FINANCIAL MANAGEMENT

Introduction

Financial management is a process which brings together planning, accounting, auditing, budgeting, reporting and production of the project with the aim of managing the resources and achieving the objectives of the project. This is the fundamental ingredient for the success of a project. That is why policies and activities of the project require financial management.

In this course, students are provided with financial skills theory and management of capital, profits and investments. This course gives an understandings of financial statements, recognitions and matching of expenses and income, financial projections, audit requirements, working capital; management ratio analysis reporting and disclosures for outside users, oversight and accountability and regulatory responsibilities.

The way in which a company finances its assets has an effect on the return on owners’ capital and the overall cost of capital. Gearing up the capital structure together with tax allowances on interest payments can enhance the return on shareholders’ funds but carry risks if taken too far. Capital is invested either in fixed assets or in working capital. Both the raising of capital and its use affect the share price of a private- sector company through the impact on reported profit.

Capital is not free. The owners of firms and financial institutions require a return on their investments in the company. In turn the company must earn a return of assets at least equal to this cost of capital. To do otherwise will not satisfy the providers of that capital and will make the raising of future capital more difficult, if not impossible. Firms need to set a minimum required rate of return against which the profitability of proposed new investments is measured. This required rate must at least be equal to the cost of the different types of capital used in the business.

The are two main source of new capital for new investments. Firms can either barrow the money, usually form a financial institution, or they can obtain it from the owners. In this latter case, new equity capital can be obtained in one of two ways.

Companies occasionally sell new shares to existing shareholders on a rights’ issue. This may be unpopular as it tends to depress the existing hare price on the stock exchange. The other way companies obtain new capital for the owners is by not paying out all the profit earned as dividends. By this means companies are assured of the extra capital they need and they save the expense of issuing new shares. Most firms use a mix of borrowed and owners’ capital and the relationship between the two is known as capital gearing. Accompany is said to be highly geared when it has a large amount of borrowed capital relative to owners’ capital. It is lowly geared

when the proportion of borrowed capital is small. Strictly speaking, gearing is the use of any prior charge capital including preference shares.

Low gearing High gearing

Owners Capital (Share capital + Retained Profits) 90% 50%

Borrowed Capital 10% 50%

Total Capital 100% 100%

Cost of borrowed capital

The rate of interest which has to be paid on new loans to get them taken up by investors at par can be regarded as the cost of borrowed capital. Such rates of interest vary over time in sympathy with interest rates obtainable on alternatives investments. They vary slightly according to the size of the loan and the degree of risk attached to the particular firm. An alternative approach can be used to find the current cost of borrowing for a firm which has existing quoted loans or debentures. If the fixed rate of interest on such loans is less than the current going rate, these securities will have a market price of less than the par value of the stock. This means investors will obtain an annual return from the interest payments and a capital gain on the eventual repayment of the stock at par.

The cost of equity capital

The equity of a company is its risk capital, embracing ordinary share capital and retained profits which can be regarded as having the same cost. Companies retained profits to short-circuit paying out all profits with one hand while asking shareholders to buy new hares with the other. There is clearly a saving in administrative costs and professional fees by returning profits, so this alternative will be slightly cheaper in practice. When put simply, the cost of equity is the return shareholders expect the company to earn in their money. It is their estimation, often not scientifically calculated of the rate of return which will be obtained both from future dividends and an increased share value. Unfortunately, simple concepts are not always so easy to apply in practice and the cost of capital is a favorite battlefield for academics with no one agreed solution.

It is possible to calculate the cost of equity as the discounted cash flow yield achieved from the estimated future dividends and the increased share value at a future point of time. An alternative approach is to take the current dividend yield for a company and add the expected annual growth. For example F. J. Management Ltd currently pay a net dividends of 10p on each ordinary share which is quoted at ₤2 on the stock exchange. Growth of profits and dividends has averaged 15% over the few years. The cost of equity for FJ . Management Ltd can be calculated as:

Current net Dividend x100%+15%

Cost of Equity Capital = Current Market Price

= 10p x 100% +15%

£2

= £0.1 x 100% +15%

£2

= 5% + 15%

= 20%

Managing the working capital

The capital of a company is employed is two distinct areas. Some of it goes to provide the permanent or fixed assests, such as buildings, plant and vehicles. The remainder goes to provide the working capital necessitated by having to pay for the cost of goods and sevices before recovering the money form customers.

Fixed Assets (Buildings, Plant, Vehicles)

Capital Employed

(Shareholders’ funds, Working Capital (Stocks, debtors, cash less creditors)

Loans, debentures etc.)

The employment of capital. Figure 1.2

Working capital is the value of all the current assets less the value of the current liabilities. It therefore includes the cost of stocks of raw materials, work- in- progress and finished goods together with the amount owned by customers less the amount owed to suppliers

Working Capital = Stock + Debtors + Cash - Creditors

The key to managing working capital successfully is to find the right balance between liquidity and profitability. A firm needs to be liquid enough to pay the wages and other bills when required, but on the other hand it needs to carry sufficient stocks so that production is not excessively disrupted nor customers dissatisfied with stock-outs! Both these requirements can be met given unlimited working capital but much of it would be idle for long periods of time. This means that profit would be lost due to the extra holding costs of large stocks and the interest cost of the capital involved. Therefore we have to strike a balance between profitability and liquidity recognizing that they pull in opposite directions

Management of debtors and creditors

Apart from retail shops, most companies sell on credit so their managers must decide whom to sell to, on what terms ans how to follow up late payments. When another firm applies for credits as a potential customer, it would be rash to agree credit without checking on credit worthiness. Checks should include talking to other suppliers who have been quoted as trade references and checking bank references. Unfortunately the latter may say little more than the length of time the account has been operated. A copy of the clients annual accounts can be requested and checked thoroughly using ratio analysis techniques to look at the profitability, liquidity and debt capacity. Having decided whom to sell to, a firm must now decide the terms of sale being the length of the credit period and whether to offer cash discounts for early payment. The length of credit period is often settled by the normal terms for that particular industry, firms compete with one another for custom andit would be difficult for one firm to impose a shorter credit period than its competitors, unless it had some compensating advantages.

Cash discounts are a way of stimulating early payments, thereby reducing the amount of working capital required. If a cash discount of 2% is offered for payment of invoice within two weeks, this may persuade customers to accept instead of taking a further four weeks’ credit. A discount of 2% for four weeks is equivalent to an annual rate of 26%. If credit customers would have taken a further six weeks to pay after the expiry of the discount period then the 2% discount is equivalent to an annual rate of 17%.

Early payment induced by not having to borrow so much capital. Some firms offer a tapering discount/penalty scheme where the cash discount redures in steps as the normal credit period shortens, but after that a stepped penalty is added to the invoice value according to the lateness of payment. An example is:

Payment within 2 weeks of invoice date 3% discount

Payment within 4 weeks of invoice date 2% discount

Payment within 6 weeks of invoice date 1% discount

Payment after 6 weeks of invoice date 1% penalty

Payment after 8 weeks of invoice date 2% penalty

If payment is not forth coming in the stipulated time a reminder letter should be sent followed by a more strongly worded letter about a fortnight later. Should payment still not received, consideration should be given to terminate supplies and instituting legal action and the customer informed accordingly.

Management of stocks

When looking at the current ratio, it is assumed that stocks represent half of current assets. There are three possible kinds of stocks raw materials, work in progress and finished goods. In manufacturing industry all three types are likely to be present unless the product is a customers’ one off specification, when completed work is not usually held in stock. In service industries physical stocks are not so prevalent but work in progress in the form of wages, salaries and overheads may be very significant. In an ideal situation firms would need no stocks. Raw materials would be delivered daily; production would be completed the same day and the finished goods would immediately be sold and delivered to customers. This situation is most unusual in practice because firms buy in bulk to reduce the unit cost of purchases and to hold some of the stock as an insurance against non-delivery. Production is not completed in some industries.

To ensure that production is never halted for lack of materials or component parts and that customers are never dissatisfied, might entail holding very large stocks.

MANAGING THE WORKING CAPITAL

The capital of accompany is employed in two distinct areas. Some of it goes to provide the permanent or fixed assets such as buildings, plant and vehicles. The remainder goes to provide the working capital necessitated by having to pay for the cost of goods and services before recovering the money form customers.

Working capital is the value of all the current assets less the value of the current liabilities. It therefore includes the cost of stocks of raw materials, work in progress and finished goods together with the amount owned by customer less the amount owned to supplies.

The key to managing working capital successfully is to find the right balance between profitability and liquidity. A firm needs to be liquid enough to pay the wages and other bills when required, but on the other hand it needs to carry sufficient stocks so that production is not unduly

disrupted nor customers dissatisfied with stock outs: both these requirements can be met given unlimited working capital but much of it would be idle for long periods of time.

Having looked at working capital requirements, let us now look at how each constituent part is best managed.

The management of cash

There two key instruments for managing cash- the cash budget and the forecast flow statement. The former is the more detailed statement showing all the cash receipts and payments for the coming year broken down into monthly intervals.

When compiling a cash budget it is essential to allow for the time lags on transactions. If a firm finds that credit customers take an average of eight weeks to settle their account, then sales that takes place in month one will appear as a cash inflow in month three. Similarly, purchases will not be paid for in the month of purchase but in a later month depending on the credit period obtained from suppliers. Note the absence of depreciation which is not a expense. The other instrument which helps to manage cash is the forecast cash flow statement. It might be thought that it is similar to the cash budget but there are important distinctions. A cash flow statement is a summary of the detailed cash transactions. The first entry, for example, shows the cash flow from operating activities of which profit is the main constituent item. The cash budget, however details the individual items of income and expenditure as they are paid not when they were initially incurred. The cash flow statement is therefore very useful in identifying the causes of the change in the liquid position. It highlights changes in stocks and debtors and in the level of investing activities or new financing for example which are not obvious from the cash budget which records the actual receipts and payments of cash.

Armed with these two statements we should now know the size, duration, and causes of potential surpluses or deficits of cash. Short-term cash surpluses of a few months duration should be invested short term to earn more profit while being capable of being turned back into cash when required. The taking of cash discounts for early payment to suppliers may be advisable if the annual rate of interest so earned exceeds that available on financial investments. If a surplus is disclosed that is expected to continue in later years, though must be given to using this in the expansion or diversification of the existing business or in the acquisition of new businesses.

Forecast cash deficits obviously pose more of a problem than cash surplus. A short term deficit lasting only a few months will be disclosed in a cash budget and explained in the forecast sources and application of funds. If the cause is a seasonal increase in stocks and debtors then the evidence of these statements will usually persuade the bank managers to extend overdraft facilities. Failing this a firm may have trim stocks, re-negotiate credit term, defer capital expenditure and somehow level the peak cash outflows.

Long term cash deficits are caused by a move to an increased volume of business, large capital expenditure programmes or simply the effects of inflation which require more cash to finance the same activities. Such events have to be met by introducing new long term capital. This may take a form of right s issue of new shares or a loan or debenture repayable over a number of years or in a

lump sum on redemption. Sale and leaseback of valuable premises may be a one- off way of releasing funds for other uses but the rent will reduce profits in much the same way as would interest do on a loan,

INVESTMENT:

In the business environment, Capital investment is the important step. Investment appraisal is concerned with decisions about whether, when and how to spent money on capital projects. Such decisions are important for the companies involved because too often large sums of money are committed in an irreversible decision, with no certain knowledge of the size of future benefits.

Suppose a printing firm is considering buying a binding machine for $20,000 which reduce labour costs on this activity by $6,000 per annum for each of the five years the is expected to last. What the management of the firm has to consider is whether a return of $6,000 per annum for five years justifies the initial investment of $20,000.

The essence of all investment appraisals is to measure the worthwhileness of proposals to spent money by comparing the benefits with costs. If this measurement is done badly, it can hamper a firm’s growth and employment prospects for years to come, and may lead to an inability to attract new investors. Financial institutions finance firms with capital in the expectation of a reasonable rate of return. If a firm invests those finances in projects which do not yield a reasonable return then investors will be wary of that company in the future.

Types of Investment situation:

There are a number of basic situation where an appraisal takes place.

Expansion – assessing the worthwhileness of expanding existing product lines requiring additional investment in buildings, plant, stocks, debtors etc.

New product/diversification – assessing the viability of the more risky investment in totally new products.

Cost saving – assessing the profitability of a cost-saving scheme; for example, when an investment in a new machine automates an existing manual process.

Replacement – deciding whether and when to replace an old machine with a new one to save operating costs or reduce wastage.

Financing – comparing the cost of purchasing an asset outright with the alternative cost of leasing.

All the above investment situations have the common approach. In each case we must decide whether the benefits we get from initial investment are sufficient to justify the original capital outlay.

Investment Appraisal Methods

1. Present Value:

Suppose $1 was invested one year ago at the interest rate of 10% p.a. after a year the sum has grown from $1 to $1.1. If the same amount was invested two years ago it would have grown to $1.21 with first year’s interest re-invested. Compound interest measures the future value of money invested sometime in the past. It is equally possible to look at money in the reverse direction, namely, the present value of money receivable at a future point in time. The present value of future sum of money is the equivalent sum how that would leave the recipient in difference between the two amounts. The present value or equivalent sum to $1 receivable in one year’s time is that amount which, if invested for one year, would accumulate to $1 in one year’s time.

Example

Table 1 shows the present value factors compared with the compound interest factors at the same interest rate.

Present Value of $1 Receivable

In a future year with interest at 10%

Future value of $1 with compound interest at 10%

Year 0 (now) 1.000 1.000

1 0.909 1.100

2 0.826 1.210

3 0.751 1.331

Using a 10% rate of interest R1 receivable in one year’s time has an equivalent value now of R0.909 because R0.909 for one year at 10% will accumulate to R1. the relationship between the factors is that one is the reciprocal of the other for the same year. For example, for year 3

1

0.751 = 1.331

2. True rate of return

The profitability of an investment should be measured by the size of the profit earned on the capital invested. This is what the rate of return method attempts to do without perfect success. An ideal method will not rely on averages but will relate these two factors of profit and capital employed to each other in every individual year of the investments’ life. A useful analogy can be made with a building-society a sum of money each year. Part of this sum is taken as interest to service the capital outstanding leaving the remainder as a capital repayment to reduce the capital balance. The profitability of the investment from the society’s viewpoint can be measured by the rate of the interest payment assuming that the yearly capitals have paid off the mortgage.

Table 2 sets the yearly cash flows of a typical building-society mortgage of R20.000 repayable over ten years with interest at 12% p.a. on the reducing balance. The small surplus remaining at the end of ten year is negligible given the size of the annual cash flows. This building society is getting a true return of 12% pa on the reducing capital balance of the mortgage.

Annual Cash-Flow : $

Interest Payment at 12% p.a.

Capital Repayment

Capital Outstanding Balance

Year 0 -20,000

1 + 3,540 2,400 1,140 20,000

2 + 3,540 2,263 1,277 18,860

3 + 3,540 2,110 1,430 17,583

4 + 3,540 1,938 1,602 16,153

5 + 3,540 1,746 1,794 14,551

6 + 3,540 1,531 2,009 12,757

7 + 3,540 1,290 2,250 10,748

8 + 3,540 1,020 2,520 8,498

9 + 3,540 717 2,823 5,978

10 + 3,540 379 3,161 3,155

6 (Surplus)

The true rate of profitability is 12%. This can be proved using the simpler present value approach as in table 3 (below). To do this the cash flows are tabulated yearly and brought back (discounted) to their present value by the use of present value factors. In effect, interest I deducted for the waiting time involved. The remaining cash is therefore available to repay the original investment. The profitability of the investment is measured by the maximum rate of interest which can be deducted, while leaving enough cash to repay the investment. This rate of interest is the same 12% as found in Table 2. the surplus of R3 is negligible given the size of the annual cash flows. The effect of using present value (PV) factors on the future cash flows us ti take interest than 12% was applied in Table 3, then not all the capital would be repaid over the ten year life. If a lower rate of interest than 12 was used the capital repayments would be viable, but what rate of return they can expect on a project. To answer this question the NPV method is taken a stage further. The annual cash flows are discounted at a high trial rate of interest at FJ Management Ltd. Such trial is an educated guess but a high rather than lower rate is chosen because of the NPV surplus which previously occurred.

Assuming a trial rate of 30% was chosen, and then the annual cash flows can be discounted by the present value factors at 30% as shown below:

Table 5

Annual Cash Flow

$

PV Factor at 30%

PV

$ $

Year 0 - 150,000 1.000 -150,000

1 +60,000 0.769 +46,140

2 +60,000 0.592 +35,520

3 +60,000 0.455 +27,300

4 +60,000 0.350 +21,000

5 +40,000 0.269 +10,760

6 +20,000 0.207 + 4,140

+144,860

NPV $5,140

As there is a deficit net present value of R5.140 the rate of return is less than 30%. This is because too much interest has to be deducted to allow all the capital to be repaid. If instead of going to an estimated trial rate of 30% the annual cash flows had been repeatedly discounted at 1% intervals from the 20% required rate, then a zero net present value would have been found at about 28%. This is the true of return of the project and is known as the discounted cash flow yield (DCF). In other words, the DCF yield is the solution rate of interest which when used to discount annual cash flows on a project, gives an NPV of zero. The DCF yield is also known as IRR.

Interpolation

The NPV calculation at 20% and 30% yield a surplus of R28.060 and a deficit of R5.140 respectively. By interpolation which can be proved by calculation:

28,060 x (30% - 20%)

20% + 28,060 + 5,140 = 28.5%

Another method of interpolation takes the form of a simple graph with the rate of interest on the vertical axis and the NPV on the horizontal axis. The NPVs from the trial at the company’s required rate are then plotted against their respective interest rates and the two plots joined by a straight line. The approximate DCF yield is where the straight line intersects the vertical axes at zero NPV. It is possible to calculate the DCF yield to one or more decimal places. Although one decimal may be justifiable there is usually no case for further precision. This is because the basic data on which the calculations are performed are only estimates of future events. Some managers may have access to calculations or computers which can rapidly the question of a project’s rate of profitability though interpolation is an obvious shortcut.

CONCLUSION:

Having explained the Financial Management and what it involves, I conclude by Risk Assessment in financial statements. Risk management is of utmost importance and must be highly considered in business entity.

CHECKLIST

“Risk Assessment” Do Financial Statements Capture Risk?

Have We Been &Where Are We Going?

Valuation Basics, Accounting-based Valuation, Multiples Analysis

Cash Flow Analysis, Refresher on Financial Statements

Detecting Accounting Manipulations.

Part 1 of Project (Cash Flow Projections/Earnings Quality Analysis)

Risk Assessment (Credit), Cost of Capital Calculations

Risk and Analyzing Accounting Trading Strategies

Mergers and Acquisitions, and Stock Options.

– Off Balance Sheet Activities, Pension Plans, International Accounting and Valuation

Financial Statement Analysis –Risk Assessment

• Common-Size Financial Statements (cross-sectional analysis)

– E.g. deflate all financial numbers by total assets

• Trend Financial Statements (time-series analysis)

– Compare growth rates over time

Financial Ratio Analysis

– Profitability ratios, short-term liquidity ratios, long-term solvency ratios

Accounts Receivable Turnover

Measures how soon sales will be become cash:

Accounts Receivable Turnover = Net Sales on Account

Average Accounts Receivable

Perhaps a more intuitive measures of the rate at which A/R are being collected is the day’s receivable outstanding:

Days Receivable Outstanding = 365 / Accounts Receivable Turnover

Inventory Turnover Ratio

This ratio measures how quickly inventory is being sold.

Inventory Turnover = Cost of Goods Sold

Average Inventory

Perhaps a more intuitive measure of the rate at which inventory is being sold is the days inventory held:

Days Inventory Held = 365/Inventory turnover

Fixed Asset Turnover

Measures the relations between sales and the investment in property, plant, and equipment.

How efficiently is the firm using its fixed assets to generate sales?

Fixed asset turnover = Sales

Average fixed assets

Accounts Payable Turnover

Measures how quickly a firm is paying its

Suppliers.

Accounts Payable = Purchases

Turnover Av. Accounts Payable

Also can be expressed as:

Days Payable Outstanding = 365/ (Accounts Payable Turnover Rate)

Analysis of Short-Term Liquidity

•Sheds light on a firm’s ability to pay for obligations that come due during its operating cycle (e.g., wages, purchases of inventory).

• Commonly used measures of short-term debt paying ability include:

- Current Ratio

- Quick Ratio

- Operating Cash Flow to Current Liabilities Ratio

Current Ratio

Current Ratio = Current Assets

Current Liabilities

This ratio matches the amount of cash and other current assets that will become cash within one year against the obligations that come due in the next year.

Basic rule of thumb: A minimum current ratio of 1.0.

Quick Ratio

A variation of the current ratio is the quick ratio or acid test ratio.

Quick Ratio = Cash + Mkt Securities + AR = CA-Inv

Current Liabilities CL

Include in the numerator only those current assets that the firm could convert quickly into cash

Operating Cash Flow to Current Liabilities Ratio

• Another measure a firm’s short-term liquidity.

– The advantage is that it is based on cash flow AFTER the funding needs for working capital (i.e., accounts receivables and inventory) been made.

Operating Cash Flow

Average Current Liabilities

Long-Term Solvency Ratios

Measure a firm’s ability to meet interest and principal payments on long-term debt (and similar obligations, like long-term leases) when they come due.

Obviously, the best indicator for assessing long-term solvency risk is a firm's ability to generate earnings over a period of years.

Long-Term Solvency Ratios

Long-Term = Long-Term Debt

Debt Ratio Long-Term Debt + Shareholders Equity

Debt/Equity = Long-Term DebtRatio Shareholders’ Equity Liabilities/Assets = Total LiabilitiesRatio Total Assets

Interest Coverage Ratio

Measures how many times a firm’s net income before interest expense and income taxes exceeds its interest expense.

Net Income + Interest Expense + Income Tax Expense+ Minority Interest in Earnings

Interest Expense

Interest coverage ratios less than 2.0 suggest a risky situation.

Summary of Risk Assessment using Financial Information

. Analysis of a particular firm’s financial ratios over a period of years allows one to track historical trends and variability in the ratios over time.

. Key is compare with industry benchmarks.

. An important part of the analyst’s job is to use financial ratios to identify aspects of the firm that warrant deeper investigation.

BIBLIOGRAPHY

Eugene F. Brigham and Michael C. Ehrhardt (2005).

Financial Management – Theory and Practice. Published by: Thomson Corporation, USA.