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policy regarding payables, receivable and inventories. Its year-end working

capital is as follows:

Accounts receivable $200,000

Inventories $100,000

Accounts payable ($50,000)

Net working capital $250,000

If the company continues to sell the same volume of product and to incur

the same costs, what will the working capital level be at the end of the year

(a) if there is no inflation and (b) if inflation of 10% pa hits all costs and

revenues?

With no inflation the working capital will remain unchanged at $250,000.

If there is inflation of 10% which impacts all costs and revenues then all

working capital items will increase by this amount and so the net working

capital will also rise by 10% to $275,000.

84 The five financial building blocks

Stripping out financing charges

A companyâ€™s income statement shows the following:

Profit before tax and interest $10,200,000

Interest charge ($1,300,000)

Tax charge ($3,115,000)

Net income after tax $5,785,000

What would be the net profit when financing charges are removed?

We need to calculate the implied tax rate. This is equal to the tax charge as

a percentage of the profit before tax but after interest.

$3,115, 000 Ã· $8, 900, 000 = 35%

So the tax relief associated with the interest charge is $455,000. The resultant

income statement excluding finance charges will be as follows:

Profit before tax and interest $10,200,000

Tax charge ($3,570,000)

Net income after tax $6,630,000

Effect of making a payment in advance

A company pays its insurance premium of $85,000 for the coming year just

before the start of the year in order to ensure that its insurance remains valid

at all times. What will be the impact of this on the income statement and the

balance sheet for the current year?

We follow the matching convention and so do not include the insurance

charge as a cost in the current year. We have, however, paid the bill and so

we show it as a prepayment which forms part of the current assets. This

increase in current assets serves to increase year end working capital and

so it reduces funds flow. Note, however, that we would have included the

insurance premium which was paid one year earlier as a cost in this yearâ€™s

accounts.

We should now be ready to move to our two case studies.

Scaffolding example

This example concerns a business opportunity to set up a company and run

it for five years. It is simplified compared with the full detail which should be

85 Building block 3: Understanding accounts

investigated in real life, the aim being to show just enough detail so we can

see how each line of the AFS works without getting bogged down in excessive

number crunching. So, for example, we will be ignoring inflation effects.

The idea is to form a company which will provide and install scaffold-

ing. The business model is very simple. The owner plans to purchase a large

quantity of scaffolding and then offer this for rental. The service will include

installation and removal but the owner will subcontract this work to locals

who own their own lorries and are skilled scaffolders but who cannot afford

to own their own scaffolding. This installation cost will therefore be a vari-

able cost for the new company. The business will store the scaffolding on

some spare land at the corner of a farm where the owner lives. This land is

available at no cost.

The full set of business assumptions are set out below. The aim is to build

a financial model of the following situation and use this to investigate the

effect of different assumptions in order to assess the potential viability of the

business.

Scaffolding example: business assumptions

Initial cost of scaffolding â€“ $m 4

End of project scrap value of scaffolding â€“ $m 1

Inventory required â€“ $m 0.1

Fixed costs â€“ $m per year 0.2

Sales growth rate 5%

Average sale value per contract â€“ $ 1700

Estimated number of sales contracts in first year 1000

Install and remove cost per contract â€“ $ 350

Tax rate (tax is paid the following year) 0.3

Average credit period given to customers â€“ days 45

Average credit period received from suppliers â€“ days 15

Current year (it is December at present) 2007

The business will commence in January next year

Number of years the business will operate 5

Cost of capital 12.0%

Assume that tax is charged on the accounting profit

The AFS provides, in effect, a template for financial analysis. All that one has

to do is fill in the numbers! My version is given below. I suggest that readers

should first review this table and check they understand how the numbers

are working together. Note, for example, how fixed assets change each year

and how the amortisation is added back to profit as we calculate funds flow.

86 The five financial building blocks

Note also how it is the change in the balance sheet working capital that is

subtracted from profit as we move towards funds flow and not the total work-

ing capital. Once familiar with the approach, readers should then confirm

their understanding by attempting to build their own spreadsheet model and

check this against my answer.

My model shows each of the five operating years as well as a column for

the initial purchase of scaffolding and a column to show the closure of the

business after year 5. This then allows one to apply the correct discount fac-

tor to these significant flows of money. One could have included the initial

purchase of scaffolding as part of the first year of operation but this would

miss the fact that the initial money is paid out immediately. At the end of

the assumed operating period for the company the working capital returns

to zero as the final customers pay their bills, the inventory is liquidated (I

assume it is sold for what it originally cost) and the remaining bills are paid.

The largest bill is the tax charge for the final year of operation.

One important point to notice is that if one adopts the accounting

approach it is not necessary to carry out a separate calculation of when

things like tax will actually be paid. This is a big advantage of the AFS

approach. Provided you are happy to study just the funds flow within a

period and you do not want to bother with the exact date on which each

payment is made then all you need in order to calculate funds flow are the

accounting-based figures for the period including the opening and closing

balance sheet. There is no need to carry out a separate calculation of when

individual items are paid.

The final step of the AFS is to use the funds flow line as input to the value

calculation. In this case I have used mid-year discount factors for the five year

operating period with the initial capital investment being spent at the end of

December 2007 and with shutdown assumed to be at the end of the final year

of operation.34 I have chosen to round the figures in the AFS to the nearest

$0.1m. Some precision is lost but the result is a simpler presentation.

Note the way that I have used separate columns for the start-up and shutdown. This is to allow me to

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give them the correct discount factor to allow for their exact timing. By building a model in this way

it is possible to model assumptions more accurately. You do, however, need to beware of using the

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