FINANCIAL MANAGEMENT AGRIBUSINESS

5.0 Introduction

Successful financial management requires the highest degree of specialized know how
in interpreting financial information from a firm’s records. This does not necessarily
require the manager to know how to do the accounting personally or to maintain the
records of an organization. Instead, the agribusiness manager should concentrate on
understanding how the systems works and what information the record keeping
process produces for use in decision making to facilitate the achievement of the firm’s
goals and objectives.

One of the major goals of a firm is to maximize profits, for without profits a business
cannot exist for a long period of time. To achieve this goal, the agribusiness manager
has to:-
i) Manage the revenues and costs properly
ii) Consider the risk associated with various investment: A risky business should
promise higher returns.
iii) Take into account the Time and cash flows: Passage of time makes money lose
value or purchasing power. For instance, in case of debtors, one has to charge
interest on delayed payments.

Therefore as an agribusiness manager, you should aim at balancing the risk and return
of an investment in order to maximize the present value of net cash flows, wealth or
expected returns of shareholders/owners of the business. To achieve this, the following
decision making areas must be considered:

1. Management of Assets of the Firm (Investment Function):

The manager has to decide where to invest, and the various alternatives at his/her
disposal.
a. Real assets/tangible/fixed assets: land, buildings, factories, machinery etc.
b. Intangible assets: Technical expertise, trade mark, patents, franchise, goodwill
(the extent to which the price paid for a product exceeds the products physical
market value, usually because of the value of the reputation established in the
market by previous owner).
c. Financial assets: Shares, treasury bills, fixed deposits, government bonds (these
are less risky).

2. Managing the Finances of the Firm (Finance Function)

a. You have to decide on the financial structure of the agribusiness. How are you
going to finance the investment? In other words what will be the proportion of
equity vs debt? Equity includes fresh issues, owners’ savings, retained earnings
etc.

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 b. You have to establish the cost of each source (Establish which interest rates to
accept).
c. Consider the impact of the different sources of money on the profitability and
liquidity of the firm. Establish what proportion should be short term < 5years,
intermediate 5-7 years or long term >10 years.

3. Dividend Policy the firm should adopt given the firm’s business risks (Dividend
function).

The manager has to decide whether to retain the money (retained earnings) or pay
dividends. If you do not pay dividends you are denying shareholders a share of the
profit, however if you pay all your profits as dividends, it means that the growth of
your firm has to be financed through borrowings. NB: You should take that decision that
maximizes shareholders wealth. Normally a proportion is retained and the rest is paid to
shareholders.

4. Managing the Working Capital

Gross working capital = Current Assets + Current Liabilities

Net working capital = Current Assets – Current Liabilities

Because of the seasonality nature of agricultural products, there will be peak and slack
production periods.
Cash needs to intensify during the peak season when the agribusiness must pay for
increased inventory & for financing accounts receivable. It is important to know how to
finance these peak periods e.g. by using short-term credit, which matures in one season.
In highly seasonal agribusiness short-term loans are a very important part of financial
management.

5. Management of Inventory

Overstocking can be costly for your firm because of increasing storage costs, insurance,
pilferage, missed interest on money invested in inventory etc. On the other hand under
stocking implies missed sales and can lead to loss of customers to competitors.

6. Management of Cash

Too much cash or too little cash can be dangerous you will be faced with a dilemma of
whether to concentrate on profitability or liquidity. Liquidity means that money is idle,
hence missing on interest of returns you would have earned had you invested it, on the
other hand, if you focus on profitability you run a danger of becoming illiquid,
therefore you have to strike a balance.

7. Management of Debtors (Accounts receivables)

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You have to come up with a policy of managing debtors. Apply the concept of
prudence i.e. collect money owned to you as fast as possible but delay payment.

8. Management of Creditors (Accounts payable)

As much as you are applying the concept of prudence, other companies will also apply
it to your company. Therefore, have a credit period policy, which should be spelt out
clearly and always avoid bad debts.

9. Financial Statement Analysis

The manager should be familiar with the tools used for analyzing financial statements
e.g. ratio analysis, however, before the manager can carry the analysis he/she has to
establish which information is needed and the form it will take.

Business managers require information on:-

• Revenue and cost trends: production costs(direct labour, materials & expenses),
sales, overhead costs (accounting fees, advertising, insurance, interest, legal fees,
rent, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities);
• Performance trends, measured in accordance established standards of efficiency;
• The firm’s success in terms of actual profitability and profitability trends;
• The firm’s use of such resources as assets and return on current and future
investment;
• The firm’s capital structure : sources & uses of funds, and the firm’s ability to
meet future change & expansion;
• Competency of management teams in terms of their use of the resources of the
firm;
• The firm’s ability to repay long term loans/ debts (Solvency); and
• The firm’s cash position or its ability to meet current commitments, such as
payrolls & supply purchases (Liquidity).

The information supplied by the records should

i) Assist you maker wiser decision;
ii) Be prepared in such a way that can easily be understood and interpreted;
iii) Address the particular needs of the agribusiness; and
iv) Be reliable, accurate, consistent and timely.

5.1 The Accounting Process

5.1.1 What is accounting?

 Accounting is commonly referred to as the “financial language of the business” as it

is effectively employed to communicate the financial performance of a business to
various interested parties or stakeholders.

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 The process of collecting financial information about an organization, its measurement,
analysis and its reporting/communication to decision makers.”(Association of Accounting
Technicians-AAT)

Characteristics of Accounting Information

In order to meet the users’ needs, accounting information should possess certain key
qualities or characteristics. These are:

i. Relevance: It must have the ability to influence decisions i.e. the information
must be relevant to the prediction of future events (predicting how much profits
is likely to be earned next year) or help to confirm past events.
ii. Reliability: Should be free from any significant error or bias. It should be capable
of being relied on by users to mean what it’s supposed to represent.
iii. Comparability: treat items that are basically the same in the same manner for
measurement and presentation purpose to enable users identify changes in
business overtime and also evaluate/benchmark the performance of the business
in relation to other business
iv. Understandability: should be expressed as clearly as possible and understood by
those at whom the information is aimed.

Managers as stewards of scarce resources, must report periodically to owners on:

i. How they allocated the scarce resources, and
ii. Whether their allocative patterns conformed to the primary objective of earning profit to
resource owners.
iii. Other decision makers the manager would report the accounting information to include:
 Potential Investors
 Lenders /Financial Institutions
 Employees and Trade unions
 Government and regulatory bodies
 Competitors
 Customers
 Researchers, Financial/Investment analysts
 Suppliers

5.1.2 Accounting Recording System/Double entry system

i. The double entry system of accounting or bookkeeping means that every

business transaction will involve two accounts (or more).

Example 5a

Date Transaction Gain Loss

9/09 Started business with Cash Capital
K 1.5M.

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 10/09 Bought a food Machine Cash
processing machine for
K 0.5 M Cash

11/09 Bought a second hand Computer Bank

Computer for K 0.5 M,
Paying by cheque

20/09 Sold the machine as being Bank Machine

Unsuitable for K 0.5M
and received a cheque

ii. Double entry also allows for the accounting to always be in balance.

Assets = Liabilities + Owner's Equity

What a company owns (Assets) must always equal what it owes to its creditors
(Liabilities) plus what it owes to the owner(s) of the business (Equity)

iii. Failure to conform to the double entry rule of recording business transactions will
mean that accounts including the balance sheet will not balance i.e. the credits will
not be equal to the debits.

5.1.3 The Accounting Process

The following order is usually recognized in the accounting process and is repeated in
each accounting cycle.

1 Identification of occurrence of a business transaction

2 Preparation of source document(s) proving the occurrence of the business
transaction(s)
3 Recording of information in a journal
4 Debit and credit posted from journal to ledgers
5 Preparation of a trail balance
6 Making end of year adjustments
7 Preparation of financial statements

1. Business Transaction: refers to a business event that can be expressed in monetary

terms and make a change in the financial position of the business/accounting
equation. Such transactions are recorded in accounts.

2. Preparation of source documents evidencing the occurrence of business

transactions

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 Source documents provide proof of transfer of values and are a basis upon which
business transactions are entered into the books of accounts. One could say that
such documents are the building blocks for the entire record keeping system. They
include: receipts, payments vouchers, delivery notes, invoices, store requisition
notes, debit and credit notes.

3. Recording of information in a Journal/ Subsidiary Books of Accounts/ Day Book

The journal is a book of original entry and provides a chronological order of day by
day record of business transactions. Entries are made by debiting one account and
crediting the other with a brief explanation or narration of what took place.

Format of a Journal

The principal behind the journal is the same for all organizations but complexity of
the journal used by a particular organization depends on its requirements. In a small
business there may be only one book or general journal in which all the transactions
of a business are recorded. However, as a business grows in size it is advisable to
have specialized journals where particular areas of the business such as sales,
purchases & available cash etc. are recorded separately.

General journal
Date A/C L.F Ledger Debit Credit
Title/Narration folio

Advantages of a Journal

 It provides full information about a transaction;

 Provides a chronological knowledge about all the life of a business; and
 Prevents errors in posting
Disadvantage

While the journal records the business transactions chronologically, it does not put
them into any meaningful form by which the manager can interpret the information
presented.

4. Ledger/Secondary Book of Accounting

The fourth step in the process of recording is transferring of information from the
journal to the ledger, a process known as posting. A ledger is composed of a series of
records called account(s)/T account(s). An account is a place where all information
referring to a particular asset, liability or capital is entered. For instance, there will be an
account for each (i) of the creditors of the business to indicate the amount of money, or
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liability, that each creditor is owed by the business and (ii) kind of income (e.g. sales
ledger)sales and expense (purchases ledger).

All these separate accounts comprise the subsidiary ledger, which shows details of each
individual ledger. The subsidiary ledger is normally used by subordinates. There is also
a general ledger where only the total accounts of the subsidiary are entered. When
compared to subsidiary ledger, accounts in the general ledger do not show details of
each individual accounts. This is the book which is normally used by the general
manager. Note: Information in the general ledger should reconcile with that of the subsidiary
ledger.

Ledger accounts therefore, provide for the separating, categorizing and recording of
related transactions or activities within the business in an organized manner.
Maintaining financial information in separate ledger accounts not only makes it more
usable but also provides information that is more easily understood by the agribusiness
manager.

5. Preparation of Trial balance:

In the fifth step of accounting cycle a trial balance is prepared with the help of ledger
accounts list and their balances at a given time. At a particular date of period end the
accounts are listed in the order in which they appear in the ledger, with debit balances
listed in the left column and credit balances in the right column. Primarily a trial
balance is prepared to prove the arithmetical accuracy of debits and credits (double
entry) after posting and facilitate preparing financial statement. A trial balance also
uncovers errors in journalizing and posting.

It is important to note that the balancing of a trial balance does not necessarily prove
that the books are correct because there are several types of errors that will not affect
the balancing of the trial balance. Some of which include:

(i) Omitting a transaction altogether (Error of Omission);

(ii) If purchases and sales are overstated by the same amount (Compensating
error);

(iii) Mistake in the original invoice, if stated amount is US $ 100 yet the actual
amount was US$ 200 (Error of original entry); and

(iv) Error of principle: For example, in the case where a motor vehicle worth US $
5,000 is purchased & entered in the purchases account instead of motor
vehicle account

6. Making End of Year Adjustments

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Adjustments are needed to ensure that the revenue and matching principles are
followed. (i) The revenue recognition principle, states that revenue should be
recognized only when it has been realized. Realization is said to have occurred when:
 The activities necessary to generate the revenue (e.g. delivery of goods, carrying out
of repairs etc.) are substantially complete;
 The amount of revenue generated can be objectively determined; and
 There is reasonable certainty that the amounts owing from the activities will be
received.

Example 5b

A manufacturing business sells goods on credit (i.e. the customer is allowed to pay some time
after the goods have been received). Below are four points in the production or selling cycle at
which revenue might be recognized by the business:
1. when the goods are produced
2. when an order is received from a customer
3. when the goods are delivered to, and accepted by, the customer
4. when cash is received from customer
Required
A significant amount of time may elapse between these different points. At what point do you
think the business should recognize revenue?
The criteria will probably be fulfilled when the goods are passed to the customer and
are accepted by him/her. This is the normal point of recognition when goods are sold
on credit. It is also the point at which there is a legally enforceable contract between the
parties. NB: Total sales figure shown in the income statement may include sales
transactions for which the cash has yet to be received. Therefore, the total sales figure
in the income statement will be different from the total cash received from sales.
(ii) The matching principle states that expenses should be matched to the revenues they
help to generate. Such expenses could include payable salary, commission, rent,
depreciation etc. NB: When a particular expense reported in the profit and loss account is not
the same as the cash paid, it will result in some adjustments to accruals or prepayments:

Example 5c
DANA enterprise deals in agricultural machinery and equipment. It pays its sales staff a
commission of 2 per cent of sales generated, and total sales for the year amounted to $300,000.
This will mean that the commission to be paid in respect of sales for the period will be $6,000.
However, by the end of the period, the sales commission paid to staff was $5,000. If the
agribusiness reported only the amount paid, it would mean that the P and L account would not

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reflect the full expense of the year. This would contravene the matching convention because not
all of the expenses associated with the revenues of the period would have been matched in the P
and L account. This will be remedied as follows:
 Sales commission expense in the P and L A/C will include the amount paid plus the
amount outstanding (i.e. ($5,000 + $1,000).
 The amount outstanding ($1,000) represents an outstanding liability at the balance
sheet date and will be included under the heading ‘accruals’ or “accrued expenses” in the
balance sheet. As this item will have to be paid within 12 months of the balance sheet
date, it will be treated as a “current liability”.
 The cash will be reduced to reflect the commission paid ($5,000) during the period.
N.B: Sometimes, other expenses cannot be linked directly to sales e.g. electricity, rent and rates,
insurance, interest payments, licenses etc. Therefore matching will be done on a time basis.

Example 5d

DANA enterprise has reached the end of its accounting year and has only been charged
electricity for the first three quarters of the year (amounting to K1, 800). This is simply because
ZESCO has yet to send out bills for the quarter that ends on the same date as DANA enterprises
year end.
In this situation, an estimate should be made of the electricity outstanding using the bill for the
last three months of the year) supposing the figure is K600 per quarter. It will be dealt with as
follows:-
 Electricity expenses in the profit and loss account will include the amount paid,
plus the amount of the estimate (i.e. K1, 800 + 600 = K2, 400) in order to cover the
whole year.
 The amount of the estimate K600 represents an outstanding liability at the balance
sheet date and will be included under the heading ‘accruals’ or (accrued expenses’
in the balance sheet. As this item will have to be paid within 12 months of the
balance sheet date, it will be treated as a current liability.
 The cash will be reduced to reflect the electricity paid (K1, 800) during the
period.
NB: Dealing with the outstanding amount in this way reflects the dual aspect of the item and
will ensure that the balance sheet equation is maintained.

Example 5e

When the amount paid during the year is more than the full expense for the period.

Agro consults Limited, a consulting agency, pays rent for its premises quarterly in advance (on
1 January, 1 April, 1 July and 1 October) and , on the last day of the accounting year
(31stDecember), it pays the next quarter’s rent (4,000) to the following 31 st March, which is a
day earlier than required. This would mean that a total of five quarter’s rent was paid during

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the year. If Agro consults Limited reports the cash paid in the P and L A/C, this would be more
than the full expense for the year. This treatment would also contravene the matching
convention because a higher figure than the expenses associated with the revenues of the year
would appear in the profit and loss account. The problem is overcome by dealing with the rental
payment as follows:
 Show the rent for four quarters as the appropriate expense in the profit and loss
account (i.e. 4 x 4,000 = K16, 000).
 Reduce the cash to reflect the full amount of the rent paid during the year (i.e. 5 x
K4, 000 = K20, 000).
 Show the quarter’s rent paid in advance (K4, 000) as a prepaid expense on the asset
side of the balance sheet. (The prepaid expense will appear as a current asset in
the balance sheet, under the heading prepayments). NB: In the next accounting
period this prepayment will cease to be an asset and will become an expense in
the profit and loss account of that period. This is because the rent, prepaid
relates to that period and will be the rent ‘used up’ during that period.

7. Financial Statements

The accounting system normally produces three major financial reports on a regular
recurring basis. They are concerned with answering the following questions;
i. How much wealth (i.e. profit) was generated by the business over a particular
period? (Income or Profit and Loss statement)
ii. What is the accumulated wealth of the business at the end of a particular
period? (Balance sheet)
iii. What cash movements (i.e. cash in and cash out) took place over a particular
period? (The cash flow statement.)

Financial statements are prepared from adjusted trial balance directly. At first to
determine net income or net loss, the income statement is prepared from the revenue
and expense accounts. After that, the owner’s equity statement is derived from the
owner’s capital, drawing account and the net income or net loss from the income
statement.

Finally, the balance sheet is completed by listing all the assets, liabilities and owner’s
equity. Assets will always equal the liabilities and equity that is why this statement is
called balance sheet and it shows the financial condition of the enterprise at a given
time.

5.1.4 THE BALANCE SHEEET

The Format of the Balance Sheet

In practice there are two basic formats of the balance sheet, these are;
(i) the horizontal format

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 (ii) the vertical format

Horizontal Format

The horizontal format sets out the assets on one side of the balance sheet and capital
and liabilities on the other side.

Balance sheet as at 31st December 20XX for ABC LTD

Fixed Assets $ $ Capital $
Buildings 45,000 Opening Balance 50,000
Plant and Machinery 30,000 Add Profit 14,000
Motor Vans 19,000 Total Capital 64,000
Less Drawings 4,000
Total Fixed Assets 94,000 Total Capital 60,000

Long Term Liabilities

Loan 50,000

Current Assets Current Liabilities

Stock in trade 23,000 Trade Creditors 37,000
Trade debtors 18,000
Cash in bank 12,000

Total Current 53,000 Total Liabilities 87,000

Assets

Total Assets 147,000 Total Capital and Liabilities 147,000

Within each category of assets (fixed and current), shown in the above balance sheet ,
the items are listed in reverse order of liquidity (nearness to cash) that is, the assets that
are furthest from cash are listed first and the assets that are closet to cash are listed last.
This ordering of assets is a standard practice which is followed irrespective of the
format used. Current assets are listed individually in the first column, and a subtotal of
$53,000 is carried out to the second column to be added to the subtotal of fixed assets
($94,000). This convention is designed to make the balance sheet easier to read.

The equation for the horizontal layout is

Fixed + Current = Capital + Long-term + Current
Assets Assets Liabilities Liabilities

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The Vertical Layout

Currently this is the most common format. This format is really based on a
rearrangement of the balance sheet equation.

Fixed Currents Current Long Term

Assets + Assets - Liabilities - Liabilities = Capital + Profit - Drawings

In addition to this the information is presented vertically rather than horizontally.

Balance sheet as at 31st December 20XX for ABC LTD
Fixed Assets $ $
Buildings 45,000
Plant and machinery 30,000
Motor Vans 19,000
94,000
Current Assets
Stock in Trade 23,000
Trade Debtors 18,000
Cash in Bank 12,000
53,000
Less Current Liabilities
Trade Creditors 37,000
16,000
Total Assets Less Current Liabilities 110,00
Less Long Term Liabilities
Loan 50,000
Net Assets 60,000
Capital
Opening Balance 50,000
Add Profit 14,000
64,000
Less drawings 4,000 ______
60,000

Explanation of the features on the Balance Sheet

a. Assets: can broadly be divided into fixed and current assets:
a. Fixed Assets
Fixed Assets have a long life (typically for more than 1 year) and are used to generate
wealth (i.e. to produce/sell other goods/services rather than being sold. Examples:
buildings, Land, machinery, fixtures and fittings. Generally all fixed assets with the
exception of land decrease in value (depreciate) overtime. For a balance sheet to
show the true value of the assets, it must reflect the asset’s loss in value i.e. the actual
value of the asset in its present state.

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 b. Current Assets

Current Assets refer to assets that can be converted to cash during one normal
operating cycle of the business (usually 1 year). It represents the amount of cash that
might be raised quickly to meet current obligations. Current assets may include:
 Cash: these are funds that are immediately available for use without
restriction. Should be large enough to meet any obligations as they fall due
immediately e.g. cash at bank, petty cash etc.

 Accounts receivables (Debtors): refers to the total amount owed to the company
as payment of purchases. They result from granting credit to customers and may
take the form of charge accounts on which no interest or service charge is made,
or they may be of interest bearing nature.

 Inventory Stock - those items that are held for sale in the ordinary course of
business or that are to be consumed in the process of producing goods and
services to be sold. Inventory items are usually valued at cost (actual funds
expended) or market value (what they are worth), whichever is lower. Control
of inventory and inventory expenses is one of management’s most important
jobs, particularly for retailers.

 Prepaid Expenses: assets that have been paid for in advance; usually, their
usefulness is due to end after a short time e.g. prepaid insurance – a business
often pays for insurance protection for as much as 3 – 5 months in advance. The
right to this protection is a thing of value (an asset), and the prepaid or unused
portion can be refunded or converted to cash.

 Other Assets: represents other accounts for any investment of the firm in
securities, such as stock in other private companies and bonds. These have a
longer life than current asset items and are generally non depreciable in nature.
In many cases, they cannot easily be sold within the operating year or without
incurring considerable loss in value e.g. private companies stocks and bonds,
patents, franchise costs and good will. Trade mark (contracts giving exclusive
rights to perform certain functions or to sell certain goods. Note that, assets are
listed starting with the asset furthest away from being turned into cash finishing
with cash itself.

b. Capital
 Capital details the claims of the owners against the business assets. Owners receive
whatever assets are left after the liability claims have been recognized. From the
Accounting equation; Assets – Liabilities = Capital.
 Common stock represents the owners’ original or contributed investment to the
business whereas, retained earnings represents the net profits the owners have

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 chosen to leave in the business as additional contributed capital. It is an important
source of capital growth. However, if the business has been consistently producing
at a loss, the owner’s claims may be less than the initial investment.

c. Liabilities

Essentially liabilities are divided into two; Long term liabilities and Current liabilities.

i. Long-Term Liabilities

These refer to outsiders’ claims against the business that do not come within one year
e.g. bonded indebtedness, mortgages, long term loans from individuals/banks etc.

ii. Current Liabilities

These are outsiders’ claims on the business that will fall due within one normal
operating cycle, usually one year. Some examples include:

(a) Accounts payable: items which have been purchased on credit; whose payment
is expected in less than 1 year.

(b) Notes payable: are short term loans/liabilities – e.g. loans from individuals,
banks or other lending institutions that fall due within a year. Also included
within this category is the specific portion of any long term debt that will
come due within a year.

(c) Accruals: include those obligations that the business has incurred for which
there has been no formal bill/invoice e.g. Taxes. The fact that taxes do not
have to be paid until a later date in the operating year does not diminish the
daily obligation. Also wages are being earned daily or even hourly, and
constitute a valid claim on the company’s assets.

5.1.5 PROFIT AND LOSS ACCOUNT (INCOME STATEMENT)

The Profit and Loss account (also known as an Income Statement) is concerned with the
flow of wealth over a period of time, whilst the balance sheet as seen previously is a
snap shot of the stock of wealth held by the business.

The two statements are closely related. The profit and loss account can be viewed as
linking the balance sheet at the beginning of the period with the balance sheet at the
end. It shows how wealth was generated over the period.
The effect on the balance sheet of making a profit or loss means that the equation can be
extended as follows:

Assets = Capital + (-) Profit (Loss) + (Liabilities)

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This equation is the same as:

Assets = Capital + (Revenues – Expenses) + Liabilities

Format of an Income/Profit and Loss Statement

The format of an income statement varies from business to business. However,

generally the statement begins with sales.
1. Sales: these represent the money value of all the products and services that have been
sold during the period specified on the income statement. These may be either
credit/cash sales. Sometimes customers return products after the products have
already been purchased. The money value of all return is usually subtracted from the
money value of all sales. Some customers may be offered discount prices for the goods
or services they buy these also must be subtracted i.e. Sales- (Returns + Discounts) =
Net Sales

2. Cost of Goods Sold (COGS): represent the total cost to the agribusiness of goods that
were actually sold during the specified period. In the case of retail firms/trading firms,
whose purpose is to resell a previously purchased product, this category is rather
straight forward (i.e. accounting of the actual purchases plus any additional freight charges).
There is also need to balance changes in inventory to reflect actual costs incurred during
the accounting period.

In case of processing or manufacturing firms, COGS not only involves costs for raw
materials but many internal and direct manufacturing costs that have been used during
the accounting period. These are subtracted from sales to establish the gross margin.

The formula for COGS is: Opening Stock

+ Purchases (for the opening year))
- Closing stock (cost of goods unsold at the end of
the same period)
_________________
Cost of Goods Sold

3. Gross Profit/Margin: represents the difference between Turnover and COGS. It is the
money that is available to cover the operating expenses and still leave a profit. Note
that, prices of the goods that an agribusiness purchases are the most critical factor
affecting its Gross margin, as they affect COGS.

4. Add Other income: would include any income derived from other sources, such as
interest, dividends earned on outside investments, consultancies, discounts received,
commission received, rent received etc.

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5. Less Operating expenses: represents the costs that are associated with the specific
sales transacted during the time period designated on the Income statement. They
include:

 Marketing expenses: sales, wages; salaries and commission, transportation,

advertising and promotion etc.;
 Administrative expenses: auditing fees, directors’ fees, management salary, office
expenses, travel expenses etc.;
 General expenses (overhead): Insurance, rent, repairs, utilities, depreciation etc.
It would be misleading to charge the entire cost of a fixed asset to the business
during the year in which it was purchased, since the asset will last for several
years, therefore that part that is used during the operating period is reported as
an expense and it’s referred to as depreciation.

5. Profit before Interest and Tax: amount left when operating expenses are subtracted
from Gross margin.

6. Profit After Interest and Tax/Net profit: Net profit after taxes and interest have been
subtracted.

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AN ILLUSTRATION OF A TRADING PROFIT AND LOSS A/C FOR THE YEAR
ENDED 31ST DECEMBER 20XX
Amount Amount Amount
(ZMK) (ZMK) (ZMK)
Sales 12,000,000
Less: Sales Returns 50,000
Net Sales 11,950,000
Less: Cost of Goods Sold
Opening stock 600,000
Add: Purchases 4,000,000
Less: Purchases Returns 500,000
Net purchases 3,500,000
Goods available for sale 4,100,000
Less: Closing stock 1,500,000
Cost of Goods Sold (2,600,000)
Gross profit 9,350,000

Add: Other income

Commission received 80,000
9,430,000

Less: Operating expenses

Wages 1,300,000
Electricity 200,000
Rent 600,000
Bad debts 60,000
Vehicle Maintenance 1,400,000
Depreciation 500,000 4,060,000

Profit before Tax 5,370,000

Less Tax (25%) (1,342,500)
Profit After Tax/Net Profit 4,027,500

The Reporting Period

For reporting to those outside the business, a financial reporting cycle of one year is the
norm, though some large businesses will produce a half yearly, or interim, financial
statement to provide more frequent feedback on performance. However, for those who
manage a business, it is important to have much more frequent feedback on
performance e.g. quarterly or monthly basis in order to show the progress made during
the year.

17
[Link] Profit Measurement and the Calculation of Depreciation

Depreciation is an attempt to measure that portion of the cost of a fixed asset that has
been used up in generating the revenues realized during a particular period. The
depreciation charge is considered to be an expense of the period to which it relates.
To calculate a depreciation charge for a period, four factors have to be considered.

(a) the cost of the asset

(b) the useful life of an asset
(c) the residual value of an asset
(d) the depreciation method

The cost of the asset: includes all costs incurred by the business to bring the asset to its
required location and to make it ready for use i.e. cost of a acquiring the asset, any
delivery costs, installation costs (e.g. setting up a new machine) and legal costs incurred
in the transfer to legal title (e.g. in case of freehold property). Similarly, any costs
incurred in improving or altering an asset in order to make it suitable for its intended
use within the business will also be included as part of the total cost.

The useful life of the asset: an asset has a physical life and an economic life. The
Physical life of an asset will be exhausted through the effects of wear and tear and/or
passage of time. Note that, the physical life can be extended considerably through
careful maintenance, improvements etc. On the other hand the Economic life of an asset
is decided by the effects of technological progress and by changes in demand. After a
while, the benefits of using the asset may be less than the costs involved. This may be
because the asset is unable to compete with newer assets, or because it is no longer
relevant to the needs of the business. The economic life of an asset may be much
shorter than its physical life e.g. a computer may have a physical life of eight years and
an economic life of three years. The economic life of an asset will determine the
expected useful life for the purpose of calculating depreciation.

Residual value (Disposal value): when a business disposes of a fixed asset that may
still be of value to others, some payment may be received. This payment will represent
the residual value, or disposal value of an asset. To calculate the total amount to be
depreciated with regard to an asset, the residual value must be deducted from the cost
of the asset.

Depreciation method
Although there are various ways in which the total depreciation may be allocated and
from this a depreciation charge for a period derived, there are really only two methods
that are commonly used in practice.

18
 (i) The Straight Line Method; and
(ii) The Reducing (Declining) Balance Method

Straight – line method

The method allocates the amount to be depreciated evenly over the useful life of the
asset. An equal amount of depreciation will be charged for each year the asset is held.

Consider the following example;

The following information has been provided; use it to calculate the depreciation

Cost of machine $40,000

Estimated residual value at the end of its useful life $ 1,024
Estimated useful life 4 years

Solution

Total amount to be depreciated = Total cost – Estimated Residual Value

$38,976 = $40,000 - $1,024

Annual depreciation charge = Amount to be depreciated

Estimated useful life

= $38,976
4years

= $9,744/year

 The annual depreciation charge that appears in the profit and loss account in
relation to this asset will be $9,744 for each of the four years of the asset’s life.
 The amount of depreciation relating to the asset will be accumulated for as long
as the asset continues to be owned by the business.
 This accumulated depreciation figure will increase each year as a result of the
annual depreciation amount charged to the profit and loss account. This
accumulated amount will be deducted from the cost of the asset on the balance
sheet. Thus, from the example above, at the end of the second year the
accumulated depreciation will be $9,744 x 2 = $19,488 and the asset details will
appear on the balance sheet as follows:

$ $

Machine at cost 40,000

Less Accumulated depreciation 19,488

19
 20,512

 The balance of $20,512 shown above is referred to as the written – down value or
net book value of the asset. It represents that portion of the cost of the asset that has
still to be written off (i.e. treated as an expense). Note that this figure does not
represent the current market value, which may be quite different.
 The straight line method derives its name from the fact that the written – down
value of the asset at the end of each year, when graphed against time, will result
in a straight line. Figure 5.1 shows that the written down value of the asset
declines by a constant amount each year. This is because the straight line
method provides a constant depreciation charge each year.
Value of the asset

Time
Figure: 5.1 Graph of written down value against time using the straight line method

Reducing (Declining) Balance Method

The method applies a fixed percentage rate of depreciation to the written down value of
an asset each year. The effect of this will be high annual depreciation charges in the
early years and lower charges in the later years.
Supposing we used the same information in the above example but applied a 60%
percent fixed rate of depreciation of the written down value to determine the annual
depreciation charge. This will have an effect of reducing the written down value to
$1,024, after four years.

20
 $
Cost of Machine 40,000
Year 1 Depreciation charge (60% of cost) (24,000)
Written – down value (WDV) 16,000
Year 2 Depreciation charge (60% WDV) (9,600)
Written down value 6,400
Year 3 Depreciation charge (60% WDV) (3,840)
Written – down value 2,560
Year 4 Depreciation charge (60% WDV) (1,536)

Residual value 1,024

Figure 5.2 shows that under the reducing balance method, the written – down value
of an asset falls by a larger amount in the earlier years than in the later years. This is
because the depreciation charge is based on a fixed rate percentage of the written
down value.
Value of the asset

Time
Figure 5.2: Graph of Written Down Value against Time Using the
Reducing Balance Method.

Consider the following example;

21
 Assume that the machine used in the example above was owned by a business that
made a profit before depreciation of $20,000 for each of the four years in which the
asset was held.

Required

Calculate the net profit for the business for each year under each depreciation
method and comment on your findings.

Solution

1. Straight line method

(a) (b) (a-b)
Year Profit before Depreciation ($) Net profit ($)
Depreciation ($)
1 20,000 9,744 10,256
2 20,000 9,744 10,256
3 20,000 9,744 10,256
4 20,000 9,744 10,256

2. Reducing balance method

(a) (b) (a-b)
Year Profit before Depreciation ($) Net profit ($)
Depreciation ($)
1 20,000 24,000 (4,000)
2 20,000 9,600 10,400
3 20,000 3,840 16,160
4 20,000 1,536 18,464

 The above calculations reveal that the Straight Line Method of depreciation results
in a constant net profit figure over the four year period. This is because both the
profit before depreciation and the depreciation charge are constant over the period.
 The Reducing Balance Method, however results in changing profit figure overtime.
In the first year a net loss is reported, and thereafter a rising net profit is reported.

Depreciation and replacement of fixed assets

 There seems to be a misunderstanding in the minds of some people that the purpose
of depreciation is to provide the funds for the replacement of an asset when it
reaches the end of its useful life.
 On the contrary, depreciation is an attempt to allocate the cost (less residual value)
of an asset over its useful life. The resulting depreciation charge in each period
represents an expense, which is then used in the calculation of net profit for the

22
 period. It is necessary for the proper measurement of financial performance and
must be done whether or not the business intends to replace the asset in the future.
 If there is an intention to replace the asset, the depreciation charge in the Profit and
Loss account will not ensure the liquid funds are set aside by the business
specifically for this purpose.
 Although the effect of a depreciation charge is to reduce net profit, and therefore to
reduce the amount available for distribution to owners, the amounts retained within
the business as a result may be invested in ways that are unrelated to the
replacement of the specific asset.

Question: Suppose that a business sets aside liquid funds, equivalent to the
depreciation charge each year, with the intention of using these to replace the asset at
the end of its useful life. Will this ensure that there will be sufficient funds available for
this purpose?
Answer: No! Even if funds are set aside each year that are equal to the depreciation
charge for the year, the total amount accumulated at the end of the asset’s useful life
may be insufficient for replacement purposes. This may be because inflation or
technological advances have resulted in an increase in the replacement cost.
How does an agribusiness choose which depreciation method to use for a particular
asset?
The most appropriate method should be the one that best matches the depreciation
expense to the revenues that it helped to generate. The business may therefore decide to
undertake an examination of the pattern of benefits associated with each asset. N: B
Where the benefits are likely to remain fairly constant over time (e.g. buildings) the
straight line method may be considered appropriate. Where assets lose their efficiency
overtime and the benefits decline as a result (e.g. certain types of machinery), the
reducing balance method may be considered more appropriate. Where the pattern of
economic benefits is uncertain, the straight – line method is usually chosen.
N:B The accounting standard requires that businesses disclose a fair amount of detail
concerning depreciation charges, in their financial statements e.g. depreciation method,
total depreciation for the period, the accumulated amount of depreciation at the
beginning and end of the financial period, depreciation rates applied and the useful life
of the asset.

[Link] Profit Measurement and Stock Costing Method

The way in which we derive the cost of stocks sold during a period and stock held at
the end of the period is important in the calculation of profit and presentation of
financial position of a firm. There are various assumptions regarding the stock costing
method:
1. First in, first out (FIFO): The earliest stocks held are the first to be sold.
2. Last in, first out (LIFO): The latest stocks held are the first to be sold.

23
3. Weighted Average Cost (AVCO). It assumes that stocks entering the business lose
their separate identity, and any issues of stock reflect the average cost of the stocks that
are held. Therefore it applies an average cost to all stocks sold.

Example IX:
A business commenced on 1st May to supply goods to factories. During this month, the
following transactions took place:
Tonnes Cost per tonnes

May 2 Purchased 10,000 $10

10 purchased 20,000 $13
18 sold 10,000

FIFO Approach: It is the first 10,000 tonnes that are assumed to be sold first. The
remainder, which is the later purchases, will comprise the closing stock. Thus we have:
Cost of sales (10,000 @ $10 per tonne) = $100,000
Closing stock (20,000 @ 13 per tonne) = $260,000

LIFO Approach: The later purchases are assumed to be the first to be sold and so the
earlier purchases, plus any later purchases that remain unsold, will comprise the closing
stock. Thus we have:
Cost of sales (10,000 @ $13 per tonne) = $130,000
Closing stock (10,000 @ $13 per tonne + 10,000 @ $10 per tonne) = $230,000

AVCO Approach: The weighted average of the stock purchased during the period will
be determined as follows:
Average Cost = [(10,000 x $10) + (20,000 x $13] =$12 per tonne

(10,000 + 20,000)
This cost per tonne will then be used to drive both the cost of goods sold and the cost of
the remaining stocks. Thus we have:
Cost of Sales (10,000 @ $12 per tonne) = $120,000
Closing stock (20,000 @ $ 12 per tonne) = $240,000.

Exercise X
What would be the effect on the business of adopting each stock costing method in terms of:
(a) the size of the reported profit for the period, and
(b) The assets shown on the balance sheet at the end of the period?
(c) Can you explain the effect on each method on reported profit and financial position?

 The FIFO method gives the lowest cost of sales figures which when deducted
from sales will give the highest gross profit figure. This method gives the lowest cost of
sales figure because it reflects the cost of the earlier (cheaper) stocks. This method will

24
also give the highest stock figure in the balance sheet at the end of the period. This is
because it is the latter (and more expensive) stocks that are reflected in this figure.
 The last in, first out (LIFO) approach gives the highest cost of sales figure and so will
give the lowest gross profit figure. This approach gives the highest cost of sales figure
because it reflects the cost of the later (and more expensive) stocks. This approach will
also give the lowest stock figure in the balance sheet at the end of the period. This is
because it is the earlier (and cheaper) stocks that are reflected in this figure.
 The weighted Average cost will provide a cost of sales figure and closing stock
figure that fall between the two extremes.
 Where stock prices are rising, the FIFO method will give the highest gross profit and
LIFO will give the lowest gross profit. During a period of falling prices the position of
FIFO and LIFO are reversed. The AVCO method will provide a figure between these
two extremes.
 For taxation purpose especially in an inflationary economy LIFO will be preferred to
reduce the taxable income; however some revenue authorities prefer / require that
companies use either FIFO or AVCO.

iii. Profit Measurement and the Problem of Bad Debt

Where it is reasonably certain that a credit customer will not pay, the debt is regarded
as ‘bad’ and should be written off. This will involve:
 Reducing the debtors
 Increasing expenses (by creating an expense known as ‘bad debts written off) by the
amount of the bad debt is written off in the same period as that in which the sale that
gave rise to the debt is recognized

5.1.6 THE CASH FLOW STATEMENT

In order for a business to survive, the ability to make profits may not be enough. It is
worthwhile to note that some profitable agribusinesses have been severely constrained
as a result of inadequate cash. Inability to meet current financial obligations will often
force businesses to collapse. Hence, it is important for the business to generate sufficient
cash in order to meet its obligations as they arise. Also careful management of cash is
needed to pursue all the opportunities desired by management. As such the cash asset
is watched most carefully when trying to assess the ability of businesses to survive/or
to take advantage of commercial opportunities as they arise.

Profitability and Liquidity -There is a distinction between profitability and liquidity.

Profit (loss), which represents the difference between the revenues and expenses for the
period, may have little or no relation to the cash generated for the period. For example
revenues do not usually represent cash received. If a business makes a sale (revenue)
this will lead to an increase in wealth and will be shown in the profit and loss account.
However, if the sale is made on credit, no cash changes hands (not at the time of the sale
at least). Instead the increase in wealth is reflected in another asset i.e. an increase in
trade debtors. Expenses are not the same as cash paid. Consequently the net profit

25
figure (i.e. total revenue – total expenses) will not normally represent the net cash
generated during a period. For such reasons profitability and liquidity do not
necessarily go hand in hand.

It is therefore important to distinguish between profit and liquidity. Profit is a measure

of achievement, or productive effort, rather than a measure of cash generated.
Although making a profit will increase wealth, cash is only one form in which that
wealth may be held.

What Affects Profit and Cash?

The following table gives an illustration on how profit and cash for a period may be affected
differently by particular business transactions.

Transaction/event Effect on Effect on Reason

profit cash
[Link] of a None Decrease Repaying the loan requires that the cash be paid to the
loan creditors. Thus two figures in the balance sheet will be
affected, but not the profit and loss account
2. Making a sale on Increase None Making a sale on credit will increase the sale figure
credit and probably profit or loss (unless the sale was made
for a price that precisely equaled the expense
involved). No cash will however change at this point.
[Link] a fixed None Decrease Buying a fixed asset for cash obviously reduces the
asset for cash cash balance of the business, but its profit figure is not
affected
4. Receiving cash None Increase Receiving cash from a debtor increases the cash
from a debtor balance and reduces the debtors balance. Both of these
figures are on the balance sheet. The profit and loss
account is unaffected
5. Depreciating a Decrease None Depreciating an asset means that an expense is
fixed asset recognized. This causes the value of the asset as
recorded in the balance sheet to fall by an amount
equal to the amount of the expense. No cash is paid or
received
6. Buying some None Decrease Buying some stock for cash means that the value of
stock for cash the stock will increase and the cash balance will
decrease by similar amount. Profit is not affected.
7. Making a share None Increase Making a share issue for cash increases the owners’
issue for cash claim and increases the cash balance; profit is
unaffected

Definition of a cash flow statement

26
A cash flow statement is a projection of future cash needs and income of a business. It explains
the changes in the company’s cash balance by summarizing the cash receipts and disbursements
occurring over a period of time.

The Aim/Purpose of a Cash Flow Statement

A cash flow statement helps you to understand the business cash flow on monthly basis. It assists
you to:
 Assess the ability of the business to generate positive cash flows in the future;

 Plan and control of the cash by:-

o Assessing the ability of the business to meet its financial obligations/commitments. e.g.
maturing liabilities: loan repayments, interest payments, taxation due, payment of
dividends, investments and financing seasonal demands etc;
o Assessing the effect of major events or business transactions on the liquidity of the
business;
o Assessing the reasons for the differences between the reported and budgeted cash flow;

 Apart from being used by internal management, banks insist on them when applying for a
loan. Cash flow statements assist in the planning and controlling of borrowing and
investment activities so as to avoid cash shortages/excessively high cash balances. They help
you to develop sound borrowing programs and to make plans for debt servicing, by assisting
the manager to decide whether there is a need for short, intermediate or long term loans or
equity or capital e.g. If the cash amounts are ample at certain times and short at others, short-
term capital is needed. If there is a persistent shortage trend on the short term side,
intermediates or long term capital is needed.

Construction of a Cash Flow Statement

There are three key stages in preparing a cash flow statement:

i. Estimation of cash inflows: Cash flows into a business in various ways which include:
cash sales, selling of fixed assets, bank cash loan, earnings on capital investment etc.

ii. Estimation of cash outflows: Drawings (withdrawals), purchases, payments to creditors,

operating expenses such as salaries /wages, rent, electricity, taxes, repayment of loans
etc.

iii. Determination of the net cash flows and current cash position. The final stage in the
preparation of a cash flow statement is to determine the net cash flow for each month and
current cash position. These are determined are done by subtracting total cash outflow
from total cash inflow available each month, which gives you the net cash flow.

Net Cash Flow = Total Cash Inflow – Total Cash Outflow

27
There after you add the opening bank estimation of cash inflows balance to the net cash flow.
The figure gives you the closing balance which should be carried forward to the next month as
you opening balance

Closing Balance = Opening Bank Estimation of Cash Inflows + Net Cash Flow

Closing Balance = Opening Balance in the next month

Explanation of the main features of a Cash Flow Statement

A cash flow is a revenue or expense stream that changes a cash account over a given period. Cash
inflows usually arise from one of three activities - financing, operations or investing - although this
also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from
expenses or investments. This holds true for both business and personal finance

Operating activities: principal operating activities of the company and other activities;

 Return on investments and servicing of finance:

Cash inflows from these sources include:

o Interest received, also any related tax recovered; and
o Dividends received;
Cash out flows from these sources include:
o Interest paid;
o Dividend paid;
o Interest element of finance lease payments.
 Taxation: These cash inflows will be those to and from the tax authorities in relation to the
company’s revenue and capital profits, e.g. reclaiming of VAT, returns of over payment,
corporation tax;

Investing activities: the acquisition and disposal of long term assets and other investments not
included in cash equivalents;

Cash receipts include:

 Receipts from sales or disposal of fixed assets(current asset investments);
 Receipts from sales of investments in subsidiary undertakings net of any cash or cash
equivalents transferred as part of the sale;
 Receipts from sales of investments in other entities;
 Receipts from repayment or sales of loans made to other entities;

Cash payments include:

 Payments to acquire assets;
 Payments to acquire investments in subsidiary net of balances of cash or cash
equivalents acquired;
 Payment to acquire investments in other entities;
 Loans made and payments to acquire debt of other entities;

28
Financing: activities that result in changes in the size and composition of the equity capital and
borrowings of the enterprise:
Financing cash inflows include:
 Receipts from issuing shares or other equity instruments;
 Receipts from issuing debentures, loans, notes and bonds etc.
Financing cash outflows include:
 Repayments of amounts borrowed;
 The capital element of finance lease rental repayments;
 Payments to acquire or redeem the entity’s shares.

Illustration of a Cash Flow Statement

Kumulonga Farms Cash Flow Statement For the Year Ending 31/12/20XX
Cash at Beginning of Year K15,700

1 Operations Activities
Cash Receipts from Customers 693,200
Cash Paid for
Inventory Purchases (264,000)
General Operating and Administrative Expenses (112,000)
Wage Expenses (123,000)
Interest (13,500)
Income Taxes (32,800)
Net Cash Flow from Operations Activities 147,900
2 Investment Activities
Cash Received From
Sale of Property and Equipment 33,600
Collection of Principle from Loan
Sale of Investment Securities
Cash Paid For
Purchase of Property and Equivalent (75,000)
Making Loans to Other Entities
Purchase of Investment Securities
Net Cash Flow from Investment Activities (41,000)
3 Financing Activities
Cash Receipts From
Issuance of Stock
Borrowing
Cash Paid For
Repurchase of stocks (Treasury Stocks)
Repayment of Loans (34,000)
Dividends (53,000)
Net Cash Flow from Financing Activities (87,000)

Net Increase in Cash 19,500

29
 Cash at End of Year 35,200

Exercise (This an example of a typical exam question)

1. A six months cash flow projection for BaHinkuuku Farm revealed the following
information:
 Egg production costs and estimated production are as follows:
JAN FEB MAR APR MAY JUN TOTAL
Production(Number of 250 260 275 285 280 270 1620
Trays)
Monthly Production 2.50 2.70 2.90 3.10 3.10 2.90 17.20
costs (K)Millions

 In addition to the above production costs, his overhead costs are

estimated to be K 1.25 M per month;
 Eggs will be sold for cash at K17, 000 per tray,
 He hopes to contribute a sum of K0.6 million as initial capital;
 BaHinkuuku hopes to secure a loan of K2.4 million in January for this
project
 BaHinkuuku will pay back the loan of K2.4 million in six equal monthly
installments
 He will also pay a monthly flat rate of interest at 40% per annum over the
same period of time.
Required
i. Prepare a cash flow budget for BaHinkuuku farm (13 Marks)
ii. How much overdraft, if any, should the farm get to avoid liquidity
problems (2 Marks)
iii. What profit or loss will BaHinkuuku generate over the six months period?
(5 Marks)

Cash Budget for BaHinkuuku Jan –July 2011(K’Millions)

Cash In Flow JAN FEB MAR APR MAY JUN TOTAL
Opening Balance - 3.02 3.01 3.055 3.07 3.00 15.155
Capital Introduced 0.6 - - - - - 0.6
Sales 4.25 4.42 4.675 4.845 4.76 4.59 27.54
Loan 2.4 - - - - - 2.4
Total Cash In Flow 7.25 7.44 7.685 7.9 7.83 7.59 45.695
Cash Out Flow
Production Costs 2.5 2.7 2.9 3.10 3.10 2.90 17.2
Overhead Costs 1.25 1.25 1.25 1.25 1.25 1.25 7.5
Principal Loan 0.4 0.4 0.4 0.4 0.4 0.4 2.4
Repayments
Interest Payments 0.08 0.08 0.08 0.08 0.08 0.08 0.48
Total Cash Outflow 4.23 4.43 4.63 4.83 4.83 4.63 27.58
Closing Balance 3.02 3.01 3.055 3.07 3.00 2.96 18.115

30
ii) BaHinkuuku should not get an overdraft

iii) Profit or Loss for BaHinkuuku

1c) Profit or Loss for BaHinkuuku
Total Sales over the 6mths period 27.54
Less Production Costs 17.2
Gross Profit 10.34
Less Operating Overheads 7.5
Less Principal Loan Repayment 2.4
Less interest paid 0.48
Net Profit/Loss (0.04)
He made a loss of K40, 000 over the 6mths period

All expenses are matched against the revenues that were used to generate them hence
the reason for charging both the principal sum and the interest on the loan to the
trading profit and loss account. N: B Capital (Owner's equity) is not supposed to be
charged to the trading profit and loss account because all Net profits and losses after
they have been appropriated are added back to the capital account in the balance sheet
since the proprietor does get all the capital sum invested at a go but receives a return on
investment only in form of dividends.

5.1.7 Analyzing and Interpretation of Financial Statements

Financial statements of any agribusiness provide a wealth of information for managers,

owners, lending institutions, government etc. Some of this information requires little
interpretation, but much of it is meaningless unless it is put in proper perspective.
Therefore, analysis of these statements is important or else they can be almost
meaningless scraps of paper. Typically two common financial statements are used in
the financial analyses; the balance sheet and the income / profit and loss statement.
Many businesses fail because management discovered too late that plans were going
wrong. Therefore, it is important that managers continuously evaluate financial records
in order to detect the firms’ progress or lack of it towards previously determined goals.
If a problem is detected early enough as it is developing, sufficient time is allowed for
corrective action to be taken.
An analogy might be taken from a motorist. A motorist will check oil periodically, to
forewarn of potential problems, or else the engine may knock which could mean
unwarranted costly spending or even grounding the car permanently. Therefore, a spot
check of the business’s health should be taken at regular intervals. In most businesses,
the financial statements should be prepared and analyzed on a monthly basis or at the
very least on a quarterly basis, so that problems or opportunities can be determined
before they develop or pass by. Only very small and simple businesses can depend on
the annual preparation and analysis of financial statements. The cost of the process is

31
small compared to the risk of discovering too late that problems or opportunities have
been missed.

5.7.2 FINANCIAL RATIO ANALYSIS

The business that survives and prospers will have managers who use tools of financial
analysis to check on the vital financial functions and health of the firm (how successful
the business performance has been: and what problems or opportunities exist) and
Prescribe alternative / remedial courses of action that might improve performance in
the future. The tools are generally looked under financial ratios. A ratio can be defined
as an expression of a relationship between two quantities by dividing the magnitude of
one by that of the other. Such a relationship can be expressed either as a percentage,
fraction or decimal.

Why use financial Ratio Analysis?

1. Financial ratio analysis is often used to measure the performance of the many facets
of the business mentioned previously. When properly used (with its limitations
understood), it can be a very helpful management aid in decision making.
2. Easy to calculate: Most ratios compare two statistics that are normally provided in
the income statement or balance sheet. Because these data are readily available at a
more or less fixed cost, not much time or expense is required to compute a ratio.
3. Easy to make comparisons: They allow comparison of past with present
performance, as well as comparisons with firms of a similar nature. They are of
particular value to boards of directors of the corporate firms.
4. Easily understood: Not all members of the management team are financial experts,
and ratios provide over view information simple and clear for all management
personnel. Usually drawing graphs of financial ratios from trend analysis often
enhances the ability of managers to interpret data and information by presenting a
visual picture and allows for comparison of separate aspects of financial information
in a clear illustration. A graph can be widely distributed to less sophisticated
members of the management team for use in decision making, since it is easier to
conceptualize than numbers
5. Able to communicate a firm’s financial position to interested parties outside
management: For examples, financial authorities, stockholders, cooperative patrons
or investors may rely on ratios to determine a firm’s credit worthiness and success in
the use of its resources.

Limitations of Financial Ratio Analysis

Although financial ratio analysis is quick and useful in analyzing the position and
performance of a business there are some weaknesses that should be noted.
1. Any picture that it provides of the firm is based on past data. Although trends may
be note worthy, this picture should not automatically be assumed to be applicable to

32
 the future. Despite this, several methods and models using ratios have been
developed that are claimed to predict future financial distress.
2. The analysis is only as good as the accounting procedures that have provided the
information / quality of the financial statements.
3. When making comparisons between company financial ratios or between different
companies, one should keep in mind the variability of financing policies and
financial year ends accounting procedures, from firm to firm. For example if an
agribusiness were to change the way it values its inventory, assets and depreciation
method, comparisons of its ratios with previous ratios would lose their validity N:B
When comparing businesses, however, no two businesses will be identical, and the greater
the differences between the businesses being compared, the greater the limitations of ratio
analysis.
4. Time factors also pose significant restraint on ratio analysis. While the calculation of
ratios for a particular year is important, it is incomplete in one aspect in that it
ignores the time dimension. The ratios are snapshots of the picture at one point in
time. But there may be trends in motion that are in the process, rapidly eroding a
relatively good position. This is especially so for ratios based on balance sheet
figures e.g. Liquidity ratios may not be representative of the financial position of the
business for the year as a whole. For example, it is common for a seasonal business
to have a financial year end that coincides with a low point in business activity.
Thus stocks and debtors may be low at the balance sheet date, and the liquidity
ratios may also be low as a result. A more representative picture of liquidity can
only really be gained by taking additional measurements at other points in the year.

Similarly, calculating a ratio by itself will not tell us very much about the position or
performance of a business. It is only when we compare this ratio with some
‘benchmark’ that the information can be interpreted and evaluated. Bases that could be
used to compare a ratio calculated from the financial statements of a particular period
include:
a. Past periods: By comparing the ratio calculated with the ratio of a previous period,
it is possible to detect whether there has been an improvement or deterioration in
the performance. Indeed, it is often useful to track particular ratios overtime (say
five or ten years) in order to see whether it is possible to detect trends.

The need for comparison can be illustrated by the following example.

Example: Fruit Canning Company Balance Sheet May 30th 2007 To 2008
ASSETS May 30th 2014 May 30th 2015
Current Assets (ZMK) (ZMK)
Cash 2,650 2,020
Marketable Securities 3,500 3,800
Accounts Receivable 3,580 2,600
Inventory 5,450 5,900
Total 15,180 14,320

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Suppose Mundia, the manager of Fruity canning company notes that Accounts
receivable for May stands at K3, 580. That figure in itself may have little significance.
However, if he notes that last year’s May accounts receivable was K2, 600 she can be
alerted to a potential problem or opportunity. Many reasons could account for the
change. More questions may well be needed to provide sufficient information for the
manager. May be product prices could have simply gone up by 25% thereby raising the
value of accounts receivable, or the total number of sales could have been 25% percent
higher or the company has relaxed in collecting debt etc.
However, the comparison of ratios from different time periods brings certain problems.
These are:
 There is always a possibility the trading conditions may have been quite
different in the periods being compared
 When comparing the performance of a single business overtime, operating
inefficiencies may not be clearly exposed e.g. the fact that the net profit per
employee has risen by 10 percent over the previous period may at first sight
appear to be satisfactory; however, this may not be if similar businesses have
shown an improvement of 50 percent for the same period
 There is also the problem of inflation, which may have distorted the figures
on which the ratios are based. Inflation can lead to an overstatement of profit
and an understatement of asset values.

b. Planned performance: The comparison of planned performance with actual

performance may therefore be a useful way of revealing the level of achievement
attained. However, the planned levels of performance must be based on realistic
assumptions if they are to be useful for comparison purposes.
c. Similar businesses: In a competitive environment, a business must consider its
performance in relation to that of other businesses operating in the same industry.
Survival may depend on the ability to achieve comparable levels of performance.
However, when making comparisons between companies, one should keep in mind
the following:
 Comparisons should be done on a particular ratio achieved by similar
businesses during the same period
 Competitors may have different year ends, and therefore trading conditions
may not be identical
 Differences in accounting policies could have a significant effect on reported
profits and assets values (for example, different methods of calculating
depreciation or different methods of valuing stock)
 It may be difficult to get hold of the financial statements of competitor
businesses. Sole proprietorships and partnerships, e.g., are not obliged to
make their financial statements available to the public. In the case of limited
companies, there is a legal obligation to do so. However, diversified
businesses may not provide a detailed breakdown of activities sufficient for
analysts to compare them with the activities of other businesses.

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Selection of the Proper Ratios

One of the major problems the agribusiness manager faces is that regarding the choice
of ratios to calculate and discuss. The problem is made relatively simple if:-
a) The target users are known
b) The purpose of analysis / why the information is needed is determined

Different users of financial information are likely, to have different information needs,
which will in turn determine the ratios they find useful. For example, shareholders are
likely to be interested in their returns in relation to the level of risk associated with their
investment. Thus profitability, investment and leverage ratios will be of particular
interest. Long-term lenders are concerned with the long – term viability of the business
and to help them assess this, profitability and Leverage ratios of the agribusiness are
also likely to be of particular interest. Short – term lenders, such as suppliers of goods
and services on credit, may be interested in the ability of the business to repay the
amounts owing the short term period. Consequently, the liquidity ratios should be of
interest.
The general guide is to employ the principle of management by exception.
Agribusiness managers must study their own operations and use those financial ratios
that are best for the unique business involved. However, the first consideration to be
made in selecting critical ratios is whether those ratios cover those areas of the business
where knowledge is critical to their existence e.g. A fertilizer business is seasonal hence
would be interested in Accounts receivables and inventory. While on the other hand a
food processor would be extremely aware of changes in costs for direct labor, raw
material and supplies because they account for a major portion of the production costs.
Types of Ratios
Category of Ratios
 Liquidity Ratios - Indicate a company’s short-term debt-paying ability
 Solvency Ratios/Equity (Long-Term Solvency) Ratios – Shows the relationship between
debt and equity financing in a company
 Profitability Ratios - Relate income to other variables
 Operating or Efficiency Ratios –These show the trends in production and performance;
Competency of the mgt. team; competitiveness of the firm; etc.

Profitability Ratios
1. Earnings on Sales
2. Return on Sales
3. Return on Equity
4. Return on Assets
5. Gross Margin Ratio
Liquidity Ratios
1. Net working Capital

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 2. Current ratio
3. Quick (Acid-test) ratio
Solvency Ratios
1. Debt-to-Equity
2. Solvency ratio.
3. Debt-to-Assets
Operating or Efficiency Ratios
1. Asset Turnover ratio
2. Inventory Turnover Ratio
3. Accounts Receivable Ratio

Financial Statements to be used for computing these ratios;

MULENGA CORPORATION
Balance Sheets
December 31, 2012 and 2011
2012 2011
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000

Fixed Assets (Property and equipment):

Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000

Total assets $ 346,390 $ 300,000

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 MULENGA CORPORATION
Balance Sheets
December 31, 2012 and 2011
2012 2011
Liabilities and Stockholders' Equity
1.0 Liabilities
1.1 Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000

1.2 Long-term liabilities:

Notes payable, long-term 70,000 78,000
Total Long Term Liabilities 70,000 78,000
1.3 Total Liabilities 112,000 120,000
2.0 Equity
2.1 Stockholders' Equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital (Stockholders Equity) 185,500 130,000
2.2 Retained earnings 48,890 50,000
2.3 Total stockholders' equity 234,390 180,000

3.0 Total liabilities and stockholders' equity $ 346,390 $ 300,000

MULENGA CORPORATION
Income Statements
For the Years Ended December 31, 2012 and 2011
2012 2011
1 Net sales $ 494,000 $ 450,000
2 Cost of goods sold (140,000) 127,000
3 Gross margin 354,000 323,000
4 Operating expenses (270,000) 249,000
5 Net operating income 84,000 74,000
6 Interest expense (cost of borrowing) (7,300) 8,000
7 Net income before taxes 76,700 66,000
8 Less income taxes (30%) (23,010) 19,800
9 Net income $ 53,690 $ 46,200

Profitability Ratios

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Profitability ratios include several different indicators that help assess the firm’s profitability and
record of performance. The net sales figure is used in three of the five ratios rather the gross
sales figure because the net sales is not inflated by amounts that were ultimately returned to
customers in form of discounts and allowances, or returned merchandise. The five profitability
ratios are:
 Earnings on Sales
 Return on Sales
 Return on Equity
 Return on Assets
 Gross Margin Ratio

a. Earnings on Sales (EOS): Measures the proportion of the sales dollar/kwacha

which is retained as operating profit.
EOS = Net Operating Profit/Net Sales

EOS = $84,000/$494,000 = 0.17

For every $1 in net sales, the firm generates $0.17 as net operating profit.

b. Return on Sales (ROS): Measures the proportion of the sales dollar which is retained as net
profit.
ROS = Net Profit/Net Sales
ROS = $53,690/$494,000 = 0.109
For every $1 in net sales, the firm generates $0.109 as net profit

c. Return on Equity (ROE): It is probably the most widely used profitability ratio and takes the
investor’s view point. It is used to evaluate and compare investment opportunities.

ROE = Net Profit/Owners Equity

ROE = $53,690/$234,390 = 0.229

For every $1 that the firms’ owners invest in the business, the firm generates $0.229 net profit.

d. Return on Assets (ROA) or (Return on Investment ROI): It measures the net profit generated on
the total investment in the business. It not only shows the return to equity (owners), but also
the return to creditors’ investment in the business. ROA is more inclusive than ROE….why?
It measures net returns relative to both outsiders and insider’s investment in the business. The
ROA figure gives investors an idea of how effectively the company is converting the money it
has to invest into net income. The higher the ROA number, the better, because the company is
earning more money on less investment.

In the computation of ROA (ROI), we add the interest expense to ignore the costs associated
with funding those assets.

ROA = (Net Profit + Interest Expense)/Total Assets

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 ROA = ($53,690 + $7,300)/$346,390 = 0.176

For every $1 of the firms’ assets in the business generates $0.176 net profit.

e. Gross Margin Ratio: It is also called the gross profit ratio. It shows how much a firm has left
from each kwacha of net sales to pay operational and other business expenses as well as
make a profit.

GMR = Gross Margin/Net Sales

GMR = $354,000/$494, 000 = 0.177 or expressed as a percentage17.1%. For each dollar a

business generates, the business retains $0.177 as gross profit.

This number represents the proportion of each dollar of revenue that the business retains as gross
profit.

 This ratio is crucial. Any drop in GM is a signal for immediate managerial action.
 Small changes in the GM have a greater impact on the “bottom line”

Liquidity Ratios

Liquidity refers to the ability of the firm to pay bills as they come due. Hence the focus of Liquidity
ratios is on assets that can be easily be converted to cash, and liabilities that must be paid in the
short term. Three important Liquidity Ratios are -
 Net working Capital
 Current ratio
 Quick (Acid-test) ratio

The following data on NORTON CORPORATION shall be used to compute the liquidity ratios;
1 Cash 30,000
2 Accounts receivable, net
Beginning of year 17,000
End of year 20,000
3 Inventory
Beginning of year 10,000
End of year 12,000
4 Total current assets 65,000
5 Total current liabilities 42,000

Net Working Capital: The excess of current assets over current liabilities.

Net Working Capital (NWC) = Total Current Asset – Total current Liabilities
NWC = $ 65,000 - $ 42,000 = $23,000

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While this is not a ratio, it does give an indication of a company’s liquidity.

This firm can pay its short-term debt obligations and still have $23,000 left over as a cash or
operating liquidity cushion.

Current Ratio or Working Capital Ratio: Measures the ability of the company to pay current
debts as they become due.

CR = Total Current Assets/Total Current Liabilities

CR = $65,000/$42,000 = 1.55
There is $1.55 of current assets for every $1 of current debt.
 Limitation: there is concern among financial analyst that the current ratio may have some
limitation as an indicator of a firm’s ability to meet current liabilities.
 The need to quickly liquidate inventories, accounts receivable, marketable securities etc.,
to raise cash many cause a sharp decrease in their value. It is for this reason that the
Quick ratio recommended.

Quick (Acid-test) Ratio

What are quick assets?

Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes
Receivable.
Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of
$20,000.

Acid Test Ratio = Quick Assets/Current Liabilities

Acid Test Ratio = $50,000 /$ 42,000 = 1.19

• For every $1 in current liabilities there is $1.19 in quick assets.

• A quick ratio between 0.8 and 1.0 signifies sufficient strength in liquidity.

Solvency Ratios

Another challenge for management is to keep the firm solvent. Solvency is related primarily to
the firm’s ability to meet long-run obligation or total liabilities. Solvency ratios pinpoint the
portions of a business’s capital requirements that are being furnished by owners and by lenders.
Evaluation of solvency ratios gives an indication of the likelihood that lenders will incur problem
in recovering their money. These ratios can have a real effect on the amount of long-term money
a firm can borrow. And also affect alternative sources of outside capital. Solvency ratios can also
indicate when a firm should consider borrowing more of its capital needs, with consequent
opportunity for increasing return on its own investment. We shall look at the following three
Solvency Ratios:
 Debt-to-Equity
 Equity or Long Term Solvency ratio.

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  Debt-to-Assets

Debt to Equity Ratio

Debt Equity Ratio = Total Liability/Total Owners Equity

Debt Equity Ratio = $112,000/$234,390= 0.477

Lenders tend to be nervous when the ratio is greater than one (1).

Equity or Long Term Solvency Ratio

It measures the proportion of total assets provided by stockholders.

Date Required
MULENGA CORPORATION
2012
1 Net operating income $ 84,000
2 Net sales 494,000
3 Interest expense 7,300
4 Total stockholders' equity 234,390
5 Total liabilities 112,000

1 Common shares outstanding

Beginning of year 17,000
End of year 27,400

2 Net income $ 53,690

3 Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300

4 Total assets
Beginning of year 300,000
End of year 346,390

Equity Ratio = Stock holders Equity/Total Assets

Equity Ratio = $234,390/$346,390 = 0.676

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67.6% of the assets are owned by the stock holders.

Debt to Assets Ratio

A financial ratio that measures the extent of a company’s or consumer’s leverage. The debt ratio
is defined as the ratio of total debt (liabilities) to total assets, expressed in percentage, and can be
interpreted as the proportion of a company’s assets that are financed by debt.

The higher this ratio, the more leveraged the company and the greater its financial risk. Debt
ratios vary widely across industries, with capital-intensive businesses such as utilities and
pipelines having much higher debt ratios than other industries like technology. In the consumer
lending and mortgage businesses, debt ratio is defined as the ratio of total debt service
obligations to gross annual income.

Debt to Assets Ratio = Total Liabilities/Total Assets

Debt to Assets Ratio = $112,000/$346,390 = 0.323 or 32.3%

A debt ratio of greater than 1 indicates that a company has more debt than assets. Meanwhile, a debt
ratio of less than 1 indicates that a company has more assets than debt. Used in conjunction with
other measures of financial health, the debt ratio can help investors determine a company's risk level.

Efficiency Ratio

This part of ratio analysis offers the greatest opportunity for management to develop unique,
meaningful ratios that will be of greatest value to its business in the efficiency and operations
areas. These ratios tend to be highly tailored to fit the specific type of business being evaluated.

Asset Turnover Ratio

The amount of sales generated for every dollar’s worth of assets. It is calculated by dividing the
(revenue) by assets. This ratio is more useful for growth companies to check if in fact they are
growing in\proportion to assets.

Assets Turn Over = Net Sales/ Total Assets

The asset turnover measures a firm’s efficiency at using its assets in generating sales or revenue
– the higher the number the better.

From Norton Corporations Balance Sheet and Income statement, you will obtain values for the
total assets and net sales respectively.

Assets Turn Over = 494,000/346,390 = 1.43 for the year 2012

Assets Turn Over = 450,000/300,000 = 1.5 for the year 2011

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For this ratio to be meaningful, management has to compare it with that of the previous years.
The year 2011 was obviously better in the sense that the assets generated more sales/revenue.

Inventory Turnover Ratio

A ratio showing how many times a company’s inventory is sold and replaced over a given period
of time. This ratio should be compared against industry averages. A low turnover implies poor
sales and therefore excess inventory.

Inventory Turnover Ratio = Cost of Goods sold (sales)/Average Inventory

Inventory Turnover Ratio = $140,000 = 12.73 times

($10,000+$20,000)/2

Accounts Receivable Ratio

Accounts Receivable Turnover is the ratio of Net Credit Sales of a business to its Average
Accounts Receivable during a given period, usually a year. An accounting measure used to
quantify a firm’s effectiveness in extending credit as well as collecting debt.

Accounts Receivable Ratio = Net Credit Sales/Average Accounts Receivable

Accounts Receivable Ratio = $494,000 = 26.7

($17,000+$20,000)/2

By extending accounts receivable, firms are indirectly extending interest free loans to their
clients. A high ratio implies that a business operates on a cash basis or that its extension of credit
and collection of accounts receivable is efficient.

A low ratio implies the company should re access its credit policies in order to ensure the timely
collection of imparted credit that is not earning interest for the firm.

Growth Ratios
 Sales growth rate: calculates the annual percentage growth in total sales. It measures
the firm’s growth rate in sales
 Annual percentage growth in profits: measures firm’s growth rate in profits
 Annual percentage growth in earnings per share: Measures the firm’s growth rate
in earnings per share (EPS)
 Annual percentage growth in dividends per share: Measures the firm’s growth rate in
dividends per share.

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Important Points to Remember on Ratio Analysis
1. Some ratios are expressed in reverse order i.e., “sales to receivables” to one person
may be “receivables to sales” to another. Either is correct, but the interpretation
should also be reversed.
2. All ratio comparisons should be based on similar data from similar business; to
compare the “sales to fixed assets” ratio of a big food processing plant with the same
ratio of a small farm supply business would be ridiculous.
3. Comparisons of ratios between companies or from period to period in the same
agribusiness are justified.
4. Trend is an important feature of financial ratio analysis. Gradually improving ratios
are more impressive than declining ratios.
5. The development and use of a large number of financial ratios may add confusion to
chaos; hence, ratios should be specifically selected with regard to the nature of the
problems for which solutions are desired.
6. In addition to financial ratios, ratios related to other phases of a business are often
used as measures of efficiency; for e.g., inventory turnover ratios. These may be
called management ratios, physical ratios, efficiency ratios, or industrial ratios
7. Faith in financial ratio analysis often becomes so strong with some people that it
becomes their only basis for decision making. At their best, ratios are aids to sound
decision making not substitutes
8. It is important to read any footnotes of financial statements, since various
accounting or management practices can have an effect on the financial picture of
the company.

CONCLUSION
Financial analysis is a fundamental management tool for the agribusiness manager. It
does not solve problems/ create opportunities – people do. However, it can help define
and identify problems and opportunities; and alternative courses of action may be
suggested.

5.8 FINANCING THE AGRIBUSINESS

Agribusinesses in Zambia rank lack of capital as being one of the major constraints to
their growth and success. There are commonly three types of capital referred to in
business and they include:-
 Fixed capital : Funds invested in fixed assets e.g. land, buildings, equipment,
vehicles etc
 Operating capital : Funds needed for the daily running of a business e.g. inventories,
wage and salary payments, credit outstanding, utility bills and sales expenses etc
 Organizational capital: Required legally in starting / registering a business

However, different stages in the life cycle of an agribusiness require different finances.
Some of the reasons for finance / capital requirement have been highlighted below:-

44
  Startup capital : needed by agribusinesses that are still at the concept stage of
development, through to those businesses that are ready to commence trading;
 Capital for Expansion / Growth capital: aimed at providing additional funding
for expanding businesses;
 Adjusting the financial structure: A company may require funds to adjust its
financial structure especially if it is to attract new investors i.e. leverage or debt /
equity ratio. Sources for this form of capital requirement will depend on how the
company is leveraged. It will need debt sources if the debt: equity ratio is low
and equity sources if the ratio is high. N: B you need to convince potential investors
that the adverse cash flow did not result from operational inefficiencies and poor
management;
 Recovery Capital: This is rescue finance, which is needed to turn a business
around after a period of poor performance.

Therefore, the following sections will introduce the different sources of finance
available to management, both internal and external, followed by an overview of the
advantages and disadvantages of the different sources of finances. Lastly the factors
governing the choice between debt and equity will be discussed.

Determining When Financial Resources Should Be Increased

Several questions should be asked and carefully answered as an agribusiness manager
considers the possibility of acquiring additional financial resources. These are:-
1. Are additional funds really needed in the agribusiness?
2. Why are additional funds needed?
3. What increase in revenue and / or profit will be generated by additional funds?
4. For how long a period will these additional funds be needed?
5. When will these additional funds be needed?
6. How much is needed in the way of additional financial resources?
7. Where can these additional funds be obtained?
8. How much will these additional funds cost the business?
9. If the funds are borrowed, how will the indebtedness be repaid?

Sources of Finance

When considering the various sources of finance for an agribusiness, it is useful to

distinguish between external and internal sources. Within each of these two categories
we can further distinguish between long-term and short-term sources.
 External sources of finance require the agreement of someone beyond the
directors and managers of the agribusiness whereas internal sources of finance
do not: e.g. Finance from an issue of new shares is an external source because it
requires the compliance of potential shareholders. Retained profit, on the other
hand, is considered an internal source because the directors of the business have
power to retain profits without the agreement of the shareholders, whose profits
they are.

45
  Long-term sources of finance are not due for repayment within one year where
as short-term sources are due for repayment within one year.
 Equity: This source does not have to be repaid and once invested becomes a
permanent part of the capital of the business. Lenders pay particular attention to
equity when they are making long term loan commitments, and may insist that a
larger percentage of the owner’s money be invested in the capital of the
agribusiness. Equity capital can be categorized into Long term vs. short-term
sources and internal vs. external sources.

a) Long term sources of External equity finance

1) Ordinary Shares: Ordinary shares form the back bone of the financial structure of a
business. Shares are sold primarily to people who are known to the present owner(s)
e.g. friends, relatives, employees etc. Millichamp (1997) highlights four ways a company
can obtain finance through issuing of shares, these include:
 By a general issue of shares to the public by a prospectus. This usually happens
only when a private company becomes a public company and obtains listing on
the stock exchange
 By a rights issue. This means that new shares are issued for cash to existing share
holders in proportion(pro rata) to their existing holdings
 In exchange for a business, usually a company is formed to take over a business
 In a takeover of another company. Sometimes a takeover does not involve
buying another company for cash but issuing new shares in the predator
company to the shareholders of the victim company in exchange for their shares
in the victim company. The predator company does not get cash for the new
shares but does get a subsidiary company.
Characteristics of Ordinary Shares
 There is no fixed rate of dividend, and ordinary shareholders will receive a
dividend only if profits available for distribution still remain after other investors
(preference shareholders and lenders) have received their dividend or interest
payments. If the business is wound up, the ordinary shareholders will receive
any proceeds from asset disposals only after lenders and creditors and, often,
after preference share holders have received their entitlements
 Because of the high risks associated with this form of investment, ordinary
shareholders will normally require a comparatively high rate of return
 Although ordinary shareholders have limited loss liability based on the amount
invested, the potential returns from their investments are unlimited
 Ordinary shareholders also have control over the business. They will be given
voting rights, which will give them the power to elect the directors and to
remove the directors from the office
 From the business’s perspective, ordinary shares can be a valuable form of
financing as at times, it is useful to be able to avoid paying a dividend. For

46
 example an expanding business may prefer to retain funds in order to fuel future
growth. A business in difficult times may need the funds to meet its operating
costs and so may find making a dividend payment a real burden
 Ordinary shares are redeemable, which means that the company is allowed to
buy back the shares from share holders at some agreed future date2) Preference
Shares
 Preference shares offer investors a lower level of risk than ordinary shares; hence
they are offered a lower level of return than normally expected by ordinary
shareholders.
 Shares to which a company shows preference. Provided there are sufficient
profits available, preference shares will normally be given a fixed rate of
dividend each year, and preference dividends will be paid before ordinary
dividends are paid. Should the business wind up, preference shareholders may
be given priority over the claims of ordinary shareholders. (The documents of
incorporation will determine the precise rights of preference shareholders in this
respect).
 The dividends of preference shares tend to be fairly stable over time, and there is
usually an upper limit on the returns that can be received. As a result, the share
price, which reflects the expected future returns from the share, will normally be
less volatile than for ordinary shares.
 May be redeemable; i.e. the company is allowed to buy back the shares from
shareholders at some agreed future date.

Advantages of External Equity Capital

 It permits more rapid growth of the company than would otherwise be possible
 It expands the credit base of the business i.e. ‘more equity, more borrowing
power’. It lowers interest rates, provides longer terms and fewer loan restrictions
 It reduces the risks by dividing the ownership
 Permits continuity of the business in case an owner dies
 Provides a better framework for management counsel and talents

Disadvantages of External Equity Capital

 Proprietor’s control is reduced, as is his participation in any profits of the
business;
 Flexibility of operation and decision making possessed by the sole owner
is lost when outside equity capital is used
 The sale of a portion of the equity may entail increased expense/
administration costs.
 The “timing” in obtaining outside equity capital is very critical. If an
attempt is made too late to secure such capital (as when the business is
declining), investors become reluctant. If this capital is obtained too early,
the proprietor could be sacrificing both control and profits.

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b) Long Term Sources of Internal Equity

1. Retained profits: This is the major source of internal long term financing.
Reinvestment of profits rather than the issue of new shares can be a useful way of
raising capital from ordinary share investors. There is no issue costs associated with
retaining profits, and the amount raised is certain, once the profit has been made.

Are retained profits a free source of finance to the business?

No! If profits are reinvested rather than distributed to shareholders, this means that the
shareholders cannot invest the profits made in other forms of investment. They will therefore
expect a rate of return from the profits reinvested that is equivalent to what they would have
received had the funds been invested in another opportunity with the same level of risk.
 Retaining profits will have no effect on the control of the business by existing
shareholders, where as new shares are issued to outside investors and there will be
some dilution of control
 Retained profits are already held by the business, and so it does not have to wait to
receive the funds
 There is often less scrutiny when profits are being retained for reinvestment
purposes than when new shares are being issued i.e. Investors and their advisers will
examine closely the reasons for any new share issue
 By reinvesting back profits, it may be expected that the business will expand, and
that share values will increase as a result
 In some countries not all capital gains are liable for taxation. There is a minimum
amount set below which the profits / returns are not taxed
 A further advantage of capital gains over dividends is that the shareholder has a
choice as to when the gain is realized
 A problem with the use of profits as a source of finance is that the timing and level
of profits in the future cannot always be reliably determined.

2. Owners Contribution: e.g. through personal savings.

3. Reducing stock levels. If a business has a proportion of its assets in the form of stock
there is an opportunity cost, as the funds tied up cannot be used for other opportunities.
A business may be overstocked as a result of poor buying decisions in the past. This
may mean that a significant proportion of stocks held are slow moving or obsolete and
cannot, therefore, be reduced easily. However, the agribusiness must ensure that there
are sufficient stocks available to meet likely future sales demand. Failure to do so will
result in lost customers.
4. Tighter Credit Control: By exerting tighter control over trade debtors it may be
possible for a business to reduce the proportion of assets held in this form and so
release funds for other purposes e.g. by collecting accounts receivables promptly. It is
important, however, to weigh the benefits of tighter credit controls against the likely
costs in form of lost customer goodwill and lost sales. To remain competitive, a

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business must take into account the needs of its customers and the credit policies
adopted by rival businesses within the industry.
5. Delaying Payment to Creditors: By delaying payment to creditors, funds are retained
within the business for other purposes. This may be a cheap form of finance for a
business. However, there may be significant costs associated with it. For example, the
business may find it difficult to buy on credit when it is a slow payer.
6. Sell of Unused Assets

c) Other External Sources of Finance

1. Commercial Bank Loans: Commercial Banks have many kinds of loans, such as
short, intermediate and long term loans. Intermediate term loans are between one to
five years, amortized i.e. paid back in installments over the life of the loan. It provides
the agribusiness with a source of capital that will allow growth or modernization
without forcing the owners to surrender control of business. Other loans include line of
credit, special loans. These have been discussed in the proceeding sections.
Lenders will enter into a contract with the business in which the rate of interest dates of
interest payments, capital repayments and security for the loan are clearly stated. In the
event that the interest payments or capital repayments are not made on the due dates,
the lender will usually have the right, under the terms of the contract, to seize the assets
on which the loan is secured and sell them in order to repay the amount outstanding.
Security for a loan may take the form of a fixed charge on particular assets of the
business (freehold land and premises are often favored). It’s most reasonable that the
agribusiness cannot transfer / sell those assets without consulting the lender. Also the
security can be a floating charge i.e. the loan is secured by the entire spectrum of assets
by the company. Bankers sometimes charge service charges
Or they may require monthly and annual financial statements or other financial
information regarding inventories and accounts payable and sometimes the way the
agribusiness expends its capital funds, must consult the lender. When evaluating the
loan, bankers use the three C’s of credit i.e. character, cash flow and collateral. Three
items concern the banker most:-
(i) How will you pay back the money?
(ii) How will you use the loan?
(iii) Are the financial projections of the business reasonable?

2. Term Loan: It’s a long-term loan offered by banks and other financial institutions
and can be tailored to the needs of the client business. The amount of the loan, the time
period of the loan, the repayment terms and the interest payable are all open to
negotiation and agreement, which can be very useful e.g. where all of the funds to be
borrowed are not required immediately, a business may agree with the lender that
funds are drawn only as and when required. This means that interest will be paid only
on amounts drawn and the business will not have to pay interest on amounts borrowed
that are temporarily surplus to requirements.

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4. Debenture: is long-term loan finance. This simply is a loan that is evidenced by a
trust deed. The debenture loan is frequently divided into units (rather like share
capital), and investors are invited to purchase the number of units they require.
 The debenture loan may be redeemable or irredeemable
 Debentures of public limited companies are often traded on the stock exchange,
and their listed value will fluctuate according to the fortunes of the business,
movements in interest rates etc.
 Have a fixed rate of interest whether the company makes profit or not as
compared to stock of shares.
 Features: may be simple (naked) – the loan is not backed by any charge on the
assets of the company could also be a mortgage debenture i.e. takes a charge
against the assets of the company as security for the debenture holder. They are
two forms of mortgage debentures i.e. fixed mortgage debenture and floating
mortgage debenture. Lastly the debenture could be Registered / coupon /
Bearer debentures. It’s registered if the debenture certificate shows the name of
the holder; records are kept by the holder’s trustee and are changed if the
debenture changes hands. A bearer debenture does not show the name of the
holder on the certificate and may be redeemable by whoever presents it. First,
second or third mortgages: securing different issues of debentures. That is using
the same asset to get money from 1 st, 2nd and 3rd debenture holders. In case of
fore closure the 2nd and 3rd mortgages are subject to prior claims than the first
debenture holder.

5. Leasing or Renting
When an agribusiness needs a particular asset e.g. equipment, trucks, warehouses etc,
instead of buying it directly from the supplier, the business may decide to arrange for
another business (typically a bank) to buy it and then lease it out. Though legal
ownership of the assets rests with the financial institution (lessor), a finance lease
agreement transfers to the user (lessee) virtually all the rewards and risks that are
associated with the item being leased.

Advantages
 Ease of borrowing: leasing may be obtained more easily than other forms of long
term finance. Lenders normally require some form of security and a profitable
track record before making advances to a business. However, a lessor may be
prepared to lease assets to a new business without a track record, and to use the
leased assets as security for the amounts owing.
 Cost: leasing agreements may be offered at reasonable cost. As the asset leased is
used as security, standard lease arrangements can be applied and detailed credit
checking of lesser may be unnecessary. This can reduce administrative costs for
the lessor and, thereby, help in providing competitive lease rentals.

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  Flexibility: Leasing can help provide flexibility where there are rapid changes in
technology. If an option to cancel can be incorporated into the lease, the business
may be able to exercise this option and invest in new technology as it becomes
available. This will help the business to avoid the risk of obsolescence.

 Cash flows: Leasing, rather than purchasing an asset outright, means that large
cash outflows can be avoided. The leasing option allows cash outflows to be
smoothed out over the asset’s life. In some cases, it is possible to arrange for low
lease payments to be made in the early years of the asset’s life, when cash inflows
may be low, and for these to increase overtime as the asset generate positive cash
flows.

Disadvantages
 For most businesses, leasing will cost more than borrowing. It commits the
business to certain payments, whereas if the asset were owned it could be sold to
at least minimize the financial commitment.
 Leased property often grows in value in such a case it is the lessor that will
benefit.

6. Bank Overdraft: Represents a very flexible form of borrowing. The rate of interest
charged on an overdraft will vary, however according to how credit worthy the
customer is perceived to be by the bank. One potential draw back with this form of
finance is that it is repayable on demand. This may pose a problem for a business that
is illiquid. However, many businesses operate using overdraft, and this form of
borrowing.
7. Debt Factoring: Is a service offered by a financial institution known as a factor.
Factors buy accounts receivables at a discounted price because they take on the risk of
bad debts. Their procedure is to notify the individual accounts and collect directly.
Many businesses find a factoring arrangement very convenient. It can result in savings
in credit management and can create more certain cash flows. It can also release the
time of key personnel for more profitable activities. This may be extremely important
for smaller businesses that rely on the talent and skills of a few key individuals.
However, some agribusinesses do not want their customers dealing directly with the
collecting factor as this may be an indication that the business is facing financial
difficulties. This might have an adverse effect on confidence. When considering
factoring agreements, the costs and likely benefits arising must be identified and
carefully weighed.

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8. Accounts Receivable Loans / Invoice Discounting: Involves a business approaching
a factor or other financial institution for a loan based on a proportion of the face value
of credit sales outstanding. The amount usually advanced is 75 to 80 percent of the
value of the approved sales invoices outstanding. The business must agree to repay the
advance within a short period (only 60 or 90 days).The responsibility for collection of
the trade debts outstanding remains with the business, and repayment of the advance is
not dependent on the trade debt being collected.
Invoice discounting is a much more important source of funds than factoring because:
 It is a confidential form of financing that the client’s customers will know
nothing about;
 Invoice discounting will not result in such a close relationship developing
between the client and the financial institution as factoring. It may be a short
term arrangement whereas debt factoring usually involves a longer – term
relationship between the customer and the financial institution.
 The service charge for invoice discounting is generally only 0.2 to 0.3 percent of
turnover, compared with 2.0 to 3.0 percent for factoring;
 Many businesses are unwilling to relinquish control of their customers’ records.
Customers are an important resource of the business, and may wish to retain
control over all aspects of their relationship with their customer

9. Insurance Companies: These are always looking for places to invest funds they have
collected from policy holders. They usually offer intermediate and long term loans on
fixed assets, such as equipment or real estate. If the owners or the agribusiness has
insurance policies with a particular company, that company will usually lend the
agribusiness amounts that are equal to the cash value of the policy at favorable interest
rates.
10. Trade Credit: This is credit applied by suppliers and vendors of the agribusiness
firm. If the agribusiness is credit worthy, most suppliers and vendors will allow credit
terms.
11. Customer Advances: These are very common in construction and metal fabrication
industries.
12. Private Lenders: Interests rates are very high, repayment periods are very short and
consequences of default payment are extremely harsh.
13. Director Loans: Where the owner decides to lend the agribusiness some money
from other enterprises.
14. Bonds: Usually issued by corporations. They are an obligation by the corporation to
pay a certain sum at a specified time in the future. They are issued in series and are
redeemed in the order in which they are issued. Usually, bonds carry a specified rate of
interest that is paid on an annual basis.
15. Promissory Notes: Promise by the borrower to pay to the lender a particular
amount of money and a particular amount of interest after a specified period of time.
For example Agribusiness firms may accept promissory notes from their customers.

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This can be traded with the bank in case cash is needed so that the debtor has to pay to
the bank.
16. Stock Exchange: The stock exchange is an important primary and secondary capital
market for large businesses. As a primary market its function is to enable businesses to
raise new capital. As a secondary market, its function is to enable investors to sell their
securities (i.e. shares and loan capital) with ease.

Advantages

 The secondary market role of the stock exchange means that shares and other
financial claims are easily transferable.
 Prices of shares and other financial claims are constantly under scrutiny by
investors and skilled analysts and this helps to ensure that the prices quoted for a
particular share reflects its true worth.
 It’s a useful vehicle for a successful entrepreneur wishing to realize the value of
the business that has been built up. By floating (listing) the shares on the stock
exchange, and thereby making the shares available to the public, the
entrepreneur will usually benefit from a gain in the value of the shares held and
will be able to realize that gain easily, if required, by selling some shares.

Disadvantages
 Strict rules are imposed on listed businesses, including requiring additional
levels of financial disclosure to that already imposed by law and by the
accounting profession (e.g. listing rules require that half yearly financial reports
must be published).
 The activities of listed businesses are closely monitored by financial analysts,
financial journalists and such scrutiny may not be welcome; particularly if the
business is dealing with sensitive issues or experiencing operational problems.
 Listed businesses are under pressure to perform well over the short term. This
pressure may detract from undertaking projects that will only yield benefits in
the longer term.
 If the market becomes disenchanted with the business, and the price of its shares
falls, this may make it vulnerable to a takeover bid from another business.
 Finally, the costs of obtaining a listing are vast and this may be a real deterrent
for some businesses.

Comparison of Equity Financing With Debt Financing

Equity Financing
1. Equity avoids heavy interest charges on credit. Fixed interest payments may take a
big portion of the profits leaving little dividend for the share holders. NB: Unlike
dividends, interest has to be paid whether a business makes profit or not.

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2. Equity financing contributes to a strong debt equity ratio thus giving the business a
better credit rating.
3. The company is in a better position to finance its expansion and future plans.
4. Unlike the debt financing no collateral is required and thus the assets of the
company are free to be used in the short term gap financing.
5. The entrepreneur has to give part of ownership to the new shareholders.

Debt Financing
1. Debt financing generates extra profits for share holders; where return on investment
is greater than the cost of finance.
2. Creditors have no voting rights and therefore decision making remains in the hands
of the owner(s). N:B This may not always be the case, sometimes Lenders, especially
institutional lenders decide to sit on The Board of Directors in most cases where the
loan is big (i.e. interference with running of the business).
3. Interest Rates and Taxes – Interest paid is deductible from the business’s taxable
profits, because the interest is a business expense.
This can be illustrated by the example I below:
Before loan after loan
$ $
Operating Profit 50,000 50,000
Interest charges - 4,000
______ ______

Profit before taxes 50,000 46,000

Income Tax (25%) 12,500 11,500
Net profit after taxes 27,500 34, 500
4. Several factors affect the net cost of borrowed capital e.g. repayment terms and
conditions. This can be illustrated by the examples below:
Example II
If Mulenga borrowed $50,000 in year 1 at a simple interest of 8%, his cost will be $?
Annual interest rate = Interest paid x 100%
Amount borrowed

8% = 4,000 x 100%
50,000
Sometimes, however loans are discounted, which means that the amount of interest to
be paid is deducted from the sum of capital at the time it is borrowed.

Example III
If the loan were repaid in installments, the real rate of interest would increase
substantially.
APR = 2xPxF

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 B x (T + 1)
Where: APR = Annual real % rate of interest
P = Payments per year
F = Dollars paid in interest
B = Amount of Capital borrowed
T = Total number of payments

APR = 2 x12 x $4,000 = 96,000 = 14.8%

$50,000 X (12 + 1) 650,000

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