MAC2602-study Guide 2

© 2012 University of South Africa
All rights reserved
Printed and published by the

University of South Africa
Muckleneuk, Pretoria
MAC2602/2/2013–2019
98917625
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INTRODUCTION
CONTENTS
PART 3: MANAGING AND INVESTING FUNDS 1

Topic 6: Analysis of financial information 3
Study unit 15: Objectives and sources of financial analysis 5
1 Introduction 5
2 The objectives of financial analysis 5
3 The users of financial information and analysis 6
4 Sources of information regarding an organisation 6
4.1 Financial information 7
4.2 Strategic (non-financial) information 8
5 The major limitations of financial information 9
6 Techniques used in performing financial analysis 10
7 Summary 14
Study unit 16: Ratio analysis 15

1 Introduction 15
2 Financial information provided 15
3 Growth ratios 18
4 Ratio analysis 20
5 Measuring profitability and performance 22
5.1 Profit margins 22
5.2 Performance ratios 24
6 Measuring liquidity – short-term funds 29
6.1 Current ratio 30
6.2 Liquid asset ratio (or acid test or quick ratio) 30
6.3 Inventory days 31
6.4 Inventory turnover ratio 31
6.5 Receivable days (debtors' collection period) 32
6.6 Payable days (creditors' payment period) 33
6.7 Cash conversion cycle (days) 34
6.8 Cash ratio 35
7 Measuring solvency and financial/capital structure – long-term funds 35
7.1 Interest cover ratio 35
7.2 Debt to equtiy ratio (or leverage ratio) 36
7.3 Debt ratio (or gearing ratio) 37
7.4 Total assets to total debt 38
7.5 Financial leverage effect 38
8 Measuring how the organisation relates to financial market ratios 39
8.1 Earnings per share 39
8.2 Dividend pay-out ratio 40
8.3 Dividend cover ratio 41
8.4 Price/earnings ratio 42
8.5 Earnings yield 43
8.6 Dividend yield 43
9 Summary 44
iii .........................
INTRODUCTION
Topic 7: Analysing and managing working capital 49
Study unit 17: Working capital management 51
1 Introduction 51
2 Working capital definitions and concepts 52
3 Managing inventory 53
3.1 The economic order quantity (EOQ) model 54
3.2 Re-ordering and safety stock 54
3.3 Just in Time (JIT) – manufacturing inventory systems 54
4 Managing accounts receivable and credit sales 56
5 Managing accounts payable 60
5.1 The cost of financing trade accounts when discounts are offered 61
6 Managing cash and cash equivalents 65
6.1 Compiling a cash flow budget/forecast 66
6.2 Matching cash inflows and outflows 66
6.3 Accelerate cash availability 66
6.4 Delay payments 67
6.5 Liquidate (sell) short-term investments 67
7 Short-term financing 69
8 Summary 70
Study unit 18: Working capital policies and the working capital cycle 74
1 Introduction 74
2 Working capital policy 74
2.1 Working capital investment policies 75
2.2 Working capital financing policies 76
3 Working capital cycles 79
4 Summary 81
Topic 8: Capital investments and capital budgeting techniques 85

Study unit 19: Capital investments 87
1 Introduction 87
2 Objective of capital investments 87
3 Types of capital expenditure 88
4 Project analysis 90
5 Classification of capital investment projects 91
6 Factors affecting the capital budgeting decision 93
7 Cash flow estimation 94
8 Rules regarding timing of cash flows 99
9 The discount rate 100
10 Capital budgeting techniques 101
11 Summary 101
Study unit 20: Traditional methods/techniques 107

1 Introduction 107
2 The payback period (PB) method 107
2.1 Advantages 108
2.2 Disadvantages 108
2.3 Evaluation criteria 109
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INTRODUCTION
3 The accounting rate of return (ARR) method 110
3.1 Advantages 112
4 Summary 113
Study unit 21: Discounted cash flow methods/techniques 115

1 Introduction 115
2 Overview of discounted cash flow methods 115
3 Net present value (NPV) method 116
3.1 Advantages 116
4 Internal rate of return (IRR) method 126
4.1 Advantages 127
4.4 Difference between the net present value and the internal rate of return
method 127
5 Profitability index (PI) 132
6 Summary 134
PART 4: RISK MANAGEMENT 151

Topic 9: Risk theory and approaches to risk management 153
Study unit 22: Risk concepts and objectives in a business context 155
1 Introduction 155
2 What is risk? 155
3 Why incur risk? 157
4 Where are risks relevant? 158
5 Risk management strategy 159
6 Definition of risk management 160
7 Why risk management? 161
8 The objective of risk management 162
9 Benefits of effective risk management 162
10 Requirements for effective risk management 163
11 Summary 163
Study unit 23: C

omponents and role players of an adequate risk management
programme 164
1 Introduction 164
2 Components of a risk management programme 164
2.1 Role of the board of directors 167
2.2 Role of management/risk management group 167
2.3 Role of the risk management department 167
2.4 Role of internal audit and audit committee 168
3 Risk management approaches 169
3.1 COSO’s risk management model 169
3.2 IRM risk management standard 170
3.3 CIMA’s risk management cycle 171
3.4 Australia / New Zealand standard 171
4 Summary 172
v .........................
INTRODUCTION
Topic 10: Risk identification and documentation 175
Study unit 24: Categories of risk facing an organisation 177
1 Introduction 178
2 Principal risk objectives/categories 178
2.1 Strategic risk 178
2.2 Operational risks 181
2.3 Reporting risk 182
2.4 Compliance (legal) risk 182
3 The main types of risk 183
3.1 Business risk 184
3.2 Economic risk 184
3.3 Financial risk 184
3.4 Market risk 185
3.5 Social risk 186
3.6 Political risks 186
3.7 Information risks 186
3.8 Technological risks 187
3.9 Environmental risk 187
3.10 Compliance risk 187
3.11 Reputation risk 187
4 Summary 188
Study unit 25: Risk identification and the risk register 189
1 Introduction 189
2 Risk or event identification as defined within ERM 189
3 Risk identification process 189
4 Methods to identify risks 190
5 Documentation of risks 195
6 Access to risk registers 197
7 Summary 197
Topic 11: Risk assessment, the management of risk and risk reporting 199
Study unit 26: Assessment of inherent risk 201

1 Introduction 201
2 Assessment of risks as defined within ERM 201
3 Risk assessments with the likelihood and impact matrix 202
4 Summary 205
Study unit 27: Risk responses to manage risks and the assessment of residual risk 206
1 Introduction 206
2 Risk responses are included in the risk management strategy 206
3 Risk responses 206
4 Who is responsible for risk responses? 207
5 Assessment of the residual risk 209
6 Summary 211
Study unit 28: Risk monitoring and reporting 212

1 Introduction 212
2 Risk monitoring 212
3 Residual risk reporting 213
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INTRODUCTION
3.1 Risk reporting 213
3.2 What the IRM standard indicates that the board of directors should do 213
4 Summary 214
GLOSSARY 215
INTEREST FACTOR TABLES A TO D 227

Table A: Present value of R1 received/paid after n years 227
Table B: Present value of R1 per annum received/paid at the end of the
year for n years 228
Table C: Future value of R1 received now, after n years 229
Table D: Future value of R1 per annum received for n years at the end
of each year 230
vii .........................
INTRODUCTION
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INTRODUCTION
PART 3
Managing and investing funds
MAC2602
Principles of strategy, risk & financial management techniques
Study guide 1 Study guide 2
Part 1 Part 2 Part 3 Part 4

Strategy and Introduction
Managing and Risk management
strategic to financial
investing funds
planning management,
financing and the
cost of capital
Topic Topic Topic Topic

1 Development of 2 Introduction 6 Analysis 9 Risk theory and
the to financial of financial approaches
organisation’s management information to risk
strategy 3 Time value of 7 Analysing and management
money managing 10 Risk
4 Sources and working capital identification
forms of finance 8 Capital and
investments and documentation
5 Capital structure
and the cost of capital budgeting 11 Risk
capital techniques assessment, the
management
of risk and risk
reporting
1 .........................
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TOPIC 6
Analysis of financial information
LEARNING OUTCOMES
After studying this topic, you should be able to:

–– define and identify the sources and limitations of financial information
–– explain the objectives of financial analysis
–– calculate, analyse and interpret growth rates and different ratios

Introduction Managing and
Strategy and Risk management
to financial investing funds
strategic
management,
planning
financing and the
cost of capital
Topic Topic Topic 6 Topic
1 Development 2 Introduction 6 Analysis of financial 9 Risk theory and

of the to financial information approaches to
organisation’s management SU 15: Objectives and risk management
strategy 3 Time value of sources of financial 10 Risk
money analysis identification and
4 Sources and SU 16: Ratio analysis documentation
forms of finance 7 Analysing and managing 11 Risk assessment,
5 Capital structure working capital the management
and the cost of of risk and risk
8 Capital investments and
capital reporting
capital budgeting
techniques
3 .........................
INTRODUCTION
In this part of the guide we are teaching you how an organisation can manage its funds.
To assist in the effective management of these funds, it is necessary to have knowledge
about the organisation and its industry. Deeper knowledge will be gained by analysing
financial and other information about the organisation and its industry.
Benjamin Franklin, an American statesman, once said:

“An investment in knowledge pays the best interest.”
When it comes to investments, nothing will pay off more than educating yourself. Do the
necessary research, study and analyse before making any investment decisions, either in
your personal capacity and/or as the manager of an organisation’s funds.
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TOPIC 6
1 STUDY UNIT 15
1Objectives and sources of financial analysis
In this study unit
1 Introduction
In this unit, we will define, as well as identify, the objectives, users, sources and limitations
of financial information. We will also discuss the techniques used in performing financial
analysis.
2 The objectives of financial analysis

Analysis implies that financial information has to be examined or broken down in order
to be useful.
ANALYSE
To analyse is to examine in detail in order to discover meaning or to break down into

smaller parts.
The three main objectives of financial analysis are:
1. an evaluation of an organisation’s prospects for the future (to help external fund
providers with investment decisions)
2. to evaluate the performance of an organisation’s management as reflected in an
analysis of their historical financial information in the annual financial statements
3. for internal decision-making by management regarding investment of funds, cash
management, and so on
Financial analysis will therefore assist in managing long- and short-term funds as well as
guide decisions regarding distributions to the owners of an organisation. The management
of short-term funds will be discussed in topic 7 and long-term funds in topic 8.
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Study unit 15
3 The users of financial information and analysis
The purpose of financial reporting is to satisfy the information needs of the users of the
financial information. The financial reports are used for several purposes, including the
evaluation of the organisation’s financial performance, its current financial position and its
cash generation and utilisation. The users of the financial information are outlined below:
a. Capital providers and financial analysts

Capital providers include current and potential new providers of share capital in the
organisation and institutions which are or may lend money to the organisation. The equity
holders are concerned about the prospects for growth and the lenders are more concerned
about the organisation’s cash flows and solvability (total assets exceeds total liabilities).
Investors analyse the financial information themselves in order to base their investment
decisions on the outcome of such analysis, or make use of financial analysts to assist them. A
financial analyst analyses financial information to forecast business, industry and economic
conditions for use in making investment decisions. They then make recommendations
about the investment value, whether to “buy” or “sell” or “hold” the shares or whether the
debt is secure/safe (“hold”).
b. Creditors
Creditors provide products and services to an organisation on credit. They have to be paid
for the products and services and they are therefore concerned about the organisation’s
cash flows and liquidity (ability to meet short-term obligations).
c. Management
The organisations’ own management includes the board of directors and managers of
departments. The financial analysis can show their successes/strengths and failures/
weaknesses in running the business operations. They can use the analysis to correct
mistakes and improve performance. The analysis assists them in managing the long- and
short-term funds as well as decisions regarding the income distribution of the organisation.
d. Other users
Other users include employees, auditors and the South African Revenue Service (SARS).
Employees are concerned about profits earned by the organisation and how this is
distributed; the ability of the organisation to pay their salaries; annual salary increases;
and payments made to managers. Employee unions analyse the information on behalf of
their members and use it in negotiations with management.
Financial analysis and interpretation will enable auditors to be in a better position to express
an opinion regarding the fairness of the figures in the financial statements. The analysis
would also indicate if the organisation is solvent and liquid, which will have an effect on
the presentation and disclosure of the financial statements.
SARS uses the financial information to verify the income taxation received from the
organisations.
4 Sources of information regarding an organisation

Information regarding an organisation can be grouped into two main categories, namely
financial information and strategic information. We will investigate both in more detail now.
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TOPIC 6
4.1 Financial information
FINANCIAL INFORMATION
Financial information refers to the financial results, position and cash flows of an
organisation’s business operations in a specific period, stated in rand and cent terms.
The main source of historical financial information about an organisation is its annual
report. With a listed company, the financial statements are part of an organisation’s
annual report which provides information to the public about the organisation’s operations,
objectives and other relevant information.
You would know from your Financial Accounting modules that the financial statements
consist of a statement of profit or loss and other comprehensive income, a statement of
financial position, a statement of cash flows, a statement of changes in equity and notes
to the financial statements. The directors’ report and auditors’ report also form part of the
financial statements. This is mailed to all registered shareholders and is also available
from the organisation’s website.
As previously mentioned, the annual report of an organisation is the main source of financial
information and therefore the financial analysis will be based on the information therein. The
annual report contains at least the mandatory annual financial statements, but usually also
provides a lot of feedback from the operations of an organisation. The first section contains
the voluntary information. This section normally gives descriptive information about the
organisation’s operating results, a summary of the performances and new developments
that may impact future performances. There is normally a letter from the chief executive
officer or chairman and the executive director of each of the business units, as well as the
finance and human resource directors. The second section consists of the annual financial
statements. This section contains the information prescribed by statute and GAAP. The
detail will be discussed in your Financial Accounting modules.
Financial information about organisations is also published in newspapers and financial

journals like Businessweek, et cetera. Organisations are also increasingly publishing
voluntary financial information, for example, results presentations to analysts and other
forward-looking financial information, on their websites.
Ac t ivi t y 15.1
Access the following website of a company, Exxaro Ltd: www.exxaro.com.
Exxaro is a South African-based mining group, listed on the JSE. Assume
you are a potential investor. Can you identify the main source of financial
information on the website? List briefly the types of financial information you
could find there.
1 Fe edback on ac t ivi t y 15.1

If you enter the website of Exxaro Ltd., you will find the home page. You will
notice a heading/tab called “Investors/Annual report archive” or “Publications”.
The annual report of the different years can be viewed there, which is the main
source of the organisation’s historical financial information.
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Study unit 15
Other information that you will also find at the page called “Investors” is:
zz Notice of the general meetings
zz Financial archive
zz Share data
zz Financial calendar
zz Analyst and broker information
zz Shareholders’ analysis
4.2 Strategic (non-financial) information

It is important to note that “information” should include not only the financial information,
but other strategic information about an organisation and its industry as well.
The strategic information about an organisation tells us how the business of the organisation
is managed and what its long-term goals are. Disclosing this information is part of good
corporate governance, which is guided by the King III Report and Code. It is intended that
the King III Report should apply to all organisations. Refer to study unit 5, section 5 on
corporate governance and sustainability.
Strategic information may include the following:

zz the type of industry
zz type of products or services
zz the future prospects of the organisation
zz market share of an organisation
zz if the organisation has a major competitor (now or in the future)
zz whether or not the organisation has a significant customer, single supplier
zz legal and regulatory environment
Conditions wherein the organisation operates can either have a positive or negative
effect on the organisation. These possible effects are discussed in your strategy and risk
management topics.
Potential investors, for example, will have to also take account of such strategic information
as part of their evaluation, before deciding on whether an organisation is a good investment
option or not.
Strategic (non-financial) information can be found …

zz in the voluntary section of the annual report.
zz on the organisation’s website (presentations to analysts, about us, etc).
zz articles in financial journals and/or industry journals, such as SA Mining.
Activity 15.2
Use the same website as in Activity 15.1: www.exxaro.com. Exxaro is a South
African-based mining group, listed on JSE. Can you find and list strategic
information which may affect the organisation?
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TOPIC 6
2 Feedback on activity 15.2
If you enter the website of Exxaro Ltd., you will find the home page. You will
notice a heading called “Publications”. In the annual report, you can find the
following strategic information:
zz The type of industry – Exxaro is a mining company. [Home page]
zz Type of products or services – “Exxaro is a diverse resources group with
a portfolio of coal, mineral sands and base metals assets as well as a
significant indirect interest in iron ore.” [Home page]
zz The future prospects of the organisation – The new projects are listed on
the web page and from that we can see that the future prospects of Exxaro
is strong and positive. [Year under review/Growth]
zz If the organisation has a competitor (now or in the future) – This will not
necessarily be published on the website. Information on this can be obtained
from industry reports, management or minutes of the meetings of the board
of directors.
zz Does the organisation have a significant customer, single supplier? – This
is part of the risk management of the company where the sustainability of
the operations are discussed and rated. [Sustainability/Risk management]
zz Legal and regulatory environment – This information can be found under
the Governance section of the annual report. [Annual Report / Governance
review]
5 The major limitations of financial information

a. The financial information is the responsibility of the directors as stated in the directors’
report. It is reviewed by independent auditors who then state their opinion regarding
the fairness of the financial performance, position and cash flows in the financial
statements. The audit does not guarantee the total accuracy, but only give a fair level
of assurance that the figures presented are in accordance with International Financial
Reporting Standards (IFRS) in the case of a listed company. We can therefore never
assume that the financial information is 100% accurate.
b. Another limitation of the financial statements is that they are, to an extent, subjective
and reflective of the judgement of the accountants who prepared it. Although the IFRS
helps to align the accounting policies of an organisation, there are still certain industry-
specific transactions that may have an effect on the way the financial information is
accounted for, or technical errors may occur.
c. In some instances, financial statements still reflect information on a historical cost basis,
and thus do not include the effect of inflation or changes in, for example, an asset’s
value. The result is that true fair market values are often not reflected for non-financial
instruments in the statement of financial position. For example, in South Africa, the
inflation rate has been high for a number of years until recently, which may result in the
carrying value of certain assets not being reflective of their fair market value.
d. Financial statements represent past results which will not necessarily predict what the
future results will be. The annual report also has a tendency not to reflect all the failures
and mistakes and can exaggerate achievements of management. Future market trends
like: new competitors, smaller markets or substitute products, economic conditions like
foreign exchange factors and future management are all factors not included in the
historical financial information provided in the financial statements. However, information
9 .........................
Study unit 15
about this might be presented in the operational reviews presented in the first part of
a typical annual report, or in the Investor Relations pages on the website.
e. There is limited guidance on forward-looking information of an organisation.
Organisations can be sued if they don’t achieve specific targets. See the disclaimer
on the website of Exxaro:
Disclaimer of Exxaro:
Warranties
1. Exxaro does not give any warranty or representation; express or implied, relating
to information contained on this website or on any other website linked to this
website or the accuracy of such information.
2. Exxaro does not warrant that this website or any website to which this website
is linked or the content thereof is error free.
3. Exxaro does not give any warranty or representation, other than any warranty
or representation that has been expressly set out in these terms and conditions.
Forward-looking information
This report includes certain information that is based on management’s reason-
able expectations and assumptions. These forward-looking statements include,
but are not limited to, statements regarding estimates, intentions and beliefs, as
well as anticipated future productions, reserves, costs and market conditions.
While management has prepared this information using the best of their experi-
ence and judgement, in all good faith, there are risks and uncertainties involved
which could cause results to differ from projections.
6 Techniques used in performing financial analysis

We have already explained that “to analyse” means to examine in detail in order to discover
meaning or to break down into smaller parts in order to make information useful.
Note
In this topic we will focus on the analysis of financial information. If strategic or non-financial
information is provided in the question, you should use it to give context to the financial
analysis. For example, turnover decreased by 25% because a new competitor entered
the market or because of cheap imports.
Various techniques can be used for the analysis of financial information in order to arrive
at a conclusion about the organisation. The information will always be compared with the
previous years’ results or industry/similar organisation averages. This comparison gives
more meaning to the information.
Below is figure 15.1 that illustrates the different techniques in performing financial analysis
on historical financial information.
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TOPIC 6
Source: Author, 2012
FIGURE 15.1: Different techniques for performing financial analysis on historical
financial information
In the case of the three techniques in the top part of figure 15.1, namely, comparative
financial statements, common size statements and indexed financial statements,
the financial statements have to be redrafted (redoing the financial statements in a different
format) to prepare the information for analysis.
a. Comparative financial statements offer the statements in a table format for a required
period of time, for example, five or ten years. The trend over the years can then be
calculated and analysed.
b. Indexed financial statements are redrafted on an indexed basis in order to overcome
some of the limitations of the comparative financial statements. The same table format is
used, but the first year is shown as the base year (set equal to 100) and the subsequent
years and figures are shown as percentages of that year. This gives the reader a good
overview of the growth or decline from the base year to a certain date. This can also
be presented in a graph.
c. Common size statements are redrafted to normalise financial statements whereby each
item on the statements are stated as a percentage of the total of the specific section.
For example, in the statement of financial position, current and non-current assets will
be stated as a percentage of the total assets; in the statement of profit or loss and
other comprehensive income, the figures will be stated as a percentage of revenue.
11 .........................
Study unit 15
Activity 15.3
You are given the following comparative statement of profit or loss and
other comprehensive income of World Cup Ltd for five years:
20x5 20x4 20x3 20x2 20x1

R’000 R’000 R’000 R’000 R’000
Revenue 3 640 2 552 1 506 2 054 1 569
Cost of sales (1 503) (998) (525) (553) (402)
Gross profit 2 137 1 554 981 1 501 1 167
Operating costs (778) (650) (445) (506) (150)
Distribution costs (258) (203) (145) (123) (53)
Administrative expenses (15) (13) (11) (14) (9)
Other expenses (3) (36) (32) (22) (26)
Net operating profit /(loss) 1 083 652 348 836 929
Interest and other income 39 36 25 19 22
Earnings before interest and 1 122 688 373 855 951
tax (EBIT)
Interest expense (106) (102) (54) (86) (93)
Profit before tax 1 016 586 319 769 858
Income tax expense (284) (164) (89) (215) (240)
Net profit 732 422 230 554 618
REQUIRED
Redraft the comparative statement of profit or loss and other comprehensive
income of World Cup Ltd by using the following techniques:
a. indexed statements
b. common size statements
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TOPIC 6
a. Indexed statements
20x5 20x4 20x3 20x2 20x1
% % % % %
Revenue 232 163 96 131 100
Cost of sales 374 248 131 138 100
Gross profit 183 133 84 129 100
Operating costs 519 433 297 337 100
Distribution costs 487 383 274 232 100
Administrative expenses 167 144 122 156 100
Other expenses 12 138 123 85 100
Net operating profit /(loss) 117 70 37 90 100
Interest and other income 177 164 114 86 100
Earnings before interest and 118 72 39 90 100
tax
Interest expense 114 110 58 92 100
Profit before tax 118 68 37 90 100
Income tax expense 118 68 37 90 100
Net profit 118 68 37 90 100
b. Common size statements

20x5 20x4 20x3 20x2 20x1
% % % % %
Revenue 100,0 100,0 100,0 100,0 100,0
Cost of sales 41,3 39,1 34,9 26,9 25,6
Gross profit 58,7 60,9 65,1 73,1 74,4
Operating costs 21,4 25,5 29,5 24,6 9,6
Distribution costs 7,1 8,0 9,6 6,0 3,4
Administrative expenses 0,4 0,5 0,7 0,7 0,6
Other expenses 0,1 1,4 2,1 1,1 1,7
Net operating profit /(loss) 29,8 25,5 23,1 40,7 59,2
Interest and other income 1,1 1,4 1,7 0,9 1,4
Earnings before interest and 30,8 27,0 24,8 41,6 60,6
tax
Interest expense 2,9 4,0 3,6 4,2 5,9
Profit before tax 27,9 23,0 21,2 37,4 54,7
Income tax expense 7,8 6,4 5,9 10,5 15,3
Net profit 20,1 16,5 15,3 27,0 39,4
Note
Can you see from the common size statements that the gross profit % declined from 74,4%
(20x1) to 58,7% (20x5) and the net operating profit % almost halved from 59,2% (20x1) to
29,8% (20x5)? This is confirmed by viewing the indexed statements: cost of sales, operating
costs and distribution costs reflect an unusually high increase from the base year (20x1).
13 .........................
Study unit 15
Indicated in the bottom left part of figure 15.1 is failure prediction, which is a technique,
used to predict the possibility of failure of an organisation – in advance. This will assist
management to take precautionary steps to prevent such a failure.
Indicated in the bottom right part of figure 15.1 is trend analysis, which is a technique that
is used to determine the trends in financial results of an organisation. This technique is
used after other techniques, for example, the comparative financial statements, common
size statements or indexed financial statements have been applied. The trend of the figures
in these statements is determined in order to identify whether the organisation is heading
in the right direction or not.
There will be more detailed discussions on these two techniques in your later MAC modules.
Indicated in the bottom part of figure 15.1 is ratio analysis, which is a very important
technique as it is the most informative one. It gives essential information to the analysts
about almost all the aspects of an organisation. We will discuss ratio analysis in more
detail in the next study unit.
7 Summary
In this study unit, we have discussed the objectives of financial analysis. The users
of financial information and analysis were listed and we have indicated how they will
use the financial analysis to their benefit. We have also discussed the main source of
financial information which is the annual report. We have also listed and discussed the
major limitations of financial information. We presented a broad overview of the different
techniques to be used in financial analysis.
The technique that we will be focusing on is ratio analysis which will be discussed in detail
in the next study unit.
Self-assessment activity
After having worked through the study unit, you should be able to answer the following
questions:
a. What are the purposes or objectives of financial analysis?
b. Define financial information.
c. What is the main source of financial information?
d. What are the limitations of financial information provided by the organisation?
e. Name the users of financial analysis and how they will use the information for their benefit.
f. Name the different techniques that can be applied in financial analysis.
g. Describe briefly how each technique is used in performing financial analysis.
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TOPIC 6
2 STUDY UNIT 16
2Ratio analysis
In this study unit
1 Introduction
In the previous study unit, we discussed the objectives and sources of financial information
and analysis. In this study unit, we will be focusing on the calculation, analysis and
interpretation of growth percentages and ratios.
We will illustrate calculations of growth percentages as well as different ratios. These

calculations, in turn, will be analysed and interpreted in order to increase our understanding
of, amongst other things, the organisations operations and how to manage the long- and
short-term funds of the organisation.
2 Financial information provided

We will now illustrate how to perform calculations, analysis and interpretation of some key
ratios. The statement of profit or loss and other comprehensive income and statement of
financial position of Anco Limited, presented below, will be used as the source of information
throughout this study unit.
15 .........................
Study unit 16
Anco Limited (or Anco Ltd)
Statement of profit or loss and other comprehensive income for the period ended
31 December 20x2
20x2 20x1
R’000 R’000
Revenue 6 633 5 960
Cost of sales (3 655) (3 125)
Gross profit 2 978 2 835
Operating costs (1 506) (1 206)
Distribution costs (650) (539)
Administrative expenses (205) (246)
Other expenses (156) (78)
Net operating profit /(loss) 461 766
Interest and other income 55 36
Earnings before interest and tax (EBIT) 516 802
Interest expense (335) (265)
Profit before tax 181 537
Income tax expense (54) (161)
Net profit # 127 376
Without minority interest, this is also equal to earnings attributable to shareholders in

#
this case study.
........................ 16
TOPIC 6
Statement of financial position as at 31 December 20x2
20x2 20x1
R’000 R’000
ASSETS
Non-current assets
Property, plant and equipment 7 254 6 652
Other investments 655 569
Total non-current assets 7 909 7 221
Current assets
Inventories 290 303
Trade and other receivables 250 222
Cash and cash equivalents 354 156
Total current assets 894 681
TOTAL ASSETS 8 803 7 902
EQUITY AND LIABILITIES

Capital and reserves
Share capital 1 000 1 000
Retained earnings 1 646 1 519
Total equity 2 646 2 519
Non-current liabilities
Interest-bearing borrowings 5 220 4 770
Deferred tax 332 299
Total non-current liabilities 5 552 5 069
Current liabilities
Trade and other payables 365 245
Current tax payable 89 48
Current provisions 151 21
Total current liabilities 605 314
TOTAL EQUITY AND LIABILITIES 8 803 7 902
The following additional information applies:

zz Anco Ltd has 5 million authorised shares. They have issued 1 000 000 shares.
zz Assume that 100% of ordinary shares were recently valued at R3 million (20x1: R2,8
million) and that the market value of all liabilities equals the carrying value for both
years.
zz The market value of each share after the release of these audited annual financial
statements was 300 centsa (20x1: 280 centsa)
zz The dividend per share is 6 centsa (20x1: 5 centsa)
zz The opening balance of inventory for 20x1 was R79 000.
17 .........................
Study unit 16
zz The opening balance of capital and reserves for 20x1 was R2 350 000 and for total
assets it was R7 530 000.
zz The amount of sales on credit is 60% of revenue for both years.
zz Actual purchases made by Anco Limited on credit were R3 642 000 (20x2) and
R3 349 000 (20x1).
zz Value added tax (VAT) is calculated at a rate of 14%.
a
Note that in the normal practice of the financial markets, share prices and figures such as dividend
per share are expressed in cents, not rands.
Note
For the simplification of calculations below, the thousands in the figures were not shown.
3 Growth ratios
GROWTH RATE
Growth rate simply refers to the percentage that a line item in an organisation’s financial
information has increased or decreased from one period/year to another.
The growth rate provides an indication of the success of the organisation’s operations
over a number of periods or years. The method of calculating the growth rate is, for this
example, as follows:
Key formula: GROWTH RATE
Year 20x2 – Year 20x1

x 100
Year 20x1
Note
1. The annual growth rate is calculated relative to the earlier period/year (in this case
the year 20x1, which is used as the denominator – to be written below the line in the
calculation).
2. Growth rates can also be used to index figures by keeping the denominator constant
and equal to the base year for all the years covered in the table. You had practice
doing that with the indexed statements.
When there is an increase or decrease in the growth rate, further comparison and
investigation should be done in order for the result to be sensible. It can also be read in
conjunction with other ratios analysed, which may help clarify the results, for example,
borrowings increased, leading to positive growth in the interest expense.
Growth rates can be calculated on figures in the statement of profit or loss and
other comprehensive income as well as the statement of financial position and statement
of cash flows.
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TOPIC 6
Ac t ivi t y 16.1
Calculate the growth rate for Anco Ltd for the year ended 31 December 20x2
in the following line items:
a. revenue
b. cost of sales
c. operating costs
d. interest expense
e. profit for the year
f. property, plant and equipment
g. inventory

Growth rate calculations:
a. Revenue
Year 20x2 – Year 20x1 673

x 100 = x 100
Year 20x1 5 960
= 11,29% growth (increase)
Revenue has increased with 11,29% from Year 20x1 to Year 20x2.
b. Cost of sales

x 100 = x 100
Year 20x1 3 125
Cost of sales has increased with 16,96% from Year 20x1 to Year 20x2.
c. Operating costs

x 100 = x 100
Year 20x1 1 206
Operating costs has increased with 24,88% from Year 20x1 to Year 20x2.
d. Interest expense

x 100 = x 100
Year 20x1 265
Interest expense has increased with 26,42% from Year 20x1 to Year 20x2.
19 .........................
Study unit 16
e. Profit for the year (net profit)
Year 20x2 – Year 20x1 (249)

x 100 = x 100
Year 20x1 376
= 66,22% decline (decrease)
Basic interpretation:
Profit for the year decreased by 66,22% from Year 20x1 to Year 20x2. Although
revenue increased, the expenses increased by a higher percentage, resulting
in the decline in the profit.
f. Property, plant and equipment

x 100 = x 100
Year 20x1 6 652
Property, plant and equipment have increased with 9,05% from Year 20x1 to
Year 20x2.
g. Inventory
Year 20x2 – Year 20x1 (13)

x 100 = x 100
Year 20x1 303
= -4,29% decline (decrease)
Inventory has decreased with 4,29% from Year 20x1 to Year 20x2.
Note
When answering growth and ratio analysis questions where you have to comment and
interpret the answer, you will NOT earn marks for merely stating, for example, cost of
sales increased by 11%. You should bring ratios in context with one another and with the
background information provided in the question.
4 Ratio analysis
Ratio analysis is a financial analysis technique and designed to assist in the evaluation of an
organisation’s financial results and the starting point for successful financial management.
RATIO ANALYSIS
Ratio analysis is a method whereby further calculations are performed on a set of
financial statements and is intended to create more meaningful information. Ratio
analysis can be made even more useful when we compare the calculated ratios to the
same ratios calculated for previous years or to industry norms and other ratios of the
same set.
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TOPIC 6
We have grouped the ratios in the following four classifications:
1. Profitability and performance
Profit is an important measure of an organisation’s success. Within a certain time-
horizon an organisation has to be profitable to both survive and to ensure continued
support and funding from equity and debt providers. Profitability ratios only measure the
organisation’s success in generating profits. To enable us to make informed decisions
and judgements, we need to also relate the profits to other financial information, for
example, inflation or the exchange rate. Performance ratios and calculations also
indicate if sufficient returns were generated.
2. Liquidity
Liquidity ratios measure the organisation’s ability to meet short-term financial
obligations. Lenders and suppliers who provide products and services on credit are
concerned about these ratios. It also provides an indication of the efficiency in which
an organisation’s current assets are managed.
3. Solvency and financial/capital structure

Solvency and financial/capital structure ratios measure the organisation’s financial
health. Here we can ask for example: Is the organisation able to pay its debts, or is
it in financial distress? Are the organisation’s assets sufficient to cover its liabilities?
Is the balance between debt and equity in an organisation’s capital structure proper
given its specific business environment and industry? Too much debt will increase
the organisation’s cost of funding.
4. Financial market
The aforementioned categories of ratios largely relate to the internal management
of an organisation and are more under the control of management. In contrast, the
financial market is not controllable by management and is normally of specific interest
to investors. The ratios and calculations that fall under this category can also be used
by management to assist them in making dividend decisions, which will be discussed
in your later MAC modules. It is also used in calculating the cost of different classes
of funding, and used in valuations. You will learn about this in your third-year MAC
module, MAC3702.
The answers to your ratio calculations can be classified as:

a. percentages (normally where calculating margins, growth, or changes in figures);
b. cover ratios (normally expressed as the “number of times”, for example, “revenue
covers (exceeds) total assets 2 times”), or
c. proportional ratios (normally where something is expressed relative to something
else, for example debt to equity or “the asset turnover equals 2:1” (but, importantly, the
latter figure represents the “1” – we therefore do not use 1:0,5 for example)).
Further notice that the formulae below represent general formulae and that, in some
cases, alternative and additional formulae are available. We recommend that you follow
the formulae in this guide, but also recommend that you always show the formula used in
your calculation, where appropriate.
Activity 16.2 (Enrichment activity)

Access Aspen Holdings’ website at www.aspenpharma.com and open the
2011 Annual Report. Page to the “Ten Year Review” and the “Definitions and
Formulas”.
21 .........................
Study unit 16
Did you notice the slight variations from the general ratio definitions?
Figure 16.1 show the important margins and ratios that belong to the categories of profitability,
liquidity, solvency and financial market.
Solvency and
Profitability and
Liquidity financial/capital Financial market
performance
structure
zz Grossprofit zz Current ratio zz Interest cover zz Earnings per
margin zz Liquid asset ratio share
zz Operating profit ratio (or acid zz Debt to equity zz Dividend payout
margin test or quick ratio ratio
zz Net profit margin ratio) zz Debtratio (or zz Dividend cover
zz Return of equity zz Receivable gearing) ratio
(ROE) days (debtors’ zz Totalassets to zz Price earnings
collection total debt ratio ratio
zz Return on assets
period)
(ROA) zz Financial zz Earnings yield
zz Payable days leverage
zz Asset turnover zz Dividend yield
(creditors’ ROE:ROA
payment period)
zz Inventory days
zz Inventory
turnover ratio
(times)
zz Cash
conversion
cycle – days
zz Cash ratio

FIGURE 16.1: Categories and common ratios
5 Measuring profitability and performance

5.1 Profit margins
There are three types of profit margins namely, the gross profit, operating profit and the net
profit margin.
Key formula: GROSS PROFIT MARGIN

Gross profit
x 100
Revenue
Where Gross profit = Revenue – Cost of sales
The gross profit margin is calculated by stating gross profit as a percentage of revenue for
the period. The gross profit margin shows the proportion of sales that is available to cover
other expenses and to earn a profit, after accounting for cost of goods sold. For certain
stable industries, this percentage will normally be fairly constant from one year to the next
(stable industries may create stable conditions, justifying stable mark-ups).
........................ 22
TOPIC 6
Changes in these percentages should be traced back to factors that have an effect on gross
profit, for example, trade discounts, mark-ups, purchasing details (like bulk discounts or
theft), inventory levels, inventory valuation policies, and changes in the scale of operations.
Changes in mark-up percentages may affect revenue and the gross profit of the organisation.
An increase in the mark-up will increase the profit earned on each item sold, due to the
higher selling price of each item, but the higher prices may discourage customers, which
may then result in lower total sales and lower total net profit. You will learn more about
setting of selling prices in MAC2601 and later modules.
The gross profit (GP) margin is calculated for Anco Ltd:
20x2 20x1
Gross profit 2 978 2 835
x 100 = x 100 = x 100
Revenue 6 633 5 960
= 44,90% = 47,57%
zz The gross profit margin has decreased from 47,57% in 20x1 to 44,90% in 20x2.
zz The change in gross profit margin is relatively small (depending on industry) indicating
that mark-up has not changed significantly.
zz This reduction is slightly disconcerting, however, as it took place in spite of a likely
increase in the scale of operations of the organisation. (We can assume that the scale
of operations increased as the revenue grew by 11,29% during this time – this growth
percentage probably exceeds the inflation rate during the same period; if revenue
growth equals the inflation rate over a period then there is effectively no real growth.)
When the scale of operations increase, we might expect savings due to efficiencies
of scale (fixed costs spread over more products). This would result in improved gross
profits. See cost-volume-profit analysis in MAC2601.
zz A lower gross profit margin might be the result of a number of factors, including cost of
sales inflated (eg where inventory is obsolete or unpopular) and old or stolen inventory.
Key formula: OPERATING PROFIT MARGIN

Operating profit
x 100
Revenue
Where operating profit = profit after accounting for operating expenditure, but before
finance cost, tax and investment income. The latter items are excluded as it does not form
part of the operating activities of an organisation.
The operating profit margin is the operating profit expressed as a percentage of revenue.
Changes in this percentage can be ascribed to the change in the gross profit margin or
the changes in the operating costs, for example, administrative, distribution and other
operating expenses.
The operating profit margin is calculated for Anco Ltd:
20x2 20x1
Operating profit 461 766
x 100 = x 100 = x 100
Revenue 6 633 5 960
= 6,95% = 12,85%
23 .........................
Study unit 16
zz The operating profit margin has decreased from 12,85% in 20x1 to 6,95% in 20x2.
zz This is attributable to the decrease in the GP margin and the increase in the overall
operating costs, in particular, operating cost, distribution cost and other expenses.
There was a slight saving in administrative expenses that had a small positive effect.
zz As a management accountant, you would analyse the growth rates of these expenses
in detail.
Key formula: NET PROFIT MARGIN

Net profit
x 100
Revenue
Where net profit = profit after accounting for finance cost, tax and investment income,
or the final “bottom line”.
The net profit margin expresses the relationship between net profit and revenue and
gives an indication of the overall profitability of an organisation. It also gives insight into
management’s overall performance.
The net profit (NP) margin is calculated for Anco Ltd:
20x2 20x1
Net profit 127 376
x 100 = x 100 = x 100
Revenue 6 633 5 960
= 1,91% = 6,31%
zz The net profit margin has decreased from 6,31% in 20x1 to 1,91% in 20x2.
zz This is attributable to the decrease in GP margin, and the increase in overall operating
costs and interest expense.
zz The slight increase in interest and other income had a small positive effect.
5.2 Performance ratios

There are three types of performance ratios namely, return on equity, return on assets
and asset turnover.
Return on equity (ROE) is a measure of the performance realised by management for the
equity holders (shareholders) and expresses net profit as a percentage of equity. In this
module, we will only be focusing on ordinary shareholders. The effect of minority interests
will be covered in MAC3702.
Key formula: RETURN ON EQUITY (ROE)

Net profit
x 100
Equity
Note
ROE measures the organisation’s ability to earn a return on the owners’/shareholders’

capital. In order to calculate a meaningful return, we seek a relationship between the figure
........................ 24
TOPIC 6
used as the numerator (above the line) and the figure on which the return is calculated – the
denominator (used below the line). Firstly, you should realise that equity holders receive
their reward last; after all other expenses have been paid, including the interest paid to
the providers of debt capital. It is therefore appropriate to use net profit as the numerator
in this calculation (above the line) as it represents the remaining amount, after all other
expenses have been paid; and furthermore, net profit is normally available for distribution
as a dividend to the holders of equity. (The exact proportion paid out as a dividend and
other considerations are discussed in your later MAC modules.)
The ROE is calculated for Anco Ltd:
20x2 20x1
Net profit 127 376
x 100 = x 100 = x 100
Equity 1 646 2 519
= 4,80% = 14,93%
zz The ROE has decreased from 14,93% in 20x1 to 4,80% in 20x2.

zz The reason for the decrease is to be found in the significant decrease in the net profit
and a slight increase in the carrying value of equity.
To overcome movements in equity in the year, this return is sometimes also calculated
based on opening balances of capital and reserves or on the average of the opening and
closing balances.
Based on the opening balance basis, the ROE is now calculated as follows:
20x2 20x1
Net profit 127 376
x 100 = x 100 = x 100
Equity 2 519 2 350
= 5,04% = 16,00%

See additional information provided.
Based on the average basis, the ROE is now calculated as follows:
20x2 20x1
Net profit 127 376
x 100 = x 100 = x 100
Equity 2 583 2 435
= 4,92% = 15,44%

(2 646 + 2 519) ÷ 2 = 2 583

(2 519 + 2 350) ÷ 2 = 2 435
zz The ROE based on the averages are normally more accurate, as it assumes that the
movements in equity were spread during the year.
25 .........................
Study unit 16
zz The ROE calculation based on the market value of Anco Ltd:
20x2 20x1
Net profit = 127 376
x 100 x 100 = x 100
Equity 3 000 2 800
= 4,22% = 13,43%
zz Based on the market value of the equity, the ROE has decreased from 13,43% in 20x1
to 4,22% in 20x2.
zz The ROE based on market values are less than based on book values.
zz The market values give a better indication of the true ROE.
Return on total assets (ROA) is a measure of the performance generated on all the
assets employed in the business and expresses EBIT as a percentage of the total assets
employed.
Key formula: RETURN ON TOTAL ASSETS (ROA)

EBIT
x 100
Total assets
Note
In calculating this return, we once again seek a relationship between the figure used
as the numerator (above the line) and the figure on which the return is calculated – the
denominator (used below the line). The appropriate return generated on total assets, to be
used as the numerator (above the line), is EBIT as this figure includes the operating profit,
and interest and other income earned by the total assets. Recall that total assets consist of
non-current assets (property, plant and equipment) and current assets (inventories, trade
and other receivables, other investments as well as cash and cash equivalents).
Capital-intensive businesses, such as airlines and companies involved in heavy industry,

will normally display a low ROA as a great investment in assets is required in order for these
businesses to generate a return. Against this, organisations requiring a low investment in
assets, such as service organisations, generally display a higher ROA. For this reason,
ROA is normally only comparable between organisations in similar industries.
The ROA is calculated for Anco Ltd:
20x2 20x1
EBIT 516 802
x 100 = x 100 = x 100
Total assets 8 803 7 902
= 5,86% = 10,15%
zz The ROA has decreased from 10,15% in 20x1 to 5,86% in 20x2.

zz The reason for the decrease is that the EBIT decreased and total assets increased.
........................ 26
TOPIC 6
zz This implies that the organisation bought new assets, but generated an overall lower
return on the new total assets.
zz This poor performance may be caused by a lack of skills in managing the new assets
or the timing of the investment, for example, if invested close to the year-end, it would
not have had time yet to deliver a return.
To overcome movements in assets during the year, this return is sometimes also calculated
based on opening balances of total assets or on the average of the opening and closing
balances.
Based on the opening balance basis, the ROA is now calculated as follows:
20x2 20x1
EBIT = 516 802
x 100 x 100 = x 100
Total assets 7 902 7 530
= 6,53% = 10,65%

See additional information provided.
Based on the average basis, the ROA is now calculated as follows:
20x2 20x1
EBIT 516 802
x 100 = x 100 = x 100
Total assets 8 353 
7 716
= 6,18% = 10,39%

(8 803 + 7 902) ; 2 = 8 353

(7 902 + 7 530) ; 2 = 7 716
zz The ROA based on the averages are normally more accurate, as it assumes that the
movements in assets were spread during the year.
The ROA calculation based on the market value of Anco Ltd:
20x2 20x1
EBIT 516 802
x 100 = x 100 = x 100
Total assets 9 157 8 183
= 5,64% = 9,80%

3 000 + 5 552 + 605 = 9 157

2 800 + 5 069 + 314 = 8 183
zz Based on the market value of the equity, the ROA has decreased from 9,80% in 20x1
to 5,64% in 20x2.
zz The ROA based on market values are less than the return based on carrying values.
zz The market values give a better indication of the true ROA.
27 .........................
Study unit 16
Note
As total assets = total equity and liabilities, we can also use the “other side” of the statement
of financial position to calculate the market value of total assets. We just substitute the
accounting carrying value of equity with the market value of equity.
Return on operating assets and other assets can also be calculated by using a return
attributable to the specific asset as the numerator (above the line) and the value of the
specific asset as the denominator (below the line). This will be dealt with on third-year level.
DU PONT RATIO
Du Pont ratio is a method that breaks down the return on total asset ratio (ROA) into
two components – a profit margin and an asset turnover rate.
The return on total asset ratio (ROA) broken down into the two components (Du Pont ratio)
is done by merely incorporating revenue as both a numerator and denominator, as follows:
Key formula: DU PONT RATIO
EBIT Revenue EBIT

x =
Revenue Assets Assets
Asset turnover is normally expressed as a simple ratio (number of times) and not as a
percentage. It shows how much revenue is generated per rand invested in total assets. An
organisation that generates more revenue with a given number of assets is more efficient
in this regard (this is also industry dependent).
Note
The impact of depreciation: Non-current assets that are old and have a low book value
will generate a higher asset turnover than an organisation with newer assets, even if they
are in the same industry.
Key formula: ASSET TURNOVER

Revenue
x 100
Total assets
The asset turnover is calculated for Anco Ltd:
20x2 20x1
Revenue 6 633 5 960
= =
= 0,75 times = 0,75 times
zz The asset turnover remained constant at 0,75 times for both 20x1 and 20x2.
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TOPIC 6
zz This implies that the organisation is generating the same revenue given the total asset
investment.
zz This can also be compared with industry averages. If this ratio is below industry
averages, ways and means should be sought to make more efficient use of assets:
Revenue should be increased, or unproductive assets should be sold, or a combination
of these two.
The different profit margins were illustrated in the beginning of section 5. The profit
margin that we use in the Du Pont ratio, is the earnings before interest and tax (EBIT)
divided by revenue.
Key formula: EBIT PROFIT MARGIN

EBIT
x 100
Revenue
The EBIT profit margin is calculated for Anco Ltd:
20x2 20x1
EBIT 516 802
x 100 = =
Revenue 6 633 5 960
= 7,78% = 13,46%
zz The EBIT profit margin decreased from 13,46% in 20x1 to 7,78% in 20x2.
zz This is attributable to the decrease in the GP margin and the increase in the overall
operating costs, in particular, operating cost, distribution cost and other expenses.
There was a slight saving in administrative expenses that had a small positive effect.
Therefore: ROA =
20x2 20x1
EBIT Revenue EBIT
x = = 0,75 x 7,78% = 0,75 x 13,46%
Revenue Assets Assets
= 5,84% = 10,10%
zz The ROA has decreased from 10,10% in 20x1 to 5,84% in 20x2.

zz Compare this with the first ROA calculation above. Can you see the answer is the
same? (The rounding to 2 decimals creates a small difference!)
6 Measuring liquidity – short-term funds

A business organisation’s liquidity is very important to its operations. These ratios indicate
the ability of the organisation to generate and conserve cash from its working capital.
(Working capital refers to the current assets and current liabilities, which is directly related
to the operating activities of an organisation. It will be discussed in detail in topic 7.) We
discuss these ratios separately below, each under a separate heading.
29 .........................
Study unit 16
6.1 Current ratio
This is the primary measure of an organisation’s liquidity. This ratio is best viewed within
the context of a particular industry. However, for most types of businesses, current assets
should be more than current liabilities to ensure liquidity, which means that the ratio should
exceed 1, but a ratio that is too high can indicate one of the following conditions: Current
assets might be overstated (valued too high), current assets are not converted into cash
fast enough, or too much money is tied up in non-productive current assets. For many
organisations, the current ratio remains close to 2:1, but this can differ significantly per
industry. For example, due to its particular trade environment, food retailers and wholesalers
often have a current ratio below 1:1, which is the result of buying most/all of its inventory
(normally its largest current asset) on credit, but selling most goods on a cash-basis. Notice
that this ratio is stated as a number, not as a percentage.
Key formula: CURRENT RATIO

Current assets:Current liabilities
The current ratio is calculated for Anco Ltd:
20x2 20x1
Current assets:Current liabilities = 894:605 = 681:314
= 1,48:1 = 2,17:1
zz The current ratio has decreased from 2,17:1 in 20x1 to 1,48:1 in 20x2.
zz The decrease to 1,48 implies that R1 of current liabilities are covered by only R1,48 of
current assets.
zz To properly evaluate this change, additional knowledge of the industry in which Anco
Ltd operates should be sought. The current ratio of Anco Ltd should then be compared
to the average of the industry, or rather, to organisations representing “best practice”
for the industry.
6.2 Liquid asset ratio (or acid test or quick ratio)

This ratio is more conservative than the current ratio and recognises the fact that inventory
may take longer to convert into cash than other current assets, such as accounts receivable.
For many businesses the liquid asset ratio remains close to 1:1, but this can differ significantly
per industry.
Key formula: LIQUID ASSET RATIO

Current assets less inventory:Current liabilities
The liquid asset ratio is calculated for Anco Ltd:
20x2 20x1
Current assets less inventory:Current liabilities = 604:605 = 378:314
= 1,00:1 = 1,20:1
zz The liquid asset ratio has decreased from 1,20:1 in 20x1 to 1,00:1 in 20x2.
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TOPIC 6
zz Although there is a decrease, it still shows that the organisation can meet its current
liabilities without much difficulty.
zz To properly evaluate this change, additional knowledge of the industry in which Anco
Ltd operates should again be sought.
6.3 Inventory days

This calculation measures the days of sales in inventory and indicates the period an inventory
item will lie in stock from its purchase (in the case of a reseller) or production (in the case
of a manufacturer) up to date of sale. As revenue increase, we expect the inventory levels
to increase as well, to ensure that the organisation does not run out of stock (when the
organisation is out of stock, it will lose customers and sales). In such a case, however,
the inventory days should still remain fairly constant. An increase in the inventory days
may mean that the organisation does not properly manage inventory levels; a decrease
in inventory days implies lower inventory holding costs to the organisation, but may have
a negative effect where this results in an out-of-stock scenario.
Key formula: INVENTORY DAYS

Inventory
x 365 (or x 12 if months are used)
Cost of sales
The inventory days is calculated for Anco Ltd:
20x2 20x1
Inventory 290 303
x 365 = x 365 = x 365
Cost of sales 3 655 3 125
= 29 days = 35 days
zz The inventory days decreased from 35 days in 20x1 to 29 days in 20x2.

zz This decrease implies that inventory has been managed better, especially considering
that revenue has increased with 11%.
zz The organisation should ensure, however, that it does have sufficient inventory so as
not to reach an out-of-stock situation.
Note
Sometimes the working capital days are calculated based on 360 days (30 days per month).
Please read the question carefully to see what number you should use.
6.4 Inventory turnover ratio

The inventory turnover ratio is a measure of the number of times inventory is sold or used
in a year. This calculation is the inverse of the inventory days. A low turnover is not good,
as the value of inventory tend to decline as they are in the warehouse for longer periods
and inventory holding costs are higher. Organisations that are selling fresh products have
a very high turnover.
31 .........................
Study unit 16
Key formula: INVENTORY TURNOVER RATIO (RATE)
Cost of sales
Inventory
The inventory turnover rate is calculated for Anco Ltd:
20x2 20x1
= =
Inventory 290 303
= 12,60 times = 10,31 times
zz The inventory turnover rate increased from 10,31 times in 20x1 to 12,60 times in 20x2.
zz The increase is normally an indication of good inventory management. It also could
lead to saving in costs like inventory holding costs.
If average inventory is used, the calculation will be as follows:
Key formula: INVENTORY TURNOVER RATIO (RATE) – FOR AVERAGE

INVENTORY
Cost of sales
Average inventory
The inventory turnover rate is calculated for Anco Ltd:
20x2 20x1
= =
Average inventory 297 191
= 12,33 times = 16,36 times

(290 + 303) ÷ 2 = 297

(303 + 79) ÷ 2 = 191
zz The inventory turnover rate decreased from 16,36 times in 20x1 to 12,33 times in 20x2.
zz The big difference in the turnover rate in 20x1 is due to the low opening balance of
inventory in the beginning of 20x1.
zz The decrease in the turnover rate could indicate that the organisation’s inventory levels
are too high.
zz As cost of sales occur over the entire year, it is better to use an average inventory
measure.
6.5 Receivable days (debtors' collection period)

This calculation measures the number of days it takes for credit sales to be converted into
cash, or for the average debtor to pay his debt. For most organisations, debtors should
pay within a month or two of the sale (once again this will normally display a trend within
an industry) so average receivable days should not exceed 30 days or 60 days, with too
much, respectively. Notice that the longer the organisation takes to collect the cash, the
more difficult it becomes. Debtors exceeding the allowed payment terms represent a greater
........................ 32
TOPIC 6
risk of becoming “bad debt” or irrecoverable. As the trade receivables amount includes
VAT, the credit sales should also be calculated inclusive of VAT.
Note
If information on different sales categories are given, remember to split the export sales
from the local sales, as there is no VAT on export sales.
Key formula: RECEIVABLE DAYS (DEBTORS’ COLLECTION PERIOD)

Receivables (trade and other debtors)
Credit sales
The receivable days is calculated for Anco Ltd:
20x2 20x1
Receivables 250 222
x 365 = x 365 = x 365
Credit sales 4 537 4 077
= 20 days = 20 days

6 633 x 60% x 1,14 = 4 537

5 960 x 60% x 1,14 = 4 077
zz The receivable days stayed constant on 20 days for both 20x1 and 20x2.
zz This answer is best compared to that of the industry, but is nonetheless positive as
sales have increased by 11% (see paragraph 0) and the collection period has not
changed.
Normally, an increase in revenue can result in an increase in debtors, but we expect the
ratio to stay the same, for example, 15 ÷ 150 x 365 = 36,5 days and if both increase, the
number of days stay the same: 16 ÷ 160 x 365 = 36,5 days. If the ratio gets worse, it means
that the organisation has increased the revenue by allowing “easy” debt. Although profits
may increase, it can become risky as the organisation may run into cash flow problems,
or debtors may not pay.
6.6 Payable days (creditors’ payment period)

This calculation measures the number of days it takes for the organisation to pay its
creditors. For most organisations, a period between 30 and 60 days are considered to be
normal. Current payables are a form of finance that is mostly free, dependant on timely
payment discounts (if not taken then there is an “opportunity costs” to this) and other late
payment costs (such as interest on overdue accounts charged by the creditor). The efficient
management of payable days will depend on a number of factors, including industry norms
and credit terms. As the trade payables amount includes VAT, the credit purchases should
also be calculated inclusive of VAT.
Key formula: PAYABLE DAYS (CREDITORS’ PAYMENT PERIOD)

Payables (trade and other creditors)
Credit purchases
33 .........................
Study unit 16
The payable days is calculated for Anco Ltd:
20x2 20x1
Payables 365 245
x 365 = x 365 = x 365
Credit purchases 4 152 3 818
= 32 days = 23 days

3 642 x 1,14 = 4 152

3 349 x 1,14 = 3 818
zz The payable days has increased from 23 days in 20x1 to 32 days in 20x2.
zz The 23 day period in 20x1 is almost the same as the 20 receivable days in 20x1, which
is not a good indication for cash flow management.
zz The increase to 32 days in this scenario can be interpreted as positive as it is greater
than the corresponding receivable days, thereby financing the receivables and a
portion of inventory, but is dependent on a number of factors, including its effect on
supplier relationships. It should also be compared to the norm for the industry.
6.7 Cash conversion cycle (days)

The cash conversion cycle indicates the number of days it takes for cash to flow through
the operating activities, from initial purchases on credit, until it is eventually converted into
a cash inflow. The cycle is determined by taking the receivable days, adding the inventory
days and subtracting the payable days. If the number of days in the cycle decreases, it
indicates an improvement in the cash flow from operating activities.
The cash conversion cycle days is calculated for Anco Ltd:
20x2 20x1
Period of credit taken by customers (Receivable days) 20 20
Plus: Number of days of inventory (Inventory days) 29 35
49 55
Less: Period of credit granted by suppliers (Payable days) (32) (23)
Total cash conversion cycle 17 days 32 days
zz The cash conversion cycle days has decreased from 32 days in 20x1 to 17 days in
20x2.
zz This implies that the organisation has improved its cash flow from operating activities.
Note
In topic 7 on working capital management you will learn more about techniques to manage
the cash conversion cycle and its components to remain within industry norms and funding
available to the organisation.
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TOPIC 6
6.8 Cash ratio
The cash ratio is not commonly used, but can be used to determine the organisation’s
immediate ability to pay its short-term obligations. The higher the ratio, the more liquid the
organisation, but too high a ratio can also mean “unproductive cash” that is not generating
a sufficient return (eg a return that could have been generated if it was invested in assets
and investments).
Key formula: CASH RATIO

Cash
Current liabilities
Note
Unproductive cash: Bank balances with positive balances earn much lower interest than
when it’s invested in the money market or fixed term investments. Ultimately, funds should
not lie in cash, but be invested in operating assets that generate higher returns.
The cash ratio is calculated for Anco Ltd:
20x2 20x1
Cash 354 156
= =
Current liabilities 605 314
zz The cash ratio has increased from 0,50 times in 20x1 to 0,59 times in 20x2, but has
not changed much.
zz As the resulting ratios are below 1, it implies that cash cannot cover short-term
obligations in either year.
zz This will be of concern only if there is a possibility of trade and other payables
suspending credit (consider increased accounts payable days/creditors’ payment
period, with a possible strain on relationships), or debt providers cancelling the loan
agreement (consider the terms and conditions in the loan agreement).
7 Measuring solvency and financial/capital structure – long-term

funds
These ratios tell more about the organisation’s ability to repay its long-term debts, which
include the repayment of the capital and also the payment of interest. It provides information
about the risk that shareholders and debt providers are taking. These ratios are sensitive to
the industry. We discuss these ratios separately below – each under a separate heading.
7.1 Interest cover ratio

This ratio measures the number of times the operating profit will cover the interest expense.
The more times earnings before interest and tax (EBIT) cover the interest, the safer it is
to borrow additional funds.
35 .........................
Study unit 16
Key formula: INTEREST COVER RATIO
EBIT
Interest expense
The interest cover ratio is calculated for Anco Ltd:
20x2 20x1
EBIT 516 802
= =
Interest expense 335 265
zz The interest cover ratio has decreased from 3,03 times in 20x1 to 1,54 times in 20x2.
zz As the coverage is declining, it indicates that the organisation probably cannot afford
to significantly increase interest-bearing debt in its capital structure.
7.2 Debt to equity ratio (or leverage ratio)

The debt to equity ratio is an important ratio as it measures the level of financial risk (as
discussed in the part on risk management of this study guide). Debt financing creates an
obligation that has to be settled, for example, through capital and interest payments that
has to be paid whether the organisation can afford it or not, thereby creating financial risk.
The debt to equity ratio measures the relationship between an organisation’s debt financing
(financing with an obligation to settle, as mentioned) and equity financing (financing without
an obligation to settle, eg dividends may be paid but isn’t compulsory).
For the purposes of calculating this ratio, debt financing commonly comprises only long-
term interest-bearing debt (including its current portion, which is normally payable within
the next 12 months); equity comprises the organisation’s assets less liabilities belonging
to shareholders, or simply put, the total shareholders’ interest. When determining the
debt-portion of this ratio, non-interest bearing debt and current liabilities (other than the
current portion of long-term debt, if any) are usually excluded, as we are concerned here
with the portion of debt representing long-term capital financing.
Key formula: DEBT TO EQUITY RATIO

Long-term interest bearing debt (including its current portion):Equity
The debt to equity ratio is calculated for Anco Ltd:

20x2 20x1
Long-term debt # (including
its current portion):Equity = 5 220 + 0:2 646 = 4 770 + 0:2 519
= 1,97:1 = 1,89:1
#
Long-term debt is long-term interest bearing debt.

In this case there is no current portion of long-term debt.
zz The debt to equity ratio has increased from 1,89:1 in 20x1 to 1,97:1 in 20x2.
zz Both ratios indicate that the organisation has high gearing, as the long-term debt
portion is nearly twice as much as the equity portion.
zz Notice that this calculation used carrying values, which often understates the value of
equity. (We therefore prefer that this ratio be calculated based on market values, as
detailed below.)
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TOPIC 6
The debt to equity calculation based on the market value of Anco Ltd:
20x2 20x1
Long-term debt # (including
its current portion):Equity = 5 220 + 0:3 000 = 4 770 + 0:2 800
= 1,74:1 = 1,70:1
#
Long-term debt is long-term interest bearing debt.

In this case there is no current portion of long-term debt.
zz Based on the market values, the debt to equity ratio has increased from 1,70:1 in 20x1
to 1,74:1 in 20x2.
zz The debt to equity ratio based on market values is still relatively high, but less than the
ratio based on carrying values as equity is not understated in this case.
zz The market values give a better indication of the true debt to equity ratio.
7.3 Debt ratio (or gearing ratio)

This ratio measures the percentage of total funds provided by holders of debt, including
all forms of debt. It tells us how much of the organisation’s assets are financed by total
debt. A high debt ratio is risky to investors, debt providers and other creditors as it points
to higher financing risk.
Key formula: DEBT RATIO

Total debt
x 100
Total assets
The debt ratio is calculated for Anco Ltd:

20x2 20x1
Total debt 6 157 5 383
x 100 = x 100 = x 100
= 69,94% = 68,12%

5 552 + 605 = 6 157

5 069 + 314 = 5 383
zz The debt ratio has increased slightly from 68,12% in 20x1 to 69,94% in 20x2.
zz Both these percentages are considered high in most industries, the norm being about
50%. Note that this is also industry dependant.
The debt ratio calculation based on the market value of Anco Ltd:
20x2 20x1
Total debt 6 157 5 383
x 100 = x 100 = x 100
Total assets 9 157 8 183
= 67,24% = 65,78%

5 552 + 605 = 6 157 and

5 069 + 314 = 5 383
Total assets = Total debt + total equity, therefore:


6 157 + 3 000 = 9 157 and

5 383 + 2 800 = 8 183
37 .........................
Study unit 16
The debt ratio has increased from 65,78% in 20x1 to 67,24% in 20x2. The debt ratio based
on market values is slightly less than based on carrying values as equity is not understated
in this case. The market values give a better indication of the true debt ratio.
7.4 Total assets to total debt

This ratio indicates the number of times debt is covered by assets. The same figures are
used as in the debt ratio above, just in the inverse. In this case, the higher the ratio, the
lower the risk is for investors and creditors.
Key formula: TOTAL ASSETS TO TOTAL DEBT

Total assets
Total debt
The total assets to total debt ratio is calculated for Anco Ltd:
20x2 20x1
= =
Total debt 6 157 5 383
zz The ratio has decreased from 1,47 times in 20x1 to 1,43 times in 20x2.
zz Both these ratios are considered too low in most industries (a similar unfavourable
result as for the debt ratio above).
The total assets to total debt calculation based on the market value of Anco Ltd:
20x2 20x1
= =
Total debt 6 157 5 383
zz The ratio has decreased from 1,52 times in 20x1 to 1,49 times in 20x2.
zz The total assets to total debt ratio based on market values is higher than that based
on carrying values (book values).
zz The market values give a better indication of the total assets to total debt ratio.
7.5 Financial leverage effect

This ratio refers to the degree the organisation is utilising (leveraging) debt when they
acquire additional assets in order to increase the returns to equity holders. This ratio should
be evaluated in conjunction with the capital expenditure for the period and changes in the
gearing ratio. The ratio should be greater than one, indicating that returns to equity holders
(ROE) has benefited from debt financing of assets. It can also indicate that a high amount
of borrowed funds are used in high risk investments in order to maximise the returns for
equity holders.
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TOPIC 6
Key formula: FINANCIAL LEVERAGE EFFECT
Return on equity (ROE):Return on assets (ROA)
The financial leverage is calculated for Anco Ltd:
20x2 20x1
Return on equity (ROE)*:
Return on assets (ROA)* = 4,80:5,86 = 14,93:10,15
= 0,82:1 = 1,47:1
and
Gearing ratio (debt ratio) = 69,94% = 68,12%
(*See profitability ratios)
zz The financial leverage has decreased from 1,47:1 in 20x1 to 0,82:1 in 20x2.
zz The gearing (debt) ratio only increased slightly. This means that new capital expenditure
was funded in the same debt to equity ratio as before.
zz The gearing (debt) ratio is already quite high, limiting the extent to which further debt
financing can be obtained.
zz In the absence of increased gearing (debt ratio), we would expect the same returns
as before.
zz However, as discussed before, both the ROE and ROA declined due to lower profits.
The leverage effect is:
20x2 20x1
ROE* = 4,80% = 14,93%
Less: ROA* = 5,86% = 10,15%
= (1,06)% = 4,78%
(*See profitability ratios)
zz The financial leverage effect has decreased from 4,78% in 20x1 to –1,06% in 20x2.
zz The decrease in the financial leverage effect is an indication of the inefficient use of
borrowed funds.
zz The ROE is an indication of the return the shareholders receive on their investment.
zz The negative return in 20x2 is shows that the organisation did not use the borrowed
or own funds effectively.
8 Measuring how the organisation relates to financial market

ratios
When measuring how the organisation is judged or valued by the financial market, several
ratios and other calculations can assist in the process. Here we highlight only a few.
8.1 Earnings per share

Earnings per share (EPS) are an organisation’s net profit (after minority interest) divided
by the number of ordinary shares issued. EPS will be used later in calculating the price/
earnings ratio.
39 .........................
Study unit 16
Key formula: EARNINGS PER SHARE
Earnings (or net profit)
Number of shares issued
EPS represents historical financial information and is therefore also subject to the limitations
in financial information as discussed in study unit 15, section 5. Notice further that EPS
can be manipulated to an extent by making changes in accounting policies.
Note
The finer calculations involving diluted earnings, normalised earnings, headline earnings,
et cetera, will be covered in later FAC and MAC modules.
The earnings per share are calculated for Anco Ltd:
20x2 20x1
Earnings (or net profit) 127 376
= =
Number of shares issued 1 000 1 000
= R0,127 = R0,376
= 12,7 centsa = 37,6 centsa
a
Notice that in the financial markets, earnings per share are normally expressed in cents, not rands.
zz The earnings per share have decreased from 37,6 cents in 20x1 to 12,7 cents in 20x2.
zz This decrease is mainly attributable to the decrease in GP margin, and the increase in
overall operating costs and interest expense.
zz The slight increase in interest and other income had a small positive effect.
8.2 Dividend pay-out ratio

This ratio indicates the proportion of earnings per share paid out to the shareholders in
the form of a dividend. A low dividend pay-out ratio can indicate that the organisation
is in a growth phase and is retaining money to invest in profitable projects (which might
eventually increase the share price and or allow for the payment of greater future dividends).
Warren Buffet, the well-known investor and CEO of Berkshire Hathaway Inc, a US
conglomerate, famously follows a general policy of not paying any dividends to investors
in this conglomerate, instead choosing to reinvest funds in order to generate capital growth.
An individual company might, however, have a high dividend pay-out ratio where its
investors prefer high current pay-outs rather than capital growth, or where the organisation
represents a mature organisation in a stable phase of its life-cycle (no expansions are
envisioned). Furthermore, dividend pay-out ratios are sometimes comparable between
business organisations within the same industry.
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TOPIC 6
Key formula: DIVIDEND PAY-OUT RATIO
Dividend per share (DPS)
Earnings per share (EPS)
The dividend pay-out ratio is calculated for Anco Ltd:
20x2 20x1
Dividend per share (DPS) 6 5
= =
Earnings per share (EPS) 12,7 37,6
= 47,24% = 13,30%
zz The dividend pay-out ratio has increased from 13,30% in 20x1 to 47,24% in 20x2.
zz The ratio increased as a greater proportion of the earnings per share was paid out to
shareholders in 20x2 in the form of a dividend.
zz The dividend itself increased from 5 cents to 6 cents.
Note
Organisations usually try to keep their dividends constant or to increase it slightly if they
feel confident that they can maintain the new level in the future. In times of decreasing
earnings, the pay-out ratio would therefore increase “artificially”. You will learn more about
distributions to equity holders in your later MAC modules.
Organisations that have a low dividend pay-out ratio, say below 60% of earnings, will have
more money to invest back into the organisation and grow the share price.
8.3 Dividend cover ratio

Dividend cover measures an organisation’s ability to pay its dividend payments to the
shareholders. A healthy, growing company will have a high coverage ratio, which indicates
that it has little difficulty in paying its dividends, and is retaining earnings (cash) to fund
expansion projects. The dividend cover is the inverse of dividend pay-out ratio, which was
calculated above. Normally, a ratio of 2 or higher is considered that the organisation can
well afford the dividend, and anything below 1,5 is risky. When the ratio is below 1, the
organisation is using its retained earnings from a previous year to pay this year’s dividend.
Key formula: DIVIDEND COVER RATIO

The dividend cover ratio is calculated for Anco Ltd:
20x2 20x1
= =
Dividend per share (DPS) 6 5
41 .........................
Study unit 16
zz The dividend cover ratio has decreased from 7,52 times in 20x1 to 2,12 times in 20x2.
zz The ratio decreased as there are less EPS in 20x2 to cover the higher dividend per
share.
zz As the ratio in 20x2 is higher than 2, it shows that the organisation can still well afford
the dividend payment.
8.4 Price/earnings ratio

The price/earnings (P/E) ratio, also known as a P/E-multiple, expresses the relationship
between the market price of an organisation’s shares and its earnings per share (both
variables have to be available). The P/E ratio can be considered as “the number of years’
earnings that are represented by the current share price” (SAICA, 2009:4).
Key formula: PRICE/EARNINGS RATIO

Share price
Earning per share (EPS)
Generally, the market price of the shares of an unlisted (private) organisation is not
easily available. A P/E ratio is therefore normally only calculated for listed organisations,
which have published share market prices (based on regular buy and sell transactions
on a securities exchange), or for private organisations where there was a recent share
transaction or where the value of the private shareholding was recently quantified by a
specialist appraiser. In fact, appraisers often make use of a market-comparable approach
to value a private shareholding, using a method that utilises the P/E multiple of a similar
listed organisation as a point of departure in the valuation.
Note
You will learn more about valuations and the different market indicators used in your third-
year MAC modules.
The price/earnings ratio is calculated for Anco Ltd:
20x2 20x1
Share price 300,0 280,0
= =
Earning per share (EPS) 12,7 37,6
= 23,62 = 7,45
zz The price/earnings ratio has increased from 7,45 in 20x1 to 23,62 in 20x2.
zz Although the earnings per share decreased in 20x2, the share price still increased
slightly, even after release of the downturn in the EPS, and this resulted in a higher
P/E ratio. In other words, roughly a year ago the market priced a share at 7,45 times
the 20x1 EPS, but currently it prices a share at 23,62 times the 20x2 EPS.
zz A higher P/E ratio in this case, is a sign of optimism in the future, relative to the poor EPS
on which it is based. This implies that the market expects the EPS to improve significantly
in the future which will bring the P/E ratio back to previous levels, or slightly higher.
zz P/E ratios can be placed in a better context by comparing them to the P/E ratios of
similar (normally listed) organisations, calculated at the same date.
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TOPIC 6
8.5 Earnings yield
The earnings yield is the inverse of the price/earnings (P/E) ratio.
Key term: EARNINGS YIELD

The earnings yield on an organisation’s share is an estimate of the expected return
from the organisation’s share. The future earnings is expressed as a percentage of the
value of the share. The earnings yield can also be determined by finding a comparable
earnings yield from a similar share and adjust it for growth and risk.
Key formula: EARNINGS YIELD

Share price
The earnings yield is calculated for Anco Ltd:
20x2 20x1
= =
= 4,23% = 13,43%
zz The earnings yield has decreased from 13,43% in 20x1 to 4,23% in 20x2.
zz The earnings per share decreased in 20x2 AND the share price still increased slightly.
This combination resulted in a lower earnings yield.
zz A lower earnings yield is a sign of optimism in the future, relative to the EPS on which
it is based. This implies that the market expects the EPS to improve significantly in
the future.
zz Earnings yields can be placed in a better context by comparing them to the earnings
yields of similar (normally listed) organisations, calculated at the same date.
8.6 Dividend yield

The dividend yield measures the return from distributions that the shareholders will earn
from their investments in relation to the share price. The higher the dividend (distribution)
is, the higher the return will be.
DIVIDEND YIELD
The dividend yield on an organisation’s share is the organisation’s total annual dividend
payments divided by its price per share. The dividend yield can also be determined by
finding a comparable dividend yield from a similar share and adjust it for growth and
risk.
43 .........................
Study unit 16
Key formula: DIVIDEND YIELD
Share price
The dividend yield is calculated for Anco Ltd:

20x2 20x1
Dividend per share (DPS) 6,0 5,0
= =
= 2,00% = 1,79%
zz The dividend yield has increased from 1,79% in 20x1 to 2,00% in 20x2.
zz Although the dividend per share increased in 20x2, the share price also increased
slightly. This still resulted in a slightly higher dividend yield.
zz A higher dividend yield is a sign of a higher return to the shareholders, but does not
necessarily indicate whether the organisation is profitable or not.
zz Dividend yields can be placed in a better context by comparing them to the dividend
yields of similar (normally listed) organisations, calculated at the same date.
Note
Remember: where appropriate, always show your calculations and attempt to show as
much insight as possible in your discussions. For discussions, a good understanding of
the interactions between figures, calculations and ratios is required. For a test or exam,
always analyse exactly what is required. Make sure you understand which calculations
and ratios belong to each of the four categories. The number of marks should offer your
further guidance on the extent of the calculations and discussions to be presented.
9 Summary
In this study unit, we have examined how to calculate growth rates and ratios. An income
statement and balance sheet were provided to base the calculations on. The ratios were
classified into four categories namely, profitability and performance, liquidity, solvability
and financial/capital structure, and financial market. Different ratio formulas were given,
calculations were performed and the results were analysed and interpreted. These
techniques assist us in making decisions in managing the funds of the organisation or
with respect to our investment decisions.
In the next topics we will examine how these ratios assist us in managing working capital
and income distribution in the organisation.
questions:
a. Why are growth ratios important?
b. Name and describe the four classifications that ratio analysis consists of.
c. List the ratios in each classification and describe how the ratio will assist you in financial
analysis of an organisation.
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TOPIC 6
QUESTION 1
Calculate the following ratios for years 20x2 and 20x1 by using the selected information
below. Discuss your findings and offer detailed reasons for the change in the ratios from
the one year to the next.
a. gross profit margin

b. operating profit margin
c. return on total assets
d. current ratio
e. debt to equity ratio
20x2 20x1
R’000 R’000
Revenue 777 663
Net operating profit /(loss) 93 48
Gross profit 312 298
Operating costs (101) (150)
20x2 20x1
R’000 R’000
Total assets 969 879
Interest-bearing borrowings 572 555
Total current assets 94 89
Total equity 330 265
Total current liabilities 67 59
The current portion of interest-bearing borrowings included in current liabilities is R34 000
(20x2) and R33 000 (20x1).
(We deliberately do not reflect these items in the order in which they would appear in the
annual financial statements.)
Solution to self-assessment activity

QUESTION 1
For the simplification of calculations below, the thousands in the figures were not shown.
a. Gross profit margin
20x2 20x1
Gross profit 312 298
x 100 = x 100 = x 100
Revenue 777 663
= 40,15% = 44,95%
45 .........................
Study unit 16
Discussion and detailed reasons:
The gross profit margin decreased from 44,95% in 20x1 to 40,15% in 20x2, which could be
due to a number of factors, including a reduction in GP margins, old or obsolete inventory
written off. We can predict that the scale of operations increased as the revenue grew by
17,20% during this time – this growth percentage probably exceeding the inflation rate
during the same period; if revenue growth equals the inflation rate over a period then there
is effectively no real growth. When the scale of operations increase, we might expect
savings due to efficiencies in scale (fixed costs spread over more products). This would
result in IMPROVED gross profits. We can therefore eliminate REDUCTION in the GP%
as a reason.
b. Operating profit margin
20x2 20x1
Operating profit 93 48
x 100 = x 100 = x 100
Revenue 777 663
= 11,97% = 7,24%

The operating profit margin increased from 7,24% in 20x1 to 11,97% in 20x2 due to the large
saving in operating cost, which decreased significantly, even though revenue increased
for this year. This saving was large enough to also compensate for the lower gross profit
margin earned in 20x2, which reduced from 44,95% in 20x1 to 40,15% in 20x2.
Note
In order to discuss possible reasons for a change in a margin between years, we have to
refer to relative changes in the variables that were used to calculate it (relative to revenue
for each year, in this case). This is the reason why we discuss changes in gross profit
margin (this is already relative to revenue and gross profit is incorporated into operating
profit) and change in operating costs relative to revenue (operating cost is the last cost
incorporated in order to calculate operating profit).
c. Return on total assets
20x2 20x1
EBIT 93a 48a
x 100 = x 100 = x 100
Total assets 969 879
= 9,60% = 5,46%
a
Operating profit equals EBIT in this case, as no other income was supplied.

The ROA has increased from 5,46% in 20x1 to 9,60% in 20x2 due to the large increase
in operating profit (which equals EBIT in this case) relative to the smaller increase in total
assets. The organisation therefore generated a greater return on total assets (including new
assets acquired) in 20x2, relative to 20x1. This increase implies good skills in managing the
existing and new assets in 20x2. Further reasons should be sought for this improvement,
........................ 46
TOPIC 6
such as the type of new assets acquired, changes in market conditions, changes in
management or competitors, and so on.
d. Current ratio
20x2 20x1
Current assets:Current liabilities = 94:67 = 89:59
= 1,40:1 = 1,51:1

The current ratio has decreased from 1,51:1 in 20x1 to 1,40:1 in 20x2. In order to evaluate
whether this represents an improvement or not, detailed knowledge of the organisation and
its industry will be required. Nonetheless, it could be interpreted as positive as it points to
improved working capital management (less cash invested in debtors and inventory). On
the other hand, a lower current ratio could be a warning of future cash flow problems (eg
if debtors do not pay on time in future, or if inventory is not sold fast enough, the current
assets will not convert to cash quickly enough to enable the organisation to pay the current
liabilities, when due).
e. Debt to equity ratio
20x2 20x1
Long-term debt # (including its
current portion):Equity = 606:330 = 588:265
= 1,84:1 = 2,22:1
#
Long-term debt is long-term interest bearing debt

572 + 34 = 606

555 + 33 = 588
The debt to equity ratio has decreased from 2,22:1 in 20x1 to 1,84:1 in 20x2. The decrease
in the ratio shows that the level of debt capital increased by a smaller amount relative to the
increase in equity for 20x2. The organisation therefore reduced its level of debt in 20x2,
but it still represents a high level. This is at least a positive sign for investors, as the lighter
gearing indicates a reduction in the risk of the organisation not being able to repay its debt.
47 .........................
Study unit 16
........................ 48
TOPIC 7
TOPIC 7
Analysing and managing working capital
LEARNING OUTCOMES

–– define and explain working capital, net working capital and working capital management
–– discuss strategies on how to monitor and manage each component of working capital
–– calculate the effective cost of discount forfeited
–– prepare basic cash flow forecasts
–– define the concepts of working capital policy and working capital cycle
–– calculate the weighted cost of different financing policies
–– calculate the cash conversion cycle days
Part 1 Part 2
Part 3 Part 4
Introduction
Strategy and Managing and Risk management
to financial
strategic investing funds
management,
planning
financing and the
cost of capital

organisation’s management risk management
7 Analysing and managing
strategy 3 Time value of working capital 10 Risk
money identification and
SU 17 Working capital
documentation
4 Sources and management
forms of finance 11 Risk assessment,
SU 18 Working capital
the management
5 Capital structure policies and the
of risk and risk
and the cost of working capital cycle
reporting
capital 8 Capital investments and
capital budgeting techniques
49 .........................
Study unit 16
INTRODUCTION
Management of the working capital of the organisation is one of the most important
functions of the financial manager. This determines how much cash is available to sustain
the day-to-day activities of the organisation. Managing the working capital requires close
cooperation with other managers in the organisation, that is, the purchasing manager,
stores manager, accounts receivable manager and the accounts payable manager. The
financial manager should also maintain a good relationship with his/her bank manager.
........................ 50
TOPIC 7
3 STUDY UNIT 17
3Working capital management
In this study unit
1 Introduction
A profitable organisation has to decide on whether to retain its profits for reinvestment
(including investment in capital projects (topic 8) and working capital (this topic) or to
distribute the profits as dividends. This decision is partially based on the outcomes of the
financial analysis discussed in topic 6.
In this study unit, we will explore the various concepts regarding working capital. We will
discuss strategies to monitor and manage the different categories of working capital. We
highlight the purpose and importance of the optimum level of working capital.
NOTE
The concepts discussed in this study unit links closely to ratios covered in topic 6. Make
sure that you understand the ratios discussed in topic 6 before progressing to this topic.
51 .........................
Study unit 17
2 Working capital definitions and concepts
NET WORKING CAPITAL
Net working capital refers to the current assets less current liabilities, which is directly
related to the operating activities of an organisation.
The term gross working capital (or sometimes only called working capital) refers to the
current assets. The term net working capital is the excess of current assets over current
liabilities. This is computed by subtracting the current liabilities from the current assets.
You will know from your Financial Accounting modules that current assets include:
zz inventory
zz trade receivables
zz cash and cash equivalents
Current liabilities include:

zz trade payables
zz taxation due to the South African Revenue Services (SARS)
zz the short-term portion of long-term loans
` Net Working Capital = Current Assets – Current Liabilities
The level of the net working capital has important implications for the rest of the business.
We will briefly highlight each.
1. The net working capital figure is an important indication of the short-term solvency
of an organisation. The higher the level by which the current assets cover the current
liabilities, the more solvent the organisation is in the short term (it then has a higher
ability to meet its short-term liabilities).
2. Net working capital can also be linked to the concept of liquidity. (Recall that liquidity
represents the length of time until assets can be converted into cash, or the funds
available for immediate investment.) Normally, the higher the level by which the current
assets cover the current liabilities, the less liquid the organisation would be as more
cash is then tied up in the net working capital balance. (The measurement of liquidity
was highlighted earlier, in study unit 16, section 6.)
3. Net working capital can further be linked to the concept of profitability, in which
case lower net working capital levels can often be linked to lower profitability. For
example, if an organisation lowers its net working capital levels in order to improve
liquidity, it might have to limit the amount of credit sales, which, in turn, could lower
the interest from current or prospective customers, and thus the level of revenue and
profit that might otherwise have been earned. (The measurement of profitability and
performance was highlighted earlier, in study unit 16, section 5.)
WORKING CAPITAL MANAGEMENT
Working capital management refers to the controlling of balances included in the current
assets and current liabilities, the way the related functions within the organisation are
performed and the way working capital is financed.
As described, the efficient analysis and management of working capital are important in
the management of an organisation’s short-term solvency, liquidity and profitability. In fact,
the objective of working capital management is often to balance the level of net working
........................ 52
TOPIC 7
capital between operational requirements (often calling for higher levels) and cash flow
requirements (often necessitating lower levels).
Next, we will discuss basic strategies in the management of each component of net
working capital.
3 Managing inventory
INVENTORY
Inventory of a reseller is represented by purchased goods (held to be sold), and of a

manufacturer by the completed products (held to be sold), work-in-process products
(intended for sale) and raw material inventory (held for use in production). Both types
of organisations can also have stores of consumable items.
Managing the organisation’s inventory is important as it ensures that the level of inventory
is adequate to sustain the operations, whilst the inventory costs are kept at a minimum.
The adequate inventory level will differ from organisation to organisation, as it depends on
the type and complexity of the business. Although the management of inventory is not the
direct responsibility of the financial manager, he/she should still provide advice to make
sure that it is managed cost effectively.
Note
The scientific management of inventory levels is a very advanced field. This forms part
of what is called “supply chain management”. People qualify as specialists in this area
by completing specific qualifications in this field. In MAC2601 and MAC3701 you will only
be provided a very rudimentary education in this area. The financial manager therefore
acts in an advisory capacity where the organisation is large enough to employ supply
chain specialists!
The management of inventory involves having a delicate balance between the benefits of
holding inventory, and the costs of holding and ordering too much inventory.
Having inventory on hand at all times will:

zz reduce “out of stock” situations – the risk of inventory required for production or by a
customer not being on hand. This situation leads to loss of income.
zz prevent disruptions in the manufacturing operations, which are normally costly.
zz require less detailed planning (production scheduling) as there are always enough
inventories.
zz retain customers (all else being equal) and prevent them from going to another supplier.
On the other hand, keeping (too much) inventory incurs:

zz holding cost
zz ordering cost
zz physical stores/infrastructure required to maintain the inventories in good condition
zz systems to manage/control it
zz greater risk of obsolescence
53 .........................
Study unit 17
HOLDING COSTS
Holding costs are the costs of holding inventory and includes storage costs (eg renting
warehouse space and security), insurance costs (for protection against losses), cost
of obsolescence (inventory ageing or deteriorating whilst in storage) and opportunity
cost (funds invested in inventory could have earned a return elsewhere at a certain
rate, eg earning the weighted average cost of capital).
ORDERING COSTS
Ordering costs are the costs associated with placing an order, receiving the deliveries
and the associated payment.
Inventory management refers to the methods the organisation uses to control its inventory.
An organisation can buy or develop a system to help them with the managing process (refer
to your Accounting Information (AIN) modules for the discussion on types of accounting
systems and databases). Some of the methods and models are discussed briefly below.
3.1 The economic order quantity (EOQ) model

The EOQ model uses certain assumptions to determine the optimum order quantity that
will minimise the total relevant inventory holding cost and ordering cost. The focus of this
model is on incremental (additional) holding and ordering cost associated with the inventory;
the model ignores the costs that are not relevant (ie those that will not change) within a
short-term time horizon, such as the acquisition cost of inventory and fixed costs that will
not change within this time.
For today’s economy, where inventory holding costs are very high and the risk of obsolescence
is high (fast changing world, global competition), the EOQ model normally indicates that
total inventory costs are minimised by ordering smaller quantities, more frequently.
3.2 Re-ordering and safety stock

An order for inventory has to be placed in advance in order for the inventory to be delivered
to the organisation at the time when it is needed. The time elapsed from placing an order
until inventory is delivered is called “lead time”. When the organisation knows with certainty
the quantity of inventory that is required during a period, the quantity to be ordered can
be calculated exactly by taking the lead time into account.
However, an organisation is normally uncertain about the exact level of demand and is
therefore often required to keep additional safety stocks to prevent “out-of-stock” situations.
Safety stock therefore represents emergency inventory that is held and used when normal
inventory is depleted. There are holding costs attached to these safety stock items, which
should be weighed up against lost revenues when a sale can’t be made or when production
stands still.
3.3 Just in Time (JIT) – manufacturing inventory systems

Several western companies emulated Japanese firms by implementing JIT manufacturing
systems during the 1980s and 90s. (Japanese firms were highly successful then, even
though their current performance seems to be less inspiring.) JIT systems pursue excellence
in all phases of manufacturing and, if suitable to the business environment and properly
implemented, it can reduce costs, time and inventory-holding.
........................ 54
TOPIC 7
Inventory holding cost are reduced specifically as a JIT system requires that suppliers
deliver the exact quantity and type of inventory “just in time” to be used in the manufacturing
process. However, a JIT system is often difficult to successfully introduce in practice, as
it requires a total re-engineering of business practices, including the requirement of very
good relationships between the organisation and its suppliers. As a result, the system can
normally work only for large and powerful organisations where the suppliers are located
nearby and will do their best to keep the organisation’s support.
Note
The three methods/models used to manage and control the costing of inventory will be
explained in more detail and applied in MAC2601, MAC3701 and MAC4861/2.
The results of the inventory management actions are measured in the inventory days
(refer to topic 6).
INVENTORY DAYS
Length of time that inventory remains unsold (in the case of goods for sale) or remains
unused (in the case of raw materials).
Key formula: INVENTORY DAYS

zz Purchased inventory: Inventory value ÷ cost of goods sold x 365 (or 360)
days
zz Manufactured inventory: Inventory value ÷ cost of goods sold x 365 (or 360)
days
zz Raw material inventory: Inventory value ÷ raw material expense included in cost
of goods sold x 365 (or 360) days
Ac t i v i t y 17.1
Assume you are the financial manager of Decorplan CC, an organisation that
sells blinds for windows. How do you think the next two aspects would impact
on the management of Decorplan’s inventory?
zz type and complexity of the blinds
zz type of customers
1 Fe e d b a c k o n a c t i v i t y 17.1
zz Type and complexity of the inventory
Will the blinds be custom-made in specific measurements and on requests
or manufactured in standard sizes?
zz Type of customers
Will the customers be large groups, for example, Builders City or only
private clients?
55 .........................
Study unit 17
Level of inventory
The adequate level of inventory can be determined if the above questions
are considered.
–– If blinds are custom-made, the level of inventory will be lower (it will
not fit other windows) than when it is manufactured in standard sizes.
–– If the type of customers is large groups, the level of inventory will be
higher than private client type of customers as their premises are larger
(more windows).
Note
In your AIN2601 module you will learn how to generate reports from Pastel that will indicate
which inventory are slow moving and is at risk for obsolescence. You will also learn about
the classes of inventory; re-order levels for each inventory code, et cetera. The inventory
classed as slow moving would be subjected to provision for obsolescence.
4 Managing accounts receivable and credit sales

ACCOUNTS RECEIVABLE (TRADE DEBTORS)
Accounts receivable refers to the amount outstanding in respect of previous credit

sales that customers/debtors have to pay in the near future.
Normally an organisation would prefer to sell its products and services for cash, but by
granting credit to customers, revenue and profits may increase and the organisation will
stay competitive.
Note
You may have experienced this yourself as a customer. Depending on your finances, you
might prefer to shop at a retailer that allows you to open an interest-free account instead
of paying cash. In your later MAC modules you will learn how to weigh up the costs of
each option.
A large balance of trade accounts receivable, relative to revenue, implies that the organisation
grants credit to customers easily and is willing to wait relatively longer to be paid. The
downside to this is that there is a cost involved, since it is similar to an interest-free loan
given to customers. There is also a risk involved in that the amount owed by the customers
will not be collected and it will become bad debt.
Managing the level of credit sales is important as it also has an effect on the profitability
of the organisation. The effective managing of credit sales (and the resulting accounts
receivable) requires a balance between an increase in revenue and profits, an increase in
holding cost of accounts receivable (the effective cost of offering this “interest-free loan”)
and an increase in bad debts. Accounts receivable are managed by having a credit policy
and enforcing it.
........................ 56
TOPIC 7
The credit policy is the main instrument used to influence the balance of accounts
receivable. It affects the revenue, selling prices, types of inventory and marketing methods.
The credit policy focuses on the following four areas:
1. Creditworthiness
This refers to the financial strength of customers and their ability to repay debt. When
applying for credit, you will be asked to identify yourself and to provide proof of residence
and income. The company providing the credit will probably also do a credit check with
the credit bureaus (such as Experian or TransUnion) to see if your payment history is in
order. You have probably opened accounts with clothing stores or cell phone providers
yourself. The same process applies to organisations.
A more lenient credit policy, with lax creditworthiness requirements, might lead to increased
revenue (more customers will be able to buy on credit), but also to higher bad debts (the
customers might not be able to pay their accounts).
2. Credit period
This refers to the length of time customers are given to pay their outstanding balance. If
properly enforced, a shorter credit period will lower the balance of accounts receivable.
This is not the same indicator as the actual debtors’ (receivable) days outstanding! See
discussion later on.
3. Discounts
This refers to discounts given to customers for early payments (before the credit period
expires). The credit policy indicates the discount percentage as well as the period in which
the payment must be made in order to qualify for the discount. A larger discount will reduce
the amount of the accounts receivable outstanding, as customers will be motivated to pay
earlier, but it reduces the profitability as the discount awarded is expensed!
4. Collection policy
This refers to the methods the organisation uses to collect overdue accounts receivable. A
more aggressive collection policy will result in a lower balance of trade accounts receivable
as payments are actively “chased”, but if the policy is too aggressive, it may damage the
relationship between the organisation and the customer, which might reduce future sales.
Customers that stay in default are usually reported to the credit bureaus (such as Experian
and TransUnion) which keep a database of individuals’ and organisations’ payment records.
Having a bad credit record will affect the ability of the debtor to obtain credit in the future.
Note
The credit period and the discount collectively form the “credit terms”. Credit terms are often
described using specific terminology, for example, a credit policy of 2/10 net 60, implies
that a 2% discount is offered to customers paying within 10 days, but that the debt has to
be paid on/before 60 days from the date of sale.
Refer to section 5, Accounts payable, for the discussion on what the effective cost of the
discount offered is.
57 .........................
Study unit 17
The balance of the accounts receivable (in the debtors’ ledger and the statement of
financial position) is determined by the volume of credit sales, and the payments received
in respect thereof. The net result is measured in the receivable days measure and the
debtors’ ageing schedule (report).
RECEIVABLE DAYS
Receivable days (or the debtor collection period) is a measurement of the number of
days it takes the average debtor to pay for the goods/services bought on credit.
Key formula: RECEIVABLE DAYS

Outstanding (unpaid) accounts receivable ÷ credit sales x 365 (or 360) days
AGEING SCHEDULE (FOR DEBTORS)

An ageing schedule for debtors (or debtors’ age analysis report) is a classification of
accounts receivable within bands of different outstanding periods, normally including,
current debt, up to and including 30 days, up to and including 60 days, up to and
including 90 days, and greater than 90 days.
This ageing schedule reflects the accounts receivable balance, segregated into bands
according to the age of each invoice. The ageing schedule will also indicate whether the
organisation’s credit policy is adequately enforced or not (debtors in the bands greater
than the credit period should be a minimum!).
This ageing schedule can be compiled from the organisation’s accounts receivable (debtors’)
ledger. There are also computer systems available that makes it easy to determine the
age of each debtor’s invoice. These systems can then also generate an ageing schedule
for debtors.
Note
In your AIN2601 module you will learn how to view the debtors’ age analysis report in
Pastel. The overdue amounts are also used to determine your provision for doubtful debts.
The balance outstanding of accounts receivable and the receivable days should be
monitored closely, to reduce the possibility of bad debts. Shareholders (or owners), investors
and banks are also interested in this balance as it will have an impact on their investment.
Calculating the receivable days (as discussed in study unit 16, section 6) and analysing the
organisation’s ageing schedule, assists the financial manager in managing the balance.
When the receivable days start to increase relative to prior periods, or the ageing schedule
shows that the percentage of past-due accounts is increasing, the organisation often needs
to tighten its credit policy.
Ac t i v i t y 17. 2
The ageing schedule of two garden centres, Sunshine and Moonlight, are
supplied as at the end of March 20x1. Both organisations have approximately
the same (rand) balance for accounts receivable.
........................ 58
TOPIC 7
Sunshine Moonlight
Days Balance Percentage Balance Percentage
out- of the of total of the of total
standing account balance account balance
0–10 859 960 61% 509 632 35%
11–30 559 677 39% 426 301 29%
31–60 255 690 18%
60 + 262 906 18%
1 419 637 100% 1 454 529 100%
The credit terms offered to the customers of Sunshine are: 2,5/10 net 30 (if
payment is made within 10 days, the customer will receive a discount of 2,5%;
or else the total amount is due within 30 days).
The credit terms offered to the customers of Moonlight are: 2/10 net 30.
REQUIRED
Analyse the two ageing schedules and discuss possible issues by referring
to the credit policy.
2 Fe e d b a c k o n a c t i v i t y 17. 2
Analysis of the ageing schedules:
The ageing schedule of Sunshine indicates that all its customers pay within the
allowed credit period which is 30 days. A total of 61% makes use of the 2,5%
discount by paying within 10 days and 39% pays within 30 days and does not
receive any discount.
The ageing schedule of Moonlight indicates that several of its customers are
not complying with its credit terms. A large proportion of the accounts receivable
balance, equalling 36% (18%+18%), is more than 30 days old. This is the case
in spite of Moonlight’s credit terms that require full payment within 30 days.
Discussion of the issues by referring to the credit policy:

1. Creditworthiness
Based on an analysis of the ageing schedule, it seems that Sunshine might
have stricter assessment procedures of the creditworthiness of customers.
Moonlight, on the other hand, seems to be more lenient in granting credit to
customers. This may have increased their revenue, but could also result in
higher bad debts.
2. Credit period
The credit period granted to trade debtors of both organisations is the same.
3. Discounts
The customers of Sunshine are more eager to make use of the 2,5% discount on
early payments. It seems that the smaller discount of 2% offered by Moonlight
to their customers was not sufficient to motivate them to pay earlier.
59 .........................
Study unit 17
4. Collection policy
Based on an analysis of the ageing schedule, it seems that Sunshine might
have stricter debt collecting procedures as all the customers of Sunshine are
paying within the required period of 30 days as was stipulated in the credit
policy. Moonlight might have to use a more aggressive collection policy, but
be wary not to damage relationships with their customers.
5 Managing accounts payable

TRADE ACCOUNTS PAYABLE (TRADE CREDITORS)
Trade accounts payable refers to the amount of purchases on credit that has to be paid
to the suppliers/creditors in the near future. Total accounts payable may also include
other accounts payable, which do not relate directly to the main operations (trading
activities) of the organisation.
We have already explained the term net working capital in section 2 when we discussed
working capital. In the previous sections, we have addressed the management of accounts
receivable and inventory. We will now look at the managing of current liabilities and we will
focus on the management of trade accounts payable, since it normally forms the biggest
part of current liabilities.
Trade accounts payable is a type of financing that arises naturally from normal operations.
It emanates from credit given by an organisation’s suppliers and is often the largest source
of short-term credit, especially for small organisations.
The advantages are that it is usually offered and relatively easy to obtain, assuming a
good credit record. It is largely interest-free if payments occur in line with the credit terms
(but not always cost-free as we will explain below).
The cost disadvantages can be high however, since failing to pay accounts payable on
due dates could lead to poor relationships with suppliers or suppliers may refuse to extend
further credit to the organisation. Interest and recovery fees are usually charged when
payment terms is exceeded. The impact on the organisation’s credit rating (by the credit
bureaus) is also very negative for future transactions on credit.
Proper management of the accounts payable process is necessary, because the decisions
regarding payments to suppliers may have significant effects on the cost of financing and
therefore have an impact on the organisation’s profit. As part of this process, the credit terms
of the suppliers’ credit policy should be taken into account when payments are planned.
ACCOUNTS PAYABLE (CREDITORS) DAYS

Payable days (or the creditor payment period) is the measurement of the average
number of days the organisation takes to pay for the goods/services received on credit
from its suppliers.
Key formula: PAYABLE DAYS

Outstanding (unpaid) accounts payable ÷ credit purchases x 365 (or 360) days.
........................ 60
TOPIC 7
Note
When you are analysing a statement of financial position and the amount of credit purchases
were not given, a rough alternative is to use the cost of sales figure.
AGEING SCHEDULE FOR CREDITORS
An ageing schedule for creditors (or creditors’ age analysis report) is a classification
of accounts payable within bands of different outstanding periods, normally including
current debt, up to and including 30 days, up to and including 60 days, up to and
including 90 days, and greater than 90 days.
This ageing schedule reflects the accounts payable balance, segregated into bands
according to the age of each invoice due/unpaid. The ageing schedule will also indicate
which payments are long overdue, in dispute and/or accruing interest.
This ageing schedule can be compiled from the organisation’s accounts payable (creditors’)
ledger. There are also computer systems available that makes it easy to determine the
age of each suppliers’ invoice. These systems can then also generate an ageing schedule
for creditors.
Note
In your AIN2601 module you will learn how to view the creditors’ age analysis report in
Pastel as well as amounts due for payment. The overdue amounts are the ones at risk.
5.1 The cost of financing trade accounts when discounts are offered
The implied monetary cost of finance, through the use of trade accounts payable, lies in
the settlement discount forfeited if payment is postponed (at this point in your studies,
ignore the interest charged on overdue accounts).
This is illustrated by the following example:

The credit terms allowed by a supplier is 2/10 net 30 (indicating that if payment is made
within 10 days after invoice date, the customer will receive a settlement discount of 2%;
otherwise, the total amount is due within 30 days after invoice date). As the amount paid
could be less by using the discount (paying on day 10), there is an implied cost (opportunity
cost) involved if the payment is postponed (to day 30) and the discount is forfeited.
Another way to look at it is that the discount is invested (“left” with the supplier or “paid
back” to the supplier) in order to make use of the credit from day 11 to day 30! This is then
the cost of the financing.
For this example, assume further that the value of the invoice is R200 and that the
organisation will be forfeiting the discount if they decide not to pay within 10 days. The
discount amount lost would equal: 2% x R200 = R4
or alternatively:
The organisation would pay the full R200 if settled at 30 days, but only the following amount
if settled within 10 days: R200 x [(100 – 2) ÷ 100] = R200 x [98 ÷ 100] = R196.
61 .........................
Study unit 17
Therefore, R200 – R196 = R4 is the discount lost, or alternatively, the implied finance
charge for postponing payment by 20 days (30 days less 10 days). (We will describe later
how to convert this to a percentage.)
Due to the nature of credit terms in general, managing the accounts payable involves two
distinct periods:
1. Period of free credit

This refers to the credit received and utilised during the period that discount is available
(in our example: day 1 to 10).
2. Period of costly credit

This refers to the credit used after the period of free credit and which has costs involved
based on unused discounts (in our example: day 11 to 30). The cost of not taking discounts
can be significant and, furthermore, the risk of being classified as a “late payer” can also
lead to more strict credit terms.
The decision whether to make use of trade discounts or to use the full credit period, should
be part of the organisation’s short-term financing decisions. Postponing payments to
creditors may be costly, but should be compared to the cost of other short-term financing
sources (usually the bank overdraft).
The following equation can be used to calculate the implied nominal percentage cost, on
an annual basis, of not taking discounts:
Key formula: IMPLIED NOMINAL ANNUAL PERCENTAGE COST OF ACCOUNT

PAYABLE (CREDIT)
Discount% 365 days
rNOM = x
100 – discount% Days credit outstanding – discount period
If we apply this formula to the example earlier in this section, then we could calculate the
implied annual percentage cost of the financing of postponing payment to 30 days:
2 365 days
rNOM = x
(100 – 2) (30 – 10)
2 365 days

rNOM = x
98 20
=
0,3724
=
37,24%
or alternatively
R4 365 days

rNOM = x
(R200 – R4) (30 – 10)
R4 365 days

rNOM = x
R196 20
=
0,3724
=
37,24%
........................ 62
TOPIC 7
Note
Notice that this is a very high annual rate. Continuously forfeiting discounts by postponing
payments can thus be an expensive form of finance.
The nominal annual cost equation does not take the effect of compounding into account.
The following familiar equation (refer to topic 3 – time value of money) is used to calculate
the effective annual rate:
Key formula: EFFECTIVE ANNUAL PERCENTAGE COST OF ACCOUNT PAYABLE

(CREDIT)
Effective annual rate (EAR) = (1 + periodic rate)n – 1
Where:
The periodic rate = discount % ÷ (100% – discount %)
n = the number of interest periods per year
If we now apply this formula to the example earlier in this section, then we could calculate
the implied effective annual cost percentage of postponing payment to 30 days:
n = 365 ÷ 20
= 18,25 interest periods in a year
Thus:
EAR = [1 + periodic rate]n – 1
365/20
= [1 + (

2%
100% – 2%
)] –1
18,25
= [1 + ( 982 )]
–1
18,25
= [1,0204] –1
= 1,4459 – 1
= 0,4459
= 44,59%
Note
Notice that the implied effective annual rate is even higher than the nominal cost due to
the effect of compounding.
Rule: WHEN TO TAKE UP DISCOUNT OFFERED

The effective cost of discount forgone should be weighed against the organisation’s
regular cost of short-term funding (usually the overdraft rate). If the overdraft rate is lower,
the discount should be taken. When the overdraft rate is higher, it is not cost-effective to
take the discount (you will be paying more than you are saving in the discount received)!
63 .........................
Study unit 17
Note
The same calculations should be done when an organisation is considering whether to

OFFER discounts to its clients. In this case, the effective cost of discount should be less
than the cost of financing from short-term sources!
Arwin CC purchases an average of R300 000 of inventory from its supplier on
an annual basis. The credit terms of the supplier is 2/10 net 45 and is strictly
enforced. The cost of other short-term financing options (such as the bank
overdraft) has an effective annual rate of 13%.
REQUIRED
a. Determine the true total monetary cost of the inventory to Arwin if all
purchases are paid within the discount period.
b. Calculate the nominal annual cost of credit if Arwin follows the policy of
paying for the purchases on the latest date allowed.
c. Advise Arwin on the best short-term financing option.
[Use four decimal places and round only the final answer to two decimal places.]
a. The true (net cash) price of the inventory is:
98*
R300 000 x = R294 000
100
*(100 – 2 ' 100)
Note
This net amount is only used for decision-making purposes! Remember that
in terms of IAS2 settlement discount cannot be netted off the purchase price
for purposes of valuing inventory!
b. The nominal annual cost of credit if discount is not taken:

Discount% 365 days
rNOM = x
2 365 days

rNOM = x
(100 – 2) (45 – 10)
2 365 days

rNOM = x
98 35
=
0,2128
=
21,28%
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TOPIC 7
c. I n order to determine which form of short-term financing is the best option,
we have to compare like-to-like: An effective annual rate was provided for
other short-term financing. We therefore have to calculate the same rate
for the implied cost of not taking the settlement discount on trade accounts.
The effective annual rate rate of utilising the full credit period, instead of
taking the settlement discount, can be calculated as follows:
EAR = [1 + periodic rate]n – 1
2% 365/(45 – 10)

=
[1 +
( 100% )] –1
– 2%
10,4286
= [1 + ( 982 )]
–1
10,4286
= [1,0204] –1
= 1,2345 – 1
= 0,2345
= 23,45%
Arwin can borrow from other short-term financing options at an effective

annual rate of 13%. This is far less than the rate of credit (applicable to
day 11 to 45) if discount is not taken. Therefore, Arwin should preferably
make use of alternative short-term financing options first (if sufficient total
funds are available) and rather pay the supplier on the 10th day following
the invoice date, in order to receive the discount.
6 Managing cash and cash equivalents

The net result of all the management actions to optimise the inventory levels, accounts
receivable and accounts payable, is reflected in the cash or overdraft balance! We will
now investigate how this aspect of current assets should be managed.
CASH AND CASH EQUIVALENTS

Cash is the money the organisation has on hand (eg petty cash, undeposited payments
received) as well as the money in the bank (eg cheque accounts or short-term deposits).
Cash and cash equivalents are needed in every organisation for the operations to run
smoothly. It is used, for example, to pay salaries and other expenses, buy assets or pay
liabilities. Cash generally earns a lower rate of return than financial instruments, short-term
investments or non-current capital assets. It is therefore important to properly manage
the levels of cash held.
Too high levels of cash will reduce the profitability of the organisation due to the low return
that is earned thereon. Too low levels of cash on the other hand will increase the risk that
the organisation will not have enough funds when it is needed, or that it will have to borrow
cash at higher interest rates (eg use a bank overdraft). There are four possible reasons
for holding enough cash:
1. Transactions – routine transactions are paid in cash or via a bank transfer. These
are transactions that are done on a regular basis and include payments to suppliers,
employees, taxation, et cetera.
2. Precautionary balances – there can be unpredictable or unforeseen transactions
and therefore the organisation would need additional cash in reserve. Examples
65 .........................
Study unit 17
of these transactions are delayed payments by debtors, payments of the excess to
an insurance claim in case of an accident or fire, or legal costs. A greater level of
uncertainty in a cash forecast model warrants a higher level of precautionary cash
balances. This is the equivalent of safety stock.
3. Opportunities – Unexpected opportunities may arise, for instance, investment
opportunities, unexpected changes in exchange rates, and so on. The organisation
will need sufficient cash to take advantage of that opportunity, otherwise it will be lost.
4. Obligations – A bank, for example, may require that their customers (the organisation)
maintain a minimum amount of cash in their account.
It is easier to manage an organisation with sufficient cash resources (less planning is

required) and it also indicates that the organisation is more liquid. An organisation may
experience financial distress if there is not enough cash.
The disadvantage of too much cash, as we mentioned before, is that cash earns little
interest and therefore a low return on investment. The objective is to have the minimum
of cash on hand, but to have enough cash to run operations effectively. The question that
arises is: How much cash is enough?
We will now look at different techniques that can assist with cash management.
6.1 Compiling a cash flow budget/forecast

A cash budget or forecast is the best known cash management technique. A cash budget
can be compiled daily, weekly, monthly or for any required period. It indicates whether a
cash surplus or shortfall can be expected in the specified period. Management uses the
cash budget to plan for the period ahead, estimate short-term cash requirements and use
it to evaluate subsequent performance.
Note
Preparing detailed cash budgets based on sales, production and payment terms will be
discussed in more detail in MAC2601.
6.2 Matching cash inflows and outflows

By performing cash flow forecasting, the timing of cash payments and requirements can
be planned to match with the cash receipts. This “matching” will entail that when you
receive cash from debtors, you will then pay the outstanding creditors and other expenses.
Matching cash flows provide cash when it is needed and thus enable the organisation
to lessen the cash balances that has to be kept in reserve.
6.3 Accelerate cash availability

There are different payment methods used by debtors, each taking longer or shorter to
reflect as cash in the supplier’s bank account.
1. Cheque payments were popular years ago, but very few organisations still accepts
cheques today. Cheque payments necessitated a lengthy administrative process
resulting in a long delay before it is reflected as cash in the bank.
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TOPIC 7
2. Another payment method, which is much faster and effective, is the electronic funds
transfer (EFT) method. If the customer uses the same bank as the organisation,
the transfer will reflect the same day or if it is a different bank, the transfer will reflect
within two to three days.
3. The direct debit method is another efficient payment method where funds are
automatically deducted from the customers’ account and added to the organisation’s
account. A direct debit is only suitable to certain businesses, but has the added
advantage of a reduction in debtor reconciliations (as there will be fewer problems
with payment references and in allocating amounts).
4. Credit cards are another method of payment in the retail industries. The payment is
reflected in the organisations account within two days, but the drawback is that credit
card fees are expensive. However, many customers prefer to pay by credit card, so
the organisation has to weigh-up the benefit of increased sales versus increased
financing fees.
Accelerating the cash availability means that you “move” your customers (by promotions
and incentives) to the payment method that reflects as cash soonest.
6.4 Delay payments

If the organisation currently settles early in order to take up discount offered, it can decide to
rather delay payments to the normal credit period. However, bear in mind that this involves
the effective cost of forfeiting the discount. In extreme cash flow shortages, the organisation
can approach its suppliers with a request for extension. This might entail further interest
charges. The long-term relationship with the suppliers should not be damaged.
6.5 Liquidate (sell) short-term investments

An organisation can also hold short-term investments in addition to the cash balances. These
short-term investments include money market financial instruments such as commercial
paper (unsecured promissory notes) issued by banking and non-banking institutions like
SABMiller and Sappi with exceptional credit ratings, treasury bills (issued by the government)
and negotiable certificates of deposit (issued by authorised deposit-taking institutions).
These are liquid financial instruments (it is traded on the money markets) and it can be
sold within a day or on very short notice. This is very important as an organisation normally
needs the cash immediately for emergencies or other opportunities. Money market financial
instruments usually earn a superior return to the interest paid on normal bank accounts
(if any).
The management of Flashco Limited is concerned about their cash flows for the
next three months. Flashco have invested R15 million in a short-term financial
instrument that will expire (repaid) only at the end of March (expected interest
R260 000). Their cash balance at the beginning of the January is R9 million. The
expected OPERATING cash flows over the next three months are as follows:
January February March

R’000 R’000 R’000
Expected cash inflows per month 55 988 44 890 74 552
Expected cash outflows per month 54 890 71 255 69 556
67 .........................
Study unit 17
You may assume that cash flows will occur at the end of every month, with
inflows occurring right before the outflows.
REQUIRED
a. Compile a simplified cash flow budget for the months ending January,
February and March.
b. Advise the management of Flashco on possible corrective actions that
may be required.
a. Simplified cash flow budget for the three-month period:
January February March

R’000 R’000 R’000
Expected cash inflows (given) 55 988 44 890 74 552
Expected cash outflows (given) (54 890) (71 255) (69 556)
Expected net cash inflow/(outflow)
for the month 1 098 (26 365) 4 996
Plus Opening cash balance
– positive/(negative) 9 000 10 098 (16 267)
Plus Inflow from short-term
financial instrument 15 260
Closing cash balance – positive/
(negative) 10 098 (16 267) 3 989
b. Advice:
The calculated cash balance of Flashco Limited had a negative balance of R16,2 m
at the end of February. Flashco would either have to apply for a bridging loan
or an overdraft facility at the bank (at least equal to this amount) from the end
of February to the end of March, or request that the short-term investment
be terminated earlier, if possible (but they must consider possible penalties).
Because of the uncertainty involved in the cash flows and budgeting process,
we would advise them to apply for more finance than indicated by the calculation
above, for example R20 million, to support the negative balance at the end of
February.
All efforts should be made to encourage debtors to pay early (end February
and not in March) and suppliers should be approached for a delay in payment
from the end of February to March.
Since there is a positive cash balance at the end of January, the financial
manager of Flashco should consider investing the excess cash in short-term
investments. This will likely earn a higher return than the current bank account.
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TOPIC 7
Note
Notice the importance of the assumption that cash flows would occur at the end of every
month, with inflows occurring right before the outflows. If not the case, cash flows could
occur during the month, which would necessitate a similar cash flow budget prepared on
a daily basis (or even before every payment is made).
7 Short-term financing
Rule: MATCHING MATURITIES
The maturity of the assets (current or non-current) should be matched with the maturity of
the financing (current or non-current). Matching maturities further implies that the financing
term (and related cash outflows) should match the duration of the asset that is supported
(and its related cash inflow benefits).
A basic principle of effective financing is that short-terms assets (current assets) should
mostly be financed by short-term financing instruments (current liabilities). In study unit
18, section 2.2, we will discuss this in more depth.
Where an organisation uses short-term instruments to finance non-current assets that

offer benefits over a longer timeframe, there may be a mismatch between cash outflows
(to repay interest and capital in the short-term) whilst the cash inflows (from the assets)
arise over a longer period. This may create financial distress.
SHORT TERM
Short term refers to a period of one year or less.
As mentioned earlier, accounts payable is a spontaneous form of short-term financing that

arises from normal operations, but this is not always adequate to finance all the current
assets. As a result, additional sources of finance are often required and these could
further be classified as either short-term or long-term finance. When considering short-
term financing, certain inherent advantages and disadvantages have to be considered.
Advantages of short-term financing are:

zz It can generally be obtained much faster than long-term financing – lenders of long-
term financing will require a more detailed investigation of the organisation’s financial
status.
zz As the term is of a short period, it can be obtained for periodic needs and the
organisation does not have to commit for long periods.
zz It may not be necessary to offer collateral for short-term financing.
zz Interest rates on short-term financing may be lower than interest rates on long-term
financing. (Here we should compare short and long-term financing on a like-for-like
basis – both options with collateral, or without as the risk also impacts on the cost of
debt.)
Disadvantages of short-term financing are:

zz The interest expense may fluctuate more on the short term.
zz Short-term finance might in some cases be cancelled with little or short notice,
which could create financial distress where an organisation cannot arrange for
alternative finance at short notice. (Notice that this is especially relevant in today’s day
and age, where banks are stricter in offering finance than in the past.)
69 .........................
Study unit 17
Forms of short-term financing (excluding accounts payable) include bank overdrafts and
short-term bank loans. Bank overdrafts and bank loans are provided by most commercial
banks. Large companies with excellent credit ratings may also sell commercial paper
(promissory notes) in the money market to raise financing for periods of 1–270 days. The
interest rates offered (paid to the holders) on these notes are often cheaper than that
obtained from the organisation’s bank.
8 Summary
In this study unit we have explained working capital management and how to manage
each component of working capital. In managing inventory, the advantages and disadvantages
of holding inventory were discussed as well as methods to assist in managing inventory.
In managing accounts receivable, the credit policy has been discussed and the ageing
schedule identified as a way to monitor the balance. In managing accounts payable as a
type of short-term financing, we explained that there is a cost involved if early settlement
discounts are not taken. As part of “cash management”, the reasons for holding cash and
cash management techniques were explained. Lastly, the advantages and disadvantages
of short-term financing were pointed out.
In the next study unit, we will continue with the topic of working capital by discussing
working capital policies and working capital cycle.
questions:
a. Why is the management of inventory important?
b. Why is the management of accounts receivable important?
c. Explain the periods associated with “free credit” and “costly credit” when referring to
trade accounts payable.
d. Why is cash management important?
e. Name the different cash management techniques.
f. Give the main reasons for holding cash.
g. What are the advantages and disadvantages of short-term financing?
QUESTION 1
The following are selected items from Green Industries Ltd’s trial balance at 31 December
20x1.
Accounts receivable R 265 110

Accounts payable R 656 000
Cash R 120 500
Accruals R90 650
Property, plant and equipment R 980 000
Long-term debt R3 500 900
Inventory R 550 000
Investments R1 400 400
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TOPIC 7
(We deliberately do not reflect these items in the order in which they would appear in the
annual financial statements.)
a REQUIRED
a. Calculate the gross working capital.
b. Calculate the net working capital.
QUESTION 2
Go-to-Basic Corporation buys its inventory from any of four suppliers. The suppliers all offer
basically the same quality and their prices are competiitve. Their credit terms, however,
vary noticeably as follows:
Supplier Credit terms

EverGreen 1/5, net 20
LetsSave 2,5/10, net 35
SimplicityCorp 0,5/10, net 20
Universe&I 2/5, net 30
Live-from-Earth 3/5, net 45
a REQUIRED
a. Calculate the implied nominal annual interest rate associated with each policy. Use a
365-day year and round your final answer to two decimal places.
b. If Go-to-Basic buys inventory from the SimplicityCorp supplier, advise them of the best
financing option if they pay an effective annual rate of 12% for other working capital
financing?
QUESTION 1
a. Gross working capital
Accounts receivable R 265 110
Cash R 120 500
Inventory R 550 000
Gross working capital R 935 610
b. Net working capital

Current assets (Gross working capital) R 935 610
Less: Current liabilities: R 746 650
Accounts payable R 656 000
Accruals R 90 650
Net working capital R 188 960
71 .........................
Study unit 17
QUESTION 2
a. Nominal interest rate
EverGreen
Discount% 365 days
rNOM = x
1 365
= x
99 (20 – 5)
= 0,2458
= 24,58%
LetsSave
Discount% 365 days
rNOM = x
2,5 365
= x
97,5 (35 – 10)
= 0,3744
= 37,44%
SymplicityCorp
Discount% 365 days
rNOM = x
0,5 365
= x
99,5 (20 – 10)
= 0,1834
= 18,34%
Universe&I
Discount% 365 days

rNOM = x
2 365
= x
98 (30 – 5)
= 0,2980
= 29,80%
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TOPIC 7
Live-from-Earth
Discount% 365 days

rNOM = x
3 365
= x
97 (45 – 5)
= 0,2822
= 28,22%
b. Effective annual rate rate

EAR = (1 + periodic rate)n – 1
Effective annual rate of discount not taken, thus of postponing payment.

EAR = (1 + periodic rate)n – 1
= (1 + 0,5/99,5*)[365/(20 – 10)] – 1
= (1,0050)36,5 – 1
= 20,08%
(*Use the periodic rate of the option/supplier with the lowest nominal rate. In this case
SimplicityCorp = 18,34%)
Go-to-Basic can obtain short term funding through other instruments (options) at an
effective annual rate of 12%.
The effective cost of postponing the payment from the 10th to the 20th day (taking 10 days
extra credit) after invoice, is 20,08%, while the other funding is available at 12% should they
wish to pay on the 10th day. The 12% is less than the rate of credit, if discount is not taken.
Therefore, they should preferably make use of alternative short-term financing instruments
(options) first (if sufficient total funds are available) and rather pay the supplier on the 10th
day following the invoice date, in order to receive the discount.
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Study unit 17
4 STUDY UNIT 18
Working capital policies and the working

4
capital cycle
In this study unit
1 Introduction
In the previous study unit, we have explained why the management of working capital is
important as well as the factors that affect the level of working capital and cash balances.
In this study unit, we will be focusing on working capital policies, which include investment
and financing policies. The working capital cycle will also be explained and illustrated.
2 Working capital policy

WORKING CAPITAL POLICY
The working capital policy of an organisation stipulates the appropriate amount for
the net working capital balance and for each of its components (investment policy),
and, in addition, how the net working capital balance should be financed (financing
policy).
We already explained that working capital is an important and necessary component for
most organisations in conducting their operations. The holding of working capital is however
costly as it is money that could have been invested in other return-generating assets. This
policy should strike an appropriate balance between the level of cash and inventories on
hand, the level of accounts receivable, and the level of accounts payable.
The following matters have an effect on an organisation’s working capital policy:

1. the total amount of working capital required
2. financing of working capital by short- or long-term funds
3. the nature and source of short-term financing used
4. the management of each component of working capital
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TOPIC 7
The working capital investment policy of an organisation will be addressed next. Thereafter,
we will address the question of how the investment in working capital should be financed
by discussing the working capital financing policy of an organisation.
2.1 Working capital investment policies

An organisation must determine what the optimum level of investment in working capital
should be. Every organisation needs a minimum level of investment in working capital in
order to support its basic operations. The organisation could be at risk if the investment
in working capital is lower than this minimum requirement. These risks were discussed in
the previous study unit in sections 2 and 3.
When a low level of net working capital is kept compared to total assets, it is described as
an aggressive investment policy. In contrast, when the investment in working capital
of an organisation is high when compared to all the assets of the organisation, the risk is
much lower. However, as with investments in general, lower risk usually warrants a lower
expected return on that investment. Since working capital does not actively generate
income, the return of the organisation will be lower and therefore also the profitability of
the organisation. As a result, where the investment in working capital of an organisation
is high compared to all assets, it is called a conservative investment policy.
In general, for most businesses the net working capital varies directly with sales. (Where
more products are sold, more inventories will generally have to be kept on hand, more
debtors will owe the organisation money from sales on credit, etc).
When an organisation’s business is seasonal (ie in agriculture, or beer sales that is
correlated to the weather or seasons), the sales will vary throughout the year, and so will
its working capital needs. Seasonal business is the reason for the distinction between
permanent and temporary working capital.
PERMANENT and TEMPORARY WORKING CAPITAL
z Permanent working capital supports a constant minimum level of sales.

z Temporary working capital supports seasonal peaks in the organisation’s operations.
See Figure 18.1 below for a graphical presentation of these two concepts.
Source: Kriek, Beekman & Els (adapted), 2008

FIGURE 18.1: Permanent and temporary working capital
75 .........................
Study unit 18
2.2 Working capital financing policies
After the organisation has determined the optimum level of investment in working capital,
the next step is to decide on how to finance the amount of working capital that is required.
The extreme opposite options are predominantly long-term funding (conservative policy) and
predominantly short-term funding (aggressive policy). The moderate policy is somewhere
between the two extremes.
The current ratio (as explained in study unit 16, section 6) can give an indication of which
policy the organisation is following. This ratio indicates the ability of the organisation to
pay its current liabilities with its current assets. The higher the ratio, the more conservative
the working capital policy would be. We will now look at the three different working capital
financing policy options, as well as the advantages and disadvantages of each.
1. Conservative financing policy

In the case of the conservative policy, the organisation makes use of more long-term
financing. Short-term financing is only used to support the peaks of the temporary working
capital. When temporary working capital is low, the total funding will mainly consist of long-
term funds; excess money will be invested in short-term deposits or financial instruments.
The advantages of a conservative financing policy are that the risk of not being able to
fund the ups and downs in working capital is low, as the repayment of the long-term funds
is not due soon.
The disadvantage is that the interest rates on long-term funds are generally higher than
those of short-term funding. This is one of the reasons why this policy is more expensive
and this then has a negative effect on the profitability of an organisation.

FIGURE 18.2: The conservative financing policy
2. Aggressive financing policy

In the case of the aggressive policy, the organisation makes use of more short-term
financing. Here short-term financing is supporting the entire temporary and some of the
permanent working capital.
The advantage is that the profitability of the organisation should increase. The reduction
of costs is possible because short-term funds are generally cheaper than long-term funds.
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TOPIC 7
The disadvantage is a greater level of financing risk, as the risk of the organisation not
being unable to repay the funding when it is due, is higher.

FIGURE 18.3: The aggressive financing policy
3. Moderate financing policy

This policy lies between the two extreme policies above. Long-term financing is used to
finance fixed assets and permanent working capital and short-term financing is used to
finance the temporary working capital. Here the matching maturities concept, that matches
the maturity of the assets with the maturity of the financing, is applicable.

FIGURE 18.4: The moderate financing policy
Ac t ivi t y 18.1
Winter-Heat Limited manufactures and sells electric heaters. Most of the
manufacturing is done in the five months from October to February in order to
have the heaters ready to sell in the autumn and winter months. The company
holds permanent net working capital of R1 200 000 all year, with total net
working capital increasing to R6 000 000 during these five months. Secured
long-term financing has an interest rate of 12% and secured short-term financing
is available at 10%. Winter-Heat Limited is considering two financing options:
77 .........................
Study unit 18
Aggressive – Finance half of permanent working capital with long-term funds and
the remaining permanent and temporary working capital with short-term funds.
Conservative – Finance the entire permanent and half of the temporary working
capital with long-term funds and the remaining temporary working capital with
short-term funds.
REQUIRED
a. Calculate the cost of each option.
b. Motivate why the financial manager may choose the expensive policy.
[You may ignore the effect of compounding in your answer. Round only the
final answer to the nearest rand.]

a. The following calculations should be done in order to calculate the cost
of each option:
Aggressive
financing R R
policy
Half of (1 200 000 ' 2) = 600 000 x 12% 72 000
permanent for
full year
Half of 600 000 x 10% 60 000
permanent for
full year
Temporary for (6 000 000 – 1 200 000) = 4 800 000 x 10% x (5 ' 12) 200 000
5 months
Total 332 000
Conservative
financing R R
policy
Permanent for 1 200 000 x 12% 144 000
full year
Half temporary (4 800 000 ' 2) = 2 400 000 x 12% x (5 ' 12) 120 000
for 5 months
Half temporary 2 400 000 x 10% x (5 ' 12) 100 000
for 5 months
Total 364 000
Note
The temporary working capital is only required from October to February (5

months).
b. The financial manager may choose the conservative option, even if it

represents the more expensive one, because the financing risk is lower for the
organisation. Short-term financing may be unavailable for small companies
like Winter-Heat and, where available, may be recalled at short notice,
which may create financial distress.
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TOPIC 7
Note
Both options provided in the question represent secured debt (where collateral has to be
offered). This would therefore not create a benefit for either option.
3 Working capital cycles

Certain cycles can be associated with the use of working capital in an organisation’s
operations. These cycles are: inventory is purchased from suppliers on credit; inventory
is then sold to customers on credit; the next step is the collection of accounts receivable;
and finally, payment is made to accounts payable. The cycles are segregated into two
distinct areas: the operating cycle and cash conversion cycle.
OPERATING CYCLE
The operating cycle focuses on an organisation’s internal (thus excluding accounts
payable) cycle’s impact on cash flow. It represents the length of time from committing
cash for purchases of inventory to the inflow of cash from the sale of inventory on
credit.
Key formula: OPERATING CYCLE

Operating cycle = inventory days + accounts receivable days
CASH CONVERSION CYCLE
The cash conversion cycle focuses directly on the cash flow associated with the overall
cash flow from operations (including accounts payable). It represents the length of time
between when an organisation makes payments to its creditors (outflow of cash) and
when an organisation receives payments from its customers (inflow of cash). As the
cash conversion cycle includes the cash flow benefit afforded by accounts payable,
this cycle is shorter than the operating cycle.
Key formula: CASH CONVERSION CYCLE

Cash conversion cycle = inventory days + accounts receivable days – accounts payable days
Number of days inventory (Inventory days)

+
Period of credit taken by customers (Receivable days)
–
Period of credit granted by suppliers (Payable days)
=
Total cash conversion cycle

FIGURE 18.5: The calculation of the cash conversion cycle
79 .........................
Study unit 18
The cash conversion cycle consists of the following:
1. Inventory turnover (conversion) time (= inventory days)
In a manufacturing organisation, it is the time that is required to convert raw materials
into finished goods and then to sell the inventory.
2. Receivables collection time (= receivable days)

The time required to collect the receivables after the credit sale.
3. Payables deferral time (= payable days)

The time it takes from purchasing the inventory or raw materials to the payment thereof.
4. Cash conversion time (= cash conversion cycle – days)

The net of the length of the above times (inventory, receivables and payables) and
equals the time from cash expenditure to the receipts from sales.
The cash conversion cycle is an important cycle as it contributes to our understanding of

how the organisation’s operations are running on an on-going basis. Managing the cash
conversion cycle is important as longer cycles consume more financial resources.
The cash conversion cycle can be shortened in a number of ways, including:

zz reducing inventory levels by implementing inventory management systems
zz delaying payments to suppliers or obtaining more finance
zz recovering outstanding accounts sooner by making the credit terms more strict or by
improving on the collection process
Each of these methods, in turn, has associated advantages and disadvantages. (These were
discussed earlier in the previous study unit, sections 3, and 5.) The calculation of the cash
conversion-cycle days was explained as part of ratio-analysis, in study unit 16, section 6.
Activity 18.2
RoofJacks is a manufacturer of roof trusses and a range of roofing materials.
The company wants to improve on their cash conversion cycle to eliminate the need
for additional funds to finance their working capital. An extract from the company’s
financial statements of the most recent financial year is offered below.
The total amount of credit purchases relating to inventory for the year were
R254 521. Total sales revenue (all on credit) was R390 000. Cost of sales
amounted to R245 112 for the year.
Balances at year-end:
R
Inventories 88 965
Trade receivables 74 556
Trade payables 36 559
REQUIRED
a. Calculate the cash conversion-cycle days for the most recent financial year.
b. Suggest how RoofJacks can shorten their cash conversion cycle.
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TOPIC 7
You may assume that year-end balances were reflective of average balances
for the year. Round only the final answer to the nearest rand. Use 365 days
per year.

a. The cash conversion cycle days:
Receivables 74 556
x 365 = x 365
Credit sales 390 000
= 70 days
Payables 36 559
x 365 = x 365
Credit purchases 254 521
= 52 days
Inventory 88 965
x 365 = x 365
Cost of sales 245 112
= 132 days
Cash conversion cycle Days

Number of days of inventory (Inventory days) 132
Plus: Period of credit taken by customers (Receivable days) 70
202
Less: Period of credit granted by suppliers (Payable days) (52)
Total cash conversion cycle 150
b. How to shorten the cash conversion cycle days:
Refer to section 3.
4 Summary
In this study unit, we have defined working capital policy and listed the factors that may
have an effect on the policy. The working capital investment policy was explained as well as
the different working capital financing policies. We defined operating cycle and illustrated
the calculation of the cash conversion cycle.
questions:
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Study unit 18
a. Define working capital policy.
b. Explain the difference between permanent and temporary working capital.
c. Name and describe the different working capital financing policies.
d. Define the operating cycle.
e. Define the cash conversion cycle.
f. Explain how the cash conversion cycle days are calculated.
QUESTION 1
New Harvest Limited has an inventory turnover rate of ten times, an accounts collection
period (receivable days) of 45 days and turns over its payables (payable days) once in
two months.
a REQUIRED
a. Calculate the length of the operating cycle.
b. Calculate the length of the cash conversion cycle.
(Use a 360-day year.)
QUESTION 2
Ladybird Limited is in a seasonal business as their high income period is in the summer
time. They require a permanent base of net working capital of R10 million throughout the
year, but that requirement temporaralily increases to R20 million during the 6-month summer
period each year. Ladybird Limited has two financing policy options for net working capital:
1. Finance all net working capital needs with short-term debt at 12,5%.
2. Finance permanent net working capital with equity at a cost of 18% and temporary net
working capital with a short-term loan at 12%.
REQUIRED
a
a. Calculate the cost of each financing policy option.

b. Which option will you classify as the aggressive working capital policy? Why?
c. Which option will you choose and why?
QUESTION 1
a. Operating cycle
Inventory turnover rate (number of times inventory is sold or used in a year – refer to topic
6) converted into days are:
360-day year / 10 times = 36 days
Inventory days 36

Plus: Receivable days 45
Operating cycle 81 days
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TOPIC 7
b. Cash conversion cycle
Inventory days 36

Plus: Receivable days 45
Less: Payable days 60
Cash conversion cycle 21 days
QUESTION 2
a. The following calculations should be done in order to calculate the cost of each option:
Financing
policy:
Option 1 R R
Permanent 10 000 000 x 12,5% 1 250 000
for full year
Temporary (20 000 000 – 10 000 000) = 10 000 000 x 12,5% x (6 ' 12) 625 000
for 6 months
Total 1 875 000
Alternatively: R R
Balance 10 000 000 x 12,5% x (6 ' 12) 625 000
of working
capital for
6 months
Balance 20 000 000 x 12,5% x (6 ' 12) 1 250 000
of working
capital for
6 months
Total 1 875 000
Financing R R
policy:
Option 2
Permanent 10 000 000 x 18% 1 800 000
for full year
Temporary (20 000 000 – 10 000 000) = 10 000 000 x 12% x (6 ' 12) 600 000
for 6 months
Total 2 400 000
b. The first financing policy is the aggressive policy, because the organisation makes use of
more short-term financing. The short-term financing is supporting the entire temporary
and all of the permanent working capital. Short-term financing is more volatile.
c. The financial manager may choose the conservative option, which is the second
option, even if it represents the more expensive one, as the financing risk is lower for
the organisation.
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Study unit 18
References and additional reading
Kriek, JH, Beekman, E & Els, G. 2008. Fundamentals of finance. 4th edition. Durban:
LexisNexis.
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TOPIC 7
TOPIC 8
Capital investments and capital
budgeting techniques
LEARNING OUTCOMES

–– discuss the purpose and importance of capital investment decisions
–– classify projects into types of expenditure and types of projects
–– determine relevant cash flows for the capital budget of a project
–– list and define traditional capital budgeting techniques
–– list and define discounted cash flow capital budgeting techniques
–– a
pply the capital budgeting techniques in the evaluation of different capital projects,
asset acquisitions and investment decisions

Introduction Managing and Risk management
Strategy and
strategic to financial investing funds
financing and the
cost of capital

organisation’s management risk management
7 Analysing and managing
strategy 3 Time value of working capital 10 Risk
money identification and
8 Capital investments and documentation
4 Sources and capital budgeting techniques
forms of finance 11 Risk
SU 19 Capital investments assessment, the
5 Capital structure
SU 20 Traditional methods/ management
and the cost of
techniques of risk and risk
capital
SU 21 Discounted cash reporting
flow methods/
techniques
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Study unit 18
INTRODUCTION
In topic 7, we dealt with managing the investment in working capital (current or short-term
assets) and sources of financing available for this investment type. In this topic, we will
explain how an organisation can invest in long-term (non-current) assets such as property,
plant and equipment by looking at capital budgeting, investment appraisals and valuation
methods.
We have already dealt with the basics of financing long-term assets in topic 4 – sources
and forms of finance and topic 5 – capital structure and the cost of capital.
Note
This topic relies strongly on your knowledge of topic 3 – time value of money and topic 5 –
capital structure and the cost of capital. If you get stuck, please refer back to these topics!
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TOPIC 8
5 STUDY UNIT 19
5Capital investments
In this study unit
1 Introduction
In this study unit, we provide an overview of capital investments whilst distinguishing
between different types of investments. We also discuss the project analysis process and
different classifications of capital projects.
2 Objective of capital investments

As a shareholder or owner of an organisation, you would have an expectation to earn a
return on your investment, whether it is in the form of dividends/distributions or capital
gain. Therefore, the role of management is to use the funds in the organisation to increase
the value for the shareholder/owner, whilst still taking cognisance of the interest of other
stakeholders, that is, creating long-term sustainable wealth as discussed in topics 1 and
2. The management should also manage the risks which face the organisation (you will
learn more about that in the next part on risk management).
You will know from your Financial Accounting modules that the organisation’s cash
outflows are either classified as expenses or as assets. Investments in assets can be
divided into two further categories, namely short-term (current) assets and long-term
(non-current) assets. Investment in working capital was covered in topic 7. Funds that
are invested in assets, large projects and capital market instruments (refer to topic 4) are
long-term assets. Examples include machinery that needs to be replaced, start-up cost for
a new business or long-term projects. This topic deals with long-term capital investments.
When making capital investment decisions, management’s objective is therefore to

select assets and projects that will increase the long-term sustainable value of the
organisation. Management has to invest the funds sensibly. Capital budgeting decisions
are the most important investment decisions made by the management of an organisation.
Capital investments create value if they are worth more than what they cost. Most of the
time, capital investments produce most of an organisation’s income in future years.
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CAPITAL INVESTMENTS / EXPENDITURE (also called CAPEX)
Long-term assets (eg non-current) such as property, plant and equipment acquired
individually or as part of large projects that generate returns (cash inflows) over a
number of years.
Note
The definition also includes investments in financial instruments (ie shares, debentures) issued
by other organisations where the intention is a long-term investment and not speculation.
Large companies usually own shares in their subsidiaries and associate companies instead
of holding all the long-term assets directly in their own legal organisation (ie instead of
buying another plant in their own name, they buy shares in another company that owns
such a plant).
In this topic, we will focus on non-financial (tangible) long-term assets. You will learn more
about the advanced issues surrounding the acquisition of shares in another organisation
in MAC3702 and MAC4861/2. The basic evaluation process though is largely the same.
Although we use the term “capital expenditure” in our MAC modules, it does not mean it
is expensed to the statement of profit or loss and other comprehensive income in terms
of International Financial Reporting Standards (IFRS) – it still remains a long-term asset!
SUSTAINABLE CAPITAL BUDGETING

Sustainable capital budgeting involves planning and evaluation of how funds are spent
on capital investments that will ultimately add to the organisation’s value while taking
cognisance of the social, environmental and governance impact of the decision.
Capital budgeting is an organisation’s formal process for the acquisition and investment
of capital. It involves an organisation’s decision to invest its current funds for addition,
modification and replacement of long-term assets.
The capital budgeting decision is an important one for any organisation, in the sense
that it determines the nature of the organisation’s operations and products over the long
term. Before the organisation commits its scarce and valuable capital resources to capital
investments (fixed productive projects/assets), it needs to be assured of the profitability as
well as an acceptable return on the funds invested therein. Therefore, capital budgeting
provides methods by which capital investments are evaluated.
The evaluation forms the basis of deciding whether a specific capital asset/project makes
sense for a particular organisation at a specific time and whether it is in line with long-term
strategic goals.
3 Types of capital expenditure

The capital expenditure process starts with an organisation’s strategic plan, which states
the strategy for the next three to five years. Strategic objectives are then converted into
business plans that give details of quantifiable targets for each business unit (refer to topic 1).
The capital budget forms part of the business plans (you will learn more about the details
surrounding the budgeting process in your MAC2601 module) and outline the reasons and
budgeted amount required for capital expenditure.
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TOPIC 8
Types of capital expenditures are as follows:
zz Major repair or upgrade
After some time, plant and equipment must undergo major repairs, be rebuilt or updated
with new technology. This usually restores the asset to its previous condition and output
capacity. These decisions do not require a detailed analysis and are made during the
course of the business operations. (Note that the taxation treatment of this expenditure is
different than that for replacement and expansion!)
zz Replacement
The replacement of assets is done when it’s irreparable, worn out or damaged. These
decisions involve the replacement of the asset with a similar or updated one. These
decisions will require a detailed analysis and also approval from the organisation’s board
of directors. Project cash flows can be forecasted with a greater degree of accuracy, based
on existing sales and manufacturing conditions.
zz Expansion
The expansion of a business unit involves producing new products, entering into a new
market or increasing capacity. These decisions will require a detailed analysis and also
approval from the organisation’s board of directors. Project cash flow estimates are subject
to greater uncertainty regarding eventual success of the new products or new markets.
Ac t ivi t y 19.1
You are given the following examples of capital expenditure:
a. A
manufacturing company decides to increase the output of existing
products. This involves the purchase of new equipment to produce more
products and extension of their distribution system.
b. A
delivery company has a fleet of delivery vehicles. They decide to renovate
the vehicles and their engines rather than to purchase new ones.
c. A
n organisation has a machine that has become obsolete and has to decide
whether to replace the machine with a similar one or to purchase a different
machine that would require a change in the production process. The new
machine may provide cost savings with respect to labour or material usage
and/or may improve product quality.
REQUIRED
Identify the correct type of capital expenditure for each example.

Refer to section 3.
a. This type of capital expenditure is an expansion as it involves increases of
capacity and the company’s distribution system.
b. This type of capital expenditure is a major repair or upgrade as the repairs
will restore the vehicles to its previous condition and output capacity instead
of purchasing new ones.
c. This type of capital expenditure is a replacement as it will replace an old
machine. Although it has other benefits as well (if a different machine is
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purchased), it still is not an expansion, as the output (capacity) was not
improved!
4 Project analysis
PROJECT ANALYSIS
Project analysis is the detailed examination of all the technical specifications (operational),
marketing (sales units, market, etc) and financial aspects (costs and revenues) and/or
problems of a project before funds are allocated and work on it is started.
The project analysis process involves the following steps:
PROJECT ANALYSIS PROCESS

Proposal generation
Project evaluation
Project selection
Implementation, monitoring and post-implementation audit
1. Proposal generation
The first step is the generation of a capital investment proposal. This entails the gathering
of information, both financial and non-financial.
Examples of the proposals for capital investment may include some of the following:
zz proposals to add a new product to the product line (to be sold in existing or new
markets)
zz proposals to expand the production capacity in existing product lines (to be sold in
existing or new markets)
zz proposals to reduce the costs of the output of the existing products without changing
the scale of operation
zz proposals to upgrade the production facilities to meet new environmental regulations
regarding gas emissions, effluents, and so on
2. Project evaluation
The proposal is then received by management and compared to other proposals.
Management has to ensure that all cash inflows from a project will be sufficient to cover
the initial cash outflow that will take place. An estimation of benefits and costs are measured
in terms of cash flows which are mainly dependant on future uncertainties.
The risk associated with each project should be analysed carefully and sufficient provision
must be made for covering the different types of risks.
Environmental, social and governance impacts should also be evaluated properly.
3. Project selection
Capital investment criteria should be compiled by management (the board) to judge
the attractiveness of the project. These selection criteria should be consistent with the
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TOPIC 8
organisation’s objective of increasing sustainable long-term wealth. The criteria should
include financial and non-financial parameters.
The screening and selection procedures for approving the investment proposal will be
different from organisation to organisation. The board (or top management) approves
selected projects and it is usually awarded a “vote number” and minuted as such.
Once the proposal for capital expenditure is approved (vote number obtained), it is the duty
of the financial manager to investigate the different alternatives available for acquiring the
funds, in line with the target capital structure of the organisation (refer to topic 5).
Note
There is a difference between the approval of the project (getting the vote number) and
getting approval in each financial year to spend the money (in line with the overall approval
granted)! The board sits at different intervals in the year. The budget is submitted for approval
to the board at a specific sitting (before the start of the new financial year).
4. Implementation, monitoring and post-implementation audit of the project.

The financial manager has to prepare a capital budget (detailing how and where the funds
will be spent) and various reports in order to get authorisation from the organisation’s board
of directors as the money is actually spent.
Systematic procedures should be developed to review the performance of the capital

investments during their lifetime and after completion in the case of capital projects. It is
important to identify any significant deviations from the initial proposal and quantify these
as soon as possible.
The follow up and comparison of actual performance with the original estimates (part of
the post-implementation audit) does not only ensure better forecasting, but should also
improve the capital investment appraisal process in future and assist management not to
repeat the same mistakes there might have been made.
5 Classification of capital investment projects

Potential capital projects can be grouped into the following classifications:
PROJECT CLASSIFICATION
Independent projects (projects with unrelated cash flows)
Mutually exclusive projects (competing alternatives)
Contingent projects (acceptance depends on acceptance of another project
Divisible and indivisible projects
1. Independent projects (projects with unrelated cash flows)

Independent projects do not compete with one another in terms of functionality. Their
cash flows are also independent from one another.
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For example, a financial manager is reviewing a company’s capital investment proposals.
One proposal is to acquire a new machine for its existing product line and another proposal
is to purchase mining rights. Both these projects can be accepted if they meet the criteria
because they have different functions.
2. Mutually exclusive projects (competing alternatives)

Mutually exclusive projects are projects that do compete with one another. These are
projects for which acceptance of one prevents acceptance of the other. The different
projects are alternatives for one another, and one has to be selected.
Consider a company that has to replace a machine. There are two types of machines that
can do the job. These two projects (machines) compete with each other because they have
the same function. Only one project can be chosen. Choosing one project automatically
eliminates the other from further consideration.
3. Contingent projects (projects, of which the acceptance depends on the

acceptance of another project)
With contingent projects, the acceptance of the one project is contingent on the acceptance
of another. If there are different (sub) projects required to complete a larger project, it is
called contingent projects. These different projects are treated as a single investment for
the purpose of evaluation. In this module, we will not deal with contingent projects.
4. Divisible and indivisible projects

When a project can be broken down into smaller parts that can be executed on their own,
it is a divisible project. A project that cannot be broken down in subparts is indivisible and
has to be undertaken in its entirety.
For example, divisible projects are common in the construction industry where developments
take place in “phases”. The organisation can decide to complete Phase I now and start on
Phase II in two years’ time (or never, if conditions become unfavourable!)
An indivisible project is, for example, where an organisation wants to erect a new bottling
facility in a new area to service a different market. The whole project has to be completed
as no smaller part of the plant can operate on its own.
Note
An organisation usually has only a limited amount of long-term funding available. Therefore,
all projects under consideration cannot be accepted. The type of project plays an important
role in allocating the available money!
Activity 19.2
You are given the following examples of capital investment projects:
a. A gas company wants to build a new power plant which involves different
projects. Firstly, a power plant will have to be built. Then, in order to comply
with environmental standards, they also need to invest in suitable pollution
control equipment.
b. An automobile company decided to manufacture sedans in South Africa. It
considered three possible manufacturing sites (or capital projects) namely
KwaZulu-Natal, Northern Cape and Gauteng. Management has decided
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TOPIC 8
and selected Gauteng as a manufacturing site after their detailed capital
budgeting calculations.
c. A property developer wants to develop a vacant area into a new shopping
centre. Phase I includes the anchor retailers (such as Woolworths and
Edgars) while Phase II involves four restaurants and a stationery shop.
d. The management of a manufacturing company has three projects in mind:
(1) build a new parking area at its head office; (2) acquire a small truck; and
(3) add manufacturing capacity to one of its workshops.
REQUIRED
Identify the correct classification for each project.

Refer to section 5.
a. These are contingent projects. The acceptance of the power plant is
contingent on the acceptance of the pollution control equipment. We can
also say that the pollution control investment is a compulsory contingent
project. This is also an example of in indivisible project. It is no use to build
the plant, if the pollution control equipment is not installed too, as the plant
will not get authorisation to start production.
b. These are mutually exclusive projects. Once management has decided and
selected Gauteng as a manufacturing site, the other two possible locations
for the investment are no longer considered.
c. These are divisible projects. The developer can decide to only go ahead
with Phase I.
d. These are independent projects. Since the cash flows for each project are
unrelated, accepting or rejecting one of the projects will have no effect on
the others.
6 Factors affecting the capital budgeting decision

Because the amount of funds available at any given time for new capital investments is
limited, management needs to use capital budgeting techniques to determine which assets
or projects will earn the highest return over an applicable period of time.
Apart from the returns of the individual projects under consideration, some of the factors
listed below also influence the capital allocation decision:
zz availability of funds
zz current and target capital structure of the organisation
zz legal factors
zz lending policies of financial institutions
zz immediate need for the project
zz future earnings
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Some of the risks and uncertainties in capital budgeting decisions include:
zz expected economic life of the asset or project
zz environmental, social and governance impact of the project(s)
zz the duration of the construction and ramp-up phase (getting the equipment ready to
produce at specified capacity)
zz recoupment value of the assets and working capital (if any) at the end of the project
zz overall capacity of the asset or project (output units)
zz selling price of the product
zz future demand for the product
zz reaction from competitors – affecting the projected sales volumes
zz South African Revenue Services’ (SARS) allowances for capital expenditure
zz production cost
zz successfully implementing new technology or new production techniques
zz inflation rates for different input costs
zz exchange rates, especially with imported plant and equipment and where the output
of the project is exported
zz tax rate
7 Cash flow estimation

Almost all the techniques (discussed in the next two study units) used in capital budgeting
appraisal is based on cash flows. Cash inflows and outflows are assessed in order to
determine whether the returns generated by the capital investment meet a sufficient target
benchmark, which is often the weighted average cost of capital (discussed in section 9).
The cash flow information needed to perform the capital budgeting appraisal or evaluation
is mostly obtainable within the organisation. It often starts with sales representatives and
marketing managers who are in the market place talking to potential and current customers.
Cost accountants and production engineers determine the cost of producing a product and
any capital expenditure necessary to manufacture it. Where the project involves optimising
production processes, the production managers will provide the details surrounding savings,
increased output levels, and so forth.
When preparing a proposal, it is important for the financial manager to only include cash
flows that are relevant to the capital investment decision.
A few of the cash flow concepts will be discussed next.
1. Relevant cash flows

Relevant cash flows are inflows and outflows that arise in the future as a result of the
investment decision being approved. Its inclusion or exclusion from the capital budgeting
calculation can affect the overall investment decision. For example, if the project is not
accepted, the machine will not be bought and no costs will be incurred. Relevant cash
flows will therefore be included in the capital budgeting calculation.
Examples of relevant cash flows are:

zz the acquisition cost of a machine (outflow of funds)
zz proceeds from sale of any project assets at the end of its useful life (estimated residual
value)
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TOPIC 8
zz the initial investment in working capital for the project, such as the additional
inventories to support the new operation, or increases in accounts receivable due to
new customers taken on
zz the cash sales attributed to the new machine and the payments in respect of variable
costs associated with the sales
zz salaries of the additional employees that needs to be hired specifically for the new
operation
zz rent to be paid for additional space for the new machine
Non-cash flow items are not included in the capital budgeting calculation. An example
of a non-cash flow item is depreciation and amortisations. Depreciation is an accounting
entry and not a flow of funds and therefore it must not be treated as a cash flow. However,
it has an effect on the income tax liability and must be taken into account when the cash
flow pertaining to the income tax liability is to be calculated (more on that later). Another
example is bad debts written off. The credit sale that gave rise to the debtor is only an
accounting entry; no cash has yet flowed.
Non-relevant cash flows include, for example, the rent of a factory if an organisation wants
to add a new product to the existing product lines. The new product will be manufactured in
the existing factory, so the rent of the factory is not relevant. If the project to manufacture
the new product is rejected, the rent still needs to be paid, because current products will
still be manufactured in the factory.
Note
The same principle applies as that in Relevant Costing covered in MAC2601. We only include
incremental cash in or outflows. Existing cash flows or cash flows already committed
before the investment decision is irrelevant. For example, if an additional machine can be
accommodated on the factory floor, we will not include a pro rata portion of the factory
rental to the project (even though the rental is paid in cash) as there is no increase in
the total amount of rental paid as a result of the investment decision. However, should
additional premises need to be rented, that rental will be included as additional cash fixed
cost of the project!
2. Working capital
Net working capital invested normally consists of additional inventories that are required to
support a new business operation or plant, and which will also have an effect on accounts
payable (inventories bought on credit), accounts receivable (increase in credit sales) and
cash. The amount invested is reflected as an outflow at the beginning of the investment
period.
The investment in net working capital is returned/realised at the end of the investment
period as the working capital is no longer required and the cash that was tied up in it is
now made available. For example, the last inventory has been sold, the debtors have all
paid and the creditors have been settled. It reflects as a net cash inflow at the end of the
investment period.
Should there be an annual change in the level of the working capital related to the project,
the net movement would reflect as either an outflow (increase in working capital balance)
or inflow (reduction in working capital balance).
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For example, let us assume the working capital required over the life of the project is as
follows:
0 1 2 3 4
R R R R R
Working capital 50 000 55 000 56 000 49 000 0
This can be reflected in the capital budget cash flows in two ways:
a. Net movements
Annual net cash movement (50 000) (5 000) (1 000) 5 000 49 000
b. Annual balances
Working capital opening balance 0 50 000 55 000 56 000 49 000

Working capital closing balance (50 000) (55 000) (56 000) (49 000) 0
3. Sunk costs
Sunk costs are costs that have already been committed or that have already taken place in
the past and will not be considered in the capital budgeting calculation. Sunk costs cannot
be changed or reversed by the acceptance or rejection of the project.
Examples of sunk costs include:

zz costs of research and development relating to the project which has already taken
place
zz patent fees for protection of intellectual property rights (new products/techniques
developed)
zz costs of feasibility studies
zz market research costs (if extensive market research has proved a demand for a new
product and the product is then being manufactured, the market research cost is sunk
costs and will be irrelevant to the capital budgeting decision)
4. Wear and tear allowances for taxation calculation

For accounting purposes, assets are depreciated by writing off a depreciation charge over
the productive life of the asset. SARS too allows a capital allowance on assets purchased.
In many cases this allowance (called wear and tear) occurs at a higher rate (to encourage
organisations to invest in productive capacity and create employment) than that which is
used to depreciate the asset for accounting purposes. It bears no correlation to the life
of the asset. This results in the taxable income being different to the accounting profit
before tax.
For example, an asset with a cost of R600 000 may have a useful life of six years. For
accounting purposes, we will charge depreciation at R100 000 per annum and deduct that
from the profits of the business. SARS may allow a wear and tear allowance of 20% per
year, which means that R120 000 is allowed as a deduction in the calculation of taxable
income. If we assume the organisation has other net cash profits before tax of R1 000 000,
the impact is as follows:
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TOPIC 8
Statement of profit or loss and other comprehensive income
R
Other net cash profits 1 000 000
Depreciation (100 000)
Profit before tax in statement of 900 000
profit or loss
NOTE
Normal tax (see below) (246 400)
Profit after tax 653 600 Do you notice that when we
add back the accounting
depreciation, we are back to
The calculation of taxable income will be as follows: the other net cash profits?

Add back depreciation 100 000
Deduct wear and tear (120 000)
Taxable income 880 000
Normal tax at 28% 246 400
Cash flow for capital budgeting:

R NOTE
Depreciation does not
Add back: Non-cash 100 000 feature in cash flows as it is
depreciation a non-cash item. It is added
Net cash from operations 1 000 000 back to profit. We include the
tax payment as an outflow.
Less: Taxation paid (246 400)
Net cash flow for the period 753 600
When the wear and tear allowance is different to the accounting depreciation, the asset will
also have a tax value which is different from the accounting book value. For the example
above, it looks as follows:
Year 0 1 2 3 4 5 6
R R R R R R R
Original cost price 600 000
Book value end of
year 500 000 400 000 300 000 200 000 100 000 0
Tax value end of 480 000 360 000 240 000 120 000 0
year
Another aspect that should be considered is where the asset is disposed of. When the
proceeds are more than the tax value, a recoupment of previous wear and tear allowances
occurs. This is added to the taxable income. For example, let us assume the asset was
sold at the end of year four for R150 000.
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For accounting purposes, the loss is R(50 000) (= R150 000 – R200 000).
For taxation purposes, the recoupment is R30 000 (= R150 000 – R120 000), which is
added to the taxable income. If we once again assume the organisation has other net cash
profits before tax of R1 000 000, the impact is as follows:
Year 4
R
Depreciation (100 000)
Loss on sale of asset (50 000)
Profit before tax in statement of
profit or loss 850 000
Normal tax (see below) (254 800)
Profit after tax 595 200
The calculation of taxable income will be as follows:

Add back: Depreciation 100 000
Loss on sale 50 000
Deduct wear and tear (120 000)
Recoupment of wear and tear 30 000
Normal tax at 28% R254 800
5. Normal income tax

This also is a relevant cash flow, as it has to be paid according to the Income Tax Act
based on the taxable income generated by the project (after taking account of wear and
tear allowances). The relevant cash flows (returns available to owners/fund providers)
are always net of tax. A detailed tax calculation (see previous point) is usually a part of
determining the after tax cash flows relating to the project.
Note
You will learn more about how taxable income is determined in your Taxation modules.
For purposes of MAC2602, we will limit it to very basic calculations.
6. Opportunity costs
Opportunity costs are net cash inflows that could have been generated from an alternative
investment or transaction and is therefore a lost (forfeited) return. The lost return can be
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TOPIC 8
viewed as a cost that arises from a lost opportunity and will be included in your capital
budgeting calculation.
An example is if a new project is implemented which requires the use of an existing

machine. The decision leads to the machine not being available to earn income for its
existing application any longer. The net cash income lost is a relevant cost to the capital
budgeting decision of the new project. The implication is that the new project must recoup
at least this lost income and more!
7. Financing costs
Financing costs (interest etc) is NEVER taken into account in the capital budgeting exercise.
Even though the interest on debt financing represents a cash outflow, the weighted average
cost of capital (used as the discount rate), based on the target capital structure, includes
the required return of all providers of capital (after tax) and will ensure that providers of
debt (and equity) will receive their return.
In topic 5 we have stressed that we use the target capital structure (or the actual, when
the target structure is unknown), because the source of funding for the next expansion
of the organisation is driven by the objective of moving towards to the target structure,
irrespective of how the funds are invested!
Note
In the next two study units, you will get the opportunity to see how all the different aspects
discussed above is treated in the capital budget!
8 Rules regarding timing of cash flows

In the discounted cash flow techniques, we take into account both the timing of cash flows
as well as the streams of cash flows over the full life time of the project.
A capital budget is usually prepared in a spread sheet like the example below:
Period
Example NPV 0 1 2 3
R R R R R
Capital outlay (cash outflow) (90 000) – – –
Realisable value (inflow) – – – 5 0002
Working capital (20 000) – – 15 0002
Net cash inflow from – 80 0002 50 000 2
35 0002
operations
Normal tax payments – (15 000)2 (6 000)2 (3 000)2
Net cash inflow/(outflow) (110 000) 65 000 2
44 000 2
52 0002
PV factor of R1 at 10% p.a. 1,000 1÷(1+ 0,1)1 1÷(1+ 0,1)2 1÷(1+ 0,1)3
OR per Table A 1,000 0,909 2
0,8262 0,751 2
Present value 24 481 (110 000) 59 085 2
36 3442 39 0522
99 .........................
Study unit 19
The following guidelines will assist you in populating the spread sheet:
Rule: TIMING OF CASH FLOWS

zz The initial cost of the investment or capital outlay always occurs in year 0 and is an
outflow (negative amount), which can be seen as the beginning of year 1. The present
value of R1 now (year 0), is R1 regardless of the size of the discount rate.
zz Cash flows (in and out) that occurs during any period is said to occur at the end of that
period/year. So, if a relevant cost occurs during the first year, it will be included in year
1, which is the end of year 1.
zz Cash flows that occur at the beginning of a period/year are taken to have occurred at
the end of the previous period/year. So, if a relevant cost occurs at the beginning of the
second year, it will be included in year 1, which is the end of year 1.
zz Any sale of assets or recoupment of working capital at the end of the project is reflected
as an inflow at the end of the last year.
Activity 19.3
The business that you work for, Refti Limited, owns a piece of land that have
cost them R500 000 five years ago. The land can be used for a new building
or it can be sold for R650 000.
REQUIRED
Identify the relevant costs when they decide to build a building on the piece of
land instead of selling the land.

The R500 000 are sunk costs, as the money was paid in the past. The cost
is irreversible and cannot affect your capital budgeting decision regarding the
erection of the new building. It is therefore an irrelevant cost.
The R650 000 is an opportunity cost as it is a lost opportunity when they decide
not to sell the land, but to build a building on it. It is therefore a relevant cost
and to be included in the capital budgeting calculation for the building.
9 The discount rate

In the previous section, we identified the cash flows that are relevant to the capital investment
decision. In topic 3, we have learned that money has a time value. Some of the methods
that will be discussed in the next sections and study units are based on the time value of
money. The correct decisions can only be made if all cash flows are measured at the same
point in time. Therefore, all cash flows must be discounted back to today’s value (called
the net present value (NPV) of the project).
The discount rate used is the weighted average cost of capital (WACC), which was discussed
in topic 5. The cost of capital is the rate of return that a capital investment must earn to be
accepted by management. The providers of the capital need the project to deliver at least
this minimum return on the investment.
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TOPIC 8
Note
This rate is sometimes adjusted for risk if the risk of the project differs from that of the
organisation in general (on which the WACC was based). You will learn more about this
in later MAC modules.
10 Capital budgeting techniques

Capital budgeting techniques help the management of an organisation to analyse the
business opportunities in order to decide on the best capital investments. Various
techniques have been developed to determine whether an investment opportunity meets
the organisation’s requirements for a “satisfactory return”. These methods/techniques are
classified as follows:
Traditional methods/techniques (also called conventional methods)

They are based on highly simplified and at times, unrealistic assumptions. They fail to take
into account the effect of risk factors or the time value of money.
The following traditional methods/techniques will be discussed and illustrated in study unit 20:
1. payback period
2. accounting rate of return (ARR)
Discounted cash flow methods/techniques (also called profitability methods)

They are more realistic as they take the time value of money into consideration when
the return on an investment is calculated through the application of discounted cash flow
methods.
The following discounted cash flow methods/techniques will be discussed and illustrated
in study unit 21:
1. net present value (NPV)
2. internal rate of return (IRR)
3. profitability index (PI)
11 Summary
In this study unit, we discussed the meaning and function of capital investments and
capital budgets. We discussed types of capital expenditure and the stages in the execution
and completion of a project. We also explained the different classifications of capital
investment projects. The importance of capital budgeting, factors influencing the decision
and the risks and uncertainties involved in these decisions were highlighted. We briefly
discussed sources of information and explained relevant cash flows and the discount rate.
We also listed the different capital budgeting techniques.
In the next study unit, we will illustrate the traditional methods used in capital budgeting.
101 .........................
Study unit 19
questions:
a. Define capital investments.
b. Define capital budgeting.
c. What is the objective of capital investments?
d. Name and describe the different types of capital expenditure.
e. Discuss the project analysis process.
f. Discuss the classifications of capital investment projects.
g. List some of the factors influencing the capital budgeting decision.
h. List some of the risks and uncertainties in capital budgeting decisions.
i. Define relevant cash flows, sunk cost and opportunity cost.
j. Which rate can be used as the discount rate?
k. Name the conventional methods/techniques.
l. Name the profitability methods/techniques.
QUESTION 1 – Eskom
a
You are given the following examples of capital expenditure of Eskom:

a. During the 1980s, Eskom realised that they supplied an excess electricity. The supply
was much more than the demand. They then decided to mothball three power stations,
of which Camden power station was one. In 2006, Eskom realised that there was going
to be a 15% shortfall in meeting the demand and they decided to start up the Camden
power station again to ensure that the supply is sufficient. However, the control systems
used (a major part of the plant) in the Camden power station was installed before 1980
and was too old and worn-out. It had to be replaced.
othball: If an organisation mothballs a factory, building or plant, it closes it or does
M
not use it for a long time, but may open it or use it again in future. Minimal maintenance
is done to prevent damage and to ensure a smooth start-up when it is required again.
b. Eskom is currently producing 40 gigawatts of electricity to satisfy the country’s electricity
needs. Their predictions show that the electricity demand in 2015 will be 43 gigawatts.
They decided to build the Madupi power station that will produce 3,6 gigawatts.
c. During the nine warmer months of a year, Eskom does the necessary major repairs
and maintenance on their generators to make sure that they will be able to generate
sufficient power during the three winter months when the demand is very high.
REQUIRED
a
Identify the correct types of capital expenditure for each example.
QUESTION 2 – Gunsite company

a
The Gunsite company manufactures a line of hunting rifles. Management is considering a

new business opportunity to produce a new product. New legislation by the government
requires that six months from now, all current and future rifle owners must store their rifles
in a rifle safe certified by the South African Bureau of Standards (SABS). The new product
line entails the manufacture and supply of SABS approved rifle safes.
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TOPIC 8
The opportunity has been investigated carefully and the following information is estimated:
Cost of new production machinery and equipment includ-

ing transport and setup costs R500 000
Expense of appointing and training new employees R225 000
Pre-start-up advertising and other miscellaneous R 60 000
expenses
Additional selling expenses per year after start-up R180 000
Unit sales prediction:
Year 1 650
Year 2 1 590
Year 3 1 320
Year 4 1 400
Unit selling price R2 700
Unit cash cost to manufacture (50% of revenue) R1 350
Last year, in anticipation of this new opportunity, Gunsite bought the rights to a new safe
design which has SABS approval, for R85 000.
Gunsite’s production facilities are currently being utilised to capacity, so a new workshop
has to be found for the incremental production. The company owns a plot near the present
facility on which a new building can be constructed for R700 000. The land was purchased
ten years ago for R300 000 and now has an estimated market value of R1 010 000.
If Gunsite produces rifle safes, it expects to increase some of its current sales of rifles, as
there will be more feet in the shop. An addition of ten percent of the rifle sales are expected
to come from this new business each year and will contribute an additional cash profit of
R70 000 per year.
Gunsite’s general overhead includes salary payments, repairs and maintenance. Small
one-time increments in business don’t affect overhead spending, but a major continuing
increase in volume would require additional support. Management estimates that additional
cash spending in overhead areas will amount to about 3% of the new project’s revenue.
Incremental inventories are estimated at R220 000 at start-up and for the first year. After
that, the working capital requirement will decrease to R80 000 and remain at that level for
the duration of the project.
The useful life of the machinery and equipment is six years and wear and tear for taxation
purposes is deductible at 20% per annum based on the cost of the asset by using the
straight line method.
The company’s current tax rate is 28%.
a REQUIRED
a. Calculate the total initial cash outlay (period 0) relating to the new product line of rifle
safes.
b. Estimate the cash flows of the new product line of rifle safes for the first four years.
[Round your figures to the nearest rand.]
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Study unit 19
Feedback on self-assessment activity
a QUESTION 1 – Eskom
a. This type of capital expenditure is replacement as the control system was worn out
and had to be replaced.
b. This type of capital expenditure is an expansion as they will be building a new power
station to increase capacity of power supply.
c. This type of capital expenditure is a major repair as equipment needs to be maintained
and repaired. One can even argue that some of the expenditure is normal maintenance,
but we need more information on the details.
a QUESTION 2 – Gunsite company

a. The initial outlay (period 0) for the new product line of rifle safes.
Assets necessary to get started R
Machinery and equipment 500 000
New building construction 700 000
Initial working capital (inventory) 220 000
Total of assets 1 420 000
Operating costs necessary to get started R

Appointing and training of new employees 225 000
Advertising and miscellaneous 60 000
Net operating costs  285 000
Note
The expenses are paid upfront in period 0, but remember that the tax deduction of these
expenses takes place at the end of year 1. You should include it as a deduction in the
calculation of the taxable income of year 1.
Opportunity cost of the land R

Market value – current selling price 1 010 000
The historical cost of the land (R300 000) is a sunk cost and is excluded!
Note
We will ignore the capital gains tax on the potential sale as it falls outside the scope for
MAC2602.
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TOPIC 8
The total initial outlay for the new product line is as follows:
Total initial outlay R

Assets necessary to get started 1 420 000
Operating costs necessary to get started 285 000
Opportunity cost of the land 1 010 000
Total for year 0 2 715 000
b. The cash flow estimation for the first four years of the new product line –
the rifle safes
Years
1 2 3 4
Units 650 1 590 1 320 1 400
R R R R
Turnover (units x R2 700) 1 755 000 4 293 000 3 564 000 3 780 000
Cash gross profit (units x R1 350) 877 500 2 146 500 1 782 000 1 890 000
Increase in current rifle sales 70 000 70 000 70 000 70 000
Selling expenses (180 000) (180 000) (180 000) (180 000)
Depreciation (non-cash flow) – – – –
General overhead (3% x turnover) (52 650) (128 790) (106 920) (113 400)
Net cash income before tax 714 850 1 907 710 1 565 080 1 666 600
Taxation paid  (92 358) (506 159) (410 222) (438 648)
Working capital
(R220 000 – R80 000) 140 000 – – –
Net cash flow 762 492 1 400 551 1 154 858 1 227 952
Taxation calculation: Years
1 2 3 4
R R R R
Net cash income before tax 714 850 1 907 710 1 565 080 1 666 600
Start-up operating costs (from a. ) (285 000) – – –

Wear and tear (R500 000 x 20%) (100 000) (100 000) (100 000) (100 000)
Total taxable income 329 850 1 807 710 1 465 080 1 566 600
Taxation at 28% (92 358) (506 159) (410 222) (438 648)
Note
The R85 000 that was spent on the new SABS approved design, is not taken into account
in the relevant cash flow estimation. It is a sunk cost, as the cost occurred in the past
and is irrelevant whether the new rifle safe opportunity was accepted or not. Only future
105 .........................
Study unit 19
cash flows that depend on the decision to go ahead should be included in the cash flow
estimation.
Also note that there are no financing costs deducted as it is included in WACC when the
NPV and IRR techniques are applied.
........................ 106
TOPIC 8
6 STUDY UNIT 20
6Traditional methods/techniques
In this study unit
1 Introduction
In the previous study unit, we discussed the importance of capital budgeting. Two different
capital budgeting techniques namely traditional and discounted cash flow were identified.
This study unit provides an illustration of the underlying principles involved in the evaluation
of capital assets/projects by virtue of examples that cover the traditional methods/techniques
for evaluating capital investments. These include the payback period- and the accounting
rate of return methods.
2 The payback period (PB) method

PAYBACK PERIOD
The period of time required to recoup the total capital amount invested through the
cash generation from the project.
In other words, it calculates the time it takes the cash inflows from a capital project to
equal the cash outflows, that is, to break even.
A long payback period means capital is tied up for a long time, which increases business
risk (the longer the time horizon, the greater the uncertainty regarding cash flows and the
business environment). Organisations use this method to set a maximum payback time,
above which investments are no longer acceptable. The calculated payback period of a
project is therefore compared with the target period that is set by management.
This method is based on simplicity and is very popular in practice. It is a very crude measure
though, and should be used in conjunction with other methods.
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Study unit 20
Key formula: PAYBACK PERIOD
Remaining cost to recover
PB = Years before break-even year +
Cash flow during the break-even year
Where:
Years before break-even year = number of years that the cumulative cash outlay
is still negative
Remaining cost to cover = capital outlay (investment) less cash recovered in
years before the break-even year or cumulative
negative cash outlay at the start of the break-
even year
Cash flow during the break-even year = cash flow during the year in which break-even
takes place
Cash flows = operational cash flows AFTER tax
Example:
Periodic Cumulative (unrecovered cash outlay)
cash flow or excess cash inflow
Outlay (investment) = R(10) m R(10) m
After tax cash inflow year 1 = R2 m R(8) m
After tax cash inflow year 2 = R3 m R(5) m Last year that cumulative outlay is still
negative
After tax cash inflow year 3 = R6 m R1 Break-even occurs somewhere in this
year
After tax cash inflow year 4 = R2 m R3

PB = Years before cost recovery +
Cash flow during the year
= 2 + (5 ÷ 6)
= 2,8333 years
2.1 Advantages
zz The method involves a simple calculation.
zz Acceptance or rejection of the project can be made easily.
zz It is biased towards short-term projects and liquidity and favours investments that free
up cash for other uses more quickly.
zz It is a good method for evaluating high risk projects. The longer it takes to recover the
initial investment, the higher the risk of the project. It thereby potentially eliminates the
uncertainty of later years’ cash flows.
2.2 Disadvantages
zz The method does not recognise the importance of time value of money.
zz It does not recognise patterns of cash flows.
zz It does not take risk explicitly into account.
zz It ignores cash flows after the payback period (break-even). It therefore ignores the
need to make profits from a project.
zz The target payback period is subjectively set by management.
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TOPIC 8
2.3 Evaluation criteria
The acceptance or rejection of the project is based on the cash flow generation of a project.
After your calculation of the payback period, you can evaluate the project as follows:
zz If the payback period is shorter than the target payback period (as set by management),
the project should be considered for funding.
zz If the payback period is longer than the target payback period (as set by management),
the project should be rejected.
zz If projects are mutually exclusive, the project with the shortest payback period should
be considered for funding, but the target payback period should still be taken into
consideration.
Based on the disadvantages listed above, it is therefore recommended that this method
be used in conjunction with other methods before final decisions are made.
Ac t ivi t y 20.1
A business has to choose between two machines, Sip and Huk:
zz Sip has a cost of R100 000 and will give a net cash flow saving in operating
cost after tax of R25 000 per annum for five (5) years.
zz Huk has a cost of R110 000 and will give a net cash flow saving in operating
cost after tax of R26 000 per annum for five (5) years.
zz Depreciation amounts to R20 000 for Sip and R22 000 for Huk per annum,
but it has not been included in determining the cost saving as it does not
constitute cash flow.
REQUIRED
a. Calculate the payback periods for both Sip and Huk.
b. Which machine should be chosen if we use this method in isolation? Why?
c. If management has set a target payback period of four (4) years, which
machine should be rejected?

a. The payback periods for both Sip and Huk:

R100 000
Sip: Payback period =
R25 000
= 4 years


R110 000
Huk: Payback period =
R26 000
= 4,23 years
109 .........................
Study unit 20
Note
This is an alternative method to calculate the payback period where we have

equal cash inflows per year! The annual cash inflows are treated as an
annuity. We therefore do not need to calculate the cumulative unrecovered
cash outlay for each year.
Proof for Huk:

R’000 Cumulative (unrecovered cash outlay)
or excess cash inflow
Outlay (investment) = R110 R(110)
Cash inflow year 1 = R26 R(84)
Cash inflow year 4 = R26 R(6) Last year that cumulative outlay
is still negative
Cash inflow year 5 = R26 R20 Break-even occurs somewhere
in this year

PB = Years before cost recovery +
Cash flow during the year
6
= 4 +
26
= 4,2308 years
b. The payback period of Sip and Huk should be compared. The payback
period of Sip is shorter than that of Huk. Therefore, machine Sip should
be chosen.
c. Machine Huk should be rejected as its payback period is longer than the
target of four (4) years.
3 The accounting rate of return (ARR) method

ACCOUNTING RATE OF RETURN (ARR)
This is based on an investment’s (project’s) average net PROFIT after tax (not cash
flow), divided by its average book value. It is also called the average rate of return
on investment/capital (ROI or ROC) method.
The accounting rate of return method calculates the average rate of return generated by
the investment over its useful life (life span). If this return exceeds a target rate of return
(set by management), the investment project should be undertaken.
Key formula: ACCOUNTING RATE OF RETURN (ARR)

Average net profit after taxation 100
ARR = x
Average investment 1
........................ 110
TOPIC 8
Where:
Average net profit after taxation = the average annual profit after taxation for the whole
period (life of the project/asset)
Average investment = the average of the original investment cost (outlay) and
any residual value at the end of its useful life (usually
Rnil). (This is equal to the cost of the investment ÷ 2
if depreciation is levied on the straight-line basis!)
Example:
Outlay (investment) = R10 m Depreciated straight-line over 4 years, no
residual value
Annual profit (loss) after
depreciation charged
After tax cash inflow year 1 = R2 m R(0,5) m
After tax cash inflow year 2 = R3 m R0,5 m
After tax cash inflow year 3 = R6 m R3,5
After tax cash inflow year 4 = R2 m R(0,5)
Total over 4 years = R3 m
Average over 4 years = R0,75 m

Average investment (R10 m ÷ 2) R5 m

ARR = x
Average investment 1
R0,75 100
= x
R5 m 1
= 15%
Note
The average investment can also be calculated as the average of the book values over
the life of the asset:
Outlay (investment) = R10 m Depreciated over 4 years, no residual value
Book value Average book value

End of year 1 = R7,5 m R8,75 m = (10 + 7,5) ÷ 2
End of year 2 = R5 m R6,25 m = (7,5 + 5) ÷ 2
End of year 3 = R2,5 m R3,75 m = (5 + 2,5) ÷ 2
End of year 4 = R0 m R1,25 m = (2,5 + 0) ÷ 2
Total over 4 years = R20 m
÷4
Average book value over 4 years = R5 m or = R10 m ÷ 2
Where assets are not depreciated on the straight-line basis, OR the residual value is
significant, you should rather determine the average investment based on the average
book values and not on the investment divided by two! The reason is that there is not a
gradual decline (to Rnil) in the book value over the useful life.
111 .........................
Study unit 20
3.1 Advantages
zz It is very simple to understand and use.
zz It provides a better means of comparison of projects than the payback period method,
because it takes into account the saving over the entire economic life of the project.
zz It can readily be calculated by using the accounting data.
zz A rate is always easy to interpret.
3.2 Disadvantages
zz It ignores cash flows.
zz It ignores time value of money.
zz It ignores risk.
zz It ignores the fact that the profits earned can be reinvested.
zz It does not consider the length of life of the projects.
zz The target rate of return is set subjectively by management.
Note
Where managers’ performance are measured based on return on investment (ROI), the
timing of the profits (how much is generated in which year) can have an impact on whether
a project that should be accepted, based on the average ARR, is accepted or not. You will
learn more about this in MAC3701 in Performance Management.

After your calculation of the ARR, you can evaluate the project as follows:
zz If the ARR of the project exceeds the target rate (as set by management), the project
should be considered for funding.
zz If the ARR of the project is lower than the target rate (as set by management), the
project should be rejected.
zz If projects are mutually exclusive, the project with the highest ARR should be considered
for funding, but the target rate should still be taken into consideration.
Based on the disadvantages listed above, it is therefore recommended that this method
be used in conjunction with other methods before final decisions are made.
Activity 20.2
Use the same information as in activity 20.1 before.
REQUIRED
a. Calculate the ARR for both Sip and Huk.
b. Which machine should be chosen? Why?
c. If management has set a target rate of 10%, which machine should be
rejected?
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TOPIC 8
a. The ARR for both Sip and Huk:
Sip: ARR = x
Average book value 1
(R25 000 – R20 000) 100

= x
(R100 000 + 0) ' 2 1
= R5 000(1) 100
x
R50 000(2) 1
= 10%

Huk: ARR = x
(R26 000 – R22 000) 100

= x
(R110 000 + 0) ' 2 1
=
R4 000 100
x
R50 000(2) 1
= 7,27%
(1)

The average annual profit is brought about by the net saving in after tax cost,
which is calculated at R5 000 per annum for machine Sip and R4 000 per
annum for machine Huk (the cash flow figures provided in activity 20.1 were
before depreciation, but already after taxation).
(2)

As depreciation is calculated on the straight-line basis, we can use the short-
cut and divide the investment amount by two.
b. The ARR of Sip and Huk should be compared. The ARR of Sip is higher
than that of Huk. Therefore, machine Sip should be chosen (in the absence
of other methods).
c. Machine Huk should be rejected as its ARR is lower than the target rate
of 10%.
4 Summary
In this study unit, we discussed traditional techniques used in capital budgeting. Advantages,
disadvantages and evaluation criteria of the payback period method and the accounting
rate of return method were explained. We illustrated these techniques in the calculations
of different activities.
In the next study unit, we shall proceed with the illustration of discounted cash flow
techniques used in capital budgeting.
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Study unit 20
After having worked through this study unit, you should be able to discuss the following:
a. the advantages, disadvantages and evaluation criteria of the payback period method
b. the advantages, disadvantages and evaluation criteria of the ARR method
The next question will assess your skills in calculating the payback period and the use of
the ARR method.
a QUESTION 1
A project requires a cash outlay of R200 000 and generates cash flow savings in operating
cost after tax of R80 000, R70 000, R40 000 and R30 000 during the next four years.
Depreciation of R50 000 per year has not been deducted from the operating cash flow
after tax figures as it is a non-cash item.
a REQUIRED
a. What is the project’s payback period?
b. What is the accounting rate of return (ARR) for the project?
QUESTION 1
a
a. The project’s payback period:

Payback period = 1 year : R200 000 – R80 000 = R120 000
= 2 years: R120 000 – R70 000 = R50 000
= 3 years: R50 000 – R40 000 = R10 000
= 3 years and (R10 000 ÷ R30 000) x 12 months
= 3 years and 4 months
b. The accounting rate of return (ARR) for the project:

ARR = x
(R55 000 – R50 000) 100

= x
(R200 000 – 0) ' 2 1
= R5 000(1) 100

x
R100 000 1
= 5%
Average operating cash flow after tax for 4 years

(1)
= (R80 000 + R70 000 + R40 000 + R30 000) ÷ 4

= R55 000
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TOPIC 8
7 STUDY UNIT 21
7Discounted cash flow methods/techniques
In this study unit
1 Introduction
In the previous study unit, traditional techniques used in capital budgeting were discussed
and illustrated. This study unit provides a further illustration of the underlying principles
involved in the evaluation of capital assets/projects by virtue of examples that cover the
discounted cash flow methods/techniques for evaluating capital investments. These include
the net present value, internal rate of return and profitability index methods/techniques.
2 Overview of discounted cash flow methods

These methods factor in the timing of cash flows and it considers cash flows after the
payback period (ie all the cash flows over the life of the investment or project) and are
an improvement on the traditional methods such as payback period and accounting rate
of return.
The presence of time as a factor in investment decision-making is fundamental because

the real value of money fluctuates over a period of time. A total of R40 000 received today
has more value than R40 000 received in five year’s time (refer to topic 3). In evaluating
investment projects, it is therefore important to consider the timing of returns on investment.
We will now discuss each of the three methods in more detail.
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Study unit 21
3 Net present value (NPV) method
NET PRESENT VALUE
Net result of future periodic net after tax cash flows discounted to present value, using
an appropriate rate, and the present value of the capital invested in the project.
The net present value method is a discounted cash flow (DCF) method because it takes
cash flows and time value of money into account. It is considered as the best method of
evaluating capital investment proposals and it is widely used in practice.
Key formula: NET PRESENT VALUE

n
/
NPV== t t G – I
C
(1+k)
t=1
Where:
n = number of periods (life of the project)
t = specific period
k = discount rate (= WACC ± risk adjustment, if any)
Ct = net cash flow for period t
I = initial capital investment at period 0 (note, this is not a figure “1”, but “I” for “Investment”)
The NPV method involves the following steps which are represented in the formula above:
1. Determine and calculate the net cash flows PER PERIOD for the entire life of the
investment/project/asset. This is Ct in the formula.
2. Discounting each of the net cash flows by an appropriate discount factor (refer to
study unit 19, section 9 and topic 5 – capital structure and cost of capital). This is the
denominator (1 + k)t in the above formula.
3. Add together the discounted cash flows for each period (the present values) 1 to t.
This is the ∑ in the formula.
4. The net value (NPV) is derived by subtracting the amount invested at point 0 (this is
the I in the formula) from the total present values of all the project generated cash
flows, calculated in step 3.
In applying this method, an acceptable discount factor (or required rate of return), normally
based on the weighted average cost of capital (WACC) (refer to topic 5), is calculated. It is
this percentage at which the cash flows are discounted to obtain a net present value. The
NPV’s of each project will be used for measurement against the accept or reject criteria.
3.1 Advantages
zz This method recognises the time value of money.
zz It considers the cash inflow of the entire project.
zz The discount rate can be adjusted to take account of the riskiness of the investment/
project.
zz It assumes that surplus cash inflows can be reinvested at the WACC.
3.2 Disadvantages
zz The concept of WACC is difficult to understand.
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TOPIC 8
zz The calculation of the WACC is complex and subject to interpretation.
zz The risk premium/discount that is added to the WACC can be manipulated by
management.
zz The result of the discounted cash flows is a rand amount, rather than a rate (%), which
makes it more difficult to interpret.

Determine what has to be decided on. This could be, inter alia:
zz whether a single project is to be undertaken or not (compare cash cost with cash
advantages)
zz a choice between alternative projects (compare equivalent periodic cash advantages
with each other)
zz to decide whether capital must be invested to obtain a saving in operating costs
(compare the cash costs before investment with cash costs after investment)
The cash flows pertaining to each project must be included in a time schedule or time
statement and a net cash flow per period must be determined. The NPV can be calculated
using the formula for present value, the factor tables or a financial calculator. (These
methods were discussed and explained in topic 3 – time value of money.)
After your calculation of the NPV, you can evaluate the project as follows:
zz If the NPV is positive (exceeds 0), the project may be accepted.
zz Should the NPV be negative (lower than 0), the project must be rejected.
zz A NPV of nil, where the present values of the cash inflows and cash outflows are equal,
means that the project may still be accepted and the internal rate of return (IRR) has
been achieved.
zz If the projects are mutually exclusive, the project with the highest positive (exceeds 0)
NPV may be accepted.
We will now demonstrate the application of this method with the next two activities.
Ac t ivi t y 21.1 – Projec t s Yum, Tum and Pun

An organisation should choose between three projects namely Yum, Tum and
Pun. The cost of each of these projects are R100 000 and they are mutually
exclusive. Assume a required rate of return on capital of 14%.
The net cash inflow from operations after tax for each project is as follows:
Project
Year Yum Tum Pun

R R R
1 50 000 60 000 20 000
2 50 000 50 000 40 000
3 25 000 40 000 80 000
117 .........................
Study unit 21
REQUIRED
a. Evaluate the above three projects by calculating their NPV as follows:
i. Project Yum by using the factors from the tables and combining years
with the same cash flows.
ii. Project Tum by using the factors from the tables and a financial
calculator.
iii. Project Pun by using the factors from the tables and Microsoft Excel.
b. Conclude on what project should be accepted.

a. i. Project Yum by using the factors from the tables and NOT combining
years:
Years
0 1 2 3
R R R R
Net cash inflow from
operations – 50 000 50 000 25 000
Net cash inflow/(outflow) (100 000) 50 000 50 000 25 000

PV factor of R1 at 14% p.a.
(Table A) 1,000 0,877 0,769 0,675
Present values (100 000) 43 850 38 450 16 875
NPV (825)
Combining of years
Where the cash flows of more than one year are identical, they may be combined
in one column to save time and space. These cash flows are treated as an
annuity (refer to topic 3 – time value of money). The PV factor that is used
then is from Table B which is a present value (PV) of cash flow per annum. By
using Table B, the cash flow is projected for multiple years, as illustrated below.
Project Yum (years of identical cash flow COMBINED)
Years
0 1–2 3
R R R
Capital outlay (cash outflow) (100 000) – –
Net cash inflow from operations – 50 000 25 000
Net cash inflow/(outflow) (100 000) 50 000 25 000
PV factor of R1 at 14% p.a. (Table A) 1,000 1,646 0,675
Present values (100 000) 82 300 16 875
NPV (825)
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TOPIC 8
Note
Please note that the cash flow for one year is indicated in the column, and
not the cash flow per year multiplied by the number of years.
Calculation:
 Factor
Year 1: Table A at 14%, year 1 0,877

Year 2: Table A at 14%, year 2 0,769
Years 1 to 2 1,646
OR
Year 1 – 2: Table B at 14%, 2 years = 1,647
The difference is due to rounding and can be ignored.
a. ii. Project Tum by using the factors from the tables and a financial
calculator:
Years
0 1 2 3
R R R R
operations – 60 000 50 000 40 000
(Table A) 1,000 0,877 0,769 0,675
Present values (100 000) 52 620 38 450 27 000
NPV 18 070
Financial calculator
In order to use your financial calculator, read the manual, as each calculator has
its own specific way of working. The following steps have been demonstrated
for a Sharp and HP financial calculator:
119 .........................
Study unit 21
SHARP EL-738 Hp10BII
Key in: Display will read: Key in: Display will read:
Clear all registers first: 2ndF C ALL 1 P_Yr then 0.0000
CFi 2ndF CA 0.0000 3rdF C MEM 0 c FLo clr then 0.0000
2ndF 1 I/YR 1.0000
Enter data sets:

+/– 100 000 ENT DATA SET:CF 0.0000 100000+/– CFj CFLO/CF-100,000.0000
60 000 ENT DATA SET:CF 1.0000 60000 CFj CFLO/CF 60,000.0000
40 000 ENT DATA SET:CF 3.0000 40000 CFi CFLO/CF 40,000.0000
Clear cash flow registers:

ON/C 0.0000
2ndF CASH RATE (I/Y) =
2ndF CA RATE (I/Y) = 0.0000
Enter rate:
(I/Y) 14 ENT RATE (I/Y)= 14.0000 14 I/YR 14.0000

Use arrows to get to NPV NET_PV = 0.0000
and press COMP 18’103.8160 2ndF NPV 18 103.8160
Thus, the net present value is R18 104 (rounded to the nearest rand) according
to the financial calculator and is R18 070 according to the method using the
factors from the tables. The difference of R34 is due to the fact that the factors
in the tables are rounded off.
a. iii. Project Pun by using the factors from the tables and Microsoft Excel:
Years
0 1 2 3
R R R R
operations – 20 000 40 000 80 000

(Table A) 1,000 0,877 0,769 0,675
Present values (100 000) 17 540 30 760 54 000
NPV 2 300
Using Microsoft Excel:

Net present value problems can also be solved by using a spread sheet
program. The spread sheet is designed to keep track of all the cash flows and
the periods in which they occur. The following spread sheet setup shows how
to calculate the NPV for project Pun.
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TOPIC 8
NOTE
Notice that the preset NPV formula (in Excel, not your ﬁnancial calculator)
only determines the net present values of the cash flows in all other years,
excluding period 0! Therefore, you should only enter the cash flows in years 1
to 3, along with the discount rate. You then add/deduct the cash flow in year 0 to
the total of the NPV formula calculation to arrive at the NPV for the investment.
Remember to keep track of signs. Cash outflows are negative and cash inflows
are positive.
Thus, the net present value is R2 320 according to Microsoft Excel and is
R2 300 according to the method using the factors from the tables. The difference
of R20 is due to the fact that the factors in the tables are rounded off.
b. Conclusion
An overview of the three projects, bearing in mind the project cost of R100 000
each, reflects that project Yum has a negative net present value (cash inflow).
It does not meet the 14% return which is required and will not provide for the
return of the capital invested and the required interest thereon.
Project Tum has a positive net present value of R18 070, which indicates
that its return substantially exceeds the required 14% per annum. In the next
section, we will revisit how to calculate the internal rate of return (which you
encountered in topic 5 – capital structure and cost of capital).
Project Pun with a positive net present value of R2 300, indicates that its
internal rate of return is also in excess of 14% per annum.
121 .........................
Study unit 21
Project Yum cannot be recommended, whilst projects Tum and Pun are both
acceptable, with Tum being preferred as it has the highest NPV.
Where the amounts to be invested differ, the most profitable project is that for
which the ratio of income to investment is the highest. You will learn how to
calculate this in the section on the profitability index.
Where sufficient funds are available for investment in both projects and they
are divisible projects, the maximum amount should be invested in Tum and
the balance in project Pun.
Note
Qualitative issues as discussed in topics 1 and 2 should also be considered when making
the final investment decision. These issues include the consideration of other stakeholders
as well as non-financial aspects such as environmental, social and governance in order to
ensure the long-term sustainability of the organisation. It is no longer acceptable to make
decisions based on financial impact alone.
Abrey Ltd is considering the replacement of its machine Adro, which is currently in use,
The following information regarding the two machines is available:

with a new machine, Bedro.
Machine
Adro Bedro
R R
Cost price 49 000 56 000
Book value – Current 28 000 –
Tax value – Current 12 250 –
Market value – Current 10 000 –
Useful life:
– Original 7 years 4 years
– Remaining 4 years –
Estimated costs:
– Direct material (per unit) 100 cents 100 cents
– Annual fixed costs (including depreciation) R25 000 R52 000
– Annual variable conversion costs (based on annual
production) R25 000 R36 000
Annual production:
– Maximum production (units) 25 000 45 000
– Maximum sales (units) 40 000 40 000
– Selling price (per unit) 500 cents 500 cents
Annual wear and tear allowance for taxation purposes
(R49 000 ' 4) (R56 000 ' 4) R12 250 R14 000
Annual depreciation (R49 000 ' 7) (R56 000 ' 4) R 7 000 R14 000
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TOPIC 8
Additional information:
1. The annual production for Bedro will be limited to the maximum number of units that
can be sold annually, whilst the production for Adro, should it be retained, will be
limited to the maximum annual production.
2. The rate of taxation is 28% and VAT can be ignored.
3. Management requires a return of 12% on capital projects.
4. Assume that all cash flows, except initial capital outlays which occur at the beginning
of the year, occur at the end of the year concerned.
REQUIRED
a
Determine whether machine Adro should be replaced by machine Bedro. Execute your
calculations to the nearest rand, and round off all your factors to three decimal places.
Feedback on self-assessment activity – Abrey Limited
Option 1 – Retain existing Adro
Years
0 1 2–4
R R R
Opportunity cost – current market value forfeited (10 000) – –
Sales (25 000 x R5) – 125 000 125 000
Material costs (25 000 x R1) – (25 000) (25 000)
Fixed costs (R25 000 – R7 000) – (18 000) (18 000)
Variable costs – (25 000) (25 000)

Taxation – (13 160) (15 960)

Factor at 12% 1,000 0,893 2,144l
Present values (10 000) 39 149 87 990
Net present value R117 139
Note
In years where the cash flows FOR ALL LINE ITEMS ARE CONSTANT/IDENTICAL, we
treat the net cash flows as an annuity in order to save time! See calculation l.
As Adro is an older machine, its output is limited to 25 000 units, even though the market
can take 40 000 units. Remember to always base your calculations on the lowest number
of units that can physically be manufactured or that which can be sold!
123 .........................
Study unit 21
Calculations:
 Tax disadvantage as a result of not selling Adro at the beginning of year 4
(= year 1 of the capital budget)
R
Current market value (proceeds) 10 000
Current tax value (end of year 3) 12 250
Scrapping allowance forfeited 2 250
Note
The present market value of Adro together with the forfeiture of the tax saving which
would have resulted from the scrapping allowance is the “cost”/price of retaining the Adro
machine. This is the cash flow which is forfeited by retaining the machine, in other words,
an opportunity cost. The tax effect is still considered as a year-end cash flow and is taken
into account in year 1.
The question indicated that there are four years left. Therefore, the book and tax values
provided for machine Adro is at the end of year 3. The potential sale could have taken
place at the beginning of year 4. We therefore calculate the opportunity cost based on the
values and proceeds as at the end of year 3.
 Taxation
Years
1 2–4
R R
Sales 125 000 125 000
Material costs (25 000) (25 000)
Fixed costs (18 000) (18 000)
Variable costs (25 000) (25 000)
Wear and tear (12 250) –
Scrapping allowance forfeited 2 250 –
Taxable amount 47 000 57 000

Taxation at 28% (13 160) (15 960)
 Factor – Years 2–4

Years 1–4: Table B at 12%, year 4 3,037
Minus: Year 1: Table A at 12%, year 1 (0,893)
= Years 2–4 2,144
OR
Per Table A (Year 2) 0,797

(Year 3) 0,712
(Year 4) 0,636
2,145
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TOPIC 8
The difference is due to the factors being rounded off in the tables.
 Note that the tax value of Adro is R12 250 at the time of the decision (= end of year
3). The annual wear and tear allowance is given as R12 250, therefore the wear and
tear allowance may only be claimed for one remaining year (the fourth year), where
after the asset would have been written off fully for tax purposes. NO wear and tear
allowance can therefore be claimed in years 5–7 in the life of the asset (or years 2–4
for the capital budget)!
Option 2: Acquire new Bedro
Years
0 1–4
R R
Cost price (56 000) –
Sales (40 000 x R5) – 200 000
Material costs (40 000 x R1) – (40 000)
Fixed costs (R52 000 – R14 000) – (38 000)
Variable costs – (36 000)

Taxation – (20 160)
Net cash inflow/(outflow) (56 000) 65 840
Factor at 12% (Table B) 1,000 3,037
Present values (56 000) 199 956
Note
As Bedro is a new machine, its potential output of 45 000 units is higher than the 40 000
units that the market can take. Remember to always base your calculations on the lowest
number of units that can physically be manufactured or that which can be sold!
Calculations:
 Taxation
Years 1–4
R
Sales 200 000
Material costs (40 000)
Fixed costs (38 000)
Variable costs (36 000)
Wear and tear (14 000)
Taxation at 28% (20 160)
125 .........................
Study unit 21
Note
The market value of Adro and the tax effect thereon cannot be treated as a cash inflow for
Bedro. The new machine (Bedro) must be considered in isolation as the two options are
mutually exclusive projects: either we keep the existing machine, or we buy a new machine.
Bedro should achieve a positive NPV on its own, without including cash flows from Adro.
Recommendation:
Adro should be replaced with Bedro as it renders a higher positive net present value.
Note
You will have more opportunities to assess your skills with NPV calculations at the end
of this study unit!
4 Internal rate of return (IRR) method

The internal rate of return method is also a discounted cash flow (DCF) method and requires
that the actual rate of return of the project be calculated.
INTERNAL RATE OF RETURN (IRR)
The rate at which cash flows must be discounted so that the present value of the cash
inflows equals the present value of the initial cash outflow. That is the rate at which
the NPV will be equal to Rnil.
It is called the internal rate, because it depends mainly on the outlay and proceeds associated
with the projects and not on any rate determined outside the investment.
Key formula: INTERNAL RATE OF RETURN (IRR)

n
/
0== t t G – I
C
(1+r)
t=1
Where:
r = internal rate of return
n = number of periods (life of the project)
t = specific period
Ct = net cash flow for period t
I = capital investment at period 0
........................ 126
TOPIC 8
Note
Note that this is based on the NPV formula. There are two differences:
1. We have pre-set the NPV to Rnil.
2. The “k” is replaced with “r” as we do not know what return will generate a NPV of Rnil.
When you are instructed NOT to use a financial calculator, you will “find” the “r” by
means of interpolation. Refer back to topic 3 if you are not sure how interpolation works.
4.1 Advantages
zz This method recognises the time value of money.
zz It considers the cash inflow of the entire project.
zz The IRR attempts to find the maximum rate of interest at which funds invested in the
project could be repaid out of the cash inflows arising from the project.
zz The result of the discounted cash flows is a rate (%), which makes it easier to interpret.
zz It is very popular in the business world.
4.2 Disadvantages
zz It assumes that surplus cash inflows can be reinvested at the IRR, which is an unrealistic
rate for future reinvestments.
zz It may give results that are inconsistent with the NPV method, especially in the case
of mutually exclusive projects.
zz It can generate more than one IRR for the same project when there are inconsistent
cash flows, that is net inflows followed by net losses again.

The internal rate of return is the true interest rate earned on an investment over the course
of its useful life (eg the discounted rate of return). Management may once again set a
minimum IRR which should be exceeded. This is referred to as the hurdle rate. The hurdle
rate can be set equal to the WACC plus/minus any adjustment for project specific risk.
zz If the IRR exceeds the required (acceptable) rate of return or the WACC, the project
may be accepted.
zz Should the IRR be lower than the required (acceptable) rate of return or the WACC,
the project must be rejected.
zz If the projects are mutually exclusive, the project with the highest IRR and exceeding
the required (acceptable) rate of return or the WACC, may be accepted.
4.4 Difference between the net present value and the internal rate of
return method
These two methods use the same process (discounted cash flows), but sometimes result in
widely different rankings, especially when the useful lives and the discounting rates of the
projects differ considerably. The difference between the two methods can be summarised
as follows:
127 .........................
Study unit 21
i. Net present value method: This method assumes re-investment of the net cash
flows at the acceptable rate of return or the WACC. It calculates the NPV, given the
discount rate.
ii. I nternal rate of return method: This method assumes re-investment of the net cash
flows at the internal rate of return. It assumes that NPV is nil and calculates the
discount rate that makes NPV nil.
Note
Unless the internal rate of return method is specifically requested, the net present value
method should be used in the examination.
We will now demonstrate how to calculate the IRR in the next activity.
Activit y 21. 2 – Project s Yum, Tum and Pun

Refer to the information in activity 21.1.
REQUIRED
a. Evaluate the above three projects by calculating their IRR’s as follows:
i. Project Yum by using a financial calculator.
ii. Project Tum by interpolating between 25% and 26%.
iii. Project Pun by interpolating between 15% and 16% and using
Microsoft Excel.
b. Which project shoud be accepted? Explain how you reached your conclusion.

a i. The IRR of Project Yum by using a financial calculator:
Financial calculator
In order to use your financial calculator, read the manual, as each calculator
has its own specific way of working. The following has been done with a Sharp
and HP financial calculator:
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TOPIC 8
SHARP EL-738 Hp10BII
Key in: Display will read: Key in: Display will read:
Clear all registers first: 2ndF C ALL 1 P_YR then 0.0000
CFi 2ndF CA 0.0000 3rdF C MEM 0 C FLo clr then 0.0000
2ndF 1 I/YR
Enter data sets:

+/- 100 000 ENT DATA SET:CF 0.0000 100000+/- CFj CFLO/CF-100,000.0000
25 000 ENT DATA SET:CF 3.0000 25000 CFi CFLO/CF 25,000.0000
Clear cash flow registers:
ON/C 0.0000
2ndF CASH RATE (I/Y) =
2ndF CA RATE (I/Y) = 0.0000
and
press COMP to get the IRR RATE (I/Y) = 13.4765 2ndF IRR/YR 13.4765
As regards the internal rate of return, it is clear that project Yum, with a negative
NPV, will have an internal rate of return which is below 14%. The calculated
IRR is 13,48% (rounded to two decimal places).
Note
Let us see if a discount rate of 13,48% will indeed return a R Nil NPV.
Years
0 1 2 3
R R R R
Capital outlay
(cash outflow) (100 000) – – –
Net cash inflow
from operations – 50 000 50 000 25 000
Net cash inflow/
(outflow) (100 000) 50 000 50 000 25 000
PV factor of R1 1,000 1'(1+0,1348) 1
1'(1+0,1348) 2
1'(1+0,1348)3
at 13,48% p.a. 1,000 0,881 0,777 0,684
Present values (100 000) 44 050 38 850 17 100
NPV Nil
129 .........................
Study unit 21
The objective is then to calculate the effective interest rate for projects Tum
and Pun, that is, where the net present value of inflows = initial capital outlay:
a ii. The IRR of Project Tum by interpolating between 25% and 26%

Project Tum
Years
0 1 2 3
R R R R
Net cash in-/(outflow) (100 000) 60 000 50 000 40 000
Present value factor of
R1 at 25% p.a. 1,000 0,800 0,640 0,512
Present values (100 000) 48 000 32 000 20 480
NPV 480
Present value factor of
R1 at 26% p.a. 1,000 0,794 0,630 0,500
Present values (100 000) 47 640 31 500 20 000
NPV (860)
Interpolation (R480 – R0)

25% + = x 1%G
[R480 – (–R860)]
R480
= 25% + = x 1%G
R1 340
= 25% + [0,358 x 1%]
\ Effective rate (IRR) = 25,36%
a. iii. The IRR of Project Pun by interpolating between 15% and 16%

and using Microsoft Excel
Project Pun
Years
0 1 2 3
R R R R
Net cash in-/(outflow) (100 000) 20 000 40 000 80 000
Present value factor of R1 at
15% p.a. 1,000 0,870 0,756 0,658
Present values (100 000) 17 400 30 240 52 640
NPV 280
Present value factor of R1 at
16% p.a. 1,000 0,862 0,743 0,641
Present values (100 000) 17 240 29 720 51 280
NPV (1 760)
........................ 130
TOPIC 8
Interpolation (R280 – R0)
15% + = x 1%G
[R280 – (–R1 760)]
R280
= 15% + = x 1%G
R2 040
= 15% + [0,137 x 1%]
Using Microsoft Excel:

Calculating the IRR can be a long process. Knowing all the cash flows and an
approximate return, will allow you to use a spread sheet formula from Microsoft
Excel and get an answer right away. The spread sheet below shows the setup
for calculating the IRR for project Pun
NOTE
Notice that, unlike the NPV formula (in Excel), the IRR formula accounts for
all cash flows in ONE step, including the initial cash flow in year 0. There is
no need to add the initial investment later to the formula. Also, you will need
an estimated rate to calculate the IRR, for example, the WACC which will be
given to you in the activities and questions. If the WACC is not given, Excel
uses 10% as default from which to extrapolate!
Remember to keep track of signs. Cash outflows are negative and cash inflows
are positive.
131 .........................
Study unit 21
Thus, the IRR is 15,12% according to Microsoft Excel and is 15,14% according
to the interpolation method. The difference of 0,02% is due to rounding.
b. Conclusion
An overview of the three projects, bearing in mind the project cost of R100 000,
shows that project Yum has an IRR of 13,48%. It does not meet the 14% return
which is required and will not provide for the return of the capital invested and
the required interest thereon.
Project Tum has an IRR of 25,36%, which shows that its return substantially
exceeds the required 14% per annum.
Project Pun with an IRR of 15,14%, indicates that it exceeds the 14% return
which is required.
Project Yum cannot be recommended, whilst projects Tum and Pun are both
acceptable, with Tum (with the highest IRR) being preferred.
In this case, the IRR method ranked the projects in the same order as the
NPV method!
Where the amounts to be invested differ, the most profitable project is that of
which the ratio of income to investment is the greatest. We will cover this in
the next section.
Where sufficient funds are available for investment in both projects, the
maximum amount should be invested in Tum and the balance in project Pun,
assuming it is divisible.
Note
You will have more opportunities to assess your skills with IRR calculations at the end of
this study unit!
5 Profitability index (PI)

The profitability index, or PI, method compares the present value of future cash inflows
with the initial investment on a relative basis.
PROFITABILITY INDEX
The PI is the ratio of the present value of cash flows (PVCF) to the initial investment
of the project. PI is also known as a benefit/cash ratio.
........................ 132
TOPIC 8
Key formula: PROFITABILITY INDEX
PVCF
PI =
Initial investment
In this method, a project with a PI greater than 1 is accepted, but a project is rejected
when its PI is less than 1. Note that the PI method is closely related to the NPV approach.
In fact, if the net present value of a project is positive, the PI will be greater than 1. On the
other hand, if the net present value is negative, the project will have a PI of less than 1.
The same conclusion is reached whether the net present value or the PI is used. In other
words, if the present value of cash flows exceeds the initial investment, there is a positive net
present value and a PI greater than 1, indicating that the project is acceptable.
This method is useful to rank projects where the initial investment differs, but the
NPVs are all positive and close to each other.
Activity 21.3
Refer to the information in activity 21.1
REQUIRED
Evaluate the three projects by calculating their profitability index (PI). You may
use the information calculated in activity 21.2

a. i. The PI of Project Yum:
99 175
PI = = 0,99175
100 000
a. ii. The PI of Project Tum:

118 070
PI = = 1,1807
100 000
a. iii. The PI of Project Pun:

102 300
PI = = 1,0230
100 000
b. Conclusion
Accept project if PI > 1
Reject if PI < 1
According to the PI, Project Yum is rejected as being < 1. Project Tum’s and
Pun’s PI’s are greater than 1 and both can be accepted. As these are mutually
exclusive projects, preference should be given to Project Tum with the highest PI.
133 .........................
Study unit 21
Note
The cash flows in the numerator (above the line) of the fraction are the total project cash
flows excluding the investment’s amount! In other words, it is NOT the NPV amount, but
total of net cash flows from year 1 to the end of the project!
6 Summary
In this study unit, we focused on discounted cash flow techniques for capital budgeting. We
discussed the advantages, disadvantages and evaluation criteria of the net present value,
internal rate of return, and profitability index methods. We illustrated these techniques in
different approaches.
This study unit concludes the part dealing with capital investments. In the next part we
will look into risk management.
After having worked through this study unit, you should be able to answer the following
questions:
a. List the advantages, disadvantages and evaluation criteria of the NPV method.
b. List the advantages, disadvantages and evaluation criteria of the IRR method.
c. Briefly describe the differences between the NPV and IRR method.
d. Define the PI method.
The next questions will assess your skills in using discounted cash flow techniques.
QUESTION 1 – Nkonki Limited

Nkonki Limited operates a large fleet of delivery vehicles in order to make deliveries to its
customers. A cost-benefit analysis has previously indicated that the maximum period to
retain a vehicle, based on the assumption that the average vehicle would cover 30 000
kilometres a year, is five years. The asset register indicated that four vehicles are due for
replacement. The accountant gathered the following information:
zz The cost price of a new delivery vehicle is R360 000.
zz Depreciation is calculated by taking the realisable value into account.
zz It has a residual (realisable) value of R10 000 at the end of year five.
zz It is estimated that the operating costs per vehicle (including depreciation) will be
R170 000 for the first year and R190 000 per annum for years two to five.
Sibiya Transport, which satisfactorily serves a number of other firms in the area, has offered
a similar service to the company at R220 000 per delivery vehicle, per year.
The company’s required rate of return is calculated to be 15% per annum.
a REQUIRED
Apply the net present value method and make a recommendation on whether Nkonki
Limited should purchase and operate the four delivery vehicles themselves or accept
Sibiya Transport’s offer.
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TOPIC 8
Ignore taxation and assume that management and administration costs will be the same
for both alternatives. Calculate and indicate the discounting factors that you used.
QUESTION 2 – Lex Power Limited

The company, a manufacturer of power tools, is considering buying a new machine. They
have gathered information on two possible options – machine Zin or machine Wic.
1. The following information regarding the machines is available:
Machine
Zin Wic
R R
Cost price 100 000 80 000
Working capital required 10 000 8 000
Net operating income before tax 25 000 21 100
Realisable value at end of useful life 20 000 18 000
Useful life 5 years 5 years
2. Taxation:
zz Wear and tear allowances are calculated on the straight-line method at 25% per
annum, on the cost of the asset.
zz Normal income tax rate – 28%.
3. In determining net operating income, depreciation has already been taken into account.
Depreciation is calculated by taking the realisable value into account.
4. Management requires a 23% after-taxation return on all capital investments.
REQUIRED
a
Determine, using the internal rate of return method, whether machine Zin or machine Wic
should be purchased, by interpolating between 22% and 24%.
Assume that all cash flows occur at the end of each year, except the initial capital outlays,
which occur at the beginning of year 1.
[Calculations must be rounded off to the nearest rand.]
QUESTION 3 – Cyco Limited

The company uses a certain machine, TS.40, in a manufacturing process. The supplier
of the TS.40 has demonstrated an improved model, TS.50, to management. Management
consequently approached the management accountant for an opinion in this regard.
135 .........................
Study unit 21
The following information is available:
Machine
TS.40 TS.50
R R
Cost 400 000 700 000
Realisable value – end of useful life 80 000 100 000
– current 200 000 –
Annual net cash inflow before taxation 95 000 150 000
Useful life – total 5 years 6 years
– remaining 3 years –
1. Wear and tear for taxation purposes is deductible at 20% per annum based on the
cost of the asset by using the straight-line method.
2. The present rate of taxation 28%.
3. The company requires a 15% rate of return on investments.
REQUIRED
a
Advise management whether TS.40 should be replaced by TS.50, by using the net present
value method.
[Execute your calculations to the nearest rand and round all your factors to three decimal
places.]
QUESTION 1 – Nkonki Limited

Option – Own vehicles
Years
0 1 2–4 5
R R R R
Cost price (360 000) – – –
Operating costs – (170 000) (190 000) (190 000)
Add back – depreciation 
– 70 000 70 000 70 000
Residual (realisable) value – – 10 000
Net cash outflows (360 000) (100 000) (120 000) (110 000)
Factor at 15% 1,000 1 ' (1+0,15) 1
 1 ' (1+0,15) 5
1,000 0,870 1,986 0,497
Present values (360 000) (87 000) (238 320) (54 670)
NPV for one vehicle (R739 990)
........................ 136
TOPIC 8
Option – Sibiya Transport service
NPV = R220 000 per annum for 5 years at 15% p.a.
= (R220 000) x 3,353
= (R737 660)
 Depreciation
Value to be depreciated = original cost price less realisable value
= R360 000 – R10 000
= R350 000
Depreciation over life = R350 000 ÷ 5 years

= R70 000 per year
Note
Discounted cash flow techniques only work with estimated cash flows. You therefore have
to ADD BACK NON-CASH FLOW items!
 Annuity for years 2 to 4

= [1 ÷ (1+ 0,15)2] + [1 ÷ (1+ 0,15)3] + [1 ÷ (1+ 0,15) 4]
= 0,756 + 0,658 + 0,572
= 1,986
 Annuity for 5 years

= [1 ÷ (1+ 0,15)1] + [] + [1 ÷ (1+ 0,15)5]
= 0,870 + 1,986 + 0,497
= 3,353
Note
Even if the time value of money (TMV) tables or factors are not given to you in a question or
as an addendum to the paper, you should still be able to work out the factors mathematically
based on your knowledge of topic 3 – time value of money!
Remember to group years with EXACTLY the same cash flows and to use an annuity
factor. It saves time in that you don’t have to write out the figures in three columns (in
this scenario). You should then use an annuity as it is the same cash flow for x-number
of periods!
Recommendation:
Based on the financial analysis alone, the company should accept the offer of Sibiya
Transport as their offer presents a LOWER negative net present value.
Note
In this scenario, we were comparing the net COSTS of two options that were mutually
exclusive. You should remember to select the option with the lowest cost! When you
137 .........................
Study unit 21
are comparing options for projects with cash inflows, you should select the option with
the highest NPV.
Question 2 – Lex Power Limited
Capital budget – Machine Zin Years

0 1–4 5
R R R
Cost price (100 000) – –
Working capital* (10 000) – 10 000
Net operating income – 25 000 25 000
Add back: Non-cash items
– depreciation (R100 000 – R20 000) ÷ 5 – 16 000 16 000
Realisable value – – 20 000
Taxation j – (4 480) (17 080)
Net cash in-/(outflow) (110 000) 36 520 53 920
Factor at 22% (Table B, 4 years) ; (Table A, 1,000 2,494 0,370

5 years)
Present values (110 000) 91 081 19 950
Factor at 24% (Table B, 4 years) ; (Table A, 1,000 2,404 0,341
5 years)
Present values (110 000) 87 794 18 387
Net present value (R3 819)
Interpolation (R1 031 – R0)

22% + = x 2%G
[R1 031 – (–R3 819)]
R1 031
= 22% + = x 2%G
R4 850
\ Effective rate (IRR) = 22% + [0,2126 x 2%]
= 22,43%
Note
The interval between 22% and 24% is 2%. The interpolation fraction is therefore based
on 2%!
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TOPIC 8
* Working capital is an amount invested once at the beginning of the investment period
(outflow) and realised at the end of the investment period (inflow), as the working capital
is no longer required and the cash that was tied up in it is made available.
Calculations:
 Taxation
Years
1–4 5
R R
Net cash income (R25 000 + R16 000) 41 000 41 000
Wear and tear (R100 000 x 25%) (25 000) –
Wear and tear recouped k – 20 000
Taxation at 28% (4 480) (17 080)
 Wear and tear recouped

R
Cost 100 000
Less : Wear and tear (R100 000 x 25% x 4) (100 000)
Tax value at end of useful life NIL
Realisable value 20 000
Wear and tear recouped 20 000
Capital budget – Machine Wic Years

0 1–4 5
R R R
Cost price (80 000) – –
Working capital* (8 000) – 8 000
Net operating income – 21 100 21 100
Add back: Non-cash items
– depreciation (R80 000 – R18 000) ÷ 5 – 12 400 12 400
Realisable value – – 18 000
Taxation j – (3 780) (14 420)
139 .........................
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Years
0 1–4 5
Factor at 22% (Table B, 4 years); (Table A, 1,000 2,494 0,370
5 years)
Present values (88 000) 74 122 16 680
Factor at 24% (Table B, 4 years); (Table A, 1,000 2,404 0,341
5 years)
Present values (88 000) 71 447 15 372
Net present value (R1 181)
Interpolation (R2 802 – R0)

22% + = x 2%G
[R2 802 – (–R1 181)]
R2 802
= 22% + = x 2%G
R3 983
= 22% + [0,7035 x 2%]

Calculations:
 Taxation
Years
1–4 5
R R
Net cash income (R21 100 + R12 400) 33 500 33 500
Wear and tear (R80 000 x 25%) (20 000) –
Wear and tear recouped m – 18 000
Taxation at 28% (3 780) (14 420)
 Wear and tear recouped
R
Cost 80 000
Less: Wear and tear (R80 000 x 25% x 4) (80 000)
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TOPIC 8
Conclusion:
The company should buy machine Wic, as it renders a higher internal rate of return and
the IRR of 23,41% is also higher than the 23% after-taxation return that management
requires on all capital investments.
Note
QUESTION 3 – Cyco Limited
Capital budget – TS.40 Years

0 1 2 3
R R R R
Realisable value –
proceeds forfeited (200 000) – – –
operations – 95 000 95 000 95 000
Proceeds on realisation – – – 80 000
Taxation k – (15 400) (4 200) (26 600)
Factor 1,000 1 ' (1+0,15)1 1 ' (1+0,15)2 1 ' (1+0,15)3
Factor at 15% (Table A) 0,870 0,756 0,658
Present values (200 000) 69 252 68 645 97 647
Net present value 35 544
Calculations:
 Scrapping allowance forfeited – TS.40
R
Cost 400 000
Less: Wear and tear to date [(R400 000 x 20%) x (5 – 3) years] (160 000)
Tax value at date of decision 240 000
Current realisable value 200 000
Realisation allowance forfeited at date of decision 40 000
141 .........................
Study unit 21
Note
The machine has a total useful life of 5 and a remaining useful life of 3 years. We therefore
know that it has been used productively for 2 years at the time that this decision is being
taken, during which period wear and tear would have been written off, for 2 years.
 Taxation
Years
1 2 3
R R R
Net cash inflow from operations 95 000 95 000 95 000
Wear and tear (R400 000 x 20%) (80 000) (80 000) (80 000)
Scrapping allowance forfeited j 40 000 – –
Wear and tear recouped l – – 80 000
Taxable amount 55 000 15 000 95 000
Taxation at 28% (15 400) (4 200) (26 600)
 Wear and tear recouped

R
Cost 400 000
Capital budget – TS.50 Years

0 1–5 6
R R R
Cost (700 000) – –
Net cash inflow from operations – 150 000 150 000
Proceeds on realisation – – 100 000
Taxation m – (2 800) (70 000)
Factor at 15% (Table B); (Table A) 1,000 3,352 0,432
Present values (700 000) 493 414 77 760
Net present value (128 826)
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TOPIC 8
Calculations:
 Taxation
Year
1–5 6
R R
Net cash inflow from operations 150 000 150 000
Wear and tear (R700 000 x 20%) (140 000) –
Wear and tear recouped n – 100 000
Taxation at 28% (2 800) (70 000)
 Wear and tear recouped
R
Cost 700 000
Recommendation:
Machine TS.40 renders the positive required rate of return, while TS.50 does not render
the required rate of return. Thus TS.40 should be retained and not be replaced by TS.50.
Note
Where the periods of the two projects are different, the equivalent annual income method
has to be used. This method will be dealt with in your third-year module, MAC3702. In this
activity, machine TS.40 had a positive NPV and TS.50 had a negative NPV and therefore the
recommendation could be done without performing the equivalent annual income method.
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Study unit 21
COMPREHENSIVE SELF-ASSESSMENT ACTIVITY
QUESTION 4 – Alpha Limited

The budget committee of the company is faced with a choice between two machines, A
and B, which differ in their production characteristics and capabilities.
The following information regarding the two machines is available:
Machine
A B
R R
Cost price 1 000 000 1 500 000
Residual (realisable) value at end of useful life 110 000 160 000
Annual income after depreciation and income tax 152 000 183 000
Required working capital 180 000 220 000
Expected useful life 10 years 10 years
1. The company can invest all its funds at a rate of 12% per annum, which is also
regarded as an acceptable return on the investment in either of the above machines.
2. The accounting policy of the company is to provide for depreciation on the straight-
line method, over the useful lives of the machines after taking the residual (realisable)
value into account.
3. The South African Revenue Services allows wear and tear allowances on the same
basis as that determined for depreciation.
a REQUIRED
a. Apply the following methods to evaluate the two mutually exclusive options available
to Alpha Ltd and comment on the results of each:
i. net present value (NPV), indicating the factors you used
ii. internal rate of return (IRR), using 12% and 18% to interpolate
iii. profitability index (PI)
iv. payback period (PB)
v. accounting rate of return (ARR)
b. Make a final recommendation based on your calculations and deliberations in a.
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TOPIC 8
FEEDBACK ON COMPREHENSIVE SELF-ASSESSMENT ACTIVITY
QUESTION 4 – Alpha Limited

a. i. Net present value method
Machine
A B
Years Years
0 1–9 10 0 1–9 10
R R R R R R
Cost price (1 000 000) – – (1 500 000) – –
Working capital  (180 000) – 180 000 (220 000) – 220 000
Annual cash flow
from operations j – 241 000 241 000 – 317 000 317 000
Realisable value – – 110 000 – – 160 000
Present values (1 180 000) 241 000 531 000 (1 720 000) 317 000 697 000
Factor at 12% k 1,000 5,328 0,322 1,000 5,328 0,322
(1 180 000) 1 284 048 170 982 (1 720 000) 1 688 976 224 434
Net present value R275 030 193 410
Calculations:
 Annual cash flow from operations, after taxation
Machine
A B
R R
Profit after depreciation and tax 152 000 183 000
Add back: Non-cash items – Depreciation
R1 000 000 – R110 000 89 000 –

10
R1 500 000 – R160 000 – 134 000

10
Annual cash flow from operations, after taxation 241 000 317 000
 PV factors
Years 1–9: Table B at 12% = 5,328
Year 10: Table A at 12% = 0,322
Or
145 .........................
Study unit 21
1 ' (1 + 0,12)1 0,893
1 ' (1 + 0,12)2 0,797
1 ' (1 + 0,12)3 0,712
1 ' (1 + 0,12) 4 0,636
1 ' (1 + 0,12)5 0,567
1 ' (1 + 0,12)6 0,507
1 ' (1 + 0,12)7 0,452
1 ' (1 + 0,12)8 0,404
1 ' (1 + 0,12)9 0,361
Annuity 5,329 #
1 ' (1 + 0,12)10 0,322
#
Small rounding difference may occur.
Note
Tip: when using your pocket calculator:

Enter 1 ÷ 1.12 = to get factor for year 1, then add to memory.
Press = again to get factor for year 2, then add to memory.
Press = again and add to memory each time until you reach year 9, then add to memory.
Press = again to get factor for year 10, write down – DO NOT ADD TO MEMORY.
Press memory recall to get the cumulative factor for the 9-year annuity!
 Combining of years
In deciding which years may be combined, you must be guided by the information in the
specific question. Often the first and last year differ from the rest, but sometimes all the
years differ and would have to be kept apart (column for each year).
 Working capital
Working capital is an amount invested once at the beginning of the investment period
(outflow) and realised at the end of the investment period (inflow), as the working capital
is no longer required and the cash that was tied up in it is now made available. It is not an
annual outflow, unless the working capital levels differ in each year (then the net increase
or decrease is reflected as an (outflow) or inflow respectively.
a. ii. Internal rate of return (IRR)
Machine
A B
Years Years
0 1–9 10 0 1–9 10
Cash flow from a. (1 180 000) 241 000 531 000 (1 720 000) 317 000 697 000
Factor at 18%  1,000 4,303 0,191 1,000 4,303 0,191
Present values (1 180 000) 1 037 023 101 421 (1 720 000) 1 364 051 133 127
Net present value R(41 556) R(222 822)
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TOPIC 8
 Factors at 18%
1 ' (1 + 0,18)1 0,847
1 ' (1 + 0,18)2 0,718
1 ' (1 + 0,18)3 0,609
1 ' (1 + 0,18) 4 0,516
1 ' (1 + 0,18)5 0,437
1 ' (1 + 0,18)6 0,370
1 ' (1 + 0,18)7 0,314
1 ' (1 + 0,18)8 0,266
1 ' (1 + 0,18)9 0,225
Annuity 4,302#
1 ' (1 + 0,18)10 0,191
# Small rounding differences may occur between already rounded annual factors and
when one uses the factor from the tables or calculate it without rounding.
Machine A Machine B
Interpolation (R275 030 – R0) (R193 410 – R0)
12% + = x 6%G 12% + = x 6%G
[R275 030 – (–R41 556)] [R193 410 – (–R222 822)]
R275 030 R193 410
= 12% + = x 6%G = 12% + = x 6%G
R316 586 R416 232
\ Effective rate = 12% + [0,8687 x 6%] = 12% + [0,4647 x 6%]
(IRR) = 17,2122% = 14,7882%
Note
The interval between 12% and 18% is 6%. The interpolation fraction is therefore based
on 6%!
Due to the fact that we used factors individually rounded to 3 decimals for the NPV
calculations at 12% and 18%, our answer might be slightly different than when you use
your financial calculator or Excel. Excel generate an IRR of 17,0666% for machine A and
14,498% for machine B.
a. iii. Profitability index
The PI of Machine A
(275 030 + 1 180 000)

PI = = 1,2331
1 180 000
The PI of Machine B
(193 410 + 1 720 000)

PI = = 1,1124
1 720 000
According to the PI, both of the above machines should be accepted, as both have a PI
greater than 1. Machine A is the highest. This correlates with the NPV calculation which
also indicated that Machine A should be selected.
147 .........................
Study unit 21
a. iv. Payback period method
Machine
A B
Cash outflow R1 180 000 R1 720 000
Annual cash inflow (from a. above) R241 000 R317 000
R1 180 000 R1 720 000
R241 000 R317 000
Payback period = 4,9 years = 5,4 years
Note
We can use the annuity method of calculating the payback period as the cash flows in
years one to nine is identical and the break-even occurs BEFORE year ten, which have a
different annual cash flow! Remember that the last year of the capital budget usually has
a different cash flow (as a result of residual values etc) and if the break-even occurs in the
last year, you have to use the pro rate method to calculate the portion of the year, that is
the remainder of cash outflow to be covered divided by the cash flow in last year. Where
each year’s cash flow varies, you have to use the tabular and pro rate method.
The payback period method indicates that once again, Machine A is preferred as the
payback period is the shorter of the two options.
a. v. Accounting rate of return

As the assets’ residual value at the end of the period is greater than 10% of the original
cost, it cannot be considered to be immaterial. We will therefore have to calculate the
average investment as follows:
Machine A Machine B
R R
Original investment 1 000 000 1 500 000
Less: residual value 110 000 160 000
Depreciable value 890 000 1 340 000
Average value (÷ 2) 445 000 670 000
Add: residual value 110 000 160 000
Average investment value (1) 555 000 830 000
Annual profit after tax (2) 152 000 183 000
Return (2) ÷ (1) 27,39% 22,05%
Machine A generates a higher ARR than Machine B, despite the fact that Machine B has
a higher annual profit (B’s asset base is also that much higher).
........................ 148
TOPIC 8
Note
The assumption in the calculation of the asset base is that the residual value is outstanding
for the entire life of the project. We therefore do not apply an average to it.
The ARR is based on the investment in non-current assets only. We therefore ignore the
working capital investment.
b. Recommendation
All the methods indicate that machine A should be purchased and in the absence of any
other qualitative issues that favour machine B, we recommend that machine A is acquired.
Note
149 .........................
Study unit 21
........................ 150
TOPIC 8
PART 4
Risk management
PURPOSE
Risk management is concerned with identifying, assessing and managing threats/risks

resulting from pursuing the organisation’s strategies (SAICA, 2010, Detailed Guideline for
Academic Programmes).
The purpose of this part is to define risk and to explain risk management. This includes
risk identification, risk assessment, managing the risk and risk reporting.
MAC2602
Principles of strategy, risk & financial management techniques

Strategy and Introduction
Managing and Risk management
strategic to financial
investing funds
financing and the
cost of capital
1 Development 2 Introduction 6 Analysis 9 Risk theory and

of the to financial of financial approaches
organisation’s management information to risk
strategy management
3 Time value of 7 Analysing and
money managing 10 Risk
working capital identification
4 Sources and
and
forms of finance 8 Capital
documentation
investments and
5 Capital structure
capital budgeting 11 Risk
and the cost of
techniques assessment, the
capital
management
of risk and risk
reporting
151 .........................
Study unit 21
NOTE
We touched on risks and stakeholder management in topic 1 – development of the

organisations’ strategy and topic 2 – introduction to financial management, earlier in this
module. You will also find this background useful when you encounter the internal control
and governance modules in Auditing. The knowledge and skills you acquire in this part of
MAC2602 will further find practical applications in the advanced financing, capital structure,
working capital management and capital investment topics covered later in MAC3702 as
well as in MAC3701 (decision-making).
........................ 152
TOPIC 8
TOPIC 9
Risk theory and approaches to risk management
LEARNING OUTCOMES

–– define risk in a business context
–– identify the objective of risk management
–– explain what the components are of an adequate risk management programme

Strategy and Introduction to Managing and Risk management
strategic financial manage- investing funds
planning ment, financing and
the cost of capital
Topic Topic
Topic Topic 6
1 Development 2 Introduction 9 Risk theory and approaches

6 Analysis
of the to financial to risk management
of financial
organisation’s management information SU 22: Risk concepts and
strategy 3 Time value of objectives in a
7 Analysing and
money business context
managing
4 Sources and working capital SU 23: Components
forms of finance and role players
8 Capital
of an adequate
5 Capital structure investments and
risk management
and the cost of capital budgeting
programme
capital techniques
10 Risk identification and
documentation
11 Risk assessment, the
management of risk and risk
reporting
153 .........................
Study unit 21
INTRODUCTION
The main purpose of this topic is to introduce you to the concepts of risk and risk management.
You will also learn about the objective of risk management and the components of an
adequate risk management programme.
This topic includes a fair amount of theory best understood by applying it to your own life
or in a business environment.
........................ 154
TOPIC 9
8 STUDY UNIT 22
Risk concepts and objectives in a business

8
context
In this study unit
1 Introduction
In this study unit, we will define risk in a business context and introduce you to risk
management and its objective.
2 What is risk?
RISK
The typical dictionary definition of risk is a chance or possibility of danger, loss, injury
or other adverse consequences.
Risk is associated with something happening with a negative future outcome.
The Chartered Institute of Management Accountants (CIMA) (2011:10) defines business

risk facing an organisation as risks that affect the achievement of the organisation’s overall
objectives that should be reflected in its strategic aims.
155 .........................
Study unit 22
Ac t ivi t y 22 .1
You also face risks in your own life. An example is that your car could be stolen.
a. Identify some risks in the picture below:
Source: © 1998 – 2012 Signnetwork.com

FIGURE 22.1: Bart Simpson
b. Name three other risks in your own life.
1 Fe edback on ac t ivi t y 22 .1
a. Risks from the picture could include:
z Bart is riding a skateboard and may fall off and injure himself.
z Bart may be hit by a car and be seriously injured.
z Bart is not wearing a helmet, which is required by legislation. This
contravention could result in a fine.
b. Risks in your own life could include:

z traffic congestion on the road to the exam centre on the day of your
exam, which could result in you being late; or
z that your car or other belongings are stolen.
NOTE
Drury (2011) notes in Management and Cost Accounting that risk is inherent in a situation
and exist where there are several possible outcomes but there is relevant past experience
to predict the possible outcome.
Uncertainty exists where there are several possible outcomes, but there is little previous
statistical evidence to predict the possible outcomes. Uncertainty can possibly be reduced
by gaining more information.
........................ 156
TOPIC 9
This distinction is not essential and we shall use the terms interchangeably.
Business leaders are often confronted by uncertainties and risk in decision-making. The
inability to predict the precise outcome of a decision, that is the inability to predict the sales
volumes of a new product – normally due to a lack of information – creates risk.
3 Why incur risk?
Source: CIMA (2011:11)

FIGURE 22.2: Why incur risk?
z Taking risks allows the organisation to be more competitive and to generate higher
returns. For example, you could launch a new technologically advanced product even
though there is uncertainty whether customers will buy the new product.
z Benefits could be financial in the form of higher returns or reduced cost.
z Benefits could be intangible, for example, gaining more valuable client information to
be used for future products.
Risk taking could result in losses, but in business, the potential rewards of risk taking
usually become greater when the chance of loss becomes greater.
Activity 22.2
With enough capital, you could start a company that manufactures solar-
powered vehicles or you could place your money in the bank and earn interest
on the investment.
Illustrate the concept of risk versus reward when evaluating the risks associated
with each option.

The risks for a company that manufactures solar-powered vehicles are
significant, as the vehicles may be unroadworthy if it does not comply with
government standards and related regulations. Customers may be sceptical
and question the vehicles’ performance and endurance, and the organisation
could fail. Alternatively, the vehicles could be far less expensive to operate,
with cleaner emissions, which could receive government’s support and be a
huge success with large returns.
157 .........................
Study unit 22
In comparison, the risk/chance that the money in the bank could be lost is very
low, but the potential return on the investment is also lower.
Activity 22.3
Quickclean (Pty) Ltd, a facilities management company that provides cleaning
and security services, has a number of business objectives including the
following: “Grow the brand in a socially and economically effective way to
obtain a significant market share in the Limpopo province.”
The management of the organisation has recently learnt that provincial
government tenders in Limpopo are mainly awarded to organisations with a
very high (level 1 or 2) broad-based black economic empowerment (BBBEE)
rating. Quickclean (Pty) Ltd is BBBEE compliant, but only has a level four (4)
rating, which is not deemed high enough. The very high BBBEE requirement
is the main reason why very few facility management organisations operating
in Limpopo submit tenders to the provincial government.
REQUIRED
Explain what you think the risk is for Quickclean (Pty) Ltd. Also, explain why
there could be an opportunity for Quickclean (Pty) Ltd.

Quickclean (Pty) Ltd will not be successful in its tender applications to do work
for the provincial government in Limpopo with its current BBBEE rating. This
reduces the organisation’s ability to get work and the risk is that the organisation
may not achieve its objectives and fail to realise a profit to ensure the continued
success/sustainability of the business.
Very few facility management companies currently operating in Limpopo are
BBBEE compliant so there is an opportunity for Quickclean (Pty) Ltd to get
very lucrative government contracts if it increases its BBBEE rating.
4 Where are risks relevant?

We have already noted that risks are relevant in everybody’s day-to-day lives.
In the financial world, one finds different types of risk. Risks can come from uncertainty
in financial markets, such as the future rand/dollar exchange rate, project failures, legal
liabilities, credit risk, accidents, natural causes and disasters, as well as fraud and error.
For management accounting, the concepts of probability and sensitivity will be considered
in decision-making techniques as well as consequences of relevant costing decisions.
In financial accounting, risk is considered when evaluating investment and financing

decisions as well as hedging techniques. Hedging is a transaction that lowers or even
eliminates an organisation’s risk due to fluctuating commodity prices, interest rates and
exchange rates.
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5 Risk management strategy
The purpose of the risk management strategy is to support the achievement of the required
organisation objectives.

FIGURE 22.3: Risk Management Strategy
RISK APPETITE (RISK TOLERANCE)

This refers to the amount of risk an organisation is willing to accept in pursuit of value/
benefits.
The risk appetite is related to an organisation’s strategy and may be expressed as the
acceptable balance between growth, risk and return. The risk appetite may be clear/
explicit in an organisation’s strategies, policies and procedures. Alternatively, it may
be implicit, needing to be determined from an analysis of the organisation’s decisions
and actions.
It can be classified as follows:
– risk averse – an organisation or investor who will attempt to avoid risk by opting
for “safer” investments, such as government bonds despite the lower returns on
“safer” investments
– risk neutral – an organisation or investor with a balanced view
– risk seeking – an organisation or investor who is an aggressive risk taker and willing
to take many risks in search of high returns
RISK CULTURE
This is the set of shared attitudes, values and practices that characterise how an
organisation considers risk in its day-to-day activities.
This is driven by management and can be determined by analysing the organisation’s
practices, especially rewards or sanctions for risk-taking or risk-avoiding behaviour.
RISK CAPACITY
This is the maximum amount of risk that the organisation can accept.
BOARD OF DIRECTORS
The board of directors (the board) consist of members/directors who are elected to the
board by the shareholders to oversee the activities of the organisation and to provide
stewardship and leadership from the very top.
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Activity 22.4
Illustrate your risk appetite if the following are risks in your own life:
zz traffic congestion on the road to the exam centre on the day of your exam,
which could result in you being late
zz that your car or other belongings are stolen

Your risk appetite may be that:
zz If your risk appetite is low, you will leave home three hours before the exam
starts and attempt to avoid the risk of traffic congestion that may cause
you to be late.
zz If your risk appetite is high, you will leave home an hour before the exam
starts and accept the risk of traffic congestion that may cause you to be late.
zz Your risk appetite may be low to suffering losses when your car or personal
belongings are stolen, so you will want to arrange insurance to reduce the
risk.
6 Definition of risk management

Below are a few definitions of risk management by different organisations.
 Risk management is the process to reduce significant risks facing the organisation in a
cost effective manner to contribute to the achievement of the organisation’s objectives.
 CIMA’s official terminology (2011:36) defines risk management as:

“The process of understanding and managing the risks that an organisation is subject
to in attempting to achieve its corporate objectives.”
 The Committee of Sponsoring Organisations of the Treadway Commission (COSO)

defines Enterprise Risk Management (ERM) as follows:
“A process affected by an organisation’s board of directors, management and other
personnel, applied in strategy setting across the organisation. This process is designed
to identify potential events that may affect the organisation (risk), to manage risks
within the organisation’s risk appetite, and to provide reasonable assurance regarding
the achievement of organisation objectives.”
 The Institute of Risk Management gives the following definition for risk management:
“The process by which organisations methodically address the risks attached to their
activities to achieve sustained benefit.”
NOTE
You will not be required to distinguish between the different definitions. Any one of the
definitions will be accepted for assessment, as they all convey the same basic message.
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TOPIC 9
The risk management process can be illustrated as follows:

FIGURE 22.4: Components of the risk management process
Based on Valsamakis, Vivian & Du Toit (2010:145), the above components can be
described as follows:
z RISK IDENTIFICATION
The process to identify internal and external events, which could affect the achievement
of the organisation’s objectives. This includes risks and opportunities.
z RISK ASSESSMENT
Risks are analysed by considering the impact (potential damage or loss) and likelihood
of the risk occurring. Risks are assessed at an inherent basis (risk exposure before
considering risk responses) and residual basis (risk exposure after considering risk
responses).
z RISK RESPONSE
Measures to reduce the likelihood and/or impact rating of a risk event.
z RISK FINANCING
Maintaining a balance between the economic and operational cost of risk reducing
measures and the achievement of the organisation’s objectives.
7 Why risk management?

The King Report on Governance for South Africa 2009 (King III) states that an
organisation’s strategy, risk, performance and sustainability are inseparable.
King III requires the board of directors (the board) to disclose how the board has satisfied
itself that risk assessments, responses and interventions are effective. Due care and
diligence will need to be exercised and disclosed. This due care and diligence are achieved
through:
z the structures of governance – risk/audit committee
z adoption and implementation of an annual risk management plan
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Study unit 22
zz effective risk management practices through the application of recognised frameworks,
methodologies, continuous assessments and monitoring
zz applying risk considerations into the decision-making frameworks (appetite/tolerance)
and specific decisions
zz ensuring that the board receives adequate assurance on the effectiveness of the risk
management process and on the management of specific risks
zz disclosing how the board is satisfied with the effectiveness of risk management in the
organisation
8 The objective of risk management

The objective is to add maximum sustainable value by aligning the risk management
function to the achievement of the organisation’s business objectives.
It involves:
zz the identification and treatment of risks with reference to the organisation’s vision,
mission and strategic objectives
zz addressing risks (threats) and opportunities
zz increasing the probability of success by reducing uncertainties
Risk management should form part of every organisation’s strategic management. Risk
management should add value by controlling the probability (likelihood) and/or impact of
unfortunate events and should maximise the realisation of opportunities.
In CIMA’s Official Learning System, Collier & Agyei-Ampomah (2009:122) also indicates
that an organisation’s risk management strategy should include the following elements:
zz the risk profile/risk appetite of the organisation, that is stating the level of risk it finds
acceptable
zz the risk management process (risk identification and assessment) that the organisation
practices
zz the organisation’s preferred option for risk treatment (that is retention, avoidance,
reduction, or transfer)
zz who is directly responsible for the organisation’s risk management
zz how reporting and monitoring take place
9 The benefits of effective risk management

The following are benefits of effective risk management:
zz aligning the risk appetite and business strategy
zz linking growth, risk and return
zz focus management responses on the most significant risks
zz improving decision-making, planning and prioritisation by contributing to a structured
understanding of the business activities and volatility
zz developing and supporting people and the organisation’s information base
zz minimising operational losses and optimising operational efficiency
zz protecting and enhancing the organisation’s brand and image
zz contributing to a more sustainable supply chain and operating environment
zz identifying and managing risks throughout the whole organisation
zz seizing opportunities
zz reducing the cost of finance
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10 Requirements for effective risk management
The following are requirements for effective risk management:
zz management commitment to effective risk management
zz integration with the strategic planning process
zz using a common language and framework
zz acceptance of risk management as a continuous process
zz wide ownership with a supportive culture across the organisation
zz effective risk management should be embedded in the organisational processes
NOTE
The rest of the study units to follow will elaborate on the components of the risk management
strategy. At the end of this part of the study guide, you should be able to compile an
organisation’s risk management strategy or evaluate a strategy presented to you.
11 Summary
zz In this study unit, we defined risk as a chance or possibility of danger, loss, injury or
other adverse consequences.
zz Organisations take risks to gain a competitive advantage and increase returns.
zz For business decisions, the direct relationship between potential benefits and the
associated risks should always be considered.
zz Concepts of risk appetite and culture were explained, as well as the relevance of risk
in financial management and management accounting.
zz The need to manage risks to contribute to the achievement of business objectives was
described.
zz The key elements of a risk management strategy were identified.
The next study unit will address the components and role players of an adequate risk
management programme.
Having worked through this study unit, you should be able to answer the following questions:
a. Illustrate the relationship between risk and return.
b. Explain the concepts risk, risk culture and risk appetite.
c. Summarise the three (3) categories of risk appetite.
d. Discuss the five (5) key elements of an organisation’s risk management strategy as
defined by CIMA.
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9 STUDY UNIT 23
Components and role players of an

9
adequate risk management programme
In this study unit
1 Introduction
In the previous study unit, we defined and explained risk, risk management and mentioned
the requirements of a risk management strategy. In this study unit we will cover the
requirements of KING III for risk management and discuss the inter-related components of
the COSO Enterprise Risk Management (ERM) Framework (refer to section 2) to formulate
a risk management plan.
2 Components of a risk management programme

A risk management programme is necessary to achieve the organisation’s risk management
objectives and could be based on the principles of the Committee of sponsering organisations
of the Treadway Commission (COSO)’s Enterprise Risk Management (ERM) – Integrated
Framework (COSO, 2004).
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TOPIC 9
The figure below represents COSO’s risk management framework.
Source: COSO (2004)
FIGURE 23.1: Enterprise Risk Management (ERM) Integrated Framework

Various other commonly used frameworks are also available and will be discussed later
in this study unit. They make use of similar concepts and terminology so it is apt that we
describe COSO’s ERM framework first.
The eight (8) inter-related components of the enterprise risk management (ERM) programme
are:
INTER-RELATED COMPONENTS OF ERM RESPONSIBLE PARTY

1 Internal (control) environment: The tone Board of directors (the
of the organisation and management’s board).
operating style. This sets the basis of how risk
is managed, including the risk management
philosophy and risk appetite.
2 Objective setting: A process to define The board.
the organisation’s objectives to realise the
organisation’s mission – whilst being aware of
the risk appetite.
3 Event identification: The process to identify The board can delegate
internal and external risk events, which could this responsibility to a sub-
affect the achievement of objectives. This committee (risk committee or
includes risks and opportunities. audit committee).
4 Risk assessment: Risks are analysed by The board is ultimately
considering the impact (potential damage or responsible. Management
loss) and likelihood, as a basis for determining and the risk management
how the risk should be managed on both an department will usually do
inherent (gross) and residual (net) basis. the assessments and provide
feedback to the board or a
sub-committee thereof.
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Study unit 23
INTER-RELATED COMPONENTS OF ERM RESPONSIBLE PARTY
5 Risk response: Management decides whether The board should ensure
to avoid, accept, reduce or share the risk. A set that management considers
of actions is designed to align the residual risk and implements appropriate
ratings with the organisation’s risk appetite. risk responses. The board
does this by approving and
monitoring the annual risk
management plan.
6 Control activities: The internal control system, The board should ensure
including all the policies and procedures to continuous risk monitoring
help ensure that risk responses are adequate by management and the risk
and effective. The adequacy and effectiveness management department.
of risk responses are assessed based on The board does this by
feedback from management, risk management, approving and monitoring
internal audit and external audit. the annual risk management
plan.
7 Information and communication: Relevant The board should ensure
information is identified, captured and that there are processes in
communicated. This enables people to carry place enabling complete,
out their responsibilities. timely, relevant, accurate and
accessible risk disclosure to
stakeholders.
8 Monitoring: The entire ERM is monitored The board does this by
through ongoing management activities and approving and monitoring
separate evaluations and modified when the annual risk management
necessary. plan.
 INHERENT RISK
This involves the assessment of risk before the application of any controls, transfer or
management responses.
 RESIDUAL RISK
It is the risk that remains after the application of any controls, transfer or management
response to mitigate the risk under consideration.
 RISK MANAGEMENT PLAN

It is the document of identified risks (derived with reference to the organisation’s
objectives) with the corresponding risk assessment to create risk responses. The
achievement of the risk management plan is the responsibility of the risk management
group.
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TOPIC 9
Role players in the execution of the risk management strategy
ROLE PLAYERS RESPONSIBILITIES
board of directors zz ultimately responsible for risk management
audit committee zz board committee charged with oversight of internal
control systems and financial reporting
zz works with external and internal auditors
risk committee (the zz board committee with direct responsibility for risk
work will be done by management
an audit committee if
a risk committee does
not exist)
risk management zz group of senior and middle management responsible
group (lead by the risk for risk management processes
manager and the risk zz report to the board via the audit and risk committee
department)
zz monitor the effectiveness of the overall risk
management process and make recommendations for
improvement
internal audit function zz test the adequacy and effectiveness of key internal
controls;
zz provides recommendations to improve the risk
management process
2.1 Role of the board of directors

zz The board is ultimately responsible for effective risk management.
zz The board is responsible for defining the organisation’s risk appetite.
2.2 Role of management/risk management group

The board requires management to ensure effective risk management, make
recommendations for improvement and to maintain a good control environment.
A good control environment includes an internal control system, which consists of all
the policies and procedures necessary to ensure that the organisation’s objectives are
achieved, including:
zz the orderly and efficient conduct of the organisation
zz the safeguarding of assets
zz the prevention and detection of fraud and error
zz accuracy and completeness of the accounting records
zz timely preparation of reliable financial information
2.3 Role of the risk management department

Based on adaptations from the Institute of Risk Management (IRM) and CIMA (2011:69)
the role of the risk management department/risk manager’s function includes the following:
zz setting policy and strategy for risk management
zz primary champion of risk management at strategic and operational level
zz building a risk aware culture within the organisation including appropriate education
zz establishing internal risk policy and structures for business units
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Study unit 23
zz designing and reviewing processes for risk management
zz coordinating the various functional activities which advise on risk management issues
within the organisation
zz identification and evaluation of the risks affecting an organisation based on the
organisation’s strategy, operations and policies
zz developing risk response processes, including contingency and business continuity
programmes
zz implementing a set of risk indicators and reports including losses, incidents, key risk
exposures and early warning indicators
zz liaising with insurance companies with regards to cover available, claims and conditions
zz facilitates the monitoring of risk responses based on the risk management plan and
reports on the results thereof
zz monitors the implementation of internal audit recommendations
zz preparing reports on areas of significant residual risk and the achievement of the risk
management plan for the board and the stakeholders
The risk management department, usually through the chief risk officer or risk manager,
reports to the board or a sub-ordinate committee, such as the risk and compliance committee.
Note that these reports may have statutory requirements, such as the Sarbanes-Oxley
(SOX) reports for United States companies.
2.4 Role of internal audit and audit committee

Risk management is an important precursor to internal control as it allows the internal
controls to be focused on the most significant risks. Based on COSO, a model of internal
control contains five (5) elements:
1. a control environment that includes management values, operating style, organisation
structure, authority and policies
2. the risk assessment of internal and external risks
3. control activities, which should be integrated with a risk assessment
4. a system for monitoring the effectiveness of internal controls
5. means by which information can be captured and communicated
The role of internal audit is therefore to focus on the significant risks, as identified by
management, and to audit the risk management processes across an organisation. This
includes the testing of the effectiveness and adequacy of controls set to address significant
risks to provide reasonable assurance of the effectiveness and adequacy of the financial
controls, efficiency of operations and compliance with laws and regulations.
Therefore, risks are assessed and control activities introduced to mitigate the risks to
an acceptable level (risk appetite). The monitoring of the controls is the responsibility of
management, assisted by the risk management function.
Internal audit can provide advice to the board, or a sub-committee of the board, such as
the audit committee, regarding the effectiveness of the processes to identify and assess
inherent risks, the adequacy and effectiveness of risk mitigation and the effectiveness of
the residual risk assessment.
NOTE
The monitoring of risk mitigating actions such as internal controls remains the responsibility
of management. An internal audit review cannot be regarded as a control as the internal
audit function should remain independent from management and test the adequacy and
effectiveness of controls.
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TOPIC 9
Ac t ivi t y 23.1
Use your knowledge of the eight components of the ERM programme and rank
the following in chronological order/order of dependence:
a. The board of directors approves a risk management programme, which
could include all the components of enterprise risk management.
b. The organisation’s vision, mission and strategies are formulated.
c. A risk management strategy is defined.

a. The organisation’s vision, mission and strategies are formulated and
are used as a basis for risk management.
b. A risk management strategy is defined with reference to the organisation’s
vision, mission and objectives.
c. A risk management programme is drafted to achieve the effective
identification, assessment and evaluation of risks and the reporting thereof.
The risk management programme should ideally include all the components
of enterprise risk management as defined by COSO.
3 Risk management approaches

Over the years, several risk management standards or approaches have been developed.
We will name four and briefly discuss them.
3.1 COSO’s risk management model

The Committee of Sponsoring Organisations of the Treadway Commission (COSO)
established the following Enterprise Risk Management Framework in 2004 (refer to
section 2):
zz internal environment or control environment (to establish the tone of the organisation
and management’s operating style towards the management of risks)
zz objective setting
zz event identification
zz risk assessment
zz risk response
zz control activities
zz information and communication
zz monitoring
With this framework in mind, one has to identify the risks applicable and categorise them
into the following risk objectives (see figure 23.1):
1. Strategic: High level goals and related risks which are aligned with the organisation’s
mission and strategic objectives
2. Operations: Risks related to the efficient and effective use of resources
3. Reporting: Reliability of reporting
4. Compliance: Comply with laws and regulations
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Study unit 23
This will then allow you to assess, respond and control the risks.
This process takes place at organisation-, division-, business unit and subsidiary level.
3.2 IRM risk management standard

According to the Institute of Risk Management (IRM), risk assessment comprises the analysis
and evaluation of risk through processes of identification, description and estimation. Risk
assessment leads to risk evaluation, which leads to decision-making.
The IRM risk management standard is also clear about the fact that risks could result from
internal and external factors.
Source: AIRMIC, ALARM, IRM (2002:4)

FIGURE 23.2: The Institute of Risk Management risk management standard (adapted)
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TOPIC 9
3.3 CIMA’s risk management cycle
This model is based on the principle of continued feedback that is inherent in management
control systems. The figure below indicates the flow of information needed to make decisions.
Source: CIMA (2009:123)

FIGURE 23.3: CIMA risk management cycle
3.4 Australia/New Zealand standard

The International Standard Association within the International Organisation for
Standardisation (ISO) considers the Australia/New Zealand standard for adoption as an
ISO standard. The standard is a generic guide for managing risk and can be applied to a
wide range of activities. It comprises five steps, namely:
1. Establish the goals and context for risk management.
2. Identify risks.
3. Analyse risks and estimate the level of risk faced.
4. Evaluate and rank the risks.
5. Treat the risks through appropriate options.
Communication and monitoring are ongoing processes.
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Study unit 23
Activity 23.2
A newly established organisation has built a brewery and hopes to establish itself
as a leading player in the South African beer industry with the establishment of
various unique brands. Identify what could be regarded as the organisation’s
main “risk objectives”, with reference to the COSO risk management framework.

After considering the internal and external environment, the organisation defined
the following objectives:
a. Strategic: Establish the organisation as leading player in the South
African beer industry. This could be done by identifying
opportunities in the market and positioning the new brands
in such a way to achieve sustained success.
b. Operations: Produce and deliver products of the highest quality in an
efficient, effective and timely manner.
c. Reporting: Providing reliable and timely information aligned with reporting
standards and best practices to enable stakeholders to
analyse data and make sound business decisions.
d. Compliance: Conform to all legislative requirements for licensing, production,
distribution, branding, advertising, labour relations, taxation,
and so forth.
4 Summary
In this study unit, we explained the responsibility of the board of an organisation to disclose
the effectiveness of risk assessments and responses. This is achieved with due care and
diligence by adopting a risk management programme. The success of this programme
is largely dependent on a good internal control environment and a comprehensive risk
management plan with regular reporting on the achievement of this plan and the results
thereof.
We briefly discussed the eight (8) inter-related components of an effective and adequate
risk management programme. These eight components link with the Institute of Risk
Management’s risk management process, which also includes risk assessment, risk
response (treatment) and risk reporting (communication).
Four (4) risk management approaches were named and briefly discussed. From these
discussions, it became clear that most risk management approaches require an analysis of
the organisation’s strategic objectives and an analysis of the objectives of risk management.
This analysis is necessary to achieve organisation objectives while managing threats and
opportunities.
The categories of risk facing an organisation will be discussed in the next topic.
questions:
a. Identify the four (4) risk objectives as defined by COSO.
b. Briefly discuss the four (4) risk management approaches.
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TOPIC 9
c. Illustrate the inter-related components of enterprise risk management (ERM) that is
part of the COSO risk management approach.
d. Describe the role of management and risk management in the execution of a risk
management strategy.
e. Discuss methods to monitor the effectiveness of the risk management process.

AIRMIC, ALARM, IRM 2002. A risk management standard.
http://www.theirm.org/publications/documents/Risk_Management_Standard_030820.pdf
[Accessed on 22 March 2012]
http://www.signnetwork.com (Bart Simpson on a skateboard).
CIMA. 2011. CIMA Official Learning System. Paper P3 – performance strategy. 1st edition.
Oxford: Elsevier.
BPP Learning Media. 2011. Performance strategy, strategic paper P3. 3rd edition. London:
BPP Learning Media.
Collier, PM & Agyei-Ampomah, S. 2009. CIMA Official Learning System. Management
accounting risk and control strategy, paper P3. Oxford: Elsevier.
Committee of Sponsoring Organizations of the Treadway Commission (COSO).
2004. Enterprise risk management – integrated framework. www.coso.org.
Drury, C. 2011. Management and cost accounting. 7th South African edition. London:
South-Western Cengage Learning.
King Report on Corporate Governance (KING III). 2009.
Valsamakis, AC, Vivian, RW & Du Toit, GS. Risk management. 4th edition. Sandton:
Heinemann Publishers.
173 .........................
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TOPIC 9
TOPIC 10
Risk identification and documentation
LEARNING OUTCOMES

–– categorise risks facing an organisation
–– identify risks facing an organisation by using various methods
–– document risks facing an organisation in a risk register

strategic
management,
planning
financing and the
cost of capital
1 Development 2 Introduction 6 Analysis 9 Risk theory and

of the to financial of financial approaches to risk
organisation’s management information management
strategy 3 Time value of 7 Analysing and 10 Risk identification and
money managing documentation
4 Sources and working capital SU 24: Categories of
forms of finance 8 Capital risk facing an
5 Capital structure investments and organisation
and the cost of capital budgeting
SU 25: Risk identification
capital techniques
and the risk
register
11 Risk assessment, the
management of risk and
risk reporting
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Study unit 23
INTRODUCTION
In the previous topic, we explained the components of an adequate enterprise risk
management (ERM) programme. With reference to the ERM framework, this topic will deal
with the practical application of risk management by focussing on the categories and types
of risk, the tools available to identify risks and the documentation thereof in a risk register.
........................ 176
TOPIC 10
10 STUDY UNIT 24
10Categories of risk facing an organisation
In this study unit
177 .........................
Study unit 24
1 Introduction
In this study unit, we will discuss the risk objectives of an organisation and look at types
of risk that could face the organisation before we explain the methods to identify these
risks in study unit 25.
2 Principal risk objectives/categories

Risks are categorised to streamline the management of similar risks with control measures
suitable for the specific kind of risk. The categorisation of risks contributes to management
and employees’ risk awareness leading to an effective risk management programme
whereby controls and other risk mitigating actions are introduced and monitored.
You will remember the four (4) risk objectives, as defined by COSO are:
1. Strategic objectives: refer to the high-level goals of the organisation and are aligned
with the mission of the organisation.
2. Operational objectives: aim to use the organisation’s resources in an effective and
efficient manner.
3. Reporting objectives: aim to ensure reliable reporting of financial and non-financial
data.
4. Compliance objectives: target compliance with applicable laws and regulations.
These four (4) risk objectives could then be used as the basis to identify categories of
risk. A fifth category, namely information and technology as well as a sixth category
namely systematic and unsystematic risk could be added to the list of COSO categories/
risk objectives.
2.1 Strategic risk

STRATEGIC RISK
Strategic risks have more to do with the organisation’s position and relation with the
external environment in the long-term.
These strategic risks – being from the external environment – are not under the control of
the organisation, which make the risks difficult to mitigate. This business environment in
which the organisation operates determines the profit volatility. This is strategic risk. The
strategy an organisation decides on, regarding resources and possible structural changes
of the organisation has a major impact on costs, prices, products, sales and sources of
finance. However, some internal functions in an organisation have a key bearing on the
organisation’s situation in relation to its environment.
Factors, which influence strategic risks specifically, are the following:

zz industries within which the organisation operates
zz general state of the economy
zz actions of competitors
zz the specific stage of the product’s life cycle
zz price fluctuations over which you have little control
zz level of operating gearing
zz flexibility of production processes when product specifications alter
zz research and development capacity with the ability to innovate
zz significance of new technology
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TOPIC 10
In many cases, these strategic risks will be out of the control of management, but by
diversification, strategic risks can be minimised. Strategic risks are most important and
should be clearly understood.
Also refer to the first part of this study guide to understand the role of strategic risks on
the development and changes to an organisation’s strategy.
Ac t ivi t y 24 .1
The following is an extract from the MultiChoice website (www.multichoice.co.za)
illustrating the organisation’s mission statement and vision.
Read the information below as well as the ABOUT US and MEDIA section
on the MultiChoice website and try to identify some of the risks faced by the
organisation.
MISSION & VISION

MultiChoice Enriches Lives. It’s our mission to brighten people’s lives
with compelling digital media content. Whether it’s through Pay TV, the
Internet, mobile phones or any other device on the digital horizon, our
goal remains the same: We Enrich Lives. It can happen anywhere. In a
city. In a remote village. To millions of people. To one person. To some-
one we don’t know. To someone we work with. To the fortunate. To the
less fortunate.
MISSION STATEMENT
We surround you with a world of entertainment.
VISION STATEMENT
We will be Number One in all chosen market segments, as the most
trusted, best value provider of:
zz The most compelling digital media content
zz The most innovative delivery
zz The best customer care
zz Nurturing the best talent
Source: Quoted from http://www.multichoice.co.za/multichoice/view/multi

choice/en/page44128
Note
Refer to Topic 1 and 2 at the beginning of this module for definitions of an

organisations’ mission, vision and values and how these concepts are used
in strategy setting.
1 Fe edback on ac t ivi t y 24 .1
By visiting websites such as http://engineeringnews.co.za and
http://www.channel24.co.za/TV/News, you can could get information such as
the following:
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Study unit 24
Appetite for mobile TV strong, but take-up hinges on coverage, cost
Christy van der Merwe
18.02.2011
There has been a “massive leap” in interest in mobile TV in South Africa
over the past year, World Wide Worx director Arthur Goldstuck tells
Engineering News.
“We found previously that, if there is a technology that is incoming in the
future and one asks about take-up, enthusiasm is very low. But the
moment that the technology becomes available, enthusiasm leaps,”
Goldstuck notes.
In September 2010 ... the Independent Communications Authority of
South Africa (Icasa) issued mobile TV broadcasting licences to e.tv (40),
and MultiChoice (60%).
MORE
Information technology set to play a bigger role in education

Schalk Burger
2012-03-16
Information technology (IT) will increasingly be used in schools to
improve the effectiveness of teaching and the availability of materials,
says Department of Basic Education Curriculum Innovation and
e-Learning director Phil Mnisi ...
Mindset, which has a dedicated education broadcast channel on Digital
Satellite Television and on TopTV, has developed multimedia and video
lessons for pupils and teachers to use, said Mindset CEO Roith Rajpal.
The non-profit company uses multiple platforms to distribute its content
and has installed technology infrastructure at a number of schools ...
MORE
Source: Quoted from http://engineeringnews.co.za
Report: Separate channels will end pay TV

2012-06-26
Thinus Ferreira
If pay TV operators were forced to sell TV channels separately to their
subscribers on a so-called a la carte basis or as part of a so-called
“unbundling” of their TV channels, it would destroy the billion dollar pay TV
industry, a new independent analysis on the pay TV industry has found.
A new report warns that so-called “unbundling” would lead to less choice
and to only ten TV channels in America surviving the move.
Related links
• DStv Compact overtakes Premium
• Nando’s tells MultiChoice to take a hike
• DStv lifts ban of Nando’s ad
Source: Quoted from http://www.channel24.co.za/TV/News
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By analysing the above market news and reading the mission and vision of
MultiChoice, we can identify numerous possible risks, which could include:
zz The organisation will not be the most compelling digital media provider
if it is not able to secure the exclusive broadcast rights for a significant
portion of highly rated content, television series, and sporting events. The
rising cost of international content, negative currency fluctuations or the
introduction/growth of a competitor in the market increase the risk of not
being the most compelling digital media provider. Note that the introduction
of a competitor increases awareness and interest in the industry, which
could also present opportunities for growth.
zz MultiChoice will lose its attraction if it does not provide the most innovative
delivery, which includes high definition (HD) broadcasts, 3G streaming over
the internet and mobile television.
zz Not providing the best customer care could result in unhappy customers and
losses. With technology at the core of the business, it may be a challenge
to find enough skilful employees, which increases the risk of poor customer
care. Measures such as learnership programmes and skills development
initiatives could be risk responses that will contribute to reducing the
likelihood and impact of this risk.
zz If the organisation is unable to nurture the best talent, it could negatively
impact on service delivery and result in losses. Working in a stressed
working environment, which requires precision to ensure the achievement
of broadcast schedules could have a negative impact on staff morale.
zz Providing employee wellness service programmes and equipping staff with
the skills to be efficient and effective reduces the risk of not achieving this
objective.
As mentioned before, numerous other risks could be derived from the above.
Note
In your MAC modules (undergraduate and post-graduate), it is important that you read
and watch financial news reports. You will not be examined on news events, but it will give
you a better understanding of the context of what we are trying to teach you, especially if
you are a full-time student!
2.2 Operational risks

As strategic risk focuses on the long-term, operational risk is more concerned with the
day-to-day operations of the organisation.
Key term: OPERATIONAL RISK

 According to the definition by BPP Learning Media (2011:8):
“Operational risk is the risk of loss from a failure of internal business and control
processes.”
 The Basel Committee on Banking Supervision defines operational risk as:
“The risk of loss resulting from inadequate or failed internal processes, people, and
systems or from external events.”
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Examples of operational risks are:
zz losses from poor internal control systems, for example slack physical access control
resulting in theft
zz non-compliance with regulations or internal procedures
zz information technology failures
zz human error
zz loss of key-person risk
zz fraud
zz business interruptions, such as those due to power failures and no back-up power
generators
2.3 Reporting risk

REPORTING RISK
The risk refers to the provision of unreliable financial and non-financial information to
all levels of management and other stakeholders.
This could result in inappropriate decisions being made. Reporting risk is also linked to
financial risk that relates to the financial operation and position of an organisation.
2.4 Compliance (legal) risk

COMPLIANCE RISK
These risks arise from non-compliance with legislation or regulations.
This is often a significant risk as it could result in huge fines and penalties or the suspension
of operating licences which could create a going concern problem for the organisation
(organisation will not be able to continue operations).
There are often hundreds of acts, pieces of legislation and other regulations that
require compliance. This includes labour laws, tax legislation, regulations for listed
organisations (if applicable), and so forth.
The term going concern problem is one that you will come across throughout your
studies. When an organisation is threatened by a going concern problem, it is faced
with a significant event or situation that threatens the ongoing survival of the organisation.
Activity 24.2
Use the risk categories or objectives (as provided by COSO) and categorise
the following risks, which were noted by the chief risk officer of an organisation
in the courier industry, that delivers mail and packages, and committed itself
to specific delivery times and destinations:
zz There is no communication with drivers during the day to notify them of
traffic problems/delays, which sometimes result in drivers being stuck in
traffic, resulting in late deliveries.
zz The organisation’s management has decided to work for two key customers
in future. This has significant benefits for the organisation, as fixed contracts
will guarantee work and an excellent revenue stream for next few years.
However, one of the customers is already in financial distress and if the
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business is lost it will be difficult to collect the money. It will also require
marketing cost and time to expand the customer base to the current levels.
zz Drivers sometimes exceed the speed limit in an effort to get the work done
quickly.
zz A driver was recently caught delivering packages with the organisation’s
vehicle for his own benefit. He also accused other drivers of collecting
money for their own benefit for work done with the organisation’s resources.
zz In an effort to save cost, the chief financial officer has decided to reduce
the staff in the financial department and not fill the position before the end
of the financial year when the financial statements are drafted.

zz Inadequate communication with drivers resulting in late deliveries is an
operational risk, as it is part of the day-to-day activities.
zz The decision to work for only two key customers increases the risk of future
failure of the organisation if one of the key customers suffers financial losses
or close down. This is a strategic risk, as it is a long-term risk.
zz Drivers exceeding the speed limit are breaking the law. This is a compliance
risk.
zz Drivers doing deliveries for their own benefit with the organisation’s resources
are defrauding the organisation. This is an operational risk.
zz The reduction in staff in the finance department could result in inaccurate
and unreliable financial information, which is a reporting risk.
3 The main types of risk are

Business risk
Economic risk
Financial risk
Market risk
Social risk
Political risk
Information risk
Technology risk
Environmental risk
Compliance risk
Reputation risk
We will now discuss the above types of risk in more depth.
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3.1 Business risk
Key term: BUSINESS RISK
Risks that arise from the activities of the organisation and relate to the people, processes,
products and structure.
This includes product failure, fraud, loss of suppliers, loss of key employees, business
interruptions, contractual inadequacy risk, and so forth. These risks are generally within the
organisation’s control and can be managed by introducing internal controls or insurance.
3.2 Economic risk

ECONOMIC RISK
Economic risks are directly related to risks that originate from activities or non-activities
in the normal economy. This includes changes to inflation, the unemployment rate and
international policy. These economic risks start before transactions take place and are
considered to be external.
To understand economic risks, one needs to have a thorough knowledge of the

organisation’s competitive position on a global basis. Other examples of these risks are:
zz Product risk
A product risk arises when consumers’ taste change and they do not purchase your product
any longer, preferring another product instead of your product. When preferences change,
your organisation’s sales drop, which result in losses. This could include changes in trends,
for example, a sudden preference for leather handbags could result in reduced sales for
handbags made from other material.
zz Stakeholder risk
Stakeholders or investors can lose interest in your organisation. A non-committed stakeholder
can be a huge risk as they might hold back new funds for new developments or the urgent
maintenance of the production plant. Employees (as stakeholders) can also be a risk in
constant strikes and disruption.
3.3 Financial risk

FINANCIAL RISK
Financial risk relates to the financial operation and position of an organisation.
The most important financial risk is that the organisation will not be able to continue to
function as a going concern. Financial risks are also linked to the organisation’s financial
structure. This is the mix of equity and debt capital, the risk of not finding funding and for
overtrading. The following are examples of financial risks:
zz Investment risk
Investment risk arises, for example, when an organisation makes a decision to invest capital
in a project, expansion, and so on, but due to uncertainties, the investment decision turns
out to have been untimely and wrong. Examples of uncertainties are insufficient data or
the definition of cost of capital wrongly interpreted.
zz Currency risk
Transactions involving foreign countries always have the possibility of a gain or loss, due
to value of one currency fluctuating in relation to another currency. To reduce or eliminate
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these risks, organisations can use hedging techniques. The three most important risks
arising from currency risks are:
–– Transaction risk – changes in the settlement values
–– Translation risk – changes to the values of foreign assets and liabilities at year-end
–– Economic risk – the effect of the exchange rate on the cost of goods
zz Interest rate risk

If an organisation has reasonably high debt not linked to a fixed rate, the uncertainty of
interest rate fluctuations is a risk. If it rises, the cost of capital can cripple the organisation.
The reverse also being true – if the organisation has high fixed rate debt and the rate drops,
the organisation cannot reap the benefits of lower finance cost. Hedging techniques also
apply.
Interest rate risk also applies to investments linked to interest rates.
zz Credit Risk
The Official CIMA Terminology (2011:23) for credit risk is:
“The possibility of losses due to non-payment by debtors. This usually applies to the
organisation’s debtors and counter parties to hedging transactions.”
Credit risk is influenced by: the organisation’s credit policy, the proportion of credit sales,
credit terms offered, the screening of debtors and debt collection procedures.
zz Trading risks
These are risks that occur due to environmental, cultural and time differences between
local and international organisations.
zz Financial records and reporting risk

Ineffective accounting systems or a breakdown in accounting systems can lead to
financial reporting risk as this could result in invalid, incomplete, and unreliable recording
of transactions in the accounting records.
Note
You will learn more about hedging currency and interest rate risk in your post-graduate
modules.
3.4 Market risk

MARKET RISK
Market risk originates from events and transactions in the market place.
Market risks are risks that can result in a financial loss for an organisation, due to the
actions of competitors or a change in the prices of commodities and investments on stock
markets. Market risks can be caused by:
zz Competitors
Actions taken by competitors can be a risk for your organisation. For example, if
your competitor introduces a new product more advanced than your own, you are in
danger of having a cash flow problem, ending in a loss, because clients may prefer to buy
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the competitor’s product, instead of yours. In addition, your competitor can offer a reduced
price for his product, at which you cannot manufacture and sell your product.
zz Commodities
The possibility exists that certain raw materials crucial to the manufacturing of a product
can no longer be supplied. This can force the organisation to use substandard raw
materials, resulting in products of lower or inferior standard being sold. This can lead
to a decline in market share and a threat to your organisation. Active trading markets
exist for certain commodities such as gold, platinum, maize, and so forth. This also
includes commodity price risk that relates to the risk of a change in commodity prices.
You can manage some of these risks by hedging contracts.
3.5 Social risk

SOCIAL RISK
Social risk relates to the impact of the organisation on the community and vice versa.
Social risks include drug addiction and social upheaval, that is as a result of, for example,
a decision to close a business unit or a mine in a small mining community.
3.6 Political risk

POLITICAL RISK
Refers to the effect that detrimental political activities or political instability have on an
organisation.
3.7 Information risk

INFORMATION RISK
Information risk is the risk that decision makers within the organisation use invalid or
poor quality information for decision-making, or the loss of information.
Good information is information that adds to the understanding of a situation. BPP Learning
Media created the mnemonic ACCURATE to help you remember the qualities of good
information. They are:
A – Accurate. Figures should add up.
C – Complete. All the required information is included.
C – Cost-beneficial. Cost to obtain information should not be more than the benefit.
U – User-targeted. The needs of the user should be kept in mind to make it user-friendly.
R – Relevant. Only information relevant to the decision must be supplied.
A – Authoritative. The source of the information must be reliable.
T – Timely. Information should be available when required.
E – Easy to use. Information should be clearly presented.
The above are the characteristics of good information. In business, one does not always
have “good” information and sometimes have to make decisions based on inadequate
information, which creates an information risk.
The information technology (IT) systems and databases of a short-term insurance company
on which all the client information is stored is an example where information risk is prevalent.
Clients’ personal information and details of their possessions are stored on these systems
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and regular back-ups and advanced data security are very important risk responses in
order to prevent the loss of information.
This is a very important risk and it is imperative for management to have proper policies
and procedures in place to keep the occurrence of such an event to the minimum.
3.8 Technological risk

TECHNOLOGICAL RISK
 Risk involved with the operation, ownership and sustainability of the organisation’s
information technology (IT) systems. This includes the negative impact on productivity,
service delivery, and so on, when IT systems fail, but also the risk associated with
missing opportunities to use technology to enable or enhance the business.
 Technological risks also refer to the manufacturing plant being outdated or a product
being obsolete when a more technologically advanced product has replaced it.
Note
The risks directly related to information technology (IT) are addressed in the AIN1501
module.
3.9 Environmental risk

ENVIRONMENTAL RISK
zz he risk relates to climate change and risk of natural disasters (deemed to be
T
external risks)
zz he risk of damage caused by a pollutant, that is, a substance or by-product
T
introduced into an environment other than its intended use/ purpose (deemed to be
within the organisation’s control). This could result in damage to the environment
as well as fines and penalties in countries with strict regulations.
3.10 Compliance risk

COMPLIANCE RISK
Risks that arise from non-compliance with legislation, regulations or internal procedures.
3.11 Reputation risk

REPUTATION RISK
A loss of reputation is the adverse consequence created by bad publicity due to the
materialisation of another risk. External stakeholders will normally perceive this loss
and it has serious consequences.
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Note
As mentioned before, the list of types of risks is endless. You have to think outside the box
and apply your mind to the circumstances of the organisation. Think of risks that may be
applicable to the specific situation in the organisation.
Activity 24.3
List some risks that may be relevant to a South African organisation manufacturing
paper from tree pulp. The organisation exports to various clients in South
America and Africa. The company operates with 80% debt capital.

With reference to the study material, there could be numerous types of risks
and the following are just a few examples that you could have considered:
zz environmental risks caused by air pollution from the paper mill (paper
manufacturing plant)
zz environmentalists may place pressure on the organisation and cause
restrictions on the cutting of trees if a conscious effort is not made to ensure
the sustainability of the water resources, fertile land, natural forests and
the biological system in the area
zz the high level of gearing increases the financial risk and could place
restrictions on future expansion as loans require fixed repayments and
are often secured by assets
zz the organisation exports to South America and other African countries,
which increases currency risk as contract values may change with currency
fluctuations
4 Summary
In this study unit, we again mentioned the four categories of objectives according to ERM.
We also discussed a significant list of types of risks. You might find other risks not mentioned
here when reading other textbooks, but as stated, you have to think outside the box.
In the next study unit, we will examine methods to identify risks.
After having worked through the study unit, determine if you are able to answer the following
questions:
a. Describe the difference between operational and strategic risks and formulate five (5)
examples of each.
b. Describe the characteristics of good information for decision-making.
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TOPIC 10
STUDY UNIT
11 25
11 Risk identification and the risk register
In this study unit
1 Introduction
In the previous study unit, we discussed the types of risk that could affect the organisation.
This study unit deals with the identification of risks. This process is often facilitated by a
risk management department and will be best to summarise it in a risk register.
2 Risk or event identification as defined within ERM

RISK OR EVENT IDENTIFICATION
Risk or event identification is the process to identify internal and external events, which
could affect the achievement of the organisation’s objectives. This includes risks and
opportunities.
Risks are identified with reference to the organisation’s strategy and objectives.
There are various methods to identify risk. In practice, members of the risk manager/
risk management department often facilitate the risk identification process with the risk
management group and the organisation may adopt either a “top down” approach, which
starts with senior management, or a “bottom up” approach, which starts with lower ranking
employees.
3 Risk identification process

z One risk identification method will not be sufficient to identify all the risk exposures.
z The risk identification process has to be supported by consulting with as many people
inside the organisation as possible. This includes management, internal audit and key
employees.
z Risk identification is a continuous process.
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4 Methods to identify risks
The methods to identify risks include the following:
METHOD DESCRIPTION
Control self-assessments Tool to assess management’s perception of perceived
completed by management: strengths, risks, weaknesses within the business
processes and the adequacy and effectiveness of the
controls designed to mitigate the risks and achieve
business objectives.
SWOT analysis: Strategic planning method used to evaluate the
strengths, weaknesses, opportunities and threats.
The management of threats and weaknesses
should be prioritised before committing time and
resources to the enhancement of strengths or
achievement of opportunities. This will contribute to
a sustained organisation.
PESTEL analysis An analysis of all the Political, Economic, Social,
Technological, Ecological, and Legal factors that
could affect the organisation.
Five Forces Model (Porter, Considers the following in an effort to identify risk:
1980) zz rivalry among existing organisations
zz bargaining power of buyers
zz bargaining power of suppliers
zz threat of new entrants
zz threat of substitute products or services
Brainstorming/risk workshops A group tries to find a solution for a specific problem
or question by gathering a list of ideas spontaneously
contributed by the group.
Stakeholder consultations Techniques involving data collection and could
include the survey of stakeholders by interview or
questionnaire.
Benchmarking Could be applied to risk management as management
identifies the best risk management practices in their
industry, or in another industry where similar processes
exist, and compare the results and processes of those
studied (the “targets”) to the organisation’s own results
and processes.
Diagnostics Diagnostics is a term used in risk management
to refer to methodologies measuring specific risk
exposures (“value-at-risk”), that is tools used to
selectively examine actions, performance and
events to measure an organisation’s safety culture.
This enables management to measure and highlight
potential shortcomings or risks.
Organisation charts and flow These charts indicate the processes/divisions of the
charts organisation and assist to identify risks as well as
indicate risk concentrations and dependencies.
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METHOD DESCRIPTION
Fish bone The process to break down a business process into
its component parts to examine all the risks to that
process.
Analysis of the financial This helps to identify values that are at risk, possible
statements legal exposures or contractual liabilities (on the
statement of financial position); and/or to indicate
sources of income and losses (statement of profit or
loss and other comprehensive income).
Results of quality control The results of quality control checks, inspections
checks, inspections and audit and audit findings will assist with the identification
reviews of risks.
Many of the above techniques are also used to embed risk awareness and risk management
into management’s activities to improve the control environment.
Note
In the rest of this and other MAC modules, you will encounter questions requiring you to
list or discuss other/ qualitative (subjective) factors when evaluating various options. The
SWOT and PESTEL analysis are useful tools to consider when answering those questions.
In the following activity, we will demonstrate the use of the more widely used techniques
of SWOT and PESTEL analysis.
Ac t ivi t y 25.1
Consider the following case study of Wakeup (Pty) Ltd, a coffee manufacturer
based in South Africa. The organisation’s differentiating factor is that it sources
unrefined or raw coffee beans from a small region in Ethiopia. These coffee
beans are roasted using a refined process to produce an aromatic and rounded
flavour. The coffee is expensive and targets a niche (exclusive) segment of
the market.
The following information was noted based on recent discussions with key
stakeholders including: The chairman of the audit committee (an independent
non-executive director), the chief executive officer (CEO), the chief financial
officer (CFO), the chief risk officer (CRO) and key members of management,
including the head of the legal department:
zz The organisation has a strong financial position to facilitate the financing
of future projects.
zz The organisation has an excellent distribution network across South Africa.
zz This distribution network is used to supply two large retailers with stores
across South Africa.
zz Only one of the retailers has placed their order for the next quarter.
zz Based on market research, Wakeup’s aromatic and rounded coffee blends
will be very popular in the fast growing Russian and Brazilian markets.
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Study unit 25
zz The economic downturn in South Africa is a concern as expensive coffee
is a luxury item and there are inexpensive substitutes.
zz Wakeup has a contract with an international company for the coffee beans
to be shipped in special containers from Ethiopia to South Africa. The
shipping company has expressed concerns about the growing number
of pirate attacks off the Somalian coast, but has indicated that alternative
routes are not economically viable. The attacks have resulted in some
cargo being lost or stolen and in the shipping company not achieving the
delivery dates.
zz There is currently a legal dispute over the patent rights of one of the coffee
blends sold by Wakeup.
zz The company has a strong and stable base of employees with very good
succession planning.
zz Wakeup has a strong and recognisable brand in South Africa.
REQUIRED
a. Draft a SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis.
b. Draft a PESTEL analysis.

a. SWOT analysis for Wakeup (Pty) Ltd
Strengths Weaknesses
zz The organisation has a zz Wakeup has a small
strong financial position to customer base and
Internal perspective
facilitate financing future only supplies two large

projects. retailers.
zz The organisation has an zz Wakeup produces
excellent distribution network expensive coffee
across South Africa. blends, which could
zz Strong and stable base of result in reduced sales
employees with good in the current
succession planning. economic downturn.
zz Strong and recognisable zz Currency risk
brand in South Africa. exposures from
imports.
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Opportunities Threats
zz Opportunity to expand to the zz Only one of the retailers
fast growing Russian and has placed its order for
Brazilian markets. the next quarter.
Growing number of
External perspective
zz
pirate attacks off the
Somalian coast could
result in delayed
delivery dates or the
coffee beans (raw
material) being lost or
stolen.
zz There is currently a
legal dispute over the
patent rights of one of
the coffee blends sold
by Wakeup.
Note
This is a SWOT analysis, but based on the above, a number of significant risks
can be identified. The assessment of the risks resulting from the threats and
weaknesses will be more significant than the advancement of the strengths and
opportunities. This is apparent because the threats and weaknesses need to be
addressed to ensure the sustainability of the organisation before committing time
and resources to the enhancement of strengths or achievement of opportunities.
b. PESTEL analysis:
ANALYSIS CONSIDERATIONS
Political factors zz The government stability in lucrative Russian
and Brazilian markets needs to be considered.
zz Some governments offer agricultural subsidies
which could influence the price of raw coffee
beans in those countries.
zz Taxation policies in South Africa, Ethiopia and
other potential markets. The taxation policies
of countries where significant competitors are
based should also be considered.
zz Some governments and regions offer tax
incentives/ grants, which could facilitate new
projects or expansion.
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Study unit 25
Economic factors zz The sustainability of Wakeup’s two large
customers is important when identifying future
risks.
zz Other growing markets around the world offer
the opportunity for expansion.
zz The economic downturn could result in reduced
sales as unemployment increases and people
have less disposable income.
zz Rate of inflation in Ethiopia could see an
increase in commodity prices, which will be
hard to control.
zz Stricter credit control from banks makes it
harder to acquire finance for expansions.
zz Interest rate fluctuations could influence the
cost of production.
zz Exchange rate fluctuations could influence
the competitiveness of Wakeup’s product
pricing if it hopes to expand into international
markets. It could also increase the risk of
more inexpensive substitutes in the South
African market.
Social factors zz Lifestyle changes influence demand, that is
when people work harder and spend more
time at work, it could influence the demand
for coffee.
zz Behaviour that is socially acceptable, will
drive demand.
zz The influence of consumer protection
movements, which seek to protect consumers
from dishonest packaging, advertising and
guarantees. This includes promoting healthier
products.
zz The effect of changes in demographics and
increased urbanisation.
Technological zz Government spending on new technologies.
factors zz Advancements in the production process
which could make it cheaper, quicker and
more cost effective.
zz Advancements in the transport of goods and
improvements to ensure that goods remain
dry and unscathed.
zz The ability to apply technologically advanced
production processes in foreign markets
needs to be considered.
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TOPIC 10
Ecological factors zz Environmental laws and regulations.
zz By-products of the coffee production process
and the cost and effect of waste disposal.
zz The sustainable management of the fertile
land by the Ethiopian coffee bean suppliers.
zz Changing weather patterns.
Legal factors zz Foreign trade regulations regarding the
unroasted/ raw coffee beans (agricultural
commodity) and the coffee (finished product).
zz Laws and regulations including labour laws,
product safety, and so forth.
zz The organisation is involved in a legal dispute
over patent rights.
These are only some considerations that could be considered when doing a
PESTEL analysis and there are many more.
We will discuss the assessment of risks in study unit 26 and risk responses (methods to
address risks) in study unit 27.
5 Documentation of risks
The risk management department often facilitates this process and documents the risks
in a risk register.
RISK REGISTER
A risk register is a summary of identified risks, which are listed, described and assessed/
measured (based on their potential impact and likelihood).
Data that could be included in a risk register is:

zz risk objective/category that the risk relates to
zz date when the risk was identified
zz description of the risk
zz inherent risk rating (based on the impact and likelihood of the risk, which will be
discussed in the next topic)
zz root cause analysis
zz risk responses (risk mitigating action plan, which will be discussed in the next topic)
if any
zz the target/ implementation date of the risk responses (This is important as the risk
register is a living document, which will change as the organisation grows and changes.)
zz residual risk rating (to be discussed in the next topic)
zz the “owner” of the risk (The individual responsible for ensuring that risks are appropriately
engaged with risk responses.)
zz interdependencies with other risks
Various software packages are available for the recording, storing and management of
risk registers.
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Study unit 25
Activity 25.2
Based on the Wakeup case study noted in activity 25.1 of this study unit, there
is a growing number of pirate attacks off the Somalian coast, which could result
in delayed delivery dates for the coffee beans (raw material) or the coffee beans
(raw material) being lost or stolen.
The risk is that the operations department may be unable to manufacture
coffee without the raw material or that unacceptable delays occur while the
raw material is at sea.
REQUIRED
Indicate how this risk could be documented and tracked in a risk register.
Risk Risk Date of Risk Inherent Risk Risk Residual Risk

objective/ type the risk description risk responses response risk owner
category identifi- assess- target assess-
cation ment date ment
Operational Com- 1 March Insufficient Critical Negotiate 30 April Medium Head
modity 20XX coffee beans (20) insurance 20XX (6) of
risk to ensure for the Opera-
an effective shipments tions
and efficient or
manufacturing
find a
process
feasible
alternative
supplier
Legends:
Critical Usually represented by the colour red
High Usually represented by the colour

orange
Medium Usually represented by the colour yellow
Low Usually represented by the colour green
Note
The calculation of the inherent risk assessment, formulation of risk responses, as well as
the calculation of the residual risk assessment will be discussed in the next topic.
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6 Access to risk registers
Access to edit the risk registers should be limited to key personnel, that is the members
of the risk management department. Access to view the risk registers should be broader
to enable those members of management responsible for the implementation of risk
responses to understand their roles and responsibilities. However, the ability to view the
risk registers should also be limited to prevent the risks and weaknesses of the organisation
from becoming public knowledge, which could be used by competitors or by people with
malicious intent.
Access controls over the risk register is clearly important. Consider other general controls
that need to be applied to ensure the effective documentation of risks and related information.
7 Summary
In this study unit, we focused on the initial identification of risk and the subsequent
documentation of risks. The process to draft and update risk registers on a periodic basis
is often facilitated by the risk management department.
We will discuss the assessment of inherent risk in study unit 26, the assessment of
residual risks and risk responses to manage risk in study unit 27 and risk monitoring and
risk reporting in study unit 28.
questions:
a. Illustrate methods to identify risks and discuss how the result of external- and internal
audit can assist in identifying risks.
b. State data that will typically be noted when drafting a risk register.
Enrichment/additional reading
Browse the internet for examples of risk management software and reflect on everything
that management will need to consider when buying and implementing the software.

Basel Committee on Banking Supervision. 2003. Sound practices for the management
and supervision of operational risk. Basel: Bank for International Settlements.
BPP Learning Media. 2011. Performance strategy, strategic paper P3. 3rd edition. London:
BPP Learning Media.
MultiChoice Africa. Mission and Vision.
http://www.multichoice.co.za/multichoice/view/multichoice/en/page44128
[Accessed on 9 July 2012]
http://engineeringnews.co.za
http://www.channel24.co.za/TV/News
197 .........................
Study unit 25
........................ 198
TOPIC 11
TOPIC 11
Risk assessment, the management of risk
and risk reporting
LEARNING OUTCOMES

–– evaluate the assessment of inherent and residual risks
–– formulate risk responses to manage risks
–– discuss risk reporting

strategic
management,
planning
financing and the
cost of capital
Topic Topic
Topic Topic
1 Development 2 Introduction 9 Risk theory and approaches

6 Analysis
of the to financial to risk management
of financial
organisation’s management information 10 Risk identification and
strategy 3 Time value of documentation
7 Analysing and
money managing 11 Risk assessment, the
4 Sources and working capital management of risk and risk
forms of finance reporting
8 Capital
5 Capital structure investments and SU 26 Assessment of
and the cost of capital budgeting inherent risk
capital techniques SU27 Risk responses to
manage risks and the
assessment of residual
risk
SU 28 Risk monitoring and
reporting
199 .........................
Study unit 25
INTRODUCTION
The previous topic focussed on the identification of risk. Topic 11 will explain the assessment
of risk, risk responses to reduce or mitigate the risk, and risk reporting.
........................ 200
TOPIC 11
STUDY UNIT
12 26
12Assessment of inherent risk
In this study unit
1 Introduction
In the previous study units, we dealt with the identification and documentation of risk
events. In this study unit, we will examine the next step in the ERM risk management
model, which is the assessment of risks at the inherent risk level. This process is often
facilitated by a risk management department in consultation with management and should
be summarised in a risk register.
2 Assessment of risks as defined within ERM

Risks are analysed by considering two dimensions, namely the impact (potential damage
or loss) and the likelihood of the event occurring. This is used as a basis for determining
how the risk should be managed on both an inherent (gross) and residual (net) basis.
The following definitions are critical:
INHERENT RISK AND RESIDUAL RISK

INHERENT RISK involves the assessment of risk BEFORE the application of any
risk responses.
Risk responses can include the introduction of internal controls, the transfer of the risk
or management responses.
RESIDUAL RISK involves the assessment of risk AFTER taking into account the
application of any internal controls, transfer or management responses to reduce the risk.
The residual risk rating will indicate whether the remaining risk is within the organisation’s
risk appetite. Risk responses are discussed in the next study unit.
201 .........................
Study unit 26
3 Risk assessments with the likelihood and impact matrix
The process to assess risks through the likelihood or impact matrix is called risk mapping.
For many organisation’s a 3x3 matrix of high/medium/low will suit their needs, while for
others a 5x5 matrix or even a 7x7 matrix may be more suitable.
Figure 26.1 (CIMA 2009) below illustrates one way in which risks can be assessed by
using a 5x5 matrix.
LIKELIHOOD/PROBABILITY
Assessment Measure- Description
ment
extreme 5 expected to occur
very high 4 will probably occur
medium 3 can occur at some time and may be difficult to

control
low 2 not expected to occur
negligible 1 may occur only in exceptional circumstances
IMPACT/CONSEQUENCE
Assessment Measure- Description
ment
extreme 5 impact or consequence of the risk will threaten the
survival or viability of the organisation
very high 4 will have a significant impact on the achievement
of organisation objectives or threaten the contin-
ued operation of the organisation
medium 3 will have a moderate impact on the achievement of
organisation objectives
low 2 will threaten efficiency or effectiveness of some
aspects of the organisation
negligible 1 limited effect and the impact or consequence of
the risk can be dealt with by routine operations
Source: CIMA (2009)

FIGURE 26.1: Risk assessments with the likelihood and impact matrix
Legends:
Critical usually represented by the colour red
High usually represented by the colour orange
Medium usually represented by the colour yellow
Low usually represented by the colour green
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TOPIC 11
The risk assessment is calculated by multiplying the likelihood measurement with the
impact measurement.
Ac t ivi t y 26.1
Browse the internet for images of risk-rating matrices.

Various images of risk rating matrices are available on the internet. The following
is an illustrative example of a risk-rating matrix with the calculated values (results
of the risk assessments) in brackets:
IMPACT LIKELIHOOD
Negligible (1) Low (2) Medium (3) Very high (4) Extreme (5)
Extreme (5) medium (5) medium (10) high (15) critical (20) critical (25)
Very high (4) low (4) medium (8) medium (12) high (16) critical (20)
Medium (3) low (3) medium (6) medium (9) medium (12) high (15)
Low (2) negligible (2) low (4) medium (6) medium (8) medium (10)
Negligible (1) negligible (1) negligible (2) low (3) low (4) medium (5)
Legends:
Negligible usually represented by the colour blue or no

colour
Activity 26.2
The following three (3) risks were identified as part of a brainstorming session
facilitated by the risk analyst (a member of the risk management department):
a. A foreign competitor will be introducing new technologies, which can result
in the organisation’s products becoming outdated.
b. Employees can enter into inefficient or wasteful contracts on behalf of the
organisation.
c. A fluctuation in currencies can have a negative effect on the price of
imported raw materials. The organisation currently imports 2% of its raw
material from Australia, but can buy the raw material from local suppliers.
The following likelihood and impact ratings were attributed to each risk event:
203 .........................
Study unit 26
a. New technologies to be introduced by a competitor:
Likelihood: Will probably occur (4).
Impact: The impact or consequence of the risk will threaten the survival
or viability of the organisation (5).
b. Inefficient or wasteful contracts:

Likelihood: Can occur at some time and may be difficult to control (3).
Impact: Will have a significant impact on the achievement of
organisation objectives or threaten the continued operation
of the organisation (4).
c. A fluctuation in currencies:
Impact: Limited effect and the impact or consequence of the risk can
be dealt with by routine operations as a small percentage of
raw material is imported and the raw materials can be sourced
from local suppliers (1).
REQUIRED
Populate the following selected fields of the risk register. Indicate the applicable
risk type and complete the inherent risk rating.
Risk objective/ Risk type Risk description Inherent

category risk rating

Calculation of inherent risk ratings:
a. new technologies to be introduced by a competitor: 4 x 5 = 20
b. inefficient or wasteful contracts: 3 x 4 = 12
c. a fluctuation in currencies: 3x1=3
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TOPIC 11
The following represents selected fields of the risk register after taking the
above information into account.
Risk Risk type Risk description Inherent risk

objective/ rating
category
Strategic risk Technological New technologies to be 20
risk introduced.
Operational risk Business risk Inefficient or wasteful 12
contracts can be
entered into on behalf of
the organisation.
Financial risk Currency risk Fluctuation in 3
currencies can have a
negative effect on the
price of imported raw
materials.
Legends:
4 Summary
In this study unit, we discussed the concepts “inherent” and “residual risk”. We also noted
that the most common way of assessing risks is through the likelihood and impact matrix.
Risk assessments are evaluated to make decisions about the significance of the risks and
to determine what risk response will be most appropriate.
Risk responses and the assessment of residual risk will be discussed in the next study unit.
After working through this study unit, you should be able to define:
a. inherent risk
b. residual risk
205 .........................
Study unit 26
STUDY UNIT
13 27
Risk responses to manage risks and the

13
assessment of residual risk
In this study unit
1 Introduction
In the previous study unit, we discussed the concepts “inherent” and “residual risk” as
well as the assessment of risks. In this student unit, we will discuss strategies to manage
risks and how to reduce risks so that the residual risk ratings are at an acceptable level.
2 Risk responses are included in the risk management strategy

We have learned that an organisation’s risk management strategy should include:
z the risk profile/risk appetite of the organisation, that is stating the level of risk it finds
acceptable
z the risk management processes (risk identification and assessment) the organisation
practices, together with its preferred option for risk treatment (that is, avoidance,
reduction, transfer, or retention and acceptance)
z who is directly responsible for the organisation’s risk management
z how reporting and monitoring processes will take place
3 Risk responses
The purpose of risk responses is to reduce the likelihood and/or impact rating of a risk event.
COSO’s ERM lists the following possible risk responses (mitigating actions):
1. Avoid: Action is taken to avoid activities, which give rise to high-risk events, that is,
to refrain from business activities in a certain geographical market, such as in a war-
torn country. Management accepts that avoiding the risks outweighs the benefits.
2. Reduce: Action is taken to mitigate the risk likelihood or impact, or both, generally
through preventative and detective internal controls.
3. Transfer or share: Action is taken to transfer a portion of the risk to a third party
through, for example, insurance, hedging or outsourcing.
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TOPIC 11
4. Accept: No action is taken to change the impact or likelihood of the risk. These risks
have a low impact when they occur and the “cost versus benefit” does not justify the
mitigation of the risk.
Note
Based on Valsamakis, Vivian & Du Toit (2010:145), risk financing is a critical term which
forms a close link with risk control as it strives to ensure that the cost of risk management
does not exceed the benefit.
4 Who is responsible for risk responses?

The implementation of adequate and effective risk responses is the responsibility of the
risk management team or management. The monitoring and review of risk responses
should be done by management and the risk management department (based on the risk
management plan) to ensure that:
zz risk responses were adequate and effective and achieved their objectives
zz the residual risk assessment was reasonable, based on the information and data used
zz knowledge and awareness of risk management in the organisation are enhanced for
future benefit
Ac t i v i t y 2 7.1
With reference to activity 22.4 in study unit 22, what do you think are the risk
responses or mitigating actions to the activities below?
zz If your risk appetite is low, you will leave home three hours before the exam
starts and attempt to avoid the risk of traffic congestion that may cause
you to be late.
zz If your risk appetite is high, you will leave home an hour before the exam
starts and accept the risk of traffic congestion that may cause you to be late.
zz Your risk appetite may be low to suffering losses when your car or personal
belongings are stolen so you will want to arrange insurance to reduce the
risk.
1 Fe e d b a c k o n a c t i v i t y 2 7.1
zz Avoidance – if you leave home three hours before the exam starts, you
will attempt to avoid the risk
zz Acceptance – if you leave home an hour before the exam starts, you will
accept the risk
zz Transfer – when you arrange insurance, action is taken to transfer the
risk
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Study unit 27
Ac t i v i t y 2 7. 2
Consider the following risks and the corresponding inherent risk ratings and
formulate suitable risk responses if you assume that the organisation’s risk
appetite is low:
Risk Risk type Risk description Inherent Risk

category risk response
rating
Strategic risk Technological New technologies to 20
risk be introduced.
Operational Business risk Inefficient or wasteful 12
risk contracts are entered
into on behalf of the
organisation.
Financial risk Currency risk Fluctuation in 3
currencies can have
a negative effect on
the price of imported
raw materials.
2 Fe e d b a c k o n a c t i v i t y 2 7. 2
The risk responses below were introduced to align the residual risk ratings
with the organisation’s risk appetite (refer to study unit 22, section 5), which is
low, for these types of risks.
Risk Risk type Risk description Inherent Risk response

Strategic Technological New technologies to be 20 i. Obtain the
risk risk introduced. rights to
incorporate the
new technology
into the current
products.
Operational Business Inefficient or wasteful 12 i. Draft a policy
risk risk contracts can be and procedure
entered into on behalf document
of the organisation. for contract
management;
ii. Have the board
approve a
delegation of
authority; and
iii. Appoint a lawyer
to review and
sign-off on all
contracts.
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TOPIC 11
Risk Risk type Risk description Inherent Risk response
Financial Currency Fluctuation in 3 i. Accept the risk.
risk risk currencies can have a
negative effect on the
price of imported raw
materials.
Legends:

colour
5 Assessment of the residual risk

Residual risk takes into account the application of any internal controls, transfer or
management responses to reduce the likelihood and potential impact of the risk under
consideration.
Ac t i v i t y 2 7. 3
Based on the feedback on activity 27.2 above, calculate the residual risk ratings
for the risks above and complete the risk register.
Assume the following likelihood and impact or ratings:
zz New technologies:
Likelihood: Will probably occur (4). Previously (4).
Impact: Limited effect and the impact/consequence of the risk as the
organisation will incorporate the new technology in its products
(1). Previously (5).
zz Inefficient or wasteful contracts:

Likelihood: May occur only in exceptional circumstances (1). Previously
(3).
Impact: Will have a significant impact on the achievement of
organisation objectives or threaten the continued operation
of the organisation (4). Previously (4).
209 .........................
Study unit 27
A fluctuation in currencies:
Previously (3).
Impact: Limited effect and the impact or consequence of the risk could
be dealt with by routine operations as a small percentage of
raw materials are imported and the raw materials could be
sourced from local suppliers (1). Previously (1).
3 Fe e d b a c k o n a c t i v i t y 2 7. 3
Calculation of residual risk ratings:
1. New technologies: 4 x 1 = 4.
2. Inefficient or wasteful contracts: 1 x 4 = 4.
3. A fluctuation in currencies: 3 x 1 = 3.
The following diagram represents selected fields of the risk register after taking
the information above into account.
Risk Risk type Risk description Inherent Risk response Residual

category risk rating risk rating
Strategic Technological New technologies 20 i. Obtain the rights 4
risk risk to be introduced. to incorporate the
new technology
into the current
products.
Operational Business risk Inefficient or 12 i. Draft a policy 4
risk wasteful contracts and procedure
can be entered document
into on behalf of for contract
the organisation. management;
ii. Have the Board
approve a
delegation of
authority; and
iii. Appoint a lawyer
to review and
sign-off on all
contracts.
Financial Currency risk Fluctuation in 3 i. Accept the risk. 3

risk currencies can
have a negative
effect on the price
of imported raw
materials.
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TOPIC 11
Legends:

colour
Note
 Can you see that the residual risk rating is clearly in line with the organisation’s low risk
appetite?
 Students should be able to identify and discuss risk responses at the organisation
level. Modules presented by the Department of Auditing will address the identification
of risks and risk responses within each audit cycle.
6 Summary
Risk response is the process of selecting and implementing measures to reduce or
mitigate the risk to an acceptable level. The acceptable level will be determined by the
organisation’s risk appetite, bearing in mind that a certain level of risk is required to acquire
the desired level of return. Remember that the potential benefits increase as the exposure
to risk increases.
We also discussed and did a practical example to perform a residual risk assessment, which
takes into account the application of risk responses to reduce risk to an acceptable level.
The next study unit will elaborate on risk reporting.
Describe practical examples of avoidance, reduction, transfer or sharing and acceptance,

which could be applied to mitigate risks.
211 .........................
Study unit 27
STUDY UNIT
14 28
14Risk monitoring and reporting
In this study unit
1 Introduction
In the previous study unit, we discussed risk responses to reduce risks to an acceptable
level. We also did a residual risk assessment, which assesses the likelihood and impact
of the risk on the organisation after taking into account the risk responses to the risk.
2 Risk monitoring
RISK MONITORING
According to Valsamakis, Vivian & Du Toit (2010:146), risk monitoring entails the
continuous evaluation of the organisation operations to ensure the adequacy of control
measures and to identify new risks to the organisation.
Methods available to the risk management team or risk management department to monitor
the effectiveness of the risk management process include:
z Loss management: Losses are recorded and a loss report drafted to summarise loss
events, values and root causes. Risk responses are the implemented to prevent or
reduce the likelihood of similar events occurring in future.
z Key risk indicators: Key trends are measured against a specific threshold and risks
are highlighted when the threshold is breached. For example, an organisation selling
products over the phone may set a maximum waiting time of one minute for all customer
calls to be answered. If that waiting time is breached, it is an indicator to management
to take action to prevent a negative impact on the organisation.
z Risk and control self-assessments completed by management: This is an analysis
of the organisation objectives and processes. Tool to assess management’s perception
of perceived strengths, risks, weaknesses within the organisation processes and the
adequacy and effectiveness of the controls designed to mitigate the risks and achieve
organisation objectives. This is also an effective method to identify risks.
z Scenario management: This is a method to determine future risks, based on the
views of experts.
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TOPIC 11
3 Residual risk reporting
Periodic risk reporting to the board will enable the board to achieve its responsibilities in
terms of King III. Effective risk reporting will enable the board to consider the following:
zz the nature and extent of risks facing the organisation
zz the extent and categories of risk which is regarded as acceptable (risk strategy)
zz the likelihood of risk materialising
zz the cost and benefit of risk responses
Key term: RISK REPORTING
Risk reporting is concerned with periodic (usually quarterly) reports to the stakeholders
and the board of directors or a sub-committee of the board, such as the risk
and compliance committee, setting out the organisation’s risk management policies
and to provide information for the stakeholders to evaluate whether the policies are
effectively achieved.
There is also a need for residual risk reporting where significant risks facing the organisation
(despite efforts to reduce these risks) are highlighted to review the adequacy and effectiveness
of the risk responses and possibly to gain alternative opinions from relevant stakeholders.
3.1 Risk reporting

Risk reporting includes the following:
1. feedback on the annual review of the risk forecast
2. a review of management’s responses to significant risks and the risk strategy
3. results from the monitoring of risk responses and significant residual risks that exist
4. results from the regular monitoring of significant key risk indicators (early warning
systems) that could indicate a material change in the organisation’s risk profile that
increase exposures or threaten areas of opportunity
5. results of audit reviews to assess the adequacy and effectiveness of the risk
management process and mitigating action plans to reduce risks to an acceptable level
3.2 What the IRM-standard indicates that the board of directors

should do
The board should do the following:
zz know about the most significant risks facing the organisation
zz know the possible effects on shareholder value of deviations to expected performance
ranges
zz ensure appropriate levels of awareness throughout the organisation
zz know how the organisation will manage a crisis
zz know the importance of stakeholder confidence in the organisation
zz know how to manage communications with the investment community where applicable
zz be assured that the risk management process is working effectively
zz publish a clear risk management policy covering risk management philosophy and
responsibilities
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Study unit 28
Ac t ivi t y 28.1
Access the following link and view Implats’ Annual Report for 2009 to gain
an understanding of the importance of risk management, the role of the
audit committee and how key risks are included in the annual report (especially
on page 109):
http://www.implats.co.za/reports/2009/AR/f/implats_ar09.pdf
You can also access the following link to view the Implats’ Risk Report for
2009, which illustrates how the organisation reported inherent risks and how
the risks were mitigated:
http://www.implats.co.za/cr/files/risk_management_sep09.pdf
4 Summary
In this study unit, we mentioned that risk reporting to the stakeholders and the board, or a
sub-committee, is critical for them to measure the achievement of the organisation’s risk
management policies. The reporting is more concerned with the processes to manage
risks and with the reporting of risks with significant residual risk ratings.
We also discussed the benefits of risk management and that it plays an important role in
the achievement of the objectives of the organisation, because risk management improves
the organisation’s ability to respond and mitigate risks efficiently and effectively. It enables
it to take advantage of opportunities without harming its objectives or reputation.
Now that you have worked through this study unit, you should be able to answer the following:
a. How could effective risk reporting contribute to the board of directors achieving their
responsibilities in terms of King III?
b. What are the components of effective risk reporting to the board of directors?

CIMA. 2011. CIMA Official Learning System. Paper P3 – performance strategy. 1st edition.
Oxford: Elsevier.
Committee of Sponsoring Organizations of the Treadway Commission (COSO). 2004.
Enterprise risk management – integrated framework. www.coso.org. [Accessed on
22 March 2012]
Implats. Annual Report 2009. http://www.implats.co.za/reports/2009/AR/f/implats_ar09.pdf
Implats. Risk Factors September 2009.http://www.implats.co.za/cr/files/risk_management_
sep09.pdf [Accessed on 22 March 2012]
Valsamakis, AC, Vivian, RW & Du Toit, GS. Risk management. 4th edition. Sandton:
Heinemann Publishers.
........................ 214
TOPIC 11
15GLOSSARY
ACCOUNTING RATE This is based on an investment’s (project’s)

OF RETURN: average net PROFIT after tax (not cash flow), divided by
its average book value. It is also called the average rate
of return on investment/capital (ROI or ROC) method.
ACCOUNTS PAYABLE Payable days (or the creditor payment period) is the
(CREDITORS) DAYS: measurement of the average number of days the
organisation takes to pay for the goods/services received
on credit from its suppliers.
ACCOUNTS Accounts receivable refers to the amount outstanding in
RECEIVABLE: respect of previous credit sales that customers/debtors
have to pay in the near future.
AGEING SCHEDULE Ageing schedule (or creditors’ age analysis report) is
FOR CREDITORS: a classification of accounts payable within bands of
different outstanding periods, normally including current
debt, up to and including 30 days, up to and including 60
days, up to and including 90 days, and greater than 90
days.
AGEING SCHEDULE Ageing schedule (or debtors’ age analysis report) is a
FOR DEBTORS: classification of accounts receivable within bands of
different outstanding periods, normally including, current
debt, up to and including 30 days, up to and including 60
days, up to and including 90 days, and greater than 90
days.
ANALYSE: To analyse is to examine in detail in order to discover
meaning or to break down into smaller parts.
ANNUITY DUE: An annuity where the payments fall due at the beginning
of each payment interval (period) is an annuity due. The
last payment of an annuity due is one payment before the
end of the term.
BANK LOAN: Medium and smaller companies mainly use bank loans
for long-term financing. The loan may be a term loan
that is repayable over a fixed period that relates to
the specific financing requirement or the loan can be
structured in the form of a loan facility from which the
company draws down as needed (the money is only
advanced by the bank when the client needs it to make
a payment to a supplier, etc, up to the maximum loan
amount approved). The costs involved (apart from the
repayment of the capital amount) are interest charges as
well as a charge for the right to use the loan facility.
BANK OVERDRAFT: A bank overdraft is the facility that allows an organisation
to use more money than is available in its bank account.
BANKER’S A banker’s acceptance is created when the organisation
ACCEPTANCES (BA’s): sells a bill of exchange to the bank.
215 .........................
Study unit 28
BARRIERS TO ENTRY: Barriers to entry are factors that prevent new players to
enter a specific industry or market. These factors refer
to the position of the current players, for example, they
have good economies of scale, customers are loyal to
their brand, and they have a well-established distribution
channel.
BARRIERS TO EXIT Barriers to exit are factors that prevent an organisation
from leaving (exiting) the market for a specific product.
If the cost of exiting is higher than the cost (losses)
of remaining in the market, the organisation will be
prohibited from exiting and will still be competing for
market share.
BOARD OF The board of directors (the board) consist of members/
DIRECTORS: directors who are elected to the board by the
shareholders to oversee the activities of the organisation
and to provide stewardship and leadership from the very
top.
BOND/DEBENTURE: A bond/debenture is a long-term contract between the
organisation that issues the bond/debenture (borrower),
and the buyer of the bond/debenture (lender of the
money or investor). The main terms of this contract are
the repayment conditions and the interest rate to be paid.
BUSINESS RISK: Risks that arise from the activities of the organisation and
relate to the people, processes, products and structure.
CAPITAL: Capital is a long-term asset or the money used to
support long-term assets and projects and is displayed
as long-term debt and equity on the statement of
financial position.
CAPITAL GROWTH: Capital growth is the growth of an investment in a
business. It means that the investment can be sold after
a few years for more than it was bought for. Capital
growth includes minimum annual returns.
CAPITAL Long-term assets (eg non-current) such as property,
INVESTMENTS/ plant and equipment acquired individually or as part of
EXPENDITURE: large projects that generate returns (cash inflows) over a
number of years.
CAPITAL MARKET: A capital market is a financial market in which longer-
term (longer than one year) debt and equity securities
are traded.
CAPITAL STRUCTURE: Capital structure is the manner in which an organisation’s
assets are financed. It is normally expressed in
percentages of each type of capital used by the
organisation, such as debt and equity.
CASH AND CASH Cash is the money the organisation has on hand (eg
EQUIVALENTS: petty cash, unbanked payments received) as well as the
money in the bank (eg cheque accounts or short-term
deposits).
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TOPIC 11
CASH CONVERSION The cash conversion cycle focuses directly on the
CYCLE: cash flow associated with the overall cash flow from
operations (including accounts payable). It represents
the length of time between when an organisation makes
payments to its creditors (outflow of cash) and when
an organisation receives payments from its customers
(inflow of cash). As the cash conversion cycle includes
the cash flow benefit afforded by accounts payable, this
cycle is shorter than the operating cycle.
CASH FLOW: Cash flow is any receipt or payment of money that occur
at a specific point in time. It includes capital and interest.
CLOSE A close corporation (CC) is a business that is formed as
CORPORATION: a legal person that exists separate from its owners. A
maximum of ten owners, called members, which must be
natural persons, are allowed.
COMPANY: A company is a business form that is a legal organisation
distinct from its “owners”. “Owners” are referred to as
shareholders and can be one or more individuals or
organisations.
COMPLIANCE RISK: These risks arise from non-compliance with legislation or
regulations.
COMPOUNDING: Compounding refers to the calculation of interest on
a principal (initial) amount and adding that interest to
the principal for investment in the following period. The
interest is therefore not paid at the end of the period in
which it accrues. In the next period(s), interest is earned
on the interest re-invested.
CORE VALUES: Core values are the principles that guide an organisation
by describing how every employee is expected to
behave.
CORPORATE Corporate culture entails employees’ shared beliefs,
CULTURE: values and symbols (see also core values).
CORPORATE Corporate governance is a set of processes, customs,
GOVERNANCE: policies, laws and institutions affecting the way that a
business is managed. It also includes the relationships
among the many stakeholders involved and the goals of
the business.
COST OF CAPITAL: Cost of capital is defined as being the rate of return that
an organisation must earn on its investments to ensure
that the minimum requirements of the providers of capital
are met.
COUPON INTEREST This is the fixed interest rate that the issuing organisation
RATE: is required to pay on the face value of the bond. This is
similar to the coupon payment divided by the par value.
217 .........................
Study unit 28
CREDIT RATING A credit rating agency is an organisation that provides
AGENCY: international financial research on bonds and other
debt instruments issued by business and government
organisations. The agency ranks the creditworthiness
of borrowers/issuers by using a standardised ratings
scale. The payment history as well as financial heath
(ability to pay future obligations) is taken into account in
determining the credit rating.
DILUTION: Dilution occurs when new ordinary shares are issued.
The existing shareholders must then share the control of
the organisation with a greater number of shareholders.
The control (voting power) that the existing shareholders
had over the organisation will be diluted due to the
increase in the number of shareholders.
DISCOUNTING: Discounting is the process used to determine the original
investment (principal) amount by discounting the future
value, which resulted from the compounding of interest,
back to the present value. (Discounting is thus used to
determine the present value of an investment.)
DIVIDEND YIELD: The dividend yield on an organisation’s share is the
organisation’s total annual dividend payments divided
by its price per share. The dividend yield can also be
determined by finding a comparable dividend yield from a
similar share and adjust it for growth and risk.
DU PONT RATIO: Du Pont ratio is a method that breaks down the return
on total asset ratio (ROA) into two components – a profit
margin and an asset turnover rate.
ECONOMIC RISK: Economic risks are directly related to risks that originate
from activities or non-activities in the normal economy.
This includes changes to inflation, the unemployment
rate and international policy. These economic risks start
before transactions take place and are considered to be
external.
EFFECTIVE ANNUAL Effective annual interest rate (EAR) refers to the
INTEREST RATE: annual rate, which derives the same result as the
compound interest rate, at a given periodic rate, for a
given number of compounding periods PER year. The
effective annual rate is therefore the annual rate, which,
if compounded once a year, will give the same result as
the interest per period compounded a number of times
per year.
ENVIRONMENTAL The risk relates to climate change and risk of natural
RISK: disasters (deemed to be external risks).
The risk of damage caused by a pollutant, that is a
substance or by-product introduced into an environment
other than its intended use/ purpose (deemed to be
within the organisation’s control).
EXTRAPOLATION: Extrapolation refers to the calculation when you need
to determine an actual rate where this actual rate lies
outside (not within) two specific rates.
........................ 218
TOPIC 11
FACTORING: Factoring is a form of debtors financing which results in
improving the debtors’ collection period.
FINANCIAL Financial information refers to the financial results,
INFORMATION: position and cash flows of an organisation’s business
operations in a specific period, stated in rand and cent
terms.
FINANCIAL Financial leverage is the extent to which debt is used in
LEVERAGE: the capital structure of an organisation. (An organisation
that has a high percentage of debt in its capital structure
will be regarded as having a high degree of financial
leverage.)
FINANCIAL RISK: Financial risk relates to the financial operation and
position of an organisation.
FUTURE VALUE: The future value is the amount that an investment will be
worth at a future date if invested at a particular simple or
compound interest rate.
GROWTH RATE: Growth rate simply refers to the percentage that a
line item in an organisation’s financial information has
increased or decreased from one period/year to another.
HOLDING COSTS: Holding costs are the costs of holding inventory and
includes storage costs (eg renting warehouse space and
security), insurance costs (for protection against losses),
cost of obsolescence (inventory ageing or deteriorating
whilst in storage) and opportunity cost (funds invested
in inventory could have earned a return elsewhere at a
certain rate, eg earning the weighted average cost of
capital).
HUMAN RESOURCES: The term human resources (HR) refer to the workforce
(employees) of an organisation.
INDUSTRIAL Industrial relations deal with the employment relationship
RELATIONS: (workplace relationships).
INFORMATION RISK: Information risk is the risk that decision makers within the
organisation use invalid or poor quality information for
decision-making, or the loss of information.
INHERENT RISK: This involves the assessment of risk before the
application of any controls, transfer or management
responses.
INSTALMENT SALE An instalment agreement entails the granting of a loan
AGREEMENT (ISA): to an organisation (buyer) by the supplier (seller) of
assets such as machinery, equipment and vehicles itself
(supplier credit), or granted by banks. The conditions,
interest rate, instalment amount and frequency of
payment as well as the period of the agreement are set
out in the specific contract.
INTEREST: Interest is the price paid for borrowed money or received
for money invested.
219 .........................
Study unit 28
INTERNAL RATE OF The rate at which cash flows must be discounted so that
RETURN: the present value of the cash inflows equals the present
value of the initial cash outflow. That is the rate at which
the NPV will be equal to Rnil.
INTERPOLATION: Interpolation refers to the calculation when you need
to determine an actual rate, where the actual rate lies
between two specific rates.
INVENTORY: Inventory of a reseller is represented by purchased
goods (held to be sold), and of a manufacturer by the
completed products (held to be sold), work-in-process
products (intended for sale) and raw material inventory
(held for use in production). Both types of organisations
can also have stores of consumable items.
INVENTORY DAYS: Length of time that inventory remains unsold (goods for
sale) or remains unused (raw materials).
LEASE: A lease is a form of financing movable assets. Just like
a loan, it can be structured in various ways. The lessor
(granting the lease) remains the owner of the asset, while
the lessee has the use of the asset. Lease payments are
determined in such a way as to offer the lessor the cost
of the asset plus a reasonable return thereon.
MARKET RATE/ The market rate is the current or ruling market rate
RULING INTEREST of return. It is obtained from similarly publicly traded
RATE: instruments – a pre-tax rate.
MARKET RISK: Risk associated with the economical environment
in which all organisations do business and which is
influenced by interest rates, exchange rates, oil prices
and various other factors that are difficult to quantify.
Market risk therefore originates from events and
transactions in the market place.
MATURITY DATE/ The maturity date is the date when a bond/debenture will
REDEMPTION DATE: be redeemed.
MISSION STATEMENT: A mission statement defines the core purpose of the
organisation, by broadly stating the reason(s) why the
organisation exists.
MONEY MARKET: The money market is a financial market used mainly for
raising short-term (of less than one year) finance.
MORTGAGE LOAN: Mortgage loans are long-term loans raised against the
value of property. The loan is normally secured over the
value of the property offered as security.
NET PRESENT VALUE: Net result of future periodic net after tax cash flows
discounted to present value, using an appropriate rate,
and the present value of the capital invested in the
project.
NET WORKING Net working capital refers to the current assets less
CAPITAL: current liabilities, which is directly related to the operating
activities of an organisation.
........................ 220
TOPIC 11
NOMINAL ANNUAL In cases where interest is calculated more than once a
RATE: year, the annual rate quoted is the nominal annual rate or
nominal rate.
NOMINAL INTEREST This is the named or quoted rate usually stated on
RATE: annually compounded basis. It may be different from the
effective rate due to non-annual compounding.
OPERATING CYCLE: The operating cycle focuses on an organisation’s internal
(thus excluding accounts payable) cycle’s impact on cash
flow. It represents the length of time from committing
cash for purchases of inventory to the inflow of cash from
the sale of inventory on credit.
OPERATIONAL RISK: “Operational risk is the risk of loss from a failure of
internal business and control processes.”
OPPORTUNITY COST: Opportunity cost is the cash that could have been
realised from the best alternative use of the funds that
were given up.
ORDERING COSTS: Ordering costs are the costs associated with placing
an order, receiving the deliveries and the associated
payment.
ORDINARY ANNUITY: An ordinary annuity is an annuity where the payments
take place at the end of each year or period (payment
interval) at the same time that interest is calculated.
ORDINARY An ordinary preference share is a security that pays a
PREFERENCE SHARE: constant dividend into perpetuity (if not convertible or
redeemable).
ORDINARY SHARE: This is a security offered to investors in order to raise
capital for the company. Investors receive dividends as
return on their investment as well as capital growth if the
share price increases and they sell their shares.
ORGANISATIONAL The structure of a business can be defined as
STRUCTURE: organisational arrangements, systems for gathering
together human, physical, financial, and information
resources at all levels of the system.
PARTNERSHIP: Partnership is where a business is formed by between
two and twenty individuals or organisations. It is
unincorporated. Partners are severally and jointly
responsible for all the debts of the partnership.
PAR VALUE/ Par value is the stated value (nominal or face value) of
REDEMPTION VALUE/ bonds /debentures. This is the value which the holder will
NOMINAL VALUE/ receive at redemption and also the value on which the
FACE VALUE: bond or debenture pays interest.
PAYBACK PERIOD: The period of time required to recoup the total capital
amount invested through the cash generation from the
project.
PERIODIC PAYMENT: The periodic payment I or PMT, is the amount of the
annuity, namely the stream of equal amounts, invested
per period or the equal periodic repayments of a loan.
221 .........................
Study unit 28
PERIODIC RATE: The periodic rate is the rate charged by a lender or paid
by a borrower each period.
PERMANENT Permanent working capital supports a constant minimum
WORKING CAPITAL: level of sales.
PERPETUITY: Perpetuity means that the cash flow will be received or
paid periodically at certain time intervals into infinity,
since there is no termination date. Another example of a
perpetuity would be a non-redeemable preference share
paying a fixed dividend.
POLITICAL RISK: Refers to the effect that detrimental political activities or
political instability have on an organisation.
PRESENT VALUE: The present value is the current value of future cash
flows, determined by application of the discount rate
(discounting).
PROFITABILITY: Profitability is the term used to describe the annual return
or compensation earned on an investment.
PROFITABILITY INDEX The PI is the ratio of the present value of cash flows
(PI): (PVCF) to the initial investment of the project. PI is also
known as a benefit/cash ratio.
PROJECT ANALYSIS: Project analysis is the detailed examination of all the
technical specifications (operational), marketing (sales
units, market, etc) and financial aspects (costs and
revenues) and/or problems of a project before funds are
allocated and work on it is started.
RATIO ANALYSIS: Ratio analysis is a method whereby further calculations
are performed on a set of financial statements and
is intended to create more meaningful information.
Ratio analysis can be made even more useful when
we compare the calculated ratios to the same ratios
calculated for previous years or to industry norms and
other ratios of the same set.
RECEIVABLE DAYS: Receivable days (or the debtor collection period) is a
measurement of the number of days it takes the average
debtor to pay for the goods/services taken on credit.
REPORTING RISK: The risk refers to the provision of unreliable financial and
non-financial information to all levels of management and
other stakeholders.
REPUTATION RISK: A loss of reputation is the adverse consequence created
by bad publicity due to the materialisation of another risk.
RESIDUAL RISK: Residual risk involves the assessment of risk AFTER
taking into account the application of any internal
controls, transfer or management responses to reduce
the risk.
RETURN ON ASSETS This is a measure of performance generated on all the
(ROA): assets employed in the organisation and expresses
earnings before interest and taxes (EBIT) as a
percentage of the total assets employed.
........................ 222
TOPIC 11
RETURN ON EQUITY: This is a measure of the performance realised by
management for the equity holders (shareholders) and
expresses net profit as a percentage of equity.
REVOLVING CREDIT: Revolving credit allows the organisation to withdraw
money up to the original limit once a certain percentage
(20% to 30%) has been repaid.
RISK: The typical dictionary definition of risk is a chance
or possibility of danger, loss, injury or other adverse
consequences.
RISK APPETITE: The risk appetite is related to an organisation’s strategy
and may be expressed as the acceptable balance
between growth, risk and return.
RISK ASSESSMENT: Risks are analysed by considering the impact (potential
damage or loss) and likelihood of the risk occurring.
Risks are assessed at an inherent basis (risk exposure
before considering risk responses) and residual basis
(risk exposure after considering risk responses).
RISK CAPACITY: This is the maximum amount of risk that the organisation
can accept.
RISK CULTURE: This is the set of shared attitudes, values and practices
that characterise how an organisation considers risk in
its day-to-day activities.
RISK FINANCING: Maintaining a balance between the economic and
operational cost of risk reducing measures and the
achievement of the organisation’s objectives.
RISK IDENTIFICATION: The process to identify internal and external events,
which could affect the achievement of the organisation’s
objectives. This includes risks and opportunities.
RISK MANAGEMENT It is the document of identified risks (derived with
PLAN: reference to the organisation’s objectives) with the
corresponding risk assessment to create risk responses.
RISK MONITORING: Risk monitoring entails the continuous evaluation of
the organisation operations to ensure the adequacy
of control measures and to identify new risks to the
organisation.
RISK OR EVENT Risk or event identification is the process to identify
IDENTIFICATION: internal and external events, which could affect the
achievement of the organisation’s objectives. This
includes risks and opportunities.
RISK REGISTER: A risk register is a summary of identified risks, which are
listed, described and assessed/measured (based on their
potential impact and likelihood).
223 .........................
Study unit 28
RISK REPORTING: Risk reporting is concerned with periodic (usually
quarterly) reports to the stakeholders and the board
of directors or a sub-committee of the board, such as
the risk and compliance committee, setting out the
organisation’s risk management policies and to provide
information for the stakeholders to evaluate whether the
policies are effectively achieved.
RISK RESPONSE: Measures to reduce the likelihood and/or impact rating of
a risk event.
RISK-FREE RATE: The risk-free rate is the return that can be earned on
investments that has zero risk. An example of a risk-free
instrument is government bonds and the return thereon
will represent the risk-free rate.
RULING INTEREST The market rate is the current or ruling market rate
RATE/MARKET RATE: of return. It is obtained from similarly publicly traded
instruments – a pre-tax rate.
SALE AND Trading organisations who own fixed property at times
LEASEBACK: find it more rewarding to sell the properties to a financial
institution at a capital profit. A leaseback agreement for
a reasonably long term is then entered into immediately,
to protect the trading organisation (which operates from
this premises) – the period can sometimes be as long as
30 years.
SHORT-TERM: Short term refers to a period of one year or less.
SIMPLE INTEREST: Simple interest is the interest calculated on the principal
only for the entire term.
SINGLE CASH FLOW: A single cash flow is a once-off (non-repetitive) cash
inflow or outflow.
SOCIAL RISK: Social risk relates to the impact of the organisation on
the community and vice versa.
SOLE Sole proprietorship is where a business is formed by a
PROPRIETORSHIP: single individual who is the owner of that organisation. It
is unincorporated, meaning the owner and the business
is treated as the same legal persona.
SPECIFIC RISK: This is the risk associated with an investment in a
specific company.
STAKEHOLDERS: Stakeholders are those persons and organisations
that are affected by the activities of the organisation
and therefore have an interest in the strategy of an
organisation. Stakeholders include staff, shareholders,
creditors, suppliers, customers, government, local
authorities, professional bodies, pressure groups and the
community at large.
........................ 224
TOPIC 11
STRATEGIC Strategic financial management is the identification
FINANCIAL of possible strategies capable of maximising an
MANAGEMENT: organisation’s net present value, the allocation of scarce
capital resources among the competing opportunities
and the implementation and monitoring of the chosen
strategy so as to achieve stated objectives.
STRATEGIC Strategic objectives clearly formulate measures of
OBJECTIVES: progress and targets to be achieved in a specific time
frame.
STRATEGIC Strategic planning is the process of defining the
PLANNING: organisation’s strategy and making decisions about the
allocation of its resources to follow this strategy. The
allocation of resources includes the organisation’s capital
and people.
STRATEGIC RISK: Strategic risks have more to do with the organisation’s
position and relation with the external environment in the
long-term.
STRATEGY: Strategy is about choosing long-term activities to
achieve the purpose set out in the mission statement and
ultimately moving towards realising the vision.
SUBSTITUTE Substitute products refer to alternative products having
PRODUCTS: the ability of satisfying customers’ needs effectively (for
example, plastic bottles instead of glass bottles).
SUSTAINABILITY FOR Sustainability for a business means that all their
BUSINESSES: products, processes and manufacturing activities meet
customer needs, while at the same time treating the
environment in such a manner that it does not decrease
the ability of future generations to meet their own needs.
This entails that products, processes and activities
should be designed and executed in such a way that
current environmental concerns (eg the use of renewable
resources) are taken into account while still maintaining
a profit. A business should use sustainable development
and distribution methods to influence the environment,
growth of the business and society. Sustainable
development within a business can create value for its
investors, customers and the environment.
SUSTAINABILITY FOR Sustainability for humans is the potential for long-term
HUMANS: maintenance of well-being which has environmental and
social dimensions.
SUSTAINABLE Sustainable capital budgeting involves planning and
CAPITAL BUDGETING: evaluation of how funds are spent on capital investments
that will ultimately add to the organisation’s value while
taking cognisance of the social, environmental and
governance impact of the decision.
SWOT ANALYSIS: The SWOT analysis approach is to identify and
analyse internal and external factors that are of
strategic importance, and classify them into strengths,
weaknesses, opportunities and threats.
225 .........................
Study unit 28
TAKE-OVER: Take-over is the term used when referring to the
transfer of control of a company from one group of
shareholders to another group of shareholders.
TARGET CAPITAL Target capital structure or optimal capital structure is a
STRUCTURE: mix of the two capital components at which the share
price is maximised – if all other things are kept the same.
TECHNOLOGICAL Risk involved with the operation, ownership and
RISK: sustainability of the organisation’s information technology
(IT) systems.
Technological risks also refer to the manufacturing plant
being outdated or a product being obsolete when a more
technologically advanced product has replaced it.
TEMPORARY Temporary working capital supports seasonal peaks in
WORKING CAPITAL: the organisation’s operations.
TRADE ACCOUNTS Trade accounts payable refers to the amount of
PAYABLE: purchases on credit that has to be paid to the suppliers/
creditors in the near future. Total accounts payable may
also include other accounts payable, which do not relate
directly to the main operations (trading activities) of the
organisation.
TRADITIONAL Traditional financial management is the management
FINANCIAL and control of money and money-related operations
MANAGEMENT: within a business. Financial management therefore
includes planning, organising and controlling the financial
activities of a business. The financial activities include
the acquiring of funds as well as the use of these funds
by applying general management principles.
UNEQUAL CASH Unequal cash flows can occur repetitively at the end of
FLOW: each year or period (payment interval).
VISION STATEMENT: The vision statement defines where the organisation
wants to go in the future.
WORKING CAPITAL Working capital management refers to the controlling
MANAGEMENT: of balances included in the current assets and current
liabilities, the way the related functions within the
organisation are performed and the way working capital
is financed.
WORKING CAPITAL The working capital policy of an organisation stipulates
POLICY: the appropriate amount for the net working capital
balance and for each of its components (investment
policy), and, in addition, how the net working capital
balance should be financed (financing policy).
YIELD TO MATURITY The discount rate that achieves a net present value
(YTM): (NPV) of NIL for all the cash in- and outflows.
........................ 226
TOPIC 11
TABLE A
PRESENT VALUE OF R1 RECEIVED/PAID AFTER N YEARS
Study unit 28
227 .........................
TABLE B
PRESENT VALUE OF R1 PER ANNUM RECEIVED/PAID AT THE END OF THE YEAR FOR N YEARS
TOPIC 11
........................ 228
If you need to use a factor for annuities due (paid in advance or at the beginning of the period):
1. Look up the factor for periods n + 1 2. Then add one (the PV of R1 invested now is R1). Or use the mathematical formula.
TABLE C
FUTURE VALUE OF R1 RECEIVED NOW, AFTER N YEARS
Study unit 28
229 .........................
TABLE D
FUTURE VALUE OF R1 PER ANNUM RECEIVED FOR N YEARS AT THE END OF EACH YEAR
TOPIC 11
........................ 230
If you need to use a factor for annuities due (paid in advance or at the beginning of the period):
1. Look up the factor for periods n + 1 2. Then subtract ONE
Or look up factor for n and multiply with (1 + i)
Or use the mathematical formula.
Notes
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PART 3: MANAGING AND INVESTING FUNDS 1

Study unit 16: Ratio analysis 15

Topic 8: Capital investments and capital budgeting techniques 85

Study unit 20: Traditional methods/techniques 107

Study unit 21: Discounted cash flow methods/techniques 115

PART 4: RISK MANAGEMENT 151

Study unit 23: C

Study unit 26: Assessment of inherent risk 201

Study unit 28: Risk monitoring and reporting 212

INTEREST FACTOR TABLES A TO D 227

Study guide 1 Study guide 2

Part 1 Part 2 Part 3 Part 4

Topic Topic Topic Topic

After studying this topic, you should be able to:

Study guide 1 Study guide 2

Part 1 Part 2 Part 3 Part 4

Topic Topic Topic 6 Topic

1 Development 2 Introduction 6 Analysis of financial 9 Risk theory and

Benjamin Franklin, an American statesman, once said:

1Objectives and sources of financial analysis

In this study unit

2 The objectives of financial analysis

To analyse is to examine in detail in order to discover meaning or to break down into

The three main objectives of financial analysis are:

a. Capital providers and financial analysts

4 Sources of information regarding an organisation

Financial information about organisations is also published in newspapers and financial

1 Fe edback on ac t ivi t y 15.1

4.2 Strategic (non-financial) information

Strategic information may include the following:

Strategic (non-financial) information can be found …

5 The major limitations of financial information

6 Techniques used in performing financial analysis

20x5 20x4 20x3 20x2 20x1

b. Common size statements

In this study unit

We will illustrate calculations of growth percentages as well as different ratios. These

2 Financial information provided

Without minority interest, this is also equal to earnings attributable to shareholders in

this case study.

EQUITY AND LIABILITIES

The following additional information applies:

Key formula: GROWTH RATE

Year 20x2 – Year 20x1

1 Fe edback on ac t ivi t y 16.1

Year 20x2 – Year 20x1 673

= 11,29% growth (increase)

Year 20x2 – Year 20x1 530

Year 20x2 – Year 20x1 300

Year 20x2 – Year 20x1 70

Year 20x2 – Year 20x1 (249)

f. Property, plant and equipment

Year 20x2 – Year 20x1 602

Year 20x2 – Year 20x1 (13)

3. Solvency and financial/capital structure

The answers to your ratio calculations can be classified as:

1 Development 2 Introduction 6 Analysis of financial 9 Risk theory and

Key formula: INVENTORY TURNOVER RATIO (RATE) – FOR AVERAGE