Working Capital Management & Revenue Recognition

Module Four: Session 5 WORKING CAPITAL MANAGEMENT & REVENUE RECOGNITION Module 4: Session 5 1 18/03/2025

The objectives of the session 1. To enable trainees understand the management of items of working capital 2. To create awareness of the treatment of contract revenue, profits and work in progress. Module 4: Session 5 2 18/03/2025

Working Capital composition Working Capital: Working capital is composed of short-term assets; inventories and accounts receivable less short-term liabilities - primarily accounts payable and cash. Accounts Receivable: Also called debtors??? have received goods or services on credit. The longer they take to pay the more capital is required and the higher the risk of default. Accounts Payable: Also called trade creditors are suppliers of goods or services on credit. The longer the credit allowed to the business the less the working capital investment. Inventory: Materials and consumables to ensure that works progress smoothly without stoppages due to stock outs. Cash and bank: Stock of cash to meet the operational needs that are not supplied on credit and to meet creditors payments when due. Other short-term finance options: Improving the liquidity of working capital can involve the use of business stand by facility and deposits/investments of temporary excess cash. Module 4: Session 5 3 18/03/2025

A simplified cash cycle CASH ACCOUNTS RECEIVABLE MATERIALS, WAGES, MACHINE HIRE etc CERTIFIED WORK WORK IN PROGRESS Module 4: Session 5 4 18/03/2025

Cash cycle example Year Annual credit purchases Annual works billed Annual cost of works Value of inventory Value of work in progress 35,000m Accounts receivable Accounts payable 2006 2007 113,000m 180,000m 160,000m 25,500m 37,000m 45,000m 20,750m Average 21,500m 23,500m 36,000m 40,000m 17,750m 35,000m 14,750m Module 4: Session 5 5 18/03/2025

Example: cash cycle determination Raw materials stock = Less credit from suppliers 17,750 x 365/113,000 = 57 23,500 x 365/113,000 = 76 19 Work in progress Credit given to customers 40,000 x 365/180,000 = 81 Operating cycle (in days) 36,000 x 365/160,000 = 82 182 Module 4: Session 5 6 18/03/2025

Working capital management: Inventory A lot of resources are tied in inventory: materials such as bitumen, gravel, aggregate, sand, cement, fuel etc. Good inventory management requires four things: 1. Determination of an Economic Order Quantity, 2. Determination of the Order Level 3. Determination of Safety Stock 4. Adequate internal controls over procurement and storage. Module 4: Session 5 7 18/03/2025

Inventory management - EOQ The investment in inventory decision seeks to balance: 1. The cost of holding inventory, 2. The cost of ordering inventory, 3. Reducing the risk of stock outs. An economic order quantity balances the first two by minimising the cost of holding stock and the cost of ordering it. Economic Order Quantity Q = (2DO/C), Where D is the annual demand, O is the order costs per batch and C is the annual carrying cost per unit. The Order Level triggers the procurement process to start; also ensures delivery of new batch before stock runs out. Order Level = (Average usage x Average lead time). Safety Stock is roughly based on maximum lead time and the maximum usage less the order level. Module 4: Session 5 8 18/03/2025

Internal control over inventory Adequate internal controls to be maintained over inventory include: Separate the following functions: Procurement purchasing office Recording and payment accounts office Custody - stores Provide physical security over the inventory, Carry out regular physical verification, assess its state Reconcile physical inventory with stock ledgers Use the oldest inventory first while issuing out materials. Module 4: Session 5 9 18/03/2025

Working capital management: Accounts receivable Amounts due from customers if not well managed will cause loss. The general principle is that goods or services sold should be paid for as soon as possible preferably cash on delivery. This may not be possible because of: Convenience Industry norm Competitors terms Nature of customer. Generally, credit should be offered only in order to boost profitability through increased sales. Module 4: Session 5 10 18/03/2025

Setting credit policy When setting credit policy balance between attracting business and investing more in debt. The following ingredients should be considered: Access to credit credit-vetting The normal credit period The credit limit Procedure on delayed payment Cash discounts to attract early payment Each of the above considerations will have an effect on the level of investment in debt and the competitiveness of the business. These need to be balanced. Module 4: Session 5 11 18/03/2025

Cash management Why hold cash? Balance the risk of running out of cash and having too much cash which will not earn a return. Ascertain and maintain Safety Cash by reference to cash needs of the business to cover a defined period depending on the speed of inflow of cash. Excess short term cash should be invested in quickly convertible securities to contribute to profitability. Temporary cash deficits should be provided for by arranging standby bank facilities. Module 4: Session 5 12 18/03/2025

Working capital management: over trading risk Sound businesses with opportunity run short of funds to work with as a result of handling too much business. Adventurous managers may attempt to keep very low levels of working capital in order to invest funds in profitable ventures. Investing highly in profitable ventures enhances income generation but risks failure due to: Risk of stock outs Risk of tight credit Risk of cash outs An enlightened financial manager should have a feel for the right amount of working capital on a continuous basis to ensure proper functioning of the business. Module 4: Session 5 13 18/03/2025

Challenges of large contracts in financial reporting Income to be recognized in income statement Spread of profits over the contract period Spread of loss over the contract period What to include as account receivable What to include as work in progress The answer to these challenges depend on: Whether a profit or a loss is anticipated The degree of completion of the contract. Module 4: Session 5 14 18/03/2025

Calculation of %ge of completion There are two ways in which stage of completion can be calculated: 1. Revenue basis: work certified to date/contract price. 2. Cost basis cost to date/total contract costs. Revenue and profits will only be considered on an ongoing contract when it has substantially advanced. Module 4: Session 5 15 18/03/2025

Revenue Recognition in construction Example 1 ABC commenced a contract that is expected to take more than one year to complete. The contract summary at 31 December 2010 is as follows: a. Progress payments b. Contract price c. Certified work d. Cost to date e. Estimated total cost to complete 2,520 $000 1,400 2,736 1,824 2,160 Module 4: Session 5 16 18/03/2025

Profit recognition computation Expected profit $000 Contract price 2,736 Estimated contract cost 2,520 Expected profits 216 Stage of completion 1,824 2,736 = 216x0.667 66.67 % X 0.667 Profit to be recognised 144 Module 4: Session 5 17 18/03/2025

Contracts presentation in F/s Income statement figures Balance sheet figures $000 $000 Cost to date 2,160 Revenue 2,376x66.67 % 1,824 Add rec. profits Less progressive payment 144 Less gross profit 144 1,400 Cost of sales Balancing figure 1,680 Due on contract 904 Module 4: Session 5 18 18/03/2025

Example 2 - Loss making contract IAS 11 provides that that If a loss is anticipated, then the entire loss should be recognised immediately. Revenue will be recognised as equivalent to the contract costs expected to be recoverable, i.e. cost less profit. DEF commenced a contract that is expected to take more than one year to complete. The contract summary at 31 March 2010 is as follows: $000 3,780 4,500 3,600 a. Progress payments b. Contract price c. Cost to date d. Estimated further cost to completion 1,200 Module 4: Session 5 19 18/03/2025

Income statement computation Expected profit $000 Contract price 4,500 Total contract cost 4,800 (3,600+1,200) Expected loss (300) Revenue: Cost to date 3,600 Less loss (300) Revenue 3,300 Module 4: Session 5 20 18/03/2025

Contracts presentation in F/s Income statement figures Balance sheet figures $000 $000 Cost to date 3,600 Revenue Cost to date 3,600 Add loss Less progressive payment (300) 3,780 Less loss 300 Revenue 3,300 Due on contract (480) Module 4: Session 5 21 18/03/2025

Group Activity 1. What constitutes working capital? Explain what constitutes a cash cycle and explain reasons for holding cash. 2. Explain the key components of an inventory management system. 3. Explain the working capital dilemma of a finance manager. 4. Explain how a long term contract is treated in the income statement and the balance sheet. 5. Explain what overtrading means and how it may be detected. Module 4: Session 5 22 18/03/2025

END Q & A Module 4: Session 5 23 18/03/2025