CHAPTER 14 FINANCIAL MANAGEMENT - Edu @ Thinus

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CHAPTER 14FINANCIAL MANAGEMENT

Chapter content Introduction The financial function and financialmanagement Concepts in financial management Objective and fundamental principles offinancial management Cost-volume-profit relationships The time value of money Financial analysis, planning and control

Chapter content (continued) Asset management: The management ofcurrent assets Asset management: Long-term investmentdecisions and capital budgeting Financing Long-term financing The cost of capital Summary

Introduction Art and science of obtaining enough financefor a business at lowest cost, investing inassets earning greater interest than cost ofcapital, and managing profitability, liquidityand solvency of the business Nature and meaning of financial managementand relationship with other functionalmanagement areas Introduction to basic concepts and techniques Goal and fundamental principles discussed How to finance a business and evaluateinvestment decisions

The financial function andfinancial management Concerned with the flow of funds– acquisition of funds (financing)– application of funds for the acquisition of assets(investment)– Cash inflow and cash outflow of the firm– administration of, and reporting on, financialmatters

The financial function andfinancial management (continued) Performs following tasks:– Financial analysis, reporting, planning andcontrol– Management of the application of funds– Management of the acquisition of funds.

The relationship between financialmanagement, other functional managementareas, related disciplines and the environment

Concepts in financialmanagement Balance sheet is an instant photo of thefinancial position of the business Asset side reflects all the possessions of thebusiness:– Fixed assets– Current assets.

Concepts in financialmanagement (continued) Liabilities side reflects the nature and extentof interests in assets:– Long-term funds– Shareholders’ interest– Short-term funds.

Capital Accrued power of disposal over productsand services used by a business to generatea monetary return or profit Capital for investing in fixed assets – theneed for fixed capital Capital for investing in current assets – theneed for working capital

Income Receipts resulting from the sale of productsand/or services Income Units sold x Price per unit Can also be obtained from other sourcessuch as interest on investments

Costs Monetary value sacrificed in the productionof goods and/or services produced for thepurpose of resale Costs can be subdivided:––––––––Direct costIndirect costOverhead expensesFixed costsVariable costsSemi-variable costsVariable cost per unitTotal costs.

A graphical representation of totalfixed costs

A graphical representation offixed costs per unit

Profit Favourable difference between the incomeearned during a specific period and the costincurred to earn that income A loss occurs when the cost exceeds theincome Profit or loss Income – Cost Profit or loss (Price x Units sold) – Cost

The income statementFurnishesdetails about themanner in whichthe profit or lossfor a particularperiod wasarrived at andhow it has beendistributed

Objective of financialmanagement Long term objective should be to increasethe value of the business This can be accomplished by:– Investing in assets that will add value to thebusiness– Keeping the cost of capital as low as possible. Short term financial objective should be toensure the profitability, liquidity and solvencyof the business

Fundamental principles offinancial management The risk-return principle The cost-benefit principle The time value of money principle

Cost–volume–profit relationships Profitability is determined by the unit selling price ofa product, the cost of the product and the level ofactivity of the business Change in one of these three components will resultin a change in the total profit earned Each of these components have to be viewed inconjunction with one another A break-even point is reached, where total costs areequal to total income A change in one of the variables will result in thebreak-even point changing

Break-even analysisN F(SP – V)N the number of units (volume)(SP – V) the marginal income orvariable profit

The time value of money Considers the combined effect of bothinterest and time Can be approached from two perspectives:– The calculation of the future value of some givenpresent value– The calculation of the present value of someexpected future amount.

The relationship betweenpresent value and future value

The future value of a singleamount Future value of an initial investment or principle isdetermined by means of compounding Amount of interest earned in each successive periodis added to the amount of the investment at the endof the preceding period Interest is therefore earned on capital and interest ineach successive period The formula for calculating the future value of anoriginal investment is:FVn PV (1 i)n

The present value of a singleamount Present value of a future value is the monetaryamount which can be invested today at a giveninterest rate (i) per period in order to grow to thesame future amount after n periods Discounting process is the reciprocal of thecompounding process The formula for calculating the present value of afuture single amount is:PV FVn1(1 i)n

Financial analysis, planning andcontrol Financial analysis necessary to monitor thegeneral financial position of a business andto limit the risk of financial failure of thebusiness as far as possible Financial managers have a number of toolsat their disposal to conduct financialanalyses:––––The income statementThe balance sheetThe funds-flow statementFinancial ratios.

The income statement

The balance sheet

The flow of funds in a business

The funds-flow statement Helps with the analysis of the changes in thefinancial position of the business betweentwo consecutive balance-sheet dates Reflects the net effect of all transactions fora specific period on the financial position ofthe business Two approaches for drawing up a funds-flowstatement:– According to changes in the net working capital– According to changes in the cash position.

Financial ratios Financial ratio gives the relationshipbetween two items (or groups of items) inthe financial statements Serves as a performance criterion to pointout potential strengths and weaknesses ofthe business

Financial ratios (continued) Four types of ratios:––––Liquidity ratiosSolvency ratiosProfitability, rate of return or yield ratiosMeasure of economic value.

Liquidity ratiosIndicate the ability of a business to meet itsshort-term obligations as they become duewithout curtailing or ceasing normal activitiesCurrent ratio Current assetsCurrent liabilitiesAcid-test ratio Current assets less inventoryCurrent liabilities

Solvency ratiosIndicate the ability of a business to repay itsdebts from the sale of the assets on cessationof its activitiesDebt ratio Debt x 100Assets1Gearing ratio Owners’ equityDebt

Profitability, rate of return oryield ratiosGross profit margin Gross profit 100Sales1Return on shareholders'interest Net profit after tax 100Shareholders' interest1Net profit margin Net income 100Sales1Return on owners' equityReturn on total capital (after tax) Operating profit less tax 100Total assets1 Net income 100Owners' equity 1

Measures of economic value Measures of economic value are theeconomic value added (EVA) and marketvalue added (MVA) EVA EBIT (1 – T) – cost of capitalexpressed in Rand EBIT earnings before interest and tax T tax rate

Financial planning and control Integral part of the strategic planning of thebusiness Done in most businesses or organisations bymeans of budgets

An integrated budgeting system Operating budgets– Cost budgets– Income budgets– Profit plan or profit budget Financial budgets––––Capital expenditure budgetThe cash budgetFinancing budgetThe balance sheet budget

The integrated budget system

Traditional budgeting Using the actual income and expenditure ofthe previous year as a basis and makingadjustments for expected changes incircumstances

Zero-base budgeting Enables the business to look at its activitiesand priorities afresh on an annual basisbecause historical results are not taken as abasis for the next budgeting period

The management of currentassets Current assets include items such as cash,marketable securities, debtors and inventory Current assets are needed to ensure thesmooth and continuous functioning of thebusiness

The management of cash andmarketable securities Costs of holding cash:– Loss of interest– Loss of purchasing power. Costs of little or no cash:––––Loss of goodwillLoss of opportunitiesInability to claim discountsCost of borrowing.

Marketable securities Investment instruments on which a businessearns a fixed interest income Three reasons to have a certain amount ofcash available:– The transaction motive– The precautionary motive– The speculative motive.

The cash budget Determining the cash needs of a businessis crucially important Cash budget is a detailed plan of future cashflows for a specific period Composed of three elements:– Cash receipts– Cash disbursements– Net changes in cash.

The cash cycle Investing cash in raw materials Converting the raw materials to finishedproducts Selling the finished products on credit Ending the cycle by collecting cash

The management of debtors Debtors arise when a business sells oncredit. Credit granted to individuals is referred to asconsumer credit Credit extended to businesses is known astrade credit

The management of debtors(continued) Three most important facets of themanagement of debtor accounts are:– The credit policy– The credit terms– The collection policy.

The credit policy Credit policy contains information on howdecisions are made about who to grantcredit to and how much The four Cs of credit:––––Character: The customer's willingness to payCapacity: The customer's ability to payCapital: The customer's financial resourcesConditions: Current economic or businessconditions.

The credit terms Credit terms define the credit period andany discount offered for early paymentDiscount is usually offered for earlypaymentWhere early payment is not made, nodiscount is applicable and the full amountbecomes due

The collection policy Collection policy concerns the guidelines forcollection of debtor accounts that have notbeen paid by due dates Costs of granting credit include the following:– Loss of interest– Costs associated with determining customer’screditworthiness– Administration and record-keeping costs– Bad debts.

The management of stock(inventory) Conflict between profit objective andoperating objective Costs of holding stock:––––Lost interestStorage costInsurance costsObsolescence.

The management of stock(inventory) (continued) Costs of holding little or no stocks:––––The loss of customer goodwillProduction interruption dislocationLoss of flexibilityRe-order costs.

Long-term investment decisionsand capital budgeting Capital investment involves the use of fundsof a business to acquire fixed assets such asland, the benefits of which accrue overperiods longer than one year Importance of capital investment projects:– Relative magnitude of the amounts involved– Long-term nature of capital investment decisions– Strategic nature of capital investment projects.

The evaluation of investmentprojects Basic principle underlying the evaluation ofinvestment decision-making is cost benefitanalysis – cost of each project is comparedto its benefits Two additional factors require furtherconsideration when comparing benefitsand costs:– Benefits and costs occur at different times– Costs and benefits are accounting concepts thatdo not necessarily reflect the timing and amountof payments to the business.

Cash-flow concepts Cash flow represents cash transactions Three cash-flow components used for capitalbudgeting:– Initial investment– Expected annual cash flows over the life of theproject– Expected terminal cash flow, related to thetermination of the project. Annual net cash flows are calculated as theearnings before interest and tax, plus anynon-cash cost items such as depreciationminus cash outflows for particular year

Cash-flow concepts (continued) Concepts to understand:––––Initial investment (C0)Annual net cash flows (CFt)Life of the project (n)Terminal cash flow (TCF)

The net present value method The formula used to calculate NPV is:– NPV present value of net cash inflows – initialinvestment The application of NPV involves:– Forecasting the three components of project cash flows asaccurately as possible– Deciding on an appropriate discounting rate– Calculating the present values of the three project cashflow components for a project– Accepting all projects with a positive NPV and rejecting allthose with a negative NPV, in accordance with NPVdecision criteria.

Decision criteria for the NPV Accept all independent projects with apositive NPV (NPV 0) Reject all independent projects with anegative NPV (NPV 0) Projects with NPV 0 make no contribution tovalue and are usually rejected

Risk and uncertainty Risk is defined as any deviation from theexpected outcome Risks may or may not occur Uncertainty describes a situation where themanagers are simply unable to identify thevarious deviations and are unable to assessthe likelihood of their occurrence Sensitivity analysis is a method that can beused to take risk into account in capitalinvestment decisions

Financial markets Financial markets and financial institutionsplay an important role in the financing ofbusinesses– Financial markets are channels through whichholders of surplus funds make funds available tothose who require additional finance– Financial institutions act as intermediaries onfinancial markets between savers and those witha shortage of funds– Financial intermediation is the process in whichfinancial institutions pool funds from savers andmake these funds available to those requiringfinance

Money and capital markets Money market is the market for financialinstruments with a short-term maturity– Funds are borrowed and lent for periods of oneday or for a few months Funds required for long-term investment areraised and traded by investors on the capitalmarket– Mostly takes place on the JohannesburgSecurities Exchange (JSE)– Long-term investment transactions of this naturecan also be done privately

Types of institutions Financial institutions divided into two broadcategories:– Deposit-taking institutions– Non-deposit institutions

Types of institutions (continued) Deposit-taking institutions– Private-sector bank, such as ABSA, Nedbank,FNB, Standard Bank and Investec Non-deposit-taking institutions– Short-term insurers, such as Outsurance,Santam and Mutual & Federal– Life assurers, such as Old Mutual and Sanlam– Pension funds– Provident funds

Short-term financing Common forms of short-term financing:––––Trade creditAccrualsBank overdraftsFactoring.

Short-term financing Trade credit– Occurs mainly in the form of suppliers’ credit– Prompt payment is often secured in the form ofrebates– Advantages of trade credit: Readily available to businesses that pay their suppliersregularly It is informal It is more flexible than other forms of short-termfinancing.

Short-term financing Accruals– Accruals are a source of spontaneous finance Accrued wages represent money that a business owesits employees (wages or salaries) Accrued tax is a form of financing which is determinedby the amount of tax payable and the frequency withwhich it is paid

Short-term financing Bank overdrafts– Overdraft facility allows the business to makepayments from a cheque account in excess ofthe balance in the account– Bridges the gap between cash income and cashexpenses– Interest charged on overdraft is negotiable and isrelated to the borrower’s risk profile– Interest is charged daily on the outstandingbalance

Short-term financing Debtor finance– Involves the sale of debtors to a debtor-financingcompany: Invoice discounting is the sale of existing debtors andfuture credit sales to a debtor financing company Factoring is similar to invoice discounting, except thefinancer undertakes to administer and control thecollection of debt.

Short- term financing plans

Shareholders’ interest Shareholders’ interest in a company issubdivided into owners’ equity andpreference shareholders’ capital Owners’ equity consists of funds madedirectly available by the legal owners in theform of share capital Preference-shareholder capital falls betweendebentures and ordinary shares in terms ofrisk

Owners’ equity Ordinary shareholders are true owners of abusiness Two types of ordinary shares:– Par value shares– Non-par value shares. A co-owner of the business, the ordinaryshareholder, has a claim to profits

Owners’ equity Important characteristics of the ordinaryshare:– Liability of ordinary shareholders is limited to the amount ofshare capital they contributed to the business– No certainty that money paid for shares will be recouped– Ordinary shares in listed company are tradable on stockexchange– Ordinary shareholders are owners of the business andusually have full control of it– Business has no legal obligation to reward ordinaryshareholders for their investment in shares– Share capital is available to the business for an unlimitedperiod.

Preference-shareholders’ capital Two types of preference shares:– Ordinary preference share– Cumulative preference share. Characteristics of preference shares:– Have a preferential claim over ordinary shareson profit after tax– Have a preferential claim over ordinary shareson the assets of the business in the case of liquidation– The term of availability is unlimited– Authority can vary between full voting rights and no votingrights at all.

Sources and forms of long-termfinancing

Long-term debt Refers to debt that will mature in a year ormore Usually obtained in two ways:– Loans Debentures Bonds Registered term loans– Financial leasing (credit) Direct financial leasing Leaseback agreements

Sources of financing for smallbusinesses Personal funds Loans from relatives and friends Trade credit Loans or credit from equipment sellers Mortgage loans Commercial bank loans Small-business loans Taking in partners Selling capital shares Venture-capital funding

The cost of capital Financial management should ensure that only thenecessary amount of capital is obtained Cost and risk should be kept to a minimum In capital investment decisions, cost of capitalserves as a benchmark for investment proposals In financing decisions, various types of capitalearmarked for financing investments of a businessshould be combined so that the cost of capital to thebusiness is kept to a minimum

Risk For an investor, risk consists of twocomponents:– Possible loss of the principal sum (the originalamount invested)– Possibility that no compensation will be paid forthe use of the capital (no interest or dividendpayments).

Summary Nature of financial function and task offinancial management Concepts and techniques in financialmanagement Goals and principles of financial management Financial analysis, planning and control Management of the asset structure includinginvestments

Summary Guidelines and techniques for short- andlong-term investments Nature and characteristics of long-term capital Factors involved in determining cost of capital Risk involved

financial management Cost-volume-profit relationships The time value of money Financial analysis, planning and control . Chapter content (continued) Asset management: The management of current assets Asset management