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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. 1. Management Accounting

A business has a legal responsibility to present each year an audited set of accounts. Such statements are known as its financial accounts. Management accounts serve a completely different purpose. These are financial statements produced for use inside the business. Their objective is to provide the information necessary to manage the business effectively.

Managerial requirements are threefold:

(i) Planning

Planning is the process of setting overall objectives—the strategic plan—and then determining what actions and resources will be required to achieve these— the operating plan. Operational planning involves deciding what to produce, how to cost and price the production, how to provide and allocate the resources necessary to keep the business running.

Making projections about the performance of the enterprise becomes easier with experience. How does a new business start to estimate the results it will achieve? The difficulty, and possible inaccuracy, does not invalidate the undertaking. A business must have an operating plan, an agreed set of objectives and targets. Without this, it is very difficult to know whether performance is good or bad, or to decide whether changes need to be made. An operating plan, expressed in financial terms, is called a budget.

Imposing the discipline of stopping to reflect on what is likely to happen increases the chances that everything material will be thought of. A business might be caught unawares justifiably by what is unforseeable—a typhoon might destroy the workshed; a new tourist market might open up—but it shouldn't be taken by surprise by what is forseeable with a little thought—the roof might need repairing; an adult education class might be starting.

Budgets give everybody something to work towards. People are motivated to perform more effectively if they understand clearly what is expected of them.

(ii) Monitoring

This is the process of comparing plans with actual performance. Assumptions made in projections can be wrong. It is vital to monitor what actually happens in day to day operations. Businesses cannot survive on fine plans which don't actually come to fruition.

Management accounting information must be timely. It is for each business to decide exactly what information it needs at what time. In a periodic statement for internal uses the budget is set down against actual performance, and the variance shown (Figure 10).

Figure 10. Fibre Mat Society Monthly Statement of Profit & Loss








Cost of goods sold




Gross profit








Note: adverse variances are shown in brackets

The budget provides the yardstick against which to measure performance. Where the variance is significant, questions must be asked, and answered in the next stage of planning.

The involvement of the artisans in discussing performance is a valuable educational element, and can bring out new ideas.

(iii) Control

Where performance is unsatisfactory, it is the task of management to take corrective action, and to ensure awareness of responsibilities among everybody. Clearly, adverse variances indicate the need to look in further detail at what has gone wrong. A distinction needs to be made between variances which are controllable and those which are not. For example, if the cost of raw materials is above budget, it might be because the price went up unexpectedly—a noncontrollable factor—or because the artisans were careless in using it—a controllable factor, necessitating action.

The process of planning, monitoring and control must be followed by one of replanning in the light of actual performance and new realistic targets. Indeed, the whole procedure is a continuous one. Successful management depends on the careful interpretation of current financial information, so that both difficulties and opportunities can be understood quickly and responded to in time.

The limitations of financial information in a social production unit need to be recognized. It says nothing about the quality of the enterprise, its employment policy, the special benefit to the community. As well as financial statements, a unit would want to produce projections and reports which deal with the non quantitative aspects of its activities, analyzing the impact on people's lives of the income-generation opportunity. The social objectives must always inform the planning, and be given full account in monitoring performance. To argue for proper financial management is not to undermine the social purpose of the enterprise. On the contrary, it aims to strengthen this, by guarding against financial difficulties which might threaten its effectiveness.

IV.2. Planning for working capital requirements

Determining the working capital requirements is part of the operational planning of a business. It is concerned with the effect of target operations on the enterprise's liquidity.

It is not possible to generalize about what level of working capital a business requires. This depends on the type of business, its size, sales policy, the trade norms, seasonality, interest rates and other factors. What the minimum cash balance should be, how much trade credit should be given and can be taken, whether stocks should be high or low: these are questions for each individual business. The important thing is that it does ask these questions, and then manages its affairs with regard to the answers.

(i) Setting targets

At a meeting of its management committee Fibre Mat Society decides that its target sales for 1986 7 will be 150,000. This would represent only a modest increase, but market conditions seem difficult at present. Nobody is showing much interest in the range, and customers are taking longer than usual to settle their dues. In the circumstances, everyone would be happy if sales could just push ahead a little bit, so that the Society's good record of employment in the needy local community could be maintained. It was estimated that 14,000 sales per month would be achieved in October, November and December and 12,000 per month for the rest of the financial year.

Some further decisions are made at the meeting. In response to recent difficulties in obtaining raw material supplies, the maximum credit period taken will henceforth be 60 days, as it will remain for other suppliers. Artisans will be paid immediately, as they always used to be before money got tight. No new fixed assets will be purchased. It was assumed that stock and debtors would remain as at present in cash terms; a small decrease relative to sales. Overhead costs should not increase in the coming year because of improved efficiencies.

Having set its targets the Society invites its accountant to look at the financial implications, and report back.

(ii) Working capital budget

The means to express a plan in financial terms is a budget. Realizing that the Society's worsening liquidity situation can only be aggravated by its decision to make payments more quickly, the accountant first establishes a working capital budget. The objective is to find out whether sufficient funds will be—or can be —made available to carry out operations at the target level.

A working capital budget is not concerned with profitability projections. If Fibre Mat Society manufactures a mat in August at a cost of 40 and sells it for 46 in September on three months' credit it has made a profit of 6. However, it will receive the revenue only in December, although it bore the cost in August. A working capital budget looks at the effect of having to wait before that revenue is received.

It would normally be drawn up in the form of a monthly cash flow projection. In order to ascertain the outflows and inflows in each month, the proposed expenditure and income is calculated in terms of when the cash will be paid out or received.

Expenditure: Production costs:

· if stock held remains constant, production at the level of cost of sales will be required. The Society's mark-up on direct costs is assumed to be 25%, so that new stock must be produced to the value of 120,000. Seasonal sales fluctuations imply that production costs will be 11,200 October to December, and 9,600 January to September. According to the 19X5-6 profit and loss account, 60% of these costs are labour, and 40% materials and other direct costs. The monthly labour cost will be 6,720 October to December and 5,760 January to September. The monthly raw materials cost will be 4,480 October to December and 3,840 January to September.

· Material costs will be paid two months after taking delivery, but artisans will be paid the same month as production.

· At the start of the year. the artisans are owed 6,600 and raw material suppliers 13,200. The artisans must be paid in October; repayment of the debt to the suppliers will be spread equally between the first two months.

Other expenses:

· Indirect costs will be incurred at the rate of 1,350 per month, payable two months later.

· At the start of the year 2,7()() credit is outstanding and must be settled in the first two months, 1,35() per month.


· Sales will be 14,000 per month October to December and 12,000 per month January to September. Because debtors are taking 117 days to pay, the cash will be received only in the fourth month after sales.

· 12,500 must be deducted from sales revenue because the cash has already been received as advance payments for some small export orders. Assuming the goods to be produced and supplied in October the effect will be to reduce February's cash inflow.

· At the start of the year debtors total 45,000. As the balance sheet does not show the age of the debt, it will be assumed that this will come in at the end of each month as follows: 16,000 in October, 8,000 in November, 9,000 in December and 12,000 in January.

In this way, the operating targets of the business are translated into cash movement terms. Cash flows relating to the previous financial year's transactions must be included. Those relating to the current year's transactions, but which would not be paid or received until the following year, would not be included.

Depreciation is not included in a cash flow projection, because it is not a cash expense. Bank interest is not included here because the objective is to point up the financing requirement, on which the amount of bank interest would depend. It is a fairly simple exercise to add the bank interest calculation in at the end when the overall picture emerges.

(iii) Cash flow tabulation

The cash projections are now tabulated month by month, adding in the opening cash balance, which is calculated as cash on hand minus overdraft (Figure 11).

It can be seen that, at target operational level, the Society's total financing requirement would increase to over 55,000, although it would not require this amount throughout the year.

Even if the bank were willing to meet this requirement, the additional interest charge would be considerable. Assuming a rate of 18%, and an overdraft level rounded to 47,000 for eight months and 57,000 for four months, in order to allow for interest payments as well, the interest expense for the year would be 9,05O, an increase of 3,500 on 1985-6. Yet gross profit would increase by only 2,000, with a 2()% profit margin on an additional 10,000 sales. Hence, despite an increase in sales at the normal profit margin, profitability would actually decrease.

It is unlikely that the bank would in fact extend its overdraft facility in the light of present trends, even were it to have a policy of trying to help small employment generating units. It would probably look for evidence that the Society was addressing its mounting liquidity problem by seeking to generate cash internally.

IV.3. Releasing cash from other assets

(i) Reducing debtors and stocks

The Society's liquidity problem is due above all to the amount of cash blocked by excessively high levels of debtors and stocks. Consider the effect if the Society brought down its average collection period for accounts receivable from the present 117 days to 60 days. Average debtors would be reduced to 1/6 of sales, at 1986-7 target, 25,000. The difference of 20,000 from the present level would be released as cash. Addressing this problem alone would avoid the need for any further overdraft facility, as the bank manager is likely to point out.

A similar effect would come from a faster turnover of stock. If average stockholding in the coming year could be reduced to a quarter of cost of goods sold without affecting sales, then stock would be 30,000. In other words a further 1 (),000 could come off the overdraft by increasing stock turnover to 4 times.

The Society's accountant reports back to the management committee that the present targets could not be financed without eroding profitability. The new target figures of debtors and stock are suggested, and agreed. However, it is estimated that some costs will be incurred in collecting old debts and that a few might need writing off. Further, some stock is obsolescent, and should be sold off at a discount. After further discussion, it is decided that existing debtors could be persuaded to settle within two months but that 2,000 should be written off as debt collection and bad debt costs; and that 10,000 stock will be sold at cost price in November, thereafter keeping stock at 30,000: all other targets to remain the same. The accountant is requested to draw up new projections for comparative purposes.

Cash flow estimates would differ from the original projection as follows:

Figure 11. Fibre Mat society - Cash flow projection 1986-7

Figure 12 Fibre Mat society - Cash flow projection 1986-7 - Revised

Expenditure: Production costs:

· with constant sales, the reduction in stock implies that less new stock will be manufactured. This will be 8,000 at cost, of which 60% is labour—4,800— and 40% materials and other direct costs—3,200. It will be assumed that this reduction will be spread over two months to minimize hardship to the artisans.


· Sales revenue will be received in the second month after sales instead of the fourth.

· Opening debtors would now pay as follows: 21,500 in October, 21,50{) in November.

The new cash flow projection is shown in Figure 12.

Instead of increasing its financing requirement by more than 50%, the Society can now reduce it by nearly the same amount. The interest expense, based on average month end figures of borrowing, adding 500 per month to allow for interest, would be in round figures 3,550. Comparative profit and loss projections could now be made (Figure 13).

Figure 13. Fibre Mat Society—Projected Profit & Loss Account, Year

Ended 30 September 1987

Original projection

Revised projection




Less cost of

goods sold

Opening stock


40 000

Direct production costs




Materials and other







Closing stock





Gross profit




Rent of workshop



Packing &distribution



Vehicle maintenance



Bank interest






Debt collection




Net trading profit

1 500

3 000

Although in the revised projection gross profit would be reduced by 2,000 because of selling 10,000 stock at cost, and 2,000 sales revenue would be written off, still the Society would make more profit, because of reducing interest by more than the amount of lost revenue. It would also be considerably more free of pressure of debt.

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.