Cover Image
close this bookFinancial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)
View the documentAcknowledgements
View the documentIntroduction
close this folderI. Cost calculations in the handicraft industry
View the document(introduction...)
View the documentI. 1. Production costs
View the documentI.2. Overhead apportionment
View the documentI.3. Selling and distribution costs
View the documentI.4. Ways to reduce costs
close this folderII. Pricing
View the document(introduction...)
View the documentII. 1. Value in the market
View the documentII.2. Costs and pricing
View the documentII.3. Contribution analysis
close this folderIII. The concept of working capital
View the documentIII.1. Defining working capital
View the documentIII.2. The role of working capital
View the documentIII.3. Performance measurement
View the documentIII.4. Profits
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
View the documentConclusion
View the documentA manual of credit & savings for the poor of developing countries

III.4. Profits

(i) Profit and loss account
In Figure 9 the profit and loss account - otherwise called the income statement - of Fibre Mat Society reveals an enterprise which is trading at a small profit.

Figure 9. Fibre Mat Society - Profit and Loss Account, Year Ended 30 September 1986



Less cost of goods sold:

Opening stock


Direct production costs:



Materials & other




Closing stock



Gross Profit 28,000


Rent of workshop


Packing & distribution


Vehicle maintenance


Bank interest









Net trading profit:3.000

This gives us some further information with which to evaluate performance, especially when viewed in connection with the balance sheet (Figure 8). First, it is apparent that stocks have increased by 100% during the year. This could well mean a build-up of slow-moving stock. Without past figures, it is impossible to see sales trends, which might explain a rise in stocks; one would also want to know if any change in sales policy has been made which might necessitate higher stock-holding. Second, we can now see debtor and stock figures in relation to sales. This allows for further ratio analysis to be made. The rate at which debtors are settling their accounts may be calculated by the debtors turnover ratio:

Debtors turnover = ( Sales ) / (Debtors ) = 140,000 / 45,000 = 3.11

This is then expressed in terms of average collection period of debts by dividing the ratio into 365:

Average collection period = 365 / 3.11 = 117 days

This would be a very unsatisfactory state of affairs and an indication of bad debtor management. It might actually be worse than it appears. If a proportion of the sales were for cash then the sales on credit would be less than 140,000 and the average collection period correspondingly larger. The ratio tends to confirm the earlier conclusion stock. Most likely this Society has a product range of declining appeal. Not only are stocks building up in the Society, but also they are not being sold easily by the customers, hence payments are being delayed.

As with the debtors turnover ratio, this can be expressed in a more meaningful way as a number of days stock held:

Days stock held = 365 / 2.8 = 130 days

Had we made the calculation using the beginning of year stock figure or the average—i.e. 30,000—clearly the turnover ratio would look healthier.

Creditors may be looked at in the same way as debtors. The amount of credit the Society is taking from its suppliers can be calculated by the ratio:

Purchases / Creditors = 69,000 / 15,900 = 4.34 = 84 days credit

This ratio includes all supplies, including items charged to overheads. It could be separated between suppliers of raw materials and indirect items, as the figure for creditors is broken down in the balance sheet. Credit taken from raw material suppliers would be:

( 13.200 / 52.800 ) X 365 = 90 days

and from suppliers of items charged to overheads would be

2700 x 365 = 60 days.

It is possible that suppliers would not be content to allow this situation to continue. Even without past statements for identification of trends by comparative ratio analysis over two or more years, it is likely that Fibre Mat Society is heading for difficult times.

(ii) Profitability and liquidity

The problem is essentially this: although the Society is trading profitably at present, its cash is tied up in excessively high levels of debtors and stocks. The conversion of assets into cash is unacceptably slow.

The management of working capital seeks to obtain the right level of liquidity. A business with insufficient liquidity, if unable to delay payments or borrow externally, could face technical insolvency. This is a situation where sufficient assets exist to meet liabilities, but they cannot be converted quickly enough into cash. It is different from legal insolvency, a state in which assets are actually insufficient to meet liabilities.

Conversely, an over liquid enterprise is guilty of idleness: keeping too high a level of cash and other liquid assets, rather than investing them in strategies for growth.

Consider the current position. The Society has 5,000 in cash, the most liquid asset. It has short-term cash payment obligations of 22,500 creditors and deferred wages, even discounting its bank overdraft. How can it meet these obligations unless stocks and debtors are turned quickly into cash?

It is in the first instance for the purpose of ensuring adequate liquidity to meet operational needs that working capital management is a fundamental part of the financial control of an enterprise.

(iii) The effect of liquidity difficulties

Profit and cash are separate concepts, and the evidence of one does not automatically imply the existence of the other. Yet, it is evident that a shortage of liquidity can affect profitability adversely.

First, it might necessitate borrowing externally in order to finance current assets. Profit is reduced by the amount of interest paid, by 5,550 in the case of Fibre Mat Society. In its estimate of overheads (Figure 2) the Society had apparently made very little allowance for bank interest.

Second, it might result in lost sales, because the expenditure necessary to finance production could not be met.

Third, the value of assets might undergo a reduction: some stock might become obsolescent, some debtors might go bad.

Fourth, it might oblige an enterprise to make short-term decisions which are not in its long-term interests.

Faced with a liquidity problem, and lack of access to external funds, a business has perhaps four courses of action open to it:

· Dispose of assets. Disposal of fixed assets, part of the permanent capital structure of the enterprise, might seriously impair operational capacity. The Society could sell its van; but leasing, or using public transport, might be more expensive. If stocks are sold off quickly, an amount less than their true value might be realised.

Debtors might be reduced, but to call cash in urgently might necessitate offering generous discounts. Imposing an excessively tight credit policy might alienate customers.

No asset should ever be left idle. There might be scope for leasing out under utilised assets. If Fibre Mat Society only uses its van four days a week, maybe it could be hired out the other three.

· Increase selling prices. This is fine if the market will accept it; if not, sales income is likely to decrease.

· Cut operating costs. If scope for efficiencies exist, then this is fine. What must be avoided is a reduction in quality of raw materials purchased, or cutting corners in production, which would reduce the quality of the finished products.

· Defer payments. In other words, increase liabilities, and hold on to the cash. Some additional credit might be available, but suppliers might be disaffected, causing future difficulties in obtaining supplies.

It is true that the objective of a social production unit would differ from that of a normal enterprise in that it is not profit-maximizing. It might be satisfied to realise a very small profit, or simply to break even, in order to achieve the basic aim of employment generation. Nevertheless, even such a unit wants to earn as much as possible so that it can either invest for growth, enabling further employment, or increase distributions in the form of wages or bonuses. Whatever the type of enterprise, or its corporate strategy, it should seek to run its affairs in the most efficient and profitable manner. Profit—or minimization of loss in a subsidised unit—is always the means to achieve the objective of a business, whether that objective is that the proprietors make a personal profit or that some social benefit results.

The concept of working capital is ultimately related to that of profit. Profit is the objective of operations; working capital is the means to undertake operations. It is vital to keep this perspective in view, because whilst working capital may be concerned with only short-term assets and liabilities, an enterprise's liquidity position will influence its profit performance. This is the second fundamental purpose of working capital management.