Budgeting

Budgeting is the process of preparing a financial plan for a business by preparing reports that estimate or predict the
financial consequences of likely future transactions.

Budgets Actual (historical)

Report future events Report historical events
Use estimates or predictions Uses actual verifiable data (for most)

Budget process must be continuous and flexible. They are not perfect, as they are only predictions of future events.

Importance of Sales Budget

1) Main revenue item and cash flow

- Cash sales
- Receipts from Debtors
- Sales Revenue
2) Estimating expenses which vary with number of units sold
- Cost of Goods Sold
- Wages
- Corresponding cash outflows
3) Estimating number of stock purchases
- Stock Control
- Creditors Control
- Payments to Creditors
- Cash Purchases of Stock
Budgeted Cash Flow Statement
Budgeted Cash Flow Statement
Budgeted Profit and Loss Statement
Budgeted Profit and Loss Statement
Budgeted Profit and Loss Statement
Budgeted Cash Flow Statement
Budgeted Balance Sheet
Budgeted Balance Sheet
Budgeted Cash Flow Statement
Budgeted Cash Flow Statement

Role of Budgeting

1) Assists planning by predicting what is likely to occur in the future. This allows the owner to prepare for what is
likely to occur so that possible problems may be managed and possible opportunities may be taken
2) Aids decision making by providing a benchmark/yardstick/standard against which actual performance can be
measured. This allows the owner to identify areas in which performance is unsatisfactory, so that remedial
action can be taken (this can include budgeted ratios and other indicators of performance).
Budgeting process

Budgeted reports
predicts what is likely
to occur

Actual reports
Decisions
prepared to detail
made to improve
what has happened
performance for
in the current
the next period
period

Variance reports
prepared to highlight
differences/problem
areas

Budgeted reports
Budgeted Cash Flow Statement
Budgeted Cash Flow Statement is an accounting report that shows estimates of cash receipts and cash payments, and
an estimated bank balance, at a particular point in time in the future.

Cash flow is the lifeline of a small business as they cannot function without it. It shows the business’s ability to meet
debt obligations over the budget period. It is crucial to know the expected cash situation of the business in the
forthcoming months, as many businesses purchase stock on credit over 30 or 60 day terms.

Many forecasts are quite straight-forward but the most difficult is the cash proceeds from sales. To make forecasts,
management ensures that all relevant information is available before sales estimates are finalised. An informed
decision is more likely to result in an accurate budget than one based on guesswork because of a lack of information.
Such information include:
 Likelihood to continue trading as successfully
 Plan to sell same stock lines or experimenting
 Any general or local competitors in the market (any new)
 External factors (government decisions, state of economy, environmental factors)
 Population changes (demographics, e.g. more aging)
 Technology (new ones), keeping up with new trends
 Ability to cope with expected demand
Not all credit sales are excluded from the Budgeted Cash Flow Statement. Schedule of collections is a table used by
businesses (that sell stock on credit to help predict cash inflows from debtors by identifying how much percentage pay
in the first month, second, and so on. Similarly, schedule of payments is a table used by businesses (that purchase
stock on credit) to help predict cash outflows to creditors. In both tables, you must deduct discounts from amounts.

For a Budgeted Cash Flow Statement of a quarter, the format of showing all three months separately is preferable to
simply adding up all receipts and payments for the quarter and resenting them as one figure, as this allows
management to calculate an estimated cash balance at the end of each month.

Operating activities, ideally, must be positive. This area shows the movements of cash in and out of the business that
result from the provision of goods and services in the day-to-day operations of the business. This area shows the
ability to meet ongoing obligations. When budgeted as negative, users can use this forewarning to address the
problem before it hits. This can be done in two ways:
1) Strategies to increase expected inflows
- Increasing sales: promotions, greater advertising, discounting prices
- Increasing receipts from debtors: offering discounts, contacting slow payers, reminder notices
2) Strategies to decrease expected outflows
- Deferring payments to creditors
- Cutting back cash paid for expenses: must be careful as some expenses are vital for earning sales
(hence the generation of cash inflows), and cutting theses may actually worsen the cash situation
rather than improving it

Consecutive budgets allow identification of monthly and seasonal trends, which can help in deciding when to
undertake a particular cash activity (such as cash purchase of non-current assets or repayment of a loan).

Planning

This report allows the users to predict a cash surplus or deficit. The may react to either by following:
1) In case of budgeted overall cash deficit:
- Defer the purchase of non-current assets, or use credit facilities or a loan for their purchase
- Leasing non-current assets rather than purchasing it
- Defer loan repayments
- Make a cash capital contribution
- Organise (or extend) an overdraft facility
- Cut back on personal cash drawings
- Reducing/postponing the payment of expenses
2) In case of budgeted overall cash surplus:
- Purchase more/newer non-current assets [expansion]
- Purchase stock on cash for discounts
- Increase loan repayments
- Increase cash drawings
- Expand trading activities by increasing advertising, employees and etc.
- if started with an overdraft, do nothing and let the cash budget bring balance to positive
Decision making

This report provides a benchmark (target/goal to motivate staff and management) for the assessment of the
business’s actual cash performance. By comparing it to actual cash flows, the users can identify problem areas, and
then act to correct the situation. They could assess:
 Debtor collection procedures
 Creditor payment policies
 Level of cash drawings

Budgeted Profit and Loss Statement

Budgeted Profit and Loss Statement is an accounting report that shows estimates of revenues, expenses and thus
profit over a specific period of time in the future.

Budgeted net profit equals revenue expected to be earned during the budget period minus expenses expected to be
incurred in that period.

Planning

This report assist planning because it indicates the future requirements of the firm relating to issues like staffing
(hiring/firing/wages), stock levels, or advertising campaigns.

If the result predicted by the budget fit in with management’s overall objectives, the budget should be adopted and
put into action. If it is seen as unsatisfactory, it should be reviewed and changes introduced until management is
happy with the goals contained in the budget. This is possible as a budget is a workable document that is based on
attainable goals.

Decision making

This report provides a benchmark for measuring actual performance. The users can assess:
 The level of sales (and the effectiveness of advertising)
 The mark-up achieved
 The level of stock loss (to assess stock management procedures)
 Expense control
 Staff performance

Vertical analysis of Profit and Loss Statement

Vertical analysis is a report that expresses every item as a percentage of a base figure (in this case, Sales revenue).
Such analysis helps with expenses control, as the users can identify and highlight increases in expenses, not just in
amounts, but also as a percentage of sales. Such reports that use percentages rather than dollar values to allow easier
comparison of results are called common size statements.
Budgeted Balance Sheet
Budgeted Balance Sheet is an accounting report that shows estimates of assets, liabilities and owner’s equity at a
specific date in the future.

Planning

It is used for:
 Reporting the future situation of non-current assets [capital spending]
 Examining the future liquidity position of the business
 Evaluating the gearing in the future [reliance on borrowed funds]
 Shows future details about owner’s equity, including future net profits and drawings
 The expected carrying value of non-current assets helps preparation of their replacement
 When used in conjunction with Budgeted Cash Flow Statement, it can be used to control loan repayments and
cash drawings.

Decision making

This report provides a benchmark for indicators that assess liquidity and stability [beyond VCE course]. It can also be
used to calculate the budgeted Working Capital ratio, which can then be used to assess liquidity. Comparison of
Budgeted Balance Sheet and historical Balance Sheet allows management to identify the key changes that are
expected to occur in the budget period.

Performance evaluation
Analysing is the examination of the financial reports in detail to identify changes or differences in performance

Interpreting is the examination of the relationships between the items in the financial reports in order to explain the
cause and effect of changes or differences in performance.

Trend analysis

Trend analysis is measuring the change in a financial item or a ratio over several reporting periods. Trend is the
pattern formed by changes in an item over a number of periods. This information is often presented as line or bar
graphs to satisfy Understandability.

Horizontal analysis

Horizontal analysis is the comparison of reports from one reporting period to the next, and identifying the increase or
decrease in specific items in the report.
Variance

Variance is the difference between an actual figure and a budgeted figure. It is expressed in dollar terms or in
percentages. There are two types of variances:
1) Favourable variance (a.k.a. positive variance) is a situation in which the actual result is better than the result
predicted in the budget
2) Unfavourable variance (a.k.a. negative variance) is a situation in which the actual result is worse than the
result predicted in the budget

If a budget contains too many variances, management should attempt to find explanations for these and make
adjustments in its future planning. For example, an unexpected event (e.g. bad debts) should be noted for future
budgets.

Actions are often necessary to ensure budgets can be met. Therefore, even when a budget is prepared for a quarterly
period, it should be reviewed after each month. If results are not as expected, decisions must be made to get the plan
back in line with that outlined in the budget.

If reports are prepared quarterly, ideally, at the end of each month, a budget variance report should be prepared an
then a new quarterly budgeted report should be prepared. This achieves the goal of budgeting as an ongoing process
that involves future planning which is continuously updated.

Variance report (a.k.a. performance report) is an accounting report that is used to compare a business’s budget
predictions with the actual results achieved. It is prepared to show variances between a budgeted report and the
actual report. These reports are invaluable tools for assessing profitability because they draw attention to areas in
which performance has been below expectation.

Benchmark

Benchmark is an acceptable standard against which the firm’s actual performance can be assessed. These may
include:
 Performance in previous periods allows for the preparation of a horizontal analysis and identification of trends.
Using this benchmark enables an assessment of whether profitability has improved or deteriorated from one
period to the next.
 Budgeted performance for the current period allows for the preparation of a variance report, and enables an
assessment of whether profitability was satisfactory or unsatisfactory in terms of meeting the firm’s goals and
expectations.
 Performance of other similar firms is sometimes expressed as an ‘industry average’. It allows the firm’s
performance to be compared against other firms operating under similar conditions (this is sometimes known
as an ‘inter-firm comparison’)
Profitability
Profitability is the ability of the business to earn profit, as measured by comparing against such as sales, assets or
owner’s equity.

A business’s ability to earn profit is dependent on its ability to earn revenue and control expenses. Consequentially,
any assessment of profitability must examine the firm’s performance in these two areas, with an analysis of the Profit
and Loss Statement a logical starting point. This assessment must not be based on the dollar terms only, as there are
many factors affecting the ability to earn revenue and control expenses, and these factors’ significance must be
considered when assessing profitability. Profitability is a relative measure, as it does not just consider the level of
profit, but its comparison with another base (e.g. assets and owner’s equity).

Strategies to improve profitability

Earn Revenue
Earning revenue is heavily dependent on the firm’s efficiency as shown in the efficiency ratios. To improve this, a
business may change its:
1) Selling price
Decreased selling price could generate greater sales revenue, while increased selling price could generate
greater revenue and gross profit per sale.
2) Selling price
Increased, or targeted more accurately at prospective customers (market niche)
3) Stock mix
Slow-moving stock must be replaced with fat-moving ones
4) Non-current assets
More, or more efficient non-current assets may enable the firm to generate more revenue
5) Customer service
Customer-friendly, staff training, after service, extra services, etc.

Controlling Expenses
A firm must have the ability to manage its expenses so that they either decrease, or in the case of variable expenses,
increase no faster than sales revenue. It must be acknowledged that an increase in revenue will rarely happen without
an increase in expense. However, if theses expense increases overtake the increases in revenue, we will in fact
experience a decrease in net profit. Thus, we need to evaluate expenses control, and this is achieved through the
three profitability indicators: Net Profit Rate, Gross Profit Rate, and Adjusted Gross Profit Rate.

To improve this, a business may change its:

1) Management of stock
Alternative supplier may provide cheaper and/or better quality stock, while different ordering procedures
could reduce storage costs and stock losses, or generate price discount
2) Management of staff
Different rostering systems, appropriate incentives, and extra training may improve staff productivity and
performance.
3) Management of non-current assets
Inefficient, under-utilised or unreliable assets are ultimately expensive, and should be replaced or removed.

Advices that may be right for a similar business may not be for another. Therefore, there is no “must” but
“recommendations”.
Analytical ratios
Analytical ratio is a comparison of two items that are somehow related in order to analyze an aspect of business
performance.

Ratios are usually compared to benchmarks, or tools used to measure performance by comparing financial results in
some established criteria. This is to measure how the business performed compared to:
 Previous reporting periods (for trend)
 Industry averages, or similar businesses
 Budget estimates, or predicted results (level of performance defined by budgets)
 Alternative investments

Profitability
Return on Owner’s Investment

Net Profit
Average Owner ′ s Equity

Measurement: percentages

Definition
Return on Owner’s Investment is a profitability indicator that measures how effectively a business has used Owner’s
Equity to earn profit by calculating the net profit as a percentage of average owner’s equity during the reporting
period.

Notes
Return on Owner’s Equity is from an investor’s point of view. Given the risk that comes with running a business, the
owner will expect a higher ROI than alternative investments. For this reason, the ROI must be comparable with
interest on term deposit, dividends on shares and etc.

Limitations
An increase in Return on Owner’s Investments does not always mean a favourable outcome. It may simply mean that
the owner is investing less in the business and not mean that net profit has increased.

Changes
Increased by:
Increase in Achieved through:
Net Profit  Increase in sales
 Decrease expenses
 Others as outlined under “Strategies to improve profitability”
Decrease in Achieved through:
Average Owner’s Equity  Cut down of capital contribution
 More drawings

In such cases of reduction in OE increasing the ROI, this will lead to higher gearing
(percentage of a firm’s assets that are financed by its liabilities). This means there is a
higher risk of the business becoming unable to repay its debts and meet the interest
payments

An optimal condition would have a gearing high enough to maximise the ROI, without
sending the business into difficulties in relation to its debt burden.

Return on Assets

Net Profit
Average Total Assets

Measurement: percentages

Definition
Return on Assets is a profitability indicator that measures how effectively a business has used Owner’s Equity to earn
profit by calculating the net profit as a percentage of average total assets during the reporting period.

Notes
It is always lower than the Return on Owner’s Investment, because the average owner’s equity is always lower than
average total assets, except in extreme cases where they are equal. The difference between the two is dependent on
the firm’s gearing.

Average Total Assets do not change significantly unless unexpected events occur. Therefore, an increase in Return on
Assets is most likely to be caused by an increase in Net Profit.

Changes
Increased by:
Increase in Achieved through:
Net Profit  Increase in sales
 Decrease expenses
 Others as outlined under “Strategies to improve profitability”
Decrease in Achieved through:
Average Total Assets  Selling of high-value assets (eg. Premises) and withdrawing the amount or
repaying debts
 Rent instead of purchasing NCAs
 Big repayment of large loans
 Liquidation of the business by external equities
Net Profit Rate

Net Profit
Sales

Measurement: percentages

Definition
Net Profit Rate is a profitability indicator that measures the firm’s control over expenses by calculating the percentage
of sales revenue that is retained as net profit.

Notes

Limitations
Net Profit Ratio may be increased by a cut down in expenses which may decrease Sales (but not as much as the
decrease in expenses). This may appear favourable, but in dollar terms, the business may be earning less net profit
than previously.

Changes
Increased by:
Increase in Achieved through:
Net Profit  Decreasing expenses
 Others as outlined under “Controlling Expenses” in “Strategies to improve
profitability”
Decrease in Does not work, as a decrease in sales would decrease the net profit
Sales

Gross Profit Rate

Gross Profit
Sales

Measurement: percentages

Definition
Gross Profit Rate is a profitability indicator that measures the average mark-up by calculating the percentage of sales
revenue that is retained as Gross Profit.

Notes
It allows users to assess the adequacy of the mark-up to see if it is large enough to cover other expenses, and thus
shows whether the mark-up is to blame for a lower Net Profit Rate.

Limitations
Higher GPR always indicates a higher average mark-up on sales. Increase in GPR does not always mean a good thing.
An increase in GPR can occur with a decrease in Sales:
 Increased selling prices may lower demand
 Buying from a cheaper supplier may result in poorer quality goods and thus higher Sales Returns, which reduce
sales and customer satisfaction, also affecting future sales

In both cases gross profit per item increases but gross profit as a whole (in dollar terms) decreases.
Changes
Increased by:
Increase in Achieved through:
Mark-up  Increasing the selling price
 Decreasing the cost of goods sold
o Buying from a cheaper supplier with similar quality
o Taking advantage of bulk pricing (if possible)
Decrease in Does not work, as a decrease in sales would decrease the net profit
Sales

Liquidity
Working Capital Ratio

Current Assets
Current Liabilities

Measurement: ratio of x:1

Definition
Working Capital Ratio is a liquidity indicator that measures the ratio of current assets to current liabilities, to assess
the business’s ability to meet its short-term debt obligations.

Notes
A satisfactory liquidity would exist if the Working Capital Ratio was at least 1:1. This would indicate that there is at
least $1 of Current Assets to repay every $1 of Current Liabilities. However, a WCR of 1:1 is still not very satisfactory,
as it leaves no margin for error.

There is a problem with liquidity if:

 WCR is lower than 1:1
The business will have difficulties meeting its debts as they fall due. This may for them to go through
liquidation (selling of its assets for immediate cash). In order to survive, the owner may need to:
- Make a (cash) capital contribution
- Seek additional finance by entering into (or extending) an overdraft facility
- Take out a long-term loan

 WCR is much greater than 1:1

Although this may mean that there is little liquidity problems, it is still a problem. Such high WCR may be the
cause of idle assets. Problems in having idle assets are:
- Cash at Bank: - little interest is paid out in business accounts
- Stock Control: - additional storage costs
- greater chance of stock loss, damage, obsolescence and thus stock write
downs.
- Debtors Control: - debtors may be “ageing”, meaning they are likely to be written off as bad
debts later on

Possible solutions to such issues are:

- Using excess cash to repay debts, purchasing NCAs or drawings
- Allowing stock to run down before re-ordering (adopt Just-In-Time ordering method)
- Contact debtors to collect amounts outstanding
Changes
Increased by:
Increase in Achieved through:
Current Assets  Taking out long-term loans
 Capital contributions of current assets, mainly cash
 Selling of non-current assets for cash
Decrease in Achieved through:
Current Liabilities  Taking out long-term loans to repay short-term debts
 Using capital contributions to repay short-term debts
 Sell non-current assets to repay short-term debts

Quick Asset Ratio

Current Assets − (Stock Control + Prepaid Expenses)

Current Liabilities − (Bank overdraft)

Measurement: ratio of x:1

Definition
Quick Asset Ratio is a liquidity indicator that measures the ratio of quick assets to short-term liabilities, to assess the
firm’s ability to meet its immediate debts.

Notes
This ratio shows the firm’s immediate liquidity as Current Assets that cannot be quickly turned into cash and Current
Liabilities that do not require immediate cash obligations have been excluded from calculation.

Changes
Increased by:
Increase in Achieved through:
“Quick Assets”  Taking out long-term loans
 Capital contributions of current assets, mainly cash, and not stock
 Selling of non-current assets for cash
Decrease in Achieved through:
“Quick Liabilities”  Taking out long-term loans to repay short-term debts
 Using capital contributions to repay short-term debts
 Sell non-current assets to repay short-term debts
 Using overdraft facility to repay short-term debts
Cash Flow Ratio

Net Cash Flow from Operating Activities

Average Current Liabilities

Measurement: times per period

Definition
Cash Flow Ratio is a liquidity indicator that measures the number of times net cash flows from the provision of goods
and services in the day-to-day operations of the business (operating activities) is able to cover average Current
Liabilities.

Notes
There is no certain point/where CFR is satisfactory, unlike WCR and QAR. CFR becomes higher when the reporting
period is longer.

Changes
Increased by:
Increase in Achieved through:
Net Cash Flow from  Increasing inflows:
Operating Activities o More cash sales
o Improve collections from debtors and more credit sales
 Decreasing outflows
o Reduce rent expense (get cheaper lease)
o Reduce interest expense (repay long-term debt)
Decrease in Achieved through:
Current Liabilities  Pay off short-term debts using capital contribution
 Reduce bank overdraft

Interest Cover

Net Cash Flow from Operating Activities (before interest)

Interest

Measurement: times per period

Definition
Interest Cover is a liquidity indicator that measures the number of times net cash flows from the provision of goods
and services in the day-to-day operations of the business (operating activities) is able to cover interest.

Changes
Increased by:
Increase in Achieved through:
Net Cash Flow from  Increasing inflows:
Operating Activities o More cash sales
o Improve collections from debtors and more credit sales
 Decreasing outflows
o Reduce rent expense (get cheaper lease)
Decrease in Achieved through:
Interest expense  Repay debts

Efficiency
Asset Turnover

Sales
Average Total Assets

Measurement: times per period

Definition
Asset Turnover is an efficiency indicator which measures how productively a business has used its assets to earn
revenue.

Notes
Relationship between Asset Turnover and Return on Assets
These two indicators both assess the firm’s ability to use its assets, the only difference being that ROA relates to net
profit and ATO to Sales.

This means that an increase in ATO does not guarantee an increase in ROA. However, if an increase in ATO is much
higher than the increase in ROA, it indicates a change (unfavourable) in expense control.

Relationship between Net Profit Ratio, Asset Turnover and Return on Assets
ATO – ability to use assets to earn sales
NPR – ability to retain that sales revenue as net profit.
Thus, ROA would depend on both.

Alas,
ATO x NPR

Sales Net Profit

= Average x
Total Assets Sales

Net Profit
= Average Total Assets

= ROA

Changes
Increased by:
Increase in Achieved through:
Net Cash Flow from  Increasing inflows:
Operating Activities o More cash sales
o Improve collections from debtors and more credit sales
 Decreasing outflows
o Reduce rent expense (get cheaper lease)
Decrease in Achieved through:
Interest expense  Repay debts
Speed of Liquidity

Liquidity as shown in liquidity ratios of WCR and QAR give a static view of a firm’s liquidity. In actual fact, a business
can survive with a low WCR and QAR with a fast enough trading cycle. This can be calculated by using efficiency
indicators.

Stock Turnover

Average Stock x 365

Cost of Goods Sold

Measurement: days

Definition
Stock turnover is the average number of days it takes for a business to convert its stock into sales. This ratio evaluates
the success or otherwise of management’s investment in its stock.

Notes
Assessment
Stock Turnover should take into account the nature of goods sold. Perishable and obsolescence-prone goods must
have a lower STO than others.

With most stock, there can be a problem if:

 STO is too slow
High number of days mean the firm will be less able to generate sales, and thus less able to generate cash
inflows (cash sales and receipts from debtors) in time to meet debt obligations as the fall due.
Possible solutions may be:
- Increasing sales through advertising, lowering selling prices, changing stock mix
- Decreasing the level of stock on hand by ordering less, ordering small amounts more frequently
(Just-In-Time ordering), replacing slow-moving stock lines.

 STO is too fast

Low number of days may mean that the selling prices are too low, and this would mean a loss in potential
revenue and profit. It could also be because the business is holding too little stock. This would lead to higher
delivery costs (more frequent) and the loss of possibility of bulk purchase discounts.

As the STO only shows the average time taken to sell stock, decisions must not be made on STO alone. Individual stock
cards need to also be analysed, so that the user has detailed information about the speed at which specific lines of
stock are selling.

Factors
Factors affecting stock turnover are;
 Range of products being sold
 The length of time business have been operating
 Size of the business
 Competition in the local area
Management
Stock is the bloodline of any trading business. It is easily the most valuable asset apart from the premises. Some
procedures used to control stock are:
1) Determine an appropriate level of stock on hand by setting minimum and maximum levels of inventory
This can be used to adopt Just-In-Time ordering which is a method of purchasing inventory whereby the new
order of goods arrive just before the business runs out of stock
2) Physically rotate stock to avoid NRV issues
Older units should be on prominent display so that the customers are encouraged to first purchase those units
closer to expiry date. This avoids NRV issues through damage and obsolescence.
3) Maintain an appropriate stock mix by identifying and removing slow-moving lines
Clearance sale  look for better alternatives or stop altogether
n.b. Some “slow-moving” lines can compose of highly profitable items, and these are not considered slow-
moving
4) Monitoring seasonal products
Stock that are subject to seasonal demands must be run down to a very low level or cleared out altogether at
the end of the season to avoid becoming dead stock.
5) Monitoring products subject to technological obsolescence
It would be unwise to stock up technological goods just because the supplier is offering a very good price.
Theses can become superseded by newer models. Therefore, the business must take care to not over-commit
to purchases.
6) Changing with the times to ensure stock is up-to-date
Business must change to adapt to changing markets, competitors, and customers, so stock should reflect this
change.
7) introducing complementary goods
Increased range of stock may attract customers
e.g. menswear  seatbelts, ties, shirts, trousers
mobile phone  batteries, hands-free kits
8) Monitoring selling prices
Cost price should be monitored to ensure mark-up remains profitable. An increase in cost price should lead to
increase in selling price but it is often difficult to do so, due to competition.
9) Ensuring that adequate stock security is in place
Stock is the second most theft-targeted asset after cash. Some strategies to tackle this issue are:
- Security guards
- Undercover security personnel
- Video surveillance
- Security tags on products
- Two-way mirrors
- Dye bombs
- Electronic security gates at all exits
- Random checks on staff
10) Avoiding stock losses
There are also other causes to stock losses, and this can be dealt by:
- Checking all deliveries of stock against invoices received
- Filing documents in an organised fashion to avoid ‘double invoicing’ by suppliers
- Securely placing cash in registers in all cash sales (avoid staff pocketing cash from cash sales by not
recording the sale  later identified as stock loss)
11) Reducing selling price of slow-moving lines
12) Relocating stock within store to highlight particular goods
13) Running special promotions of targeted stock lines
14) Combining items to promote particular products (e.g. ice cream + drink combo)
Limitations
An increase in Cost of Goods Sold is not always a favourable indicator. Although at most times it represents an
increase in volume of stock sold, it may simply represent a rise in cost prices. Therefore, it is necessary that Sales
Revenue is assessed alongside STO.

Debtors Turnover

Average Debtors x 365

Credit Sales

Measurement: days

Definition
Debtors turnover is the average number of days it takes for a business to collect cash from its debtors.

Notes
Assessment
Debtors Turnover can be compared with the benchmarks outlined before, and also with the credit terms.

Debtors ageing analysis is a listing of the amount and proportion of debtors according to the length of time they are
owing. Age analysis of debtors is a table that classifies debtors’ accounts according to the age of their debt.
Total Debtors 0 – 30 days 31 – 60 days 61 – 90 days
Amount $14000 $10500 $2000 $1500
Percentage 100.0% 75.0% 14.3% 10.7%

An ideal situation would have 100.0% here

*this assumes 30-day credit terms

This table should be prepared regularly (preferably, monthly) and compared with previous analyses so that
management can see any trends emerging.

Management
Stock is the bloodline of any trading business. It is easily the most valuable asset apart from the premises. Some
procedures used to control stock are:
1) Extensive credit checks
Selling on credit is a legitimate tactic to increase stock turnover, as new clients may be attracted to the
business if a credit facility is available. However, it is useless if they are not eventually turned to cash. Credit
checks should be conducted on prospective customers, checking:
- Banking history
- Loans and/or credit card history
- References from other businesses
- References from financial institutions
- Cash forecasts and/or budgets
- Profit and Loss Statements
- Balance Sheets
- Using agencies
 2) Offering discounts for prompt payment
3) Charging interest on overdue amounts (need to be stated on original contract)
4) Sending reminders via fax or email
5) Sending monthly statements regularly
6) Threatening not to provide credit in the future
7) Making personal visits to the customer’s place of business
8) Threatening clients with legal action
9) Employing a debt collection agency
10) Taking legal action to recover the debt

The business must be able to coax credit customers into paying overdue amount without undue embarrassment. This
is to avoid losing slow-paying but large customers. This is why italic options are the last resort.

Creditors Turnover

Average Creditors x 365

Credit Purchases

Measurement: days

Definition
Creditors turnover is the average number of days it takes for a business to pay its creditors.

Notes
Why credit purchases
Credit purchases are preferred, because:
1) It gives the business time to try to sell its stock and turn it into cash
2) Trade credit is basically interest-free finance.

Payments to Creditors
Payments should be made at a time so that the business has time to generate cash from the stock it purchased on
credit. However, late payments can lead to disadvantages, such as:
- Interest charges on late accounts
- Removal of credit facilities
- Reduction in credit rating

The ability to repay creditors may simply reflect the current state of the liquidity of the business; that is, its ability to
meet its debt obligations as they fall due.

Limitations of ratio analysis

Ratio analysis is limited in its nature as they can only be as accurate as the information on which they are based. It is
also questionable, because:
 Ratios are based on historical data
Past results do not correspond to future events
 Historical cost accounting
Inflation can distort real meaning, depreciation may not be accurate, and turnover rates may be distorted
  Changes in accounting methods
If management changes methods, details will be made available regarding the change (Relevance) but ratios
are still difficult to compare
 Inter-firm comparisons
Every business is unique in financial structure (assets, revenues, expenses, etc.). Even with industry averages, it
is not accurate and only a suspect at its best.
 Frequency of reporting
Ratios are only very useful with frequent, detailed reporting
 Limited information
Many owners with limited accounting knowledge do not undertake a comprehensive reporting system, leading
to limited analysis.

Non-financial information
Non-financial information is any information that cannot be fond in the financial statements, and is not expressed in
dollars and cents, or not reliant on dollars and cents for its calculation.

Financial reports are limited, because:

 They use historical data, and do not guarantee future events
 Many indicators rely on averages, and this may conceal details about individual items
 Different accounting methods used by different firms undermine comparability of reports and indicators

Non-financial information provides information about:

1) Firm’s relationship with its customers
It is difficult to attract customers, so it is crucial to keep them by assessing customer satisfaction. This includes:
- Customer satisfaction surveys
o Feedback forms
- Number of repeat sales
- Number/amount of sales returns
Sales Returns
o Sales returns ratio % = Total Sales 𝑥 100
- Number of customer complaints
- Number of sales enquiries/catalogue requests
- Degree of brand recognition (based on market research)
2) Suitability of stock
Businesses must continuously assess the suitability of their stock to make sure they are meeting the demands
of customers:
- Number of customer satisfaction
- Number of sales returns
- Quality reassurance
Pur chases Returns
o Purchases returns ratio % = Total Pu rch ases 𝑥 100
3) Quality of management
A good owner needs to have:
- Good communication skills (deal with customers, staff, etc.)
- Adequate management skills (controlling stock, debtors, creditors, etc.)
- Ability to adapt to change (keep up with current trends, visions of future, changing bad methods)
- Ability to develop/stock new product (be aware of market changes)
- Flexibility in responding to customers’ needs (treat on individual basis)
- Ability to recognise one’s own weaknesses
4) Profit compared to hours worked
Net Profit
Profit per hour = Hours worked
There is no definite answer for acceptable profit per hour, because of:
- Potential for growth in the business
- Potential for salary increases
- Risks of unemployment if employer goes out of the business
- Excitement of running a business
- Security of employment as a salary earner
- Risk of having insufficient cash to pay drawings (profit does not equal cash)
- Security in having a salary deposited into a bank account every week or every month
- Alternative investments
5) Firm’s relationship with its employees
- Structured performance appraisals
- Number of days lost due to sick leave/industrial action
- Staff turnover/average length of employment
6) State of the economy
A shrinking economy will affect even a strong firm. This includes:
- Interest rates
- Unemployment rate
- Number of competitors
- Level of inflation
- Consumer confidence
- Actions of big businesses
- Government decision-making (e.g. introduction of GST)
- Wage demands by unions
- Taxation changes
- Technological change
- Market trends
Cash cycle
Cash cycle is the process of turning stock into sales, and then turning theses sales into cash. It is calculated as STO +
DTO.

Purchase stock on
cash/credit
Stock Turnover

Pay cash to creditors

Sell stock on cash/credit
*not part of cash cycle

This is not always the case.

Some creditors demand Debtors Turnover
payment earlier than
debtors turnover
Collect cash from
debtors

Faster cash cycle is highly advantageous as the cash is available at n earlier date and can therefore be used by
management as it sees fit.

Ideally, STO + DTO should be as fast as possible, and CTO should be as slow as possible.
This may be achieved by buying stock on credit and selling them in cash.