Generic - Introduction To Financial Management (20 Credits)

INTRODUCTION TO FINANCIAL MANAGEMENT (20
CREDITS)
Module Guide
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MANCOSA
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This module guide,
Introduction to Financial Management (20 Credits)(NQF Level 5)
will be used across the following programmes:
Higher Certificate in Accounting
Higher Certificate in Events Management

Introduction to Financial Management (20 Credits)
Table of Contents
Preface 2
Unit 1: Financial Management Important Concepts 7
Unit 2: An Introduction to Budgeting 22
Unit 3: Working Capital Management 47
Unit 4: Finance Sourcing 82
Unit 5: Cost-Volume-Profit Relationships 95
Unit 6: Relevant Costs and Revenues for Decision-Making 123
Unit 7: Capital Budgeting 145
Bibliography 175
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Preface
A. Welcome
Dear Student
It is a great pleasure to welcome you to Introduction to Financial Management (IFM520). To make

sure that you share our passion about this area of study, we encourage you to read this overview
thoroughly. Refer to it as often as you need to since it will certainly make studying this module a lot
easier. The intention of this module is to develop both your confidence and proficiency in this
module.
The field of Financial Management is extremely dynamic and challenging. The learning content,
activities and self- study questions contained in this guide will therefore provide you with
opportunities to explore the latest developments in this field and help you to discover the field of
Financial Management as it is practiced today.
This is a distance-learning module. Since you do not have a tutor standing next to you while you
study, you need to apply self-discipline. You will have the opportunity to collaborate with each other
via social media tools. Your study skills will include self-direction and responsibility. However, you will
gain a lot from the experience! These study skills will contribute to your life skills, which will help you
to succeed in all areas of life.
Throughout the module, think points and illustrative examples have been included. Self-assessment
activities and solutions appear at the end of each chapter in order to test your understanding of the
section. You are strongly advised to do the self-assessment activities after studying each chapter, as
it will stimulate your interest and enhance your understanding of the work covered in the section.
In order to ensure a quality module, a number of reference books have been consulted to draw up
this module. In order to enhance your knowledge, you are advised to consult the recommended
books that are indicated at the start of each chapter.
Please note that some Activities, Think Points and Revision Questions may not have answers
available, where answers are not available this can be further discussed with your lecturer at
the webinars.
We hope you enjoy the module.
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must obtain permission from the copyright owner.
B. Module Overview
The module is a 20 credit module at NQF level 5
The aim of this module, Introduction to Financial Management, is to introduce you to the concepts of
financial management and to understand the role of the financial manager in a business
environment.
C. Learning Outcomes and Associated Assessment Criteria of the Module
D. How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module,
by breaking your studies into manageable parts. The Module Guide gives you extra theory and
explanations where necessary, and so enables you to get the most from your module. The purpose
of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
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prescribed textbook and recommended readings. We suggest that you briefly skim read through the
entire guide to get an overview of its contents. At the beginning of each Unit, you will find a list of
Learning Outcomes . This outlines the main points that you should understand when you have
completed the Unit/s. Do not attempt to read and study everything at once. Each study session
should be 90 minutes without a break.
This module should be studied using the prescribed and recommended textbooks/readings and the
relevant sections of this Module Guide. You must read about the topic that you intend to study in the
appropriate section before you start reading the textbook in detail. Ensure that you make your own
notes as you work through both the textbook and this module.
In the event that you do not have the prescribed and recommended textbooks/readings, you must
make use of any other source that deals with the sections in this module. If you want to do further
reading, and want to obtain publications that were used as source documents when we wrote this
guide, you should look at the reference list and the bibliography at the end of the Module Guide. In
addition, at the end of each Unit there may be link to the PowerPoint presentation and other useful
reading.
E. Study Material
The study material for this module includes programme handbook, this Module Guide, a list of
prescribed and recommended textbooks/readings which may be supplemented by additional
readings.
F. Prescribed Textbook
The prescribed and recommended readings/textbooks presents a tremendous amount of material in
a simple, easy-to-learn format. You should read ahead during your course. Make a point of it to re-
read the learning content in your module textbook. This will increase your retention of important
concepts and skills. You may wish to read more widely than just the Module Guide and the
prescribed and recommended textbooks/readings, the Bibliography and Reference list provides you
with additional reading.
The prescribed and recommended textbooks/readings for this module are:
Prescribed Textbook(s)
Marimuthi, F., and Steyn, F. (2020) Cost and Management Accounting: Operations and
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Management. Third Edition. Juta and Company Ltd.
Recommended Reading(s)
Hefer, J., and Walker. T. (2020) Financial Management: Turning Theory into Practice. Second
Edition. Cape Town South Africa: Oxford University.
Conradie, W., Fourie, M.W., and Pellissier, R. (2022) Basic Financial Management. Third Edition.
Claremont South Africa: Juta.
G. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to
help you study. It is imperative that you work through them as they also provide guidelines for
examination purposes.
~~~~~~~~~~~~~~
Special Feature Icon Description
The Learning Outcomes indicate what aspects of the particular

LEARNING
Unit you have to master and demonstrate that you have
OUTCOMES
mastered them.
The Associated Assessment Criteria is the evaluation of student

ASSOCIATED
understanding with respect to agreed-upon outcomes. The
ASSESSMENT
Criteria set the standard for the successful demonstration of the
CRITERIA
understanding of a concept or skill.
A think point asks you to stop and think about an issue.

THINK POINT Sometimes you are asked to apply a concept to your own
experience or to think of an example.
You may come across activities that ask you to carry out specific
tasks. In most cases, there are no right or wrong answers to
ACTIVITY
these activities. The aim of the activities is to give you an
opportunity to apply what you have learned.
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At this point, you should read the reference supplied. If you are
unable to acquire the suggested readings, then you are
READINGS
welcome to consult any current source that deals with the
subject. This constitutes research.
PRACTICAL
Real examples or cases will be discussed to enhance
APPLICATION
understanding of this Module Guide.
OR EXAMPLES
You may come across knowledge check questions at the end of

KNOWLEDGE
each Unit in the form of Multiple-choice questions (MCQ’s) that
CHECK
will test your knowledge. You should refer to the module for the
QUESTIONS
answers or your textbook(s).
You may come across self-assessment questions that test your

REVISION understanding of what you have learned so far. These may be
QUESTIONS attempted with the aid of your textbooks, journal articles and
Module Guide.
Case studies are included in different sections in this module

CASE STUDY guide. This activity provides students with the opportunity to
apply theory to practice.
VIDEO You may come across links to videos as well as instructions on

ACTIVITY activities to attend to after watching the video.
6
Unit
1: Financial Management Important
Concepts
Unit 1: Financial Management Important Concepts
7
Unit Learning Outcomes
Prescribed and Recommended Textbooks/Readings
Marimuthi, F., and Steyn, F. (2020) Cost and Management Accounting:
Operations and Management. Third Edition. Juta and Company Ltd.
Hefer, J., and Walker. T. (2020) Financial Management: Turning Theory
into Practice. Second Edition. Cape Town South Africa: Oxford
University.
Conradie, W., Fourie, M.W., and Pellissier, R. (2022) Basic Financial

Management. Third Edition. Claremont South Africa: Juta.
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1.1 Introduction
According to Conradie and Fourie (2013:2) managers or entrepreneurs need not be chartered
accountants or specialists in the world money markets. However, they need to have insight into the
core concepts and fundamental elements of financial management.
Furthermore, the role of financial managers used to involve accurate record keeping, preparation of
financial statements, and managing cash. Nowadays financial managers are involved with the
amount of capital employed by an entity, the allocation of funds to various projects and activities, and
the measurement of the results of each allocation. Financial managers need to acquire skills to make
correct decisions in a fast-moving and technologically changing environment.
Think Point 1.1

A student asks: “If I don’t want to become a financial manager, do I still
need to study financial management?” Respond to this question.
1.2 Financial Function

Conradie and Fourie (2013:2) state that the financial function, although distinguished from other
business functions, is as important as all the other functions. Furthermore, all business functions not
only have financial implications for an enterprise but they are also interrelated.
The financial function is concerned with the following:
The acquisition of funds (financing)

The application of funds to acquire assets (investment), and the administration of, and reporting
on, financial matters
Practical Application or Examples 1.1
• Ensuring that all financial transactions are recorded accurately and

systematically
• Ensuring that payments and cash received from sales are safeguarded
and banked as quickly and as efficiently possible
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1.3 Financial Management

Conradie and Fourie (2013:4) define financial management as the function being responsible for the
acquisition of the necessary financial resources to ensure the most advantageous financial results
for the entity over both the short- and long-term. Financial management also covers the responsibility
to ensure that the entity makes the best possible use of its financial resources.
According to Marx and Swart (2014:10) the primary functions of a financial manager are as follows:
Making investment decisions

Making financial decisions
Ensuring profitability of the entity
Ensuring a positive cash flow
Ensuring solvency
Think Point 1.2

What would you say are the main decisions a Financial Manager needs to
consider when making financing decisions about the firm’s financial
structure?
1.4 Goals of Financial Management

Marx and Swart (2014:7) contend that the medium-term to long-term goals should be to increase the
value of the entity, thereby increasing shareholder wealth. This can be achieved by:
Investing in assets that will add value to the entity

Keeping the cost of capital as low as possible
The short-term financial goal should focus on ensuring profitability, liquidity and solvency.
Profitability refers to the ability of an entity to generate revenues that will exceed total costs, by
utilising the entity’s assets for productive purposes. Liquidity is the ability of the entity to satisfy its
short-term obligations as they become due. Solvency refers to the extent to which an entity’s total
assets exceed its total liabilities.
1.5 Important Concepts in Financial Management

Marx and Swart (2014:9) emphasise the importance of a knowledge of key concepts in financial
management which include the following:
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Capital
Money market and capital market
Financial statements
Financial structure
Investment
Financing
1.5.1 Capital
Capital may be defined as the funds invested in an enterprise. Capital may also include funds that
have been earned by the enterprise but not distributed to the owners (i.e. retained profits). When
determining the capital requirements for an enterprise one needs to estimate the fixed capital
requirements as well as working capital requirements.
Fixed capital refers to capital that is required for acquisition of non-current assets such as land,
buildings, machinery, equipment, and vehicles. Assets are resources that are controlled by an
enterprise from which economic benefits will be derived either now or in the future. Non-current
assets are assets that have a useful life of more than one year.
Working capital is capital required to obtain current assets. Current assets are assets that are
expected to be turned into cash within a year e.g. inventories/materials, credit allowed to debtors.
Capital may be classified as follows:
Short-term capital: is capital usually available for a period of up to a year

Medium-term capital: is capital available for a period between one and five years
Long-term capital: is capital that is made available for a period of five years or more
Capital may be obtained from the following sources:
Own capital: is capital provided by the owner(s) of the enterprise

Borrowed capital: is capital that is obtained from banks and other financial institutions on which
interest is payable
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Think Point 1.3

Are the long- and short-term goals of a listed company different from those
of a small firm? Explain.
1.5.2 Money market and capital market
When enterprise needs to borrow funds, it can approach institutions in the money market or capital
market. The money market consists of institutions and individuals who lend or borrow money in the
short-term i.e. for a period of one day or for months e.g. a bank overdraft facility. The period of
transactions depends on the needs of users and institutions with a shortage of funds. The capital
market consists of institutions and individuals who lend or borrow money in the long-term e.g. a
mortgage bond repayable over a period of 20 years.
Revision Questions
The performance of the JSE is measured by increases in the JSE All Share
Index (ALSI). How would changes (increases or decreases) in the ALSI
benefit or disadvantage employees who are members of pension funds?
1.5.3 Financial statements
Financial statements report on the financial position of an entity at a certain point in time and the
changes in the financial position over a period of time. The financial statements and what they are
intended to report on are illustrated below:
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Activity 1.1
Use Google to find the website of a company listed on the JSE. Find a copy of
its latest annual report and see if you can identify the above statements.
1.5.4 Financial structure
The financial structure of an enterprise is graphically illustrated in the form of a Statement of

Financial Position. The Statement of Financial Position reports on the financial position of an
organisation at a specified point in time. It is basically a summary of an organisation’s assets, equity
and liabilities at a point in time. This is illustrated below:
Figure 1-1
The following is a brief explanation of the main items in the Statement of Financial Position:
Assets are the resources that are controlled by an enterprise from which economic benefits will be
derived either now or in the future. (Refer to paragraph 5.1 for a distinction between current assets
and non-current assets).
Liabilities are claims on the assets of an organisation. Simply put, it refers to what an organisation
owes. Non-current liabilities are debts that are payable after more than one year from the
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Statement of Financial Position date. Current liabilities are debts that are payable within 12 months
of the Statement of Financial Position date.
Equity may be viewed as the residual claim that the owner(s) has on the assets of the organisation
after all the liabilities have been settled. It normally consists of two parts viz. that which is invested in
the organisation and that which is earned by the organisation and left in the organisation (i.e.
retained profits).
1.5.5 Investment
Investment may be described as the use of capital to acquire non-current assets such as property
and machinery to be put to productive use, as well as the acquisition of current assets such as
inventories in order to generate income.
Think Point 1.4

Why must a firm invest in both non-current assets and current assets?
1.5.6 Financing
This refers to the various ways by which an enterprise obtains its funds in order to meet its capital
needs. Financing may be secured from the owners, suppliers, and creditors while other funds may
be obtained from the retained earnings in the enterprise.
Liquidity
Liquidity is the measure of the ability of an enterprise to have sufficient cash on hand to meet its
obligations at all times. In other words, the enterprise can pay all its bills when due.
Solvency
Solvency refers to the ability of an enterprise to be able to repay its debts and satisfy any claims
against it. The total debt (liabilities) must be covered by a realistic value of the total assets. An
enterprise is considered to be insolvent if the total liabilities exceed the realistic value of assets.
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Profitability
Profitability is the effectiveness with which an enterprise has employed both the total assets and the
net assets (equity). This is assessed by relating net profit to resources utilised in generating the
profit.
Case Study 1.1
Emali Construction (Pty) Ltd won a state tender to construct 500 homes in the
Bakabung area near Rustenburg. A government official is insisting on a bribe
of R250 000. The owner of the construction firm decides to paint the houses
with only one coat of paint on the outside in order to save R350 000. Will this
building contractor survive for long? Motivate your answer.
(Hint: consider wealth maximisation vs profit maximisation)
Knowledge Check Questions 1.1

1. Match the terms in column A with the statements in column B. Write down
the letter of the correct answer.
1.The resources that are controlled by an enterprise from

A. Ass
which economic benefits will be derived either now or in
ets
the future. The claims on the assets of an organisation.
B. Non
-
2.Assets that have a useful life of more than one year.
current
assets
C. Curr
3.Assets that are expected to be turned into cash within a
ent
year.
assets
D. Equ 4.The residual claim that the owner(s) has on the assets of
ity the entity after all the liabilities have been settled.
E. Liab
5.The claims on the assets of an organisation.
ilities
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F. Non-
current 6.Debts that are payable after more than one year from
liabiliti the Statement of Financial Position date.
es
G. Cur
rent 7.Debts that are payable within one year of the Statement
liabiliti of Financial Position date.
es
8.The use of capital to acquire non-current assets to be

H. Inve
put to productive use as well the acquisition of current
stment
assets.
I. Fina 9.The various ways by which an enterprise obtains its

ncing funds in order to meet its capital needs.
J. Liqui 10.The measure of the ability of an enterprise to have

dity sufficient cash on hand to meet its obligations at all times.
K. Solv 11.The ability of an enterprise to be able to repay its debts

ency and satisfy any claims against it.
L.
12.The effectiveness with which an enterprise has
Profita
employed both the total assets and the net assets (equity).
bility
2. What are the main functions of a financial manager?
3. Differentiate between the long-term and short-term goals of financial

management.
4.Briefly state the function of each of the following financial statements.

Statement of Financial Position
Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
5. Study the following information and answer the questions that follow.
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Pixma Limited began operations in January 20.15 with R900 000 obtained
from selling 450 000 ordinary shares at an issue price of R2 each.
During the year it purchased plant and equipment for R750 000 and land for
R450 000, financing the purchase with a mortgage bond of R287 500, a long-
term loan of R595 000, and cash for the balance.
On 31 December 20.15:
The amount owing by trade debtors totaled R43 000.
R32 000 was owing to trade creditors.
Inventories on hand amounted to R67 000.
The bank balance was overdrawn by R24 000.
Retained earnings at the end of the financial year amounted to R30 000.
Calculate the following as at 31 December 20.15:
5.1 Own capital
5.2. Borrowed capital
5.3. Current assets
5.4. Non-current assets
5.5. Total assets
5.6. Equity
5.7. Non-current liabilities
5.8. Current liabilities
5.9. Total liabilities
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Answers to Activities
Think Point 1.1

One needs to prepare oneself for the workplace of the future. In order to reduce costs, many
businesses are reducing management jobs and squeezing together the various layers of the
corporate pyramid. Consequently, the responsibilities of the remaining managers are being
broadened. A successful manager must be able to move both vertically and horizontally within an
organisation. Therefore, mastery of basic financial management skills is important requisite in the
workplace
Think Point 1.2

Making financing decisions.
Two major decisions have to be made about the firm’s financial structure:
1. The most appropriate mix of short-term and long-term financing
2. Determining which individual short-term or long-term sources of financing are best at a given
point.
Some of these decisions are dictated by necessity, but some require an in-depth analysis of the
available alternatives, their cost and their long-term implications as part of financial planning.
Think Point 1.3

Student is required to apply their own knowledge
Think Point 1.4

A firm must invest in both non-current assets and current assets.
Non-current assets include buildings, equipment and vehicles. No firm can operate without such
assets. These types of assets are used over several years until they need to be replaced, and hence
are classified as non-current assets. Sometimes they are also called fixed assets. The cost of using
such assets cannot be charged against the income of the firm in one year, and needs to be charged
as depreciation against the revenue over their useful life.
A firm also needs current assets, such as cash and stock. Some firms have to sell their goods on
credit, and debtors (accounts receivable) then also become a current asset. It is not only necessary
to have these assets for operational purposes, but the firm must use such assets productively in
order to achieve an acceptable return in order to remain financially viable (sustainable).
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Activity 1.1
19
6. B The capital market consists of the demand and supply of long-term funds.
Case Study 1.1

(Suggested points to consider)
1. Some believe that the owners’ objective is to maximise profit, while others believe it is to
maximise wealth. From a financial management point of view, the goal is to maximise the
shareholders’ wealth. Wealth maximisation is preferred to profit maximisation for several reasons.
The following three reasons are generally agreed on: Shareholders expect to receive a return in
the form of periodic cash dividend payments and of increases in the value of their shares (in the
case of a company). The market price of a company’s shares reflects a perceived value of
expected future dividends as well as of actual current dividends. If a shareholder in a company
wishes to sell the shares, he or she will have to do so at or near the prevailing market price. Since
it is the market price of the share that reflects an owner’s (shareholder’s) wealth in a firm at any
time, the financial manager’s goal should be to maximise the market price of the shares, and thus
the shareholder’s wealth.
2. Profit maximisation is a short-term approach, while wealth maximisation is based on long-term
prospects. A firm wishing to maximise profits could use low-quality materials in products while
making a strong sales effort to market its product or service at a price that yields a high profit per
unit. This short-term strategy could result in high profits for a short while, but sales might decline
significantly once clients discover the poor quality of the product or service.
3. Profit maximisation does not take risk into consideration, whereas differences in risk receive high
priority when evaluating alternative investments in the case of a wealth-maximisation approach. A
basic premise of financial management is that there is a trade-off between risk and return:
shareholders expect to receive higher returns from higher risk investments, and vice versa.
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Financial managers should therefore consider risk from their respective viewpoints when
evaluating potential investments.
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Unit
2: An Introduction to
Budgeting
Unit 2: An Introduction to Budgeting
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University.

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2.1 Introduction
Marx and Swart (2014:94) state that any budget is only as good as the planning that preceded the
budgeting process. They also state that no budget is perfect but that it is better to use budgets than
to have no budgets at all.
Conradie and Fourie (2013:123) point out that although budget formats may vary from one entity to
the next, the principles remain the same. In order to be successful the strategic plans of the entity
need to be translated into budgets.
A budget may be defined as a written document that expresses management’s goals and forecast in
financial terms for a specified future period. Simply put, it is a financial plan for a future period.
2.2. Why Budgets are Drawn Up

Conradie and Fourie (2013:126) provide the following reasons for drawing up budgets:
It is a useful instrument that enables management to evaluate whether goals have been
achieved. By comparing actual results with budgeted results, financial control is possible
Budgets make the heads of different departments accountable for their actions and decisions
Budgets create cost awareness amongst the staff
Budgets enable an entity to make efficient use of available resources
A budget provides a framework from which the marketing department can develop campaigns to
implement in the next period
2.3 Master Budget and Components

The master budget is compiled from a number of other budgets, each drawing on different
components of the entity. Conradie and Fourie (2013:127) illustrate the sources of a master budget
in Figure 2-1:
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Figure 2-1: Sources of a master budget
Video Activity 1.1
Watch the video on “The Master Budget” and explain the reason for compiling
each budget.
https://www.youtube.com/watch?v=Wy9MGFjS7ZA&feature=emb_rel_end
Think Point 2.1

There is a view that a firm should not simply use the previous year’s actual
sales and expenditure figures as the point of departure for budgeting and
then make minor adjustments to provide for changing circumstances such
as inflation. Do you agree? Explain.
Conradie and Fourie (2013:128) provide the following overview of the budgeting process
2.3.1 Sales budget
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The starting point for any budget in an entity is the sales budget. This can only be drawn up once the
sales forecast has been determined. It is useful to do some research to confirm the sales
predictions. The sales forecast is very important because it is the point of departure for the sales
budget and other budgets. The first step in compiling a sales budget is to determine the expected
sales.
Assume that Oceana Limited estimates that its sales for the first six months of 20.16 is R200
000. This comprises the sale of 1 000 units at a price of R200 per unit. This may be illustrated in
Figure 2-2 as follows:
Expected sales units X Unit price = Expected sales value
1 000 units @ R200 each = R200 000

Figure 2-2 Sales projection for 6 months
2.3.2 Production budget
Based on the sales projection, the production plan (or purchases plan in the case of a
merchandising enterprise) may now be determined. The number of units to be produced will depend
upon of following three factors:
Opening inventory
Sales forecast
Closing inventory
Suppose that Oceana Limited expects an opening inventory of 150 units at R120 each and that its
desired closing inventory is 200 units. The number of units that should be produced for the forecast
period (6 months) is calculated in Figure 2-3:
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Figure 2-3
2.3.3 Materials purchases budget
The materials purchase budget is prepared once the production budget has been drawn up. Many
entities keep materials on hand at all times to accommodate unforeseen changes in
demand. Suppose each product produced by Oceana Limited requires 1 kg of materials at a cost of
R66 per unit. The manufacturer also desires to keep an inventory of 200 kg of the materials on hand
at the end of each month. A basic material purchases budget is as follows:
Figure 2-4
2.3.4 Direct labour budget
The direct labour budget also depends on the production budget. It is prepared by multiplying the
number of direct labour hours needed to produce each unit by the number of units to be
produced. Suppose each product of Oceana Limited requires 1 hour of direct labour time at a cost of
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R44 per hour. The following is an example of a direct labour budget:
Figure 2-5
2.3.5 Manufacturing overheads budget
In a manufacturing overhead budget overhead costs are estimated. These costs may be
determined in a number of ways, including department predetermined overhead rates and activity-
based costing. In the case of Oceana Limited, suppose variable manufacturing overheads are based
on the labour hours worked at a rate of R12 per hour and that the fixed manufacturing overheads
cost R1 750 per month.
The following is an example of a manufacturing overhead budget using the predetermined overhead
rate:
Figure 2-6
2.3.6 Cost of sales budget
Now that the sales projection and production costs are available, the costs of sales can be
determined. The value of cost of sales depends upon the inventory valuation method used. Suppose
that Oceana Limited uses the FIFO (first-in-first-out) method. Using this method, the cost of sales will
be calculated firstly from the sale of the opening inventory and then from the sale of the goods to be
manufactured during the forecast period. The calculation is illustrated in Figure 2-7 below:
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Figure 2-7
Using the FIFO method, Oceana Limited expected sales of 1 000 units would first come from the 150
units (at R120) in opening inventory. The remaining 850 units would come from the production of 1
050 units.
This would result in the desired closing inventory of 200 units. The value of the closing inventory (see
above) is required for the Statement of Financial Position and may be calculated as follows:
R138 600 ÷ 1 050 = R132 per unit
200 units X R132 = R26 400
2.3.7 Estimate other expenses
The figures from the previous period are often used as a base for expense projections. Estimates are
required for selling, general, administrative and other operating expenses. Interest expense is then
charged according to the provisions of the enterprise’s outstanding debt. The Statement of
Comprehensive Income will be complete once the income tax (not applicable to sole proprietorships
and partnerships) is estimated to determine the profit after tax.
In the case of Oceana Limited the following estimates apply for the budget period (6 months):
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2.3.8 Pro Forma Statement of Comprehensive Income
Using the estimates and other information from paragraphs 3.1 to 3.7 above, the Pro Forma
Statement of Comprehensive Income of Oceana Limited for the six-month period can now be drawn
up:
Pro Forma Statement of Comprehensive Income
Figure 2-8
2.3.9 Preparing a Pro Forma Statement of Comprehensive Income and a Pro Forma Statement
of Financial Position using the percentage-of-sales method
According to Gitman et al. (2014:126) a simple method of drawing up a pro forma Statement of
Comprehensive Income is the percentage-of sales method. Once sales are forecast, the various
items from the financial statements are expressed as a percentage of the projected sales. The
rationale for this approach is the tendency for variable costs and most current assets and current
liabilities to vary directly with sales. Obviously, this will not hold true for all items in the financial
statements, and certainly some independent estimates of individual items will be required.
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Percentage-of-sales forecast may be done using the following three steps:
Step 1
Examine historical data to determine which financial statement items varied in proportion to sales in
the past. This enables the forecaster to determine which items can be safely estimated as a
percentage of sales and which must be forecast using other information.
Step 2
A forecast of sales must now be done. Since many items are linked to the sales forecast, it is
important to estimate sales as accurately as possible.
Step 3
The last step is to extrapolate the historical patterns to the newly estimated sales e.g. if inventories
have historically been about 15% of sales and next year’s sales are forecast to be R1 000 000, then
one would expect inventories to be R150 000.
Consider the Statement of Comprehensive Income of Star Ltd for 20.15:
Pro Forma Statement of Comprehensive Income for the year ended 31 December 20.15
31
Figure 2-9
If Star Ltd identified cost of sales, operating expenses and interest expense as varying in proportion
to sales in the past, then the following percentages would be obtained:
Expenses expressed as a percentage of sales
32
Figure 2-10
Consider the Statement of Financial Position of Star Ltd at the end of 20.15:
Statement of Financial Position as at 31 December 20.15
Figure 2-11
From the above one observes that the equipment represents 25% of sales, inventories of R51 000 is
17% of sales and so on.
Let us assume that the sales of Star Ltd are expected to increase from R300 000 to R450 000 for
33
20.16. We further assume that 60% of profits are paid out in dividends. The amount of external long-
term funding required must be calculated. The pro forma Statement of Comprehensive Income and
Statement of Financial Position at the end of 20.16 are expected to be as follows:
Pro Forma Statement of Comprehensive Income for the year ended 31 December 20.16
Figure 2-12
Pro Forma Statement of Financial Position as at 31 December 20.16
34
Figure 2-13
The percentages obtained from figure 2-11 were used to calculate the amounts for 20.16 with the
exception of equity. For example, the equipment figure of R120 000 is 25% of the expected sales of
R450 000 for 20.16. Equity increases by the portion of the net profit that is not expected to be given
as dividends i.e. Equity balance + Profit after tax – Dividends.
The equity and current liabilities add up to R259 140 which is R64 860 less than the total assets of
R324 000. The R64 860 represents the external funding required.
Activity 2.1
Could one use financial ratios to evaluate the budgeted statement of financial
performance? Once analysed, how would management prioritise expenses
for reduction should austerity be required?
35
Revision Questions
Successful budgeting depends to a large extent on whether the principles of

budgeting have been applied correctly. What are some principles of
budgeting that may contribute to meaningful budgets?
2.4. Cash Budget

A cash budget may be described as a simple listing of projected cash receipts and payments over a
forecast period. Conradie and Fourie (2013:137) emphasise the importance of a cash budget by
describing it as the main lifeline of an entity and is also the most important result of drawing up all the
other budgets. It can help management to make timeous provision for cash shortages and to
consider the necessary financing options. Management can also decide how excess cash can be
invested.
Items that do not represent cash flows e.g. depreciation are omitted from a cash budget. The time
intervals selected may be daily, weekly, monthly, or even quarterly.
Think Point 2.2

Drawing up a cash budget is time-consuming. So why do you think an
enterprise may find it necessary to do day-by-day projections (day-by-day
budget)?
Activity 2.2
If all the funds approved in budgets are not spent, does this prove good
financial management or bad financial management? Justify your answer.
Figure 2-14 shows a typical format of a cash budget:
36
Figure 2-14
Think Point 2.3

The cash budget is used in order to help ensure the cash inflows will
exceed cash outflows most of the time. What are the three key indicators
within a cash budget?
1. Brad Limited sells a single product at a selling price of R50 per unit. The
estimated sales volumes for 4 months of 20.16 are as follows:
Units
37
April 7 000
May 10 000
June 8 000
July 9 000
Management’s policy is to maintain ending finished goods inventory each
month at a level equal to 50% of the next month’s budgeted sales. The
finished goods inventory on 31 March 20.16 is estimated at 3 500 units.
To make one unit of finished product, 3 kilograms of materials are
required. The cost per kilogram of raw material is R6.
Other production costs per unit as at 31 march 20.16 are as follows:

Direct labour
Overheads
R10
R7
As from 01 April 20.16 direct labour costs are expected to increase by

10%. Overheads are expected to increase by 2%.
1.1 Prepare the sales budget for April, May and June 20.16.
1.2 Calculate the number of units that must be produced for April, May and
June 20.16.
1.3 Calculate the total production cost for April, May and June 20.16.
1.4 Calculate the cost of sales for April, May and June 20.16 (if the FIFO
method to value inventories is used).
2. The information given below was supplied by Maltex Manufacturers.

The number of units to be sold for the different months of 20.16 are as
follows:
July 3 900
August 4 300
September 6 100
October 6 800
There will be no work in progress at the end of any month.
Finished units equal to 40% of the sales for the following month will be
in inventory at the end of each month.
38
REQUIRED
Prepare a production schedule (production requirements in units) for each
month of the quarter ending 30 September 20.16.
3. In November 20.15 GHI Limited started making budget plans for the 12
months commencing 01 January 20.16. Projected sales volume was R8 700
000 as compared to an estimated R7 350 000 for the financial year ended 31
December 20.15. The estimates of the operating results for the current year
(20.15) are shown in the Statement of Comprehensive Income below.
Following this statement are the specific working assumptions with which to
plan the financial results for the next year.
Statement of Comprehensive Income for the year ended 31 December
20.15
Assumptions for the financial year 20.16:

Manufacturing labour will fall to 24% of sales because volume efficiency
would more than offset higher wage rates.
Materials cost would increase to 14.5% of sales because some price

increases wouldn’t be offset by better utilisation.
Overhead costs would rise above the current level by 6% of the 20.15
Rand amount, reflecting higher costs. Additional variable costs would
be incurred at the rate of 11% of the incremental sales volume.
39
Depreciation will increase by R20 000, reflecting the addition of some

production machinery.
Selling expenses would rise more proportionately, by R250 000, since

additional effort would be required to increase sales volume.
General administrative expenses would drop to 8.1% of sales.
Income tax is estimated at 30% of pre-tax profits.
Required
Prepare a Pro Forma Statement of Comprehensive Income for GHI Limited
for 20.16.
4. INFORMATION
Refer to the Statement of Financial Position as at 31 December 20.15
given below.
The sales for the year ended 31 December 20.15 was R400 000
The sales are expected to increase to R500 000 for the year ended 31
December 20.16
The after-tax return on sales is 25%. Eighty percent (80%) of the profits
is paid out in dividends
The amount of external funding required (non-current liabilities) must be

calculated
40
REQUIRED
Prepare the Pro Forma Statement of Financial Position of CVB Limited as at
31 December 20.16 using the percentage-of-sales method.
41
Think Point 2.1

Yes. Such adjustments create an in-built bias towards continuing the same activities year after year
without critically re-evaluating possible changes, as for example identified during the SWOT analysis.
Etc
Activity 2.1
Activity 2.2
Think Point 2.2

If daily fluctuations in cash are likely to be large, as in the banking business, then day-to-day
projections are necessary.
Think Point 2.3

The cash budget is used in order to help ensure the liquidity of the firm, in other words, to ensure
cash inflows will exceed cash outflows most of the time during the year. The cash budget indicates:
a) the extent, time and sources of expected cash inflows
b) the extent, time and purposes of expected cash outflows
c) the expected availability of cash in comparison with the expected need for it.
Knowledge Check Questions 1

1.1
42
43
44
N.B. Overheads:
* 1 486 000 X 6% = 89 160
** (8 700 000 – 7 350 000) = 1 350 000 X 11% = 148 500

3.
45
4.
46
Unit
3: Working Capital
Management
Unit 3: Working Capital Management
47
University.

48
3.1 Introduction
Marx and Swardt (2013:187) define working capital as funds required for the day-to-day running of
an enterprise i.e. funds that will work for an entity in generating profit, meeting short-term obligations
and providing a pool of cash necessary for short-term liquidity. Net working capital is the difference
between an entity’s current assets and current liabilities. When current assets exceed current
liabilities, an entity is said to have a positive working capital.
Current assets, a major component of working capital, are assets that are expected to be turned into
cash within a year and include the following:
Cash
Accounts receivable
Inventory
Current liabilities, the other component of working capital, are debts that are payable with 12
months. They include:
Accounts payable
Short-term loans
Bank overdrafts
Video Activity 3.1
Watch the video on “Working Capital Management” and identify the various
components of Working Capital.
https://youtu.be/-gmEeZRV9Rg
3.2 Working Capital Cycle

According to Bartlett et al. (2014:743) the working capital cycle refers to the life cycle of the various
components of net working capital as they are converted from cash to working capital, to cash and
back to working capital. An appropriate working capital policy for an entity can be developed once
management understands the entity’s working capital cycle.
A typical working capital cycle for an entity, also known as the cash conversion cycle, is illustrated in
Figure 3-1:
49
Figure 3-1
The working capital cycle commences with the ordering of inventory and moves in a clockwise
direction, to end when cash is received for the goods sold on credit. This cash is then used to
purchase more goods. Creditors are paid at some stage during this continuous cycle.
3.3 Management of Cash

Bartlett et al. (2014:764) state that the definition of cash for the purposes of managing working
capital includes cash balances in bank accounts, short-term deposits and other non-restricted cash
sources.
They also note that there are competing objectives associated with cash management. On the one
hand there has to be sufficient cash available to sustain the entity’s daily operations, to finance
continued growth and to provide for unexpected expenditures. However, an entity can reduce its
returns by holding too much cash, since the yield on cash is low and thus cash kept on hand affects
profitability.
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3.3.1 Motives for holding cash
Cash may be the most liquid asset but it can also be the most unproductive asset of an entity. Cash
can reduce the risk of technical insolvency by providing a pool of funds to pay bills as they become
due. However, cash is also a non-earning asset. Despite this there are strong motives for holding
cash. These motives include the following:
Transaction motive
Cash held for transaction purposes allows the enterprise to meet cash needs that arise in the
ordinary course of business e.g. pay wages, purchase inventory etc.
Compensating balances
Banks that provide loans to entities may require that the entity leave a certain minimum amount on
deposit to help offset the cost of the services provided to them.
Precautionary motive
Cash is required to provide a safety cushion or buffer to meet unexpected cash needs e.g. a creditor
demanding payment earlier than expected.
Speculative motive
Cash is held in order to take advantage of potential profit-making situations that may arise at any
time e.g. place a larger order for inventory than usual in order to exploit a temporary price
advantage.
Think Point 3.1

How can cash flow predictability affect an enterprise’s demand for cash
through the precautionary motive?.
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3.3.2 Marx and Swardt (2013:210) provide the following strategies for an entity:
Stretching accounts payable
This involves stretching the payment period to creditors beyond the credit terms allowed but without
affecting credit ratings negatively. However, if a creditor offers a discount for prompt settlement of
account, the enterprise must compare the benefit of early payment with the cost of forgoing the cash
discount. The calculation for the cost of forgoing a cash discount is explained in Unit 4 (paragraph
4.4.1).
Efficient purchasing and inventory management
Another way of improving liquidity is to increase inventory turnover. This may be achieved in the
following ways:
Improving the accuracy of demand forecasts and better planning of purchases to coincide with
these forecasts
Through better purchasing planning, an enterprise can reduce the length of the purchasing
cycle. This should increase inventory turnover
Speeding up the collection of accounts receivable
This may be achieved in the following ways:
Offer a cash discount for early settlement of accounts

Use an aggressive collection policy
In order to ensure that debtors adhere to the credit terms, the enterprise must ensure that:
The enterprise’s credit policy has appropriate criteria to determine to whom credit should be
extended
The enterprise’s collection policy should clearly define the steps that should be followed to ensure
prompt collection of accounts receivable
Gitman et al. (2014:590) add the following strategy:
Managing mail, processing and clearing time
It is important to reduce the clearing time when collecting from customers and to increase them when
paying suppliers.
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Other strategies suggested by Bartlett et al. (2014:765) include the following:
Drawing up a cash budget
The cash budget is the most important tool for managing the cash of an entity. It forecasts the cash
receipts and cash payments of an entity, and determines the expected closing balance of cash at the
end of each period. Cash shortages can be identified in advance and the entity can plan proactively
in this regard.
Managing cash shortages
When a cash flow problem is predicted, managers can choose one or more of the following options
to rectify the problem:
Increase the cash inflows

Decrease the cash outflows, or
Obtain bridging finance
Think Point 3.2

Identify ways in which an entity can increase its cash inflows and decrease
its cash outflows
The entity can take short-term loans or increase its bank overdraft facility to manage cash
shortages. However it must be noted that an overdraft facility incurs high interest costs and the
overdraft can be recalled by the bank at any time.
Sweeping accounts
Management can optimise its cash resources on a day-to-day basis by managing its bank overdraft
facility and by placing unused cash on short deposit to limit interest expense and maximise interest
income. This may be achieved through the use of sweeping accounts. A sweep account is a
combination of two or more accounts at a bank, where at least one account (the operating account)
is used to deposit money received from customers and to make operating payments. The other
account is a higher interest bearing deposit account. Usually any surpluses are automatically cleared
from the operating account to the higher interest deposit account on a daily basis.
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Video Activity 3.2
Watch this video to get an understanding of sweeping accounts

https://www.investopedia.com/terms/s/sweepaccount.asp
3.4 Management of Accounts Receivable/Trade Debtors

Marx and Swardt (2013:229) state that in an effort to achieve wealth maximisation for the owners of
an entity, management needs to maximise the sales without incurring too much risk. One of the
available methods of increasing sales is through the extension of credit to customers. Accounts
receivable represents the granting of credit on an open account by an entity to its customers.
Accounts receivable are considered to be a necessary cost to an entity, because the granting of
credit would enable the entity to achieve higher level of sales than would be the case if it operated on
a cash-only basis. Bartlett et al. (2014:757) recommend that management must fully understand the
additional costs associated with selling on credit. One is the opportunity cost associated with
extending credit. Since cash will be received at a later stage, management forfeits the opportunity to
invest the cash in projects or assets that can generate higher returns that those generated from the
credit sales. Extending credit also results in finance costs for the entity since management may have
to look at sources of financing to pay for inventory, operating expenses and other day-to-day costs
until the debts are collected. Other costs associated with the provision of credit include costs
associated with bad debts, collections and settlement discounts.
Marx and Swardt (2013:230) provide the following discussion of three important focus areas in the
management of accounts receivable viz. the establishment of a credit policy, following up on
delinquent accounts, and monitoring and control of accounts receivable.
3.4.1 Establish a credit policy
In establishing a credit policy, decisions should be made on the following:
Credit selection
Credit standards
Credit limits
Credit terms
Collection policy
1. Credit selection
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Credit selection in an entity involves decisions about whether credit should be extended to a
customer and how much. The credit selection process that is described below focuses on the credit
application form, information needed to determine creditworthiness and an evaluation of applicants
(credit analysis).
1.1. Application for credit form
The credit selection process normally starts with the development of a well-designed and neatly
printed application form. The form is very important because it not only forms the basis of the credit
contract, but it is also a vital document in litigation. The following minimum information should be
obtained from the applicant:
Full name, identification number, home address and telephone numbers

Marital status
Employer details and employee reference number
Bank particulars and credit card information
Trade and personal references
1.2. Sources of information
The next step is to verify the information supplied by the applicant on the application form by making
use of one or more of the following sources of information:
Trade references
Bank references
Credit agencies
Own records
Civil judgements
1.3. Credit analysis
The last step in the credit selection process is an evaluation of the applicants (called credit
analysis). The purpose of this step is to evaluate the creditworthiness of the customers and to
estimate the maximum amount of credit they are capable of supporting. One of the methods used to
do this is to classify applicants according to five dimensions, the so-called five Cs of credit viz.:
Character – refers to the willingness of the applicant to pay and is measured by the payment
55
history of the applicant

Capacity – is the ability of the applicant to pay by a designated due date. Evidence of this is
obtained by examining the applicant’s income and expenses
Capital – refers to the financial position of the applicant. Data may be obtained from the
applicant’s financial statements. Ratio analysis may be used
Conditions – refer to the current economic or business conditions prevailing
Collateral – is the security that the applicant can offer in the event of non-payment of account
2. Credit standards
Credit standards refer to the minimum requirements that must be met before extending credit to a
customer. These may include the credit history of the applicant and the applicant’s income. Any
tightening or relaxation of the entity’s existing credit standards will have a direct impact on the sales
volume, level of accounts receivable and bad debts expenses.
3. Credit limits
Credit limits should be set in order to limit risks to the entity, and these will vary from customer to
customer depending on the enterprise’s confidence in the applicant’s creditworthiness. These credit
limits should be rigorously applied until such time there is a review by senior employees.
Think Point 3.3

Suppose that the accounting clerk compares an order with the file on a
customer and discovers that the order exceeds the R8 000 single
purchase limit authorised for the customer. A check also reveals that the
order will place the total receivables balance over the R25 000 limit. If you
are the financial manager, what possible actions could you take?.
4. Credit terms
Credit terms specify the repayment terms required of credit customers. Typically, credit terms may be
indicated as follows:
2/10 net 30 days
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This means that the customer will receive a discount of 2% if the account is settled within 10 days
from the start of the credit period. If the customer does not take advantage of the discount, the
account must be settled within 30 days from the start of the credit period.
Credit terms therefore cover the following three parameters:
Credit period: is the period for which credit is granted e.g. 30 days
Cash discount: is the percentage (e.g. 2%) that is deducted from the purchase price of the
goods, if the customer pays the account within a specified period of time
Cash discount period: is the specified period of time (e.g. 10 days) during which the discount is
offered
A change in the credit terms can affect an entity’s net profit and return on investment
5. Collection policy
The collection policy of an entity refers to the different procedures that should be followed to collect
accounts receivable once they become due. An effective collection policy should be geared towards
ensuring that:
Debtors settle their accounts timeously, as delays may lead to liquidity problems
Bad debts are kept to a minimum
The collection of accounts receivable commences with the correct and timeous mailing/faxing/e-
mailing of invoices. Invoices should be dated at the earliest date possible, usually the date of
delivery.
Sending out statements regularly is important as some customers pay only when the statement is
received.
3.4.2. Follow-up of delinquent accounts
The longer an account remains outstanding, the more difficult it is to collect. Prompt follow-up can
prevent losses. The following methods may be used to collect overdue accounts:
Letters: The timing, content and wording of the letter is important. Many businesses send out two
standard letters to customers before sending a final letter of warning
Telephone calls: These should be used preferably for larger, problem debts because of the
57
higher costs attached to making telephone calls

Personal visits: These can an effective means of getting customers to settle their accounts
Collection agencies: These agencies may be used if all else has failed but one must be aware
of the collection costs payable to the agency
Legal action: It can be time-consuming and may sometimes cost more than the amount
recovered. Legal action should be considered if all reasonable efforts to recover the debt were
unsuccessful, there are no reasons for the dispute of the claim and the debtor is able to pay
3.4.3. Monitoring and control of accounts receivable
A close scrutiny and evaluation of the payment patterns of debtors and the bad debts costs of the
entity can help to monitor the effectiveness of the credit and collection policy.
1. Monitoring payment patterns
It is important to keep adequate and accurate records of every debtor. One method of monitoring the
payment behaviour of debtors is to use a ratio to determine the time it takes to collect debts from
customers who buy on credit.
The formula is as follows:
If the collection period (45 days) exceeds what is specified in the policy (e.g. 30 days), then steps
need to be taken to remedy matters. The collection period may also be compared to the collection
period of the previous year to determine if there is an improvement or deterioration.
Another method of monitoring accounts receivable is to draw up an ageing schedule. An ageing

schedule indicates how long accounts receivable have been outstanding at a point in time.
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Suppose that at the end of a particular month, an entity has outstanding debtors totalling R170 000
and the credit terms are 30 days. Table 3-1 shows the ageing schedule:
Table 3-1: Ageing schedule
The ageing schedule reveals that 65% of accounts are overdue of which 24% is over 90 days
outstanding.
2. Monitoring bad debts
Bad debts may be monitored by using the following ratio:
An entity usually has confidence limits based on the expected value of this ratio e.g. a bad debts
ratio of 5% of credit sales is generally expected for the entity. The entity also determines historic
random variation to this ratio e.g. historically variations of 1% were experienced. If the actual bad
debts ratio falls outside these limits, then an investigation becomes necessary.
3.5 Management of Inventory

According to Marx and Swardt (2013:258) inventory ties up an entity’s valuable cash resources,
thereby forcing it to forego other profitable opportunities. Since inventory is the least liquid of the
current assets, it must be managed as efficiently as possible.
3.5.1 Inventory valuation
Of great concern for to firm is determining the actual value of its inventory on hand. The method that
59
is used to establish the value of inventory has a significant influence on gross profit reflected in the
Statement of Comprehensive Income and the value of inventory in the Statement of Financial
Position. Marx and Swardt (2013:262) elaborate on the four most common methods used to value
inventory:
First-in-first-out (FIFO)
Last-in-first-out (LIFO)
Weighted average cost
Specific identification
1. First-in-first-out (FIFO)
When using the FIFO method to value inventory, the units sold will be based on the cost of the units
first purchased. This implies that inventories on hand will be valued at the cost of the units purchased
last. The following example illustrates this method:
On 31 August 20.14 the firm purchased another four laptops at R7 600 each. During the financial
year six laptops were sold at R10 000 each. This left the firm with seven laptops as closing inventory.
Gross profit and closing inventory, based on the FIFO method, are reflected in the following extract
from the Statement of Comprehensive Income:
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2. Last-in-first-out (LIFO)
Using this method, the cost of goods sold is based on the last units placed in inventory, while the
remaining inventory value consists of the goods first placed in inventory. In terms of tax legislation,
this method of valuing inventory is no longer allowed in South Africa. The main reason for this is the
tax advantages gained during periods of inflation.
Example 3
Using the same set of details used in example 2 we now calculate the gross profit and closing
inventory.
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Think Point 3.4

What is the impact of the carrying value of inventory (in the Statement of
Financial Position) and the cost of goods sold when LIFO rather than FIFO
method to value inventories is used during periods of inflation?
3. Weighted average cost
This method results in the cost of goods sold and closing inventory falling somewhere between the
values obtained using FIFO and LIFO methods. The average cost per unit is determined by dividing
the total cost of similar items by the number of items purchased.
Example 4
Using the same set of details used in example 2 we now calculate the gross profit and closing
inventory. The weighted average cost per unit is R6 461.54 (R84 000 ÷ 13).
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4. Specific identification
Using this method a unique cost is attached to each item in the inventory. This valuation method is
usually used for high cost, slow-moving inventories e.g. motor cars and jewellery.
Example 5
Regal Motors, a dealer in second-hand vehicles, purchased the following vehicles during the
financial year ending 28 February 20.15:
The firm has no opening inventory. During the year, the business sold the Red Toyota Yaris for R90
000, the White VW Jetta for R66 000 and the Green Toyota Camry for R80 000.
The gross profit for Regal Motors for the financial year, using the specific identification method of
inventory valuation, is reflected below:
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3.5.2 Economic order quantity
Marx and Swardt (2013:269) state that the objective of inventory management is to achieve the
lowest acquisition cost of inventory for the entity. This can be achieved by determining the economic
order quantity.
Managers need to consider the two main costs in any purchasing order viz. the cost of purchasing
and the cost of holding the inventory. The cost of purchasing inventory includes the costs involved
in negotiations, cost of telephone and faxes, stationery, internet usage and receiving the goods. The
cost of holding inventory include the cost of storage, loss of interest on capital tied up in inventory,
personnel costs, insurance, goods going out of fashion or becoming obsolete.
Thus one finds that if small quantities are purchased each time, the cost of purchasing will be high as
many orders need to be placed. On the other hand if larger quantities are purchased, the cost of
holding inventory becomes high. Somewhere between these two extremes is a point where the total
cost of purchasing and holding the inventory is at a minimum.
The quantity ordered at this point is the economic order quantity (EOQ).
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Example 6
Juno Limited purchases 800 school bags at R60 each per annum. The bags are sold at R80 each at
a steady rate during the year. The cost of placing a single order amounts to R20.25. Inventory
holding cost amounts to R4 per unit. Calculate the economic order quantity.
Solution
3.5.3 Analysing inventory turnover
In evaluating the effectiveness of an enterprise’s inventory management, it is common to use the

number of times inventory on hand has been sold out and replaced during the period of analysis
(Marx and Swardt, (2013:278). The higher the turnover rate the better, as this would improve cash
inflows. Inventory turnover is calculated as follows:
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Example 7
Smart Stores had the following value of inventories during 20.15:
01 January R50 000

31 December R 30 000
Cost of sales for 20.15 amounted to R800 000.
Required
Calculate and comment on the inventory turnover.
Solution
Smart Stores has a fairly high inventory turnover rate with inventories replaced approximately every
19 days.
3.5.7 Preventing losses of inventory
Marx and Swardt (2013:280) suggest the following ways of minimising losses as a result of damage
and theft:
Goods purchased should be checked to determine whether the supplier has delivered what has
been ordered
Regular stocktaking should be done to detect shortages in inventory
Adequate and secure storage facilities should be available
Surveillance equipment such as closed circuit TVs should be used
Items of inventory can be tagged with magnetic plastic devices that have to be removed by the
cashier
High-priced items should be kept out of reach or at counters with salespersons in attendance
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Provision should be made for eventual losses of inventory by insuring against these risks.
3.6 Management of Accounts Payable/Trade Creditors

Bartlett et al. (2014:762) describe trade creditors as creditors who come into existence as a result of
purchasing inventory on credit or from receiving services on credit. Trade creditors are also referred
to as accounts payable.
3.6.1 Strategies for the management of accounts payable
Bartlett et al. (2014:762) suggest the following strategies for an entity:
Management should balance the entity’s cash flow requirements with its supplier
relationships. Suppliers offer different payment terms, discount structures etc.
Management need to compare their terms of contract with market trends and where necessary
negotiate for better payment terms
A well-managed IT system helps to ensure that the right suppliers are paid within the optimal
payment period, and that material discounts are claimed. (Refer to topic 5 (paragraph 4.1) for
determining the cost of not accepting a discount)
A policy regarding trade credit should be established and followed
Exploit trade credit as far as possible, as the advantages of credit purchases usually outweigh the
costs of claiming credit
The most useful ratio in the monitoring of trade credit is the creditor payment period. This ratio
tells us how long, on average, an enterprise takes to pay for goods bought following the purchase
on credit. The formula to calculate it is as follows:
Example 8
The accounts payable balance of Virgo Stores was R50 000 on 31 December 20.15. Credit
purchases of inventory for 20.15 amounted to R500 000.
Required
Calculate and comment on the creditor payment period.

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Solution
Unless Virgo Stores is receiving cash discounts for early settlement of accounts, it should negotiate
for credit terms up to 90 days and pay at the end of the credit period.
Revision Questions
Trade credit is an important source of credit for a business. What are the
reasons a financial manager will use trade credit?
3.7 Management of Liquidity

One of the main issues in the management of working capital is the concept of liquidity. Liquidity
ratios are used to measure the ability of an enterprise to meet its short-term obligations.
The most commonly used liquidity ratios are the current ratio and acid test ratio.
3.7.1 Current ratio
The current ratio attempts to show the ability of an enterprise to pay off the short-term debts using its
current assets. Current ratio is calculated as follows:
3.7.2 Acid test ratio
The intention of the acid test ratio is to test the settlement of current liabilities under distress
conditions, on the assumption that inventories would not be readily converted into cash. The
calculation is done as follows:
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Example 9
The following is an extract of the Statement of Financial Position of Envoy Stores as at 28 February
20.15:
Extract of Statement of Statement of Financial Position
Required
Calculate and comment on the following:
Current ratio
Acid test ratio
Solution
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The current ratio indicates that the business should be able to pay its short-term debts when they fall
due i.e. the liquidity position is satisfactory. The acid test ratio indicates that the business may have
difficulty paying its short-term debts under distress business conditions.

1. Match the motives for keeping cash in column A with the examples in
column B.
A. Trans
action 1.Sales are expected to slow down.
motive
B. Preca
utionary 2.Pay expenses and purchase inventory.
motive
C. Specu 3.A requirement that an entity leave a certain minimum

lative amount on deposit to help offset the cost of the services
motive provided to them in respect of a loan.
D. Comp
ensating 4.Take advantage of profitable opportunities.
balances
2. Suggest appropriate strategies that an entity may use in the management

of cash.
70
3. What is the danger of stretching accounts payable?
4. Discuss the following important components of a credit policy.

Credit selection; Credit standards; Credit limits; Credit terms; Collection policy
5. Suggest two ways of speeding up the collection of overdue accounts.
6. Describe the steps that may be followed in collection of delinquent

accounts.
7. Describe five credit standards (the 5 Cs) that may be used to evaluate the
creditworthiness of debtors.
8. Name two goals that an effective debtor collection policy should aim at.
9. FM Stores has a R60 000 balance of accounts receivables on 01 June.

After checking the ledger cards for accounts receivable, the financial manager
discovered that:
R30 000 represented sales made in May
R15 000 represented sales made in April
R10 000 represented sales made in March
R2 000 represented sales made in February
R3 000 represented sales made in January.
Required
Prepare a debtor age analysis showing the Rand amount outstanding and the
percentage outstanding.
10. You are the newly appointed management accountant at Kelso

Industries. The company uses the EOQ model to determine the quantity of
raw material Z54 to order from REM Ltd. The following details regarding raw
material Z54 are brought to your attention:
Kelso Industries consumes 2 400 units of material Z54 each working
day.
It is estimated that there are 250 working days in the 20.15 financial
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year.
The cost of placing an order amounts to R120.
The cost of holding inventory per unit is estimated at R3,90 plus 11% of
the invoice price per unit.
The invoice price per unit is R10.
Required
Calculate the EOQ for raw material Z54 for the 20.15 financial year.
11. Heathrow Suppliers anticipates sales of 5 250 units per month, a

purchase price of R20 per unit, an ordering cost of R2 per order, and a
carrying cost of 20 percent of the unit purchase price. Calculate the most
advantageous quantity for the firm to order each time for the year.
12. Determine the value of inventory as at 31 March 20.16 and gross profit for
March 20.16 using the first-in-first-out method (FIFO), weighted average cost
method and last-in-first-out method (LIFO) from the following information:
13. You are provided with the inventory record of Coolman Traders, which
sells refrigerators, for the month ended 31 October 20.15. The business uses
the specific identification method to value inventories.
Inventory record for refrigerators for the month ended 31 October 20.15
Model Cost Inventory Purchases Sales Inventory
price on 01 on 31
October October
R Units R Units R Units Price R Units R
Defi 4 000 10 40 36 6 000
Kelvi 5 000 4 60 44 7 000
Sami 6 000 8 30 28 8 200
22 130 108
13.1 Complete the inventory record (above) with the missing figures and
amounts.
13.2 Determine the value of inventory as at 31 October 20.15 and gross profit
for October 20.16.
14 Excerpts of financial data for Zebcom Enterprises for 20.15 are as follows:
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Statement of Comprehensive Income for the year ended

31 December 20.15
R
Sales (all credit) 3 201 150
Cost of sales (all credit) 2 618 010
Opening inventory 38 860
Purchases (all credit) 3 061 350
3 100 210
Less: Closing inventory (482 200)
Statement of Financial Position as at 31 December 20.15
R
Current assets 2 866 530
Inventories 482 200
Accounts receivable 261 290
Marketable securities 326 950
Cash 1 796 090
Current liabilities 1 088 860
Accounts payable 190 660
Other current liabilities 898 200
14.1 Calculate the current ratio and acid test ratio. How has the enterprise’s
liquidity changed over this period, if the current ratio and acid test ratio for
20.14 were 8.46:1 and 8.39:1 respectively?
14.2 Compute the following for 20.15 (ratios for 20.14 are given in brackets):
Inventory turnover (20.14: 20 times)
Debtor collection period (20.14: 29,24 days)
Creditor payment period (20.14: 43,83 days)
14.3 What is your interpretation of the enterprise’s performance with respect

to your answers in 8.14.2?
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Think Point 3.1

The more predictable the inflows and outflows of cash for an enterprise, the less the need for cash to
be held for precautionary purposes.
Think Point 3.2
Think Point 3.3
Several actions are possible:
Raise the limits if the firm has demonstrated that it pays its accounts promptly
Investigate further by enquiring about the order from the customer e.g. did the customer know the
order was larger than the limit? Did it want to be considered for higher limits? After a review a
new limit may be set
Deny the request if the information available does not favour raising the limit
Think Point 3.4
During periods of inflation (when costs are rising), LIFO results in a lower closing inventory and a
higher cost of goods sold than FIFO. This is because the LIFO assumption results in the most
recent, higher, costs being transferred to cost of goods sold (cost of sales).
Video Activity 3.1
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To be discussed during webinar/s with lecturer.
Video Activity 3.2
To be discussed during webinar/s with lecturer
Knowledge Check Qustions 1

1.
1.1 D
1.2 A
1.3 B
1.4 C
2. See paragraph 3.2
3. The firm’s credit rating may deteriorate.
Suppliers may be reluctant to allow credit in future.
Creditors may charge interest.
5. Offer a cash discount for early settlement of accounts.
Use an aggressive collection policy.
7. Refer to paragraph 4.1.1.3
8. Debtors must settle their accounts timeously.
Bad debts must be kept to a minimum.
9. Debtors Age analysis
10.
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11.
12. FIFO
76
77
LIFO
13.1
78
13.2
14.1
79
One could say that high liquidity ratios for 20.04 may point towards slack management in respect of
the idle cash. The ratios for 20.1 have dropped to more acceptable levels. The current ratio for 20.1
indicates that the business would be able to pay off its short-term debts as the ratio is more than the
norm of at least 2:1. The norm for the acid test ratio is at least 1:1. Thus, under distress business
conditions, the business (with a ratio of 2, 19:1) should be able to pay off its short-term debts.
14.2
N.B. Average inventory = (R482 200 + R38 860) ÷2 = R260 530
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14.3 Inventory turnover has dropped sharply from 20 times to 10,05 times per annum suggesting
that the enterprise may have lost control over the management of inventory.
Collections from debtors appear to be good with the outstanding debt expected to be collected
within 30 days.
Creditors accounts are being settled earlier than the previous year and the enterprise should not
settle accounts earlier than required unless a discount for early settlement is forthcoming.
81
Unit
4:
Finance Sourcing
Unit 4: Finance Sourcing
82
University.

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4.1. Introduction
There are various financing opportunities available in the economy from which entrepreneurs can
choose. It is the responsibility of management to fund its strategic business design with an
appropriate combination of capital sources that will help to bring about the desired increase in
shareholder value. It is therefore necessary to examine the key considerations in assessing the
financing options open to management.
4.2. Factors Related to Finance Sourcing

According to Conradie and Fourie (2013:99) there are several important factors relating to any
particular source of finance that should be considered before a financing decision is made. These
include:
It is important to match the life expectancy of the asset(s) with the length of time for which the
source of finance is made available
Availability and accessibility of finance may mean that some desired forms of finance are not
available whilst others are easily available
The costs associated with each source of finance must be carefully considered
One’s desire to be independent may be threatened as more and more outside capital is used in
the entity. This is especially the case when more partners or shareholders are brought in
Most forms of finance limit the freedom of the application of the finance i.e. it must be used for a
specific purpose e.g. a mortgage bond may only be used for the acquisition of land and buildings
The impact that the specific form of finance has on the liquidity and profitability of the entity must
be considered
The tax deductibility of the costs related to the source of finance is important
4.3. Financial Markets

Financial markets are the channels through which holders of surplus funds (savers) make their
funds available to those who require additional finance. Financial institutions act as intermediaries
in financial markets between the savers and those with a shortage of funds. Marx and Swardt
(2013:32) add that the financial markets consist of the money and capital markets. The capital
market makes funds available for long periods of time e.g. mortgage bond.
The money market is one where funds are borrowed or lent for short periods of time, usually less
than a year e.g. bank overdraft.
A distinction can also be made between the primary market where new capital is raised and the
secondary market where trading in securities, after they have been issued, takes place. The
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Johannesburg Securities Exchange (JSE) is an example of a market that allows savers to convert
their investments into cash.
Activity 4.1
1. Which five banks are the biggest in South Africa?

2. What is the market share of each of these banks?
4.4. Short-Term Financing

Short-term financing include debts/obligations where repayment has to be made within one
year. From a cost point of view, it is advisable to finance current assets needs with short-term
funds. Conradie and Fourie (2013:98) elaborate on various forms of short-term financing. We focus
on the following:
Trade credit
Accruals
Bank overdraft
4.4.1 Trade credit
Trade credit mainly takes the form of suppliers’ credit. Payment is not made when the goods or
services are purchased. The enterprise is only expected to pay after 30, 60 or 90 days, depending
on the credit terms granted. In order to encourage prompt payment, suppliers often offer a cash
rebate/discount for early payment. Let’s examine how the advantage of a cash discount may be
calculated. The following formula may be used to determine the cost of not accepting a cash
rebate/discount:
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Practical Application or Example 4.1
Vita Distributors’ normal credit terms to Nyrere Stores are 30 days but is
prepared to allow a 2% rebate if Nyrere Stores pays the account within 10
days. Calculate the cost to Nyrere Stores of not accepting the discount.
Think Point 4.1

Refer to Example 1. What would be some of the consequences to Nyrere
Stores if it did not pay its account within 30 days?.
4.4.2 Accruals
Accruals refer to liabilities for services provided to the enterprise for which payment has not yet been
made. Wages and taxes are common examples. Employees are actually providing short-term
financing for the enterprise by waiting for a week or month to be paid rather than being paid
daily. Accrued tax also represents a form of financing. The extent of financing from accrued taxes is
determined by the amount of tax payable and the frequency of payment. Since accruals have no
associated cost, they are a valuable source of finance.
4.4.3 Bank overdrafts
Banks provide this facility for enterprises to make payments from a cheque account in excess of the
balance in the account. It provides a means to bridge the gap between cash receipts and cash
payments. Overdraft limits are usually reviewed annually. Interest that is charged on an overdraft is
negotiable and is linked to the risk profile of the borrower. Banks charge interest daily on the
outstanding balance owing. This implies that interest is only charged on the portion of the overdraft
limit that is used. Some banks even charge a fixed monthly overdraft facility fee.
Vita Distributors’ requires a Bank overdraft of R75 000 for 3 months. Home
Bank is happy to consider the overdraft at an interest rate of 8.25% pa.
Calculate the interest Vita Distributors will pay if the full overdraft is utilised.
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4.5. Long-Term Financing

Long-term financing can come from internal and external sources. Marx and Swardt (2013:32)
analyse the following forms of long-term financing:
Equity financing
Debt financing
4.5.1 Equity financing
The primary source of long-term financing is the owners of the entity. Equity may be defined as the
funds made available by the legal owners in the form of capital as well as indirect contribution in the
form of undistributed/retained profit. In the case of companies shareholders become owners of the
company through the purchase of ordinary shares. This entitles the shareholder to a claim to
profits. The portion of the profit paid to shareholders is called dividends. Retained profit represents
profit that could have been paid out to shareholders but were retained by the company for the
purpose of self-financing. The cost to the company for ordinary shares is the flow of dividends.
Finance may also be obtained by companies through the issue of preference shares which is
considered to be a hybrid form of financing, since they have characteristics of both debt and equity
financing. Preference shareholders enjoy a preferential claim on the profits and assets of the
company above ordinary shareholders. The dividend on preference shares is limited to a fixed
percentage of the face value of the share.
Think Point 4.2

Dividends tend to be more expensive than a similar gross equivalent loan
interest rate. Explain why.
Revision Questions
Research and discuss the characteristics of Hybrid Financing.
4.5.2 Debt financing
Debt financing involves the procurement of borrowed funds from financial institutions or individual
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investors. Long-term debt refers to debt that is repaid in more than a year’s time. Although all long-
term debts are subject to interest expense, interest payments are deductible for tax purposes. Some
of the important forms of long-term debt will now be discussed.
Debentures
Debentures are the most common form of long-term debt for companies. A debenture may be
defined as a written acknowledgement of debt that specifies the amount, period, interest rate, fees,
repayment terms etc. Debentures are normally unsecured. A certificate is issued to the lender and
this certificate is negotiable. Payment of the principal sum plus interest is made to the holder of the
certificate. The cost to the company is a fixed interest charge.
Bonds
Bonds, unlike debentures, are secured by specific assets of the entity. Mortgage bonds, for example,
are secured loans and these are granted using fixed property as security. The value of the property
usually determines the amount that may be raised. If the enterprise is liquidated, the proceeds from
the secured assets would first be used to settle the claim of the secured provider of the credit. The
interest rate on mortgage bonds is not fixed but changes with market forces.
Video Activity 4.1
Watch the video on “Debenture vs. Bond: What's the Difference?”

https://www.investopedia.com/ask/answers/122414/what-difference-between-
debenture-and-bond.asp
4.6. Financial Leverage

According to Conradie and Fourie (2013:101) financial leverage is related to the cost and use of
borrowed capital in an entity. Financial leverage can increase the expected return to owners at the
cost of greater risk. Financial leverage involves the substitution of fixed-cost debt financing for
equity. Since this substitution increases fixed interest expenses, financial leverage increases the
variability of return s to owners. Financial leverage can increase owners’ risk as well as return.
With financial leverage an advantage is gained from the expectation that funds borrowed at a fixed
interest rate can be used for investment opportunities earning rates of return greater than the interest
paid on these funds. The difference accrues as profit to the owners of the enterprise and enhances
the return on equity. However if the return earned is less than the interest rate on loans, the opposite
would apply.
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The higher the proportion of debt – and its fixed interest charges – in the capital structure, the
greater will be the leverage contribution to the return on equity for a given positive return achieved
on the investment. Conversely, if achieved returns fall below the rate of interest, the fixed nature of
the interest expense will begin to magnify the reduction in return on equity.
Activity 4.2
Visit the website of the SARB and read the latest quarterly bulletin.
What are the most recent economic developments? How will this impact on
interest rates and exchange rates?
4.7. Problems in Obtaining Finance

There are many factors that may influence the ability of an enterprise to secure adequate
financing. Conradie and Fourie (2013:103) provide the following factors:
A lack of sufficient own capital discourages lenders from providing loans

A lack of experience in financial management creates difficulties in convincing suppliers of
finance to assist
Inadequate collateral available that may be required by providers of finance
Poor creditworthiness e.g. poor payment record, cash flow problems, high debt ratio
Other factors may include:
Poor sales potential
High business risk
Incomplete or unimpressive business plan
Inability to provide security
Interest rate too high making finance unaffordable
Lack of management skills by the owner to make the business successful
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1. Would you consider the Johannesburg Securities Exchange (JSE) to be
part of the secondary market? Explain why.
2. Distinguish between the capital market and money market.
3. Midrand Manufacturers normal credit terms to Gina Traders are 30 days

but is prepared to allow a 3% discount if Gina Traders pays the account within
12 days. Calculate the cost to Gina Traders of not accepting the discount.
4. Explain how the employees of an enterprise may actually be a source of

short-term financing to the enterprise.
5. Explain how banks charge interest on bank overdrafts.
6. Evaluate loans as a source of finance to businesses.
7. Discuss the form of long-term debt available only to (public) companies.
8. Discuss a form of secured long-term debt where the interest rate is not
fixed.
9. What do you understand by financial leverage?
10. Return/Cost, risk and control are important considerations in deciding on

a form of finance. Complete the following table by indicating how these
considerations apply to long-term debt and equity.
11. Jackson Traders purchased inventory on credit for R1 000. The supplier
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offered Jackson Traders the option to settle the account by paying R980 up to
the 10th day or pay R1 000 at the end of 30 days. Jackson Traders can
borrow from its bank at 15 percent to settle the account within 10 days.
Should Jackson Traders borrow the funds? Motivate your answer.
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Activity 4.1
Think Point 4.1

The cost of the discount foregone (37,24%).
• Interest may be charged by Vita Distributors.
• The firm’s credit rating would deteriorate, along with its ability to obtain future credit
Think Point 4.2

Dividends are not tax-deductible in arriving at a company’s tax liability while interest is tax-deductible.
Activity 4.2

1. Yes. The secondary market is one where trading in securities, after they have been issued,
takes place. The JSE allows for trading of shares that have been already issued by public
companies.
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2. Refer to paragraph 4.3.
3.
4. Employees are providers of short-term financing for the enterprise by waiting for a week or
month to be paid rather than being paid daily.
5. Banks charge interest daily on the outstanding balance owing. This implies that interest is only
charged on the portion of the overdraft limit that is used.
6. Loans offer businesses the following advantages:
Costs are limited in that they are determined by the loan interest rate
Interest payments are deductible for tax purposes
The control of the owners is usually not influenced by the issue of more loans
Loans do not dilute the earnings of ordinary shares
However, a disadvantage is that fixed interest payments and priority claims of loans in the case of
liquidation increase the risks, inherent in the business, to the owners.
7. Refer to paragraph 5.2.1 (debentures).

8. Mortgage bonds are secured loans and these are granted using fixed property as security. The
value of the property usually determines the amount that may be raised. If the enterprise is
liquidated, the proceeds from the property would first be used to settle the claim of the secured
provider of the credit. The interest rate on mortgage bonds is not fixed but changes with market
forces.
9. Refer to paragraph 4.6.
10.
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11.
Yes. Borrow and pay within 10 days as the benefit (37.24%) is greater than the interest rate to
borrow (15%).
94
Unit
5: Cost-Volume-Profit Relationships
Unit 5: Cost-Volume-Profit Relationships
95
University.

96
5.1 Introduction
According to Cloete et al. (2014:58) cost-volume-profit (CVP) analysis implies an important
relationship between costs, volume and profits. It is an important tool for financial managers in
decision-making as it examines the effect on profits when there are changes in factors such as
product prices, variable cost per unit, total fixed costs, the level of activity (volume) and the product
mix.
Using CVP analysis, financial managers would be able to get information relating to the following:
How profits are affected by a change in costs

The effect that a change in sales volume will have on profit
The profit that is expected from a certain sales volume
The volume of sales required to achieve a targeted profit
The level of output of production whereby the income and costs will be the same
5.2 Marginal Costing Statement

Cloete et al. (2014:29) state that the marginal costing statement is the preferred format for CVP
analysis because of its prudent approach to measuring profit. It is simple to use and provides the
best information for planning, control and decision-making purposes.
Using this approach all costs are classified as fixed or variable. Fixed costs are costs that remain the
same irrespective of the level of output. Variable costs are costs that vary as output changes.
All variable costs are subtracted from sales before arriving at marginal income or contribution. Fixed
costs are deducted after marginal income has been calculated.
Think Point 5.1

What is a Semi-Variable cost? Provide an example.
The following is an example of a Marginal Costing Statement:
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Example 1
5.3 Cost-Volume-Profit Analysis using the Marginal Income Approach

CVP analysis is based on the marginal costing approach. The Marginal Costing Statement is useful
when determining the effects of changes in selling price, cost or volume on profit.
The following example will be used to illustrate the CVP analysis:
Example 2
The following is a budgeted Marginal Costing Statement of Salsa Ltd, a manufacturer of a single
product called component X:
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5.3.1 Marginal income
Marginal income is the excess of sales over the variable costs. It refers to the amount of money
available to cover firstly the fixed costs and then to generate profit. If the fixed costs are greater than
marginal income, then a loss will result.
Example 3
If Salsa Ltd sells only one item of component X, the marginal costing statement will appear as
follows:
For each additional unit of component X that Salsa Ltd sells, an additional R10 marginal income
becomes available to cover the fixed costs.
5.3.2 Calculation of break-even point (using the marginal income method)
Conradie and Fourie (2014:111) define break-even point as the level of business sales required that
realises neither a profit nor a loss. Expressed in another way, the volume of sales at which marginal
income is equal to fixed costs is called the break-even point. The break-even quantity is the
minimum quantity that must be sold to ensure that fixed costs are covered.
Video Activity 5.1
Watch the video on “break-even point”

https://youtu.be/AsHjjRKeHkg
Break-even quantity can be calculated using the marginal income method as follows:
99
Example 4
Using the figures from example 2, break-even quantity may be calculated as follows:
The break-even value (i.e. break-even point in Rands) is calculated as follows:
Example 5
Using the figures from example 2, break-even value may be calculated as follows:
To reach break-even point during July 20.16 Salsa Ltd needs to sell 20 000 units. This can be proven
as follows:
100
5.3.3 Calculating break-even value using the marginal income ratio
Variable costs and marginal income may be expressed as a percentage of sales. Using the figures
from example 2 (Salsa Ltd), this can be illustrated as follows:
Marginal income ratio is the percentage of marginal income to sales.
Marginal income ratio may be expressed as follows:
Example 6
The marginal income ratio for Salsa Ltd is:
The break-even value may be calculated as follows:
Example 7
The break-even value for Salsa Ltd is calculated as follows:
101
Think Point 5.2

What are the underlying assumptions of breakeven analysis?
5.4 Applying the Cost-Volume-Profit Analysis

The information contained in example 2 (Salsa Ltd) will be used to illustrate the application of CVP
analysis. This information is reproduced below:
5.4.1 Calculation of sales required to attain a targeted net profit
Cost-profit-volume analysis may be used to determine the sales required to attain a targeted net
profit. This can be done in one of two ways.
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The first is as follows:
Example 8
If Salsa Ltd targets a net profit of R40 000 from the sale of component X, the sales required will be as
follows:
The second way of calculating the required sales for a targeted net profit is as follows:
Example 9
The sales required by Salsa Ltd to realise a profit of R40 000 is:
103
5.4.2 Margin of safety
Cloete et al. (2014:59) state that margin of safety gives an indication of how close an entity is
operating to the break-even point. It shows by how much sales can decrease before the break-even
point is reached or before losses are incurred. The margin of safety may be expressed in value, units
or as a percentage:
Example 10
The margin of safety for Salsa Ltd may be calculated as follows:
104
Video Activity 5.2
Watch the video on “Margin of Safety”

https://www.youtube.com/watch?v=i5sonnlqdjE
5.5 Applying the Cost-Volume-Profit Analysis with Changes in Selling Price, Variable Costs,
Fixed Costs and Number of Products Marketed
Thus far it has been assumed that factors such as prices, costs and volumes remained the same. We
are now going to examine the application of the cost-volume-profit analysis with changes in selling
price, variable costs, fixed costs and number of products marketed. To illustrate this, the following
information from example 2 (Salsa Ltd) will be utilized.
5.5.1 Change in selling price
Whenever enterprises increase the selling prices of their products, the result is usually a drop in
sales volume. The decrease in sales is the result of consumer reaction to the price increase. The
cost-volume-profit (CVP) analysis can be used by financial managers to determine the level to which
sales volume can decline before this impacts negatively on its targeted profit.
Example 11
Salsa Ltd plans to increase the selling price of component X by 10% and targets a net profit of R40
000. Using the information from example 2 (reproduced above), calculate the quantity of component
X that must be sold to:
11.1 break even
11.2 achieve a target profit of R40 000.
Solution
105
5.5.2 Change in variable cost
If management can succeed in reducing variable costs, then the number of units needed to achieve
a targeted profit will fall. This is illustrated as follows:
Example 12
Using the information from example 2, suppose Salsa Ltd succeeds in reducing variable costs by
10% (with the selling price remaining at R40). The targeted profit is R40 000.
Required
Calculate the quantity of component X that must be sold (rounded off to nearest whole number) to:
12.1 break even
12.2 achieve a target profit of R40 000.
Solution
106
5.5.3 Change in fixed costs
If fixed costs (e.g. rent) increase, then the number of units needed to achieve a targeted profit will
increase. This is illustrated as follows:
Example 13
Using the information from example 2, suppose the fixed costs increase by R20 000 (with no change
to the selling price or variable cost). The targeted profit is still
R40 000.
Required
Calculate the quantity of component X that must be sold to:
13.1 break even
13.2 achieve the target profit of R40 000.
Solution
107
5.5.4 Change in the product mix
Break-even calculation becomes complicated when more than one product is marketed. As each
product has its own marginal income ratio, a sales mix is determined so that a marginal income ratio
based on the weighted average is calculated in order to determine break-even quantity and
value. This is illustrated as follows:
Example 14
XYZ Enterprises manufactures and sells 3 different products viz. product X, product Y and product
Z. The following details apply
Required
Calculate the break-even quantity and break-even value for each product.
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Activity 5.1
How could the owner of a firm lower the breakeven point of his or her firm in
order to reduce risk?
5.6 Limiting Assumptions of Break-Even and Cost-Volume-Profit Analysis

Cloete et al. (2014:83) identify the following assumptions associated with CVP analysis that need to
be taken into consideration, since they affect the reliability for planning and decision-making:
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The price of the product will remain unchanged as the level of activity changes, within the
relevant range
Within the relevant range, costs are linear and can be accurately separated into fixed or variable
costs
All variable costs will vary with only either production level or sales level
In entities that sell various products, the sales mix is constant
There are no inventories i.e. the number of units produced equals the number of units sold
5.7 Summary of the Ratios

5.7.1
5.7.2
5.7.3
5.7.4
5.7.5
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5.7.6
5.7.7
5.7.8
1.
1.1 The difference between sales and variable costs is called ____________.
1.2 Break-even point is reached when ____________ is equal to

____________.
1.3 The ____________is the amount by which the actual level of sales
exceeds the break-even point.
1.4 The break-even quantity will ____________ if there is an increase in fixed

costs.
1.5 One of the key assumptions underlying break-even analysis is that costs
are classified as either ____________ or ____________.
2. Bysan Ltd plans to manufacture a new product and the following

111
information is applicable:
Estimated sales for the year 20.16 7 000 units at R40 each
Estimated costs for the year 20.16
Direct material R12 per unit
Direct labour R2 per unit
Factory overheads (all fixed) R24 000 per annum
Selling costs 30% of sales
Administrative costs (all fixed) R32 000 per annum
3. AIM Ltd supplies component J to furniture manufacturers. The marketing

manager is of the opinion that if the selling price of component J is reduced,
sales could increase by 25%. The following information is available:
Present Proposed
Selling price per unit R6 R5
Sales volume 100 000 units 25% more
Variable costs R400 000 Same unit variable cost
Fixed costs R140 000 R140 000
Net profit R60 000 ?
3.1 Calculate the expected total marginal income and profit or loss on the
marketing manager’s proposal.
3.2 Calculate the number of sales units required under the proposed price to
make a profit of R60 000.
3.3 Calculate the sales value required under the proposed price to make a
net profit of
R60 000.
Yashik CC manufactures one product. The following details relating to the

product applies:
Direct materials cost per unit R20
Direct labour cost per unit R30
Variable overheads per unit R22
Total fixed costs R36 000
Selling price per unit R82
Number of units sold 6 000
4.1 Calculate the marginal income ratio.
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4.2 Calculate the break-even quantity and break-even value.
4.3 Calculate the margin of safety, expressed as:

4.3.1 value
4.3.2 units.
5. Kivi (Pty) Ltd manufactures and sells only one product. The budgeted
details for 20.16 are as follows:
Sales 150 000 per month
Selling price per unit R3,00
Variable cost per unit R1,40
Total fixed costs R1 350 000
5.1 Calculate the total marginal income and budgeted net profit (loss) for
20.16.
5.2 Calculate the break-even quantity and value.
5.3.1 Suppose Kivi (Pty) Ltd wants to make provision for a 10% increase in
fixed costs and an increase in variable costs by R0,20 per unit. Taking these
increases into account, calculate the following:
New break-even quantity and value
5.3.2 Safety margin (as a percentage)
5.3.3 The number of units that need to be sold to earn a net profit of
R400 000.
6. Multi Vit Ltd has the following sales mix (fixed costs amount to R300 000):
Product Sales Variable cost Proportion
Vit A R600 000 R300 000 60%
Vit B R300 000 R150 000 30%
Vit C R100 000 R150 000 10%
R1 000 000 R600 000 100%
6.1 Calculate the total break-even value.
6.2 Calculate the break-even value for each product. (Assume that the selling
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price per unit of each product is the same)
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Think Point 5.1

According to Marx et al., (2017: 371), the classification of costs is fixed, variable or semi-variable.
Semi-variable cost has elements of both fixed and variable cost. An example would be maintenance
costs.
Activity 1
Think Point 5.2

According to Marx at el., (2017:349) the usefulness of the breakeven analysis is limited only by the
degree of validity of the following assumptions, which are constant throughout the normal range of
activity:
The variable cost per unit

The selling prices for products sold
The total fixed cost
The sales mix
The inventory levels
2.
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2.1
2.2
2.3
2.4
116
3.1
3.2
3.3
117
4.
4.1
4.2
4.3
118
4.3.1
4.3.2
5.1
5.2
119
5.3
5.3.1
5.3.2
OR
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5.3.3
6.
6.1
121
6.2
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Unit
6: Relevant Costs and Revenues for
Decision-Making
Unit 6: Relevant Costs and Revenues for Decision-Making
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6.1 Introduction
Decision-making involves choosing between alternatives. According to Cloete et al. (2014:94)
managers try to maximise profits by making optimum use of existing facilities through decision-
making. Short-term decisions are those that span over a period of no more than one year. In the
short term variable costs are relevant, as well as any part of the fixed costs that may change as a
consequence of the decision. The marginal costing statement is useful for making short-term
decisions because it categorises costs according to their behaviour. Circumstances often determine
the costs that are relevant to a particular decision.
6.2 Relevant Costs and Revenues

Cloete et al. (2014:94) distinguish between costs and revenues that have an impact on decision-
making. They consider the following to be relevant costs and revenue:
6.2.1 Discretionary fixed costs
These are considered to be relevant since they can be managed. Managers have a choice whether
to incur these costs again with immediate effect. Advertising, research and development are
examples of such costs.
6.2.2 Future costs and revenues
These are considered to be relevant since they are cash flows that arise from the decision
taken. They must be future cash flows i.e. they have not been previously incurred or earned.
6.2.3 Differential cost
A differential cost is the difference in the costs between the alternatives under consideration.
6.2.4 Opportunity cost
This refers to the possible revenue that is lost as a consequence of choosing one alternative over
another.
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Video Activity 6.1
Watch the video on “Opportunity Cost” and give cite an example when you
had to choose one alternative over another.
https://www.investopedia.com/terms/o/opportunitycost.asp
6.3 Irrelevant Costs

Cloete et al. (2014:99) describe irrelevant costs as costs that do not affect the decision at hand and
can therefore be excluded from the decision-making process. The following are examples of
irrelevant costs:
6.3.1 Sunk costs
These are past costs and any decision made now or in the future cannot change these costs. Since
they have already been incurred they are irrelevant to the decision at hand. For example, a company
purchased a machine a few years ago for R200 000. The machine was purchased to produce one of
the products in the product line. If the product is now discontinued, the R200 000 is considered to be
a sunk cost, since it represents the original cost of the machine which cannot be recovered. It is
irrelevant and is thus ignored in the decision-making process.
Think Point 6.1

What do you say is the different between Opportunity cost and Sunk Cost?
6.3.2 Common costs
These are costs that are present in both options and therefore, whether they are considered or not,
they will not affect the decision at hand. For example, Mary has to decide whether to drive her car to
work or use public transport. The car license is R800 for the year and is common to both
options. Whether she drives the car to work or not, she still has to purchase a license for it. The R800
is therefore considered irrelevant to the decision at hand.
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6.3.3 Committed costs
These are costs that will be incurred in the future, but are a consequence of a decision made in the
past and therefore cannot be changed by any decision made now or in the future. Whilst they may
be irrelevant in the short term, they may become relevant in the long term. For example, Mega
Manufacturers entered into a twelve-month contract with a raw material supplier. In terms of the
contract the supplier must supply 50 000 units at a cost of R4 per unit. The cost of R200 000 cannot
be avoided until the twelve-month period is over, and is thus considered irrelevant to any decisions at
hand.
6.3.4 Depreciation
Depreciation is a historical cost and is considered to be an irrelevant cost as it does not involve the
physical flow of cash. It is an accounting entry to spread the cost of an asset over its useful life.
6.3.5 Arbitrary allocated costs
These are organisational overheads that are allocated to products or divisions on an arbitrary basis
e.g. marketing and administrative costs. They are recovered from individual products or divisions on
bases such as floor space occupied, turnover generated etc. They are irrelevant because they will be
reallocated to the remaining products or divisions should one of them be discontinued or shut down.
6.4 Non-Financial Indicators

Whilst financial indicators focus on the monetary benefits that are derived from a decision taken,
non-financial indicators are non-quantifiable or qualitative factors that influence a decision to be
taken. Cloete et al. (2014:101) provide the following examples of non-financial indicators:
Employee morale
Quality of the product(s) produced
Long-term customer satisfaction
Legal considerations
Ethical considerations
Social responsibility
A final decision should only be taken after considering the impact of both the financial and non-
financial indicators.
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Activity 6.1
A final decision should only be taken after considering the impact of both the
financial and non-financial indicators. Critically discuss.
6.5 Types of Short-Term Decisions

According to Cloete et al. (2014:102) the decision rule for short-term decisions on the basis of
quantitative indicators is to choose the alternative that provides the highest contribution (marginal
income). However, the final decision is based on both financial and non-financial indicators.
Four types of short-term decisions, outlined by Cloete et al. (2014:102) are now examined.
6.5.1 Utilisation of a single constrained resource
A constraint may be defied as something that prevents an entity from meeting its sales demand and
thus affects the profitability of the entity. Examples of constraints include limited machine hours,
limited labour hours, limited raw materials, limited floor space etc.
Financial managers would seek the best possible way of utilising the constrained resource in order
to maximise profits. Fixed costs are usually not affected by such decisions.
Example 1
The following information relates to two products produced by Tabac Manufacturers:
The operating time for the assembly machine is limited to 60 000 hours.
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Required
Determine the product mix that will maximise profits and calculate the value of contribution that
would be earned.
Solution
The following four steps are recommended:
Step 1 Calculate the contribution per unit of each product based on the constrained resource.
Step 2 Rank the products in order based on the highest contribution per unit of the constrained
resource.
Step 3 Using the ranking in step 2, determine how the constrained resource will be utilised so that
the product mix will maximise profits.
Step 4 Calculate the total contribution generated from the sales mix that was determined in step 3.
Step 1
The contribution per unit of the constrained resource is R80 for Product A and R50 for product B,
calculated as follows
Step 2
Product A generates a higher contribution per machine hour and is thus ranked number 1, and
Product B would be ranked number 2.
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Product A makes the best use of the available machine hours and the company should thus first
spend the available machine hours producing Product A according to demand. The remaining
machine hours would then be used to manufacture Product B.
Step 3
After allocating 12 000 hours for Product A, 48 000 hours (60 000 – 12 000) is available for Product
B. Since each unit of Product B requires 7.5 hours of machine time, only 6 400 units (48 000 ÷ 7.5)
can be produced of the maximum sales demand of 16 000 units.
Step 4
The contribution that would be earned is calculated as follows:
Think Point 6.2

Refer to example 1 above. Suggest ways in which the capacity of the
machine can be increased.
6.5.2 Make or buy decision
This decision has to do with either making a component in-house or purchasing it from an external
supplier. There are two types of make or buy decisions:
Where the entity is operating below full capacity, and manufacturing the component in-house
would not displace existing production
Where the entity is operating at full capacity, and manufacturing the component in-house would
displace existing production
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Video Activity 6.1
Watch the video on “Make or buy decision” to expand you understanding of

this concept.
https://www.coursera.org/lecture/uva-darden-managerial-accounting/make-or-
buy-decision-fBHfI
Example 2 (The entity is operating below full capacity, and manufacturing the component in-
house would not displace existing production)
Style Manufacturers produce lady’s dresses. One of the components for the dress is a 25 centimetre
clothes zipper. At present the manufacturer is not working at full capacity and is thus able to
manufacture the zippers in-house. The special machine used to make the zippers has no salvage
value and cannot be used to manufacture other products. An expert supervisor has been hired
specifically to check on the processing of the zippers during the manufacturing process. The
following table shows the in-house costs related to the manufacture of the zippers:
An outside supplier has offered to supply Style Manufacturers with 15 000 zippers per month for the
next twelve months, at a unit cost of R3.10. If the company buys the zippers from the outside
supplier, the production capacity used at present will be idle.
Required
Based on the information provided above, should Style Manufacturers manufacture the zipper in-
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house or should it purchase it from the external supplier?

Explain the non-financial factors that should be considered before the final decision is taken.
Solution
Step 1
Carry out a differential cost analysis i.e. compare the differential cost to manufacture with the cost to
purchase.
All the variable manufacturing costs are relevant costs as they can be avoided if the zippers are
purchased from the outside supplier. The supervisor’s salary can also be avoided since he/she has
been hired specifically for checking the zippers.
Depreciation on the special machinery is a sunk cost and cannot be avoided. Allocated fixed costs
are common costs associated with all products produced by the company and cannot be avoided.
Step 2
Based on the financial indicators, the company should purchase the zippers from the outside
supplier as it would be cheaper. The company would save R72 000 per year or R6 000 per month or
R0.40 per unit.
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Step 3
The non-financial indicators must now be considered before a final decision is taken. These include
the following:
The ability of the supplier to maintain the quality of the zippers, as this would impact on the
reputation of the manufacturer’s main product
The ability of the supplier to deliver on time to ensure uninterrupted production of the dresses
Whether the supplier will increase the price after 12 months
The possibility of the supplier being taken over by a competitor, thereby restricting supply
The effect on employee morale if employees are retrenched
6.5.3 Special order decision
Special orders are once-off orders that are not part of the normal sales of an entity. These orders are
usually below the normal selling price and are often considered when an entity has surplus
production capacity. The entity can increase its profits by accepting such orders.
Special orders may also be considered if an entity is operating at full capacity. In this instance, the
additional costs required to expand the production facility to meet the special order requirements
must be taken into consideration, as well as any lost contribution from regular sales that may be
displaced by the special order.
Example 3
Discar Limited manufactures disc pads for motor cars. It currently produces 1 400 sets of disc pads
per month, which represents 70% of its production capacity. The total monthly costs for the
manufacture of the disc pads are R210 000, of which 60% are variable costs. Discar Limited
received an order from a motor car manufacturer to supply 500 sets of disc pads at a price of R120
per set. The normal selling price is R180 per set.
Required
Based on the information provided above, should the special order be accepted? Show the
relevant calculations.
Identify the non-financial indicators that should be considered before a final decision is taken
Solution
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Step 1: Determine whether sufficient surplus capacity is available
Sufficient capacity is available as the special order is for 500 sets.
Step 2: Determine incremental revenue and costs
Incremental revenue = R120 per unit
The incremental costs are the variable costs.
Total variable costs = R126 000 (R210 000 X 60%)
Variable costs per unit = R126 000 ÷ 1 400 = R90 per unit
Step 3: Carry out incremental analysis
Discar Limited should accept the special order based on the quantitative indicators, since profits
would increase by R15 000.
Step 4: Non-financial indicators that may impact on the decision
Does the special order make the best possible use of the surplus capacity?
If the demand for the product (at normal prices) increases shortly, will the company be able to
meet this demand, considering that the surplus capacity is tied up on the special order?
What impact will be selling the product at a lower price have, if the regular customers get to know
about it?
Is additional working capital available?
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6.5.4 Closure or deletion of a business segment
A business segment refers to a division or subdivision of a large entity that generates revenue,
thereby contributing towards the profitability of the entity. This type of decision examines the option
of closing down a non-profitable business segment. Deleting a business segment often occurs if it
fails to generate an acceptable return on capital in the long term. Closing down a business segment
may also be due to a change in the long-term goals of an entity e.g. rationalisation, in order to
concentrate on fewer sectors.
The manner in which fixed costs are allocated affects the profitability of a product line or department.
When the income statement is prepared using the absorption costing method (as is done in normal
reporting), it may result in a product line or department appearing to be unprofitable. However, when
the marginal costing format is used (see topic 6), one would get a much clearer indicator of whether
a department or product line is profitable or not. Allocated fixed costs are usually not avoidable even
if the product line or department is discontinued.
Example 4
Officepro Limited has three product lines viz. desks, seating and office accessories. The sales and
cost information for the previous month of each of the product lines are as follows:
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Required
Should the office accessories line, which appears to be making a loss, be dropped? Motivate
your answer
Identify the non-financial factors that should be considered before a final decision is taken
Solution
Step 1: Carry out a differential cost analysis i.e. compare the differential cost to manufacture
with the cost to purchase.
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Avoidable costs are salaries (assuming that the workers in this line are laid off), insurance and
advertising. The rest of the costs are unavoidable as they relate to the company as a whole. The
portion of these costs that have been apportioned to the accessories product line will continue
whether the line is dropped or not.
Step 2: Total avoidable costs versus contribution
OR
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The decision should be to retain the accessories line because dropping the line would reduce net
profit by R15 000.
Step 3: Non-financial indicators that may impact on the decision
Retrenchment of employees and the impact on employee morale

Impact on satisfying customer needs
The long-term impact of the decision on the entity
Impact on the sales of the other product lines

Ginalo Ltd manufactures two products viz. Product X and Product Y. Product
X requires 2.5 kg of raw materials and 4 labour hours, whilst product Y
requires 5 kg of the same raw material and 2 labour hours. Additional
information for the past period for these two products are:
Determine the product mix that will maximise profits and calculate the value of
contribution that would be earned under each of the following independent
circumstances:
1.1 Only 1 500 kg of raw materials are available
1.2 Only 1 250 labour hours are available
2. A division of Avi Ltd is negotiating with a supplier regarding outsourcing

component X that it manufactures. The division currently manufactures
10 000 units of the component annually. The costs currently assigned to
component X are as follows:
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The supplier has offered to supply 10 000 components per annum at a price
of R28 per unit for a minimum period of 3 years. If the company outsources
component X, fixed manufacturing overheads would be reduced by R10 000
per year but non-manufacturing costs would remain unchanged.
Required
Should the division of Avi Ltd make or buy the component?
3. Babycom Ltd manufactures walking rings for toddlers. The monthly

production during the past few months was 1 000 walking rings per month
which utilised 80% capacity. The company received an order to supply 240
walking rings at R82 each. The manufacturing costs per ring are provided
below:
Required
Advise the management of Babycom Ltd whether to accept the special order
or not.
4. Sevilla Ltd is considering rationalising its existing product lines in order to

improve profitability. The budgeted income statement for four product lines
for the past six months is as follows:
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If a product line is dropped, the fixed selling and administrative costs would
remain unchanged.
Required
Determine which product line(s) should be dropped in order to improve
profitability.
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Think Point 6.1

The difference between an opportunity cost and a sunk cost is the difference between money already
spent in the past and potential returns not earned in the future on an investment because the capital
was invested elsewhere
Activity 1
Think Point 6.2

Possible answers:
Run the machine longer at optimum running speed, by letting machine operators work overtime.
Train workers who are usually not required to use the machine, so that the machine is not idle.
Ensure that there are always sufficient material inventories to keep the machine going.
Reduce or minimise set-up time.
Focus on total quality management to reduce defective units.
Etc.

1.1 Raw materials constraint
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Only 50 units (250 ÷ 5) can be produced of Product Y.
1.2 Labour hours constraint
Only 62 units (250 ÷ 4 = 62.5) can be produced of Product Y.
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2.
The component should be made in-house as there would be a saving of R40 000 compared to
outsourcing.
3. 3. First, we check if surplus capacity is available:

1 000 = 80%
20% = 1 000 ÷ 80 X 20 = 250 units
Sufficient capacity is available to meet the special order of 240 units.
Incremental analysis
The special order should be rejected as it would result in a loss of R720.
4. The budgeted marginal costing statement for the product lines are as follows:
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The marginal costing format was used to determine whether a product line generated a positive or
negative contribution. Product line C should be dropped since it generated a negative contribution.
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Unit
7:
Capital Budgeting
Unit 7: Capital Budgeting
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University.

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7.1. Introduction
According to Marx and Swardt (2013:287) capital budgeting (also known as capital investment
analysis) is the process of evaluating and selecting long-term investments that contribute towards the
goal of increasing an entity’s value.
A capital expenditure may be described as an investment made by an entity that is expected to

generate benefits over a period exceeding one year. Since long-term investments require a large
outlay of cash, the cash flows generated from the investment are important.
Think Point 7.1

What do you think are the primary motives for capital expenditure?
7.2. Capital Budgeting Process

To ensure that money invested will be to the entity’s best advantage, procedures must be developed
to ensure that the investment opportunities are properly analysed. Marx and Swardt (2013:287)
suggest the following five distinct but interrelated steps to the capital budgeting process:
Proposal generation: Capital expenditure proposals may be made by people at all levels within
the entity. These proposals usually move from the originator to a higher level in the
entity. Relatively minor expenditures may be reviewed at the next organisational level whilst
major expenditure proposals are usually reviewed at a higher level.
Review and analysis: A review of the capital expenditure proposals are done to determine their
appropriateness to the entity’s overall objectives and plans. Their economic viability is also
evaluated. The techniques that may be used are explained in paragraph 4. The analysis is
submitted to management.
Decision making: The amount to be outlaid and the importance of the investment opportunity
determine the organisational level at which the decision is made. After studying the analysis at
the appropriate level of management, a decision is made whether to invest or not.
Implementation: After approval for the proposal is obtained and funding is made available, the
implementation phase commences. Implementation is usually routine for minor outlays. For major
expenditures, greater control is necessary to ensure that what has been approved is actually
acquired and at the budgeted cost.
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Control: The monitoring of costs during the operating phase of the project is important. Actual
outcomes in respect of costs and benefits are compared with those expected. When actual
outcomes are below those projected, remedial action may be required or at the worst case
scenario termination of the project may be required.
7.3. Types of Projects

An entity may be required to choose from a number of different projects. The type of project being
considered may have an influence on the decision-making approach to follow. Marx and Swardt
(2013:290) distinguish between two project types viz. independent and mutually exclusive projects.
Independent projects: are those projects whereby the acceptance of one does not preclude
others from being considered (so long as the firm has a great deal of funds available and the
minimum investment criteria are met). There is no competition between independent projects.
Mutually exclusive projects: are projects that serve the same function. The acceptance of one
project in a group of mutually exclusive projects prevents all the other projects from the group
from being chosen. For example, if an entity can achieve its goal of increasing production
capacity in three different ways, the three alternatives are considered to be mutually exclusive.
7.4. Capital Budgeting Techniques

Marx and Swardt (2013:303) state that the goal of a financial manager is to maximise shareholders’
wealth. This may be achieved by investing in assets or projects that will add value to the entity. Thus
the costs of each project must be compared to the benefits it is expected to generate. When it comes
to capital expenditure decisions, these costs and benefits extend over many years. They are known
as cash outflows and cash inflows respectively. Cash outflows include the initial cost of the project
and any increases in costs that are expected to be incurred as a result of the project over its
life. Cash inflows include cost savings and additional revenues and any proceeds from the sale of
assets that result from the project.
Several techniques may be used to analyse these cash flows. These include:
Payback period
Accounting rate of return (ARR)
Net present value (NPV)
Internal rate of return (IRR)
The application of these techniques will be discussed in Financial Management 2B.

The first two methods ignore the time value of money i.e. they assume that a Rand received in a
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future period has the same value as the Rand received in the current period. The last two methods
consider the effect of the time value of money. Marx and Swardt (2013:304) provide an overview of
the four capital budgeting techniques mentioned above.
Video Activity 7.1
Watch the video on Capital Budgeting and identify the two criteria that may be
used to evaluate an investment decision.
https://www.youtube.com/watch?v=vXmEppcJuiQ
7.5 Payback Period

The payback period of a capital investment proposal is the amount of time it would take to recover
the original investment. It is determined by calculating how long it would take to recover the initial
investment from the net cash inflows. No adjustment is made for the time value of money. This
means that a cash inflow in, for example, year 6 is treated in the same way as a cash inflow in year
1. Furthermore, the payback method ignores cash flows beyond the payback period.
Payback period is calculated as follows if the net cash inflows are the same each year:
Example 1
Polokwane Ltd obtained information in respect of two projects, one of which it intends choosing. The
following details are available:
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Required
Calculate the payback period of each project and recommend the project that should be chosen
based on the payback period.
Solution
According to the calculation above Polokwane Ltd should choose project N since it can recover the
cash outlay in a shorter time (2 years 1 month 26 days) than project M (3 years). However, the
project manager of Polokwane Ltd must also consider that project M will be able to generate an
income of R600 000 (R200 000 X 3) for 3 years after the payback period whereas project N will only
be able to generate an income of R520 800 (for 1,86 years) after the payback period.
When the cash inflows are not even, the payback formula stated above will not work. Instead, the
cash flows must be accumulated on a year-to-year basis until the accumulated amount equals the
initial investment. Consider the following example:
Example 2
Consider two projects whose cash inflows are not even. Assume that the project costs
R200 000. The net cash inflows for each year is as follows:
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Required
Calculate the payback period of each project and recommend the project that should be selected
based on the payback period.
Solution
Project C should be chosen since the payback period (2 years, 4 months and 24 days) is less than
that of project B (4 years).
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Think Point 7.2

Despite some serious shortcomings of the payback method, it is widely
used in practice. Why do you think this is the case?
7.6 Accounting Rate of Return (ARR)

When this technique is used, calculations are made from accounting data. The focus of the
accounting rate of return is on the incremental profit that results from a project.
The Accounting Rate of Return (ARR) on an investment project is calculated as follows:
Average annual profit is calculated by adding the profits expected for each year of the project’s life
and dividing it by the total number of years. The average investment is calculated by adding the
initial investment to the scrap value (value at the end of the useful life) and then dividing by 2.
Using the ARR method, the project that is expected to realise a higher rate of return is chosen.
Example 3
Use the figures from Example 1 to calculate the Accounting Rate of Return for each project.
Solution
In calculating the average annual profit, depreciation is deducted from the annual net cash inflow
(Project M: R200 000 – R100 000 = R100 000). Using ARR, project N gives a higher rate of return
and appears to be a better investment. The average investment is calculated as follows:
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The advantage of the ARR method is that it is easy to calculate and it recognises profitability. Unlike
the payback method, it considers the entire life of the project. However, it does not take into account
the time value of money. Furthermore it uses accounting data instead of cash flow data.
7.7 Net Present Value (NPV)

Experience with money has taught us that R100 in cash today is not equivalent to R100 in cash in
one year, two years or five years’ time. We would rather receive R100 today than accept a promise to
receive R100 in a year’s time. There are several reasons for this. Suppose you received R100 today
and invested it at, say, 10% interest. In a year’s time you would receive R110. Secondly, there is an
element of risk. Lastly, one must consider the effects of inflation.
It is incorrect to simply add together cash flows that extend over several years if one wishes to
assess the future benefits of an investment opportunity. The appropriate approach is to use
discounted cash flow analysis, which takes into account the time value of money. The cash flows of
future years must be discounted to make them equivalent to those of the current year. The net
present value method and the internal rate of return method (discussed in paragraph 7.4) are two
widely used methods of discounted cash flow analysis.
One should follow the following steps to complete a net present value analysis of an investment
proposal:
Prepare a table showing the cash flows during each year of the proposed investment.
Using the required rate of return, calculate the present value of each cash flow. (Note: The
required rate of return, also called discount rate or hurdle rate, is the minimum acceptable rate of
return on investments. It usually reflects the firm’s cost of capital.) Present value tables that
appear at the end of this chapter may be used. Table 1 shows the present value of R1 at various
interest rates receivable after n years (n can represent any number). Table 2 shows the present
value of R1 at various interest rates receivable annually for n years.
Calculate the Net Present Value (NPV) which is the difference between the present values of the
projected cash inflows and the present value of the cash outflows.
If the NPV is positive, the project may be accepted on financial grounds. The higher the NPV, the
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more acceptable the project is. If the NPV is negative, the project is rejected since it would not
add value to the entity.
Example 4
Excel Ltd has a choice of two projects to invest in. The following details relate to these projects:
Required
Use the net present value method to determine which project Excel Ltd should invest in.
Solution
Project A
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Project B
Decision: Project A should be chosen since it has a higher(positive) net present value and will add
greater value to the entity.
7.8 Internal Rate of Return (IRR)

A project’s internal rate of return (or time-adjusted rate of return) as the actual economic return
earned by a project over its life. Another way of stating this is that a project’s internal rate of return
(IRR) is the discount rate at which the present value of the projected cash inflows equals the present
value of the cash outflows; therefore the IRR is the discount rate that makes the NPV of the cash
flows equal to zero.
A project is acceptable only if the IRR exceeds the required rate of return. The advantage of the IRR
method is that it considers the time value of money and is therefore more realistic than the
accounting rate of return (ARR). However, the calculation can be difficult especially when the cash
flows are not even.
When the cash flows are not even, the trial-and-error method (interpolation) for calculating IRR may
156
be summarised as follows:
Calculate the NPV at the cost of capital rate

Check if the NPV is positive or negative
If the NPV is positive, then pick another rate higher than the cost of capital rate. (If the NPV is
negative, pick a smaller rate.) The correct IRR is the one at which the NPV = 0 and lies
somewhere between two rates, with one rate indicating a positive NPV and the other rate
showing a negative NPV. (They should be consecutive rates e.g. 19% and 20%)
Use interpolation to calculate the exact rate
Example 5
Use the information in Example 4 and determine which project should be selected using the internal
rate of return.
Solution
Project A
Step 1
We notice that the NPV is positive, and is far away from zero.
Step 2
We now pick a higher rate e.g. 19%. (Trial-and-error is used to obtain the higher rate)
157
Step 3
Interpolation:
The IRR is between 19% and 20%.
Project B
Step 1
We notice that the NPV is positive, and also far from zero.
Step 2
We now pick a higher rate e.g. 16%. (Trial-and-error is used to obtain this rate)
158
Step 3
Interpolation:
Decision: Project A should be chosen since the IRR is greater
Think Point 7.3

What advantages do you think that the net present value method has over
the internal rate of return method?
159
Revision Questions
1. An investment has the following cash flows, with no scrap value expected:
Required
1.1 Calculate the following:
1.1.1 Payback Period.
1.1.2 Net Present Value (NPV) at the cost of capital of 12%.
1.1.3 Accounting Rate of Return (ARR). (Assume that depreciation is R12 000
per year)
1.2 Must the investment be considered positively or negatively? Give reasons
for your answer.
2. The financial manager at Rico Ltd had to choose between these two
projects, Alpha and Beta, each with an initial investment of R117 700. The
after-tax cash inflows are as follows:
Required
2.1 Calculate the Payback Period for each project. Which project would you
160
choose? Why?
2.2 Calculate the Net Present Value (NPV) for each project, using a discount
rate of 12%. Which project would you choose? Why?
2.3 Calculate the Internal Rate of Return (IRR) for both projects. Which
project should be chosen? Why?
1.3 Be-Active Manufacturers produces gym equipment. The firm is
considering producing one of two possible new products: either rowing
machines or treadmills. They will need to purchase new machinery to
manufacture these items. Each machine will require an investment of R600
000. Both machines will have a useful life of 5 years with no residual value.
The expected cash inflows and cash outflows from the two investment
opportunities are as follows:
Required
1.3.1 Calculate the Payback Period for the Treadmill machinery (Answer
expressed in years, months and days).
1.3.2 Calculate the Internal Rate of Return for the Rowing machinery.
161
TABLE 1
Present value of R1: PVFA (k,n) =
TABLE 2
Present value of a regular annuity of R1 per period for n periods : PVFA (k,n) =
162
Think Point 7.1

According to Marx et al. (2019:274) the primary motives for capital expenditure are:
Expansion
The need to expand the level of operations is probably the most common motive for capital
expenditure and this is typically achieved by acquiring non-current assets.
Replacement
The replacement decision is common in more mature businesses. The firm’s management
periodically examines the need to replace existing assets. Each time a machine requires a major
repair, the outlay for the repair must be evaluated in terms of the outlay to replace it and the benefits
of replacement.
Renewal
The renewal of existing assets is sometimes an alternative to replacement. Businesses wishing to
increase efficiency may find that replacing or renewing existing pieces of machinery may prove to be
the optimum solution.
Think Point 7.2

The payback period is easy to calculate and understand compared to discounted cash flow methods.
It provides a tool for roughly screening investment proposals.
If a firm is experiencing a shortage of cash, it may be critical to choose investment projects that
recoup the initial investment quickly.
The payback technique provides some insight into the risks of a project. The further into the future
the cash flows are expected to occur, the greater the level of uncertainty.
Think Point 7.3

It is easier to calculate a project’s NPV than its IRR.
One can adjust for risk when using the NPV method by using a higher discount rate for later cash
flows.
NPV always yields one answer. When cash flows change from positive to negative over the life of a
project, more than one IRR can be calculated for the one project.
163
9.1.1.1
164
9.1.1.2
9.1.1.3
165
Workings:
9.1.2 The investment should be considered positively because:

The payback period is only 3½ years.
The net present value (R8 157) is positive.
The accounting rate of return (26,67%) is higher than the cost of capital (12%).
9.2.1 Project Alpha
166
Project Beta should be chosen since the payback period (3 years, 3 months and 8 days) is less than
that of Project Alpha (3 years, 6 months and 5 days).
167
9.2.2 Project Alpha
Project Beta
9.2.3 Project Alpha

Step 1: We notice that the NPV is positive, and above zero, but not by a large margin.
Step 2: We now pick a higher rate e.g. 13%. (Trial-and-error is used to obtain the higher rate).
168
Step 3: Interpolation:
Project Beta
Step 1: We notice that the NPV is negative.
Step 2: We now pick a lower rate e.g. 9%. (Trial-and-error is used to obtain the higher rate).
169
Step 3: Interpolation:
Decision: Project Alpha should be chosen as the IRR is greater.
9.3.1
170
9.3.2
Internal Rate of Return : Rowing Machinery
171
Answers to Revision Questions
Unit 1
Unit 2
Unit 3
According to Marx et al. (2017:188), the reasons for using trade credit are Costs. The price a
supplier charges for goods must eventually cover all its costs, including the costs of its credit
department. Since suppliers bury the credit cost in the price, purchasers pay something extra to use
credit only if they fail to take any cash discounts offered. If a purchaser could find a supplier who was
willing to lower the price for an immediate cash payment, the purchaser could avoid this concealed
charge for trade credit. As this is not ordinarily possible, purchases are financed through trade credit
at ‘no cost’ to the purchaser.
Further, as the supplier does not levy a specific additional charge for trade credit, it also follows that
there is no additional cost attached to using trade credit to the fullest extent.
If the purchaser is buying goods on credit, using the full period of the cash discount is economical, or,
if the supplier allows no cash discount, the full period of net credit terms.
If the purchaser is buying on terms of net 30, the price is the same whether payment is made on the
5th or the 30th day. The purchaser pays nothing extra to use the supplier’s money for the additional
25 days. Indeed, it adds nothing to the purchaser’s costs at the time not to pay the bill promptly and
to use the supplier’s credit for 45 days.
However, this misuse of trade credit may make it difficult for a firm to secure credit elsewhere, not
only from other suppliers, but from banks and other lenders as well.
Consequently, failure to pay bills on time may raise a firm’s long-term cost.
172
Convenience. It takes very little effort to get into debt when using trade credit. Customarily, there are
no formal applications to fill in, no notes to sign and no rigid repayment dates.
If a firm fails to meet a payment on a promissory note to the bank, it may be forced into bankruptcy. If,
on the other hand, it is occasionally a little late in paying a supplier, this does little or no harm to its
credit reputation.
Flexibility. Trade credit is useful because a firm can use it when it needs to do so. Accumulation of
inventory to meet a seasonal bulge in sales is financed in part by an automatic swelling of trade
credit. Then as the business enters the selling season, it can gradually reduce its accounts payable
from collections on its own accounts receivable.
In contrast, a loan secured by a mortgage on plant and equipment cannot be changed day by day to
match seasonal movements in inventory. Since trade credit relates directly to inventory and sales, it
provides an element of flexibility needed in a firm’s sources of funds. Trade credit also contributes to
the flexibility of the firm’s financing in another sense. Because trade creditors seldom ask a business
to pledge assets to secure its debts, the use of trade credit leaves its assets unencumbered. The firm
can then seek additional funds elsewhere and can offer some of its assets as security. This freedom
is limited, however. If the firm attempts to secure additional funds by pledging to others a substantial
portion of its most valuable and liquid assets, suppliers may request that they be equally well
secured
Unit 4
Hybrid financing – preference shares

Preference shares are a hybrid form of financing, in the sense that they have characteristics of both
debt and equity financing.
Preference shares, as the name suggests, give the owner a preferential claim on the earnings and
assets of the firm above ordinary shareholders. The dividend on a preference share is limited to a
fixed percentage of the face value of the share. Similar to ordinary shares, the preference dividend is
paid from the earnings after tax (net income), which means there are no tax benefits as would be the
case with interest payments on loans.
Cumulative preference shares place an additional burden on a firm. The reason for this is that even if
173
the firm has insufficient funds to pay the current dividend at a later date, it will have to pay the
amount of this dividend plus any future dividend to its preference shareholders.
The nominal rate for preference dividends is sometimes also linked (that is, two-thirds or 70%) to the
POR. However, preference-share financing tends to be expensive because of the non-tax
deductibility of the dividend. For this extra cost, the firm has freedom from the fixed interest
commitment without relinquishing any control, since preference shares normally carry no voting
rights.
Preference shares may be redeemable; in other words, the firm may recall these shares, refund the
investors and discontinue the shares by cancelling them. This results in a reinvestment risk for the
holders of these preference shares. Normally redeemable preference shares are more similar to
debt financing than to equity financing. (Marx et al., 2017:34)
Unit 5
Unit 6
174
Bibliography
Bartlett, G., Beech, G., de Hart, F., de Jager, P., de Lange, J., Erasmus, P., Hefer, J., Madiba, T.,
Middelberg, S., Plant, G., Streng, J., Thayser, D. and van Rooyen, S. (2014) Financial
Management : Turning theory into practice. 1stEdition. Cape Town: Oxford University Press
Southern Africa (Pty) Ltd.
Cloete, M., Dikgole, I., du Toit, E., Fouché and Sinclair, C. (2014) Cost and Management
Accounting. 1stEdition. Cape Town: Juta and Company Ltd.
Conradie, W.M. and Fourie, C.M.W. (2013) Basic Financial Management. 1stEdition. Cape Town:
Juta and Company Ltd.
Gitman, L.J., Smith, M.B., Hall, J., Makina, D., Malan, M., Marx, J, Mestry, R., Ngwenya, S. and
Strydom, B. (2014) Principles of Managerial Finance. 2nd Edition. Cape Town: Pearson
Education.
Marx, J. and Swardt, C. de (2014) Financial Management in Southern Africa. 4th Edition. Cape
Town : Pearson Education (Pty) Ltd.
Sinclair C, dv Toit E, Steyn F, Fouche G Cloete M (2017) Cost and Management Accounting:
Operations and Management – A Southern African Approach. Cape Town: Juta.
175
176

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INTRODUCTION TO FINANCIAL MANAGEMENT (20

Higher Certificate in Accounting

Higher Certificate in Events Management

It is a great pleasure to welcome you to Introduction to Financial Management (IFM520). To make

We hope you enjoy the module.

C. Learning Outcomes and Associated Assessment Criteria of the Module

D. How to Use this Module

The prescribed and recommended textbooks/readings for this module are:

Management. Third Edition. Juta and Company Ltd.

Special Feature Icon Description

The Learning Outcomes indicate what aspects of the particular

The Associated Assessment Criteria is the evaluation of student

A think point asks you to stop and think about an issue.

You may come across knowledge check questions at the end of

You may come across self-assessment questions that test your

Case studies are included in different sections in this module

VIDEO You may come across links to videos as well as instructions on

Unit 1: Financial Management Important Concepts

Unit Learning Outcomes

Prescribed and Recommended Textbooks/Readings

Conradie, W., Fourie, M.W., and Pellissier, R. (2022) Basic Financial

Think Point 1.1

1.2 Financial Function

The financial function is concerned with the following:

The acquisition of funds (financing)

Practical Application or Examples 1.1

• Ensuring that all financial transactions are recorded accurately and

1.3 Financial Management

Making investment decisions

Think Point 1.2

1.4 Goals of Financial Management

Investing in assets that will add value to the entity

1.5 Important Concepts in Financial Management

Capital may be classified as follows:

Short-term capital: is capital usually available for a period of up to a year

Capital may be obtained from the following sources:

Own capital: is capital provided by the owner(s) of the enterprise

Think Point 1.3

1.5.2 Money market and capital market

1.5.3 Financial statements

1.5.4 Financial structure

The financial structure of an enterprise is graphically illustrated in the form of a Statement of

Think Point 1.4

Case Study 1.1

Knowledge Check Questions 1.1

1.The resources that are controlled by an enterprise from

8.The use of capital to acquire non-current assets to be

I. Fina 9.The various ways by which an enterprise obtains its

J. Liqui 10.The measure of the ability of an enterprise to have

K. Solv 11.The ability of an enterprise to be able to repay its debts

2. What are the main functions of a financial manager?

3. Differentiate between the long-term and short-term goals of financial

4.Briefly state the function of each of the following financial statements.

Statement of Comprehensive Income

Statement of Changes in Equity

Statement of Cash Flows

Think Point 1.1

Think Point 1.2

Think Point 1.3