Introduction
Seems that here we start getting into the semantics of words. It is important to note the difference between Costs which is what is given up in order to achieve an outcome and Costing which is the measuring, analysing and recording the transactions and achievements related to the performance of the product or service.
As a result, it becomes very important for managers to be able to plan and budget for the use of resources and anticipated outcomes. Furthermore, it is then essential to measure actual performance against the planned performance so reasons for variances can be identified. These are the tools that can enhance financial management and provide invaluable information to Boards and other stakeholders.
Planning and Budgeting
Budgeting is nothing more than a plan as to how a manager will handle the sales, costs, financing and other aspects of a business in a financial model. A budget answers several very important questions.
- Will the business generate a positive cash flow?
- Can it support the costs as they appear at present?
- How do fixed costs compare to the profit being achieved?
- Is there sufficient stock on hand to make sure production targets are met?
- Is working capital adequate to meet financial commitments?
To prepare a quality budget as opposed to some figures thrown together on a piece of paper because you have to do one, the following are essential.
- You will need to have an in-depth understanding of what has occurred in the past
- Will there be any differences this time to the past and why?
- Obtain feedback from others, particularly stakeholders and other members of the team
- Make adjustments to fine-tune. (This does not mean changing the budget to reflect actuals when a variance occurs!)
Debate abounds regarding the reasons for creating budgets and not creating budgets. Personally, I am a firm believer in creating road maps for whatever journey you are going on. A budget is no different.
Cost Drivers and Fixed vs Variable Costs
Costs are broken down into two categories which are fixed and variable. Fixed costs will be incurred even if the organisation has no sales. Variable costs, on the other hand, are linked to products or services sold. Fixed costs can still vary though. An example would be where it was mandated that you need so many staff per patient in a healthcare facility. As soon as you move into the next bracket, your fixed costs will increase. If a truck, for example, is depreciated on a per kilometre cost as opposed to a time cost, then it will be a variable cost. If depreciated on a time basis, it will be a semi-fixed or semi-variable cost.
One aspect of fixed and variable costs is important and that is the ratio between the two. The higher the ratio of fixed costs to variable costs, the more difficult for an organisation to pivot in the event of a downturn. The variable costs reduce automatically, but the fixed costs such as salaried staff, rented premises and machinery can only be reduced over time.
Break Even Analysis
The purpose of the break-even analysis is simply to know at what level of sales an organisation is profitable or cash flow neutral. This knowledge provides a solid target for an organisation to at least cover costs. Break-even analysis can be used to consider the impact of reducing sales pricing or expected units.
The models include an Accounting one and a Cash one. The Accounting one includes non-cash expenses in the equation whereas the Cash model does not. Accordingly, the Accounting model tells us at what level of sales profit is zero. The Cash model tells us at what level of sales that cash flow is neutral.
As in all financial modelling, there are some limitations. These include:-
- That there is a linear relationship between cost, volume and profit
- That there is a constant production and sales mix
- That the total revenue increases on a linear basis
- It is static and can only consider a fixed point in time
Scenario Analysis
Scenario Analysis is nothing more that applying different scenarios to an organisation and looking at the impacts of each one. Such analysis can provide insight into the most attractive model or warnings about some that may have a negative impact.
Working Capital Management
Working capital is the difference between the value of an organisation’s current assets and current liabilities. This is not necessarily all cash however and conversion of current assets such as Accounts Receivable and Inventory into cash is essential in order to meet current liabilities such as accounts payable and loan repayments. The shorter the working capital life, in other words, the conversion of current assets to cash and meeting current liabilities, the better.
As indicators of an organisation’s skill and practices in this area, you should look at Accounts Receivable Turnover. This will show the number of days it takes on average for them to get paid. Inventory stock turn ratios are also valuable to indicate if an organisation is turning over its stock on a regular basis. Sometimes, particularly in downturns, organisations can continue to carry the same level of stock as previously whereas they could reduce the amount. The opposite would apply in an upturn.
The third ratio to be looked at is how many days it is taking the organisation to pay its creditors. Most accounts are on a 30 day basis so the ratio should be as close to this as possible to indicate good management.
Most of these ratios have been discussed and demonstrated in earlier notes.
Operating cycle and cash conversion cycle
The cycle for working capital can be summarised as a process:-
- Goods or services from inventory are sold which generate either cash or accounts receivable
- Accounts receivables are converted to cash and held in bank account
- Cash is used to acquire additional inventory and pay accounts payable
- Raw materials and work in progress are converted to finished goods
- The cycle keeps going.
The calculation of the average period of collection has already been discussed in Module 3. The calculation of inventory turn or stock turn has also been covered previously.
Accounts Payable Turnover
Another ratio that comes into play with the management of working capital is the Accounts Payable Ratio. This measures the number of days an organisation takes on average to pay its creditors. This can be a difficult ratio to calculate because of its reliance on total purchases. For a manufacturing concern or retail, for example, you could use the value of purchases in the Cost of Goods Sold. However, many other items would also have been purchased on account such as office supplies, fuel etc which are included in the operating expenses of the income statement. Likewise, for an organisation with no cost of goods sold, all the credit purchases will be in the operating expenses of the income statement.
The only reliable way of calculating this figure in my view is to get a copy of the general ledger report for Accounts Payable and use the total credit figure over the period of review. This will provide several reliable figures for you.
- The opening Accounts Payable balance
- The closing Accounts Payable balance
- The total amount of purchases, i.e. credits that have been entered for the period.
The formula then becomes:-
$$Accounts\ Payable\ Ratio\ in\ Days\ =\ 365\ \div$$
$$ \frac{Total\ Purchases}{{(Opening\ Accounts\ Payable}\ +\ {Closing Accounts Payable})\ \div\ 2}$$
Ratio Reliability
Again, it is worth reiterating that ratios are signposts. They don’t necessarily provide definitive answers but are used to find anomalies and trends. It’s important to calculate each period on the same basis for consistency.
As an example, in the ratio above for Accounts Payable Days, a number of problems have been pointed out with obtaining the information to calculate this accurately. The same could be said for the Accounts Receivable days because you should also average the opening and closing values and only use sales on credit to get a more accurate result.
The above diagram shows the calculations for the cash conversion cycle and operating cycle. Both can change quickly or slowly over time is policies change internally. For example, using the diagram above, if the organisation collected its accounts more quickly, say in 60 days instead of 85, then the Operating Cycle would reduce to 151 days and their Cash Conversion Cycle to 90 days. Adjustments of policies and procedures can increase or decrease working capital in an organisation.
Easy Spreadsheet Calculations
The spreadsheet mentioned in earlier posts has been upgraded yet again. In fact, it is now at version 0.4 and contains formulae for several other ratios and a changelog so you can see what’s new. The spreadsheet has become a bit of a labour of love and I am really enjoying writing all the formulae. If you have any suggestions, please don’t hesitate to ask and I will add them if I can.
Feel free to download from the Resources link in the menu.
Summary
This week has seen a deep dive into more complex analysis. Whilst there are formulae for calculating the impact of internal policy changes on working capital, I have chosen to leave them out to avoid complexity. There are several sites on the internet that provide specific details on calculation of such things Free Cash Flow for example.
In the meantime, there is one more week of study left in this subject and the capstone assessment will be due. My methods have changed in that I will finish the modules early and devote the rest of my time to working on the assessment.
References- Course: 8006FMGT Financial Management 2022 Term 5, Topic: Week 6 Cost behaviour and Working capital management 2022, Aib.edu.au, viewed 26 September 2022, https://learning.aib.edu.au/course/view.php?id=1265§ion=8.[↩]
- Titman, S, Martin, T, Keown, AJ & Martin, JD 2018, Financial management : principles and applications, Pearson Australia, Melbourne, Vic.[↩][↩]
- Module 6 Cost behaviour and Working capital management: Operating cycle and cash conversion cycle 2022, Aib.edu.au, viewed 29 September 2022, <https://learning.aib.edu.au/mod/book/view.php?id=113115&chapterid=41308>.[↩]
