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close this bookFinancial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)
close this folderIV. Financial planning and decision making
View the documentIV. 1. Management Accounting
View the documentIV.2. Planning for working capital requirements
View the documentIV.3. Releasing cash from other assets
View the documentIV.4. Working capital decisions

IV.4. Working capital decisions

Effective financial management will increase the range of opportunities open to an enterprise to pursue its strategic plan. A liquidity problem, apart from being expensive. reduces options, and diverts the attention of management away from a longer-term perspective.

There are commonly three working capital issues on which a business would need to make a decision

· whether to offer discounts to debtors for prompt settlement of accounts

· whether to dispose of slow-moving stocks at reduced prices, and by how much to reduce them

· whether to purchase by cash or on credit, allowing for discounts which might be on offer.

(i) Debtor management

Slow settlement by customers can be a particularly difficult problem for a handicrafts production unit. A significant percentage of the costs of production are labour costs, so that the level of outside purchases is very much smaller than the level of sales. If both are on credit, it would not be possible to come anywhere near to balancing the amounts of credit taken and given. Assuming the artisans are paid on time, the working capital requirement is all the greater. The deferred wages and creditors of Fibre Mat Society total only 50% of debtors at 30 September 1986.

Where demand is buoyant, it is easier for a business to take a tougher line on credit. Perhaps references can be taken on potential customers from other of their suppliers or their bank. Placing products on consignment can be refused more easily if definite sales are easy to obtain elsewhere.

Whether or not to offer incentives, i.e. discounts, to customers will depend partly on the norms of the trade, perhaps partly on the supplier's liquidity, but above all on whether or not it is to the supplier's advantage.

Fibre Mat Society is considering offering a discount to all its debtors for immediate settlement. It wants to calculate what discount it could offer, on the assumptions that all debtors paid up and that, without a discount, the debtor pattern would remain as estimated for the cash flow projection.

In order to make financial decisions, income and/or expenditure streams should be projected for each alternative, and the most favourable one selected. In Figure 14 the costs of lost sales revenue and interest are compared, with the Society borrowing at 18%.

Figure 14. Fibre Mat Society—Effect on Income from Introducing a Discount

(i) Interest cost of servicing current debtors:

Month beginning


Interest rate

Interest cost


45 000




29 000




21 000







1 ,605

(ii) Interest cost as percentage of sales:

1,605 / 45 000 = 3.57 %

Therefore the Society would be better off introducing a discount of up to 3.5% if it brought immediate payment. Above this rate, the lost sales revenue would exceed the cost of financing the time delay in receipt

If alternatively, the Society was considering a discount policy for the future, it would assume that accounts receivable would be collected after 60 days. Two months borrowing costs the Society 3%. Therefore, it would be advantageous to introduce a discount of up to 2.5% for cash on delivery.

(ii) Stock management

As with debtors, the standard financial statements of an enterprise do not reveal the age, or quality of stocks. These would normally be recorded in the balance sheet at their historical cost; this might or might not bear close relation to their current value. The reason for recording stocks at cost, or value, whichever is the lower, and certainly not at selling price, is that they cannot realise the higher sales value until they are actually sold. If, recorded at cost, stocks are clearly overvalued, then they should be written down in the books at year end so that the accounts reflect more accurately their true value.

A business must avoid at all costs making decisions based on the illusion of unrealised profits. For example, if stock is obsolescent, it should be reduced in price in order to sell as quickly as possible. The price at which to sell is the best price obtainable in the market, irrespective of production costs. A reduced selling price does not mean a loss of profit; the profit had never been made. Much better release the cash for producing something that can be sold profitably.

Slow-moving stocks are identified by sales analysis, as indeed are fast-moving products. Monitoring sales performance and keeping a close contact with the market is the best way to decide what stocks to produce, and what to clear at what price.

It is worth repeating that the purpose of holding stocks is to achieve sales. Fibre Mat Society's accountant demonstrated that liquidity—and profitability—were improved he a higher stock turnover This is certainly true as long as stocks are not reduced below the level needed to obtain target sales. In that case, sales might decline, and with them profits. There might be lots of cash, but the Society doesn't sell cash; it sells products. Stock turnover can be improved in two ways: reducing stocks is one; increasing sales is the other. This is often a subject of dispute between the marketing person in an enterprise—who wants high stocks for maximum sales—and the accountant—who recommends low stocks for healthy turnover. If there is not a liquidity problem; and the stock is not obsolescent, the marketing person is right.

(iii) Cash and credit

If discounts are offered by suppliers, then, by implication, to purchase from them on credit bears an interest cost. Fibre Mat Society enquires about purchasing fans for its workshop. The cost would be 10,000. Terms are 30 days nett, but there is a 2% discount for cash on delivery. The Society would have to borrow this at 18%. In Figure 15 the Society calculates the best decision.

Figure 15. Fibre Mat Society—Purchasing by Cash or on Credit

(i) If purchases by cash, cost =


+ interest 9,800 x 1.5%



Nett cost=


therefore it is more advantageous to take the discount and pay cash.

(ii) The reason can be seen in another way by calculating the interest rate being charged by the supplier. The fans cost 9,800. The supplier offers 30 days credit and charges 200 for this credit. This is equivalent to an interest rate of 200 / 980 x 12 = 24.5%. Therefore it is cheaper for the Society to borrow from the bank at 18%.

(iii) Were the supplier alternatively offering 60 days credit, then the interest rate equivalent would be 200 / 9,800 X 6 = 12.25%. In this case, it would be more advantageous to the Society to accept nett terms and use the cnnnliPr'c credit because it is cheaper than the bank's

The advantage or disadvantage of giving or taking discounts can always be calculated in this way against a specific credit period option.