum of:

Months
Stock holding period 3.5
Debtors collection period 2.5
Creditors payment period (2.0)
Working capital funding period 4.0

Diagrammatically, the funding requirement may be represented as:

(b) Annual sales £2.5m

Credit sales: £2.5m x 90% = £2.25m
Factor will advance 80% of £2.25m = £1·80. This is not adjusted for bad debts since the
agreement is without recourse.
Assuming sale are evenly spread, the factor will pay (2.25 - 1.8)/12 = £37,500 each month, in
arrears by one month.
Factor service charge is 4% x £2.25m = £90,000
Commission charges payable to the sale force are ignored in the following calculations since they
are common to both. The allocated overheads are also irrelevant for the evaluation. The factor’s
better record with bad debts is not part of the evaluation of the proposal in terms of the benefits to
Special Gift Supplies.
 PAYABLE MANAGEMENT
Question 1:
ABC limited meets its Short-term fund requirements by stretching its account payable and
borrowing from a finance company. at the close of June 30, 2006, the requirements of fund
included maximum Rs. 40,000 fro finance company, attracting markup @ 24% per annum. The
remaining fund requirement was met through accounts payable stretching. It has remained a
matter of practice that 30%of funds requirement in accounts payable are normal payables and do
not attract any charges, however, balance stretched payables are charged @ 30% per annum.
One of the leading insurance company has offered financing of Rs. 80,000 @ 18% per annum per
for 5 years term. ABC Limited, in order to determine its advantages and to avoid expansive
accounts payable stretching cost wanted to evaluate the proposal based on its requirements of
funds under following conditions:
Existing position: £
Credit control salary 12,500
Bad debts 3% x £2.25m = 67,500
Annual funding costs for debtors:(2.5/12) x 12% x £2.25m = 66,250
136,250

£
Factor’s offer:
Factor finance charge: £2.25m x 80% x 15% x (1/12) = 22,500
Unfactored funding costs at Special Gift Supplies cost of capital:
£2.25m x 20% x 12% x (1/12) = 4,500
Factor service charge: 4% x £2.25m 90,000
One off payment funding costs at Special Gift Supplies cost of
capital:
£25,000 x 12% 3,000
Hence it is worthwhile to factor the debt 120,000

Rupees
Boom period Funds’ requirement 160,000
Normal Period Funds’ requirement 120,000
Recession period Funds’ requirement 90,000

Required:
Prepare a comparative evaluation sheet for above proposals and give your recommendations.
(Prepare and present all necessary workings).
Answer 1:
Cost of funds under current conditions
(Rupees)
Boom Normal Recession
Funds requirements 160,000 120,000 90,000
Normal payable with no charge 48,000 36,000 27,000
Finance Co loan 40,000 40,000 40,000
Total 88,000 76,000 67,000
Stretches payable 72,000 44,000 23,000
Cost of Funds P.A
Finance Co @ 24% 9,600 9,600 9,600
Stretched payable @ 30% (a) 21,600 13,200 6,900
Total Cost 31,200 22,800 16,500
Cost of Funds under Insurance co. Finance
Funds requirement 160,000 120,000 90,000
Term loan insurance co. 80,000 80,000 80,000
Normal payable 48,000 36,000 10,000
128,000 116,000 90,000
Borrowing from Finance Co @ 24% 32,000 4,000 Nil
There is no need of stretching A/P

Cost of Funds P.A

Cost of Funds P.A
Cost of term loan @ 18% x 80,000 14,400 14,400 14,400
Cost of Finance Co @24% x 32,000 7,680 960 --
Total Cost (b) 22,080 15,360 14,400
Savings under Ins. Finance (a-b) 9,120 7,440 2,100
Financing from Insurance Co. would he advantageous
 CASH MANAGEMENT
Question: 1
The following information has been extracted from the books of XYZ Limited: Annual interest rate
12% Fixed cost per transaction Rs. 500 Total cash required Rs. 1,200,000
Required:
(i) Calculate the target (optimum) cash balance using the Baumol model
(ii) What are the opportunity costs of holding cash, the trading cost (transaction cost) and the
total cost?
(iii) What would be the total annual cash requirement if the target cash balance is Rs.75,000?
Answer:1
Ecq=√2*conversion cost*demand for cash/opportunity cost(in decimal form)
√2x500x1,200,000/.12 = Rs. 100,000
The average cash balance will be Rs. 100,000/2=Rs. 50,000 no of transaction will be 12
Transaction cost 12x500=Rs. 6000 and opportunity cost t Rs. 50,000X.12%=Rs.6000
Average cash balance Rs. 75,000/2=Rs. 37500 the opportunity cost=Rs.37, 500X.12%=Rs. 4,500
No transactions will be 4500/500=9
The annual requirement Rs. 75,000x9=675,000
Baumol model
ECQ=√ 2 X 30 X Rs. 1,500,000 /.08
=Rs. 33541 received each time the cash is replenished
There will 45 conversions during the year
Average cash balance will be Rs. 33,541/2=Rs.16, 770
Cost of conversion =45x30=Rs.1, 350
Opportunity cost=Rs.16, 770x.08=Rs.1, 342
Total cost=Rs.2, 692
Question: 2
Danial Shaikh recently leased space in a shopping mall and opened a new business, Danial Toys
Shop. Business has been good, but Danial has frequently run out of cash. This has necessitated
late payment on certain orders, which, in turn, is beginning to cause a problem with suppliers.
Danial plans to borrow from the bank to have cash ready as needed, but first he needs a forecast
of just how much he must borrow. Accordingly, he asked you to prepare a cash budget for the
critical period around Eid-ul-fiter, when needs will be especially high.
Sales are made on a cash basis only. Danial's purchases must be paid for during the following
month. Danial pays himself a salary of Rs. 9,600 per month, and the rent is RS.4,000 per month.
In addition, he must make a tax payment of Rs.24,000 in October. The current cash on hand (on
October 1) is RS.800 (DaniaI does not want to keep more cash in hand to avoid the chances of
robbery), but Danial has agreed to maintain an average bank balance of Rs. 12,000 - this is his
target cash balance including cash in hand.
The estimated sales and purchases for October, November and December are shown below.
Purchases during September amounted to Rs. 280,000.
Rupees
Sales Purchases
October 320,000 80,000
November 80,000 80,000
December 120,000 80,000
Required:
i. Prepare a cash budget for the months of October, November and December.
ii. Now, suppose Danial were to start selling on credit from October 1, giving customers 30
days to pay. All customers accept these terms. All other facts in the scenario are
unchanged. What would the Danial's loan requirements be at the end of October in this
case?
Answer: 2
(i) Cash budget for October, November and December:

Rs.
October November December
Collection and Purchases:
Sales 320,000 80,000 120,000
Purchases 80,000 80,000 80,000
Payment *280,000 80,000 80,000
*September purchases = 280,000
Receipt from sales 320,000 80,000 120,000
Payments for:
Purchases 280,000 80,000 80,000
Salaries 9,600 9,600 9,600
Rent 4,000 4,000 4,000
Taxes 24,000 - -
Total Payments 317,600 93,600 93,600
Cash surplus / (deficit) 2,400 (13,600) 26,400

Rs.
Cash Surplus or Loan Requirements:
Cash at start of month 800 3,200 (10,400)
Cumulative cash 3,200 (10,400) 16,000
Target cash balance 12,000 12,000 12,000
Cumulative surplus cash or total loans to maintain (8,800) (22,400) 4,000
Rs. 12,000 target cash balance
ii.

If Danial began selling on credit on October 1, then it would have zero receipts during October,
down from Rs. 320,000
Thus, it would have to borrow an additional Rs. 320,000, so its loans outstanding by October 31
would be Rs. 328,800
The loan requirement would build gradually during the month. We could trace the effects of the
changed credit policy on out into November and December, but here it would probably be best to
simply construct a new cash budget.
Fraud – a deliberate misrepresentation of facts with intent of deceiving someone.
Employee fraud:
Dishonest acts performed against the company by its employees.
Theft of assets, charging lower sale price to favored customers, receiving “kickbacks” from
suppliers, overstating hours worked, padding expense amounts and embezzlement.
Embezzlement is a theft of assets which is concealed by falsification of the accounting records.
Management Fraud:
Refers to deliberate misrepresentation made by top management of a business to persons
outside of the Business organization.
The issuance of Fraudulent Financial Statements intended to mislead investors and creditors.
It is impossible to eradicate the threat of fraud, but there are several steps that employers can
take to minimize this very real risk.
Fraud has rarely been out of the headlines this year, as millions have been lost as a result of the
activities of a small criminal element. It’s tempting to think that it’ll always happen to someone
else, but fraud can strike anywhere and at any time. According to recent surveys by PwC and
Ernst & young on fraud affecting major companies.
Eighty-two per cent of the worst frauds were committed by employees, almost one-third of whom
were in management posts.
There are huge difficulties in measuring fraud. It is difficult to identify, it’s often hard to distinguish
from simple poor record-keeping and it regularly goes unreported.
Any fraud prevention and control model should achieve the following main objectives:
• deterrence;
• prevention
• disruption
• Facilitation of civil or criminal proceedings.
No system is completely watertight, but the losses can be minimized if a problem is detected at a
sufficiently early stage.
Creating the right environment is the key to success. You organization’s stance on ethical issues
will underpin its approach to fraud and should be made clear in a code of business conduct
emphasizing the norms and values expected in daily activity.
The threat of fraud will always exist. It will never be possible to eliminate the danger since many
fraudsters are sufficiently determined to beat the systems put in place to stop them. Every
organization will fall victims to fraud at some time or other, but those with and effective strategy
are much less likely to suffer significant losses as a result that those without one. It has been said
that there are three criteria that need to be met to reduce the risk of fraud: good ethics; good
people and good systems.
Internal control
• The environment in which companies conduct their business continues to change
dramatically. Economic factors, advances in technology, and increasing global
competition are just a few examples of these changes. With each new development,
management is faced with greater challenges to control costs, manage liquidity, and
achieve a competitive advantage.
• Internal Control is a process effected by an entity’s board of directors, management, and
other personnel- designed to provide reasonable assurance regarding the achievement of
objectives in the following three categories: effectiveness and efficiency of operations,
reliability of financial reporting, and compliance with laws and regulations
• Five interrelated components of an effective internal control:
• Control environment sets the tone of an organization, influencing the control
consciousness of its people. It is the foundation for all other components of internal control
providing discipline and structures.
• Risk assessment is the entities identification and analysis of relevant risk to the
achievement of its objectives, forming a basis for determining how the risk should be
managed.
• Control activities are the policies and procedures that help ensure that management
directives are carried out.
• Information and communications systems support the identification, culture, and
exchange of information in a form and time frame that enable people to carry out their
responsibilities.
• Monitoring is a process that assesses the quality of internal control performance over
time.
Internal control
Internal Control consists of the plan of organization and all related methods and measures
adopted within a business to:
1. Safe guard its assets from employee theft, robbery and unauthorized use.
 2. Enhance the accuracy and reliability of its accounting records by reducing the risk of
errors (unintentional mistakes) and irregularities (International mistakes and
misrepresentations in the accounting process.
Internal Control over Cash Receipts.
Cash receipts may result from a variety of sources: cash sales; collections on account from
customers: the receipt of interest, rents and dividends:
Investments by owners bank loans: and proceeds from the sale of noncurrent assets. Internal
control principles apply to cash receipts transactions as follows:
Principle Application to Cash Receipts

Establishment of responsibility Only designated personnel such as cashier and

each cashier department personnel should be
authorized to handle or have access to cash
receipts.
Segregation of duties Different individuals should be assigned the
duties of receiving cash, recording cash receipts
transaction, and having custody of cash.
Documentation procedures Documents should include remittance advices
for mail receipts, cash register tapes for over-the
counter receipts, and deposit slip/s fro bank
deposits
Physical, mechanical, and electronic controls Cash should be stored in company safes and
ban vaults, and access to storage areas should
be limited to authorized personnel; cash
registers should be used in executing
over-the-counter receipts.
Principle Application to Cash Receipts

Independent internal verification Daily cash counts of register receipt and receipts deposited
in the bank should be made by the treasurer’s office.
Other controls All personnel who handle cash receipts should be bonded
and required to take vacations; cash should be deposited in
the bank in total daily.
1. Control is most effective when only one person is responsible for a given task.
2. When one individual is responsible for all the related activities the potential for errors and
fraud is increased.
3. When on employee maintains the record of the asset that should be on hand and a different
employee has physical custody of the assets, the custodian of the asset in not likely to convert
the asset to personal use.
4. Documents should be pre-numbered and all documents should be accounted for.
5. Source documents for accounting entries should be promptly forwarded to accounting to help
ensure timely recording of the transaction and event.
Other Control:
1. Bonding of employees who handle cash
2. Rotating employee’s duties and requiring employees to take vocations.
Cash is the one asset that is readily convertible into any other type of assets; it is easily concealed
& transferred and it is highly desired.
Cash consists of Coins, Currency notes, Cheques, money orders and Money in hand or on
deposits. Postage Stamps (Prepaid Expense) & Post dated cheques (Receivables are not cash
16 STEPS FRAUD PREVENTION PLAN
1. Consider fraud risk as an integral part of your overall corporate risk management strategy.
2. Develop an integrated strategy for both fraud prevention and control.
3. Develop and “ownership structure” form the top to the bottom of the organization.
4. Introduce a fraud policy statement.
5. Introduce an ethics policy statement.
6. Activity promote these policies through the organization.
7. Establish a control environment.
8. Establish sound operational control procedures.
9. Introduce a fraud education, training and awareness program
10. Introduce a fraud response plan as integral part of the organization’s contingency plans.
11. Introduce a Whistle-blowing policy.
12. Introduce a “reporting hotline”
13. Constantly review all anti-fraud policies and procedures.
14. Constantly monitor adherence to controls and procedures.
15. Establish a “learn from experience” group.
16. Develop appropriate information and communication systems.
 THE CASH FLOW STATEMENT
Question: 1 –
The summarized balance sheets of Allied Limited as at December 2012 and 20013 are as follows:

2012 2013

Rs.'000'

Paid up share capital 150,000 100,000

Share premium 35,000 15,000
Profit and Loss Account 36,000 11,500
Debentures 30,000 70,000
Deferred Taxation 18,000 11,000
Creditors 48,000 34,000
Bank Overdraft - 14,000
Corporation tax payable 15,000 10,500
Proposed Dividends 20,000 10,000
Depreciation on plant and machinery 54,000 45,000
Depreciation on fixtures and fittings 15,000 13,000
421,000 334,000

Free hold property at cost 130,000 110,000

Plant and machinery at cost 151,000 120,000
Fixtures and fittings at cost 29,000 24,000
Stock 51,000 37,000
Debtors 44,000 42,800
Government stock 4,600 -
Cash at Bank 11,400 200
421,000 334,000

Additional Information:
1. There has been no disposal of freehold property in the year
2. The machine tool which had cost of Rs.8 million (in respect of which Rs.6m depreciation had
been provided) was sold for Rs.3m, and fixtures which had a cost of Rs.5m (in respect of
which Rs.2m depreciation had been provided) was sold for Rs.1m. Profits and losses on
those transactions had been dealt through the profit and loss account.
3. The corporation tax liability in respect of the year ended 31 December 2013, amounting to
Rs.8m, had been paid during the year.
 The profit and loss account charges in respect of tax were: corporation tax Rs.12.5m; deferred
tax Rs.9.5m.

4. The premium paid on redemption of debentures was Rs.2m, which has been written off to
the profit and loss account.
5. The proposed dividend for 2012 had been paid during the year.
6. Interest received during the year was Rs.450,000. Interest expense for the year charged in
profit and loss account was Rs.6.4m. Accrued interest of Rs.440,000 is included in creditors
at December 31, 2012 (nil at December 31, 2013).

Required:
Prepare a cash flow statement for the year ended 31 December 2013 as per IAS-7
Solution :1
Cash Flow Statement
Allied Limited
For the year ended December 31,2013

Rs.

Cash flow from Operating Activities

EBIT 72,950
Depreciation on machinery 15,000
Depreciation on fixture 4,000

Interest received 450

Interest paid (5,960)
Tax paid (8,000)

Working capital changes:

Increase in A/R (1,200)
Increase in inventory (14,000)
Increase in A/P 13,560
Cash inflow from Operating Activities 76,800

Cash flow from Investing Activities

Purchase of property (20,000)
Sale of machinery 3,000
Sale of fixture 1,000
Purchase of fixture (10,000)
Gov. stock purchase (4,600)
Purchase of machinery (39,000)
Cash outflow from Investing Activities (69,600)
Cash flow from Financing Activities
Redemption of debentures (42,000)
Dividend paid (10,000)
Bank OD (14,000)
Share issue at premium 70,000
Cash inflow from Financing Activities 4,000
Net increase in cash and cash equivalents 11,200
Cash and cash equivalent at beginning 200
Cash and cash equivalent at ending 11,400
Working:

Profit& Loss Account

Deferred tax 9,500 Opening bal. 11,500
Corporation tax 12,500 Interest received 450
Premium on debt 2,000 Gain on sale of machine 1,000
Dividend 20,000 Deferred tax 2,500
Interest 6,400 EBIT 72,950
Loss on sale of fixtures 2,000
Closing bal. 36,000
88,400 88,400

Dividend
Dividend paid 10,000 Opening bal. 10,000
Closing bal. 20,000 Profit& loss A/C 20,000
30,000 30,000

Creditors
Closing bal. 47,560 Opening bal. 34,000
Bal. 13,560
47,560 47,560

Dep. Plant& Machinery

Disposal 6,000 Opening bal. 45,000
Closing bal. 54,000 Profit& loss A/C 15,000
60,000 60,000

Fixture
Opening bal. 24,000 Disposal 5,000
Purchases 10,000 Closing bal. 29,000
34,000 34,000
 Disposal of Fixtures
Cost 5,000 Depreciation 2,000
Cash 1,000
Loss 2,000
5,000 5,000

Tax
Tax paid 8,000 Opening deferred tax 11,000
2,500 Opening corporation tax 10,500
Closing deferred tax 15,000 P&L deferred tax 9,500
Closing corporation tax 18,000 P&L corporation tax 12,500
43,500 43,500

Interest
Interest paid 5,960 Profit& Loss A/C 6,400
Bal. 440
6,400 6,400

Plant& Machinery
Opening bal. 120,000 Disposal 8,000
Purchases 39,000 Closing bal. 151,000
159,000 159,000

Disposal of Plant& Machinery

Cost 8,000 Depreciation 6,000
Gain 1,000 Cash 3,000
9,000 9,000

Dep. Fixture
Disposal 2,000 Opening bal. 13,000
Closing bal. 15,000 Profit& Loss A/C 4,000
17,000 17,000
A CASE STUDY
INTEGRATED FINANCIAL AND MANAGERIAL ACCOUNTING
Raziuddin has recently returned home after spending some time overseas working for a
multinational company. Whilst abroad he made regular remittances to his bank. The balance on
his account stands at Rs.2,000,000 and he intends to use this sum to start a business. In the
course of his travels he was very impressed by the quality and price of bamboo furniture
obtainable in the Far East, and he reached the conclusion that these items would find a ready
market in Pakistan. He has found a reliable supplier and plans to start trading on 1st July 2013.
Raziuddin provides you with the following information:
1. He has made arrangements to lease the premises where the furniture will be deposited until it
is sold. The ten year lease involves a total outlay of Rs. 1500,000 which he will pay full at the
end of June 2013. In the same month Raziuddin expect to acquire a van costing Rs.300,000 in
which to transport the furniture. The van will last four years and then be valueless.
2. He will take delivery of his first consignment of stock on 1st July 2013 at a cost of Rs.600,000.
further consignments of furniture, costing Rs.450,000 each, will be received at two
monthly intervals commencing August 2013 payment for purchases of stock will be made in
the month following delivery.
3. Raziuddin will advertise his furniture in trade catalogues and this will cost him Rs.15, 000 per
month commencing July 2013.
4. Sales will be made at cost plus a markup of 100%. He estimates that sales will take place
as follows:
July 2013 Zero
August- September 2013 Rs.200, 000 per month
October 2013 onward: Rs.500, 000 per month
Payment will be received in the month following sale.
5. Rates will amount to Rs.60, 000 per year, payable in half yearly installments on 1st April and
1st October. However, an initial payment of Rs.15,000 will be made on 1st July for the three
months July- September 2013.Other operating expenses of Rs.20,000 will be paid each
month; commencing July Raziuddin will make monthly drawings of Rs.70,000 also
commencing July.

Required:
1. A cash budget for the twelve month to 30 June 2014 showing the cash surplus or deficit at
the end of each month.
2. Cash account, sales account, purchase account, accounts payable and accounts
receivable account, closing stock account, prepaid Rents, operating Expense account,
depreciation expense, amortization expense, drawings accounts, capital accounts.
3. An estimated Profit and Loss for the year ended 30th June 2014.
4. A projected balance sheet as at 30 June 2014.
5. A cash flow statement for the year 30th June 2014
6. An assessment of Raziuddin proposal.
Solution: Req. 1

RAZIUDDIN
ESTIMATED STATEMENT OF CASH RECEIPTS AND DISBURSEMENTS
FOR THE YEAR ENDED
ITEM JULY AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
Cash Balance-- (625,000 (530,000 (915,000 (520,000 (575,000 (180,000 (235,000
Beginning 2,000,000 80,000 ) ) ) ) ) ) ) 160,000 75,000 470,000
Add: Cash
Receipts 200,000 200,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000
Total Cash (425,000 (330,000 (415,000
Available 2,000,000 80,000 ) ) ) (20,000) (75,000) 320,000 265,000 660,000 575,000 970,000
Less: Cash
Disbursements
Lease
Premises 1,500,000
Van 300,000

Stock 600,000 450,000 450,000 450,000 450,000 450,000

Advertisement 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000
Rates 15,000 30,000 30,000
Expenses 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Drawings 70,000 70,000 70,000 70,000 70,000 70,000 70,000 70,000 70,000 70,000 70,000 70,000
Total
Disbursement
s 1,920,000 705,000 105,000 585,000 105,000 555,000 105,000 555,000 105,000 585,000 105,000 555,000

Cash
Surplus/(Deficit (625,000 (530,000 (915,000 (520,000 (575,000 (180,000 (235,000
) 80,000 ) ) ) ) ) ) ) 160,000 75,000 470,000 415,000

Req. 2 :
SALES ACCOUNT
AUG 200,000
SEP 200,000
4,900,000 OCT-JUNE(500000*9) 4,500,000
4,900,000 4,900,000
BAL B/d 4,900,000

PURCHASE ACCOUNT
600,000
450,000
450,000
450,000
450,000
450,000
450,000 BAL c/d 3,300,000
3,300,000 3,300,000
3,300,000
 SALES ACCOUNT
AUG 200,000
SEP 200,000
4,900,000 OCT-JUNE(500000*9) 4,500,000
4,900,000 4,900,000
BAL B/d 4,900,000

PURCHASE ACCOUNT
600,000
450,000
450,000
450,000
450,000
450,000
450,000 BAL c/d 3,300,000
3,300,000 3,300,000
3,300,000

CAPITAL ACCOUNT
DRAWINGS 840,000 OPENING BAL 2,000,000
PROFIT 1,070,000
BAL C/d 2,230,000
3,070,000 3,070,000
BAL B/d 2,230,000

STOCK ACCOUNT
PURCHASE 3,300,000 SALES 2,450,000
BAL c/d 850,000
3,300,000 3,300,000
850,000

PREPAID RATES ACCOUNT

RENT 15,000
BAL c/d 15,000
15,000 15,000
15,000
 DRAWINGS ACCOUNT
CASH(7000 *12) 840,000
BAL c/d 840,000
840,000 840,000
840,000

LEASE PREMISES ACCOUNT

CASH 1,500,000 AMORTIZATION 150,000
BAL c/d 1,350,000
1,500,000 1,500,000
1,350,000

RATES ACCOUNT
CASH 15,000 PROFIT & LOSS A/C 60,000
CASH 30,000 PREPAID EXPENCE 15,000
CASH 30,000
75,000 75,000

OPERATING EXPENSE ACCOUNT

CASH 240,000 PROFIT & LOSS A/C 240,000
240,000 240,000

Req. 3
RAZIUDDIN
ESTIMATED PROFIT AND LOSS STATEMENT
FOR THE YEAR ENDED 30th June 1914
Rs. Rs.
Sales 4,900,000
Less: Cost of Goods sold
Purchases 3,300,000
Closing stock (850,000) (2,450,000)
Gross Profit 2,450,000

Less: Operating Expenses

Lease Amortization 150,000
Depreciation Expense-- Van 75,000
Advertising Expense 180,000
Rates 60,000
Total operating expenses 240,000 (705,000)

Net Profit 1,745,000

Req. 4
RAZIUDDIN
ESTIMATED BALANCE SHEET AS ON 3oth June 2014
ASSETS LIABILITIES AND CAPITAL
CURRENT ASSETS Rs. Rs. CURRENT LIABILITIES Rs.
Accounts
Inventories 850,000 payable 450,000
Accounts Receivables 500,000 OWNER'S EQUITY
Cash at bank 415,000 Capital 2,000,000
Prepaid rates 15,000 1,780,000 Add: Profit 1,745,000
FIXED ASSETS 3,745,000
Van 300,000 Less: Drawings (840,000) 2,905,000
Less:
Accumulated

Depreciation (75,000) 225,000

1,500,00
Lease Property 0
Less: (150,000
Amortization ) 1,350,000 1,575,000
Total liabilities and owner's
Total Assets 3,355,000 equity 3,355,000
Req. 5
RAZIUDDIN
CASH FLOW STATEMENT
FOR THE YEAR ENDED
Rs. Rs.
CASH FLOWS FROM OPERATING ACTIVITIES

Net Profit 1,745,000

Depreciation 75,000

Amortization 150,000

Prepayments (15,000)

Increase in Accounts receivables (500,000)

Increase in inventories (850,000)

increase in accounts payables 450,000

CASH INFLOWS FROM OPERATING ACTIVITIES 1,055,000

CASH FLOWS FROM INVESTING ACTIVITIES

Purchase of Van 300,000

Purchase of premises 1,500,000

CASH OUTFLOWS FROM INVESTING ACTIVITIES (1,800,000)

CASH FLOWS FROM FINANCING ACTIVITIES

Capital 2,000,000

Drawings (840,000)
CASH INFLOWS FROM FINANCING ACTIVITIES 1,160,000
NET CASH INFLOW FOR THE YEAR 415,000

WORKINGS
LEASE AMORTIZATION
1500000/10 150,000

DEPRICIATION
VAN
300000/4 75000 PER YEAR

MARKETING EXP
15000*12 180,000

PURCHASE
JULY 600,000
AUG 450,000
OCT 450,000
DEC 450,000
FEB 450,000
APRIL 450,000
JUNE 450,000
3,300,000
SALES
AUG-SEP
OCT- JUNE = Rs. 500000 * 9

RATES
PREPAYMENTS
5000*3 =15000

OPERATING EXP
20000 * 12 =240000

DRAWINGS
70000 *12 = 840000
COST
=Rs. 400000 *.50 200,000
=45000000 *.50 2,250,000
4,900,000 2,450,000
Req. 6

RAZIUDDIN
EVALUATION OF PROPOSAL
PROFITABILITY RATIOS
1 ROI
PROFIT /CAPITAL * 100
=1745000/2000000 *100 = 87.25%

2 PROFIT MARGIN
PROFIT/SALES *100
= 1745000/490000 *100 =35.61%

LIQUIDITY RATIOS
1 CURRENT RATIO
CURRENT ASSETS/CURRENT LIABILITIES
= 1780000/450000 = 3.95

2 QUICK RATIO
LIQUID ASSETS/ CURRENT LIABILITES
= 930000/450000 = 2.06

WORKING CAPITAL CYCLE

1 INVENTORY AGE INVENTORY /COGS *365 DAYS DAYS
(STOCK HOLDING PERIOD)
=850000/2450000 *365 127
2 RECEIVABLE AGE
(COLLECTION PERIOD) RECEIVABLE /SALES*365 DAYS

=500000/4900000 *365 37
OPERATING CYCLE 164
3 PAYABLE AGE
(PAYMENT PERIOD) PAYABLES/PURCHASES *365 DAYS
= 450000/3300000 *365 (50)
WORKING CAPITAL CYCLE 114
The proposal is worthwhile if we look profitability, liquidity, assets efficiency ratio.
An Assessment of Raziuddin’s Proposal
The projected balance sheet along with estimated cash flows and accounting ratios apparently
suggest that Raziuddin has found out a very profitable project.
At the same time he should once again reconfirm the availability of market for his imported
furniture.
Although the projected financial information strongly suggests for a “ go ahead” with this project,
Raziuddin should also consider non-financial factors like Pakistan’s security situation.