Financial Management Module
Uploaded by
sikeFinancial Management Module
Uploaded by
sike FINANCIAL
MANAGEMENT
Dr.
Gaofetoge
Ntshadi
Ganamotse
Adeelah Tariq
Rapelang D.Sekatle
1
|
P a g e
Financial
Management
Dr. Gaofetoge Ntshadi Ganamotse
Adeelah Tariq
Rapelang D.Sekatle
Commonwealth of Learning
Edition 1.0.
____________________
Commonwealth of Learning© 2013
Any
part
of
this
document
may
be
reproduced
without
permission
but
with
attribution
to
the
Commonwealth
of
Learning
using
the
CC-‐BY-‐SA
(share
alike
with
attribution).
http://creativecommons.org/licenses/by-‐sa/3.0
2
|
P a g e
Commonwealth
of
Learning
1055 West Hastings Street, Suite 1200
Vancouver, British Columbia
Canada V6E 2E9
Telephone: +1 604 775 8200
Fax: +1 604 775 8210
Web: www.col.org
E-‐mail: [email protected]
3
|
P a g e
ACKNOWLEDGEMENTS
These
training
materials
have
drawn
so
much
from
the
available
literature.
The
commonwealth
of
learning
extends
its
gratitude
to
the
many
authors
who
have
made
their
materials
available
through
online
or
print
publication.
Many
thanks
to
Mr.
Sekatle,
who
has
initiated
the
writing
of
these
materials.
4
|
P a g e
TABLE OF CONTENTS
ACKNOWLEDGEMENTS
............................................................................................................................
4
COURSE
OVERVIEW
.................................................................................................................................
8
Course
Introduction
.................................................................................................................................
8
Course
Goals
............................................................................................................................................
8
Course
Description
..................................................................................................................................
9
Required
Readings
.................................................................................................................................
11
Assignments
and
Projects
......................................................................................................................
12
Assessment
Methods
.............................................................................................................................
12
Course
Schedule
....................................................................................................................................
12
STUDENT
SUPPORT
................................................................................................................................
13
Academic
Support
..................................................................................................................................
13
How
to
Submit
Assignments
..................................................................................................................
13
Technical
Support
..................................................................................................................................
13
UNIT
ONE
-‐
INTRODUCTION
TO
FINANCIAL
MANAGEMENT
.................................................................
14
Unit
1
Introduction
................................................................................................................................
14
Unit
1
Objectives
...................................................................................................................................
14
Unit
1
Readings
......................................................................................................................................
14
Unit
1
Assignments
and
Activities
.........................................................................................................
14
Topic
1.1
Finance
and
Forms
of
Business
..............................................................................................
15
Topic
1.2
CONCEPTS
and
Principles
of
Financial
Management
.............................................................
20
Unit
1
–
Summary
..................................................................................................................................
27
UNIT
Two
-‐
FINANCIAL
INSTITUTIONS
AND
MARKETS
...........................................................................
28
Unit
2
Introduction
................................................................................................................................
28
Unit
2
Objectives
...................................................................................................................................
28
Unit
2
Readings
......................................................................................................................................
28
Unit
2
Assignments
and
Activities
.........................................................................................................
28
Topic
2.1
Financial
Institutions
..............................................................................................................
29
Topic
2.2
FINANCIAL
Markets
................................................................................................................
39
Unit
2
–
Summary
..................................................................................................................................
54
UNIT
THREE
-‐
FINANCIAL
STATEMENTS
.................................................................................................
55
5
|
P a g e
Unit
3
Introduction
................................................................................................................................
55
Unit
3
Objectives
...................................................................................................................................
55
Unit
3
Readings
......................................................................................................................................
55
Unit
3
Assignments
and
Activities
.........................................................................................................
56
Topic
3.1
STATEMENTS
of
Comprehensive
Income
and
Financial
Position
...........................................
57
Topic
3.2
Analysis
of
the
Financial
Statements
......................................................................................
69
Topic
3.3
Statement
of
Cash
Flows
........................................................................................................
82
Unit
3
-‐
Summary
...................................................................................................................................
91
UNIT
FOUR
-‐
FINANCIAL
PLANNING
.......................................................................................................
92
Unit
4
Introduction
................................................................................................................................
92
Unit
4
Objectives
...................................................................................................................................
92
Unit
4
Readings
......................................................................................................................................
92
Unit
4
Assignments
and
Activities
.........................................................................................................
92
Topic
4.1
–
Introduction
to
Financial
Planning
......................................................................................
93
Topic
4.2
-‐
Cash
Budgets
for
Cash
Planning
...........................................................................................
95
Topic
4.3
Pro
Forma
Financial
Statements:
A
Tool
For
Profit
Planning
...............................................
103
Unit
4
–
Summary
................................................................................................................................
110
UNIT
FIVE
-‐
SHORT
TERM
FUNDS
MANAGEMENT
...............................................................................
113
Unit
5
Introduction
..............................................................................................................................
113
Unit
5
Objectives
.................................................................................................................................
113
Unit
5
Readings
....................................................................................................................................
113
Unit
5
Assignments
and
Activities
.......................................................................................................
113
Topic
5.1
–
Working
Capital
Management
..........................................................................................
114
Topic
5.2
–
Inventory
Management
.....................................................................................................
120
Topic
5.3
–
Current
Liabilities
Management
........................................................................................
127
Unit
5
–
Summary
................................................................................................................................
143
FINAL
ASSIGNMENT/MAJOR
PROJECT
.................................................................................................
145
COURSE
SUMMARY
.............................................................................................................................
146
Topics
Learned
.....................................................................................................................................
146
Application
of
Knowledge
and
Skill
......................................................................................................
149
Course
Evaluation
................................................................................................................................
150
COURSE
APPENDICES
...........................................................................................................................
151
6
|
P a g e
7
|
P a g e
COURSE OVERVIEW
COURSE INTRODUCTION
Financial
management
is
an
introductory
course
which
provides
the
applied
and
realistic
view
of
financial
management
for
today’s’
entrepreneurs.
It
is
the
basis
of
fundamental
concepts
of
business
finance,
investment
and
an
understanding
of
financial
calculations.
It
sets
a
ground
understanding
of
the
elements
of
Financial
Management
in
an
Enterprise
by
describing
the
corporation
and
its
operating
environment.
The
contents
of
this
course
provide
the
understanding,
knowledge
and
essential
skills;
any
manager
should
have
when
considering
proposing
project
and
assessing
its
financial
viability
and
impact
on
the
business.
The
course
integrates
elements
of
financial
accounting
and
financial
management.
The
financial
accounting
focuses
on
key
financial
statements
such
as
Income
Statements,
Balance
Sheets,
and
Cash
Flow
Statements,
and
their
roles
in
the
measurement
of
performance
through
the
use
of
financial
and
non-‐financial
measures.
Whereas,
the
financial
Management
focuses
on
decision
making
associated
with
designing,
implementing
and
managing
an
enterprise.
This
course
will
help
entrepreneurs
to
support
accounting,
risk
management,
improve
operational
planning,
controls
and
decision
making.
Entrepreneurs
will
be
able
in
order
to
impede
the
misuse
of
funds,
maximize
the
profit
and
wealth
of
the
business
in
Long
Run.
In
addition
to
this,
the
course
along
with
other
courses,
e.g.,
business
plan
development,
operations
management
etc,
in
program
provides
the
basis
for
further
studies
related
to
finance
which
are
important
to
most
managerial
people.
This
course
assumes
that
the
students
have
prior
accounting
knowledge
as
it
is
designed
to
build
on
the
introduction
to
business
accounting,
business
planning
and
management
accounting
courses.
However,
the
course
can
also
be
taken
by
those
who
have
basic
practical
accounting
knowledge.
COURSE GOALS
Upon completion of the financial management course you will be able to:
8
|
P a g e
1. Understand
the
nature
of
finance
management
and
the
theoretical
and
conceptual
underpinning
of
the
frameworks
for
the
financial
management
2. Identify
the
nature,
characteristics
and
use
of
financial
statements
as
financial
reporting
system
3. Distinguish between financial and non-‐financial performance measurement.
4. Use the relevant costs for decision making, particularly pricing.
5. Highlight
the
issues
in
the
determination
of
the
cost
of
products
or
services
and
activities
and
the
implications
for
cost
control
and
pricing.
6. Analyze
the
relationships
between
activity
cost,
volumes
and
profit,
and
their
role
for
planning
and
decision
making
7. Make
important
financing
and
investment
decisions
by
establishing
working
capital
policies
8. Recognize the impact of management decisions on the financial health of a business
9. Employ
effective
financial
management
techniques
to
maximize
profit
and
wealth
of
the
business.
10. Understand
the
financial
planning
process,
including
strategic
and
short-‐term
financial
plans.
COURSE DESCRIPTION
To
meet
the
above
course
objectives,
the
course
is
divided
into
5
units.
A
general
overview
of
financial
management
is
introduced
in
Unit
1.
Financial
institutions
and
markets
are
covered
in
unit
2.
The
different
types
of
financial
statements
are
examined
in
unit
3,
Unit
4
covers
the
different
areas
of
financial
planning
whilst
unit
5
covers
financial
decision
making.
The
valuation
and
capital
budgeting
issues
are
covered
in
unit
6.
Each
of
the
units
is
further
subdivided
into
topics,
see
the
list
below.
Assessment
of
learning
is
provided
at
the
end
of
each
topic
and
a
summative
assessment
of
each
unit
if
given
at
the
end
of
each
unit:
9
|
P a g e
Unit
1:
Introduction
to
Financial
Management
Topic 1.1: Finance and Forms of Business
Topic 1.2: Concepts and Principles of Management
Unit 2 Financial Markets and Institutions
Topic 2.1: Financial Institutions
Topic 2.2: Financial Markets
Unit 3 Financial Statements
Topic 3.1: Statements of Comprehensive Income and Financial Position
Topic 3.2: Analysis of the Financial Statements
Topic 3.3: Statement of Cash flows
Unit 4: Financial Planning
Topic 4.1: Introduction to Financial Planning
Topic 4.2 Cash Budgets for Cash Planning
Topic 4.3 Pro-‐forma Financial Statements: A tool for Profit Planning
Unit 5: Financial Decision Making
Topic 5.1: Working Capital Management
Topic 5.2: Inventory Management
Topic 5.3: Current Liabilities Management
10
|
P a g e
REQUIRED READINGS
Materials
relating
to
financial
Management
can
be
found
on
the
web,
as
well
as
in
the
Library:
1. Geoffrey, A. Hirt, Bartley R. Danielsen Stanley B. Block (2009) Foundations of Financial
Management. McGraw Hill. ISBN: 0073363774 / 0-‐07-‐336377-‐4
2. Brigham F. Eugene and Houston F. Joel (2012) Fundamentals of Financial management.
South-‐ Western, Cengage Learning, Ohio IBN 13: 978-‐0-‐538-‐47712-‐3
3. Chandra Prassana (2010) Fundamentals of Financial Management. Tata McGraw Hill.
New Delhi in
http://books.google.co.uk/books?id=osy4UMOgpG4C&printsec=frontcover&dq=fUNDAME
NTALS+OF+FINANCIAL+MANAGEMENT,&hl=en&sa=X&ei=yJN_UZnaBMX5PLrDgdAD&sqi=2
&ved=0CFIQ6AEwAw accessed 24/04/13
4. Firer, C.; Ross, S.; Westerfield, R. and Jordan, B. (2004). Fundamentals of
Corporate Finance. McGraw Hill, New York.
5. International Accounting Standards Board (2009) Presentation of Financial
statements in http://www.iasplus.com/en/standards/standard5 accessed 23rd April
2013
6. International Accounting Standards Board (2009) International Financial Reporting
Standard for Small and Medium-sized Entities (IFRS for SMEs) in
http://eifrs.iasb.org/eifrs/sme/en/IFRSforSMEs2009.pdf accessed 25/04/2013
7. Subramanyam, K.R. and Wild John. J (2009) Financial Statement analysis, 10TH Edition
McGraw-‐Hill Irwin, New York. –in http://highered.mcgraw-‐
hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf accessed
23/04/2013
8. Stolowy, H. And Lebas, Michel J. (2002) Corporate Financial Reporting – A Global
Perspective. Thomson Learning. London.
9. Dyson, John R. (2010) Accounting for non accounting Students. Pearson Education
Limited. Harlow. In http://web.kku.ac.th/chrira/Non%20Acct.%20Dyson.pdf accessed
26/04/2013
10. Gitman, Lawrence J. And Chad J. Zutter (2012) Principles of managerial finance, 13th Ed.
P. cm. The Prentice Hall
11
|
P a g e
11. Lorenzo
P,
Argentina
and
Allende,
Sarria
(2010)
Working
Capital
Management,
Oxford
University
press
Inc.
12. Brealey,
R.A;
Myers,
S.C;
Allen,
F.
(2006)
Principles
of
corporate
finance,
6th
Ed.
dandelon.com
13. Gitman,
Lawrence
J.
(2002)
Principles
of
managerial
finance,
10th
Ed.
P.
cm.
The
Prentice
Hall
14. Sagner,
James
(2011),
Essentials
of
Working
Capital
Management,
John
Wiley
and
sons.
Inc
15. Gitman,
Lawrence
J.
Web
Chapter
Financial
Markets
and
Institutions
available
at
http://wps.aw.com/wps/media/objects/5448/5579249/FinancialMarketsandInstitutions.pd
f
ASSIGNMENTS AND PROJECTS
Assessment
of
learning
for
this
course
will
be
done
through
end
of
topic
activities,
end
of
unit
activities
and
one
major
end
of
course
assignment.
The
end
of
topic
activity
is
designed
to
reinforce
the
students
learning
at
the
end
of
the
topic
whilst
the
end
of
unit
tests
the
attainment
of
the
course
objective
in
relation
to
a
specific
unit.
The
end
of
course
assessment
requires
the
student
to
consolidate
all
the
knowledge
and
skills
acquired
from
the
course.
This
will
be
developed
by
the
respective
institutions.
ASSESSMENT METHODS
The
end
of
topic
and
end
of
unit
assessments
could
be
used
for
seminar
activities
by
your
institution.
For
the
course
assessment,
participating
universities
could
provide
their
students
with
financial
statements
from
companies
for
students
to
work
with
and
advise
management
for
these
companies
accordingly.
This
could
either
be
a
group
project
or
individual
project
depending
on
the
assessment
structure
of
the
participating
universities.
An
end
of
year
examination
could
also
be
given
to
the
students.
COURSE SCHEDULE
This
course
is
designed
to
be
completed
within
12
to
16
weeks
of
the
final
year
of
a
degree
in
entrepreneurship
programme.
12
|
P a g e
STUDENT SUPPORT
ACADEMIC SUPPORT
The
course
assumes
that
the
participating
institutions
would
have
within
their
structures,
some
means
of
supporting
student
learning.
The
module
assumes
that
besides
the
normal
lectures,
student
learning
will
be
facilitated
through
use
of
seminars,
designed
to
accord
the
students’
time
to
work
through
the
activities
either
as
a
group
or
as
individuals.
Also,
it
is
assumed
that
personal
tutorials
will
be
arranged
to
give
students
a
chance
to
reinforce
their
learning
through
a
one
to
one
intervention
as
needed
by
students.
The
student
handbook,
developed
by
the
respective
institutions,
will
provide
information
with
regards
to
access
of
resources,
e.g.
library,
lecturer
and/or
facilitators.
HOW TO SUBMIT ASSIGNMENTS
Submission
of
assignments
is
to
be
in
line
with
the
policies
and
guidelines
of
the
respective
participating
institutions.
These
should
be
included
in
the
course
handbook,
to
facilitate
motivation
of
student
learning.
TECHNICAL SUPPORT
Where
appropriate,
the
participating
institutions
should
avail
the
course
lecture
slides
in
online
sites
such
as
blackboard
or
Moodle.
Such
information
to
be
provided
in
the
course
handbook.
13
|
P a g e
UNIT ONE -‐ INTRODUCTION TO FINANCIAL MANAGEMENT
UNIT 1 INTRODUCTION
The
unit
provides
a
general
overview
of
the
concept
of
financial
management.
The
students
are
introduced
to
financial
management,
the
concepts
and
principles
used
within
the
scope
of
the
subject.
The
important
concepts
are
defined.
UNIT 1 OBJECTIVES
Upon completion of this unit, the students will be able to:
1. Differentiate
between
different
forms
of
businesses
and
explain
the
finance
implications
for
each.
2. Explain
the
concepts
and
principles
of
financial
management
UNIT 1 READINGS
To complete this unit, you are required to read the following chapters:
1. Geoffrey,
A.
Hirt,
Bartley
R.
Danielsen
Stanley
B.
Block
(2009)
2. Brigham,
F.
Eugene
and
Houston,
F.
Joel
(2012)
-‐
Chapter
1
3. Chandra
Prassana
(2010)
Chapter
1
UNIT 1 ASSIGNMENTS AND ACTIVITIES
While
crude
end
of
topic
assessment
id
provided
in
this
course
to
assess
student
learning.
The
end
of
the
participating
universities
will
develop
end
of
unit
assessment
is
to
be
designed
by
the
participating
institutions.
14
|
P a g e
TOPIC 1.1 FINANCE AND FORMS OF BUSINESS
TOPIC 1.1 INTRODUCTION
When
deciding
on
which
form
of
ownership
to
go
for,
entrepreneurs
look
for
different
considerations,
such
as
suitability,
legality
and
tax
implications.
There
are
three
main
forms
of;
sole
proprietorship,
partnership
and
the
company;
however
there
is
an
extension
to
the
company
which
is
the
close
corporation.
Each
of
these
has
advantages
and
disadvantages.
The
most
influencing
factor
to
decisions
of
ownership
is
the
country’s
respective
company
law/laws
of
incorporation.
The
nature
of
the
business
and
the
founding
structure
of
the
business
calls
for
careful
management
of
the
finances
to
lead
to
the
achievement
of
the
aspirations
of
the
owners,
which
is
growth.
Efficient
management
of
finance
entails,
acquiring
and
investing
the
financial
resources
of
an
organisation
profitably.
This
topic
introduces
financial
management
by
explaining
the
forms
of
businesses
and
implications
for
finance
and
the
concepts
and
principles
of
financial
management
TOPIC 1.1 OBJECTIVES
Upon completion of this Topic you will be able to:
1. Explain the nature of finance
2. To explain the forms of businesses and finance implications
FINANCE
Finance
is
known
as
the
art
and
science
of
managing
money
finance
is
broad
and
dynamic
field
and
it
directly
affects
the
lives
of
every
person
and
every
organization.
Every
individual
and
organization
earns
or
raises
money
and
spends
or
invests
money.
Finance
is
concerned
with
the
process,
institutions,
markets,
and
instruments
involved
in
the
transfer
of
money
among
individuals,
businesses,
and
governments.
Basic
principles
of
finance,
such
as
those
in
this
course,
can
be
universally
applied
in
business
organizations
of
different
types.
15
|
P a g e
FORMS OF BUSINESS OWNERSHIP
There
are
three
most
common
legal
forms
of
business
organization,
the
sole
proprietorship,
the
partnership
and
the
corporation.
However
some
other
specialized
forms
of
business
also
exist.
Among
the
business
organizations,
the
large
number
of
businesses
are
sole
proprietorships.
However,
corporations
are
significantly
dominant
with
respect
to
receipts
and
net
profits.
S OLE
P ROPRIETORSHIP
A
sole
proprietorship
is
a
business
founded
and
owned
by
one
person.
It
is
the
simplest
form
of
business
to
start
and
enjoys
less
government
regulation.
In
real
life
there
are
more
sole
proprietorships
than
any
other
type
of
business
businesses
that
later
become
large
corporations
start
out
as
small
sole
proprietorships.
The
advantages
are
the
owner
of
a
sole
proprietorship
keeps
all
the
profits,
there
is
only
one
person
to
make
decision
hence
quickening
the
decision
making
process,
there
is
also
no
conflict
on
decisions
made.
Flexibility
is
enhanced
and
there
is
total
responsibility
and
ownership
of
tasks
to
be
carried
out.
Above
all
the
owner
takes
all
the
profits.
However
disadvantages
are;
the
owner
has
unlimited
liability
for
business
debt,
meaning
that
creditors
can
look
to
the
proprietor’s
personal
assets
for
payment.
Because
there
is
no
distinction
between
personal
and
business
income,
all
business
income
is
taxed
as
personal
income,
there
is
no
sharing
of
ideas
on
decision
making
which
might
lead
to
less
efficient
solutions.
The
owner
might
be
overloaded
and
overworked
because
he
has
no
one
to
help.
The
life
of
a
sole
proprietorship
is
limited
to
the
owner’s
life
span
and
therefore
has
no
continuity;
above
all
the
amount
of
capital
can
be
raised
by
a
sole
is
minimal
to
the
extent
of
his
savings.
This
limits
the
business
from
exploiting
new
opportunities.
Ownership
of
a
sole
proprietorship
may
be
difficult
to
transfer
since
this
requires
the
sale
of
the
entire
business
to
a
new
owner,
(Firer
et
al.,
2004)
P ARTNERSHIP
A
partnership
is
a
kind
of
a
business
whereby
two
or
more
owners
join
together
as
partners
to
co-‐own
the
business.
The
partners
share
in
gains
or
losses
and
contribute
capital,
and
are
responsible
for
achieving
the
goals
of
the
organisation.
We
will
have
to
understand
that
for
partnership
to
start,
there
are
certain
arrangements
and
agreements
entered
into,
such
as,
16
|
P a g e
all
partners
might
be
liable
for
the
debts
of
an
organisation
(have
unlimited
liability
for
all
partnership
debt)
this
happens
in
a
general
partnership1
Because
partners
do
things
together,
in
should
be
tabulated
in
their
partnership
agreement
as
to
how
they
contribute
as
well
and
their
profit/loss
sharing
ratios.
The
agreement
might
be
informal
oral
agreement,
however
it
is
advisable
that
it
be
formalised
in
pen
and
paper
for
ease
of
conflict
resolution.
In
a
limited
partnership,
one
or
more
partners
will
be
involved
actively
in
running
the
business,
thereby
having
unlimited
liability,
while
some
of
the
partners
will
not
participate
in
the
running
of
the
business
(sleeping
partners).
A
limited
partner’s
liability
for
business
debts
is
limited
to
the
amount
that
partner
contributes
to
the
partnership.
The
advantages
of
a
partnership
are
that;
it
is
easy
to
form
and
inexpensive,
the
same
as
a
sole
proprietorship.
The
capital
contributed
can
be
quite
substantial
as
compared
to
a
sole
trader;
there
could
be
a
wide
array
of
ideas
in
decision
making
and
work
may
be
shared
among
active
partners.
However
a
partnership
also
has
its
disadvantages;
its
lifespan
is
limited,
because
when
a
partner
dies
the
partnership
has
to
be
dissolved.
Transfer
of
ownership
by
a
general
partner
is
not
easy
because
the
partnership
has
to
be
dissolved
and
new
one
must
be
formed.
Because
partners
act
for
and
on
behalf
of
the
partnership,
decisions
taken
by
partners
render
other
partners
liable.
Starting
a
partnership
means
people
intend
to
work
together
for
a
common
good,
it
goes
without
saying
that
some
will
be
charged
with
certain
responsibilities
for
and
on
behalf
of
other
partnership,
for
it
to
be
successful,
it
should
be
based
upon
trust
and
honesty.
A
written
agreement
is
very
important
especially
if
it
spells
out
clearly
the
rights
and
duties
of
the
partners;
it
helps
solve
misunderstandings
later
on.
Firer
et
al.
(2004)
argue
that
the
primary
disadvantages
of
sole
proprietorships
and
partnerships
as
forms
of
business
organization
are
(1)
unlimited
liability
for
business
debts
on
the
part
of
the
owners,
(2)
limited
life
of
the
business,
and
(3)
difficulty
of
transferring
ownership.
These
three
disadvantages
add
up
to
a
single,
central
problem:
The
ability
of
such
businesses
to
grow
can
be
seriously
limited
by
an
inability
to
raise
cash
for
investment.
1
http://www.myownbusiness.org/s4/
17
|
P a g e
C ORPORATION
The
corporation
is
the
most
important
form
(in
terms
of
size)
of
business
organization
in
most
countries.
It
is
considered
a
legal
“person”
separate
and
distinct
from
its
owners,
and
it
has
many
of
the
rights,
duties,
and
privileges
of
an
actual
person.
Corporations
can
borrow
money
and
own
property,
can
sue
and
be
sued,
and
can
enter
into
contracts.
A
corporation
can
even
be
a
general
partner
or
a
limited
partner
in
a
partnership,
and
a
corporation
can
own
stock
in
another
corporation
(Firer
et
al,
2004).
Starting
a
corporation
is
by
far
strenuous,
lengthy
and
more
complicated
than
starting
the
other
forms
of
business
organization,
this
is
because
it
requires
the
preparation
of
the
memorandum
of
association
as
well
the
articles
of
incorporation,
which
are
quite
comprehensive
documents.
According
to
the
Company
Laws
of
various
countries
the
articles
of
incorporation
must
contain
a
number
of
things,
including
the
corporation’s
name,
its
intended
life
(which
can
be
forever),
its
business
purpose,
and
the
number
of
shares
that
can
be
issued2.
The
bylaws
are
rules
describing
how
the
corporation
regulates
its
own
existence.
For
example,
the
bylaws
describe
how
directors
are
elected.
The
bylaws
may
be
amended
or
extended
from
time
to
time
by
the
stockholders.
In
a
large
corporation,
the
stockholders
and
the
managers
are
usually
separate
groups.
The
stockholders
elect
the
board
of
directors,
who
then
select
the
managers.
Management
is
charged
with
running
the
corporation’s
affairs
in
the
stockholders’
interests.
In
principle,
stockholders
control
the
corporation
because
they
elect
the
directors.
As
a
result
of
the
separation
of
ownership
and
management,
the
corporate
form
has
several
advantages.
Ownership
(represented
by
shares
of
stock)
can
be
readily
transferred,
and
the
life
of
the
corporation
is
therefore
not
limited.
The
corporation
borrows
money
in
its
own
name.
As
a
result,
the
stockholders
in
a
corporation
have
limited
liability
for
corporate
debts.
The
most
they
can
lose
is
what
they
have
invested.
The
relative
ease
of
transferring
ownership,
the
limited
liability
for
business
debts,
and
the
unlimited
life
of
the
business
are
the
reasons
why
the
corporate
form
is
superior
when
it
comes
to
raising
cash.
If
a
corporation
needs
new
equity,
it
can
sell
new
shares
of
stock
and
attract
new
investors.
The
number
of
owners
can
be
huge;
larger
corporations
have
many
thousands
or
even
millions
of
stockholders.
2
http://highered.mcgraw-‐hill.com/sites/dl/free/0072946733/301389/Ross_Sample_ch01.pdf
18
|
P a g e
TOPIC 1.1 SUMMARY
This topic has highlighted the importance of financial management for the various forms of
business. Whilst financial management is deemed important for all forms of companies,
there are differences in the requirements for financial management depending on the type
of ownership of the business.
Self-‐Reflection Question
How is the finance function organised in the different forms of companies?
19
|
P a g e
TOPIC 1.2 CONCEPTS AND PRINCIPLES OF FINANCIAL MANAGEMENT
TOPIC 1.2 INTRODUCTION
Managers, be they of a for-‐profit or not-‐for-‐profit companies or those managing large or
small firms, constantly have to make finance related decisions. The main aim of such
decisions is to generate value to the owners of the business through the operations of the
company. People who are responsible for such role in a company are said to be performing
a financial management role. This topic introduces the students to the concept of financial
management. The main focus of financial management, the role of the finance manager
and the decisions facing those charged with the financial management responsibilities are
articulated.
TOPIC 1.2 OBJECTIVES
At the end of the topic, the learners will be able to:
1. Define financial management
2. Explain the nature of the finance function
3. Explain the role of a financial manager in an organisation
FINANCIAL M ANAGEMENT
Financial
management
is
concerned
with
decisions
on
assets
acquisition,
generation
of
the
required
capital
to
acquire
the
necessary
assets
as
well
as
decisions
on
how
to
maximize.
Shareholders/owners
value
through
the
operations
of
the
firm.
As
such,
financial
managers
have
to
think
about
answering
these
basic
questions;
1. What
long
term
investments
should
we
take
on?
The
kind
of
buildings,
materials,
machinery
and
equipment
needed.
2. Where
will
the
long
term
finances
to
pay
for
the
investments
are
acquired
from?
This
will
involve
as
to
whether
the
entrepreneur
will
rely
on
savings
from
the
profits
made,
borrow
from
external
sources
or
engage
in
more
owners
to
contribute
the
capital.
20
|
P a g e
3. How
do
we
intend
to
manage
the
day
to
day
financial
activities?
Such
as
collecting
from
customers
and
paying
suppliers,
as
well
as
making
any
disbursements
concerning
the
business.
Assuming
the
manager
is
the
entrepreneur,
these
are
not
the
only
questions
that
s/he
will
have
to
answer;
they
may
not
be
exhaustive,
however
these
are
some
of
the
most
important.
Financial
management
therefore
deals
with
a
wide
range
of
issues
as
such;
simply
put;
the
acquisition
of
funds
into
the
business
and
how
to
invest
those
funds
in
the
best
possible
manner
to
ensure
organizational
growth
as
well
increasing
the
owners,
wealth.
In
this
case
we
can
believe
in
an
organisation
someone
charged
with
these
responsibility
is
fit
to
be
called
the
“Financial
Manager”,
let
us
now
look
at
what
the
Financial
Manager
is.
THE FINANCE FUNCTION AND ITS ORGANIZATION
People
in
different
areas
of
responsibility
within
the
business
interact
with
finance
personnel
and
procedures
to
get
their
jobs
done.
In
order
to
make
useful
forecasts
and
effective
decisions,
financial
personnel
must
be
willing
and
able
to
talk
to
individuals
in
other
areas
of
the
firm.
Financial
management
function
can
be
broadly
described
by
taking
into
consideration
its
role
within
the
organization,
its
relationship
to
economics
and
accounting,
and
the
primary
activities
of
the
financial
manager.
The
size
and
importance
of
the
financial
management
function
depend
on
the
size
of
the
firm.
Financial
management
can
be
performed
by
the
accounting
department
in
small
firms.
Whereas,
a
separate
finance
department
linked
directly
to
the
company
president
or
CEO
through
the
chief
financial
officer
(CFO)
is
required
in
medium
to
large
firms.
The
lower
portion
of
the
organizational
chart
in
Figure
1.1
represents
the
structure
of
the
finance
function
in
a
usual
medium-‐to-‐large-‐size
firm.
The
treasurer
focus
tends
to
be
more
external
and
is
commonly
responsible
for
handling
financial
activities,
such
as
financial
planning
and
fund
raising,
making
capital
expenditure
decisions,
managing
cash,
managing
credit
activities,
managing
the
pension
fund,
and
managing
foreign
exchange.
The
controller
focus
more
internal
and
typically
handles
the
21
|
P a g e
accounting
activities,
such
as
corporate
accounting,
tax
management,
financial
accounting,
and
cost
accounting.
FINANCIAL MANAGEMENT AND ECONOMICS
Financial managers must have an understanding of the economic framework such as
different levels of economic activity and changes in economic policy. The financial
managers need to use economic theories as guidelines for efficient business operation e.g.
supply-‐and-‐demand analysis, profit-‐maximizing strategies, and price theory etc. The most
important economic principle used in financial management is marginal analysis, which
helps managers to make financial decisions and take actions, only when the added benefits
exceed the added costs.
FINANCIAL MANAGEMENT AND ACCOUNTING
Financial management and accounting activities of a business are closely related and are
not easily distinguishable. In small firms the controller often carries out the finance
function, and in large firms many accountants are closely involved in various finance
activities. However, there are two basic differences between finance and accounting; one is
related to the emphasis on cash flows and the other to decision making.
E MPHASIS ON C ASH F LOWS
The accounting function primarily develops and reports data for measuring the
performance of the firm, and assessing its financial position. The accountant uses
standardized and generally accepted principles to prepare financial statements on accrual
basis.
On
the
other
hand,
the
primary
emphasis
of
financial
manager
is
on
the
inflow
and
outflow
of
cash
i.e.
cash
flows.
The
financial
manager
maintains
solvency
of
the
business
by
planning
the
cash
flows
necessary
to
satisfy
its
obligations
and
to
acquire
assets
needed
to
achieve
the
goals
of
the
business.
Regardless
of
its
profit
or
loss,
cash
basis
are
used
to
recognize
the
revenues
and
expenses
only
with
respect
to
actual
inflows
and
outflows
of
cash
to
make
sure
that
a
business
must
have
a
sufficient
flow
of
cash
to
meet
its
obligations
as
they
come
due.
22
|
P a g e
Example:
In
accounting
terms
Bamboo
limited
is
profitable,
but
in
terms
of
actual
cash
flow
it
is
a
financial
failure.
Its
lack
of
cash
flow
resulted
from
the
uncollected
account
receivable
in
the
amount
of
110,000.
Without
adequate
cash
inflows
to
meet
its
obligations,
the
firm
will
not
survive,
regardless
of
its
level
of
profits.
As
the
example
shows,
the
financial
manager
must
look
beyond
financial
statements
to
obtain
insight
into
existing
or
developing
problems
because
the
accrual
accounting
data
do
not
fully
describe
the
conditions
of
a
business.
However,
accountants
are
sensitive
to
the
importance
of
cash
flows,
and
financial
managers
use
and
understand
accrual-‐based
financial
statements.
By
concentrating
on
cash
flows,
the
financial
managers
should
be
able
to
avoid
insolvency
and
achieve
the
financial
goals.
D ECISION
M AKING
The
second
key
difference
between
finance
and
accounting
is
related
to
decision
making.
Accountants
devote
their
attention
to
the
collection
and
presentation
of
financial
data.
On
the
other
hands,
the
attention
of
financial
managers
is
devoted
to
evaluate
the
accounting
statements,
develop
additional
data
and
make
decisions
on
the
basis
of
their
assessment
of
the
associated
risks
and
returns.
This
does
not
mean
that
accountants
never
make
decisions
or
that
financial
managers
never
gather
data.
Rather,
the
primary
focuses
of
accounting
and
finance
are
distinctly
different.
ROLE OF THE FINANCIAL MANAGER
In
addition
to
financial
analysis
and
planning,
the
financial
manager’s
primary
activities
include
making
investment
decisions
and
making
financing
decisions.
Investment
decisions
determine
the
mix
and
the
type
of
assets
held
by
the
business.
Financing
decisions
determine
the
mix
and
the
type
of
financing
used
by
the
business.
These
types
of
decisions
can
be
viewed
in
terms
of
the
firm’s
balance
sheet,
as
shown
in
Error!
Reference
source
not
found..
However,
the
decisions
are
actually
made
on
the
basis
of
their
cash
flow
effects
on
the
overall
value
of
the
firm.
23
|
P a g e
Figure
1:
The
decisions
made
by
finance
managers
Source: Gitman et al. (2012)
As mentioned above, as companies grow and become owned by increased numbers of
individuals/organizations (shareholders), the owners are not directly involved in the day to
day decision making but employ managers to represent their interests and make decisions
on their behalf. Therefore the financial Manager would be expected to answer the
questions raised above.
The
roles
and
responsibilities
of
the
Financial
Manager
are
usually
associated
with
the
top
officer
of
an
organization
for
example,
the
Financial
Director
or
the
Chief
Finance
Officer.
The
adoption
of
organizational
structure
highlighting
the
financial
activities
within
a
firm
is
shown
in
Figure
2.
24
|
P a g e
Figure
2:
An
organisational
structure
highlighting
the
role
of
the
financial
manager
Chairman
of
the
Board
Managing
Director
Human Financial Director
Resources Markevng Operavons
Director (Responsible for Director
Director Financial Management)
Treasurer Controller
Capital
Expenditure
Cost
AccounZng
Credit
Manager
Tax
Manager
Manger
Manager
Finacial Palnning Corporate Finasncial
Foregin Exchange and Fund-‐RAising AccounZng AccounZng
Manager
Manager Manager Manager
Pension
Fund
Cash
Manager
Manager
Source: Gitman et al. (2012)
The
activities
controlled
by
the
financial
director
include
managing
the
firm’s
cash
and
credit,
the
financial
planning
and
capital
expenditure,
also
the
record
keeping
of
side
of
the
company,
this
includes
cost
and
management
accounting,
and
management
information
systems,
(Firer
et
al.,2004).
TOPIC SUMMARY
Financial
management
forms
and
important
part
of
every
business
and
should
be
carried
out
by
competent
managers.
The
three
areas
of
corporate
financial
management
we
have
described—capital
budgeting,
capital
structure,
and
working
capital
management—are
very
broad
categories.
Each
includes
a
rich
variety
of
topics,
and
we
have
indicated
only
a
few
of
the
questions
that
arise
in
the
different
areas.
The
chapters
ahead
contain
greater
detail.
25
|
P a g e
Self-‐Reflection Question
In
your
own
words,
describe
the
responsibilities
that
Financial
Managers
are
charged
with
in
an
organisation
and
the
kind
of
decisions
that
they
have
to
make,
your
answer
should
reflect
on
the
discussion
above.
UNIT
1
REFERENCES
1. Geoffrey,
A.
Hirt,
Bartley
R.
Danielsen
Stanley
B.
Block
(2009)
Foundations
of
Financial
Management.
McGraw
Hill.
ISBN:
0073363774
/
0-‐07-‐336377-‐4
2. Brigham,
F.
Eugene
and
Houston,
F.
Joel
(2012)
Fundamentals
of
Financial
management.
South-‐
Western,
Cengage
Learning,
Ohio,
ISBN
13:
978-‐0-‐538-‐47712-‐3
3. Chandra
Prassana
(2010)
Fundamentals
of
Financial
Management.
Tata
McGraw
Hill.
New
Delhi
in
http://books.google.co.uk/books?id=osy4UMOgpG4C&printsec=frontcover&dq=fUNDAME
NTALS+OF+FINANCIAL+MANAGEMENT,&hl=en&sa=X&ei=yJN_UZnaBMX5PLrDgdAD&sqi=2
&ved=0CFIQ6AEwAw
accessed
24/04/13
26
|
P a g e
UNIT
1
–
SUMMARY
ASSIGNMENTS
AND
ACTIVITIES
The
end
of
topic
assignments
have
been
employed
to
assess
student
learning
for
this
unit.
Further
activities
could
be
incorporated
in
the
students’
assignments
that
are
to
be
developed
by
the
respective
participating
institutions.
SUMMARY
The
topics
covered
in
this
unit
underscore
the
importance
of
financial
management
for
the
various
forms
of
companies.
The
roles
of
finance
managers
in
an
organisation
have
been
outlined.
The
financial
decisions
the
managers
have
to
make
in
order
to
realise
value
to
stakeholders
from
the
operations
of
the
company
call
for
managers
to
be
more
analytical
in
the
performance
of
their
day
to
day
finance
activities.
These
issues
are
covered
in
the
units
that
follow.
NEXT STEPS
Having
understood
the
basics
of
financial
management,
we
shall
now
explore
more
important
avenues
in
an
organisation,
remember
that
activities
of
an
organisation
are
recorded
and
reported,
we
will
therefore
look
at
the
various
reports
and
how
they
are
used
in
an
organisation
to
make
economic
sense.
27
|
P a g e
UNIT TWO -‐ FINANCIAL INSTITUTIONS AND MARKETS
UNIT
2
INTRODUCTION
Financial
institutions
are
responsible
to
channel
the
savings
of
individuals,
businesses
and
governments
into
loans
or
investments.
Financial
institutions
serve
its
users
as
the
main
source
of
funds.
Majority
of
individuals
and
businesses
rely
heavily
on
funds
from
financial
institutions,
in
the
form
of
loans
for
their
financial
support.
They
are
regulated
by
regulatory
guidelines
from
governments
and
are
required
to
operate
within
these
guidelines.
Financial
markets
are
the
intermediaries
that
facilitate
an
efficient
transfer
of
resources
from
severs
to
who
need
for
them.
The
financial
markets
are
responsible
to
contribute
in
economic
development
by
providing
channels
for
allocation
of
savings
to
investment.
UNIT
2
OBJECTIVES
Upon
completion
of
this
unit
you
will
be
able
to:
1. Explain
how
financial
institutions
serve
as
intermediaries
between
investors
and
firms.
2. Explain
various
types
of
financial
institutions
and
how
they
work.
3. Provide
an
overview
of
financial
markets.
4. Explain
how
investors
and
business
firms
trade
money
market
and
capital
market
securities
in
the
financial
markets
in
order
to
satisfy
their
needs.
5. Identify
the
major
securities
exchanges.
6. Understand
derivative
securities
and
explain
why
investors
and
firms
use
them.
7. Describe
the
role
of
foreign
exchange
market.
UNIT
2
READINGS
To
complete
this
unit,
you
are
required
to
read
the
following
chapters:
Gitman, Lawrence J. Web Chapter Financial Markets and Institutions available at
http://wps.aw.com/wps/media/objects/5448/5579249/FinancialMarketsandInstitutions.pd
f
UNIT 2 ASSIGNMENTS AND ACTIVITIES
(a) Identify the major financial institutions present in your country and explain the major
services offered by them. (Hint: Identify minimum 2 and maximum of 4 institutions.)
(b)
Identify
a
major
organized
securities
exchange
in
your
country
and
explain
how
it
is
different
from
a
organized
securities
exchange
in
a
foreign
country.
(Hint:
Difference
on
the
basis
of
number
and
type
of
requirements
to
be
listed
on
a
securities
exchange
for
trading.)
28
|
P a g e
TOPIC 2.1 FINANCIAL INSTITUTIONS
INTRODUCTION
Financial institutions are the intermediaries and channel the savings of individuals,
businesses and governments into loans or investments. With trillions dollar worth of
financial assets under the control of financial institutions, they are regarded as major
players in the financial marketplace. They frequently serve businesses and individuals as the
main source of funds. Some financial institutions lend the money, accepted from
customers’ savings deposits, to other customers or to businesses that needs them.
Generally, many individuals and businesses rely heavily on funds, in the form of loans, from
institutions for their financial support. The government establishes regulatory guidelines for
financial institutions and these institutions are required to operate within these guidelines.
OBJECTIVES
Upon
completion
of
this
topic
you
will
be
able
to:
1. Understand how different financial institutions serve as intermediaries between
investors and firms.
2. Identify different types of financial institutions and the services provided by them.
MAJOR CUSTOMERS OF FINANCIAL INSTITUTIONS
The major suppliers and the major demanders of funds to and from financial institutions
are individuals, businesses and government. The large portion of funds in financial
institutions are provided by the individual consumers’ savings. Individuals not only are the
suppliers of the funds to financial institutions but are also the demanders of funds from
financial institutions in the form of loans. Although, the net suppliers for financial
institutions are individuals, as a group the amount of money saved by individuals is more
than what they borrow. Also, businesses primarily deposit some of their funds in checking
accounts with various commercial banks or financial institutions. Businesses also borrow
funds from financial institutions like individuals, but businesses are considered as the net
demanders of funds. The amount of money borrowed by businesses is more than what is
saved by them.
Governments
are
another
customer
of
financial
institutions.
They
maintain
deposits
of
tax
payments,
temporarily
idle
funds
and
Social
Security
payments
in
commercial
banks.
Governments
do
not
borrow
funds
directly
from
financial
institutions,
although
they
indirectly
borrow
from
them
by
selling
their
debt
securities
to
various
institutions.
The
government
is
another
net
demander
of
funds
like
businesses
and
typically
borrows
more
than
what
it
saves.
There
are
different
types
of
financial
institutions
and
few
most
important
financial
institutions
that
facilitate
the
flow
of
funds
from
investors
to
business
firms
are
commercial
29
|
P a g e
banks,
mutual
funds,
security
firms,
insurance
companies
and
pension
funds.
A
detailed
discussion
of
each
of
these
financial
institutions
can
be
found
below.
COMMERCIAL
BANKS
Deposits
from
savers
are
accumulated
by
commercial
banks
and
are
used
to
provide
credit
to
businesses,
individuals
and
government
agencies.
Thus
they
provide
service
to
the
investors
who
desire
to
invest
funds
in
the
form
of
deposits.
Commercial
banks
provide
personal
loans
to
individuals
and
commercial
loans
to
business
firms
by
using
the
deposited
funds.
The
deposited
funds
are
also
used
to
purchase
debt
securities
issued
by
business
firms
or
government
agencies.
Commercial
banks
serve
as
a
key
source
of
credit
to
facilitate
expansion
of
businesses.
In
the
past,
commercial
banks
were
the
only
dominant
direct
lenders
to
businesses.
However,
in
recent
years
other
types
of
financial
institutions
have
begun
to
advance
more
loans
to
the
businesses.
The
objective
of
the
commercial
banks
are
to
generate
earnings
for
their
owners
which
is
similar
to
most
other
types
of
business
firms.
Generally,
the
commercial
banks
generate
earnings
by
receiving
a
higher
return
by
using
their
funds
as
compared
to
the
cost
they
incur
from
obtaining
deposited
funds.
The
paid
average
annual
interest
rate
on
the
obtained
deposits
is
usually
lower
than
the
rate
of
return
earned
on
the
funds.
For
example,
a
bank
may
pay
an
average
annual
interest
rate
of
3
percent
on
the
obtained
deposits
and
may
receive
a
return
of
8
percent
on
the
invested
funds
as
loans
or
as
investments
in
securities.
Commercial
banks
can
charge
a
higher
rate
of
interest
on
high
risk
loans,
however,
with
higher
risk
loans
they
are
more
exposed
to
the
possibility
that
these
loans
will
default.
The
traditional
and
very
important
function
of
commercial
banks
are
accepting
deposits
and
using
those
funds
for
loans
or
to
purchase
debt
securities.
In
addition
to
this
function,
banks
now
perform
many
additional
functions
as
well.
In
particular,
commercial
banks
generate
fees
by
providing
services
such
as
foreign
exchange,
traveller’s
cheques,
personal
financial
advising,
insurance
and
brokerage
services.
In
short,
the
commercial
banks
are
able
to
offer
customers
one
stop
shopping
experience.
S OURCES AND U SES OF F UNDS AT C OMMERCIAL B ANKS
Mainly, most of the funds of commercial banks are obtained by accepting deposits from
investors (customers). These customers of commercial banks are usually individuals, but
some of them are firms and government agencies that have excess cash. Some of these
deposits are held at banks for very short periods, such as a month or less than a month.
Commercial banks also able to attract deposits for longer time periods by offering
certificates of deposit, which specify a minimum deposit level e.g. 2,000 and a particular
maturity time frame (such as 1 year or so). Because most of the commercial banks offer
certificates of deposit with various different maturities, they effectively diversify the times
at which the deposits are withdrawn by investors.
30
|
P a g e
Deposits
at
commercial
banks
are
insured
up
to
a
certain
amount
by
an
independent
agency
to
maintain
stability
and
public
confidence
e.g.
Federal
Deposit
Insurance
Corporation
(FDIC)
in
United
States.
It
guarantee
the
safety
of
depositor's
accounts
in
member
banks.
The
insurance
of
deposits
helps
to
reduce
the
fear
of
depositors
about
the
possibility
of
a
bank’s
failure.
Therefore,
it
decreases
the
possibility
that
all
depositors
will
try
to
withdraw
their
deposits
from
banks
simultaneously.
As
a
result
the
banking
system
can
efficiently
facilitates
the
flow
of
funds
from
savers
to
borrowers.
Most
of
the
funds
of
commercial
banks
are
either
used
to
provide
loans
or
to
purchase
debt
securities.
In
both
of
the
cases
they
serve
as
creditors
that
provide
credit
to
those
borrowers
who
need
funds.
Commercial
banks
provide
commercial
loans
to
businesses,
make
personal
loans
to
individuals
and
purchase
debt
securities
issued
by
business
firms
or
government
agencies.
Most
business
firms
rely
heavily
on
commercial
banks
as
a
source
of
funds.
Some
of
the
commonly
known
means
by
which
commercial
banks
extend
credit
to
businesses
are
term
loans,
lines
of
credit
and
investment
in
debt
securities
issued
by
firms.
Term
loans
are
provided
by
banks
for
a
medium-‐term
to
finance
the
investment
of
a
business
in
machinery
or
buildings.
For
example,
consider
a
manufacturer
of
toy
trucks
that
plans
to
produce
toys
and
sell
them
to
retail
stores.
The
manufacturer
will
need
funds
to
purchase
the
machinery
for
producing
toy
trucks,
to
make
lease
payments
on
the
manufacturing
facilities
and
to
pay
its
employees.
With
the
passage
of
time,
the
business
will
generate
cash
flows
that
can
be
used
to
cover
mentioned
expenses.
However,
there
is
a
time
lag
between
the
cash
outflow
(expenses)
and
cash
inflow
(revenue).
This
time
lag
occurs
because
of
the
difference
in
time
when
the
business
must
cover
these
expenses
and
when
it
receives
revenue.
The
term
loan
enables
the
business
to
cover
its
expenses
until
a
sufficient
amount
of
revenue
is
generated.
The
term
loan
on
an
average
lasts
for
a
medium-‐term,
greater
than
3
years
and
less
than
10
years,
such
as
4
to
8
years.
The
rate
of
interest
charged
by
the
bank
to
the
business
firm
for
this
type
of
loan
depends
on
the
interest
rates
prevailing
in
the
market
at
the
time
the
loan
is
provided.
The
adjustment
in
the
rate
of
interest
changed
on
term
loans
is
made
periodically
e.g.
annually,
to
reflect
movements
or
changes
in
market
interest
rates.
Another
form
of
credit
provided
by
commercial
banks
to
businesses
is
a
line
of
credit.
Line
of
credit
allows
the
business
to
access
a
specified
amount
of
funds
over
a
specified
period
of
time.
This
form
of
credit
provided
by
commercial
is
especially
useful
when
the
business
is
uncertain
about
the
amount
of
borrowings
needed
over
a
given
period.
For
example,
if
the
toy
truck
manufacturer
in
the
previous
example
was
unsure
about
its
expenses
in
the
near
future,
it
has
an
option
to
obtain
a
line
of
credit
and
borrow
only
the
amount
that
it
needed.
Once
a
line
of
credit
is
approved,
it
enables
the
business
to
acquire
funds
quickly.
Line
of
credit
is
explained
in
greater
detail
later
in
the
text.
Commercial
banks
also
invest
in
debt
securities
e.g.
bonds
that
are
issued
by
the
business
firms.
The
arrangement
with
a
business
who
sell
the
security
to
a
commercial
bank
is
31
|
P a g e
typically
less
personalized
as
compared
to
when
a
bank
extends
a
term
loan
or
a
line
of
credit.
For
example,
it
may
be
just
one
of
thousands
of
investors
who
invest
in
a
particular
debt
security
issued
by
a
business
firm.
However,
we
recognize
that
credit
provided
by
a
commercial
bank
to
business
firms
goes
beyond
the
direct
loans
that
it
provides
to
business
firms,
because
it
also
includes
all
the
securities
purchased
that
were
issued
by
business
firms.
C OMMERCIAL B ANKS AS F INANCIAL I NTERMEDIARIES
Commercial banks play a number of roles as financial intermediaries. First and foremost
role of a commercial bank is to repackage the deposits received from investors into loans
that are provided to business firms. In this manner, small size deposits by individual
investors can be consolidated and channelled in the form of large size loans to business
firms. It is difficult for the individual investors to achieve this by themselves because they
do not have sufficient information about the business firms that need funds.
Second,
banks
employ
credit
analysts
to
assess
the
creditworthiness
of
businesses
that
wish
to
borrow
funds.
Individual
investors
who
deposit
funds
in
commercial
banks
are
generally
not
capable
of
performing
this
task
and
would
prefer
that
the
commercial
bank
play
this
role.
Third,
commercial
banks
are
able
to
pool
the
funds
and
have
so
much
money
to
lend
that
they
can
diversify
loans
across
several
borrowers.
In
this
manner,
the
commercial
banks
increase
their
ability
to
absorb
individual
defaulted
loans
by
reducing
the
risk
that
a
substantial
portion
of
the
loan
portfolio
will
default.
As
the
lenders,
they
accept
the
risk
of
default.
Many
individual
investors
prefer
to
let
the
bank
serve
on
their
behalf
because
they
would
not
be
able
to
absorb
the
loss
of
their
own
deposited
funds.
In
the
event
of
a
commercial
bank
closure
due
to
excessive
amount
of
defaulted
loans,
the
deposits
of
each
investor
are
insured
up
to
certain
amount
by
the
independent
agency
e.g.
FDIC
in
United
States.
Therefore
the
commercial
bank
is
a
mean
by
which
funds
can
be
channelled
from
small
investors
to
businesses
without
the
investors
having
to
engage
themselves
in
the
role
of
lender.
Fourth,
since
the
late
1980s
some
of
the
commercial
banks
have
been
authorized
to
place
the
securities
that
are
issued
by
business
firms
by
serving
as
financial
intermediaries.
Such
banks
who
act
as
financial
intermediaries
may
facilitate
the
flow
of
funds
to
businesses
by
finding
investors
who
are
willing
to
purchase
the
debt
securities
issued
by
the
these
businesses.
Therefore,
they
enable
firms
to
obtain
borrowed
funds
even
though
they
do
not
provide
the
funds
themselves.
R EGULATION OF C OMMERCIAL B ANKS
The banking system is regulated by the Reserve System often known as the central bank of
the country. The central bank is responsible for controlling the amount of money in the
financial system. It influences the operations that banks conduct by imposing regulations on
32
|
P a g e
activities
of
banks.
Some
commercial
banks
are
members
of
the
central
bank
and
are
therefore
subject
to
additional
rules
and
regulations.
Commercial
banks
are
regulated
by
various
regulatory
agencies.
For
example
in
United
States
first,
they
are
regulated
by
the
Federal
Deposit
Insurance
Corporation,
the
insurer
for
depositors.
The
FDIC
wants
to
ensure
that
banks
do
not
take
excessive
risk
that
could
result
in
failure
because
it
is
responsible
for
covering
deposits
of
banks.
The
FDIC
would
not
be
able
to
cover
the
deposits
of
all
the
depositors,
in
case
several
large
banks
failed,
and
this
could
result
in
a
major
banking
crisis.
Those
commercial
banks
that
apply
for
a
federal
charter
are
known
as
national
banks
and
they
are
subject
to
regulations
of
the
Comptroller
of
the
Currency.
As
all
national
banks
are
required
to
be
members
of
the
Federal
Reserve,
they
are
also
subject
to
Federal
Reserve
regulations.
Alternatively,
banks
can
apply
for
a
state
charter.
The
common
philosophy
of
regulators
who
monitor
the
banking
system
is
to
encourage
competition
among
banks
so
that
customers
will
be
charged
reasonable
prices
for
the
services
that
are
offered
by
banks.
In
order
to
maintain
the
stability
of
the
financial
system,
regulator
organization
also
attempt
to
limit
the
risk
of
banks.
MUTUAL
FUNDS
Mutual
funds
are
the
financial
institutions
that
sell
shares
to
individuals
and
generate
funds.
They
pool
these
generated
funds
and
use
them
to
invest
in
securities.
Mutual
funds
can
be
classified
into
three
broad
categories.
1. Money market mutual funds
2. Bond mutual funds
3. stock mutual funds
Money
market
is
known
for
trading
short
term
securities.
Money
market
mutual
funds
collect
and
pool
the
proceeds
from
individual
investors
to
invest
in
money
market
i.e.
short-‐
term
securities
issued
by
business
firms
and
other
financial
institutions.
Bond
mutual
funds
collect
and
pool
the
proceeds
from
individual
investors
to
invest
in
bonds,
where
as
the
stock
mutual
funds
collect
and
pool
the
proceeds
from
investors
to
invest
in
stocks.
Investment
companies
owns
the
mutual
funds.
Many
of
these
companies
e.g.
Fidelity
International
have
created
various
types
of
money
market
mutual
funds,
bond
mutual
funds
and
stock
mutual
funds
in
order
to
be
able
to
satisfy
various
different
preferences
of
investors.
R OLE OF M UTUAL F UNDS AS F INANCIAL I NTERMEDIARIES
The mutual funds finance new investment by firms, when they use money from investors to
invest in newly issued debt or equity securities. On the other hand, when the mutual funds
invest in debt or equity securities already held by investors, they are just transferring
ownership of the securities among investors. Mutual funds enable individual investors to
33
|
P a g e
hold
diversified
portfolios
or
combinations
of
debt
securities
and
equity
securities
by
pooling
small
investments
of
individual
investors.
Mutual
funds
are
also
helpful
to
the
individuals
who
prefer
to
let
them
make
their
investment
decisions
for
them.
The
returns
to
individual
investors
who
invest
in
mutual
funds
are
tied
to
the
returns
earned
by
the
mutual
funds
on
their
investments.
To
determine
which
debt
securities
to
purchase,
money
market
mutual
funds
and
bond
mutual
funds
conduct
a
credit
analysis
of
the
firms
that
have
issued
or
will
be
issuing
those
debt
securities.
Stock
mutual
funds
have
specific
investment
objectives
(e.g.
growth
in
value
or
high
dividend
income)
and
to
satisfy
these
specific
objectives
they
invest
in
stocks.
Stock
mutual
funds
have
potential
for
a
high
return,
given
the
risk
level
of
stock.
The
reason
that
mutual
funds
usually
have
billions
of
dollars
to
invest
in
securities,
they
use
large
amount
of
resources
to
make
their
investment
decisions.
In
general,
each
mutual
fund
is
managed
by
one
or
more
portfolio
managers.
These
managers
are
responsible
for
the
purchase
and
sale
of
securities
in
the
portfolio
of
funds.
These
managers
have
a
detailed
information
about
the
business
firms
that
issue
the
securities
in
which
they
can
invest.
It
is
possible
that
after
making
an
investment
decision,
mutual
funds
can
sell
any
securities
that
are
not
expected
to
perform
well.
On
the
other
hand,
if
a
mutual
fund
has
made
a
large
investment
in
a
particular
security,
the
portfolio
managers
of
mutual
fund
may
try
to
improve
the
performance
of
the
security
rather
than
sell
it.
For
example,
a
mutual
fund
may
hold
more
than
a
million
shares
of
a
particular
stock
that
has
performed
poorly.
Rather
than
making
a
decision
to
sell
the
stock,
the
mutual
fund
may
attempt
to
influence
the
management
of
the
business
firm
that
issued
the
security
in
order
to
boost
the
performance
of
the
firm.
These
efforts
should
have
a
favourable
effect
on
the
stock
price
of
the
firm.
SECURITIES
FIRMS
Securities
firms
are
financial
institutions
that
include
investment
banks,
investment
companies
and
brokerage
firms.
Securities
firms
serve
as
financial
intermediaries
in
various
different
ways.
First,
they
play
an
investment
banking
role
by
placing
securities
i.e.
stocks
and
debt
securities,
issued
by
business
firms
or
government
agencies.
More
precisely,
they
find
investors
who
want
to
purchase
these
securities.
Second,
securities
firms
at
times
serve
as
investment
companies
by
creating,
marketing
and
managing
investment
portfolios.
A
mutual
fund
is
an
example
of
an
investment
company.
Finally,
securities
firms
may
play
a
role
as
brokerage
firm.
In
a
brokerage
firm
role
it
helps
investors
to
purchase
securities
or
to
sell
securities
that
they
previously
purchased.
INSURANCE
COMPANIES
Financial
institutions
that
provide
various
types
of
insurance
for
their
customers
are
known
as
insurance
companies.
The
various
types
of
insurance
for
their
customers
include
life
insurance,
property
and
liability
insurance
and
health
insurance.
They
periodically
receive
payments
from
their
policyholders
which
are
known
as
premiums.
These
payments
are
34
|
P a g e
then
pooled
and
invested
until
these
funds
are
needed
to
pay
off
claims
of
policyholders.
Insurance
companies
normally
use
the
funds
to
invest
in
debt
securities
issued
by
firms
or
government
agencies.
They
also
invest
heavily
in
stocks
issued
by
business
firms.
This
way
they
help
to
finance
corporate
expansion.
Insurance
companies
also
employ
portfolio
managers.
These
managers
invest
the
funds
that
result
from
pooling
the
premiums
of
their
customers.
An
insurance
company
may
have
one
or
more
bond
portfolio
managers
who
determine
which
bonds
or
debt
security
to
purchase,
and
one
or
more
stock
portfolio
managers
who
determine
which
stocks
to
purchase.
The
main
objective
of
the
portfolio
managers
is
to
earn
a
higher
return
on
the
portfolios
for
a
given
level
of
risk.
In
this
manner,
the
return
on
the
investments
not
only
targets
to
cover
future
insurance
payments
to
policyholders
but
also
targets
to
generate
a
sufficient
profit,
which
provides
a
return
to
the
owners
of
insurance
companies.
The
performance
of
insurance
companies
is
greatly
dependent
on
the
performance
of
their
bond
and
stock
portfolios.
Like
mutual
funds,
insurance
companies
also
tend
to
purchase
securities
in
large
blocks,
and
they
normally
have
a
large
stake
in
several
different
firms.
Thus
the
insurance
companies
closely
monitor
the
performance
of
firms
in
which
they
have
invested.
Sometimes
they
attempt
to
influence
the
management
of
a
firm
to
improve
the
performance
of
the
firm
and
therefore
improve
the
performance
of
the
securities
in
which
they
have
invested.
PENSION
FUNDS
Pension
funds
are
financial
institutions
that
receive
payments
from
employees
and/or
their
employers
on
behalf
of
the
employees,
and
then
invest
these
proceeds
for
the
benefit
of
the
employees.
The
received
payments
of
pension
funds
are
called
contributions.
They
typically
invest
in
debt
securities
or
bonds
issued
by
business
firms
or
government
agencies
and
in
equity
securities
or
stock
issued
by
firms.
Like
other
financial
institutions
pension
funds
also
employ
portfolio
managers
to
invest
and
manage
funds
that
result
from
pooling
the
employee
or
employer
contributions.
They
have
bond
portfolio
managers
to
purchase
bonds
and
stock
portfolio
managers
to
purchase
stocks.
The
reason
pension
funds
make
large
investments
in
debt
securities
or
in
stocks
issued
by
firms,
they
closely
monitor
the
firms
in
which
they
invest.
Same
as
mutual
funds
and
insurance
companies,
pension
funds
may
periodically
attempt
to
influence
the
management
of
those
firms
to
improve
the
performance
of
the
firm.
SAVINGS
INSTITUTIONS
Savings
institutions
are
financial
institutions
that
also
serve
as
an
important
intermediary.
They
are
also
known
as
thrift
institutions
or
savings
and
loan
associations.
Savings
institutions
accept
deposits
from
individuals
and
use
the
majority
of
these
deposited
funds
to
provide
mortgage
loans
to
individuals.
The
participation
of
savings
institutions
is
critical
in
financing
the
purchases
of
homes
by
individuals.
They
also
serve
as
intermediaries
between
investors
and
business
firms
by
lending
these
funds
to
firms.
35
|
P a g e
FINANCE
COMPANIES
Finance
companies
mainly
generate
funds
by
issuing
debt
securities
or
bonds.
Finance
companies
lend
the
funds
to
individuals
or
firms
in
need
of
these
funds.
The
lending
of
finance
companies
are
focused
on
small
businesses.
When
extending
these
loans,
they
are
exposed
to
a
higher
level
of
risk
than
commercial
banks
that
borrowers
will
default
on
or
will
not
pay
back
their
loans.
Therefore,
the
finance
companies
charge
a
relatively
high
interest
rate
as
compared
to
commercial
banks.
COMPARISON OF THE KEY FINANCIAL INSTITUTIONS
A brief comparison of the most important types of financial institutions that provide
funding to firms is shown in Figure. The financial institutions differ from each other in the
manner they obtain funds, but they are similar in terms of providing credit to business
firms by purchasing debt securities or bonds the firms have issued. All of the mentioned
financial institutions except commercial banks and savings institutions also provide equity
investment by purchasing equity securities issued by business firms.
Figure 3: How Financial Institutions Provide Financing for Firms
Source:
Gitman
et
al.
(2012)
Securities
firms
does
not
appear
in
Figure
1
because
they
are
not
as
important
in
actually
providing
the
funds
needed
by
business
firms.
However,
they
play
an
essential
role
in
facilitating
the
flow
of
funds
from
financial
institutions
to
business
firms.
In
fact,
each
arrow
in
the
figure
representing
a
flow
of
funds
from
financial
institutions
to
business
firms
may
36
|
P a g e
have
been
facilitated
by
a
securities
firm
that
was
hired
by
the
business
firm
to
sell
its
debt
or
equity
securities
e.g.
bonds
or
stock.
Securities
firms
sometimes
also
sell
the
debt
and
equity
securities
to
individual
investors.
This
results
in
some
funds
flowing
directly
from
individuals
to
business
firms
without
first
passing
through
a
financial
institution.
CONSOLIDATION OF FINANCIAL INSTITUTIONS
In recent years there has been a great deal of consolidation among financial institutions. As
a result of this consolidation a single financial conglomerate may own every type of
financial institution. Various financial conglomerates offer all different types of services
including commercial banking services, investment banking services, brokerage services,
mutual funds and insurance services. They also have a pension fund and manage the
pension funds of other companies as well. An example of a financial conglomerate is
Citigroup Incorporation. It offers commercial banking services through its Citibank unit,
insurance services through its Travelers’ insurance unit, and investment banking and
brokerage services through its Salomon Smith Barney unit.
In
recent
years,
the
trend
of
mergers
and
acquisitions
has
made
it
possible
for
many
commercial
banks
to
expand
their
offerings
of
financial
services
by
acquiring
or
merging
with
other
financial
intermediaries
that
offer
other
financial
services.
Some
banks
even
serve
in
advisory
roles
for
businesses
that
are
considering
the
acquisition
of
other
business
firms.
As
a
result,
the
bank
expansion
is
mainly
focused
on
services
that
were
traditionally
offered
by
securities
firms.
In
general,
the
expansion
of
banks
into
these
services
has
facilitated
the
competition
and
it
is
expected
to
increase
the
competition
among
financial
intermediaries.
This
increased
competition
therefore
has
led
to
lower
the
price
that
individuals
or
business
firms
pay
for
these
services.
GLOBALIZATION OF FINANCIAL INSTITUTIONS
In recent years, financial institutions not only have diversified their services but also have
expanded internationally. This global expansion of financial institutions was stimulated by
various factors. First and foremost, the expansion of multinational corporations (MNCs)
encouraged commercial banks to expand and serve the foreign subsidiaries. Second, the
commercial banks may have more flexibility to offer securities services and other financial
services outside the parent country, where fewer restrictions are imposed on commercial
banks. Third, large commercial banks acknowledged that they could take advantage of their
global image by establishing branches in foreign countries/cities.
Financial
institutions
located
in
foreign
countries
are
responsible
for
the
facilitation
of
the
flow
of
funds
between
investors
and
the
business
firms
based
in
that
country.
During
the
1997–1998
period,
a
large
number
of
Asian
firms
were
performing
poorly
and
were
cut
off
from
funding
by
local
as
well
as
foreign
banks.
Before
this
time,
some
banks
had
been
willing
to
extend
loans
to
these
Asian
firms
without
determining
requirement
and
feasibility
of
funding.
The
crisis
helped
realize
some
foreign
banks
that
they
should
not
extend
credit
to
firms
just
based
of
their
good
performance
during
the
mid-‐1990s.
In
addition
to
that,
the
37
|
P a g e
crisis
also
caused
Asian
firms
to
realize
their
dependence
on
banks
to
run
their
businesses.
As
a
result,
Asian
firms
are
now
expanding
more
cautiously,
because
they
have
to
justify
their
request
for
additional
funding
(credit)
from
banks.
TOPIC
SUMMARY
Financial
institutions
channel
the
flow
of
funds
between
investors
and
business
firms.
Individuals
deposit
funds
at
financial
institutions
such
as
commercial
banks,
they
purchase
shares
of
mutual
funds,
they
purchase
insurance
protection
with
insurance
premiums
and
they
make
contributions
to
pension
plans.
All
of
these
financial
institutions
provide
credit
to
business
firms
by
purchasing
debt
securities.
In
addition
to
this,
all
of
the
above
motioned
financial
institutions
except
commercial
banks
purchase
stocks
issued
by
business
firms.
Self-‐Reflection Question
1. Distinguish between the role of a commercial bank and that of a mutual fund.
2. Which type of financial institution do you think is most critical for firms?
38
|
P a g e
TOPIC 2.2 FINANCIAL MARKETS
TOPIC 2.2 INTRODUCTION
Financial markets facilitate an efficient transfer of resources from those (individual or
business firms, government) who have idle resources to others (individual or business firms,
government) who have a pressing need for them is achieved through. More precisely,
financial markets provide channels for allocation of savings to investment. These provide a
variety of assets to savers as well as various forms in which the investors can raise funds
and thereby decouple the acts of saving and investment. The savers of the resources or
funds and investors are constrained not by their individual abilities, but by the ability of
economy to invest and save respectively. Therefore, the financial markets contribute to
economic development to the extent that the latter depends on the rates of savings and
investment.
TOPIC 2.3 OBJECTIVES
Upon completion of this topic you will be able to:
1. Provide an overview of financial markets.
2. Explain how firms and investors trade money market and capital market securities
in the financial markets in order to satisfy their needs.
3. Describe the major securities exchanges.
4. Describe derivative securities and explain why firms and investors use them.
5. Describe the foreign exchange market.
TYPES OF MARKETS
A market is a place where a buyer and seller interacts and make exchange of goods.
Financial markets are very important for business firms and investors because they
facilitate the transfer of funds between the investors who wish to invest and firms that
need to obtain funds. Therefore, in a financial market the investors are the sellers the fund
obtainers are the buyers and the different type of funds are regarded as goods. Second,
financial markets can accommodate the needs of business firms who wish to invest their
temporarily excess funds/savings. Third, they can accommodate the needs of investors who
wish to liquidate their investments with the intention of spending the proceeds or investing
them in alternative investments.
PRIMARY MARKETS VERSUS SECONDARY MARKETS
Primary market is a market where debt and equity securities are issued by firms. Primary
market facilitates the issuance of new securities. The offering of stock to the public for the
very first time is referred as an initial public offering (IPO). Any offering of stock by the firm
afterwards is known as a secondary offering. Securities can be sold in the so-‐called
secondary market, by investors to other investors after they have been issued for the first
time. A secondary market is one that facilitates the trading of existing securities.
39
|
P a g e
The
distinction
between
the
primary
market
and
the
secondary
market
can
be
made
with
the
help
of
following
example.
Example – Primary Market versus Secondary Market
Kenton
Co.
was
established
in
July
1991.
It
enjoyed
success
as
a
private
limited
business
firm
for
more
than
10
years,
but
it
could
not
grow
as
desired
because
of
a
limitation
on
the
amount
of
loans
it
could
obtain
from
commercial
banks.
Kenton
needed
a
large
equity
investment
from
other
firms
to
expand
its
business.
On
March
14,
2002,
With
the
help
of
a
securities
firm,
it
engaged
in
an
initial
public
offering.
it
issued
1
m illion
shares
of
stock
at
an
average
price
of
30
per
share.
Thus
the
company
raised
a
total
of
30
million.
Later
the
investors
in
Kenton’s
stock
decided
to
sell
the
stock.
They
then
used
the
secondary
market
to
sell
the
stock
of
Kenton
Limited
to
other
investors.
The
secondary
market
activity
does
not
directly
affect
the
amount
of
funds
available
to
Kenton
has
to
support
its
expansion
because
Kenton
gets
no
additional
funds
when
investors
sell
their
shares
in
the
secondary
market.
Kenton’s
expansion
over
the
next
several
years
was
successful,
and
it
decided
to
expand
further.
By
this
time,
the
stock
price
of
Kenton
Limited
was
near
60
per
share.
On
June
8,
2010,
Kenton
issued
another
1
m illion
shares
of
stock
as
a
secondary
offering.
The
new
shares
were
sold
at
an
average
price
of
60,
and
generated
60
million
for
Kenton
to
pursue
its
expansion
plans.
After
that
date,
some
of
the
new
shares
as
well
as
IPO
shares
were
traded
in
the
secondary
market.
PUBLIC OFFERING VERSUS PRIVATE PLACEMENT
The non-‐exclusive sale of securities to the general public is known as public offering. More
precisely, business firms raise funds in the primary market by issuing securities through a
public offering. The initial public offering (IPO) and the secondary offering by Kenton Co. in
the earlier example were public offerings. A public offering is usually conducted with the
help of a securities firm (a financial institution) that provides investment banking services.
This securities firm may advise the issuing firm on the size and the price of the offering. It
may also agree to place the offering with investors and may even be willing to underwrite
the offering, which means that it guarantees the dollar amount to be received by the
issuing firm.
As
an
alternative
to
a
public
offering,
business
firms
can
issue
securities
through
a
private
placement.
Private
placement
is
the
sale
of
new
securities
directly
to
an
investor
or
group
of
investors.
A
new
offering
of
securities
is
often
worth
40
to
100
million
or
may
be
more
than
that,
thus
only
institutional
investors
e.g.
pension
funds
and
insurance
companies,
can
afford
to
invest
through
private
placements.
The
major
advantage
of
a
private
placement
is
that
it
avoids
fees
charged
by
securities
firms
for
placing
the
stock.
However,
some
business
40
|
P a g e
firms
prefer
to
pay
for
the
advising
and
underwriting
services
of
a
securities
firm
over
a
private
placement.
MONEY MARKETS VERSUS CAPITAL MARKETS
Money markets are the financial markets that facilitate the flow of short-‐term funds only.
By short term we mean funds with maturities of 1 year or less than 1 year. The securities
that are traded in money markets are referred to as money market securities. To obtain
funds for a short period of time, business firms commonly issue money market securities
for purchase by investors. Business firms may also consider purchasing money market
securities with temporarily available cash. Similarly, investors purchase money market
securities with funds that they may soon need for other more profitable investments in the
near future.
In
contrast
to
money
markets,
financial
markets
that
facilitate
the
flow
of
long-‐term
funds
i.e.
the
funds
with
maturities
of
more
than
1
year
are
known
as
capital
markets.
The
instruments
that
are
traded
in
capital
markets
are
referred
to
as
securities.
As
stocks
do
not
have
maturities
and
can
provide
long-‐term
funding,
thus
they
are
classified
as
capital
market
securities.
Business
firms
generally
issue
stocks
and
bonds
to
finance
their
long-‐
term
investments
in
corporate
operations.
These
securities
are
purchased
by
institutional
and
individual
investors
who
have
funds
that
they
wish
to
invest
for
a
long
time.
INTERNATIONAL CAPITAL MARKETS
B OND
M ARKETS
Eurobond
market
is
the
oldest
and
largest
international
bond
market
where
corporations
and
governments
normally
issue
bonds
i.e.
Eurobonds,
denominated
in
dollars.
For
example,
A
U.S.
Corporation
might
issue
bonds
denominated
in
dollars
that
would
be
purchased
by
investors
in
any
of
the
European
countries.
Eurobond
market
is
appreciated
by
issuing
firms
and
governments
because
it
allows
them
to
attract
a
much
large
number
of
investors
than
would
generally
be
available
in
the
local
market.
Foreign
bond
market
is
another
international
market
which
is
for
long-‐term
debt
securities.
A
foreign
bond
is
a
type
of
bond
issued
by
a
foreign
corporation
(MNC)
or
government
and
is
denominated
in
the
investor’s
home
currency
and
sold
in
the
investor’s
home
market.
A
bond
issued
by
a
U.S.
company
that
is
denominated
in
pound
sterling
and
sold
in
United
Kingdom
is
an
example
of
a
foreign
bond.
As
compared
to
Eurobond
market,
the
foreign
bond
market
is
much
smaller
but
many
issuers
have
found
this
to
be
an
attractive
way
of
tapping
debt
markets
in
Japan,
Germany,
Switzerland
and
the
United
States.
41
|
P a g e
I NTERNATIONAL
EQUITY
MARKET
Finally,
there
is
a
recently
emerged
vibrant
international
equity
market.
This
market
has
made
it
possible
for
many
corporations
to
sell
blocks
of
shares
to
investors
in
a
number
of
different
countries
at
the
same
time.
These
market
facilities
enable
the
corporations
to
raise
far
large
amounts
of
capital
than
they
can
raise
in
any
single
national
market.
International
equity
sales
plays
an
essential
role
for
governments
who
wants
to
sell
state-‐
owned
companies
to
private
investors,
because
the
companies
being
privatized
are
often
extremely
large.
TYPES OF MARKET SECURITIES
Securities
are
generally
classified
in
two
different
types
namely,
money
market
securities
or
capital
market
securities.
K EY M ONEY M ARKET S ECURITIES
Money market securities are highly liquid securities, which means that a major loss in their
value, they can be easily converted into cash without. This is very important to business
firms and investors who may need to sell the money market securities on a moment’s
notice in order to use their funds for other more profitable purposes. The money market
securities used by firms and investors mainly includes Treasury bills, commercial paper,
negotiable certificates of deposit and foreign money market securities.
T REASURY
B ILLS
To
explain
the
treasury
bills
in
the
text
U.S
treasury
bills
are
considered
as
example.
U.S.
Treasury
issues
treasury
bills
as
short-‐term
debt
securities.
Treasury
bills
are
issued
on
every
Monday
in
two
maturities,
i.e.
13
weeks
and
26
weeks,
whereas,
Treasury
bills
with
one
year
maturity
are
issued
once
a
month.
An
auction
process
is
used
by
the
Treasury
when
issuing
the
securities
and
competitive
bids
are
submitted
by
1:00
p.m.
eastern
time
on
every
Monday.
Firms
and
investors
who
are
willing
to
pay
the
average
accepted
price
paid
by
all
competitive
bidders
can
also
submit
non-‐competitive
bids.
The
Treasury
always
has
a
plan
for
amount
of
money
to
be
raised
every
Monday.
First,
it
accepts
the
highest
competitive
bids
and
continues
accepting
the
lower
bids
until
it
has
obtained
the
amount
of
desired
funds.
The
par
value
which
is
the
principal
to
be
paid
at
maturity
on
Treasury
bills
is
minimum
10,000,
but
the
treasury
bill
purchased
by
firms
and
institutional
investors
typically
have
a
much
higher
par
value.
Treasury
bills
they
are
sold
at
a
discount
from
the
par
value
when
they
are
issued.
The
difference
between
the
par
value
and
the
discount
is
the
return
of
investor.
Treasury
bills
do
not
pay
coupon
or
interest
payments
but
instead
pay
a
yield
equal
to
the
percentage
difference
between
the
sale
price
and
the
purchase
price.
Firms
and
investors
who
wish
to
have
quick
access
to
funds
if
needed
are
the
common
demanders
of
Treasury
bills.
Treasury
bills
are
highly
liquid
because
there
is
an
active
42
|
P a g e
secondary
market
in
which
previously
issued
Treasury
bills
are
sold.
Treasury
bills
are
perceived
as
free
from
the
risk
of
default
because
they
are
backed
by
the
federal
government
and
regarded
as
risk-‐free
security.
Therefore,
the
rate
of
return
that
can
be
earned
from
investing
and
holding
a
Treasury
bill
until
maturity
is
commonly
referred
to
as
a
risk-‐free
rate.
Investors
are
sure
about
the
exact
return
they
can
earn
by
holding
a
Treasury
bill
until
maturity.
Example – Treasury Bills
Marcos
Ltd.
purchased
a
1-‐year
Treasury
bill
with
a
par
value
of
200,000
and
paid
188,000
for
it.
If
it
holds
the
Treasury
bill
until
maturity,
then
the
return
for
the
period
will
be
equal
to
6.38%
[(200,000-‐188,000)
÷
188,000]
The
return
is
uncertain
if
Marcos
Ltd
plans
to
hold
the
Treasury
bill
for
60
days
and
then
sell
it
in
the
secondary
market.
The
return
will
depend
on
the
selling
price
of
the
Treasury
bill
in
the
secondary
market
60
days
from
now.
Assume
that
Marcos
Ltd
expects
to
sell
the
Treasury
bill
for
190,000.
Therefore
its
expected
return
over
this
time
period
would
be
equal
to
1.064%
[(190,000-‐188,000)
÷
188,000]
Returns earned by investing in m oney m arket securities are generally measured on an
annualized basis. It can be done by multiplying the return by 365 (days in a year)
divided by the number of days the investment is held by the investor. In the given
example, the expected annualized return is equal to 6.47%.
190,000 − 188,000 365
! × !
188,000 60
In
the
given
example
there
is
uncertainty
because
the
investor
firm
is
not
planning
to
hold
the
Treasury
bill
until
m aturity.
If
Marcos
Ltd
planned
to
take
a
risk-‐free
position
for
the
60
days
period,
it
could
purchase
a
Treasury
bill
in
the
secondary
market
with
60
days
remaining
until
maturity.
For
example,
suppose
that
Marcos
Ltd
could
purchase
a
Treasury
bill
that
had
60
days
until
maturity
and
had
a
par
value
of
200,000
and
a
price
of
198,000.
The
annualized
yield
that
would
be
earned
in
this
case
is
equal
to
6.14%.
200,000 − 198,000 365
! × !
198,000 60
43
|
P a g e
C OMMERCIAL
P APER
A
short-‐term
debt
security
issued
by
well-‐known
and
creditworthy
firms
is
referred
to
as
commercial
paper.
It
provides
the
business
firm
an
alternative
to
a
short-‐term
loan
from
a
bank.
Some
of
the
business
firms
issue
their
commercial
paper
directly
to
investors
whereas
others
rely
on
financial
institutions
to
facilitate
the
placement
of
the
commercial
paper
with
investors.
The
minimum
denomination
of
a
commercial
paper
is
200,000,
although
multiples
of
1
million
is
the
more
common
denominations.
Typically,
the
maturities
are
between
20
and
45
days
but
they
can
be
as
long
as
270
days.
Commercial
paper
is
not
as
liquid
as
Treasury
bills
are,
because
commercial
paper
does
not
have
an
active
secondary
market
to
resell
it.
Therefore,
the
investors
who
purchase
commercial
paper
usually
plan
to
hold
it
until
maturity.
Commercial
papers
are
issued
at
discount
and
do
not
pay
coupon
or
interest
payments
like
Treasury
bills.
The
total
expected
return
to
investors
is
based
exclusively
on
the
difference
between
the
selling
and
the
buying
price.
There
is
a
possibility
that
the
firm
that
issued
commercial
paper
will
default
on
its
payment
at
maturity,
therefore,
investors
require
a
higher
return
on
commercial
paper
as
compared
to
return
expected
from
risk-‐free
(Treasury
bills)
securities
with
a
similar
maturity.
N EGOTIABLE C ERTIFICATES OF D EPOSIT
Debt securities, which are issued by financial institutions to obtain short-‐term funds, are
referred to as negotiable certificate of deposit (NCD). The minimum denomination of a
negotiable certificate of deposit (NCD) is typically 100,000, but the 1 million denominations
are more common. Commonly NCDs have maturities of 10 days to 365 days (1 year). Unlike
the other money market securities discussed earlier, negotiable certificate of deposits
(NCDs) do provide interest payments. The secondary market for NCDs exists, but it is not
very active as the secondary market for Treasury bills. Investors require a return on a
negotiable certificate of deposit that is slightly above the return on Treasury bills with a
similar maturity because of the risk that the financial institution issuing a NCD will default
on its payment at maturity.
F OREIGN M ONEY M ARKET S ECURITIES
Foreign money markets are assessable to firms and investors who wish to borrow or invest
funds for short-‐term periods. Short-‐term securities such as commercial papers can be
issued by business firms in foreign markets, assuming that they are perceived as
creditworthy in those foreign markets. Firms and investors can also attempt to borrow
short-‐term funds in foreign currencies by issuing short-‐term securities denominated in
those currencies. The major reason for a firm or an investor to borrow in foreign money
markets is to obtain funds in a currency that matches its cash flows. For example, European
subsidiary of IBM may borrow Euros which is the currency for 11 different European
countries either from a bank or by issuing commercial paper to support its European
operations, and it will use future cash inflows in Euros to pay off this debt at maturity.
44
|
P a g e
Investors
may
invest
in
foreign
short-‐term
securities
because
they
have
future
cash
outflows
in
those
currencies.
For
example,
say
a
firm
has
excess
funds
that
it
can
invest
for
three
months.
If
it
needs
Canadian
dollars
to
purchase
exports
in
3
months,
it
may
invest
in
a
3-‐month
Canadian
money
market
security
(such
as
Canadian
Treasury
bills)
and
then
use
the
proceeds
at
maturity
to
pay
for
its
exports.
Alternatively,
an
investor
may
purchase
a
foreign
money
market
security
to
capitalize
on
a
high
interest
rate.
Interest
rates
vary
among
countries,
which
causes
some
foreign
money
market
securities
to
have
a
much
higher
interest
rate
than
others.
However,
investors
are
subject
to
exchange
rate
risk
when
investing
in
securities
denominated
in
a
different
currency
from
what
they
need
once
the
investment
period
ends.
If
the
currency
denominating
the
investment
weakens
over
the
investment
period,
then
the
actual
return
that
investors
earn
may
be
less
than
what
they
could
have
earned
from
domestic
money
market
securities.
KEY CAPITAL MARKET SECURITIES
Bonds and stocks are the major capital market securities.
B ONDS
Bonds
are
long-‐term
debt
securities
and
are
used
by
business
firms
and
governments.
Business
firms
and
governments
issue
bonds
to
raise
large
amounts
of
long-‐term
funds.
Bonds
are
distinguished
by
their
issuer
and
can
be
classified
as
Treasury
bonds,
municipal
bonds
or
corporate
bonds.
T REASURY
B ONDS
Treasury
bonds
are
a
mean
of
obtaining
funds
for
a
long-‐term
period
and
are
issued
by
the
United
States
Treasury.
The
treasury
bonds
normally
have
maturities
ranging
between
10
to
30
years.
As
discussed
previously,
the
Treasury
issues
short-‐term
debt
securities
in
the
form
of
Treasury
bills
and
medium-‐term
debt
securities
in
the
form
of
Treasury
notes.
Their
maturities
range
between
1
and
10
years.
The
minimum
denomination
of
Treasury
bonds
is
1,000,
but
more
common
denominations
are
much
larger.
The
federal
government
in
United
States
borrows
most
of
its
funds
by
issuing
Treasury
securities.
Treasury
bonds
have
an
active
secondary
market,
so
it
is
easier
for
investors
to
sell
Treasury
bonds
at
any
time.
The
interest
on
Treasury
bonds
are
paid
to
the
investors
who
hold
them,
in
the
form
of
coupon
payments
every
6
months
or
semi-‐
annually.
Investors
who
invest
in
treasury
bonds
earn
a
return
in
the
form
of
these
coupon
payments
as
well
as
in
the
difference
between
the
selling
and
the
purchase
price
of
the
bond.
A
Treasury
bond
with
a
par
value
of
1,000,000
and
a
6
percent
coupon
rate
pays
60,000
per
year,
which
is
divided
into
30,000
after
the
first
six
month
period
of
the
year
and
another
30,000
in
the
second
six
month
period
of
the
year.
Interest
earned
by
investors
on
Treasury
bonds
is
exempt
from
state
and
local
income
taxes.
45
|
P a g e
Treasury
bonds
are
backed
by
the
federal
government,
therefore,
the
return
to
an
investor
who
holds
these
bonds
until
maturity
is
known
with
certainty.
The
coupon
payments
on
holding
a
treasury
bond
are
known
with
certainty,
and
so
is
the
payment
at
maturity
which
is
the
par
value.
As
a
result,
the
return
that
is
expected
to
be
earned
on
a
Treasury
bond
is
commonly
referred
to
as
a
long-‐term
risk-‐free
rate.
The
annualized
return
guaranteed
on
a
10-‐year
bond
today
provides
the
annualized
risk-‐free
rate
of
return
over
the
next
10
years,
whereas,
the
annualized
return
that
is
promised
on
a
20-‐year
Treasury
bond
provides
the
annualized
risk-‐free
rate
of
return
over
the
next
20
years.
If
investors
want
to
earn
a
risk-‐
free
return
over
a
specific
period
that
is
not
available
on
newly
issued
Treasury
bonds,
then
in
that
case
they
can
purchase
a
Treasury
bond
available
in
the
secondary
market
with
a
time
remaining
until
maturity
that
matches
their
desired
investment
period.
Municipal
Bonds
Municipal
bonds,
in
United
States,
are
the
type
of
bonds
issued
by
municipalities
to
support
their
expenditures.
They
are
commonly
classified
into
one
of
two
categories.
The
two
common
types
are
the
General
obligation
bonds
and
the
revenue
bonds.
General
obligation
bonds
are
a
mean
to
provide
investors
with
interest
and
principal
payments
that
are
backed
by
the
municipality’s
ability
to
tax.
On
the
other
hand,
revenue
bonds
are
a
mean
to
provide
investors
with
interest
and
principal
payments
by
using
funds
generated
from
the
project
financed
with
the
proceeds
of
the
bond
issue.
For
instance,
a
municipality
may
issues
revenue
bonds
to
build
a
toll
way.
To
make
interest
and
principal
payments
to
the
investors
who
purchased
these
revenue
bonds,
municipality
would
be
using
proceeds
received
in
the
form
of
tolls.
The
minimum
denomination
of
these
types
of
bonds
is
5,000;
however
larger
denominations
are
more
common.
The
interest
on
municipal
bonds
is
paid
on
a
semi-‐annual
(6
months)
basis.
The
interest
paid
on
these
bonds
is
generally
exempt
from
federal
income
taxes
and
may
even
be
exempt
from
state
and
local
income
taxes.
This
feature
of
municipal
bonds
is
very
attractive
and
enables
municipalities
to
obtain
funds
at
a
low
cost.
Because
the
investors
tend
to
be
more
concerned
with
the
after-‐tax
return,
they
are
willing
to
accept
a
lower
pre-‐tax
return
on
municipal
bonds.
A
secondary
market
for
Municipal
bonds
does
exist,
but
that
secondary
market
is
less
active
than
the
secondary
market
for
Treasury
bonds.
As
a
result,
municipal
bonds
are
less
liquid
as
compared
to
Treasury
bonds
that
have
a
similar
term
to
maturity.
Corporate
Bonds
Corporations
issue
corporate
bonds
to
finance
their
investment
in
long-‐
term
assets,
such
as
buildings
and
machinery.
The
standard
denomination
of
corporate
bonds
is
1,000,
but
at
times
other
denominations
are
issued
as
well.
Corporate
bonds
issued
in
high
volume
have
more
active
secondary
market.
Similar
to
the
municipal
bonds
there
is
less
active
secondary
market
for
corporate
bonds
than
there
is
for
Treasury
bonds;
therefore,
corporate
bonds
are
less
liquid
than
Treasury
bonds
with
a
similar
term
to
maturity.
Corporate
bonds
have
maturities
of
normally
ranging
between
10
and
30
years,
46
|
P a g e
but
at
times
they
have
maturities
of
50
years
or
more.
For
instance,
in
past
Coca-‐Cola
Company
and
Disney
issued
bonds
with
maturities
of
100
years.
I NTERNATIONAL
B ONDS
Many
business
firms
issue
bonds
in
the
international
markets
e.g.
firms
in
United
States
can
issue
bonds
in
Eurobond
market.
Issuing
bonds
in
Eurobond
market
serves
issuers
and
investors
in
bonds
denominated
in
a
variety
of
currencies.
For
instance,
General
Motors
may
consider,
issuing
a
dollar-‐denominated
bond
to
investors
in
the
Eurobond
market
or
issuing
a
bond
denominated
in
Japanese
yen
to
support
its
business
operations
in
Japan.
Investors
from
United
States
may
purchase
bonds
denominated
in
other
currencies
in
the
Eurobond
market
that
are
paying
higher
coupon
rates
than
dollar-‐denominated
bonds.
But
these
investors
will
be
subject
to
exchange
rate
risk
if,
in
the
future,
they
plan
to
convert
the
coupon
and
principal
payments
into
dollars.
Example
–
International
Bond
A
microprocessor
manufacturer
just
issued
a
20
-‐
year
bond
with
12%
coupon
interest
rate
and
a
1,000
par
value.
It
pays
interest
on
a
semi-‐annual
basis.
Investors
who
invest
in
this
bond
have
a
contractual
right
to
receive
(1)
annual
interest
of
120
(12%
×
1000),
distributed
at
the
end
of
each
6
months
as
60
(1/2
×
120)
for
20
years,
and
also
(2)
at
the
end
of
year
20,
the
1,000
which
is
the
par
value.
S TOCKS
An
equity
security
which
represents
ownership
interest
in
the
issuing
firm
is
regarded
as
Stock.
Bonds
are
issued
by
both
governments
and
businesses,
but
stock
is
issued
only
by
business
firms.
The
two
available
types
of
stock
are
common
stock
and
preferred
stock.
C OMMON
STOCK
Shares
of
common
stock
are
units
of
ownership
interest,
or
equity
in
a
business
firm.
A
return
is
earned
by
common
stockholders
either
in
the
form
of
dividends,
by
realizing
gains
through
increases
in
share
price
or
both.
P REFERRED
S TOCK
It
is
a
special
form
of
ownership
in
a
business
firm.
Preferred
stock
has
features
of
both
a
bond
and
common
stock.
A
fixed
periodic
dividend
is
promised
to
preferred
stockholders
and
this
fixed
dividend
must
be
paid
prior
to
any
dividends
payment
to
the
common
stockholders.
In
other
words,
preferred
stockholders
have
priority
over
common
stockholders
when
the
dividends
of
the
business
firms
are
disbursed.
I NTERNATIONAL
S TOCKS
Large
business
firms
commonly
issue
stock
in
international
equity
markets.
These
firms
may
be
able
to
easily
sell
all
of
their
stock
offering
by
placing
some
of
the
offered
stock
in
47
|
P a g e
foreign
markets,
if
there
is
not
sufficient
demand
in
the
home
country.
In
addition
to
this,
by
selling
some
of
their
newly
issued
stock
in
foreign
markets
firms
may
be
able
to
increase
their
global
name
recognition
in
countries
where
they
conduct
business.
Investors
usually
invest
in
stocks
issued
by
foreign
firms
because
of
the
belief
that
price
of
a
particular
foreign
stock
is
undervalued
in
the
foreign
market.
Another
belief
is
that
a
foreign
country
has
much
greater
potential
economic
growth
as
compared
to
the
home
country.
Investors
may
also
invest
in
foreign
stocks
to
achieve
international
diversification.
To
the
extent
that
most
stocks
of
firms
are
highly
influenced
by
the
economy
of
the
country,
Investors
can
reduce
their
exposure
to
potential
weakness
in
the
economy
by
investing
in
foreign
firms’
stocks
whose
performance
is
insulated
from
economic
conditions
of
home
country.
SECURITIES EXCHANGE
Securities
exchange
is
a
marketplace
where
business
firms
(sellers
of
securities)
can
raise
funds
through
the
sale
of
new
securities
and
investors
(purchasers
of
securities)
can
maintain
liquidity
by
being
able
to
resell
them
easily
when
required.
Securities
exchanges
are
commonly
known
as
“stock
markets”.
The
label
“stock
market”
is
somewhat
misleading
because
bonds,
common
stock,
preferred
stock
and
a
variety
of
other
investment
instruments
are
traded
on
these
exchanges.
The
securities
exchanges
are
classified
into
two
major
types
i.e.
the
organized
securities
exchange
and
the
over-‐the-‐counter
market.
O RGANIZED S ECURITIES E XCHANGES
Tangible organizations that act as secondary markets where outstanding securities are
resold are referred to as organized securities exchanges. The largest organized exchange in
the United States is the New York Stock Exchange (NYSE). In Canada, the largest organized
exchange is the Toronto Stock Exchange. Major European examples of organized securities
exchanges include the Amsterdam Stock Exchange, London Stock Exchange, Paris Bourse
and the Frankfurt Stock Exchange. Nigerian Stock Exchange, JSE Limited, are the examples
in Africa. In Asia, examples include the Singapore Exchange, the Tokyo Stock Exchange,
the Hong Kong Stock Exchange, the Shanghai Stock Exchange and the Bombay Stock
Exchange. In Latin America, there are such exchanges as the BM&F Bovespa and the BMV.
Australia has a national stock exchange, the Australian Securities Exchange. The regional
securities exchange also exist, e.g. in United States, the Chicago Stock Exchange and the
Pacific Stock Exchange (located in Los Angeles and San Francisco).
Majority
of
organized
exchanges
are
modeled
after
the
New
York
Stock
Exchange
(NYSE).
The
New
York
Stock
Exchange
(NYSE)
accounts
for
approximately
90
percent
of
the
total
annual
dollar
volume
of
shares
traded
on
organized
exchanges.
An
individual
or
a
business
firm
must
own
a
‘seat’
on
the
exchange
to
make
transactions
on
the
‘floor’
of
the
securities
exchange.
Most
of
the
seats
on
the
securities
exchange
are
owned
by
brokerage
firms.
To
be
listed
on
an
organized
exchange
for
trading,
a
firm
must
file
an
application
and
meet
a
48
|
P a g e
number
of
requirements.
For
example,
to
be
eligible
for
listing
on
a
securities
exchange,
a
firm
must
have
at
certain
number
of
stockholders,
each
owning
certain
number
of
shares,
a
certain
minimum
amount
of
shares
of
publicly
held
stock,
a
certain
demonstrated
before
taxes
earning
power
at
the
time
of
listing
and
a
certain
before
taxes
earning
power
for
each
of
the
preceding
time
interval
(2
year
or
so),
required
net
tangible
assets,
and
a
certain
amount
in
market
value
of
publicly
traded
shares.
Transactions
are
made
on
the
floor
of
the
exchange
through
an
auction
process.
By
making
transaction
we
mean
trading
and
the
goal
of
trading
is
to
give
both
purchasers
and
sellers
the
best
possible
deal
by
filling
buy
orders
(orders
to
purchase
securities)
at
the
lowest
possible
price
and
sell
orders
(orders
to
sell
securities)
at
the
highest
possible
price.
The
common
procedure
for
placing
and
executing
an
order
can
be
explained
by
a
simple
example.
Example – Organized Securities Exchanges
Norman
Blake,
who
has
an
account
with
one
of
the
financial
management
and
advisory
companies,
wishes
to
purchase
100
shares
of
the
IBM
Corporation
at
the
prevailing
market
price.
Norman
calls
her
account
executive,
Howard
Kohn
of
financial
management
and
advisory
company,
and
places
his
order.
Howard
immediately
has
the
order
transmitted
to
the
headquarters
of
the
financial
management
and
advisory
company,
which
immediately
forwards
the
order
to
the
clerk
of
financial
management
and
advisory
company
on
the
floor
of
the
securities
exchange.
The
clerk
dispatches
the
order
to
one
of
the
seat
holders
of
firm
(IBM
Corporation),
who
goes
to
the
appropriate
trading
post,
executes
the
order
at
the
best
possible
price
and
returns
to
the
clerk.
The
clerk
then
wires
the
execution
price
and
confirmation
of
the
transaction
back
to
the
brokerage
office.
Howard,
is
then
given
the
relevant
information,
who
passes
it
along
to
Norman.
To
complete
the
transaction
Howard
then
does
certain
paper
work.
An
order,
either
to
buy
or
to
sell,
can
be
executed
in
seconds
once
it
is
placed,
thanks
to
modern
sophisticated
telecommunications
devices.
Information
on
the
daily
trading
of
securities
is
reported
in
various
media,
including
financial
publications.
T HE O VER -‐ THE -‐C OUNTER E XCHANGE
Intangible market for the purchase and sale of securities not listed by the organized
exchanges are referred to as over-‐the-‐counter (OTC) exchange or market. Traders known as
dealers match the forces of supply and demand for securities to determine the market price
of over-‐the-‐counter (OTC) securities. For example, in United States OTC dealers are linked
with the purchasers and sellers of securities through the National Association of Securities
Dealers Automated Quotation System (NASDAQ), which is a sophisticated
telecommunications network.
49
|
P a g e
The
OTC
dealer
provides
current
“bid
prices”
and
“ask
prices”
on
thousands
of
actively
traded
OTC
securities.
The
highest
price
offered
by
a
dealer
to
purchase
a
given
security
is
referred
to
as
bid
price,
and
the
lowest
price
at
which
the
dealer
is
willing
to
sell
the
security
is
referred
to
as
the
ask
price.
As
a
result,
the
dealer
adds
securities
to
his/her
inventory
by
purchasing
them
at
the
bid
price
and
in
order
to
earn
profit
from
the
spread
between
the
bid
and
ask
prices,
the
dealer
sells
securities
from
his
or
her
inventory
at
the
ask
price.
The
trading
in
OTC
market
is
different
from
auction
process
on
the
organized
securities
exchanges.
The
prices
at
which
OTC
securities
are
traded
in
the
OTC
market
are
a
result
of
both
competitive
bids
and
negotiation.
Besides
creating
a
secondary
(re-‐sale)
market
for
outstanding
securities,
the
OTC
market
also
acts
like
a
primary
market
in
which
all
new
public
issues
are
sold.
DERIVATIVE SECURITIES MARKETS
Derivative
Securities
are
financial
contracts
whose
values
are
derived
from
the
value
of
underlying
financial
assets
(e.g.
securities).
Derivative
securities
are
also
called
derivatives.
The
value
of
each
derivative
security
tends
to
be
related
to
the
value
of
the
underlying
financial
asset
in
a
manner
that
is
understood
by
business
firms
and
investors.
As
a
result,
derivative
securities
allow
individual
investors
and
business
firms
to
take
positions
in
the
securities
on
the
basis
of
their
expectations
of
movements
in
the
underlying
financial
assets.
Specially,
investors
usually
speculate
on
expected
movements
in
the
value
of
the
underlying
financial
asset
without
having
to
actually
purchase
the
financial
asset.
In
majority
of
cases,
a
speculative
investment
in
the
derivative
can
generate
a
much
higher
return
as
compared
to
the
same
investment
in
the
underlying
financial
asset.
On
the
other
hand,
this
type
of
investment
will
also
result
in
a
much
higher
level
of
risk
for
the
investors.
Derivative
securities
are
not
just
used
to
take
speculative
positions
but
also
to
hedge
or
reduce
exposure
to
risk.
For
instance,
business
firms
that
are
negatively
affected
by
interest
rate
movements
can
take
a
particular
position
in
derivative
securities
that
can
balance
the
effects
of
movements
in
interest
rate.
Derivative
securities
can
reduce
its
risk
by
reducing
the
exposure
of
a
firm
to
some
external
force.
Derivative
securities
are
used
by
some
of
the
investors
to
reduce
the
risk
of
their
investment
portfolio.
For
example,
the
investors
can
take
a
particular
position
in
derivatives
to
protect
themselves
against
an
anticipated
temporary
decline
in
the
bonds
or
the
stocks
they
own.
Derivative
securities
are
only
traded
on
special
exchanges
and
through
sophisticated
telecommunications
systems.
Financial
institutions,
for
example,
commercial
banks
and
securities
firms
match
up
buyers
and
sellers
to
facilitate
the
trading
of
derivative
securities.
THE FOREIGN EXCHANGE MARKET
The
market
that
allows
for
the
purchase
and
sale
of
currencies
to
facilitate
international
purchases
of
products,
services
and
securities
is
regarded
as
foreign
exchange.
The
foreign
exchange
market
is
not
based
in
a
single
location
but
is
composed
of
large
banks
which
50
|
P a g e
exist
around
the
world.
The
banks
serve
as
intermediaries
between
the
buyer
(investors
or
business
firms)
and
the
seller
of
specific
foreign
currency.
There
are
two
major
components
of
foreign
exchange
market
a
spot
market
and
a
forward
market.
S POT
M ARKET
Spot
market
is
a
major
component
of
the
foreign
exchange
market
and
facilitates
the
immediate
exchange
of
currencies.
The
existing
exchange
rate
at
which
one
currency
can
be
immediately
exchanged
for
another
currency
is
known
as
the
spot
exchange
rate
or
spot
rate.
For
example,
in
past
years,
the
Canadian
dollar’s
value
has
ranged
between
0.60
and
0.80
U.S
dollars.
Alternatively,
1
Canadian
dollar
=
0.60
U.S
dollars
or
1
U.S
dollar
=
1.66
Canadian
dollar.
When
business
firms
purchase
foreign
supplies
or
acquire
a
firm
in
a
foreign
country
and
when
investors
invest
in
foreign
securities,
they
normally
use
the
spot
market
to
obtain
the
currency
needed
for
the
transaction.
Exchange
rates
were
almost
fixed
during
the
Bretton
Woods
era
(1944
to
1971).
They
could
only
change
by
1
percent
from
an
initially
established
rate.
To
maintain
stable
exchange
rates,
central
banks
of
countries
intruded
by
exchanging
their
currency
on
reserve
for
other
currencies
in
the
foreign
exchange
market.
The
boundaries
of
exchange
rates
were
expanded
to
be
2.25
percent
from
the
specified
value
by
1971,
but
this
still
restricted
exchange
rates
from
changing
significantly
over
period
of
time.
During
the
year
1973,
the
boundaries
were
abolished.
This
was
the
result
of
pressure
on
some
currencies
to
adjust
their
values
because
of
large
differences
between
the
demand
and
the
supply
of
a
specific
currency.
For
example
if
the
flow
of
trade
and
investing
between
the
United
States
and
a
given
country
changes,
the
U.S.
demand
and
the
supply
of
that
foreign
currency
for
sale
(exchanged
for
dollars)
will
also
change.
The
spot
rates
of
most
currencies
changes
because
of
the
continuous
change
in
demand
and
supply
conditions
for
a
given
currency.
Therefore,
most
investors
and
business
firms
that
will
need
or
receive
foreign
currencies
in
the
future
are
exposed
to
fluctuations
in
exchange
rate.
F ORWARD
M ARKET
The
forward
market
is
responsible
to
facilitate
the
foreign
exchange
transactions
that
involve
exchange
of
currencies
in
future.
The
specified
or
quoted
exchange
rate
at
which
one
currency
can
be
exchanged
for
another
currency
on
a
specific
date
in
future
is
known
as
the
forward
rate.
For
most
widely
traded
currency,
the
quote
for
forward
rate
is
typically
close
to
the
spot
rate
quote
at
a
given
point
in
time.
Most
of
the
commercial
banks
that
play
role
in
the
spot
market
also
participate
in
the
forward
market
by
accommodating
requests
of
individual
investors
and
business
firms.
They
provide
quotes
to
individual
investors
or
business
firms
who
wish
to
buy
or
sell
a
specific
foreign
currency
at
a
future
point
in
time.
51
|
P a g e
Individual
investors
or
business
firms
who
make
use
of
the
forward
market
negotiate
with
a
commercial
bank
for
a
forward
contract.
The
forward
contract
specifies
the
amount
of
a
specific
currency
that
will
be
exchanged
in
future,
the
exchange
rate
(the
forward
rate)
at
which
that
currency
will
be
exchanged
and
the
future
date
on
which
the
specific
exchange
will
take
place.
Forward
contract
can
be
in
the
form
of
‘buying
the
currency
forward’
or
‘selling
the
currency
forward’.
A
business
firm
can
involve
in
a
forward
contract
by
‘buying
the
currency
forward’,
if
it
anticipates
the
requirement
of
foreign
currency
in
the
future.
On
the
other
hand,
if
the
firm
anticipates
receiving
a
foreign
currency
in
future,
it
can
involve
in
a
forward
contract
in
which
it
‘sells
the
currency
forward’.
Example – Spot and forward Market
Charlie
Co.,
a
business
firm
in
United
States,
expects
to
receive
200,000
Euros
at
the
end
of
each
of
the
next
3
months
from
exporting
products
to
a
Germen
firm.
The
spot
rate
of
the
euro
is
1.20
and
the
forward
rate
of
the
euro
is
also
1.20
for
each
of
the
next
3
months.
Charlie
Co.
anticipates
that
the
value
of
euro
will
decrease
to
1.12
in
3
months.
If
Charlie
Co.
decides
not
to
use
a
forward
contract
then
it
will
be
converting
the
Euros
received
into
dollars
at
the
spot
rate
that
exists
in
3
months.
A
comparison
of
the
cash
flows
that
is
expected
to
occur
in
3
months
is
as
follows.
TABLE 1: A comparison of expected Cash flows
Choices Exchange Rate Expected Cash Inflows
Use the spot The spot rate in 3 months
1. €200,000 × 1.12 = 224,000
market is expected to be 1.12.
Use the forward The 3-‐month forward
2. €200,000 × 1.20 = 240,000
market rate is 1.20
The
comparison
shows
that
Charlie
Co.
expects
to
receive
16,000
higher
cash
inflows
as
a
result
of
hedging
with
a
forward
contract.
Thus
Charlie
Co.
decides
to
negotiate
a
forward
contract
to
sell
€200,000
forward.
Instead
of
an
exporter,
if
Charlie
Co.
were
an
investor
and
anticipated
to
receive
Euros
in
the
future,
it
could
have
been
feasible
to
use
a
forward
contract
in
the
same
m anner.
TOPIC
SUMMARY
All
types
of
business
firms
in
need
of
short
term
funds
issue
commercial
paper
as
a
means
of
obtaining
funds.
These
firms
also
invest
in
the
other
forms
of
money
market
securities
(e.g.
Treasury
bills)
when
they
have
temporarily
available
funds.
Investors
invest
in
all
the
kinds
of
securities
discussed
above.
If
investors
wish
to
invest
their
funds
for
a
very
short
time
period,
they
usually
focus
on
the
money
market
securities.
Whereas,
when
they
can
52
|
P a g e
invest
their
funds
for
long
periods
they
choose
capital
market
securities.
Although,
the
money
market
securities
provide
a
relatively
low
expected
return,
but
are
highly
liquid
and
generate
a
positive
return
until
the
investor
decides
to
use
funds
somewhere
else.
On
the
other
hand,
the
capital
market
securities
offer
higher
returns,
but
their
expected
returns
are
subject
to
a
higher
degree
of
risk.
Capital
markets
aid
in
the
exchange
of
long-‐term
securities,
therefore
they
help
to
finance
the
long-‐term
growth
of
government
agencies
and
business
firms.
In
the
capital
markets,
institutional
investors
play
a
major
role
in
supplying
funds.
Commercial
banks,
insurance
companies,
pension
funds
and
bond
mutual
funds
are
major
investors
for
bonds
in
the
primary
markets
and
secondary
markets.
Whereas,
insurance
companies,
pension
funds
and
stock
mutual
funds
are
major
investors
for
stocks
in
the
primary
and
secondary
markets.
Self-‐Reflection Questions
1. Distinguish between the roles of primary and secondary markets.
2. Distinguish between money and capital markets.
3. How can corporations use international capital markets to raise funds?
4. Why are derivative securities purchased by investors?
5. Distinguish between the spot market and forward market for foreign exchange
6. What is the meaning of the term risk free rate?
7.
Explain
why
the
firm
that
issues
a
corporate
bond
must
promise
investors
a
higher
return
than
that
available
on
a
treasury
security
that
has
the
same
maturity.
8. How does stock differ from bonds in terms of ownership privileges?
9. How does the stock exchange facilitate the exchange of stocks?
10. How does OTC market differ from the organized securities exchange?
53
|
P a g e
UNIT
2
–
REFERENCES
Frederic
S
Mishkin
and
Stanley
Eakins
(2012),
Financial
Markets
and
Institutions,
Global
7th
edition,
Person
Education
as
Prentice
Hall
Limited
Gitman, Lawrence J. Web Chapter Financial Markets and Institutions available at
http://wps.aw.com/wps/media/objects/5448/5579249/FinancialMarketsandInstitutions.pd
f
Madura,
Jeff
(2012),
Financial
Markets
and
Institutions,
10th
edition,
South-‐West,
Cengage
Learning
Limited
UNIT
2
–
SUMMARY
ASSIGNMENTS
AND
ACTIVITIES
The
assignment
and
activities
covered
in
the
unit
will
enable
the
students
to
clearly
visualize
the
role
of
financial
institutions
and
markets
and
in
what
respect
they
are
different
from
one
country
to
another.
SUMMARY
The
unit
describes
in
detail
how
financial
institutions
serve
managers
of
firms
as
intermediaries
between
investors
and
business
firms.
It
highlights
the
various
types
of
financial
institutions
and
how
they
work.
Provides
an
overview
of
financial
markets
and
explains
how
investors
and
businesses
trade
money
market
and
capital
market
securities
in
the
financial
markets
in
order
to
satisfy
their
needs.
It
sheds
light
on
the
major
securities
exchanges,
derivative
securities
and
foreign
exchange
market
and
explains
why
investors
and
business
firms
use
them.
The
roles
of
financial
managers,
financial
markets
and
investors
in
channelling
financial
flows
of
funds
are
summarized
in
the
table.
Table 2: Channelling financial Flow of Funds
Role
of
Financial
Managers
Role
of
Financial
Markets
Role
of
Investors
Financial
managers
make
The
financial
markets
provide
Investors
provide
the
financing
decisions
that
a
forum
in
which
firms
can
funds
that
are
to
be
require
funding
from
issue
securities
to
obtain
the
used
by
financial
investors
in
the
financial
funds
that
they
need
and
in
managers
to
finance
markets.
which
investors
can
purchase
corporate
growth.
securities
to
invest
their
funds.
NEXT
STEPS
Having
understood
the
types
and
roles
of
financial
institutions
and
markets
the
next
unit
will
explore
the
financial
statements.
Also,
ratio
analysis
are
highlighted
in
the
next
unit.
54
|
P a g e
UNIT THREE -‐ FINANCIAL STATEMENTS
UNIT 3 INTRODUCTION
Business
transactions
are
recorded,
summarized
and
reported
by
the
use
of
different
kinds
of
financial
statements,
each
serving
a
different
purpose.
Financial
statements
are
prepared
in
order
to
reflect
on
the
activities
of
an
organisation,
to
measure
performance,
to
benchmark
and
compare
against
other
organisations.
Financial
statements
are
the
primary
communication
tool
to
stakeholders
of
an
organisation.
This
course
primarily
focus
on
three
financial
statements,
namely;
the
statement
of
comprehensive
income,
the
balance
sheet
and
cash
flow
statements.
It
is
through
these
reports
that
the
progress
of
an
organization
can
be
measured
and
corrective
action
be
taken,
if
there
are
deviations
from
the
goals
of
the
business.
Therefore,
whilst
the
financial
planning
course
has
introduced
the
student
to
preparation
of
financial
statements,
in
this
course
the
student
is
introduced
to
the
use
of
financial
statements
as
a
financial
reporting
system
that
could
help
management
and
shareholders
to
assess
the
financial
position
of
the
business.
As
a
result,
this
unit
introduces
the
students
to
the
three
types
of
financial
statements.
Also,
the
students
are
equipped
with
the
skills
to
analyse
each
type
of
the
financial
statements.
Specific
objectives
of
the
unit
are
outlined
below.
UNIT 3 OBJECTIVES
Upon completion of this unit you will be able to:
1. Tell the difference between the various financial statements
2. Analyse and interpret the different financial statements
UNIT 3 READINGS
To complete this unit you are required to read the following book chapters:
Stolowy, H. And Lebas, Michel J. (2002) Corporate Financial Reporting – A Global
Perspective. Thomson Learning. London. – Chapters 2 and 3
55
|
P a g e
Subramanyam,
K.R.
and
Wild
John.
J
(2009)
Financial
Statement
analysis,
10TH
Edition,
McGraw-‐Hill
Irwin,
New
York.
–
Chapter
1
in
http://highered.mcgraw-‐
hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf
accessed
23/04/2013
IFRS (2012) Illustrative Financial Statements. KPMG. In
http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/IFRS-‐illustrative-‐
financial-‐statements/Documents/IFRS-‐illustrative-‐financial-‐statements-‐2012.pdf accessed
29/04/2013
UNIT 3 ASSIGNMENTS AND ACTIVITIES
To
reinforce
the
students’
learning
during
the
course
seminars,
the
participating
institutions
could
avail
published
financial
statements
of
a
local
organisation.
The
students
could
be
assigned
to
work
in
groups
to
analyse
and
interpret
the
different
financial
statements.
Another
activity
could
be
a
multiple
choice
test
designed
to
examine
the
student’s
understanding
of
the
component
parts
of
the
different
types
of
financial
statements.
The
end
of
topic
questions
are
provided
to
assess
student
learning
for
the
respective
topics.
56
|
P a g e
TOPIC 3.1 STATEMENTS OF COMPREHENSIVE INCOME AND FINANCIAL POSITION
TOPIC 3.1 INTRODUCTION
The
performance
of
a
company
should
be
measured
overtime
to
judge
as
to
whether
the
company
is
achieving
its
goals
and
delivering
value
to
its
shareholders.
Also,
the
performance
of
the
company
could
be
measured
by
making
a
comparison
with
other
similar
companies,
which
could
be
complicated
due
to
different
sizes
of
companies
and
disparity
of
their
operations.
To
do
so,
the
company’s
financial
statements
i.e.
the
balance
sheet,
the
income
and
cash
flow
statement,
which
result
from
the
financial
accounting
process,
are
analysed
using
financial
ratios.
The
analysis
of
financial
statements
using
ratios
is
termed
financial
analysis.
This
topic
explores
the
components
of
the
financial
statements.
TOPIC 3.1 OBJECTIVES
Upon completion of this topic the students will be able to:
1. Describe
the
component
elements
found
in
the
statements
comprehensive
income
and
financial
position
COMPONENTS OF THE STATEMENT COMPREHENSIVE INCOME
The
statement
of
comprehensive
income
is
based
on
the
business
transactions
that
have
been
recorded
for
a
specific
period,
usually
12
months.
It
includes
profit
or
loss
for
that
period
plus
other
comprehensive
income
recognised
in
that
period.
However,
an
entity
has
a
choice
of
presenting
two
statements
or
a
single
statement
of
comprehensive
income.
TWO
STATEMENTS
Where
the
company
presents
two
statements,
the
first
statement
is
the
income
statement
(profit
and
loss),
the
bottom
line
of
which
is
profit
or
loss.
This
approach
is
consistent
with
some
International
Financial
Reporting
Standards
(IFRSs)
(see
IAS
1.89)
that
permit
for
some
components
to
be
excluded
from
profit
or
loss
and
instead
to
be
included
in
other
comprehensive
income.
The
second
is
the
statement
of
comprehensive
income,
which
begins
with
the
profit
or
loss
from
the
income
statement
bottom
line.
57
|
P a g e
Figure
4:
Presentation
of
two
statements
PROFIT
AND
LOSS
STATEMENT
The
bottom
line
of
the
income
Operating
income
–
operating
expenses
=
PROFIT
OR
LOSS
statement
starts
the
other
STATEMENT
OF
OTHER
COMPTREHENSIVE
INCOME
comprehensive
income
Profit
and
loss
+
other
non
operating
income
The components of each of the two statements are outlined below.
C OMPONENTS OF THE P ROFIT AND L OSS
The income statement (profit or loss) is based on the business transactions that have been
recorded for a specific period, usually 12 months. The International Accounting
Standards
(IAS)
regulation
number
1.88
stipulates
that
all
items
of
income
and
expense
recognized
in
a
period
must
be
included
in
profit
or
loss
unless
a
standard
or
an
interpretation
requires
otherwise.
As
a
result
of
the
2003
revision
to
IAS
1,
the
Standard
is
now
using
'profit
or
loss'
rather
than
'net
profit
or
loss'
as
the
descriptive
term
for
the
bottom
line
of
the
income
statement.
The
profit
and
loss
statement
allows
for
the
business
to
analyse
how
the
income
(profit
or
loss)
for
the
period
was
created.
The
statement
records
the
resources
consumed
and
the
revenue
generated
from
serving
the
customers
during
a
specific
period.
The
profit
and
loss
statement
does
not
reflect
the
financial
position
of
the
firm,
but
tells
us
how
profitable
the
transactions
for
serving
the
customers
were.
58
|
P a g e
TABLE
3:
EXAMPLE
OF
THE
COMPONENTS
OF
PROFIT
AND
LOSS
STATEMENT
ABC Corporation
For
the
Year
Ended
December
31,
2007
Sales
Revenue
2,900,000
Revenue
Section
Cost
of
Goods
Sold
1,750,000
Gross
Profit
(Margin)
1,150,000
Operating
Expenses:
General
&
Administrative
Expenses
140,000
Operating
Expenses:
Selling
Expenses
80,000
Note:
Expenses
are
on
the
left
Amortization
of
Intangible
Assets
25,000
with
the
total
on
the
right.
Write
off
of
Goodwill
17,500
Restructuring
Costs
420,000
Loss
from
Inventory
Write-‐Down
130,000
Total
Operating
Expenses
812,500
Operating
Income
337,500
Other
Income
(Expense):
Other
Income
(expense)
includes
items
that
relate
to
operations
but
are
not
part
of
operations.
Note:
If
there
is
a
single
item
it
is
places
on
the
right.
Multiple
items
are
placed
on
the
left
with
the
total
on
the
right.
Interest
Income
75,000
Interest
Expense
(42,500)
Gain
on
Sale
of
Operating
Assets
78,200
Loss
on
Sales
of
Operating
Assets
(8,250)
102,500
Income
From
Continuing
Operations
Before
23,500,000
Income
Tax
Expense
Income
Tax
Expense
@
40%
9,400,000
Income
Tax
from
continuing
Income
before
Extraordinary
Items
14,100,000
operations
is
shown
as
a
separate
line
item.
Discontinued
Operations:
Operating
Income
(loss)from
Discontinued
Discontinued
Operations
Operation
Net
of
40%
tax
4,000,000
usually
have
two
components.
The
first
is
the
gain
(loss)
from
part
year
operations.
Loss
(Gain)on
Sale
of
Discontinued
The
second
is
the
gain
(loss)
Operations
Assets
Net
of
40%
tax
(15,000,000 from
the
sale
of
the
assets.
)
Loss
(Gain)
on
Discontinued
Operations
(11,000,000)
Both
are
always
net
of
Income
Tax.
Income
Before
Extraordinary
Items
3,100,000
Extraordinary
Items:
Gain
from
Early
Sale
of
Bonds
Net
of
40%
Extraordinary
Items
are
items
Tax
12,000,000
that
are
not
expected
to
Loss
From
Flood
Damage
Net
of
40%
Tax
happen
frequently
but
have
a
(3,000,000)
major
(Material)
impact
on
the
current
year’s
operations.
Items
are
report
net
of
income
tax
Gain
(Loss)
from
Extraordinary
Operations
9,000,000
Profit
or
(loss)
12,100,000
Source: extracted from
(http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Ex
ample_Comprehensive_Income_Statement.htm)
59
|
P a g e
C OMPONENTS
OF
THE
STATEMENT
OF
COMPREHENSIVE
INCOME
IN
A
TWO
STEP
APPROACH
In
a
two
statement
approach,
the
comprehensive
statement
starts
with
the
bottom
line
of
the
profit
and
loss
statement.
The
components
of
the
comprehensive
income
should
include:
• changes in revaluation surplus
• actuarial gains and losses on defined benefit plans recognised in accordance with
• gains and losses arising from translating the financial statements of a foreign operation
• gains and losses on re-‐measuring available-‐for-‐sale financial assets
• The effective portion of gains and losses on hedging instruments in a cash flow hedge.
(IFRSs, 2013)
Table 4: Example of statement of comprehensive income
Profit or (loss) 12,100,000
Other Comprehensive Income (Loss):
Comprehensive Income is from
Foreign currency translation non-‐owner transactions. The gains
adjustment loss, net of 40% tax (3,900,000) and losses are outside the control
of the owner. Items are reported
Unrealized gains on investment net of income tax.
securities, net of 40% tax 4,200,000
Total Other Comprehensive Income (Loss) 300,000
Comprehensive Income 12,400,000
Source: extracted from
(http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Ex
ample_Comprehensive_Income_Statement.htm )
60
|
P a g e
S INGLE
S TATEMENT
OF
C OMPREHENSIVE
I NCOME
The
single
statement
of
comprehensive
income
combines
the
components
of
the
income
statement
and
the
statement
of
other
comprehensive
income,
as
highlighted
in
FIGURE
5
and
example
below.
Figure 5: Presentation of a single statement of comprehensive income
STATEMENT OF COMPREHENSIVE INCOME
Profit and loss
Other comprehensive income
TOTAL COMPREHENSIVE INCOME
The
International
Accounting
Standards
(See
IAS
1)
stipulate
for
the
minimum
items
in
the
statement
of
comprehensive
income
to
include
the
following:
a) revenue
b) finance costs
c) share
of
the
profit
or
loss
of
associates
and
joint
ventures
accounted
for
using
the
equity
method
d) tax expense
e) a
single
amount
comprising
the
total
of
(i)
the
post-‐tax
profit
or
loss
of
discontinued
operations
and
(ii)
the
post-‐tax
gain
or
loss
recognised
on
the
disposal
of
the
assets
or
disposal
group(s)
constituting
the
discontinued
operation
f) profit or loss
g) each component of other comprehensive income classified by nature
h) share of the other comprehensive income of associates and joint ventures
accounted for using the equity method
i) total comprehensive income
61
|
P a g e
j) The
following
items
must
also
be
disclosed
in
the
statement
of
comprehensive
income
as
allocations
for
the
period
k) profit
or
loss
for
the
period
attributable
to
non-‐controlling
interests
and
owners
of
the
parent
l) total
comprehensive
income
attributable
to
non-‐controlling
interests
and
owners
of
the
parent
m) Additional
line
items
may
be
needed
to
fairly
present
the
entity's
results
of
operations.
n) No
items
may
be
presented
in
the
statement
of
comprehensive
income
(or
in
the
income
statement,
if
separately
presented)
or
in
the
notes
as
'extraordinary
items'.
o) The
AIS
also
requires
for
disclosure
of
the
following,
if
material,
either
in
the
statement
of
comprehensive
income
or
in
the
notes.
p) write-‐downs of inventories to net realisable value or of property, plant and
equipment to recoverable amount, as well as reversals of such write-‐downs
q) restructurings
of
the
activities
of
an
entity
and
reversals
of
any
provisions
for
the
costs
of
restructuring
r) disposals of items of property, plant and equipment
s) disposals of investments
t) discontinuing operations
u) litigation settlements
v) other reversals of provisions
The
IAS
further
stipulates
that
the
expenses
in
the
profit
or
loss
statement
be
categorised
for
analysis
either
by
nature
(raw
materials,
staffing
costs,
depreciation,
etc.)
or
by
function
(cost
of
sales,
selling,
administrative,
etc).
Where
the
expenses
are
categorised
by
function,
the
IAS,
additional
information
on
the
nature
of
expenses
must
be
disclosed,
for
example
–
at
a
minimum
depreciation,
amortisation
and
employee
benefits
expense.
Below
is
an
example
of
the
Statement
of
Comprehensive
Income.
)
62
|
P a g e
Table
5:
Example
of
a
single
statement
of
comprehensive
income
Statement of Income and Comprehensive Income
For the Year Ended December 31, 2007
Sales Revenue 2,900,000
Cost of Goods Sold 1,750,000
Gross Profit 1,150,000
Operating Expenses:
General & Administrative Expenses 140,000
Selling Expenses 80,000
Amortization of Intangible Assets 25,000
Write off of Goodwill 17,500
Restructuring Costs 420,000
Loss from Inventory Write-‐Down 130,000
Total Operating Expenses 812,500
Operating Income 337,500
Other Income (Expense):
Interest Income 75,000
Interest Expense (42,500)
Gain on Sale of Operating Assets 78,200
Loss on Sales of Operating Assets (8,250)
Total Other Operating Income(Expense) 102,500
Income From Continuing Operations Before Income Tax
Expense 23,500,000
Income Tax Expense @ 40% 9,400,000
Income before Extraordinary Items 14,100,000
Discontinued Operations:
Operating Income (loss)from Discontinued
Operation Net of 40% tax 4,000,000
Loss (Gain)on Sale of Discontinued Operations
Assets Net of 40% tax (15,000,000)
Loss (Gain) on Discontinued Operations (11,000,000)
Income Before Extraordinary Items 3,100,000
Extraordinary Items:
Gain from Early Sale of Bonds Net of 40% Tax 12,000,000
Loss From Flood Damage Net of 40% Tax (3,000,000)
Gain (Loss) from Extraordinary Operations 9,000,000
Net Income 12,100,000
Other Comprehensive Income (Loss):
Foreign currency translation adjustment loss, net of
40% tax (3,900,000)
Unrealized gains on investment securities, net of
40% tax 4,200,000
Total Other Comprehensive Income (Loss)
Financial Management Page| 63
300,000
Comprehensive Income 12,400,000
Earnings Per Share (1,000,000 shares issued and Outstanding)
Income (loss) From Continuing Operations 14.10
Loss (Gain) on Discontinued Operations (11.00)
Gain (Loss) from Extraordinary Operations 9.00
Other Comprehensive Income (Loss) 0.30
Comprehensive Income Per Share 12.40
Source:
(http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Ex
ample_Comprehensive_Income_Statement.htm )
COMPONENTS OF THE STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)
The balance sheet statement provides an up to date statement of the financial
position or net worth of the company for a given period. As stipulated by the
International Financial Reporting Board, the statement of financial position (balance
sheet) presents and classifies the resources (assets), the obligations to external
parties (liabilities to creditors) and equity to share holders for a certain period.
These comprise the accounting equation also known as the balance sheet
equation, which is expressed as: assets = Liabilities + equity
The
balance
sheet
can
either
be
presented
using
a
vertical
format
or
a
horizontal
format.
The
vertical
format
is
mostly
used
for
published
accounts.
According
to
the
International
Accounting
Standard
1,
Current
assets
are
cash;
cash
equivalent;
assets
held
for
collection,
sale,
or
consumption
within
the
entity's
normal
operating
cycle;
or
assets
held
for
trading
within
the
next
12
months.
All
other
assets
are
non-‐
current.
The
current
liabilities
are
obligations
that
are
to
be
settled
within
the
entity's
normal
operating
cycle
or
due
within
12
months,
or
those
held
for
trading,
or
those
for
which
the
entity
does
not
have
an
unconditional
right
to
defer
payment
beyond
12
months.
Other
liabilities
are
non-‐current.
Financial Management Page| 64
The International Accounting Standard 1 also requires that the minimum balance
sheet items should include:
(a) Property, plant and equipment
(b) Investment property
(c) Intangible assets
(d) Financial assets (excluding amounts shown under (e), (h), and (i))
(e) Investments accounted for using the equity method
(f) Biological assets
(g) Inventories
(h) Trade and other receivables
(i) Cash and cash equivalents
(j) Assets held for sale
(k) Trade and other payables
(l) Provisions
(m) Financial liabilities (excluding amounts shown under (k) and (l))
(n) Liabilities and assets for current tax, as defined in IAS 12
(o) Deferred tax liabilities and deferred tax assets, as defined in IAS 12
(p) Liabilities included in disposal groups
(q) Non-‐controlling interests, presented within equity and
(r) Issued capital and reserves attributable to owners of the parent
Financial Management Page| 65
However, additional line items may be needed to fairly present the entity's financial
position.
The International Accounting Standards further requires the following disclosures
in relation to issued share capital and reserves:
a) numbers of shares authorised, issued and fully paid, and issued but not fully paid
b) par value
c) reconciliation of shares outstanding at the beginning and the end of the period
d) description of rights, preferences, and restrictions
e) treasury shares, including shares held by subsidiaries and associates
f) shares reserved for issuance under options and contracts
g) a description of the nature and purpose of each reserve within equity
Table 6: Example of a Statement of Financial Position
31 December 20X7 31
D ecember
20X6
ASSETS Currency unit(000
Current asset
Cash and cash equivalents 312,400 322,900
Trade receivables 91,600 110,800
Other financial assets—derivative 2,000 1,100
hedging instruments
Inventories 135,230 132,500
Other current assets 23,650 11,350
Total current assets 564,880
578,650
Non-‐current asset
Financial assets—investments in 100,150 110,770
shares
Investments in associates 100,500 121,000
• carried at fair value 60,000 71,000
• carried at cost less impairment 40,500 50,000
Investments in jointly controlled 42,000 35,000
entities
• carried at fair value 20,000
13,000
• carried at cost less impairment 22,000 22,000
Financial Management Page| 66
Investment property—carried at 150,000 120,000
fair value
Property, plant and equipment—
carried at cost less accumulated
Depreciation 200,700 240,020
Biological assets 70,000 75,000
• carried at fair value 30,000 25,000
• carried at cost less impairment 40,000 50,000
Goodwill 80,800 91,200
Other intangible assets 107,070 127,560
Deferred tax assets 50,400 25,000
Total non-‐current assets 901,620 945,550
Total assets 1, 466,500 1,524,200
LIABILITIES AND EQUITY
Current liabilities
Bank overdrafts 10,000 7,000
Trade and other payables 90,100 160,620
Short-‐term borrowings 150,000 200,000
Current portion of bank loans 20,000 20,000
Current portion of obligations 1,500 1,200
under finance leases
Current portion of employee 15,000 10,000
benefit obligations
Current tax payable 23,500 40,800
Short-‐term provisions 5,000 4,800
Total current liabilities 315,100 454,420
Non-‐current liabilities
Bank loans 65,000
85,000
Obligations under finance leases 2,300 3,800
Environmental restoration 26,550 48,440
provision
Long-‐term employee benefit 78,000 75,000
obligations
Deferred tax liabilities 5,800 26,040
Total non-‐current liabilities 177,650 238,280
Total liabilities 492,750 692,700
Equity
Share capital 650,000 600,000
Retained earnings 243,500 161,700
Actuarial gains on defined 8,200 20,100
benefit pension plan
Gains on hedges of foreign 2,000 1,100
exchange risks of firm
commitments
Total equity attributable to owners 903,700 782,900
of the parent
Financial Management Page| 67
Non-‐controlling interests 70,050 48,600
Total equity 973,750
831,500
Total equity and liabilities 1,466,500 1,524,200
TOPIC SUMMARY
The
comprehensive
income
statement
and
the
statement
of
financial
position
are
the
basis
upon
which
the
health
of
the
organisation
can
be
assessed.
It
was
therefore
important
that
the
learners’
be
introduced
to
the
make-‐up
of
these
statements,
before
they
could
employ
them
in
the
financial
analysis.
As
a
result,
this
topic
has
introduced
the
learners
to
the
components
of
these
statements
as
required
by
the
International
Accounting
Standards
(IAS)
1.
Self-‐Reflection
Questions
1.
What
is
the
difference
between
the
single
step
and
two
steps
statement
of
comprehensive
income?
2.
List
the
items
of
the
statement
of
financial
position.
Financial Management Page| 68
TOPIC 3.2 ANALYSIS OF THE FINANCIAL STATEMENTS
TOPIC 3.2 INTRODUCTION
Financial
analysis
is
based
on
the
financial
statements,
which
have
been
introduced
above.
Financial
analysis
is
normally
performed
by
organisations
and
business
analyst
to
highlight
the
company’s
financial
position.
The
information
derived
from
the
analysis
could
help
the
business
managers
and
investors
to
gauge
the
financial
position
of
the
company
by
addressing
questions
pertaining
to
availability
of
resources
for
growth
and
for
investment.
Other
questions
that
could
be
addressed
by
financial
analysis
to
the
managers
and
investors
pertain
to
the
level
of
profitability
of
the
firm
and
generally
as
to
whether
the
company
performs
as
was
expected.
TOPIC 3.2 OBJECTIVES
At the end of the topic the students will be able to:
1. Analyse
and
interpret
the
statement
of
comprehensive
income
and
the
statement
of
financial
position
2. Advice
management
on
how
to
improve
the
financial
position
of
the
firm,
based
on
the
financial
analysis.
INTRODUCTION TO RATIO ANALYSIS
Businesses
constantly
gauge
the
performance
of
the
business
in
terms
of
its
management,
plans,
financial
situation
and
strategies
to
inform
decision
making.
Business
analysis
is
therefore
deemed
an
important
exercise
of
the
firm
as
it
informs
stakeholders
about
the
state
of
the
firm.
Whilst
there
are
several
types
of
business
analysis
(see
FIGURE
6
below),
this
course
mainly
focuses
on
financial
analysis.
Ratio
analysis
provides
ways
of
comparing
and
investigating
the
relationships
between
different
pieces
of
financial
information.
There
is
a
wide
range
of
financial
ratios
ranging
from
simple
to
complicated
computations.
However,
the
biggest
problem
with
ratios
is
that
people
calculate
them
differently.
Also,
the
definitions
of
their
sources
differ.
It
is
therefore
important
that
when
using
the
ratios
as
tools
of
analysis,
you
should
be
careful
to
Financial Management Page| 69
document how you calculate each ratio. When comparing your numbers to those of
another sources, be sure you know how their numbers are computed, (Firer et al, 2004).
The
following
questions
need
to
be
taken
into
consideration
when
analysing
statements
using
ratios:
1. How is the ratio computed?
2. What is the ratio intended to measure, and why might we be interested?
3. What is the unit of measurement?
4. What might a high or low value be telling us? How might such values be misleading?
5. How could this measure be improved?
Figure 6: Process of business analysis
Source: Subramanyam and Wild (2009)
Financial ratios are traditionally grouped into the following categories:
• Short-‐term solvency, or liquidity, ratios.
• Profitability ratios
• Investment ratios
• Asset management, or turnover or efficiency ratios
Financial Management Page| 70
Figure 7 below, depicts the four types of ratios. The four types of ratios are examined below;
Figure 7: Types of Financial Ratios
Source: Dyson (2010)
LIQUIDITY
MEASURES
As
the
name
suggests,
short-‐term
solvency
ratios
as
a
group
are
intended
to
provide
information
about
a
firm’s
liquidity,
and
these
ratios
are
sometimes
called
liquidity
measures
.The
primary
concern
is
the
firm’s
ability
to
pay
its
bills
over
the
short
run
without
undue
stress.
Consequently,
these
ratios
focus
on
current
assets
and
current
liabilities.
For
obvious
reasons,
liquidity
ratios
are
particularly
interesting
to
short-‐term
creditors.
Since
financial
managers
are
constantly
working
with
banks
and
other
short-‐term
lenders,
an
understanding
of
these
ratios
is
essential.
One
advantage
of
looking
at
current
assets
and
liabilities
is
that
their
book
values
and
market
values
are
likely
to
be
similar.
Often
(though
not
always),
these
assets
and
liabilities
just
don’t
live
long
enough
for
the
two
to
get
seriously
out
of
step.
On
the
other
hand,
like
any
type
of
near-‐cash,
current
assets
and
liabilities
can
and
do
change
fairly
rapidly,
so
today’s
amounts
may
not
be
a
reliable
guide
to
the
future.
The
figures
from
the
statement
of
financial
position
will
be
employed
to
illustrate
computation
of
the
liquidity
measures.
C URRENT RATIO
Financial Management Page| 71
One of the most widely used ratios is the current ratio. The ratio is represented as follows,
gives a relationship between current assets and currents liabilities, its measures as to how
much an organisation can be able to meet its short term liabilities as they fall due by the
conversion of its current assets.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬
Current
ratio
=
𝐂𝐮𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Example
–
Current
ratio
𝟓𝟔𝟒,𝟖𝟖𝟎 𝟓𝟕𝟖,𝟔𝟓𝟎
In
2007
= 𝟏. 𝟔 𝒕𝒊𝒎𝒆𝒔
in
2008
= 𝟏. 𝟑 𝒕𝒊𝒎𝒆𝒔
𝟑𝟓𝟏,𝟏𝟎𝟎 𝟒𝟓𝟒,𝟒𝟐𝟎
Because
current
assets
and
liabilities
are,
in
principle,
converted
to
cash
over
the
following
12
months,
the
current
ratio
is
a
measure
of
short-‐term
liquidity.
The
above
results
show
that
the
current
ratio
was
1.6
times
in
2007
and
1.3
in
2008,
this
simply
shows
how
many
times
the
current
liabilities
are
covered
by
the
current
assets.
The
higher
current
ratio
is
quite
favourable
to
the
organisation
and
other
external
stakeholders,
e.g.
creditors.
A
high
current
ratio
means
an
organisation
will
be
able
to
settle
its
short
term
liabilities
as
they
fall
due,
but
it
also
may
indicate
an
inefficient
use
of
cash
and
other
short-‐term
assets.
On
normal
circumstances,
a
current
ratio
of
above
1
is
favourable,
however
this
is
relative
to
the
industry,
a
current
ratio
of
less
than
1
would
mean
that
net
working
capital
(current
assets
less
current
liabilities)
is
negative.
Q UICK OR ACID TEST RATIO
Inventory is often the least liquid current asset. It’s also the one for which the book values
are least reliable as measures of market value since the quality of the inventory isn’t
considered.(www.mhhe.com.rwj) this is because Some of the inventory damaged,
obsolete, or lost. We know keeping large amounts of inventory is an unhealthy situation, it
compromise liquidity and show sign of problems in turning over the stock. In this case on
calculation of the quick or acid test ratio, inventory is eliminated from the current assets,
only highly liquid assets are taken
Financial Management Page| 72
(𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 ! 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲)
Quick ratio (acid test ratio) =
𝐂𝐮𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Example – Quick ratio
𝟓𝟔𝟒,𝟖𝟖𝟎!𝟏𝟑𝟓,𝟐𝟑𝟎 𝟓𝟕𝟖,𝟔𝟓𝟎 –𝟏𝟑𝟐,𝟓𝟎𝟎
In 2007 = 𝟏. 𝟐 𝒕𝒊𝒎𝒆𝒔 in 2008 = 𝟎. 𝟗 𝒕𝒊𝒎𝒆𝒔
𝟑𝟓𝟏,𝟏𝟎𝟎 𝟒𝟓𝟒,𝟒𝟐𝟎
The
acid
test
ratio
gives
us
the
result
that
it
is
not
getting
better
with
time,
the
ratio
in
2007
is
better
than
in
2008.
The
ratio
may
be
acceptable
if
it’s
comfortably
within
1,
not
forgetting
that
it
will
differ
according
to
industries.
The
ratios
above
show
that
inventory
makes
only
a
humble
part
of
the
current
asset
and
it
is
quite
at
a
safe
level.
PROFITABILITY
MEASURES
Profit
is
believed
to
be
the
most
important
measure
of
success
in
an
organisation.
Profitability
measures
as
to
whether
the
firm
is
employing
and
managing
its
resources
and
operations
efficiently.
There
are
three
commonly
used
measures
of
profitability,
namely
profit
margin,
return
on
assets
and
return
on
equity.
The
focus
in
this
group
is
on
the
bottom
line—net
income.
For
illustration
on
these
ratios,
we
will
use
figures
from
the
income
statement
and
the
balance
sheet
presented
above.
P ROFIT
M ARGIN
Companies
pay
a
great
deal
of
attention
to
their
profit
margin
this
ratio
calculates
net
income
as
a
percentage
of
sale
revenue.
It
measures
how
much
profit
is
generated
from
sales.
Remember
profit
is
the
excess
of
sales
revenue
over
costs
and
expenses.
𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
Profit
margin
= x
100
𝐒𝐚𝐥𝐞𝐬
Example
–
Profit
margin
𝟏𝟎𝟐,𝟓𝟎𝟎
In
2007
𝒙𝟏𝟎𝟎 = 𝟑. 𝟓%
𝟐,𝟗𝟎𝟎,𝟎𝟎𝟎
Financial Management Page| 73
The ratio shows that for every unit of currency, 3.5% of that is net income. If we take a
dollar as our unit of currency, it means that for every dollar-‐3.5cents are generated as net
income. In this case, the ratio may be seen as low, however it should be taken into
consideration as which other factors contribute to such figure, especially the kind of
industry the business is in. considering how low the margin is, an organisation may take on
measures to increase the ratio. Decreasing sales would not be and objective decision,
therefore it might have to maintain tight control on its costs and expenses.
A DDITIONAL RATIOS
G ROSS PROFIT RATIO
!"#$$ !"#$%&
Gross profit Ratio = x100
!"#$%
The
gross
profit
ratio
measures
the
extent
to
which
the
company
has
been
successful
in
its
trading.
The
formula
is
as
follows
Example – Return on Assets
!,!"#,!!!
Gross profit Ratio = !,!"",!!!
𝐱𝟏𝟎𝟎 = 𝟑𝟗. 𝟔𝟔%
M ARK UP R ATIO
The mark-‐up ratio measures the extent to which the gross profit adds to the cost of goods
sold to generate sales. Sales activity can be realised by reducing the mark-‐up. The attempt
to increase sales activity by reducing the mark-‐up could harm the gross profit. However,
large volume of sales could increase the profits.
!"#$$ !"#$%&
Mark
up
ratio
= 𝐱𝟏𝟎𝟎
!"#$ !" !""#$ !"#$
Example
–
mark-‐
up
ratio
1,150,000
𝐱𝟏𝟎𝟎 = 𝟑𝟗. 𝟔𝟔%
𝟏, 𝟕𝟓𝟎, 𝟎𝟎𝟎
Financial Management Page| 74
N ET PROFIT RATIO
This ratio makes an internal comparison of the net profit realised in a given period to the
sales generated in that period. Because of the different expenses that could impact the net
profit, comparison with other firms may be a challenge and would, as such, require for an
adjustment to account for such differences.
EFFICIENCY
RATIOS
The
efficiency
ratios
allow
for
an
analysis
of
how
efficiently
the
company
is
being
managed.
To
measure
efficiency,
comparison
is
made
between
two
periods
and
also
with
external
companies.
Several
ratios
could
be
employed,
in
this
course
the
focus
is
on
stock
turnover,
fixed
assets
turnover,
trade
debtor
collection
period
and
trade
creditor
payment
period.
S TOCK TURNOVER RATIO
The stock turnover ratio measures the number of times the company is able to turnover its
stock, the higher the turnover, the more efficient the company is in moving its stock. A
higher stock turnover implies that the company’s funds are not tied in non-‐moving stock
items. A comparison between 2 periods should an indication of the efficiency in moving
stock between periods. A between companies comparison would give an indication of
whether the company is more (less) efficient in moving its stocks relative to its customers.
!"#$ !" !""#$ !"#$
Stock turnover ratio =
!"#$%&' !"#$%
Example
–
Stock
turn-‐over
(in
2007)
T !,!"#,!!! = 12.94 times
!"#,!"#
This ratio implies that the company has a little over a month’ s sales in stock.
R ETURN ON A SSETS
Return on assets (ROA) is a measure of profit per dollar of assets. It can be defined several
ways, but the most common is:
𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
Return
on
assets
=
𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬
Financial Management Page| 75
Example – Return on Assets (in 2007)
𝟏𝟎𝟐,𝟓𝟎𝟎
= 𝟔. 𝟗%
𝟏,𝟒𝟔𝟔,𝟓𝟎𝟎
This
ratio
measures
how
much
net
income
is
being
generated
by
the
total
assets,
this
simply
means
how
effectively
are
the
assets
being
employed
in
order
to
generate
net
income.
It
is
favourable
if
the
ratio
is
high,
but
the
determining
factor
is
in
which
industry
is
the
business
in.
The
above
ratio
shows
that
for
every
unit
of
assets
dollar,69
cents
of
net
income
is
being
generated.
R ETURN ON E QUITY
This the measure of how much the shareholders fared in a year (Firer et al,2004). This
actually shows how much profit has been generated by the equity invested in an
organisation. The measure is calculated as follows
𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
Return
on
Equity
=
!"#$% !"#$%&
Example
–
Return
on
Assets
(in
2007)
𝟏𝟎𝟐,𝟓𝟎𝟎
= 𝟏𝟎. 𝟓%
𝟗𝟕𝟑,𝟕𝟓𝟎
T RADER DEBTOR COLLECTION PERIOD
The trade debtor collection period measures efficiency of the company in collecting from its
trade debtors. The longer collection period shows that the company takes long to collect
from its debtors, and therefore inefficient. The determination of the length of the collection
period depends of the company’s debtor collection period.
𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐭𝐫𝐚𝐝𝐞 𝐝𝐞𝐛𝐭𝐨𝐫𝐬
Trade debtors collection period = 𝒙 𝟑𝟔𝟓
!"#$%& !"#$!
Example – trade creditor payment period
A
company’s
credit
sales
for
2012
amounted
to
4452
million
and
its
trade
debtors
for
that
year
amounted
to
£394
million.
The
company’s
credit
policy
is
28
days.
𝟑𝟗𝟒
Debt
collection
period
=
𝒙𝟑𝟔𝟓 = 𝟑𝟐. 𝟑𝟎 𝒅𝒂𝒚𝒔
𝟒𝟒𝟓𝟐
Financial Management Page| 76
In this case, the company is not efficient in collecting from its debtors.
Other
sources
(books)
use
average
trade
debtors
instead
of
closing
trade
debtors,
i.e.
!
(Opening
trade
debtors
+
closing
trade
debtors).
!
T RADE CREDITOR PAYMENT PERIOD
Like the debt collection period, the management could be interested in finding out the
number of days it takes to pay out its creditors. Unlike the debt collection period, a longer
payment period (of course, within the credit contract), indicate the efficiency of the firm in
managing its finances. If the ratio goes beyond the agreed credit limit, this would a red flag
to indicate that the company is struggling to meet its obligations to trade creditors.
𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐭𝐫𝐚𝐝𝐞 𝐜𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬
Debt collection period = 𝒙 𝟑𝟔𝟓
!"#$% !"#$%& !"#$%&'('
Example – trade credit payment period
A
company’s
credit
purchases
for
2012
amounted
to
3200
million
and
its
trade
debtors
for
that
year
amounted
to
694
million.
The
credit
terms
given
to
the
company
is
50
days
𝟔𝟗𝟒
Trade
debtor
payment
period
=
𝟑𝟐𝟎𝟎 𝒙𝟑𝟔𝟓 = 𝟕𝟗 𝒅𝒂𝒚𝒔
The
ratio
shows
that
the
company
takes
more
than
2
months
to
meet
its
obligations
to
the
trade
creditors.
Failure
to
meet
credit
payment
terms
could
result
in
loss
of
credit
purchase.
This
could
put
a
strain
on
the
company’s
cash
position
as
the
company
is
required
to
make
cash
purchases.
Note
that,
the
credit
purchases
figure
is
normally
not
provided
in
the
published
accounts.
You
could
calculate
the
cost
of
sales
and
assume
that
the
purchases
were
on
credit
and
also
that
expenses
have
not
been
included
in
the
cost
of
sales,
unless
otherwise
stated,
in
which
case
they
must
be
excluded.
Average
trade
creditors
could
be
used
as
in
the
debtors
collection
period
above.
Financial Management Page| 77
INVESTMENT
RATIOS
The
investment
ratios
are
particularly
of
interest
to
the
investors
as
they
inform
the
investors
of
how
well
their
investment
in
the
company
pays
off.
This
group
of
ratios
covers
earnings
per
share,
price
earnings
and
capital
gearing
ratios.
E ARNINGS PER SHARE
The earnings per share ratio tells the percentage of dividends that are due to the ordinary
share holders after the tax and preference share holders have been paid. The earnings are
compared to the of shares at a point in time. Using the financial statements above, the
earnings per share is calculated as:
𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
Earnings
per
share
=
!"#$%& !" !"#$%&"' !"#$%!
Example – Earnings per share
𝟏𝟒, 𝟏𝟎𝟎, 𝟎𝟎𝟎
= 𝟏𝟒. 𝟏
𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎
P RICE TO EARNINGS RATIO
Share holders can compare earnings per share with their stock market price to see if there
are any gains from their investment. The price to earnings ratio assess the number of times
the market price in the earnings. This is indicative of the number of years it will take the
investor to recover their investment in shares from the earnings. A comparison of the ratio
with other companies would reveal if the investor is worse off investing in the company.
High P/E ratio is indicative of a good future as the shares prices are high and the company
might be able to pay higher dividends in future. The ratio is calculated as:
𝐦𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
Price earnings ratio =
!"#$%$&' !"# !"#$%
C APITAL GEARING RATIO
This ratio examines the extent to which the company is financed on loans (long term loans
and preference shares) relative to share holders funds. The risk associated with financing
the company from high loans is that the company will have to pay high interest and thus
reduce its ability to meet the ordinary share holders’ dividends. The other risk of relying on
high loans to finance the company is that, when the company becomes liquidated, the
Financial Management Page| 78
ordinary share holders can only be paid after all the creditors have been paid. So if the
company is not able to pay its creditors, there is a danger that the shareholders will not be
paid.
𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞𝐬!𝐥𝐨𝐧𝐠!𝐭𝐞𝐫𝐦 𝐥𝐨𝐚𝐧𝐬
Capital gearing ratio =
!"#$% !"#$%&'! !"#$%!!"#$ !"#$ !"#$%
TOPIC
SUMMARY
This
topic
has
taken
you
through
the
analysis
of
financial
statements,
mainly
following
on
the
financial
statement
examples
given
in
the
preceding
topic.
Four
types
of
ratios
have
been
introduced
in
this
topic
and
the
formula
for
calculating
these
ratios
have
been
presented
with
examples.
This
should
enable
you
to
complete
the
topic
reflection
questions
presented
below.
Self-‐Reflection Questions
1. Calculate the appropriate liquidity, profitability, efficiency and investment ratios
for both 2011 and 2012
2.
Comment
on
the
company’s
financial
performance
for
the
year
ended
31st
March
2012
Financial Management Page| 79
Additional information:
1 All sales and all purchases are on credit terms.
2 The opening stock at 1 April 2010 was £20,000.
3 There were no accruals or prepayments at the end of either 2011 or 2012.
4 Assume that both the tax and the dividends had been paid before the end of the year.
Financial Management Page| 80
5 The market price of the ordinary shares at the end of both years was estimated to
be 126p and 297p respectively.
Source: Dyson (2010, pp 233 – 238)
Financial Management Page| 81
TOPIC 3.3 STATEMENT OF CASH FLOWS
TOPIC 3.3 INTRODUCTION
Other
than
the
financial
position
of
the
company,
management
is
also
concerned
with
the
changes
in
the
cash
account
over
time.
The
purpose
of
this
topic
is
to
highlight
the
importance
of
presenting
the
state
of
affairs
of
the
cash
and
cash
equivalents
as
one
of
the
financial
statements
in
a
company.
Because
of
the
high
liquidity
of
cash
and
cash
equivalents,
the
inflow
and
out
flow
of
these
assets
need
to
be
efficiently
managed
to
avoid
paying
out
too
much
cash
that
what
is
coming
in.
TOPIC 3.3 OBJECTIVES
At the end of the topic, the students will be able to:
1. Distinguish the different types of cash flows
2. Prepare a cash flow statement
3. Analyse and interpret the cash flows of a business
CASH FLOWS
Cash
flows
are
a
revenue
or
expense
stream
that
changes
a
cash
account
of
the
business
over
a
given
period.
Figure
8
illustrates
the
cash
flows
of
business.
It
is
important
to
note
that
marketable
securities,
because
of
their
highly
liquid
nature,
are
considered
the
same
as
cash.
Both
cash
and
marketable
securities
represent
a
reservoir
of
liquidity
that
is
increased
by
cash
inflows
and
decreased
by
cash
outflows.
Cash
flows
can
be
divided
into
three
types
(1)
operating,
(2)
investment
and
(3)
financing.
The
operating
flows
are
directly
related
to
sale
and
production
of
the
products
and
services.
Investment
flows
are
associated
with
purchase
and
sale
of
fixed
assets
and
business
interests.
Therefore,
it
is
clear
that
the
purchase
transactions
would
result
in
cash
outflows,
whereas
sales
transactions
would
result
in
cash
inflows.
The
financing
flows
are
a
result
of
debt
and
equity
financing
transactions.
Incurring
or
repaying
debt
would
result
in
a
corresponding
cash
inflow
or
outflow.
Similarly,
cash
inflow
would
be
the
result
of
sale
of
stock;
the
payment
of
cash
dividends
or
repurchase
of
stock
would
result
in
an
outflow.
Financial Management Page| 82
Figure 8: The cash flows of a business
Source: Gitman et al. (2012)
PRESENTATION OF THE C ASH FLOW STATEMENT (IAS 7)
The requirements for the presentation of the cash flow statement is stipulated in the
international accounting standard (IAS) 7. Generally the information for the preparation of
the cash flow statement is drawn from other accounting and financial statements, such as
the manufacturing account, the trading account, the profit and loss account, the profit and
loss appropriation account and the balance sheet.
Figure
9
shows
that
the
cash
flow
statement
utilises
information
from
seven
sources
in
the
financial
statements.
First,
manufacturing
cost
paid
from
the
manufacturing
account.
Secondly,
cash
received
from
customers
and
cash
paid
to
suppliers
from
the
trading
account.
Thirdly,
information
on
other
cash
and
receipts
and
payments
from
the
profit
and
loss
account.
Fourthly,
information
on
tax
paid
and
dividends
paid
from
the
profit
and
loss
appropriation
account.
Fifthly,
information
on
cash,
bank
balances,
capital
expenditure
and
capital
income
from
the
balance
sheet
statement.
Financial Management Page| 83
Figure 9:The interrelationship between cash flow statement and other financial statements
Source: Dyson (2010)
Given
the
diverse
sources
of
information
for
preparation
of
the
cash
flow
statement,
the
statement
could
be
prepared
by
using
either
direct
or
indirect
or
indirect
methods.
On
one
hand,
the
direct
method
summarises
all
the
cash
book
entries.
On
the
other
hand
indirect
method
uses
information
from
the
profit
and
loss
and
the
balance
sheet
accounts.
Dyson
(2010)
gives
succinct
examples
on
this
two
methods,
which
we
will
use
to
illustrate
the
difference
between
the
two
methods.
Table 7: Example for direct method
Financial Management Page| 84
Source: Dyson (2010, pp 148 – 149)
Financial Management Page| 85
Table 8: Example for indirect method
Financial Management Page| 86
Source: Dyson (2010, pp 151 – 152)
ANALYZING THE CASH FLOW OF A BUSINESS
Cash flow is the primary focus of the financial manager both in managing finances and in
planning and decision making aimed at value creation of business. Important factors
affecting cash flow are any non-‐cash charges e.g. depreciation. From an accounting
perspective, cash flows of a business can be summarized in the statement of cash flows.
Whereas, from a financial perspective, business often focus on both operating cash flow,
and free cash flow. Operating cash flow is used in managerial decision making and free cash
flow is closely watched by investors and other parties. In accounting terms, operating cash
flow can be defined as:
Operating Cash flow = Net profits after taxes+ Depreciation and other noncash charges
Or
OCF = NPAT + Depreciation and other noncash charges
Financial Management Page| 87
I NTERPRETATION OF C ASH FLOW S TATEMENT
The statement of cash flows allows the financial manager and other interested
parties to analyze the firm’s cash flow. The major categories of cash flow and the
individual items of cash inflow and outflow needs special attention to assess
whether any developments have occurred are in line with company’s financial
policies. In addition, the statement can be used to evaluate progress toward
planned goals or to check inefficiencies. For example, the increase in account
receivable and inventory results in major cash out flows, and credit or inventory
problems may be singled with this respectively. Using projected financial
statements, the financial manager can also develop a projected statement of cash
flows. This approach can be used to determine whether planned actions are
desirable in view of the resulting cash flows. An understanding of the basic financial
principles is extremely essential to the effective interpretation of the statement of
cash flows.
O PERATING C ASH F LOW
Operating cash flow (OCF) of a business is generated by its normal operations of
producing and selling its output of goods or services. A variety of definitions of OCF
can be found in the financial literature. Equation introduced the simple accounting
definition of cash flow from operations. Here we refine this definition to estimate
cash flows more accurately. Unlike the earlier definition, this one excludes interest
and taxes in order to focus on the true cash flow resulting from operations without
regard to financing costs and taxes. Operating cash flow (OCF) .in financial
management terms it is defined in following equation:
Operating Cash flow = Earning before interests and taxes -‐ Taxes+ Depreciation
Or
OCF = EBIT –Taxes + Depreciation
Financial Management Page| 88
Comparing the two Equations reveal that the major difference between the
accounting and finance definitions of operating cash flow is that the finance
definition excludes interest as an operating flow, whereas the accounting definition
in effect includes it. In the unlikely case that a firm had no interest expense, the
accounting and finance definitions of operating cash flow would be the same.
F REE C ASH F LOW
The free cash flow (FCF) of a business is the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after the firm has
met all operating needs and paid for investments in net fixed assets and net current
assets. Free cash flow can be defined in equation form as:
Free
cash
flow
=
Operating
Cash
Flow
-‐Net
fixed
asset
investment
-‐
Net
current
asset
investment
Or
FCF = OCF – NFAI -‐ NCAI
The net fixed asset investment can be calculated as follows:
net fixed asset investment (NFAI) = Change in net fixed assets +Depreciation
Further
analysis
of
free
cash
flow
is
beyond
the
scope
of
this
introductory
course.
Clearly,
cash
flow
is
the
lifeblood
of
the
business.
SUMMARY
This
topic
had
set
out
to
introduce
you
to
the
statement
of
cash
flows.
Specifically
the
different
types
of
cash
flows
have
been
explained.
The
two
methods
used
to
present
the
cash
flow
statement
have
been
presented
and
examples
given
for
each
method.
Financial Management Page| 89
Self-‐Reflection Questions
1. What are the 3 types of cash flows
2. Explain
the
differences
and
similarities
between
the
methods
of
preparing
a
cash
flow
statement
UNIT 3 REFERENCES
1. International Accounting Standards Board (2009) Presentation of Financial
statements in http://www.iasplus.com/en/standards/standard5 accessed 23rd
April 2013
2. Subramanyam, K.R. and Wild John. J (2009) Financial Statement analysis, 10TH Edition
McGraw-‐Hill Irwin, New York. –in http://highered.mcgraw-‐
hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf
accessed 23/04/2013
3. Dyson, John R. (2010) Accounting for non accounting Students. Pearson Education
Limited. Harlow. In http://web.kku.ac.th/chrira/Non%20Acct.%20Dyson.pdf accessed
26/04/2013
4. IFRS (2012) Illustrative Financial Statements. KPMG. In
http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/IFRS-‐
illustrative-‐financial-‐statements/Documents/IFRS-‐illustrative-‐financial-‐statements-‐
2012.pdf accessed 29/04/2013
5. Stolowy, H. And Lebas, Michel J. (2002) Corporate Financial Reporting – A Global
Perspective. Thomson Learning. London. – Chapters 2 and 3
6. Subramanyam, K.R. and Wild John. J (2009) Financial Statement analysis, 10TH Edition
McGraw-‐Hill Irwin, New York. – Chapter 1 in http://highered.mcgraw-‐
hill.com/sites/dl/free/0073379433/597452/Subramanyam_fsa_sample_Ch01.pdf
accessed 23/04/2013
7. http://studentweb.usq.edu.au/home/W0054016/Pages/Financial_Acct_Folder/Exampl
e_Comprehensive_Income_Statement.htm
Financial Management Page| 90
UNIT 3 -‐ SUMMARY
ASSIGNMENTS AND ACTIVITIES
The end of topic assignment is to be developed by the participating institutions to assess
student learning for this unit. Generally the students should be required to demonstrate
their understanding of the nature of financial statements, as well as to show that they could
competently analyse and interpret the various financial statements covered in this unit.
SUMMARY
This
unit
has
covered
topics
that
will
enable
you
to
present
and
analyse
three
important
financial
statements,
namely;
the
statement
of
comprehensive
income,
statement
of
financial
position
and
the
statement
of
cash
flows.
Examples
have
been
provided,
where
feasible
to
enable
you
to
internalise
the
various
topics.
The
reflective
questions
at
the
end
of
each
topic
are
designed
to
consolidate
the
student
learning.
Having
gone
through
this
material,
you
should
therefore
be
well
equipped
to
tackle
the
end
of
unit
assignment.
NEXT STEPS
Now
that
you
have
acquired
skills
and
knowledge
of
analysis
of
the
financial
statements,
the
next
unit
takes
you
a
step
further
by
introducing
you
to
the
financial
planning
process.
Financial Management Page| 91
UNIT FOUR -‐ FINANCIAL PLANNING
UNIT 4 INTRODUCTION
Financial
planning
is
an
important
aspect
because
it
provides
road
maps
for
guiding,
coordinating
and
controlling
the
actions
to
achieve
the
objectives
of
the
business.
Major
aspects
of
the
financial
planning
process
are
cash
planning
and
profit
planning.
Cash
planning
involves
preparation
of
the
cash
budget
whereas,
profit
planning
involves
preparation
of
pro
forma
statements.
The
cash
budget
and
the
pro
forma
statements
are
useful
for
internal
financial
planning
as
well
as
they
are
routinely
required
by
present
and
future
lenders.
Long-‐term,
or
strategic,
financial
plans
are
the
starting
point
of
the
financial
planning
process.
The
strategic
plans
in
turn
help
in
the
formulation
of
short-‐term,
or
operating,
plans
and
budgets.
Generally,
the
short-‐term
plans
and
budgets
implement
the
long
term
strategic
objectives
of
a
business.
UNIT 4 OBJECTIVES
Upon completion of this unit you will be able to:
1. Understand the process of financial planning, including strategic financial plans
(long-‐term plans) and operating financial plans (short-‐term plans).
2. Discuss the process of cash planning and the preparation, evaluation and use of the
cash budget.
3. Explain the simplified procedures used to prepare and evaluate the pro forma
financial statements.
4. Identify the limitations of the simplified approaches to the preparation of pro forma
financial statement and the common uses of these statements.
UNIT 4 READINGS
To complete this unit, you are required to read the following chapters:
Gitman et al. (2012 or 2002), chapters 14 and 15
UNIT 4 ASSIGNMENTS AND ACTIVITIES
Self-‐reflection
questions
are
given
at
the
end
of
each
topic.
Guidance
on
a
comprehensive
assignment
for
the
unit
will
be
provided
by
the
instructor.
Financial Management Page| 92
TOPIC 4.1 – INTRODUCTION TO FINANCIAL PLANNING
TOPIC 4.1 INTRODUCTION
Financial planning is an important aspect because it acts as a guide to achieve the key
objectives of the business. Cash planning and profit planning are the two major aspects of
the financial planning process. There are two main types of a financial plan which include
the strategic plans and the operating plans. Strategic (Long-‐term) financial plans act as a
guide for preparing short-‐term (operating) financial plans and tend to cover periods ranging
from 2 to 10 years and are updated periodically. On the other hand the operational plans
most often cover a 1 to 2 year period.
TOPIC 4.1 OBJECTIVES
Upon completion of this topic you will be able to:
1. Understand the nature of financial planning process.
2. Identify the nature of including strategic financial plans (long-‐term plans) and
operating financial plans (short-‐term plans).
STRATEGIC FINANCIAL PLANS
Strategic (Long-‐term) financial plans includes the planned financial actions and the
expected impact of those actions over periods ranging from 2 to 10 years. Five-‐year
strategic plans are also very common and they are revised as significant new information
becomes available. Generally, businesses with high degrees of operating uncertainty,
relatively short production cycles, or both, are likely to use shorter planning horizons.
Long-‐term
financial
plans
are
part
of
an
integrated
strategy
which
includes
production
and
marketing
plans,
and
guides
the
businesses
toward
strategic
goals.
Those
long-‐term
plans
consider
proposed
expenditure
for
fixed
assets,
research
and
development,
marketing
and
product
development,
capital
structure,
and
major
sources
of
financing.
It
also
includes
termination
of
any
existing
projects,
product
lines,
or
lines
of
business;
repayment
or
retirement
of
outstanding
debts;
and
any
planned
acquisitions.
Such
plans
needs
to
be
supported
by
a
sequence
of
annual
budgets
and
profit
plans.
OPERATING FINANCIAL PLANS
Operating(Short-‐term)
financial
plans
indicate
short-‐term
financial
actions
and
the
expected
impact
of
those
actions
over
1
to
2
year
period.
Key
information
required
to
prepare
the
operating
financial
plan
is
the
sales
forecast
and
various
forms
of
operating
and
financial
data.
Examples
of
short
term
financial
plans
which
are
also
known
as
the
output
of
the
process
are
the
operating
budgets,
the
cash
budget,
and
pro
forma
financial
statements.
The
short
term
financial
planning
process
is
depicted
in
the
Figure.
sales
forecast
is
the
starting
point
of
the
process
of
short-‐term
financial
planning.
Next,
production
plans
are
Financial Management Page| 93
developed that considers the production times and include estimates of the required raw
materials. Based on production plans, the firm can easily estimate direct labour
requirements, factory overhead, and operating expenses. Next, the firm’s pro forma
income statement and cash budget can be prepared and finally, the pro forma balance
sheet can be developed.
Figure 10: Short term Financial Planning process
Sales Information needed
Forecast Output for Analysis
Long-‐Term
Production
Financing
Plans
Plans
Forecast
Pro-‐forma Cash Fixed Asset
Income Budget Outlay plan
Statement
Current-‐Period
Balance Sheet
Pro-‐forma
Balance
Sheet
Source: Gitman et al. (2012)
SUMMARY
Strategic
plans
and
the
operating
plans
are
the
two
major
types
of
financial
plan.
Strategic
(long-‐term)
financial
plans
are
a
guide
for
preparing
operating
(short-‐term)
financial
plans.
Long-‐term
plans
are
likely
to
cover
periods
ranging
from
2
to
10
years
and
are
always
updated
periodically.
Whereas,
short-‐term
plans
cover
a
1
to
2
year
period.
Self-‐Reflection Questions
1.
What
is
the
financial
planning
process?
Contrast
strategic
(long-‐term)
financial
plans
and
operating
(short-‐term)
financial
plans.
2.
Which
three
statements
result
as
part
of
the
operating
(short-‐term)
financial
planning
process?
Financial Management Page| 94
TOPIC 4.2 -‐ CASH BUDGETS FOR CASH PLANNING
TOPIC 4.2 INTRODUCTION
Cash budget are based on a sales forecast and are used in the process of cash planning to
estimate short term cash surpluses and shortages. Usually, the cash budgets are prepared
for a period covering 1 year and is further divided into months. The two major components
of a cash budgets are the net cash receipts and the net cash disbursements.
TOPIC 4.2 OBJECTIVES
Upon completion of this topic you will be able to:
1. Discuss the process of cash planning.
2. Prepare, evaluate and use the cash budget.
WHAT IS A CASH BUDGET
The
cash
budget,
also
known
as
cash
forecast,
is
a
statement
of
planned
inflows
and
outflows
of
cash
of
a
business.
It
is
used
to
estimate
short-‐term
cash
requirements
of
a
business,
with
particular
attention
to
planning
for
surplus
cash
and
for
cash
shortages.
Usually,
the
cash
budget
covers
a
1-‐year
period
and
it
is
divided
into
smaller
time
intervals.
The
number
and
type
of
intervals
are
decided
on
the
basis
of
nature
of
the
business.
If
the
business
is
seasonal
and
has
uncertain
cash
flows
the
number
of
intervals
are
greater.
Because
many
businesses
have
a
seasonal
cash
flow
pattern,
the
cash
budget
is
often
presented
on
a
monthly
basis.
On
the
other
hand,
businesses
with
established
and
stable
patterns
of
cash
flow
prefers
to
use
quarterly
or
annual
time
intervals.
THE SALES FORECAST
The
important
input
to
the
process
of
short-‐term
financial
planning
is
the
sales
forecast
of
a
business.
marketing
department
is
responsible
for
predicting
the
sales
over
a
given
period.
Based
on
the
sales
forecast,
the
financial
manager
then
estimates
the
cash
flows
that
will
result
from
forecasted
sales
receipts
and
from
cost
related
to
production,
inventory,
and
sales.
Financial
manager
is
also
responsible
to
determine
the
level
of
fixed
assets
required
and
the
amount
of
financing,
if
any,
needed
to
support
the
forecasted
sales
and
production.
In
practice,
the
most
challenging
aspect
of
forecasting
is
to
obtain
high-‐quality
data.
An
analysis
of
external
data,
internal
data,
or
a
combination
of
the
two
may
be
the
basis
of
sales.
The
observation
of
relationships
between
the
sales
of
a
business
and
some
key
external
economic
indicators
such
as
the
gross
domestic
product,
disposable
personal
income,
and
consumer
confidence
are
the
basis
of
an
external
forecast.
Forecasts
containing
these
indicators
are
easily
available
and
a
forecast
of
economic
activity
should
help
in
predicting
Financial Management Page| 95
future sales of the business because sales of the business are often closely related to some
characteristics of overall national economic activity.
Internal
forecasts
are
based
on
a
build
up
of
sales
forecasts
through
the
sales
channels
of
the
business.
Usually,
the
salespeople
of
the
business
in
the
field
are
asked
to
estimate
the
number
of
units
of
each
product
the
business
expect
to
sell
in
the
given
time
in
future.
The
sales
manager
then
collect
and
total
the
forecasts
and
may
adjust
the
figures
by
utilizing
the
knowledge
of
specific
markets
or
the
forecasting
abilities
of
salespersons.
Based
on
this
adjustments
for
additional
internal
factors
such
as
production
capabilities
may
be
made.
the
final
sales
forecast
of
the
businesses
are
typically
made
by
combining
the
external
and
internal
forecast
data.
The
internal
data
provide
information
about
future
sales
expectations
whereas,
the
external
data
offer
ways
to
adjust
the
sale
expectations
by
taking
into
account
general
economic
conditions.
The
nature
of
the
product,
a
business
offers,
also
often
affects
the
combination
and
types
of
forecasting
methods
to
be
used.
PREPARING THE CASH BUDGET
The
common
format
of
the
cash
budget
is
presented
below.
The
individual
discussion
of
each
of
the
components
of
cash
budgets
is
as
follows.
Table 9: Cash budget format
Financial Management Page| 96
CASH RECEIPTS
Total
inflows
of
cash
of
a
business
in
a
given
financial
period
is
regarded
as
Cash
receipts.
The
common
examples
of
cash
receipts
are
cash
based
sales,
collections
of
accounts
receivable
and
other
receipts
of
cash.
Financial Management Page| 97
Example –Cash Receipts
Mere Limited is developing a cash budget for January, February and March. Sales of
Mere Limited in November and December were200, 000 and 400,000 respectively.
Sales of 800, 000; 600, 000 and400, 000 have been forecast for January, February and
March respectively. Historically, 20% of the sales were on cash basis, 50% were on
credit basis (accounts receivable collected after 1 month) and the remaining 30% were
on credit basis as well (accounts receivable collected after 2 months). Bad-‐debt (the
uncollectible accounts) have been negligible. During the m onth of March, the business
will receive a 60, 000 dividend from stock in one of its subsidiary. The schedule of
expected cash receipts of the business is presented in Table:
• Forecast
sales:
provided
as
an
aid
in
calculating
other
sales-‐related
items.
• Cash
sales:
represent
20%
of
the
total
sales
forecast
of
the
business
for
that
month.
• Collections
of
Account
Receivables:
represent
the
collection
resulting
from
sales
in
earlier
months.
• Lagged
1
month:
represent
the
sales
made
in
the
preceding
month
and
generated
accounts
receivable
which
are
collected
in
the
current
month.
(50%
of
the
current
month’s
sales
are
collected
in
the
next
month).
• Lagged
2
months:
represent
the
sales
of
the
business
made
2
months
earlier
and
generated
accounts
receivable
(30%
of
sales
are
collected
2
months
later).
• Other
cash
receipts:
receipts
expected
from
sources
other
than
sales
e.g.
interest,
dividends
received,
sale
of
equipment,
stock
and
bond
sale
proceeds
and
lease
receipts.
For
Mere
Limited,
the
only
other
cash
receipt
is
the
60,000
dividend
due
in
December.
• Total
cash
receipts:
represents
the
total
of
all
cash
receipts
listed
for
each
month.
For
Mere
Limited,
we
are
concerned
only
with
January,
February
and
March
as
shown
in
the
Table.
Financial Management Page| 98
CASH
DISBURSEMENTS
Total
outflow
of
cash
of
a
business
during
a
given
financial
period
is
known
as
cash
disbursement.
The
most
common
cash
disbursements
are
Cash
based
purchases,
outlays
of
fixed-‐asset,
Payments
of
accounts
payable,
payments
of
Interest,
payments
of
Rent
and
lease,
payments
of
Cash
dividend,
payments
of
Wages
and
salaries,
payments
of
Principal
loans
,
payments
of
Tax,
etc.
It
is
essential
to
identify
that
depreciation,
a
non
cash
expense
and
other
noncash
charges
cannot
be
included
in
the
cash
budget,
because
they
represent
a
scheduled
write-‐off
of
cash
outflow
occurred
earlier.
The
reduced
cash
outflow
for
tax
payments
reflects
the
impact
of
depreciation.
Example – Cash Disbursements
Mere
Limited
has
collected
the
following
data
for
the
preparation
of
a
cash
disbursements
schedule
for
January,
F ebruary
and
M arch.
1. Purchases
of
the
business
represent
70%
of
sales.
Out
of
this
amount,
10%
is
paid
in
cash,
70%
is
paid
in
the
month
immediately
following
the
month
of
purchase,
and
the
remaining
20%
is
paid
2
months
following
the
month
of
purchase.
2. Each
month
10,000
of
Rent
will
be
paid.
3. Cost
of
fixed
salary
for
the
year
is
192,000
or
16,000
per
month.
And
10%
of
monthly
sales
are
estimated
as
wages.
4. Taxes
of
50,000
must
be
paid
in
December.
5. New
machinery
costing
260,000
will
be
purchased
and
paid
for
in
February.
6. Interest
payment
of
20,000
is
due
in
March.
7. Cash
dividends
of
40,000
will
be
paid
in
Jan.
8. 40,000
principal
payment
(Loan)
is
due
in
March.
9. No
repurchase
or
retirement
of
stock
is
expected
between
January
and
March.
The
cash
disbursements
schedule
of
the
business,
using
collected
data,
is
shown
below.
Financial Management Page| 99
• Purchases: represent 70% of the forecast sales for each month and provided to
facilitate calculation of the cash purchases and related payments.
• Cash purchases: represent 10% of the a m onth’s total purchases.
• Payments of Accounts Payable: represent the payment of accounts payable as a
result of purchases in earlier months.
• Lagged 1 month: represent purchases made in the preceding months, which are
paid for in the current month (70% of the purchases are paid 1 month later).
• Lagged 2 months: represent the purchases made 2 m onths earlier that are paid for
in the current month (20% of the purchases are paid for 2 months later).
• Wages and salaries: obtained by adding 16,000 to10% of the sales in each month.
The 16,000 represents the salary component and the remaining amount represents
wages.
• Rest of the items on the schedule of cash disbursements are self-‐explanatory.
NET CASH FLOW , ENDING CASH, FINANCING AND EXCESS CASH
Looking back at the typical format of cash budget in Table above, we can now input the first
two entries, and can continue calculating the cash needs of the business. The net cash flow
can be calculated by taking out the difference cash disbursements from cash receipts for
each period. Next, we can add beginning cash balance to the net cash flow of the business
to figure out the ending cash in each period. Finally, by subtracting the minimum desired
balance of cash from ending cash balance to determine the total financing required or the
excess balance of cash. Financing is required, in case the ending cash balance is less than
the desired minimum cash balance. This type of financing is represented by notes payable
because generally it is considered as short-‐term financing. In case the ending cash is greater
than the desired minimum balance of cash, excess cash exists. Any available excess cash is
to be invested in a short-‐term, highly liquid, interest-‐paying instrument e.g. marketable
securities.
Example
–Cash
Budget
The
cash
budget
of
Mere
Limited
is
presented,
based
on
the
data
already
developed.
At
the
end
of
December,
cash
balance
of
Mere
Limited
was
100,000,
and
its
notes
payable
and
marketable
securities
equalled
0.
As
a
reserve
for
unexpected
needs,
the
business
plans
to
maintain
a
minimum
cash
balance
of
50,000.
Financial Management Page|
100
EVALUATING THE CASH BUDGET
The cash budget specifies the expected cash shortage or surplus in each of the months or
interval covered by the forecast. The figure for each month or interval is based on the
required internal requirement of a minimum cash balance and it represents the total
available cash balance at the end of the month or interval.
At
the
end
of
every
3
months,
Mere
Ltd
expects
the
following
balances
of
cash,
marketable
securities
and
notes
payable:
The
important
point
to
note
here
is
that
the
business
has
assumed
to
liquidate
its
marketable
securities
in
first
place
to
meet
deficits
and
then
if
additional
financing
is
needed
it
can
borrow
with
notes
payable.
As
a
result
of
this
assumption,
it
will
not
be
possible
for
the
business
to
have
marketable
securities
and
notes
payable
on
its
books
present
at
the
same
time.
In
the
case
above,
where
during
the
3
months
interval,
up
to
152,000
may
become
necessary
to
borrow
therefore,
the
financial
manager
should
be
aware
of
the
fact
that
some
arrangement
is
to
be
made
to
ensure
the
availability
of
these
funds.
MANAGING THE UNCERTAINTY IN THE CASH BUDGET
In addition to the careful estimation of inputs of cash budget, there are two more ways of
dealing with the uncertainty of the cash budget. One way is to prepare a range cash budget
based on three types of forecasts that is pessimistic, most likely, and optimistic. The
optimistic to pessimistic range of cash flows makes it possible for the financial manager to
determine the amount of financing required to cover the most adverse situation. By using
the several cash budgets, based on differing assumptions, can help the financial manager to
develop a sense of understanding of the riskiness of various alternatives. The analysis of the
riskiness of various alternatives is known as the sensitivity analysis and is often used to
analyze cash flows under a various circumstances. Various software packages simplify the
process of actually performing sensitivity analysis.
Financial Management Page| 101
Another and much more sophisticated way of dealing with uncertainty of the cash budget is
simulation. Simulation of the occurrence of sales and other uncertain events, a probability
distribution of ending cash flows of the business for each month can be developed. The
financial manager can use the developed probability distribution in order to determine the
amount of financing needed to safeguard the firm in case of cash shortage. Further detail
about the sensitivity analysis and the simulation is beyond the scope of this introductory
course.
SUMMARY
To
estimate
short
term
cash
surpluses
and
shortages,
the
cash
planning
process
is
used.
Cash
planning
process
rely
on
the
cash
budget
and
on
a
sales
forecast.
The
cash
budget
is
commonly
prepared
for
a
one
year
period
and
it
is
further
divided
into
months.
It
includes
cash
receipts
and
disbursements
for
each
period
to
estimate
net
cash
flow.
Adding
beginning
cash
to
the
net
cash
flow
gives
the
estimate
the
ending
cash.
The
financial
manager
can
determine
total
required
financing
by
subtracting
the
desired
minimum
cash
balance
from
the
ending
cash
or
the
excess
cash
balance.
Either
sensitivity
analysis
or
simulation
can
be
used
to
cope
with
uncertainty
in
the
cash
budget.
Self-‐Reflection Questions
1.
What
is
the
purpose
of
the
cash
budget?
What
role
does
the
sales
forecast
play
in
the
preparation
of
a
cash
budget?
2. Describe briefly the basic format of the cash budget.
3.
How
can
the
financial
manager
use
the
two
bottom
lines
of
the
cash
budget
to
determine
the
short-‐term
borrowing
and
investment
requirements
of
a
business?
4.
What
is
the
major
cause
of
uncertainty
in
the
cash
budget,
and
what
techniques
can
be
used
to
cope
with
this
uncertainty?
Financial Management Page| 102
TOPIC
4.3
PRO
FORMA
FINANCIAL
STATEMENTS:
A
TOOL
FOR
PROFIT
PLANNING
TOPIC
4.3
INTRODUCTION
As
part
of
the
process
of
generating
positive
cash
flow,
the
financial
manager
uses
tools
such
pro
forma
financial
statements.
This
tool
is
used
with
an
aim
to
carry
out
the
responsibility
to
create
value
for
owners
of
the
business.
A
pro
forma
income
statement
rely
on
past
percentage
relationships
between
certain
cost,
expense
items
and
the
sales
of
the
business.
For
a
pro
forma
balance
sheet
values
of
some
accounts
are
estimated
and
some
are
calculated
on
the
basis
of
their
relationship
to
sales.
Pro
forma
statements
aid
to
achieve
short-‐term
financial
goals
of
a
business
because
they
are
generally
used
to
forecast
and
analyze
the
profitability
level
and
overall
financial
performance
of
the
business
so
that
the
adjustments
can
be
made
to
planned
operations.
TOPIC 4.3 OBJECTIVES
Upon completion of this topic you will be able to:
1. Explain
the
simplified
procedures
used
to
prepare
and
evaluate
the
pro
forma
income
statement
and
the
pro
forma
balance
sheet.
2. Identify
the
weaknesses
of
the
simplified
approaches
to
the
preparation
of
pro
forma
financial
statement.
3. Identify
the
common
uses
of
pro
forma
statements.
PRO FORMA FINANCIAL STATEMENTS
In cash planning process the focus is on forecasting cash flows, whereas, the focus is on
accrual concepts in profit planning process to estimate the profit and overall financial
position of the business. All Stakeholders, of the business pay close attention to the pro-‐
forma statements. Pro-‐forma statements are the projected, or forecasted, income
statements and balance sheets. There are various approaches for estimating the pro forma
statements which are based on the belief that the financial relationships reflected in the
past financial statements of the business will not change in the coming period. The most
common and simplified approaches of preparing the pro-‐forma statements are presented
in this text.
Two
major
inputs
required
for
preparing
pro
forma
statements
are:
(1)
financial
statements
of
the
business
for
the
preceding
year
and
(2)
the
sales
forecast
of
the
business
for
the
coming
year.
A
variety
of
other
assumptions
must
also
be
made
for
preparing
the
pro-‐forma
statements.
PRECEDING YEAR’S FINANCIAL STATEMENTS
The business we will use to illustrate the simplified approaches to pro forma preparation is
XYZ Manufacturing, which manufactures and sells only one product. The income statement
for the business operations is given in Table. It indicates that the business had total sales of
200,000, total cost of goods sold of 160,000, profits before taxes of 18,000, and after taxes
net profits of 15,300. 8,000 were paid in cash dividends, leaving 7,300 to be transferred to
retained earnings.
The following is the balance sheet of the business for the same year.
Financial Management Page| 103
Financial Management Page| 104
SALES
FORECAST
Similar
to
the
cash
budget,
the
major
input
for
preparing
pro
forma
statements
is
the
sales
forecast.
sales
forecast
developed
on
the
basis
of
internal
and
external
data
for
the
coming
year
of
XYZ
Manufacturing,
is
presented
in
Table.
The
unit
sale
prices
of
the
products
reflect
an
increase
from
40
to
50
This
increase
is
required
to
cover
the
anticipated
increase
in
cost
of
the
product.
PREPARING THE PRO FORMA STATEMENTS
PRO FORMA INCOME STATEMENT
Percent of sales method is a simple method for developing the pro forma income
statement. It forecasts the sales of the business and then expresses all income statement
items as percentages of forecasted sales. By using dollar values available in XYZ
manufacturing 2012 income statement, we can calculate the following percentages:
By
applying
these
calculated
percentages
to
the
forecasted
sales
of
the
XYZ
manufacturing
(270,000)
we
can
prepare
the
pro
forma
income
statement
2013.
We
ignore
any
common
stock
dividend
for
the
year
2013.The
pro
forma
income
stamen
is
shown
below.
Financial Management Page| 105
TYPES OF COSTS AND EXPENSE CONSIDERATION
The pro forma income statement in Table is prepared under assumption that all the costs
and expense of the business are variable. It assumes that for a given percentage change in
the sales of the business will result in the same percentage change in the cost of goods sold,
operating expenses and interest expense. The assumption would result in the same
percentage change in the Net profit of the business. We know that the fixed costs of the
business do not change when sales increase but the result of increased sales is the
increased profit and vice versa. This approach of preparing the pro forma income statement
implies that the business will not be able to utilize benefits of fixed costs that result from
increased sales.
The
best
approach
to
deal
with
this
to
identify
the
fixed
and
variable
elements
in
the
historical
cost
of
the
business.
In
table,
a
new
pro
forma
income
statement
has
been
developed
by
taking
into
account
the
fixed
and
variable
elements
of
the
costs
of
the
XYZ
Manufacturing.
PRO FORMA BALANCE SHEET
The simple approach to prepare the pro forma balance sheet is judgmental approach.
Under this method the values of some specific balance sheet accounts are estimated and
the external financing of the business is used as a balancing figure for balancing the
Performa balance sheet. To apply the judgmental approach to prepare pro forma balance
sheet of XYZ Manufacturing for the year 2013, a number of assumptions are required to be
made about a number of balance sheet accounts. These assumptions are as follows:
Financial Management Page| 106
A
pro
forma
balance
sheet
for
XYZ
manufacturing
for
the
year
2013
is
presented
in
the
table.
The
external
financing
of
16,586
is
required
to
balance
the
pro
forma
balance
sheet.
Requirement
of
external
financing
means
that
the
business
will
have
to
acquire
these
funds
in
order
to
support
the
increased
level
of
sales
for
coming
year.
Financial Management Page| 107
A
positive
value
of
required
external
financing
means
that
the
business
must
raise
funds
externally
using
any
form
of
financing
e.g.
debt
and/or
equity
financing
or
by
reducing
dividends
in
case
of
public
limited
company.
The
form
of
financing
is
then
decided
and
eventually,
the
pro
forma
balance
sheet
is
modified
to
replace
“required
external
financing”
with
the
planned
increases
in
the
debt
and/or
equity
accounts.
On
the
other
hand,
a
negative
value
for
“required
external
financing”
indicates
that
the
forecasted
financing
of
the
business
is
in
excess
of
its
requirement.
In
this
case,
available
funds
are
used
in
repayment
of
debt,
repurchasing
stock
or
increasing
dividends
(in
case
of
public
limited
company).
“Required
external
financing”
is
replaced
in
the
pro
forma
balance
sheet
of
the
business
with
the
planned
reductions
in
the
debt
and/or
equity
accounts,
once
the
business
determines
the
specific
action.
This
implies
that
the
judgmental
approach
can
not
only
be
used
to
prepare
the
pro
forma
balance
sheet
but
also
can
be
frequently
used
specifically
to
estimate
the
financing
requirements
of
the
business.
Financial Management Page| 108
EVALUATING THE PRO FORMA STATEMENTS
It is not easy to forecast the several variables involved in preparation of pro forma
statements. As a result, stakeholders, that is -‐ investors, lenders and managers frequently
use the techniques discussed above to make rough estimates and prepare the pro forma
financial statements. However, it is essential to be familiar with the basic weaknesses of
these simple approaches. The two assumptions to prepare the pro forma statements are
responsible for the weakness. First assumption is that the firm’s past financial condition is
an accurate indicator of its future, which is not always the case, and the second assumption
that some variables such as cash balance, accounts receivable and inventories can be
forced to take on desired values. One cannot justify these assumptions solely on the basis
of simplicity involved in calculations. However, the simplified approaches to pro forma
statement preparations are expected to remain popular , regardless of their weaknesses,
because of their simplicity. Sooner or later, the use of computer programmes to streamline
financial planning will become the standard. Regardless of the technique used to prepare
pro forma statements, the analysts must have understanding on how to use them to make
financial decisions. Pro forma statements can be used by both financial managers and
lenders to analyze the cash inflows and outflows of the business, as well as the liquidity,
activity, level of debt, profitability, and market value of the business. A variety of ratios can
be calculated from the pro forma financial statements(income statement and balance
sheet) to evaluate performance of the business. Inflows and outflows of cash can also be
evaluated by preparing a pro forma statement of cash flows. After analyzing the pro forma
financial statements, the financial manager can adjust planned operations by taking
effective steps to achieve short term financial goals. For example, if anticipated profits on
the pro forma income statement are very low, various pricing and/or cost-‐cutting actions
might be initiated. If the anticipated level of accounts receivable on the pro forma balance
sheet is very high, changes in credit or collection policy may be desired. Therefore, pro-‐
forma statements play an important role in solidifying the financial plans of the business
for the future.
TOPIC 4. SUMMARY
A pro-‐forma income statement can be developed by calculating past percentage
relationships between the sales of a business and certain cost and expense items. These
percentages are then applied to forecasts. This approach tends to understate profits when
sales are increasing and to overstate profits when sales are decreasing because this
approach implies that all costs and expenses are variable. By breaking down costs and
expenses into fixed and variable components, it is possible to avoid this problem. This way,
the fixed components remain unchanged from the most recent year, and the variable costs
and expenses are forecast on a percent of sales basis.
For
preparing
pro
forma
Balance
sheet
using
the
judgmental
approach,
the
values
of
certain
accounts
are
estimated
and
others
are
calculated,
commonly
on
the
basis
of
their
relationship
to
sales.
The
external
financing
of
a
business
is
used
as
a
balancing
figure.
A
positive
figure
of
‘external
financing
required’
indicates
that
the
business
must
raise
funds
externally
or
reduce
dividends
in
case
of
public
limited
firms.
Whereas,
a
negative
figure
means
that
funds
are
available
for
use
in
repaying
debt,
repurchasing
stock
or
increasing
dividends.
Financial Management Page| 109
Although popular approaches used for preparing pro-‐forma statements can be criticized but
simple approaches are more criticized because they rely on the assumption that the past
financial condition of a business is an accurate indicator of the future and that certain
variables can be forced to take on certain desired values. Pro forma statements are
commonly used to forecast and analyze the level of profitability and overall financial
performance of a business in order to make adjustments in planned operations to achieve
short-‐term financial goals.
Self-‐Reflection Questions
1.
What
are
the
two
major
weaknesses
of
the
simplified
approaches
to
preparing
pro
forma
statements?
2. What is the objective of financial manager in evaluating pro forma statements?
UNIT
4
–
REFERENCES
Brealey,
R.A;
Myers,
S.C;
Allen,
F.(2006)
Principles
of
corporate
finance,
6th
ed.
dandelon.com
Gitman,
Lawrence
J.
And
Chad
J.
Zutter
(2012)
Principles
of
managerial
finance,
13th
ed.
p.
cm.
The
Prentice
Hall
Gitman,
Lawrence
J.
(2002)
Principles
of
managerial
finance,
10th
ed.
p.
cm.
The
Prentice
Hall
UNIT
4
–
SUMMARY
ASSIGNMENTS
AND
ACTIVITIES
The
assignment
and
activities
covered
in
the
unit
four
will
enable
the
students
to
practice
the
learned
techniques
of
financial
planning.
The
following
is
a
general
guide
to
the
participating
institutions
on
the
type
of
assignments
.
A
financial
analyst
for
a
Company,
has
prepared
the
following
sales
and
cash
disbursement
estimates
for
the
period
January–May
of
the
current
year.
Month Sales Cash disbursements
000 000
January 500 400
February 600 300
March 400 600
April 200 500
May 200 200
The financial analyst notes that historically, 30% of sales have been for cash. Of credit sales,
70% are collected 1 month after the sale, and the remaining 30% are collected 2 months
Financial Management Page| 110
after the sale. The business wishes to maintain a minimum ending balance in its cash
account of 25000. Balances above this amount would be invested in short-‐term
government securities, whereas any deficits would be financed through short-‐term bank
borrowing. The beginning cash balance at March 1 is 115000.
The
business
expects
sales
during
2013
to
rise
from
the
2012
level
of
3.5
million
to
3.9
million.
The
interest
expense
in
2013
is
expected
to
drop
to
325,000
because
of
a
scheduled
large
loan
payment.
The
business
firm
expects
to
increase
its
cash
dividend
payments
during
2013
to
320,000.
The
year-‐end
2012
income
statement
of
the
business
is
as
follows.
Income
Statement
for
the
Year
Ended
December
31,
2012
Sales
revenue
3,500,000
Less:
Cost
of
goods
sold
1925000
Gross
profits
1,575,000
Less:
Operating
expenses
420,000
Operating
profits
1,155,000
Less:
Interest
expense
400,000
Net
profits
before
taxes
755,000
Less:
Taxes
(40%)
302,000
Net
profits
after
taxes
453,000
Less:
Cash
dividends
250,000
To
retained
earnings
203,000
i. Prepare a cash budget for March, April, and May.
ii.
How
much
financing,
if
any,
at
a
maximum
would
Carroll
Company
require
to
meet
its
obligations
during
this
3-‐month
period?
iii.
A
pro-‐forma
balance
sheet
dated
at
the
end
of
June
is
to
be
prepared
from
the
information
presented.
Give
the
size
of
each
of
the
following:
cash,
notes
payable,
marketable
securities,
and
accounts
receivable.
iv.
Use
the
percent-‐of-‐sales
method
to
prepare
a
2013
pro-‐forma
income
statement
for
the
business.
v.
Explain
why
the
statement
may
underestimate
the
company’s
actual
2013
pro
forma
income.
SUMMARY
The
unit
covers
the
importance
of
financial
planning
process.
Financial
planning
process
is
very
important
because
it
acts
as
the
starting
point
for
guiding,
coordinating
and
controlling
the
actions
of
the
business
to
achieve
their
desired
goals.
A
business
is
required
to
develop
strategic
financial
plans
as
the
starting
point
of
the
financial
planning
process.
The
strategic
plans
leads
to
the
formulation
of
operating,
plans
and
budgets.
Commonly,
the
operational
Financial Management Page| 111
plans and budgets implement the strategic goals of a business. The unit explains in detail
the two major aspects of the financial planning process which are cash planning and profit
planning. Cash planning includes preparation of the cash budget and profit planning
involves preparation of pro-‐forma financial statements. The cash budget and the pro forma
financial statements are an aid for internal financial planning and they are routinely
required by present and future creditors.
NEXT
STEPS
The
unit
comprehensively
covered
the
important
techniques
used
in
financial
planning
process.
Therefore,
the
next
unit
will
discuss
short
term
funds
management
.
Financial Management Page| 112
UNIT FIVE -‐ SHORT TERM FUNDS MANAGEMENT
UNIT
5
INTRODUCTION
Important
components
of
financial
structure
of
a
business
are
the
level
of
investment
in
its
current
assets
and
the
extent
of
its
financing
using
current
liabilities.
The
short
term
funds
management
is
the
management
of
current
assets
and
current
liabilities
and
it
is
the
most
important
activity
of
a
business.
The
financial
manger
of
the
business
needs
to
give
his
effort
and
time
to
this
activity.
The
current
assets
of
a
business
include
inventory,
accounts
receivables
cash
and
marketable
securities
whereas,
the
current
liabilities
include
accounts
payable,
accruals
and
notes
payable.
The
goal
of
short
term
funds
management
is
to
manage
the
current
assets
and
current
liabilities
to
achieve
a
balance
between
profitability
and
risk
that
contributes
positively
to
the
value
of
the
business.
UNIT
5
OBJECTIVES
Upon
completion
of
this
unit
you
will
be
able
to:
1. Understand
short-‐term
funds
management,
net
working
capital
and
the
related
trade-‐off
between
profitability
and
risk
of
a
business.
2. Discuss
different
inventory
management
views
and
the
common
techniques
of
inventory
management.
3. Identify
the
major
components
of
credit
terms
that
a
business
follows
and
the
procedures
for
analysing
them.
4. Understand
the
effects
of
stretching
accounts
payable
on
their
cost
and
the
use
of
accruals.
5. Describe
the
interest
rates
,
basic
types
of
unsecured
bank
sources
of
short
term
loans
and
basic
features
of
commercial
paper.
6. Explain
the
characteristics
of
secured
short
term
loans,
use
of
accounts
receivables
and
inventory
as
short
term
loan
collateral.
UNIT
5
READINGS
To
complete
this
unit,
you
are
required
to
read
the
following
chapters:
Gitman et al. (2012 or 2002), chapter 3
Baker, et al. (2009), Chapter 6
UNIT 5 ASSIGNMENTS AND ACTIVITIES
Thorough out the unit, self reflection questions specific to each topic are provided at the
end of each topic. A comprehensive assignment for the unit will be designed by the
instructor.
Financial Management Page| 113
TOPIC 5.1 – WORKING CAPITAL MANAGEMENT
TOPIC 5.1 INTRODUCTION
Working capital management is a strategy that focus on maintaining efficient
levels of both components (current assets and current liabilities) of working
capital. It ensures that a business has sufficient cash flow in order to meet its
operating expenses and short-term obligations as they become due. An effective
working capital management system helps a business to improve its earnings.
TOPIC 5.1 OBJECTIVES
Upon completion of this topic you will be able to:
1. Understand the short-‐term funds management.
2. Understand the concept of net working capital and the related trade-‐off between
profitability and risk of a business.
3. Describe the cash conversion cycle and its funding requirements.
WORKING CAPITAL AND NET WORKING CAPITAL
Current assets representing the portion of investment that circulates from one form to
another in the ordinary course of business is referred to as working capital. In simple words,
working capital is the total current assets of a business. Whereas, the difference between
the current assets and the current liabilities of a business are referred to as net working
capital. The value of the net working capital can be positive or negative. It is positive if the
current assets of a business are greater than the current liabilities and it is negative if the
current liabilities of a business are greater than the current assets. In equation form net
working capital is represented as:
Net working capital = Current assets – Current liabilities
Working
capital
measures
how
much
in
liquid
assets
a
company
has
available
to
build
its
business.
The
number
can
be
positive
or
negative,
depending
on
how
much
debt
the
company
is
carrying.
In
general,
companies
that
have
a
lot
of
working
capital
will
be
more
successful
since
they
can
expand
and
improve
their
operations.
Businesses
with
negative
working
capital
may
lack
the
funds
necessary
for
growth.
While
this
definition
of
working
capital
encompasses
certain
assets
and
liabilities
that
are
expected
to
be
consumed,
converted
into
cash,
or
settled
in
cash
within
the
next
year
(e.g.
such
as
prepaid
expenses
and
accrued
liabilities)
the
typical
components
of
working
capital
that
are
aggressively
managed
include:
• Cash
• Accounts
Receivable
• Inventory
• Accounts
Payable
Financial Management Page| 114
• Short-‐term debt
Recurring
business
activities
make
a
cycle
on
either
generating
or
consuming
working
capital.
Taking
a
look
at
a
manufacturing
organization,
the
following
inter-‐related
and
concurring
“cycles”
generate
and
consume
working
capital:
Inventory
(in
raw
material
form)
is
purchased
from
suppliers
on
short-‐term
(trade)
credit,
creating
Accounts
Payable
(Procure-‐to-‐Pay
Cycle)
as
given
in(www.mhhe.com/rwj.)
• Inventory
is
converted
from
raw
materials
into
finished
goods
(Inventory
Cycle)
• Inventory
(in
finished
goods
form)
is
sold
to
customers
on
short-‐term
(trade)
credit,
creating
Accounts
Receivable
(Order-‐to-‐Cash
Cycle)
• Suppliers
are
paid
in
cash,
reducing
Accounts
Payable
and
reducing
Cash
(Procure-‐
to-‐Pay
Cycle)
• Customers
remit
payment,
reducing
Accounts
Receivable
and
increasing
Cash
(Order-‐to-‐Cash
Cycle)
THE GOALS OF WORKING CAPITAL MANAGEMENT
In principle Working Capital Management ensures that an organization generates sufficient
positive working capital (specifically in the form of Cash) from ongoing business activities to
continually fund both debt payments and operating expenses. It therefore means it
consistently controls the processes (cycles) occurring within the organisation.
Because
the
processes
within
working
capital
are
interrelated,
decisions
made
within
each
one
of
the
disciplines
can
impact
the
other
processes,
and
ultimately
affect
an
organization’s
overall
financial
performance.
It
therefore
follows
that
making
a
decision
will
need
on
to
take
the
holistic
picture
of
working
capital.
One
of
the
most
important
decisions
involve
cash
holding;
how
much
cash
to
keep
and
why?
CASH AND M OTIVES FOR HOLDING CASH
Managing cash is becoming ever more sophisticated in the global and electronic age of the
new century as financial managers try to squeeze the last dollar of profit out of their cash
management strategies. Despite whatever lifelong teachings you might have learned about
the virtues of cash, the corporate financial manager actively seeks to keep this nonearning
asset to a minimum. The less cash you have, generally the better off you are, but still you
do not want to get caught without cash when you need it. Minimizing cash balances as well
as having accurate knowledge of when cash moves into and out of the company can
improve overall corporate profitability. First we discuss the reasons for holding cash and
then examine the cash flow cycle for the typical firm.
REASONS FOR HOLDING CASH BALANCES
There are several reasons for holding cash: for transactions balances, for compensating
balances for banks, and for precautionary needs. The transactions motive involves the use
of cash to pay for planned corporate expenses such as supplies, payrolls, and taxes, but also
Financial Management Page| 115
can include planned acquisitions of long-‐term fixed assets. The second major reason for
holding cash results from the practice of holding balances to compensate a bank for
services provided rather than paying directly for those services.
Holding
cash
for
precautionary
motives
assumes
management
wants
cash
for
emergency
purposes
when
cash
inflows
are
less
than
projected.
Precautionary
cash
balances
are
more
likely
to
be
important
in
seasonal
or
cyclical
industries
where
cash
inflows
are
more
uncertain.
Firms
with
precautionary
needs
usually
rely
on
untapped
lines
of
bank
credit.
For
most
firms
the
primary
motive
for
holding
cash
is
the
transactions
motive.
CASH FLOW CYCLE
Cash balances are largely determined by cash flowing through the company on a daily,
weekly, and monthly basis as determined by the cash flow cycle. As discussed in unit 4, the
cash budget is a common tool used to track cash flows and resulting cash balances. Cash
flow relies on the payment pattern of customers, the speed at which suppliers and creditors
process checks, and the efficiency of the banking system. The primary consideration in
managing the cash flow cycle is to ensure that inflows and outflows of cash are properly
synchronized for transaction purposes.
THE CASH CONVERSION CYCLE
Understanding of cash conversion cycle of a business is the important aspect of short term
financial management. We begin our discussion by representing the calculation of cash
conversion cycle and its application.
Operating
cycle
of
a
business
is
the
total
time
from
beginning
of
the
production
process
of
a
product
to
collection
of
cash
from
the
sale
of
the
finished
product.
The
operating
cycle
of
a
business
includes
inventory
and
accounts
receivables
(short
term
assets).
Operating
cycle
can
be
measured
as:
OC = AAI + ACP
Where,
OC = Operating cycle
AAI = Average age of inventory
ACP = Average collection period
Additionally,
the
purchase
of
production
inputs
on
account
are
also
included
in
the
process
of
producing
and
selling
a
product.
The
purchase
of
production
inputs
on
account
results
in
accounts
payable
and
accounts
payable
reduce
the
number
of
days
resources
are
tied
up
in
operating
cycle
of
a
business.
The
time
a
business
takes
to
pay
its
accounts
payable
is
known
as
the
average
payment
period
(APP).
Therefore,
the
cash
conversion
cycle(CCC)
is
represented
as:
Financial Management Page| 116
CCC = OC − APP
Or
CCC = AAI + ACP − APP
It
is
clear
that
a
business
can
make
changes
in
the
amount
of
resources
tied
up
in
the
routine
operation
of
the
business
by
making
changes
in
any
of
the
mentioned
time
periods
(ACP
and
APP).
Example –Cash conversion cycle
Rex
Limited
has
annual
sales
of
20
million,
a
cost
of
goods
sold
of
75%
of
sales
and
its
purchases
are
65%
of
its
cost
of
goods
sold.
Rex
Limited’s
average
age
of
inventory
(AAI),
average
collection
period
(ACP)
and
average
payment
period
(APP)
are
60,
40
and
35
days
respectively.
Therefore
the
cash
conversion
cycle
of
the
Rex
limited
is
65
days
(60
=
40
–
35).
The
total
invested
resources
in
the
cash
conversion
cycle
include
inventory,
accounts
receivable
and
accounts
payable.
60
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = (20,000,000 ×0.75)× ! ! = 2,500,000
360
40
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑣𝑖𝑎𝑏𝑙𝑒 = !20,000,000 × ! = 2,222,222
360
35
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑣𝑖𝑎𝑏𝑙𝑒 = (20,000,000 ×0.75 ×0.65)×( ) = 944,016
360
Therefore,
total
invested
resources
are
equal
to
3,774,306.
Any
changes
in
any
of
the
time
periods
will
change
the
resources
tied
up
in
operations
of
the
business.
For
instance,
if
Rex
limited
could
reduce
the
ACP
by
5
days,
the
cash
conversion
time
will
be
shortened
and
the
tied
up
resources
will
be
reduced
by
277,778.
[20,000,000
×
(5/360)].
CASH CONVERSION CYCLE’S FUNDING REQUIREMENTS
Cash conversion cycle is the basis a business uses for funding its investment in operating
assets.
PERMANENT VERSUS SEASONAL FUNDING NEEDS
There are two different types of funding needs that is permanent funding needs and
seasonal funding needs. If the sales of a business are constant then its investment in the
operating assets will remain constant and it will have permanent funding requirements. On
the other hand, if the sales of a business are cyclic then its investment in operating assets
will vary with its cycle of sales. Cyclic needs of funding are referred to as seasonal funding
requirements.
Financial Management Page| 117
AGGRESSIVE VERSUS CONSERVATIVE FUNDING STRATEGY
Short term are less expensive than long term funds but with regard to changes in interest
rates long term funds are less risky than short term. Long term funds ensure the availability
of the funds as and when they are needed. In case a business rely on short term funds, the
business is exposed to the risk of non availability of funds when they are needed to cover
the seasonal peaks. A business can chose from either an aggressive funding strategy or a
conservative funding strategy to meet the requirements of funds for investing in operating
assets. An aggressive funding strategy helps the business to meet its seasonal funding
requirements using short term financing and its permanent funding requirements using
long term financing. Alternatively, a conservative funding strategy enables a business to use
long term financing option to meet its seasonal and permanent requirements of funds.
It
is
clear
that
the
aggressive
funding
strategy
relies
heavily
on
the
short
term
financing.
It
is
more
risky
than
the
conservative
funding
strategy
because
of
the
changes
in
the
interest
rates
and
potential
difficulties
in
quickly
obtaining
these
funds
during
the
seasonal
peaks.
The
conservative
strategy
minimizes
these
risks
because
of
locked
in
interest
rates
and
the
long
term
availability
of
funds.
It
is
more
costly
than
the
aggressive
funding
strategy
due
to
the
negative
spread
between
the
surplus
funds
earning
rate
and
the
cost
of
long
term
funds
that
create
the
surplus.
The
decision
whether
to
adopt
aggressive
or
conservative
strategy
is
dependent
on
the
disposition
of
management
towards
risk
and
the
strength
of
its
banking
relationships.
TOPIC 5.1 SUMMARY
Working capital represents the operating liquidity available to a business. It is considered as
a part of operating capital, along with fixed assets such as plant and equipment. Net
working capital is a derivation of working capital that is commonly used in valuation
techniques. If current assets are less than current liabilities a business has a working capital
deficiency and is called a working capital deficit. Working capital management is a
strategy that focus on maintaining optimal levels of current assets and current
liabilities.
Financial Management Page| 118
Self-‐Reflection Questions
1.
What
is
the
working
capital
management?
Highlight
the
difference
between
working
capital
and
net
working
capital.
2.
Briefly
describe
the
reasons
for
holding
cash
and
how
does
the
cash
flow
cycle
works?
3.
what
is
difference
between
the
operating
cycle
and
the
cash
conversion
cycle
of
a
business
and
why
it
is
important
to
minimize
the
length
of
a
cash
conversion
cycle.
4.
highlight
the
benefits
and
costs
of
an
aggressive
and
a
conservative
funding
strategy.
Financial Management Page| 119
TOPIC 5.2 – INVENTORY MANAGEMENT
TOPIC 5.2 INTRODUCTION
All forms of inventory need to be financed, and the efficient management of inventory can
increase profitability a business. It is not always possible for a business to control the
amount of inventory because it is regularly affected by sales, production and economic
conditions of a any business. Inventory management techniques help managers to achieve
business objectives efficiently.
TOPIC 5.2 OBJECTIVES
Upon completion of this topic you will be able to:
1. Identify different inventory management views
2. Develop an understanding of the common techniques of inventory management.
INVENTORY: AN OVERVIEW
In a manufacturing company, inventory is usually divided into the three basic categories:
raw materials used in the product; work in progress which reflects partially finished
products and finished goods, which are ready for sale. All these forms of inventory need to
be financed and their efficient management can increase a firm’s profitability. The amount
of inventory is not always totally controlled by company management because it is affected
by sales, production, and economic conditions.
Because
of
its
cyclical
sales
that
are
highly
sensitive
to
the
economic
business
climate,
the
automobile
industry
is
a
good
case
study
in
inventory
management.
The
automakers
have
often
suffered
from
inventory
build-‐ups
when
sales
declined
because
adjusting
production
levels
required
time.
During
the
1980s,
again
in
2002–03,
2005
and
2007,
the
big
three
(General
Motors,
Ford,
and
Chrysler)
took
turns
implementing
buyer
incentive
programs
such
as
discount
financing
at
rates
well
below
market
rates
and
cash
rebate
programs
to
stimulate
sales.
These
programs
cut
profit
margins
per
vehicle
but
generated
cash
flow
and
reduced
investment
expenses
associated
with
holding
high
inventories.
Because
inventory
is
the
least
liquid
of
current
assets,
it
should
provide
the
highest
yield
to
justify
the
investment.
While
the
financial
manager
may
have
direct
control
over
cash
management,
marketable
securities,
and
accounts
receivable,
control
over
inventory
policy
is
generally
shared
with
production
management
and
marketing.
Let
us
examine
some
key
factors
influencing
inventory
management.
LEVEL VERSUS SEASONAL PRODUCTION
A manufacturing firm must determine whether a plan of level or seasonal production
should be followed. While level (even) production throughout the year allows for maximum
efficiency in the use of manpower rand machinery, it may result in unnecessarily high
inventory build-‐ups before shipment, particularly in a seasonal business. For example, a
bathing suit manufacturer would not want excess suits in stock in November. If we produce
Financial Management Page| 120
on a seasonal basis, the inventory problem is eliminated, but we will then have unused
capacity during slack periods. Furthermore, as we shift to maximum operations to meet
seasonal needs, we may be forced to pay overtime wages to labour and to sustain other
inefficiencies as equipment is overused. We have a classic problem in financial analysis. Are
the cost savings from level production sufficient to justify the extra expenditure in carrying
inventory? A few common inventory management techniques are discussed below.
ABC INVENTORY SYSTEM
ABC inventory system sorts the total inventory of a business into three groups A, B and C.
The group A includes all those items which have the largest dollar investment. Similarly, the
group B includes all those items which have the next largest dollar investment and the
group C includes items with small dollar investments. The ABC inventory system is used in
order to focus on the most important items in inventory. Usually a relatively few items will
account for a very significant value. These relatively few items with great importance are
categorized as the "A" items. It is also common for many of the items in inventory to have a
relatively small aggregate value. These items are categorized as "C" items. The remaining
items are categorized as the "B" items. By closely monitoring the "A" items, a company is
able to manage the most important items with a relatively small effort.
The
ABC
inventory
system
helps
in
managing
the
inventory
by
sorting
it
into
three
groups
or
bins
and
when
a
bin
is
nearly
empty
or
empty
,
an
order
is
placed
to
fill
the
bin.
The
large
dollar
investment
in
group
A
and
B
items
requires
a
more
sophisticated
inventory
management
approach
which
is
economic
order
quantity
and
is
discussed
next.
ECONOMIC ORDERING QUANTITY
Substantial research has been devoted to determining optimum inventory size, order
quantity, usage rate, and similar considerations. An entire branch in the field of operations
research is dedicated to the subject. In developing an inventory model, we must evaluate
the two basic costs associated with inventory: the carrying costs and the ordering costs.
Through a careful analysis of both of these variables, we can determine the optimum order
size that minimizes costs.
CARRYING
COSTS
Carrying
costs
include
interest
on
funds
tied
up
in
inventory
and
the
costs
of
warehouse
space,
insurance
premiums,
and
material
handling
expenses.
There
is
also
an
implicit
cost
associated
with
the
dangers
of
obsolescence
or
perishability
and
rapid
price
change.
The
larger
the
order
we
place,
the
greater
the
average
inventory
we
will
have
on
hand,
and
the
higher
the
carrying
costs.
Ordering
Costs
As
a
second
factor,
we
must
consider
the
cost
of
ordering
and
processing
inventory
into
stock.
If
we
maintain
a
relatively
low
average
inventory
in
stock,
we
must
order
many
times
and
total
ordering
costs
will
be
high.
The
opposite
patterns
associated
with
the
two
costs
are
portrayed
in
Figure
7–8
on
the
next
page.
Financial Management Page| 121
ORDERING COSTS
As
the
order
size
increases,
carrying
costs
go
up
because
we
have
more
inventory
on
hand.
With
larger
orders,
of
course,
we
will
order
less
frequently
and
overall
ordering
costs
will
go
down.
The
trade-‐off
between
the
two
can
best
be
judged
by
examining
the
total
cost
curve.
At
point
M
on
that
curve,
we
have
appropriately
played
the
advantages
and
disadvantages
of
the
respective
costs
against
each
other.
With
larger
orders,
carrying
costs
will
be
excessive,
while
at
a
reduced
order
size,
constant
ordering
will
put
us
at
an
undesirably
high
point
on
the
ordering
cost
curve.
As
a
second
factor,
we
must
consider
the
cost
of
ordering
and
processing
inventory
into
stock.
If
we
maintain
a
relatively
low
average
inventory
in
stock,
we
must
order
many
times
and
total
ordering
costs
will
be
high.
The
opposite
patterns
associated
with
the
two
costs
are
portrayed
in
Figure.
As
the
order
size
increases,
carrying
costs
go
up
because
we
have
more
inventory
on
hand.
With
larger
orders,
of
course,
we
will
order
less
frequently
and
overall
ordering
costs
will
go
down.
The
trade-‐off
between
the
two
can
best
be
judged
by
examining
the
total
cost
curve.
At
point
M
on
that
curve,
we
have
appropriately
played
the
advantages
and
disadvantages
of
the
respective
costs
against
each
other.
With
larger
orders,
carrying
costs
will
be
excessive,
while
at
a
reduced
order
size,
constant
ordering
will
put
us
at
an
undesirably
high
point
on
the
ordering
cost
curve.
Financial Management Page| 122
DERIVING ECONOMIC ORDERING QUANTITY FORMULA
Economic order quantity model is the most common technique used to determine the
optimal order size for inventory items. The model takes into consideration various costs
associate with inventory and determines the order size which can minimize the total
inventory cost. EOQ is the economic ordering quantity, the most advantageous amount for
the firm to order each time. We will determine this value, translate it into average
inventory size, and determine the minimum total cost amount. The terms in the EOQ
formula are defined as follows:
S = usage in units per period or Total sales per period
O = order cost per order
C = carrying cost per unit per period
Q = order quantity in units
The
first
step
is
to
derive
the
cost
functions
for
order
cost
and
carrying
cost
of
inventory.
The
order
cost
is
a
product
of
the
cost
per
order
and
the
number
of
orders
(S/Q).
Order cost = O ×S/Q
The
carrying
cost
is
equal
to
the
product
a
unit
of
inventory
per
period
and
the
average
inventory
of
a
business
(Q/2).
Carrying cost = C ×Q/2
The
total
inventory
cost
of
the
business
can
be
calculated
by
adding
the
Order
cost
and
the
carrying
cost.
S Q
Total cost = (O × ) + (C × )
Q 2
By solving the above equation we get the following formula.
2 ×S ×O
EOQ =
C
Let
us
assume
that
we
anticipate
selling
2,000
units
during
the
year;
it
will
cost
us
8
to
place
each
order;
and
the
price
per
unit
is
1,
with
a
20
percent
carrying
cost
to
maintain
the
average
inventory,
resulting
in
a
carrying
charge
per
unit
of
0.20.
Plugging
these
values
into
the
formula,
we
show:
2 ×2000 ×8
EOQ = = 400 units
0.20
Financial Management Page| 123
TOTAL COSTS FOR INVENTORY
The optimum order size is 400 units. On the assumption that we will use up inventory at a
constant rate throughout the year, our average inventory on hand will be 200 units, as
indicated in Figure below. Average inventory equals EOQ/2.
Our
total
costs
with
an
order
size
of
400
and
an
average
inventory
size
of
200
units
are
computed
below.
!"#$% !"""
1.
Ordering costs = = 5 orders
!"#$" !"#$ !""
= 5 orders at 8 per order = 40
2. Carrying costs = Average inventory in units × Carrying cost per unit
= 200 x 0.20 =40
3. Order cost 40
Carrying cost + 40
Total cost 80
Point M in Figure on the prior page can be equated to a total cost of 80 at an order size of
400 units. At no other order point can we hope to achieve lower costs. The same basic
principles of total cost minimization that we have applied to inventory can be applied to
other assets as well. For example, we may assume cash has a carrying cost (opportunity
cost of lost interest on marketable securities as a result of being in cash) and an ordering
cost (transaction costs of shifting in and out of marketable securities) and then work toward
determining the optimum level of cash. In each case we are trying to minimize the overall
costs and increase profit.
Financial Management Page| 124
SAFETY STOCK AND STOCK OUTS
In our analysis thus far we have assumed we would use inventory at a constant rate and
would receive new inventory when the old level of inventory reached zero. We have not
specifically considered the problem of being out of stock. A stock out occurs when a firm is
out of a specific inventory item and is unable to sell or deliver the product. The risk of losing
sales to a competitor may cause a firm to hold a safety stock to reduce this risk. Although
the company may use the EOQ model to determine the optimum order quantity,
management cannot always assume the delivery schedules of suppliers will be constant or
that there will be delivery of new inventory when old inventory reaches zero. A safety stock
will guard against late deliveries due to weather, production delays, equipment
breakdowns, and the many other things that can go wrong between the placement of an
order and its delivery. A minimum safety stock will increase the cost of inventory because
the carrying cost will rise. This cost should be offset by eliminating lost profits on sales due
to stock outs and also by increased profits from unexpected orders that can now be filled.
In the prior example, if a safety stock of 50 units were maintained, the average inventory
figure would be 250 units.
EOQ
Average Inventory = + Safety stock
2
400
Average Inventory = + 50
2
Average Inventory = 200 + 50 = 250
The inventory carrying cost will now increase to 50.
Carrying costs = Average inventory in units X Carrying cost per unit
= 250 X 0.20 = 50
The
amount
of
safety
stock
that
a
firm
carries
is
likely
to
be
influenced
by
the
predictability
of
inventory
usage
and
the
time
period
necessary
to
fill
inventory
orders.
The
following
discussion
indicates
safety
stock
may
be
reduced
in
the
future.
JUST-‐IN-‐TIME (JIT) INVENTORY MANAGEMENT
Just-‐in-‐time inventory management (JIT) is part of a total production concept that often
interfaces with a total quality management. It is used to minimize inventory investment.
The philosophy is that materials should arrive at exactly the time they are needed for
production or sale. In an ideal situation the business should only have work in process
inventory. JIT system uses no or very little safety stock because its objective is to minimize
investment in inventory. In order to meet this objective an extensive coordination among
the employees, suppliers and shipping companies of the business must exist to insure the
availability of material on time. If the business fails to do so it results in the shutdown of the
Financial Management Page| 125
production line until the material becomes available. Moreover, a JIT system requires high
quality material to minimize the quality issues in production.
The
major
goal
of
the
JIT
inventory
management
system
is
to
ensure
manufacturing
efficiency.
The
system
uses
inventory
as
tool
to
attain
efficiency
by
emphasizing
quality
and
timely
delivery
of
material
used.
TOPIC 5.2 SUMMARY
The level of inventory considered as appropriate by the financial managers are different
from viewpoint of marketing, manufacturing and purchasing managers. These managers
tend to have a view of keeping higher inventories and they consider the higher level of
inventory as the appropriate levels. Three commonly used techniques for effectively
managing inventory to keep its level as low as possible are the ABC system , the economic
order quantity (EOQ) model and the just in time (JIT) system.
Self-‐Reflection Questions
1.
What
are
possible
viewpoints
of
each
of
the
following
managers
about
the
levels
of
the
various
types
of
inventory:
finance,
marketing,
manufacturing
and
purchasing?
Why
is
the
inventory
considered
as
an
investment?
2.
Briefly
describe
each
of
the
following
techniques
used
for
inventory
management:
ABC
system,
economic
order
quantity
(EOQ)
model
and
just
in
time
(JIT)
system.
Financial Management Page| 126
TOPIC 5.3 – CURRENT LIABILITIES MANAGEMENT
TOPIC 5.3 INTRODUCTION
Liabilities arising from normal course of business are known as spontaneous liabilities. The
two key sources of spontaneous liabilities are accounts payable and accruals. In response to
the increasing sales of the business, the accounts payable and accruals increase. Accounts
payable increase because the purchases become necessary to meet higher level of sales.
Whereas the accruals of the business increase as wage and taxes increase because of higher
labour requirements and the increased taxes on the higher income of the business. Implicit
explicit. Both, accounts payable and accruals are types of short term financing instruments.
Short term financing obtained using accounts payable and accruals are known as unsecured
short-‐term financing because they are obtained without any collateral. these interest free
short term financing can prove to be advantageous for the business.
TOPIC 5.3 OBJECTIVES
Upon completion of this topic you will be able to:
1. Identify
the
major
components
of
credit
terms
that
a
business
follows,
and
the
procedures
for
analysing
them.
2. Understand
the
relationship
between
stretching
accounts
payable
and
their
cost.
3. Understand
the
use
of
accruals
as
a
spontaneous
source
of
unsecured
short
term
financing.
4. Understand
and
describe
the
rate
of
interest,
the
basic
types
of
unsecured
short
term
bank
loans
and
basic
features
of
commercial
paper.
5. Describe
the
various
ways
in
which
inventory
can
be
used
as
short
term
loan
collateral.
ACCOUNTS PAYABLE MANAGEMENT
Accounts payable are a result of transactions in which purchases are made without signing
any formal note to show the liability of the business (purchaser). The business agrees to pay
the required amount according to the terms and conditions stated on the invoice of the
supplier (seller).
ROLE OF ACCOUNTS PAYABLE IN CASH CONVERSION CYCLE
Cash conversion cycle as discussed earlier can be represented in equation form as :
Cash conversion cycle (CCC) = Operating Cycle (OC) -‐ Average payment Period (APP)
The
final
component
of
the
cash
conversion
cycle
is
the
average
payment
period
and
it
constitutes
of
two
parts
1. The time from the purchase until the payment.
2. Float time (the time from sending the payment until the funds are actually received)
Financial Management Page| 127
The objective of the business to delay the payment as long as possible without damaging its
credit worthiness. The business aims to pay the funds on the possible last day considering
the credit terms of the supplier. For example if the stated terms are net 30 days, then the
payment should be made 30 days from the start of credit period. Usually, the start of credit
period is the date of invoice. This approach helps business to make maximum use of the
interest free credit and does not damage the credit worthiness of the business.
Example
–
Role
of
accounts
payable
in
cash
conversion
cycle
Rex
Limited
has
an
average
payment
period
of
35
days
which
consists
of
30
days
until
payment
was
mailed
and
5
days
as
float
time.
The
average
accounts
payable
equals
947,916.
Thus
Rex
limited
can
generate
27,084
(947,916/35)
of
accounts
payable
daily.
If
Rex
Limited
has
to
mail
it
payments
in
35
days
instead
of
30
days,
its
accounts
payable
will
increase
by
135,420
(27,084
X
5).As
a
result
of
this,
Rex
limited’s
cash
conversion
cycle
will
decrease
by
5
days,
and
its
investments
in
operations
will
decrease
by
135,420.
It
is
in
the
best
interest
of
business,
if
this
action
does
not
damage
the
credit
rating
of
Rex
limited.
CREDIT
TERMS
The
credit
terms
offered
to
a
business
by
the
supplier
facilitate
the
delay
in
the
payments.
The
purchase
price
of
the
merchandise
reflects
the
cost
of
having
funds
tied
up
in
the
sold
merchandise.
Therefore,
the
purchaser
is
already
entitled
to
apply
for
this
benefit.
A
careful
analysis
of
the
credit
terms
are
needed
in
order
to
determine
the
best
strategy
for
trade
credit.
If
the
business
has
offered
the
credit
terms
with
some
form
of
cash
discount
then
in
that
case
it
has
two
options
to
choose
from
1. Take the discount
2. Give up the discount
If
the
business
plans
to
take
the
discount
it
will
have
to
make
the
payment
on
the
last
day
of
the
discount
period.
Example
–
Credit
terms
(a)
LK
industries
purchased
2,000
worth
of
merchandise
on
March
30,
terms
of
2/10
net
30
EOM
(end
of
month).
If
the
business
decides
to
take
the
cash
discount,
it
can
save
40
by
paying
1960[2,000
–
(2%
X
2,000)]
on
April
10.
Alternatively,
if
the
business
plans
to
give
up
the
discount,
it
will
have
to
make
the
payment
on
the
last
day
of
the
credit
period.
There
is
no
cost
associated
with
the
option
of
take
up
the
cash
discount
but
in
case
of
giving
up
the
discount,
there
is
implicit
cost
associated
with
Financial Management Page| 128
it in the form of implied interest rate. This implied cost will be equal to the total discount
given up.
Example – Credit terms (b)
In
the
preceding
example,
LK
industries
could
have
taken
the
cash
discount
by
paying
1960
on
April
10.
LK
industries
can
pay
by
April
30
if
it
decides
to
give
up
the
cash
discount.
The
business
can
keep
the
money
for
extra
20
days
if
it
gives
up
an
opportunity
to
save
40.
In
other
words,
it
will
cost
the
business
40
to
delay
payment
for
20
days.
Figure
shows
the
payment
options
available
to
LK
industries.
The
true
purchase
price
needs
to
be
viewed
as
the
discounted
cost
of
the
merchandise
to
calculate
the
cost
of
giving
up
the
cash
discount.
The
discounted
cost
of
merchandise
for
LK
industries
is
1,960.
The
annual
percentage
cost
of
giving
up
the
cash
discount
can
be
calculated
as
follows:
Cost of giving up cash discount = CD X 360
100% -‐ CD N
Where
CD = Stated Cash Discount in percentage
N = Number of days that payment can be delayed by giving up cash discount
An
annualized
cost
of
giving
up
cash
discount
for
LK
industries
is
36.73%
[(2%÷98%)
×
(360
÷
20)].
A
360
days
year
is
assumed
in
this
example.
Financial Management Page| 129
A simple way to calculate the approximate cost of giving up cash discount is as follows:
Approximate cost of giving up cash discount = CD × 360
N
The approximation is closer to the actual cost of giving up cash discount if the cash discount
is smaller. Using the above mentioned approximation technique, the cost of giving up cash
discount for LK industries is 36% [2%× (360 ÷ 20)].
It
is
responsibility
of
the
financial
manager
to
decide
whether
to
take
the
discount
or
not.
The
decision
must
be
made
by
taking
into
account
the
fact
that
taking
cash
discount
represents
a
source
of
additional
profit
for
the
business.
Example – Credit terms (c)
A large building supply company, Watford products, has four different suppliers,
offering different credit terms. The product and services of these suppliers are
identical. Table below represents the credit terms offered by each supplier and the
cost of giving up the cash discount.
If
the
company
needs
short
term
funds
which
are
available
from
bank
at
13%
interest
rate
and
if
each
supplier
is
viewed
separately,
which
of
the
suppliers’
cash
discount
will
the
company
give
up?
The
company
takes
the
cash
discount,
in
dealing
with
supplier
A,
because
the
cost
of
giving
up
the
cash
discount
(36%)
is
higher
than
the
cost
of
borrowing
the
funds
(13%).
With
supplier
B,
the
company
should
decide
to
give
up
the
cash
discount
because
the
cost
of
giving
up
cash
discount
(8%)
is
lower
as
compared
to
cost
of
borrowing
funds
from
bank
(13%).
Dealing
with
supplier
D
and
supplier
E,
the
company
should
take
up
the
cash
discount
because
in
both
of
the
cases
the
cost
of
giving
u p
cash
discount
is
greater
than
that
of
borrowing
from
the
bank
(21.6%
and
28.8%
versus
13%).
The
above
example
shows
that
the
cost
of
giving
up
cash
discount
is
only
relevant
when
one
is
evaluating
a
single
supplier’s
credit
terms
in
the
light
of
specific
bank
borrowing
costs.
Nevertheless,
there
is
a
need
to
consider
other
factors
relative
to
payment
strategies.
Some
businesses,
e.g.
small
or
poorly
managed
businesses,
give
up
all
discounts
because
Financial Management Page| 130
sources of un secured short term loans are scarce or not available. Or the businesses fail to
recognize the implicit costs of their action of giving up the discount.
EFFECTS OF STRETCHING ACCOUNTS PAYABLE
By stretching the accounts payable we mean that paying bills of the business as late as
possible without damaging the credit worthiness of the business. Stretching accounts
payable may be attractive financially but an important ethical issue is associated with it.
The ethical issue associated with it is that it can cause the violation of the agreements the
business entered when purchasing the merchandise. Obviously, the credibility of the
business, who purposely delay the payments for its purchases, would be damaged.
Example –Effects of stretching accounts payable
LK industries was extended credit terms of 2/10 net 30 EOM (End of month). In the earlier
example, the cost of giving up the cash discount was approximately 36%[2%× (360 ÷ 20)].
The cost of giving up the cash discount would be only 12%[2%× (360 ÷ 60)], if the business
was able to stretch its accounts payable to 70 days. Clearly, the implicit cost of giving up
cash discount is reduced by stretching accounts payable.
ACCRUALS
Another spontaneous source of unsecured short term financing is the accruals. Accruals are
the form of liabilities for services received but payment has not been made. The common
example of accruals are wages and taxes. Tax accrual cannot be manipulated because they
are payment to the government. Businesses can manipulate the wages accrual by delaying
the payment to the employees. This results in receiving an interest free credit from the
employees of the business. The pay period for hourly rate workers are regulated by state or
federal law but the frequency of the payment is at the discretion of management of the
business.
Example
–Accruals
Apollo
Limited
currently
pays
its
employees
weekly
and
its
weekly
payroll
totals
800,000.
If
the
company
were
to
extend
the
pay
period
by
1
week
throughout
an
entire
year,
the
company
would
be
borrowing
800,000
from
the
employees
for
a
year.
With
a
10%
annual
earning
rate
on
invested
funds,
the
company
could
earn
80,000
(10%
X
800,000)
per
year.
SOURCES OF UN SECURED SHORT TERM FINANCING:
The two major sources of unsecured short term financing are commercial banks and
commercial papers. These sources are different from the spontaneous sources as they are
Financial Management Page| 131
the result of negotiation and action taken by the financial manager of the business. Bank
loans are available to all sizes of business as compared to the commercial papers which are
only available to large firms only. In addition to this if a business is involved in international
activity, it can use international loans to finance the international transactions.
COMMERCIAL BANK LOANS
Bank loans are the most popular and major source of unsecured short term financing to the
businesses. The common type of short term loan provided by banks is the self liquidating
loan which is designed to meet the financing needs during the seasonal peaks only. The
financing needs of the business during the seasonal peaks rises just because of the build-‐
ups of the inventory and account receivables. The term “self liquidating” is used for these
type of loans because the funds to retire the loans are generated as soon as the inventories
and accounts receivable are converted into cash. The basic ways, the banks use to lend the
unsecured short term loans are: the single payment notes, lines of credit and the revolving
credit agreements.
LOAN INTEREST RATES
Based on prime rate of interest, the interest rate can be fixed or floating rate the prime rate
of interest, also known as prime rate, is the lowest interest rate charged by leading banks
on business loans. The changes in the demand and supply of the short term loans are
responsible for any fluctuations in the prime rate. Commercial banks determine the rate of
interest for various customers (borrowers) by adding a premium to the prime rate. The
premium is added to adjust for the riskiness of the borrower and may be up to 4 percent or
more. Typically, the premium for most of the unsecured short term loans is less than 2
percent.
FIXED RATE AND FLOATING RATE
Two possible types of interest rates are fixed or floating. A fixed rate of interest is
determined on the date of a loan at a set increment above the prime rate and it remains
unchanged until maturity of loan. A floating rate of interest is initially set at an increment
above the prime rate and is allowed to vary above prime as the prime rate varies until
maturity. Typically, the increment above prime rate on a fixed rate loan will be higher than
on a floating rate loan of equivalent risk because the lender bears high risk will fixed rate
loan. If the prime rate is unstable in nature then most short term loans are floating rate
loans and vice versa.
COMPUTING
INTEREST
The
method
of
computing
interest
is
determined
after
establishing
the
nominal
or
stated
annual
rate.
Interest
can
be
paid
either
in
advance
or
at
maturity
of
loan.
Most
of
the
commercial
bank
loans
requires
the
interest
payment
at
maturity.
If
the
interest
is
paid
when
the
loan
matures
then
the
effective
(true)
annual
rate
for
1
year
period
can
be
calculated
as:
Financial Management Page| 132
Interest .
Amount borrowed
If interest is paid in advance then it is deducted from the loan and the borrower receives
less money than what is requested. This type of loan is known as a discount loan and
effective annual interest rate for 1 year discount loan can be calculated as:
Interest
.
Amount
borrowed
–
Interest
The
effective
annual
rate
rises
above
the
stated
annual
rate,
if
the
borrower
decides
to
pay
i
n
t Example
–Computing
Interest
e A
manufacturer
of
apparel
wants
to
borrow
5,000
at
an
annual
rate
of
10%
interest
for
r 1
year.
The
business
(borrower)
will
pay
500
(10%
X
5,000)
for
the
use
of
5,000
for
1
year
e ,
if
the
interest
is
paid
at
maturity.
Using
the
given
formula
to
calculate
the
effective
s annual
rate
of
interest,
the
effective
annual
rate
is
10%
(500
÷
5,000)
t
If
the
interest
is
paid
in
advance,
the
business
will
pay
same
500
in
interest,
but
receives
o only
4,500
(5,000
-‐
500).
Using
the
given
formula
to
calculate
the
effective
interest
rate
n in
this
case
will
be
11.1%
[500÷(5,000
-‐
500)].
Hence,
advance
payment
of
interest
makes
the
effective
annual
rate
greater
than
the
stated
rate
of
interest.
l
oan
in
advance.
THE
SINGLE
PAYMENT
NOTES
A
one-‐time
short
term
loan
made
to
a
credit
worthy
business
borrower
by
a
commercial
bank
is
known
as
the
single
payment
note.
This
one-‐time
loan
is
to
meet
a
specific
need
of
the
business.
The
borrower
signs
a
note(instrument)that
states
the
terms
and
conditions
of
the
loan
i.e.
the
length
of
the
loan,
the
interest
rate
and
the
maturity.
Financial Management Page| 133
Example –Single Payment Notes
Westcliff limited, a manufacturer of blades, recently borrowed from Bank A and Bank
B, 200,000 from each bank for 90 days period. The loans were incurred when the
prime rate was 9%. Regardless of fluctuations in prime rate, the interest rate on fixed
rate loan form bank A was determined by adding 1.5% increment in the existing
prime rate (9% + 1.5% = 10.5%). The total interest cost on this loan is 5,250 [200,000
X (10.5% X 90/360)]. The effective 90 day rate on this loan is 2.625% (5,250 ÷
200,000).
Assuming
that
under
same
terms
and
circumstances,
the
loan
is
rolled
over
each
90
days
throughout
the
year
then
its
effective
annual
rate
of
interest
is
10.92%
[(1+0.02625)4
-‐
1].
It
is
because
the
cost
of
loan
is
2.625%
for
90
days
,
therefore,
it
is
necessary
to
compound
(1
+
0.02625)
for
four
90
days
periods
in
the
year
and
then
subtract
1.
Bank
B
set
the
interest
rate
on
its
floating
rate
loan,
at
1%
above
the
prime
rate.
The
charged
rate
of
interest
will
vary
with
the
fluctuations
in
the
prime
rate.
Initially,
the
interest
rate
is
10%
(9%
+
1%).
If
the
prime
rate
changes
rises
30
days
to
9.5%
and
after
next
30
days
drops
to
9.25%,
then
the
borrower
will
be
paying
0.833%
(10%
X
30/360)
for
the
first
30
days,
0.875%
(10.25%
X
30/360)
for
the
next
30
days
and
0.854%
(10%
X
30/360)
for
the
last
30
days.
The
total
interest
cost
on
the
loan
will
be
5,124
[200,000
X
(0.833%
+
0.875%
+
0.854%)]
and
the
effective
90
days
interest
rate
will
be
2.562%
(
5,124
÷
200,000).
Again
assuming
that
under
same
terms
and
circumstances,
the
loan
is
rolled
over
each
90
days
throughout
the
year
then
its
effective
annual
rate
of
interest
is
10.65%
[(1
+
0.02562)4
-‐
1].
In
the
case
of
floating
rate
loan,
the
effective
annual
rate
is
lower
than
that
of
fixed
rate
loan.
Therefore,
the
floating
rate
loan
is
less
expensive
than
the
fixed
rate
loan.
LINES OF CREDIT
An agreement between a commercial bank and a business with specified short term funds
which the bank will make available to the business over a given period of time is known as
line of credit. A similar example of this is the credit card agreement under which banks
extend the pre-‐approved credit to the cardholders. A line of credit agreement is not a
guaranteed loan and is usually made for a period of one year. The availability of the funds
to the borrower is subject to the condition of the bank having sufficient funds available. At
any point in time, the maximum amount a business can owe the bank is equal to the total
agreed amount of the line of credit.
Financial Management Page| 134
The documents needed to apply for the line of credit could include cash budget, pro-‐forma
financial statements and recent financial statements of the borrower business. This type of
loan is attractive for banks to offer as the banks do not have to check the creditworthiness
of the business each time the business borrows the money.
INTEREST
RATE:
The
interest
rate
charged
to
the
line
of
credit
is
usually
a
floating
rate.
A
floating
rate
is
the
prime
rate
plus
a
premium
which
is
also
known
as
the
interest
increment.
the
amount
of
premium
is
decided
on
the
basis
of
credit
worthiness
of
the
business.
The
interest
rate
charged
on
the
new
borrowings
and
all
outstanding
borrowings
changes
with
the
change
in
the
prime
rate.
OPERATING CHANGE RESTRICTIONS
The line of credit provider can restrict the business in the agreement not to undergo any
major financial or operational changes. The line of credit extender can cancel the line in
case of any major changes. Changes in the key personnel of the business or operations may
affect its debt paying ability and expected future success hence altering the credit
worthiness of the business. Therefore, the loan extender(bank) needs to informed about
any of these changes before taking place. In addition to this, the business is also required to
provide the regular audited or unaudited financial statements for the purpose of periodic
review.
COMPENSATING
BALANCES
The
single
payment
notes
and
lines
of
credit
require
the
borrowers
to
maintain
a
compensating
balance
equal
to
a
specific
percentage(e.g.
10-‐20
percent)
of
the
total
borrowed
amount
in
order
to
keep
the
good
reputation.
Not
only
the
compensating
balance
ensures
the
borrower
will
be
a
good
borrower
but
it
also
increases
the
cost
of
the
interest
to
the
customer.
Financial Management Page| 135
Example –Compensating balances
Strata designs, an interior design company, has borrowed 2 million under a line of
credit agreement. According to the terms of the line of credit, the interest rate is 10%
and the company is required to m aintain the 20%(400,000) of total borrowed amount
as compensating balance. Therefore, the company (borrower) can only use 1,600,000
out of the total borrowed amount by paying interest of 200,000 (10% X 2,000,000).
Thus, the effective annual rate on borrowed funds is 12.5% (200,000/1,600,000)
which is 2.5% more than the stated interest rate (10%).
If
the
company
maintains
a
balance
of
400,000
or
m ore
in
its
checking
account,
none
of
the
borrowed
2
million
is
needed
to
satisfy
the
requirement
of
compensating
balance
and
the
effective
annual
rate
equals
the
stated
annual
interest
rate.
If
the
company
normally
maintains
a
balance
of
200,000
in
its
checking
account,
only
200,000
from
the
borrowed
amount
will
be
required
leaving
1,800,000
of
usable
funds.
Hence,
a
compensating
balance
is
responsible
for
the
increase
in
cost
of
a
loan
only
if
it
is
larger
than
the
company’s
(borrower)
normal
cash
balance.
ANNUAL
CLEANUPS
In
case
of
a
line
of
credit,
the
bank
requires
the
borrower
to
have
a
zero
loan
balance
for
certain
number
of
days
during
the
period
of
extended
loan.
This
requirement
is
regarded
as
annual
cleanup.
The
idea
behind
the
annual
cleanups
are
to
ensure
that
the
business
is
using
the
funds
just
to
meet
its
seasonal
needs
and
the
short
terms
loans
are
not
taking
the
form
of
long
term
loans.
All
of
the
above
mentioned
characteristics
of
the
lines
of
credit
are
flexible
to
some
extent
because
the
banks
want
to
attract
large
and
well-‐known
businesses.
It
is
important
for
a
borrower
to
negotiate
the
optimal
level
of
funds
with
minimum
restrictions
and
a
most
favourable
rate
of
interest.
In
today’s’
world,
borrowers
are
not
interested
in
maintaining
a
deposit,
instead,
they
are
ready
to
pay
extra
fees
to
the
lenders.
On
the
other
hand
the
lenders
are
concerned
with
maximum
safety
to
get
good
return.
Negotiations
can
help
the
borrowers
and
lenders
to
produce
a
most
suitable
line
of
credit.
REVOLVING CREDIT AGREEMENT
Revolving credit is simply a line of credit guaranteed to a borrower business by a
commercial bank regardless of the scarcity of the funds. It also includes a commitment fee
because of the guarantee provided by the bank for the availability of money. This fee is
usually applied to the average unused balance of the loan and is about 0.5 percent. The rate
of interest and other terms are similar to those of line of credit.
Financial Management Page| 136
Example –Revolving credit agreement
ABC Limited, a real estate developer has a 4 m illion revolving credit agreement with a
bank with a commitment fee of 0.5%. Average borrowings of the business for the
past 1 year was 3 million. The commitment fee for the year was 5,000 (0.5% X
1,000,000) because the average unused portion of funds was 1 million (4million -‐
3million). ABC limited also had to pay interest of 320,000 on the actual 3 million
borrowed funds. The effective cost of agreement was 10.83% [(320,000 +
5,000)/3,000,000]. Although, revolving credit is more expensive than the line of credit
but, from borrower’s point of view, it is less risky because the availability of the funds
are guaranteed.
COMMERCIAL
PAPER
It
is
form
financing
used
by
very
large
business
with
unquestionable
financial
position.
It
is
a
promissory
note
with
maturity
ranging
from
3
to
270
days.
Business
with
high
credit
rating
can
issue
a
promissory
note
as
a
form
of
short
term
unsecured
financing.
There
are
no
set
denominations
for
the
commercial
papers
and
they
can
be
issued
in
the
multiples
of
100,000.
Examples
of
well
reputed
business
issuing
commercial
papers
are
the
finance
companies
and
manufacturing
businesses.
The
businesses
that
purchases
the
commercial
papers
hold
them
as
marketable
securities
in
their
books
of
accounts
to
provide
a
reserve
for
liquidity.
INTEREST RATE ON COMMERCIAL PAPER
Commercial papers are sold at a discount from the face(par) value and the interest is
determined by the size of discount and the maturity time. The actual interest earned by the
purchaser can be calculated by calculations given in the example.
Example
–
Interest
rate
on
commercial
paper
A
large
ship
building
company
issued
commercial
paper
with
500,000
par
value
with
90
day
maturity
and
sells
for
490,000.
The
purchaser
will
receive
500,000
at
maturity
(the
end
of
90
days).
Therefore,
the
interest
paid
on
the
financing
is
10,000
on
a
principle
of
490,000
and
the
effective
rate
on
the
paper
is
2.04%
(10,000/490,000).
The
interest
cost
of
a
commercial
paper
is
normally
2
to
4
percent
below
the
prime
rate
which
enables
the
businesses
to
raise
the
cheap
funds
as
compared
to
borrowings
from
commercial
banks.
The
reason
behind
this
interesting
characteristic
is
that
the
short
term
loan
providers
do
not
have
the
option
like
banks
to
make
low
risk
business
loans
at
a
prime
rate.
Although,
the
cost
of
inters
on
commercial
paper
may
be
lower
but
the
overall
cost
of
commercial
paper
may
not
be
lower
than
that
of
a
commercial
bank
loan.
There
are
additional
cost
associated
with
the
commercial
papers
e.g.
the
floatation
cost,
fees
to
Financial Management Page| 137
obtain the bank line of credit to back the paper and fees to obtain rating from a third party.
The decision of borrowing short term funds depends on prompt availability of the funds
and a reasonable rate of interest.
SECURED SHORT TERM FINANCING
This is the type of financing which a business prefers after exhausting the unsecured short
term financing sources. The type of a short term that has a specific asset pledged as a
collateral is known as the secured short term financing. The collateral could be any form of
asset e.g. accounts receivable or inventory. Secured short term financing involves the
security agreement between the lender and the borrower. A security agreement specifies
the collateral held against the secured short term loan. Also both parties agree on interest
rate, a repayment date and other provisions. A copy of the security agreement needs to be
filed with a county or state court to provide information to the subsequent lenders about
the assets of the borrower that are unavailable to use as a collateral. This filing requirement
acts as a protection to the lender by establishing legally the security interest of the lender.
CHARACTERISTICS OF SECURED SHORT TERM FINANCING
In the eye of lenders, the collateral can reduce losses in the case of borrower’s default. The
collateral ensures the recovery of some funds in the event of default. Lenders are more
interested in the repayment of loan by the borrower as scheduled. The lenders prefer to
extend less risky loans at low rate of interest than to be in a situation in which they have to
opt the option to liquidate the collateral for recovery of some funds.
COLLATERAL AND TERMS
Lenders of secured short term loan lenders prefer the collateral with a life closely matched
to the term of the loan. As mentioned earlier accounts receivables and inventory are the
common types of collaterals. They are most desirable types of collaterals because these
assets can be converted into cash very quickly as compared to fixed types of assets.
Desirable
percentage
advance
is
determined
by
the
lender
to
make
against
the
collateral.
Percentage
advance
is
the
percentage
of
the
book
value
of
the
collateral
(asset)
that
constitutes
the
principle
of
a
secured
short
term
loan.
It
is
normally
between
30
to
100
percent
of
the
book
value
of
the
collateral
(asset)
and
is
dependent
on
the
type
and
liquidity
of
collateral.
The
interest
rate
of
a
secured
short
term
loan
is
usually
higher
than
that
of
a
un
secured
short
term
loan.
The
interest
rate
on
these
types
of
loans
is
not
higher
because
the
lenders
consider
them
more
risky
but
it
is
higher
because
the
secured
short
term
loans
involves
troublesome
negotiations
and
administration.
Therefore,
the
added
compensation
is
normally
added
by
the
lenders
in
the
form
of
service
charge,
a
higher
interest
rate
or
both.
The
chief
source
of
secured
short
term
loans
are
the
commercial
banks
and
finance
companies.
These
institution
deal
with
the
secured
short
term
loans
backed
by
the
Financial Management Page| 138
accounts receivable and inventory. Commercial finance companies are the lending
institutions that offer short term and long term secured loans only. And the commercial
finance companies are not allowed to hold the deposits like commercial banks. The
borrower decides to opt for loan option from finance company only when it is unsecured
and secured short term financing options from commercial banks are exhausted. The
interest rate on the loans from finance companies are higher as compared to the
commercial bank because the finance companies generally ends up with higher risk
business borrowers.
ACCOUNTS RECEIVABLE AS COLLATERAL
Accounts receivable can be used as collateral by pledging them or factoring them. In reality
secured short term loan can be created by pledging but not factoring because factoring
involves the sale of accounts receivable at a discount. However, factoring does involve the
use of accounts receivable to obtain the secured short term funds.
PLEDGING ACCOUNTS RECEIVABLE
The use of accounts receivable as a collateral to obtain a secured short term loan is known
as pledging the accounts receivables. Accounts receivable are the attractive form of a loan
collateral because of the highly liquid nature.
The process of pledging accounts receivable involves the determination of their
attractiveness as collateral, by the lender. The lender then prepares a list of the acceptable
accounts with dates of billing and amounts. It the business borrower requires the loan for a
fixed amount then in that case the lender then selects the enough accounts to secure the
requested short term funds. On the other hand, if the business borrower requires the
maximum available loan then the lender evaluates all the accounts receivable to determine
the maximum amount of collateral.
After
completing
the
selection
procedure
of
the
accounts
receivable,
the
lender
adjusts
the
dollar
value
of
selected
accounts
receivable
for
expected
customer
returns
and
other
allowances.
If
a
customer
of
the
borrower
business
returns
merchandise
or
receive
any
form
of
allowance
such
as
cash
discount
on
early
payment,
the
collateral
is
reduced
by
the
same
amount.
The
dollar
value
adjustment
by
a
fixed
percentage
are
made
to
reduce
the
value
of
the
collateral
to
protect
the
lender
from
such
occurrences.
Next
step
is
to
determine
the
percentage
to
be
advanced
by
the
lender
against
the
collateral.
The
percentage
to
be
advanced
is
determined
by
evaluating
the
quality
of
accounts
receivable
and
their
expected
liquidation
cost.
The
determined
percentage
represents
the
principle
of
the
extended
loan
and
it
ranges
between
50
to
90
percent
of
the
face
value
of
acceptable
receivables.
In
addition
the
lender
also
files
a
lieu
to
protect
its
interest
in
collateral.
A
lieu
is
simply
a
publicly
disclosed
legal
claim
on
an
asset
(collateral).
Financial Management Page| 139
Non-‐notification basis are used to pledge accounts receivable. By non notification basis we
mean that the customer whose account has been pledged as collateral is not notified by the
borrower business. Under such arrangement, the lender trusts the borrower to remit the
payments from the customers (accounts receivable) as they are received. In case the
accounts receivable are pledged on notification basis, the customer of the borrower
business is notified to make direct payments to the lender.
Pledging
cost
of
the
accounts
receivable
is
normally
2
-‐
5
percent
higher
than
the
prime
rate.
Moreover,
to
cover
the
administration
costs,
a
service
charge
of
up
to
3
percent
may
be
imposed
by
the
lender.
Hence,
pledges
of
accounts
receivable
are
a
source
of
financing
with
high
cost.
FACTORING ACCOUNTS RECEIVABLE
Selling accounts receivable outright to a financial institution at a discount is known as
factoring. It is known as factoring because by factor we mean a financial institution. A
special financial institution which specializes in purchase of accounts receivables is known
as a factor. Some commercial banks and finance companies also offer services of factoring
accounts receivable. Factoring accounts receivable are somehow similar to borrowings with
accounts receivables as collateral but not the exactly the same as obtaining the short term
loans with accounts receivables as collateral.
The
detailed
conditions
and
procedures
are
stated
in
the
factoring
agreement.
Like
a
lender,
a
factor
(financial
institution)
chooses
the
accounts
receivable
for
purchase
and
only
selects
those
accounts
which
involves
less
credit
risks.
If
a
business
chooses
the
option
of
factoring
on
a
continuous
basis,
the
factor
(financial
institution)
will
take
the
responsibility
to
make
credit
decisions
of
the
business
because
this
will
guarantee
the
acceptability
of
accounts
receivable.
Factoring
involves
notification
basis
which
means
the
factor
is
responsible
to
absorb
the
loss
in
case
any
of
the
account
receivable
becomes
uncollectible.
A
general
practice
is
that
the
factor
does
not
pay
to
the
business
until
the
account
is
collected
or
until
the
last
day
of
the
credit
period,
whichever
occurs
first.
An
account
similar
to
the
bank
deposit
account
is
set
up
by
the
factor
for
each
customer
(the
borrower
business).
The
factor
deposits
money
into
the
customer’s
(the
borrower
business)
account
as
any
payment
is
received
or
as
the
due
date
arrives.
From
this
account
the
seller
of
accounts
receivable
(the
borrower
business)
is
free
to
withdraw
money
as
needed.
Commissions,
interest
charge
on
advances
and
interest
earned
on
surplus
are
the
different
types
of
costs
regarded
as
factoring
costs.
The
amount,
factor
(financial
institution)
deposits
in
the
account
of
the
seller
(the
borrower
business)
is
equal
to
the
book
value
of
the
purchased
accounts
receivable
less
the
agreed
commissions.
Usually,
1
to
3
percent
of
the
book
value
of
accounts
receivable
are
stated
as
commissions.
Whereas,
the
interest
charge
is
typically
2
to
4
percent
above
the
prime
rate
and
it
is
charged
on
the
actual
amount.
The
interest
payments
on
the
surpluses
are
0.2
to
0.5
percent
per
month.
Financial Management Page| 140
Some of the advantages make factoring attractive to the businesses, regardless of its high
cost. One of the advantage is the ability of factoring to turn accounts receivable
immediately into cash. Another advantage is that it guarantees the business a known
pattern of cash inflow and if the business opt for factoring on continuing basis, the business
can eliminate the credit and collection departments.
INVENTORY AS COLLATERAL
As a short term loan collateral, inventory is second to accounts receivable. The market
value of the inventory establishes its value as collateral and generally the market value of
inventory is greater than its book value. If the borrower defaults on his obligations, the
lender would be able to sell that collateral (inventory) for at least its book value.
The most important characteristic to evaluate inventory as loan collateral is its
marketability in the light of its physical properties. Perishable items, such as fresh
tomatoes, may be marketable but may not be a desirable collateral because of the physical
properties. It is quite possible that the cost of sorting and selling the fresh tomatoes is high,
which makes them a non-‐desirable collateral. Specialized items are also considered as a
non desirable e.g. it could be difficult to find a buyer for lunar roving vehicles. The lender
always looks for items as collateral with very stable market prices, marketability and
desirable physical properties.
FLOATING INVENTORY LIENS
It is a secured short term loan against inventory as collateral under which a lender’s claim is
on the borrower’s inventory in general. Businesses with stable level of inventory consisting
of diversified group of inexpensive merchandise, find the arrangement of floating inventory
liens very attractive. Examples of such items include, screws and bolts, shoes and auto tires.
Because it is difficult for a lender to verify the presence of inventory consisting of diversified
group of inexpensive merchandise, the lender extends the loan equal to less than 50
percent of the book value of the average inventory. Typically the rate of interest charged on
floating lien is 3 – 5 percent higher than the prime rate. Floating inventory lien loans are
available from commercial banks and in some cases also from finance companies.
TRUST RECEIPT INVENTORY LOANS
It is the form of a secured short term loan made against relatively expensive items of
inventory. The lender advances 80 to 100 percent of the book value of the average
inventory in exchange for the borrower’s promise to repay the loan as well as accrued
interest immediately after the sale of each item of collateral. The lender files the lien on all
the financed items of inventory and releases the lien on each item after its sale and
remittance of amount lent plus accrued interest. Periodic checks of the borrower’s
inventory are required by the lender to make sure that the required amount of collateral
are still on hand. The interest rate on Trust receipt inventory loans is usually 2 percent or
more above the prime rate.
Financial Management Page| 141
WAREHOUSE RECEIPT LOANS
A warehouse receipt loan is a secured short term loan against inventory under which the
control of the pledged inventory is transferred to the lender. The control of the pledged
inventory is sorted by a designated agent on the behalf of lender. After selecting the
desired inventory items as collateral, a warehousing company is hired as agent, by the
lender to take possession of the selected inventory.
There
are
two
types
of
possible
warehousing;
a
terminal
warehouse
and
a
field
warehouse.
A
terminal
warehouse
is
a
central
warehouse
of
the
lender
where
merchandise
of
various
customers
(borrowers)
are
stored.
This
type
of
warehouse
is
used
when
the
pledged
inventory
is
easily
transportable
and
inexpensive
to
transport.
A
field
warehouse
is
set
up
on
the
borrowers
premises
or
the
designated
agent
lease
part
of
the
borrower’s
warehouse
to
store
the
pledged
inventory.
Regardless
of
the
type
of
the
warehouse,
a
guard
over
the
inventory
is
placed
by
the
designated
warehousing
company.
Pledged
inventory
could
be
released
by
the
warehousing
company
only
with
the
written
permission
of
lender.
The
requirements
for
the
release
of
inventory
are
stated
in
the
actual
lending
agreement.
The
lender
only
selects
the
inventory
items
as
collateral
that
are
believed
to
be
readily
marketable
and
only
extends
loan
equal
to
75
to
90
percent
of
the
average
collateral’s
value.
The
cost
of
this
type
of
loan
is
higher
than
those
of
other
secured
short
term
loans
because
a
warehousing
company
is
hired
and
paid
for
guarding
and
supervising
the
pledged
inventory.
The
basic
rate
of
interest
on
warehouse
receipt
loans
range
from
3
to
5
percent
above
the
prime
rate.
In
addition
to
the
higher
rate
of
interest,
the
borrower
pays
the
insurance
costs
on
the
warehoused
pledged
inventory
and
also
absorbs
the
cost
of
warehousing
in
the
form
of
warehousing
fee
which
is
typically
between
1
to
3
percent
of
the
total
amount
of
extended
loan.
TOPIC
SUMMARY
Accounts
payable
and
accruals
are
the
two
forms
of
spontaneous
financing
for
a
business.
The
key
objective
of
a
business
is
to
hold
the
cash
intended
to
pay
its
short
term
liabilities
for
a
longer
possible
period
of
time.
This
enables
the
business
to
use
those
funds
for
its
own
purposes
for
a
longer
time
period.
In
addition
to
this,
a
business
must
need
to
arrange
for
short-‐term
funds
to
balance
out
cash
flows
.
The
quantity
and
form
of
current
liabilities
financing
should
be
provided
at
the
lowest-‐cost
funds
with
the
least
risk.
The
strategy
regarding
current
liabilities
is
expected
to
contribute
positively
to
the
value
maximization
goal
of
a
business.
Self-‐Reflection Questions
1.What
are
the
two
key
sources
of
spontaneous
short-‐term
financing
for
a
business?
Financial Management Page| 142
2.
Is
there
a
cost
associated
with
taking
and
giving
up
a
cash
discount?
How
do
short-‐term
borrowing
costs
and
stretching
accounts
payable
effect
the
cost
of
giving
up
a
cash
discount?
3.
What
is
the
relationship
between
the
prime
rate
of
interest
and
the
short-‐term
bank
borrowing?
What
is
a
floating-‐rate
loan?
4. Differentiate between a line of credit and a revolving credit agreement.
5.
How
is
commercial
paper
used
to
raise
short-‐term
funds?
Who
can
issue
commercial
paper?
Who
buys
commercial
paper?
6.
Compare
the
secured
and
unsecured
short-‐term
loans
in
terms
of
riskiness
and
interest
rates.
7.
Describe
and
compare
the
basic
features
of
the
following
methods
of
using
inventory
as
short
term
loan
collateral:
(i)
floating
lien
(ii)
trust
receipt
loan
(iii)
warehouse
receipt
loan.
8.
For
the
following
methods
of
using
accounts
receivable
to
obtain
short
term
financing,
describe
the
basic
features
of
each
and
compare
them:
(i)
pledging
accounts
receivable
(ii)
factoring
accounts
receivable.
UNIT
5
–
REFERENCES
Gitman,
Lawrence
J.
And
Chad
J.
Zutter
(2012)
Principles
of
managerial
finance,
13th
ed.
p.
cm.
The
Prentice
Hall
Lorenzo
P,
Argentina
and
Allende,
Sarria
(2010)
Working
Capital
Management,
Oxford
university
press
Inc.
Brealey,
R.A;
Myers,
S.C;
Allen,
F.
(2006)
Principles
of
corporate
finance,
6th
ed.
dandelon.com
Baker, H. K ent a nd P owell, G ary ( 2009) Understanding Financial M anagement: A
Practical Guide, black well publishing
Sagner, James (2011), Essentials of Working Capital Management, John Wiley and sons. Inc
http://www.investopedia.com/terms/w/workingcapitalmanagement.asp
UNIT
5
–
SUMMARY
ASSIGNMENTS
AND
ACTIVITIES
The
assignment
and
activities
covered
in
the
unit
four
will
enable
the
students
to
practice
the
learned
techniques
of
short
term
funds
management.
Financial Management Page| 143
SUMMARY
The
unit
describes
the
phenomenon
of
short-‐term
funds
management.
It
focuses
on
the
concept
of
net
working
capital
and
describes
the
cash
conversion
cycle
and
its
funding
requirements.
Various
different
inventory
management
views
are
discussed
to
develop
an
understand
of
the
commonly
used
techniques
of
inventory
management
system.
This
unit
further,
looks
at
various
aspects
of
spontaneous
liabilities
management
and
both
unsecured
and
secured
sources
of
short-‐term
loans.
It
explains
in
detail
how
best
to
manage
them.
For
example,
it
explains,
how
to
obtain
the
right
quantity
and
type
of
current
liabilities
financing
with
minimum
cost
and
risk.
Financial Management Page| 144
FINAL ASSIGNMENT/MAJOR PROJECT
The
final
assignment
is
to
be
set
by
the
participating
institutions.
It
is
recommended
that
the
final
project
should
give
the
student
the
opportunity
to
demonstrate
their
competencies
any
of
the
units
that
the
students
have
covered
in
this
course.
The
assignment
could
be
either
done
as
an
individual
assignment
or
a
group
assignment.
Financial Management Page| 145
COURSE SUMMARY
TOPICS LEARNED
The topics and concepts that have been covered in this course are as listed below:
Different forms of business, but common ones are:
• Sole
proprietorship
• Partnership
• Corporation
Concepts of financial management
Financial management enables managers to answer questions pertaining to:
• Long-‐term
investments
• Long
term
finances
• Management
of
day
today
activities
Three
financial
statements
are
important
for
gauging
the
health
of
the
company
by
both
the
managers
and
investors:
• Statement of comprehensive income – summarises the overall income generated
by the company
• The statement of financial position – outlines the state of finances of a company in
a given year, usually compared over 2 periods
• The statement of cash flows – analyses the cash situation of the company
Financial markets and institutions
Five major financial institutions that facilitate flow of funds
• Commercial
banks
• Mutual
funds
• Security
firms
• Insurance
companies
• Pension
funds
Capital markets
• Bond
markets
• Equity
markets
Financial Management Page| 146
Different types of market securities
• Money market securities
• Treasury bills
• Foreign money markets
• Capital markets – bonds, stocks
• Securities exchange -‐ organised and over the counter
• Derivative securities
Foreign exchange markets – stop and forward
Financial Statements
The health of the company is gauged using financial analysis and analysis of the cash flows
Ratios covered in the financial analysis:
• Liquidity
ratios
!"##$%& !""#$"
Current
ratio
=
!"#$%& !"#$"!"%"&'
(!"##$%& !""#$" ! !"#$"%&'()
Quick
ratio
(acid
test
ratio)
=
!"#$%& !"#$"!"%"&'
• Profitability
ratios
!"# !"#$%&
Profit
margin
= x
100
!"#$%
!"#$$ !"#$%&
Gross
profit
Ratio
=
x100
!"#$%
!"#$$ !"#$%&
Mark
up
ratio
= x100
!"#$ !" !""#$ !"#$
• Efficiency
Ratios
!"#$ !" !""#$ !"#$
Stock
turnover
ratio
=
!"#$%&' !"#$%
!"# !"#$%&
Return
on
assets
=
!"#$% !""#$"
𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
Return
on
equity
=
!"#$% !"#$%&
!"#$%&' !"#$% !"#$%&'
Trade
debtors
collection
period
=
x 365
!"#$%& !"#$!
Financial Management Page| 147
!"#$%&' !"#$% !"#$%&'"(
Debt collection period = x 365
!"#$% !"#$%& !"#$%&'('
• Investment
Ratios
𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
Earnings
per
share
=
!"#$%& !" !"#$%&"' !"#$%!
𝐦𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
Price
earnings
ratio
=
!"#$%$&' !"# !"#$%
𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞𝐬!𝐥𝐨𝐧𝐠!𝐭𝐞𝐫𝐦 𝐥𝐨𝐚𝐧𝐬
Capital
gearing
ratio
=
!"#$% !"#$%&'! !"#$%!!"#$ !"#$ !"#$%
There are three types of cash flows – operating flows, investment flows and financing flows.
• Operating
Cash
flow
(generated
from
normal
trading)=
Net
profits
after
taxes+
Depreciation
and
other
noncash
charges
• Free
cash
flow
(cash
flow
available
to
investors)
=
Operating
Cash
Flow
-‐Net
fixed
asset
investment
-‐
Net
current
asset
investment
• net
fixed
asset
investment
(NFAI)
=
Change
in
net
fixed
assets
+Depreciation
Two
methods
of
presenting
the
cash
flow
statement
–
direct
(based
on
the
cash
book
summary)
and
indirect
based
on
the
profit
and
loss
and
the
balance
sheet.
Financial planning
• The different types of financial plans – strategic and operating
• Cash budget and forecasting of the different parts of the budget – sales forecast,
cash receipts, cash disbursements, net cash flow, ending cash flow, financing and
excess cash
Financial Management Page| 148
• Pro forma Financial statements as tools for profit planning – pro forma income
statement, cost and expenses, pro forma balance sheet and related assumptions
Short term funds management
• Working capital management:
Net working capital = Current assets – Current liabilities
Cash conversion cycle (CCC) = OC − APP, and operating cycle (OC) = AAI + ACP)
Where:
OC = Operating cycle
AAI = Average age of inventory
ACP = Average collection period
• Inventory
management
a) Inventory
systems
–
ABC,
b) Economic
order
quantity
c) Computation
of
total
cost
and
economic
ordering
costs,
where:
o Carrying
costs:
=
C
X
Q/2
o Ordering
costs: Order cost = O ×S/Q
S Q
Total cost = (O × ) + (C × )
Q 2
2 ×S ×O
Economic Ordering Quantity =
C
d)
just
in
time
inventory
management,
• Working
capital
management
o Accounts
payable
and
credit
terms
and
the
cost
of
giving
up
discounts
o Raising
cash
through
short
financing
APPLICATION OF KNOWLEDGE AND SKILL
Given
the
importance
of
managing
finance
for
the
success
of
the
business
and
realisation
of
value
for
the
owners/share
holders,
this
course
has
equipped
you
with
financial
management
survival
skills,
Whether
you
are
taking
this
course
to
seek
employment
in
the
finance
sector
or
to
manage
the
finances
of
your
business,
you
will
find
that
this
course
has
been
tailored
to
cater
for
your
financial
knowledge
needs.
Regardless
of
the
size
and
nature
of
the
business
you
find
yourself
in
,
you
will
find
that
the
skills
acquired
from
this
course
e
are
equally
applicable.
Financial Management Page| 149
COURSE EVALUATION
The end of course evaluation is to be provided by the participating institutions.
Financial Management Page| 150
COURSE APPENDICES
Appendix one – Solution to topic 3.2 (financial analysis) reflection question
Appendix two: Solution to unit four assignment
Financial Management Page| 151
APPENDIX 1 – SOLUTION TO TOPIC 3.2 (FINANCIAL ANALYSIS)
Financial Management Page| 152
Financial Management Page| 153
Financial Management Page| 154
APPENDIX 2: UNIT FOUR ASSIGNMENT’S SOLUTION
i) Cash budget
Accounts
Cash
Budget
receivable
at
March
–
May
end
of
May
Jan
Feb
Mar
Apr
May
Jun
Jul
000
000
000
000
000
Sales
forecast
500
600
400
200
200
Cash
sales
(30
%)
150
180
120
60
60
Collection
of
A/R
Lagged
1
month
245
294
196
98
98
[(0.7
×
0.7)
=
0.49]
Lagged
2
month
105
126
84
42
42
(0.3
×
0.7)
=
0.21]
Total
cash
receipts
519
382
242
140
+
42=
182
Less:
Total
cash
disbursements
600
500
200
Net
cash
flow
(81)
(118)
42
Add:
Beginning
cash
115
34
(84)
Ending
cash
34
(84)
(42)
Less:
Minimum
cash
balance
25
25
25
Required
total
financing
(notes
Payable)
-‐
109
67
Excess
cash
balance
(marketable
securities)
9
-‐
-‐
ii)
The
company
would
need
a
maximum
of
109
in
financing
over
the
3
–
month
period.
iii)
Pro-‐forma
balance
sheet
Account
Amount
Source
of
amount
Cash
25
Minimum
cash
balance
–
May
Notes
payable
67
Required
total
financing
–
May
Marketable
securities
0
Excess
cash
balance
–
June
Accounts
receivable
182
Calculation
at
right
of
cash
budget
statement
155
|
P a g e
iv)
Pro-‐forma
income
statement
Year
2013
Income
Statement
for
the
Year
Ended
December
31,
2012
Sales
revenue
(given)
3,900,000
Less:
Cost
of
goods
sold
(55%)
2,145,000
Gross
profits
1,755,000
Less:
Operating
expenses
(12%)
468,000
Operating
profits
1,287,000
Less:
Interest
expense(given)
325,000
Net
profits
before
taxes
962,000
Less:
Taxes
(40%)
384,800
Net
profits
after
taxes
577,200
Less:
Cash
dividends
(given)
320,000
To
retained
earnings
257,200
v)
The
percent
of
sales
method
assumes
that
all
costs
are
variable
so
it
may
underestimate
actual
2013
pro-‐firma
income.
If
the
business
has
fixed
costs,
which
does
not
increase
with
increasing
sales
then
the
pro-‐forma
income
for
year
2013
would
probably
be
underestimated.
156
|
P a g e
You might also like
- Module 1 Financial Management Final - Edited 2No ratings yetModule 1 Financial Management Final - Edited 218 pages
- Flexible Instructional Delivery Plan (Fidp) : First Semester100% (6)Flexible Instructional Delivery Plan (Fidp) : First Semester7 pages
- Financial Management-A Marketing Perspective Textbook E1I1 23062020BCC-UnlockedNo ratings yetFinancial Management-A Marketing Perspective Textbook E1I1 23062020BCC-Unlocked393 pages
- COURSE OUTLINE CFI 520 Financial Management - May To Aug 2025No ratings yetCOURSE OUTLINE CFI 520 Financial Management - May To Aug 20254 pages
- BFN303 Financial Management Course GuideNo ratings yetBFN303 Financial Management Course Guide237 pages
- Chapter 1 Introduction To Financial ManagementNo ratings yetChapter 1 Introduction To Financial Management29 pages
- Business Finance Pre - Test and Lesson 1No ratings yetBusiness Finance Pre - Test and Lesson 129 pages
- Lecturenote - 1322871078financial Management I EditedNo ratings yetLecturenote - 1322871078financial Management I Edited138 pages
- FMB316D Learners Guide 2023 (Second Semester)No ratings yetFMB316D Learners Guide 2023 (Second Semester)20 pages
- Financial Management I Mount Kenya University (Mku) Notes PDF - Masomo Msingi Publishers50% (2)Financial Management I Mount Kenya University (Mku) Notes PDF - Masomo Msingi Publishers97 pages
- C3 Goals and Functions of Financial ManagementNo ratings yetC3 Goals and Functions of Financial Management6 pages
- Acf 361 Business Finance Under Revision 2No ratings yetAcf 361 Business Finance Under Revision 2133 pages
- MBA Financial Management Course OverviewNo ratings yetMBA Financial Management Course Overview15 pages
- Lecture 1 I Overview of Financial Management I Financial Management I Syeda Arooj NazNo ratings yetLecture 1 I Overview of Financial Management I Financial Management I Syeda Arooj Naz12 pages
- Assessment Instrument Development Guide - DSD2409No ratings yetAssessment Instrument Development Guide - DSD24097 pages
- Communication Theory & Process 3RD Term 2013No ratings yetCommunication Theory & Process 3RD Term 20138 pages
- International Offshore Daywork Drilling Contract (Letter Size Paper)No ratings yetInternational Offshore Daywork Drilling Contract (Letter Size Paper)36 pages
- Mathematics Original-Questioon-Paper-with-Answer-Keys-Tiruppur-District-English-Medium-PDF-DownloadNo ratings yetMathematics Original-Questioon-Paper-with-Answer-Keys-Tiruppur-District-English-Medium-PDF-Download6 pages
- Definition of Bank: According To CrowtherNo ratings yetDefinition of Bank: According To Crowther77 pages
- KODAK SONORA XTRA Process Free Plate Brochure ENNo ratings yetKODAK SONORA XTRA Process Free Plate Brochure EN6 pages
- FAR 1 - Ratios Practice Material Answers 14 March 2018No ratings yetFAR 1 - Ratios Practice Material Answers 14 March 201832 pages
- Ufo Crash Retrievals Status Report I Retrievals of The Third Kind Leonard Stringfield Instant DownloadNo ratings yetUfo Crash Retrievals Status Report I Retrievals of The Third Kind Leonard Stringfield Instant Download20 pages
- Information Technology Project Management (UCCD2043)No ratings yetInformation Technology Project Management (UCCD2043)27 pages
- Elements de Corrige de L'Anglais Bts 2004: I-Grammar and Speech FunctionsNo ratings yetElements de Corrige de L'Anglais Bts 2004: I-Grammar and Speech Functions2 pages
- 6 - International Performance ManagementNo ratings yet6 - International Performance Management9 pages
- Wave 2 Announcements: Over The Last 18 Months, We've Been Making Improvements That Have Resulted inNo ratings yetWave 2 Announcements: Over The Last 18 Months, We've Been Making Improvements That Have Resulted in1 page
- Third-Party: Third-Party Order Processing With Scheduling AgreementsNo ratings yetThird-Party: Third-Party Order Processing With Scheduling Agreements3 pages
- Test Bank For Information Systems Today, 8th Edition, Joseph Valacich PDF DownloadNo ratings yetTest Bank For Information Systems Today, 8th Edition, Joseph Valacich PDF Download123 pages
- List of Companies Removed From Dissemination BoardNo ratings yetList of Companies Removed From Dissemination Board24 pages
