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UNIT 4 FINANCIAL VIABILITY TESTS

This unit only concerns travel agencies. If your business is not a travel agency you could skip this section. However, it does illustrate some important concepts that are universally accepted.

The Travel Agents Act and its Regulations require that a travel agent be a member of a travel compensation fund in order to obtain and retain a travel agents licence.

The requirement is for agents to maintain a minimum level of capital and reserves dependent upon their scale of operations. This scale is measured by the annual turnover from travel and non-travel business. This does not mean commission but refers to gross sales. The current requirements are as follows:

Turnover Minimum                                                                                    Capital & Reserves

Less than $750,000                                                                                             $10,000

$750,000 to $1.5 Million                                                                                     $20,000

Greater than $1.5 Million                                                                                    $35,000

Have a look at the Jones Travel balance sheet in Unit 2 : Financial Statements. The figure for "Capital and Reserves" is $60,451 which includes the original owner's equity of $30,000 and undistributed profits of $30,451. The profit and loss statement shows actual total income for the year of $163,100. This is commission, not turnover. Turnover relates to total value of business written for airline tickets, accommodation, payments to operators, etc., on which commission is earned. It refers to the total monies paid by the client for travel purposes. If an agency is involved in other business activities, the gross sales from these activities must be included in the turnover figure.

Let us assume that the average commission rate for Jones Travel was 10%. This means that the turnover must have been $1,631,000.

Since the Jones Travel turnover is greater than $1.5m, it must have a minimum capital and reserves figure of $35,000. Since the capital and reserves figure exceeds this the agency has met the first part of the financial standards required.

If the capital and reserves figure is lower than required, the shortfall can be made up by a bank guarantee.

One complication is that the capital and reserves figure should not include intangible assets like goodwill, formation costs, patents and trademarks, etc. These assets cannot be relied on to produce value in a crisis and so are excluded. Jones Travel does not have any of these items under the heading of assets on its balance sheet and so no adjustment is required.

Another complication is that assets or liabilities, which relate to "related parties" should also be excluded. A related party is an individual or corporation defined as an associate in terms of section 26AAB(14) of the Income Tax Assessment Act and includes shareholders, directors, trustees, partners, proprietors or their immediate family.

Financial Ratio Analysis

In addition to the compulsory requirement for minimum capital and reserves referred to above, the trustees also require agencies to carry out financial ratio analysis in respect to their financial statements. This ratio analysis is included in 3 separate tests, which allocate points for various components of the travel agents business. The total maximum number of points is 20 and an agency must score at least 10 points.

The points system involves 3 tests:

Test 1 Client Travel Account                                                 Maximum  4 points

Test 2 Working capital available to meet overheads         Maximum   8 points

Test 3 Net tangible asset to turnover ratio                         Maximum   8 points

                                                                                                                    20 points

Test 1 : Client Travel Account

This requirement is not compulsory but is advisable for best agency practice as well as for earning the 4 points involved.

If the agency uses a separate bank account named "Client Travel Account" and operates it in accordance with the requirements set out below, it is eligible to be awarded 4 points. The travel agent must comply with the following rules:

If money is received from a client before tickets are issued, it must be banked within 2 working days into the Client Travel Account.

Such account is only to be used for clients' funds and is to be shown separately on the agent's balance sheet.

Money cannot be removed from this account until it is paid to the principals concerned or refunded to the client. Interest bearing or term deposits may be opened with any recognised financial institution.

Commission earned is not to be withdrawn until the balance has been paid to the principals concerned.

Withdrawals for clients whose funds have not been previously deposited, is not allowed.

These funds are not to be used for any other purpose or as security for any purpose

The agency's auditor is required to endorse that "to the best of my knowledge and belief the Client Travel Account has been operated in accordance with the requirements". If this endorsement is not made, the auditor is required to provide an explanation detailing the areas of variance and this explanation will be considered in the allocation of points for this test.

Test 2 : Working capital available to meet overheads

This test introduces the concept of "working capital". This is explained in more detail in Unit 7: Managing Short Term Finances. Perhaps the best way to explain it is by illustration to the Jones Travel balance sheet referred to in Unit 3.

There you will see that current assets are $32,200 and current liabilities $24,523. The difference between these two figures is called working capital which is calculated as follows:

Current assets                32,200

minus current liabilities 24,523

Working capital                7,677

The next step is to look at the overheads for Jones Travel for the year which are shown as total expenses amounting to $132,649. We divide this figure by 12 to calculate our average actual monthly overheads, the answer being $11,054. This means that if we had no income in any one month our net loss for that month would be $11,054 assuming that all of these expenses were constant (fixed costs).

How long do you think the working capital for Jones Travel ($7,677) will last in terms of financing our average monthly overheads? The answer is calculated as follows:

7,677 7,677 = 0.69 of a month (21 days)

11,054

You can see at a glance that Jones Travel is not in good financial shape to survive a significant loss of income. Have a look at the points table below to see how well they would score.

Greater than 2 months         8 points

1-2 months                             5 points

less than 1 month                 2 points

no working capital             0 points

You can see that 0.69 would achieve a score of only 2 points because 21 days is less than a month.

In the actual points calculation procedure an agency is allowed to include the amount of a bank guarantee in its working capital figure but must deduct from its current assets any loans to related parties and any other assets that are encumbered (ie. pledged as security for loans). It must also deduct from its current liabilities any loans from related parties.

Test 3 : Net tangible asset to turnover ratio

This points test asks us to identify "net tangible assets". Using Jones Travel as an illustration, this is done as follows:

total assets                                                                         94,974

minus intangibles                                                                     nil (goodwill, patents, etc.)

sub-total                                                                             94,974

minus total liabilities                                                         34,523

net tangible assets                                                            60,451

Because there were no intangible assets, you can see that the net tangible assets figure of $60,451 is what is shown for capital and reserves. The $60,451 is sometimes referred to as "net worth" or "internal funding". If you see any intangible assets on the assets side of the balance sheet, these must be deducted. A quick way for calculating net tangible assets is net worth minus intangible assets.

In the discussion on "capital and reserves" above, we referred to the concept of turnover. We assumed for Jones Travel that the turnover was $1,631,000. This must be related to the net tangible assets as follows:

net tangible assets x 100 = 60,451 x 100 = 3.7%

sales turnover              1      1,631,000

Let's see how this relates to the points test.

Greater than 3%             8 points

1.5% to 3%                     5 points

Less than 1.5%             2 points

No Tangible Assets -    3 points

You can see that 3.7% scores very well with maximum points. The logic of relating net tangible assets to turnover is that the trustees are looking for an agency to have an adequate capital base to service the volume of business being generated. Since a common cause of business failure is under- capitalisation often brought about by uncontrolled rapid expansion, it is important to set minimum standards for capitalisation and to allocate points for observance. You may notice that the minimum requirements for capital and reserves mentioned above relates to this ratio. The points system ensures that agencies are rewarded for exceeding the minimum requirements.

Think of the net tangible assets as a resource base for servicing the volume of business being transacted. These financial resources, together with the physical and human resources, must be managed wisely. This test can also be used as a test of managerial effectiveness. Whilst it is unacceptable to be under- capitalised, management should also be under pressure to maximise the level of activity in accordance with given resources in order to improve return on investment. There is tension here between the need for financial security on the one hand, and the drive for profitability on the other. A happy medium needs to be found between these two financial objectives.

In the calculations for this test, the amount of a bank guarantee can be added to the net tangible assets figure. As before, we must exclude any related party loans from the assets and liabilities and remember that turnover includes gross sales from all sources and does not refer to commission.

Points Summary

Jones Travel would score the following points using these tests:

Test 1. (Assume separate Client Travel Account kept) 4 points

Test 2.                                                                                     2 points

Test 3.                                                                                     8 points 

Total Points                                                                         14 points

Since a minimum of 10 points is required, Jones Travel would pass the test and would be able to retain its licence.

Application for participation

When an agency applies to participate in the Travel Compensation Fund it is required to pay a fee. The current fees as at 1st January 1993 are $5,600 in respect to the head office and an additional $5,225 for each branch. An amount of $5,000 is included in each of these fees to form the reserves from which consumers are compensated in the event of loss following failure of the travel agency.

Where the applicant is a company or trust, and is not an existing business, it is required to submit an audited balance sheet which meets the minimum financial guidelines outlined above under the headings "capital and reserves" and "financial ratio analysis". If the deduction of intangibles causes test failure, then a letter from the agency's auditor confirming the details of additional capital or bank guarantee arrangements should be submitted with the application.

If the applicant is an existing business (eg. a credit union of real estate agent) the agent is required to submit unaudited financial statements and copies of income tax returns for the last financial year. The financial statements should include a profit and loss statement and a balance sheet covering all business conducted by the applicant. If the applicant's points are not up to the minimum required, its auditor should provide confirmation that additional capital or bank guarantee arrangements have been made.

If the applicant is an unincorporated entity (eg. a sole proprietor or partnership) it should submit a statement of assets and liabilities independently verified by an auditor (accountant or bank manager).

All new applicants are also required to submit a detailed monthly budgeted profit and loss statement for the initial 12 months of operations showing clearly turnover (gross sales), commission and detailed operating expenses. A separate statement of acquisition and commencement costs detailing capital expenditure on fixed assets, non recurring commencement expenses and amounts paid for intangible assets, eg. goodwill, franchise fees, must also be provided.

All travel agents are required within 3 months of the end of each financial year to submit audited financial statements and the required financial analysis on the forms provided entitled "annual financial review". The assessment is confidential and a Sydney firm of chartered accountants is consulted on a regular basis to interpret contentious accounting procedures and to review assessing policy on a continuing basis.

Copyright Bill Wright 1994

Copyright 2000 Genesis Management Services Pty Ltd
Last modified: July 18, 2006