T3 | | Types of capital ( long term vs. Short term) | Budgeting | The difference between cash and profit | Selling on credit to a debtor

Question 1

What is Long-term capital aka?

Answer 1

Fixed Capital

Question 2

What is the most common source of equity long-term capital?

Answer 2

The sale of shares (equity).

Question 3

What is the most common form of borrowed long-term capital?

Answer 3

Loan from the bank.

Question 4

What is Short-term capital aka?

Answer 4

Working capital.

Question 5

What are potential sources of credit in the short term?

Answer 5

• Bank Overdraft
• An individual or business can also apply for a short-term loan from the bank. The bank will often require some type of security before the loan is granted. Interest is charged on the borrowed amount.
• A Credit card is still a form of short-term credit.
• Trade credit or supplier credit or open account credit.
• Monthly instalment

Question 6

What is a bank overdraft?

Answer 6

The bank allows the account holder to withdraw more money from the account than there is.

Question 7

Trade credit or supplier credit or open account credit.?

Answer 7

The supplier allows the buyer a quantity of credit based on the buyer’s creditworthiness. This account is considered an “open account” because it remains open as long as the buyer continues to buy and repay the account.

Question 8

Factors that drive long-term demand - vs. short-term capital affected:

Answer 8

• Nature of the business
• Size of the business
• Stage of development
• Period of production
• Inventory turnover rate
• Buy and sell terms

Question 9

The nature of the business

Answer 9

Manufacturers need more fixed (long-term) capital than retailers to buy fixed assets such as equipment to establish the manufacturing plant. A manufacturer will therefore have a greater demand for long-term / fixed capital than a retailer or services business of the same size.

Question 10

The size of the business:

Answer 10

The larger the business, the more fixed (long-term) capital will be needed to buy equipment and vehicles. The larger a business, the more working capital (short-term) it will need for salaries, water and electricity, rent and other expenses.

Question 11

The stage of development:

Answer 11

If the business is still expanding, it will probably need more fixed capital to buy additional machines and equipment. A business that has been operating for a number of years will probably already own the necessary machines and only need to replace them when they are outdated or carry too much wear and tear. Do you think new businesses should have more working capital to cover expenses than already established businesses?

Question 12

Period of production:

Answer 12

The longer it takes to produce the final product, e.g. to develop a new townhouse complex, the more working capital is needed, because working capital is “fixed” until the production is completed and in the meantime no income is received. A product that takes a relatively short period of time to produce will generate working capital faster and therefore less working capital is needed to keep the business going.

Question 13

Inventory turnover rate:

Answer 13

Inventory turnover determines how fast stock is sold. The higher the stock turnover, the less additional working capital is required, because there is a constant amount of money flowing into the business.

Question 14

Buy and Sell Terms:

Answer 14

If the business buys its stock for cash but sells it on credit, it will need more working capital than when a business sells stock for cash while purchasing the stock on credit.

Question 15

What is a budget?

Answer 15

A Budget is a tool that will assist the business (or person) to plan how much money will be available (income) and how it should best be spent (expenditure).

Question 16

The purpose of a budget

Answer 16

• A budget is a tool used for financial planning purposes, because it forces the financial manager to think about the future and what may be needed.
• Budgeting helps in the process of financial decision making, because the information is then available when needed.
• A budget is also a tool that controls when and how much money is spent and therefore helps with the financial evaluation of the various departments and also that of the business as a whole.

Question 17

Types of budgets

Answer 17

Capital budget

Short-term budget

Question 18

Short-term budget

Answer 18

Is used to do short-term financial planning to cover working capital requirements, such as paying creditors’ claims, buying stock in cash, financing debtors and covering the daily expenses of the business.

Question 19

Capital Budget

Answer 19

Is used to plan fixed (long-term) capital requirements. It is a long-term financial planning tool to plan the purchases of fixed assets such as Land and Buildings, Vehicles, and Equipment.

Question 20

Profit:

Answer 20

Profits - Expenses

Profit is the difference between income and expenses, but not all profits are in the form of cash.

Question 21

Cash flow problem:

Answer 21

If the business sells to a debtor, the business will make a profit because the selling price of the stock is more than the cost price. But the business has to wait a number of months until the debtor pays the bill and therefore enters the business before cash.

Question 22

Credit trading

Answer 22

When the business sells on credit, the buyer is called a debtor, i.e. a debtor owes money to the business where the goods were bought on credit.

Question 23

Advantages of / reasons for sale on credit:

Answer 23

A Business can sell on credit because it then increases its turnover (sales) and thereby increases the profit.
If a business grants credit to customers, it can give the business a competitive advantage in the market, because consumers do not always have cash to buy everything they need. This will create goodwill and loyalty among customers and they will continue to buy and pay later.

If the competitors also grant credit, the business will at least not be in a weaker position than its competitors if it also grants credit.

Credit stimulates the economy, as more goods are sold and businesses make more profit. This means more jobs can be created in the retail sector and even in the manufacturing sector (provided that goods are not imported).

Question 24

Disadvantages of selling on credit:

Answer 24

• The business may experience the risk of bad debt, i.e. bills are not paid and must be written off
• Credit trading increases administrative costs
• The credit merchant needs more working capital because the business has to wait to get the money from the debtor. This can cause cash flow problems if the debtors are not managed well.
• The business will experience opportunity costs.
• From the consumer’s point of view, too much credit leads to financial problems if the person buys more than he / she can afford to repay.
• If we look at the bigger picture, too much credit can lead to an increase in demand and thus demand - pull - inflation arises where this increase means that businesses push up the prices of goods.

Question 25

Why does credit trading increase administrative costs?

Answer 25

the business, e.g. Credit referrals should be obtained to determine if the potential debtor is creditworthy and this means phone calls and more paperwork that cost time and money.

it must send out statements to remind debtors to pay their bills.

it means more work and therefore more salaries to pay more employees to do the work.

Question 26

What is opportunity costs?

Answer 26

Refer to the situation where the business cannot take advantage of an opportunity that arises (e.g. buying stock on sale from the supplier), because the business does not have the cash while waiting for debtors to pay.

Question 27

Credit standards describe the criteria used when deciding whether or not to grant credit to a client, i.e. the creditworthiness of the prospective debtor is examined. These criteria may include the following:

Answer 27

A Credit application form will assist the business by asking questions related to person’s workplace

The financial position of the client.

Bank references where the seller will ask his / her own bank to obtain a status report regarding the buyer. The status report will indicate whether the buyer is acting responsibly when it comes to managing his / her current account and whether he/she writes out checks that are dishonored (checks that “hop”).

Credit bureau (e.g., ITC) checks. The credit bureau collects information on the credit reputation of buyers and this information is passed on to the seller at a price.

References from other businesses where he/she has previously bought on credit. The other business is called to find out about the potential debtor’s payment record. All such references are highly confidential.

Question 28

The credit period

Answer 28

Refers to how long debtors have to settle their account. The longer the credit period granted, the more attractive it is to the customers, but the more working capital the business will need.

Question 29

The credit limit

Answer 29

Describes the maximum credit that will be given to a debtor. The person’s credit limit is determined by his / her creditworthiness.

Question 30

Cash rebates

Answer 30

Sometimes given to encourage the debtor to pay the bill earlier. If you see something like the following on the credit statement: “3/60 net 120”, it means 3% discount will be given if the account is paid within 60 days, but the maximum number of days the debtor gets to pay is 120 days.

Question 31

Credit management:

Answer 31

Credit control is very important in any business that sells on credit to debtors.

Question 32

Why is it very important?

Answer 32

Increased credit sales mean there is higher profit, but also more risk of bad debt.

Credit sales help to build on customer loyalty (goodwill), but loyal customers mean nothing if they do not pay their debts.

It should not be too strict. If the debtor experiences financial difficulties, the law allows a debtor to receive credit counseling and thus the opportunity to negotiate new payment terms. However, this is only in the case of a debtor who has a valid problem. This allows the debtor to repay the debt without getting into worse financial trouble and also allows the business to reduce the bad debt due to non - payment.