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8/9/2019 Techniques of Financial Management
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TECHNIQUES OF
FINANCIAL MANAGEMENT
By
Emmanuel Nelson Bassey
(MBA; CNA; NIAFA; ACIN)
enbassey
books series
0011MH06
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books-i
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BOOKS PUBLISHED BY THE SAME AUTHOR
1. ANATOMY OF INTERNET2. DATA PROCESSING HAND BOOK VOL 13. QUESTIONS AND SUGESTED SOLUTIONS ON
DATA PROCESSING4. INTRODUCTION TO MS WINDOWS AND BASIC
PRINCIPLES OF COMPUTING5. PROJECT FORMULATION AND MANAGEMENT.6. NEW ERA ACCOUNTING7. COMPUTER BASED ACCOUNTING8. ELEMENT OF DATA BASE MANAGEMENT
SYSTEMS.9. ADVANCED FINANCIAL ACCOUNTING10. ADVANCED COSTING11. MANAGEMENT ACCOUNTING12. SIMPLE APPRAOCH ON FINANCIAL MANAGEMENT13. COMPUTER OPERATIONS AND PACKAGES14. MONEY MANAGEMENT AND FINANCIAL
INSTITUTIONS IN NIG.15. UNDERSTADING OFFICE ADMINISTRATION16. AN INTRODUCTION TO FINANCIAL MANAGEMENT17. BUSINESS FINANCE18. ELEMENT OF BANKING19. COMPUTER AND SOCIETY20. COMPUTER SCIENCE FOR SEC.SCH. JS 121. COMPUTER SCIENCE FOR SEC.SCH. JS 222. COMPUTER SCIENCE FOR SEC.SCH. JS 323. COMPUTER SCIENCE FOR SEC.SCH. SS 124. COMPUTER SCIENCE FOR SEC.SCH. SS 225. COMPUTER SCIENCE FOR SEC.SCH. SS 326. COMPUTER SCIENCE FOR PRI.SCH. VOL 1
27. COMPUTER SCIENCE FOR PRI.SCH. VOL 228. COMPUTER SCIENCE FOR PRI.SCH. VOL 329. COMPUTER SCIENCE FOR PRI.SCH. VOL 4
PREFACE
In preparing this edition, the opportunities have been taken
to review various texts in order to keep abreast of the
current trends in FINANCIAL MANAGEMENT.
THE AIMS
Economic performance in a democracy will depend on
markets, how they are structured, and how they function.
Markets are important because they encourage individuals
to exert their vital energies, skills, ambition and risk taking
in the economic pursuits of life. The market moderates the
interplay of these vital energies in a way that minimises
conflict and so ensures the prevalence of peace and
stability
The text is particularly relevant to:
Students in Colleges, Polytechnics and Universitiesoffering financial management.
Students preparing for foundation levelexamination of any professional examination in Nigeria infinancial management and relevant examination inmanagement science department.
School leavers, dropouts, job seekers, managersand others in industry, commerce, local authorities andsimilar organisations who wish to gain a working
knowledge of how finance could be obtained and managed The professionals and intermediates for referencepurposes. This text is to give a first hand knowledge to theprospective bankers, accountants and managementscience elite; serve as a companion/references text to the
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instructors and teachers of financial management in ourschools and colleges.It also seeks to create an avenue for professional
development in global market place.
THE SCOPE
The text comprehensively covers the principles,
techniques and methods involve in obtaining and
managing funds, investment and performance appraisal,
risk and interpretation of account.
The value of the book is considerably enhancing by the
instructive illustrations and examples provided by the
numerous exercises which it offers.
Thus, considering the scope and its approach, thebook will be found useful as a regular textbook.
Acknowledgement
This edition is as a result of joint efforts of a numberof people and many instructors, academic colleaguesand students alike. I wish to thank the many people
who have made these contributions.
The author has received continued help from a number of
colleagues through their suggestions and contributions to
individual chapters. Joseph E. Ekpo provided enthusiastic
support in this edition.
My thanks also go to those who assisted in the typing of
the manuscript: John Abednego Effiong, Bridget Obeda,Augustine.
Above all, may all glory, honour and majestybe ascribed unto our MOST HIGH GODthrough JESUS CHRIST OUR LORD ANDSAVIOUR. Amen.
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.. FOR THE STUDENTS
This book has been written specifically for you. Yourinstructor, teacher or lecturer will help youunderstand the ideas developed in the text, but ---- inthe last analysis --- it is up for you to learn.
I have concentrated on a style and format that should
help you to learn and understand when you study the
chapters even alone. In the classroom, you can
reinforce this learning and see what others have to
say or what questions they raise. Your lecturer cansupplement this process through the assignments,
lectures and testing. I hope the experience will be
satisfying for you.
LOCATIONS TO OBTAIN EN-BASSEYS BOOK
1. Gonel Systems Limited2 Alegbo Road, Effurunoff P.T. I. Road,Box 527, Effurun, Delta State. Nigeria.
2. Blessed Concept139 P.T.I. Road,Effurun, Warri. Delta State. Nigeria.
3. C.A.C.T. PUBLISHERSBlock B, Flat 8, Masoje EstatePTI Road. EffurunDelta State. Nigeria.
4. Akwa Ibom State PolytechnicContinuing Education Centre.
KM 1 Refinery Road. Effurun.Delta State. Nigeria.
5. c/o Sister UdemeAssociation Of National Accountants OfNigeria,Herbert Maculae Road, Yaba.Lagos. Nigeria.
TABLE OF CONTENTS-vii- -viii-
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Books by the same authoriii Preface ivAcknowledgement..viFor the studentsviiTable of contentsix
ONEThe scenario of financial management..11Financial management levels.17What is financial management.20Objectives of FM21Decision making24Functions of finance manager..26Goals of financial management32Sources of funds.34Evaluation of financial policy
TWOFinancial planning 45Management information for planning ..45Business forecasting..46Profit and loss forecast55Balance sheet forecast 56Capital structure57Techniques of financial analysis62
THREE
Woking capital management.79decision areas81Managing working capital .83Key working capital ratios..92Liquidity ratio94Working capital and operating cycle..99
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Principles of working capital104Concepts of working capital.106Stock control107Stock control method114
FOURForeign currency transaction.130Foreign exchange market..131Foreign exchange market in Nigeria..132Modern foreign exchange market.135
FIVEAllocation of dividend.145Dividend defined.146Types of dividends..148Method of payment150
Dividend policy..154Facts about dividend policy..154Determinants of dividend policy172
SIXMergers and Acquisition..173Classification of mergers..176Types of takeovers184Reconstruction and reorganisation..190
THE SCENARIO OFFINANCIAL
MANAGEMENT
Finance is the science of funds management. Thegeneral areas of finance are business finance, personal finance, and public finance. Financeincludes saving money and often includes lendingmoney. The field of finance deals with the conceptsof time, money and risk and how they areinterrelated. It also deals with how money is spentand budgeted.
Finance works most basically through individuals andbusiness organisations depositing money in a bank.
The bank then lends the money out to otherindividuals or corporations for consumption orinvestment, and charges interest on the loans.
Loans have become increasingly packaged forresale, meaning that an investor buys the loan (debt)
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from a bank or directly from a corporation. Bonds aredebt sold directly to investors from corporations,while that investor can then hold the debt and collectthe interest or sell the debt on a secondary market.Banks are the main facilitators of funding through the
provision of credit, although private equity, mutualfunds, hedge funds, and other organizations havebecome important as they invest in various forms ofdebt. Financial assets, known as investments, arefinancially managed with careful attention to financialrisk management to control financial risk. Financialinstruments allow many forms of securitized assetsto be traded on securities exchanges such as stockexchanges, including debt such as bonds as well asequity in publicly-traded corporations.
Central banks act as lenders of last resort andcontrol the money supply, which affects the interestrates charged. As money supply increases, interestrates decrease.
The main techniques and sectors of the financialindustry
An entity whose income exceeds their expenditurecan lend or invest the excess income. On the otherhand, an entity whose income is less than itsexpenditure can raise capital by borrowing or sellingequity claims, decreasing its expenses, or increasingits income. The lender can find a borrower, a
financial intermediary such as a bank, or buy notesor bonds in the bond market. The lender receivesinterest, the borrower pays a higher interest than thelender receives, and the financial intermediarypockets the difference.
A bank aggregates the activities of many borrowersand lenders. A bank accepts deposits from lenders,on which it pays the interest. The bank then lendsthese deposits to borrowers. Banks allow borrowersand lenders, of different sizes, to coordinate theiractivity. Banks are thus compensators of moneyflows in space.
A specific example of corporate finance is the sale ofstock by a company to institutional investors like
investment banks, who in turn generally sell it to thepublic. The stock gives whoever owns it partownership in that company. If you buy one share ofXYZ Inc, and they have 100 shares outstanding (heldby investors), you are 1/100 owner of that company.Of course, in return for the stock, the companyreceives cash, which it uses to expand its business;this process is known as "equity financing". Equityfinancing mixed with the sale of bonds (or any otherdebt financing) is called the company's capital
structure.
Finance is used by individuals (personal finance), bygovernments (public finance
), by businesses(corporate finance
), as well as by a wide variety oforganizations including schools and non-profit
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organizations. In general, the goals of each of theabove activities are achieved through the use ofappropriate financial instruments and methodologies,with consideration to their institutional setting.
Finance is one of the most important aspects ofbusiness management. Without proper financialplanning a new enterprise is unlikely to besuccessful. Managing money (a liquid asset) isessential to ensure a secure future, both for theindividual and an organization.
Personal finance
Questions in personal finance revolve around
How much money will be needed by anindividual (or by a family), and when?
Where will this money come from, and how? How can people protect themselves against
unforeseen personal events, as well as thosein the external economy?
How can family assets best be transferredacross generations (bequests andinheritance)?
How does tax policy (tax subsidies or
penalties) affect personal financial decisions?
How does credit affect an individual's financialstanding?
How can one plan for a secure financial futurein an environment of economic instability?
Personal financial decisions may involve paying foreducation, financing durable goods such as real
estate and cars, buying insurance, e.g. health andproperty insurance, investing and saving forretirement.
Personal financial decisions may also involve payingfor a loan, or debt obligations.
Corporate finance
Managerial or corporate finance is the task ofproviding the funds for a corporation's activities. For
small business, this is referred to as SME finance. Itgenerally involves balancing risk and profitability,while attempting to maximize an entity's wealth andthe value of its stock.
Long term funds are provided by ownership equityand long-term credit, often in the form ofbonds. Thebalance between these forms the company's capitalstructure. Short-term funding or working capital ismostly provided by banks extending a line of credit.
Another business decision concerning finance isinvestment, or fund management. An investment isan acquisition of an asset in the hope that it willmaintain or increase its value. In investmentmanagement in choosing a portfolio one has to
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decide what, how much and when to invest. To dothis, a company must:
Identify relevant objectives and constraints:institution or individual goals, time horizon, risk
aversion and tax considerations; Identify the appropriate strategy: active v.
passive hedging strategy Measure the portfolio performance
Public finance
In Government circle, finance is about governmentsincome and expenditure, which invariably deals witha nations budget for the year while budgets arestatements about the ways government, plans to
obtain income (i.e. revenue) and the ways it plans tospend such income during a particular year. It couldbe a deficit budget where expenditure is greaterthan the estimated revenue and as a resultgovernment plans to save for emergency situationsor carry out capital-intensive expenditure.A surplus budget where government expenditureequals estimated government revenue.The government acquires its revenue from thefollowing:
a) Indirect taxes eg custom duties, excise,purchase tax and sales tax.b) Direct taxes eg personal income tax, companytax, death duties, capital gains etc.c) Miscellaneous receipts from loans, profits,grants and fines and royalties.
Financial management entails planning for thefuture of a person or a business enterprise to ensurea positive cash flow. It includes the administrationand maintenance of financial assets. Besides,financial management covers the process of
identifying and managing risks.
The primary concern of financial management is theassessment rather than the techniques of financialquantification. A financial manager looks at theavailable data to judge the performance ofenterprises. Managerial finance is an interdisciplinaryapproach that borrows from both managerialaccounting and corporate finance.
Some experts refer to financial management as the
science of money management. The primaryusage of this term is in the world of financingbusiness activities. However, financial managementis important at all levels of human existence becauseevery entity needs to look after its finances.
Financial Management: Levels
Broadly speaking, the process of f inancial
management takes place at two levels. At theINDIVIDUAL LEVEL, financial management involvestailoring expenses according to the financialresources of an individual. Individuals with surpluscash or access to funding invest their money to makeup for the impact of taxation and inflation. Else, they
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spend it on discretionary items. They need to be ableto take the financial decisions that are intended tobenefit them in the long run and help them achievetheir financial goals.
From an organisational point of view, the process offinancial management is associated with financialplanning and financial control. Financial planningseeks to quantify various financial resourcesavailable and plan the size and timing ofexpenditures. Financial control refers to monitoringcash flow. Inflow is the amount of money coming intoa particular company, while outflow is a record of theexpenditure being made by the company. Managingthis movement of funds in relation to the budget isessential for a business.
At the CORPORATE LEVEL, the main aim of theprocess of managing finances is to achieve thevarious goals a company sets at a given point oftime. Businesses also seek to generate substantialamounts of profits, following a particular set offinancial processes.
Financial managers aim to boost the levels ofresources at their disposal. Besides, they control the
functioning on money put in by external investors.Providing investors with sufficient amount of returnson their investments is one of the goals that everycompany tries to achieve. Efficient financialmanagement ensures that this becomes possible.
Strong financial management in the business arena
requires managers to be able to:
1. Interpret financial reports including income
statements, Profits and Loss or P&L, cash flow
statements and balance sheet statements
2. Improve the allocation of working capital within
business operations
3. Review and fine tune financial budgeting, and
revenue and cost forecasting
4. Look at the funding options for business
expansion, including both long and short termfinancing
5. Review the financial health of the company or
business unit using ratio analyses, such as the
gearing ratio,
profit per employee and weighted cost of capital
6. Understand the various techniques using in project
and asset valuations
7. Apply critical financial decision making techniques
to assess whether to proceed with an investment
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8. Understand valuations frameworks for businesses,
portfolios and intangible assets
What Is Financial Management
Financial management in Nigeria economy entailsplanning, controlling, disbursement, motivation andimplementation/supervision. Without finance all theabove cannot be established and without theservices of financial management, the above cannotbe achieved.T. Lucy in his financial accounting view definedfinancial management as the classification andrecording of monetary transactions of any entityin accordance with established concepts,
principles, accounting standards and legal end ofan accounting period
The author of this book defined financial
management as the organisational activities that
involve accounting, budgeting, and cash
management.
In a broader sense, Financial Management can be
defined as The management of the finances of abusiness/organisation in order to achievefinancial objectives
Objectives of FM.
Taking a commercial business as the most commonorganisational structure, the key objectives offinancial management would be to:
Create wealth for the business(Wealth/profitmaximization)
Generate cash, and
Provide an adequate return on investment bearingin mind the risks that the business is taking and theresources invested
The above could be accomplished through:
1. Increase in profit: a firm can maximize itsvalue through an enhancement of its revenue.The revenue can be enhanced throughstepping up the volume of sales or any othersuch activities. In theory, when a firm isequilibrium, its profits are said to be maximum.
2. Reduction in cost: A firm should work by allmeans to reduce the cost of capital and tolaunch economy drive in its operations.
3. Sources of funds: a firm can raise funds invarious ways through several sources. Therisk involved in all these sources are assessedbeforehand. While the issue of capital sharesincreases the ownership funds of thecorporation, the issue of debenture and
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preference shares enhance the fixed recurringobligations of it.
4. Minimise risks: NO RISK NO GAIN is apopular slogan before embarking on any
course of action. A firm will have to calculatedifferent types of risks which it may confront.
Elements of financial management
There are three key elements to the process offinancial management:
(1) Financial Planning
Management need to ensure that enough funding isavailable at the right time to meet the needs of thebusiness. In the short term, funding may be neededto invest in equipment and stocks, pay employeesand fund sales made on credit.
In the medium and long term, funding may berequired for significant additions to the productivecapacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity tohelp the business ensure that the business ismeeting its objectives. Financial control addressesquestions such as:
Are assets being used efficiently?
Are the businesses assets secure?
Do management act in the best interest of
shareholders and in accordance with business rules?
(3) Financial Decision-making
The key aspects of financial decision-making relateto investment, capital budgeting financing anddividends:
Investments must be financed in some way however there are always financing alternatives thatcan be considered. For example it is possible to raise
finance from selling new shares, borrowing frombanks or taking credit from suppliers
A key financing decision is whether profits earnedby the business should be retained rather thandistributed to shareholders via dividends. If dividendsare too high, the business may be starved of fundingto reinvest in growing revenues and profits further.
[
Decision-making areas
Financial management decisions are as follows:
a. investment decisions
b. financing decisions
c. dividend decisions
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a). Investment decision are concerned with the
investment of funds. Funds can be invested in fixed
assets and current assets. Investment of funds in
fixed as long-term implications, but immediate
returns can be expected from investment in current
assets such as cash, receivables and inventories.
The purpose is to identify project which can be
accepted using the discounted flow (DCF) technique,
using the cost of capital as the cut-off criterion and
also to choose the projects with high net present
value (NPV) or internal rate of return (IRR) if the
resources are limited. The investment decisions are
also subjected to risk versus analysis as future cash
flows are subject uncertainty.
b. Financing decisions concerned with the
financing of business activities. The are intimately
bound with the investment decisions. The financing
decision are helpful in planning for a balanced
capital structure risk, return and control are the
crucial factors relevant in formulating the financing
decisions Various analytical techniques like
EPS/EBIT computations leverage calculations and
interest dividend coverage estimates are used in the
process of making financing decision.
c. Dividend decisions are concerned with the
disposal of profits. Dividend is generally paid as
some percentage of earnings on the paid-up capital.
The internal profitability versus the external
profitability (Walters Approach) analysis helps in
developing the pay-out rate. The part of the profit
which is not paid out as dividend constitutes the
source of internal financing.
The cost of capitals acts as the nucleus in the
financing decision-making. It has a two-day effect on
the investment, financing and dividend decision. It
influences and it turn is influenced by them. As the
cost of capital is the cut off criterion in investment
decision, it lead to the acceptance of rejection ofprojects. Raises or lowers the cost of capital. The
financing decision affecting the cost of capital as its
is the weighed average of the cost different sources
of capital. The need to the raise or lower the cost of
capital, in turn, influences the financing decisions.
The dividend decisions try to meet the expectations
of the investors reflected through the cost of capital.
Function of finance manager
The manager who looks after the activities of
financial management is known as the finance
manager or the controller of finance. He is the key
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team. He performs several important functions in
close consultation with the chief executive of the
organization. The major functions of the finance
manager are as seen below.
i) formulation of objectives
ii) forecasting and estimating capital requirements.
iii) Designing the capital structure
iv) Determining the suitable source of finance
v). Procurement of funds
vi). Investment of funds
vii). Dispersal of profits
viii). Maintaining of proper liquidity
ix). Maintaining of relations with the outside agencies
i). Formulation of objectives
Formulation of financial objectives is the fundamental
function of the finance manager. These objectives
should be in tune with the overall objectives of the
organisation.
ii). Forecasting and estimating capital
requirements.
A finance manager has to estimate and forecast the
financial requirements of a business. He should
make estimates for both short-term and long-termrequirements of funds. Unless proper thought is
given to the financial requirements of the business,
there will be either deficiency or surplus of funds. If a
business concern has excess capital, the
management may become extravagant in spending.
iii). Designing the capital structure
it denotes the kinds and proportions of differentsecurities. Thus the capital structure of a company
said to be the composition of equity and preference
capital and debt capital. After estimating the financial
requirement, the finance manager will have to design
the kind and proportion of various sources of funds
this should be based on the analysis of cost of
capital, consideration of factors such as risk, return
and control conditions in money and capital market.
iv) Determining the suitable source of finance.
The decision to tap various sources of finance
depend upon the capital structures designed. On the
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sources from which the funds are to be raised. The
management can raise finance from various sources
such as shares, debentures, financial institutions
commercial banks and so on. The finance manager
should analyse the pros and cons of all these
sources before making a final decision.
v). Procurement of funds.
After estimating the capital requirements and
deciding about the sources of finance, the finance
manager has to take necessary steps to procure the
funds.
vi). Investment of funds.
The funds procured should be prudently invested in
various projects. The technique of capital budgeting
may be helpful in selecting a project. Whole taking
investment decision the finance manger has to keep
in mind the principles of profitability, liquidity and
safety. The principle of profitability should not be the
only criterion of investment because if the fund are
blocked in unsafe projects, the solvency of the
company will be in danger.
vii) Dispersal of profits.
The finance manger has to decide how much to
retain for internal use and how much to declare as
dividend out of the profits of the company. A large
number of factors such as the trend of earning of the
company, the trend of market price of is shares, the
flow position and so on, should influence these
decisions. Thus this is an important area of financial
management .
viii). Maintaining a proper liquidity.
Every organization is required to keep some liquidity
for meeting its day-to-day needs. Availability of cash
is necessary to maintain is liquidity. Cash is needed
to pay off creditors, purchase stock of materials, pay
labour, and to meet-to-day expenses. The finances
manager has the need for liquid assets and the
arrange them in such a way that there is no scarcity
of funds.
ix). Maintaining relation with the out agencies.
The finance manager should establish and maintain
cordial business relations with outside agencies such
as financial institution, stock exchange, tax
authorities and so on.
Scope of financial management
1. FM provides a conceptual and analytical
framework for financial decision making.
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2. It covers not only acquisition of funds but also
their effective utilisation in the business as
well.
3. It is an analytical way of viewing the financial
problem of the firm.
4. It is concerned with the solution of the three
major problem relating to the financial to
the financial operation of the firm.
Goals Of Financial Management
The primary goal of financial management is the
maximization of stockholder wealth, or in other terms,maximization of the firm's profits. Other goals couldinclude-maximization of sales, maximization ofmarket share, maximization of the growth rate ofsales, and maximization of the market price of thefirm's stock. Managers are also concerned with theirsalaries and perks. Frequently these are tied toimproved return on investments (ROI), return onequity (ROE), return on assets (ROA), or return onnet assets (RONA). Two major goals of financialmanagers are profitability and viability. The firm
wants to be profitable, and it wants to continue inbusiness.
ProfitabilityIn attempting to maximize a firm's profits there isalways a tradeoff between profitability and risk. Thegreater the risk incurred in a decision, the greater theanticipated profit demanded. Frequently, the decision
is centered on whether the return on a specificinvestment is sufficient to justify the risk involved.
ViabilityFirms want to stay in business, so it should be nosurprise that one of the goals of f inancialmanagement is to guarantee financial viability. Thisgoal is often measured in terms of liquidity andsolvency.Liquidity measures the amount of resources a firm
has that are cash or are quickly convertible to cash tomeet the obligations the firm has in the near term.Generally the near-term, or current, means one yearor less. Thus a firm is liquid if it has enough currentresources to meet its current obligations as theybecome due for payment. Solvency is the sameconcept as liquidity, except it if for the long termrather than near term. Long-term simply means morethan one year. Does the firm have enough cashgeneration potential over the long term to meet themajor cash needs that will occur over this period? Afirm must plan for adequate solvency well in advancebecause the potentially large amounts of cashinvolved may take a long period of planning to
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generate. The roots of liquidity crises that put firmsout of business often are buried in inadequate long-term solvency planning in earlier years.
It is not a good idea to be too conservative and
attempt to have maximum liquidity and solvency.Given that the goal of the firm is to make moremoney now and in the future, the financial managermust balance the need for solvency and liquidity withthe need to supply funds for the firm to continue togrow and be fully invested and therefore profitable.Every dollar kept in a liquid form (such as cash,treasury bills, or money market funds) is a naira thatcould have been invested by the firm in some longer-term, higher yielding project or investment.
The role of financial management.The role of financial management can be classifiedinto five main heading:1. Raising of funds to finance a company.2 Financial analysis of companys operation andgrowth considerations.3. Forecasting, monitoring and control of workingcapital cycle.4. Selection, appraisal and control of capitalinvestment.
5. Valuation of business especially in relation toacquisition and mergers.
Responsibilities of the financial manager
1. Safeguarding funds;2. Controlling funds (receiving and
disbursement);
3. Controlling revenue and expenditure;4. Classifying and coding of transactions;5. Accounting for revenue and expenditure;6. Budget preparation, maintenance and control7. Financial auditing;8. Gathering input/output data
9. Operating decision making tools;
10.Developing methods and techniques for
11.evaluating effectiveness and efficiency;12.Transmitting information;
13.Ensuring that activities comply with the lows orregulations that governs the organisation;14. Ensuring that funds are expended on15. Programmes initially planned16. Raising funds;17. Giving financial advice.
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SOURCES OF FUNDS
Despite all the differences among companies, there
are only a few sources of funds available to all fi rms.
1. They make profit by selling the product for morethan it costs to produce. This is the most basic
source of funds for any company and hopefully the
method that brings in the most money.
2. Like individuals, companies can borrow money.
This can be done privately through bank loans, or it
can be done public through a debt issue. The
drawback of borrowing money is the interest that
must be paid to the lender .
3. A company can generate money by selling part of
itself in the form of share to investors, which is known
as equity funding. The benefit of this is that investors
do not require interest payments like bondholders do.
In an ideal world, a company would bring in all of its
cash simply by selling goods and service for profit.
But as the old saying goes, you have to spend
money to make money, and just about every
company has to raise funds at some point todevelop products and expand into new markets.
Now let look at this issue more critically from the
perspective of cash flow.
Below are the main sources of funds or capital,
available to businesses to improve and manage cash
flow.
1. Owners Capital- As you probably know, this is
often the only source of capital available for the soletrader starting in business. The same often applies
with partnerships, but in this case there are more
people involved, so there should be more capital
available. This type of capital though, when invested
is often quickly turned into long term, fixed assets,
which cannot be readily converted into cash. If there
is a shortfall on a cash flow forecast, the business
owners could invest more money in the business. For
many businesses the owner may already have all hisor her capital invested, or may not be willing to risk
further investment, so this may not be the most likely
source of funding for cash flow problems.
2. Shareholders Capital shareholders are of
course the owners of a limited company, they invest
money in the hope of capital growth, (that is the
business makes profits, grows, makes more profits,
so as the business becomes bigger their investment
will be worth), and dividend(the shareholders shareof the companies profits. It is quite normal for limited
companies to issue new shares (a Rights issue), in
an attempt to raise capital, but this is normally for
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investment, funding expansion or restructuring, not
for solving a cash flow problem!
3. Retained Profit At the end of the trading year a
business will work out its profit. All of this profit can
be taken by the owners, (this would be a dividend inlimited company), or alternatively some or all of it
could be reinvested in the company, to help the
business grow and therefore make even more profit
in the future. Retained profit is show as reserves on
Balance Sheet, but can take the form of any
business asset, so it may not be cash flow any
Retained Profit will be allowed for and shown in
opening balance, if it is held as cash.
4. Overdraft this is a form of loan for a bank. A
business becomes overdrawn when it withdraws
more money out of its account than there is in it, this
leaves a negative balance on the account. This is
often a cheap way of borrowing money as once an
overdraft has been agreed with the bank the
business can use as much as it needs at any time,
up to the agreed overdraft limit. But, the bank will of
course, charge interest on the amount overdrawn,
and will only allow an overdraft if they believe thebusiness is credit worthy i.e. is very likely to pay the
money back. a bank can demand the repayment of
an overdraft at any time. Many businesses have
been forced to cease trading b because of the
withdrawal of overdraft facilities by a bank. Even so
fro short term borrowing, an overdraft is often the
ideal solution, and make businesses often have a
rolling (on going) overdraft agreement with the bank.
This then is often the ideal solution for overcoming
short term cash flow problems, e.g. funding purchase
of raw material whilst waiting payment on goods
produced.
5. Bank Loan this is lending by a bank tobusinesses. A fixed amount is lent e.g. N10,000 forfixed period of time, e.g. 3 years. The bank willcharge interest on this, and the interest plus part ofthe capital, (the amount borrowed), will have to bepay back each month. Again the bank will only lend if
the business is credit worthy, and it may requiresecurity. If security is required, this means the loan issecured against an asset of the borrower, e.g. hisHouse if a Sole Trader, or an asset or the business.If the load not repaid, then the bank can takepossession of the asset and sell the asset to get itsmoney back! Load are normally made for capitalinvestment, so they are unlikely to be used to solveshort-term cash flow problems. But if a loan isobtained, then this frees up other capital held by thebusiness, which can then used for other purposes.
6. Leasing- with leasing a business has the use of
an asset, but pays a monthly fee for its use and will
never own it. Think, of, someone setting up business
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as a Parcel Delivery Services, he could lease the van
he needs from a leasing company. He will have to
pay a monthly leasing fee, say N 250, which is very
useful if he does not wish to spend N 8,000 on
buying a van. This will free up capital, which can now
be used for other purposes. A business looking ot
purchase equipment may decide to lease if it wishes
to improve its immediate cash flow. In the example
above, if the van had been purchased, the flow of
cash out of the business would have been N 8,000,
but by leasing the flow out of the business over the
first year would be N 3,000, leaving possible N 5,000
for other assets and investment in the business.
Leasing also allows equipment to be updated on a
regular basis, but it does cost more than outrightpurchase in the long run.
7. Hire Purchase - This is similar to leasing, but at
the end of the hire period the asset belongs to the
company that hires it. E.g. a farmer could hire
purchase a tractor.
8. Buying on credit this create creditors. If
business, which sells shoes, buys on credit from
Johnsons shoes, it may not have to pay Johnsonsfor a month after delivery. This means it could sell
the shoes at a profit and have the money at the end
of the month to it bill to Johnsons. Extending a credit
period will help short term cash floe this could be
done by delaying paying bill for extra 14 days,
meaning there will more cash in the bank for this
period unfortunately this type of action may upset
businesses suppliers, after all they have their own
cash flow to think of! The next time the business
wanted credit from a supplier they had been very
slow in paying in the past, they may be turned down!
slow payment by debtors is the problem for many
businesses, and in fact the government had tried
take action against this type of behaviour in several
budgets.
9. Selling Assets A business can sell assets it
owns to raise capital!! This is often a last gasp
measure as assets usually vitally necessary tobusiness activity. In some cases the business may
lease back the assets so that it still retains it use but
this often the preserve of big business e.g. the sale
and lease back of office blocks. Selling assets, and
leasing and assets back improves cash flow in the
short term. If the cash raised from the sale of the
assets is used effectively by the business, cash flow
and profitability can also increase in the long term.
10. Debtors if a firm is in immediately need ofcash it could chase its debtors for repayment. This
may involve giving discount for early repayment.
Chasing for early repayment may lease to long term
loss of trade as the debtors may buy from another
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business next time, but can effective method of
solving short term cash flow problems.
11. Factoring for larger firms, with a turnover
(sales) of 1,000,000 or more a year, it is possible to
let a factor manage your debtors for you. The factor(a type of finance company) will pay 80 % of the
value of an invoice at the time of sale and will take
responsibility for receiving payment from the debtor.
The balance of the debt will be passed on when the
money is received by the factor. There is of course a
charge for this and the amount of charge will depend
upon several issues such as, number of debtors, size
of debts, past bad debt history. But factoring dose
improve a businesses cash flow and it popularityamongst small to medium size businesses prove
many managers and owner regard this service as
goods value for money.
EVALUATION OF FINANCAIL POLICY
formula sheet only.
Average Tax Rate =
Current Rate =
Quick ratio =
Cash ratio =
Total Debts ratio
= =
Debt to Equity Ratio=
ROA =
Time Interest Earned =
Cash Coverage Ratio =
Total Assets Turnover =
Fixed Assets Turnover =
InventoryTurnover=OR
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Profit Margin (ROS)=
ROE =
Return on Capital
Basic Earning Power =
Earning per share =
Price - Earnings Ratio =
Dividend pay out ratio = Dividends Net Income
Market value Book Value Ratio
=
PRACTICE QUESTIONS
1. What factor has contributed to the importance
of financial management in recent years?
2. Why should finance be managed?
3. A financial manager makes decisions, which
directly affect the flow of funds in an organisation.
Discuss.
4. What are the significance of financial
management?
5. What is the role of finance in the Nigeria
economy, and how can financial management
be used to further national goals?
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FINANCIAL PLANNING
MANAGEMENT INFORMATIONFOR PLANNINGThe main sources from which information necessaryfor preliminary financial planning may be derivedfrom:
Government SourcesThis would embrace publications issued by specific
departments and by the central statistical office,which performs the major task of constructing andpresenting statistics over a very wide field ofactivities. The formation available from governmentsources is so wide that only a few can be included for
illustration purposes.a. National income and expenditure.b. Annual abstract of statistics.c. Department of employment gazette.d. Monthly digest of statistics.e. Trade and industry.f. Census of production.g. Central Bank of Nigeria Quarterly Bulletin.
Financial Institutions
a. Clearing Bank Review.b. Reviews and Statistics by Stock Exchange,c.Finance Houses Associations etc.d. Financial publications via the press e.g.e.Financial Times, Business Concord, etc.
Othersa. National Economic Development Council.b. National institute for Economic Review.c. Employees Organisations.d. Employers Organisations.
e. Trade associations
Leading indicators for financial planning are:1. Business Times Share Index2. Changes in Exchange Rates.
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3. Index of Industrial Production.4. Levels of Stocks of Raw Materials.
BUSINESS FORECASTING
IntroductionIt is necessary to distinguish between Budget andForecast. A forecast is concerned with probableevents while a budget relates to panned events anda statement of the policy to be carried out. Complexor long term forecasts naturally involve range ofproblems. In such a situation, the most convenientmethod is to subdivide the work according to themain function of the business.
In this chapter, the forecast will be subdivided into
(a) Sales forecast(b) Output forecast(c) Capital expenditure forecast(d) Trading results forecast.(e) Cash forecast.
The Accountant must be ready to supply from hisrecord to other departmental heads details andreliable background data as to past experience andrecent trends of sale, output and capital expenditureforecast.
He may be called upon to carry out the arithmeticalwork of translating quantitative estimates into moneytotals, and will act as a coordinator, Keeping watch orinconsistencies in figures submitted to him.
In addition, he will be concerned with thepresentation and interpretation of forecast tomanagement and the comparison of the forecast withthe actual results.
SALES FORECASTThe state of the market is the basic variableelements affecting the future of any business,although in conditions of high demand, shortage ofmaterials, capital or capacity may determine theextent to which demand can be satisfied
The purpose of sales forecastA sales forecast may be neededa. To establish sale budget.b. To aid management decision e.g. by estimating
the profitability of new product or by product.c. To plan production leading over to a given period,to allow for cyclical and seasonal fluctuations.d. To provide studies of the market for futurereferences and for the guidance of long termmanagement policy rather than to aid particulardecisions.
Factors influencing the level of salesFactors likely to influence the level of sales may beeither external or within the control of management.
The external factors likely to influence the level ofsales are as follows1. Fluctuation in the size of the populationand in its sex and age make up.2. The general level of prosperity. The level of
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employment and income purchasing power, the trendof consumption, the rate of investment and thepsychological factors of confidence in the future.3. The extent and severity of competition inthe market and the probable availability of substitute
products4. The repercussion of world events, such as war,international tensions, arms races, economicdevelopment projects, new inventions etc.5. Government policy and regulations e.g. importrestrictions.6. Social changes brought about by redistribution ofincome.7. Seasonal and cyclical fluctuations.
OUTPUT FORECAST
Purposes of output forecastIn order to be able to forecast output, one should beable to answer the following questions1. How can the value of sales on forecast beproduce?2. What normal stock level of finished goods andwork-in progress are necessary to make theoutput available at the time it is required?3. Can seasonal sales fluctuation be absorbed by
temporary adjustment of stock levels?4. What difficulties have to be overcome in orderto obtain raw materials, labour and services5. What is the effect of expansion, contraction orsubstitution on the available or utilization of
buildings, plant and labour?
The essence of the above questions is to be able tofind
1. A combination of plant and labour that canproduce the forecast sales at the lowest cost;2. The most efficient use of resources to meet agiven sales programme.Factors affecting output fore-casta. Materials1. Quantity required2. Quality required3. Price trends4. Availability and source of supply5. Frequency and size of deliveries
6. The possibility of using substitutes7. The production of buy-products
External factors, which must be considered inforecasting turnover from export sales, are1. Restrictions imposed by exporting country2. Restrictions imposed by the government of themarket countries.3. Restrictions imposed by trade associations andsimilar bodies set up.4. The number and extent of the sources of
competition.5. Economic trends affecting the prosperity ofparticular markets.6. The necessity of satisfying markets, which havespecial requirement due to local conditions.
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Controllable factors influencing the level of
sales are as follows;1. The use of promotion aids, such as marketresearch, advertising, incentives to salesman
and distributors.2. The ability of the organization to satisfydemand, which must in the short run, set theupper limit of sales.3. The quantity of the financial products.4. The level of selling prices, changes of whichdepend on the degree of elasticity of demandfor the product.
Additional controllable factors to be considered inrespect of export sales are;
1. Price policy. Management may consider apolicy of price discrimination in certain exportmarkets, perhaps in the form of dumping orselling below cost in order to establish controlover particular area.2. Methods of distributions. Sales may be madethrough distributors associate sellingcompanies, or direct for government buyingagencies.
b. Labour 1. The type and availability of labour.2. The size of the labour force at a particular periodhaving regards to machine, staffing etc3. The cost of labour, hours of work needed forshift work, overtime and night work.
4. Statutory regulations.5. The influence exerted by trade unions.6. The problems of redundancy and redeploymentof labour.
c. Buildings, plant and equipmentAny projected change in the products to bemanufactured, new methods of handling materialsand of production are factors which may influencethe need for alterations or additions to buildings,plant and equipment.
d. ServicesThe following internal and external services shouldbe considered.i). Coals, gas, electricity, hydraulic power,
compressed air, water supplies.ii). Adequacy of internal transport.iii). External transport by road, air and water.
CAPITAL EXPENDITURE FORECASTThe need for a forecast of capital expenditure arisesbecause circumstances change or can be changed.Factors to be considered are:1) The necessity of replacing assets as they becomeworn out or obsolete.
2) The need for more or less machinery, plant orbuilding which may be revealed by the sales andoutput forecast.3) Any important change in capital equipment.4) New or improved plant or machinery may become
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available.
FORECAST OF TRADING RESULTSThe form and extent of trading forecasts are
influenced by two factors:
The kind of activity under forecast and the purpose ofthe forecast. Forecast may be grouped into threebroad categories.1. Those concerned with a series of events and theircorrelation over a comparatively short period.2. Those dealing only with a major change inconditions or a single event, such as the marketingof a new product or by-product, the introduction ofa new process or machine or the opening of a new
market.3. Those involving a survey of all the changes inconditions and events, which may affect abusiness over a considerable period such as longplan for development over a period of, say 10 or20 years.
Period: The period covered by the trading forecastwill vary not only with the nature of the project butalso with the industry, type of business or prevailingmarket conditions.
Preparation: In the preparation of trading resultsforecast, the following consideration will have to betaken into account.(1) Changes in prices of materials, labour, plant.
Buildings and services.(2) Changes in the prices of products sold anddiscount allowed.(3) The necessity for holding larger stocks or givingextended credit.
(4) Alteration in bank credit facilities.(5) Changes in taxation.
CASH FORECASTThe liquidity of a business depends on a correctassessment of the factors affecting the cash forecast.The need to know the probable effect of futureevents on the cash position of a company arises:(1.) To ensure that sufficient cash is available forrevenue, expenditure including cover for the ordinary
trading fluctuation of manufacturing stocks andselling goods.(2.) To indicate where additional finance is neededand when.(3.) To preserve sufficient liquidity throughout theyear to reveal surplus cash resources which may beavailable for profitable investment externally of forexpansion of facilities.(4.) To provide a guide to show whether externalcapital investment must be financed from externalsources or from internal funds.
Factors affecting cash forecastsThe factors that affect cash forecast are as follows:
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(1) Programmes of expansion or contractionparticularly with regard to fixed assets.(2) Increase or decrease in level of stocks, work-in-progress and debtors.(3) Increase or decrease in value of stocks, work-in
progress and debtors through the effects of changingprice levels.
Methods of cash forecastThere are three methods of making a cash forecast:(a) Receipts and payment basis suitable for short-term forecasts.(b) Profit and loss basis suitable for longer forecasts.(c) Balance sheet basis mainly for long-termforecasts.
PROFIT AND LOSS FORECASTA profit forecast is the amount of profit you expect tomake at the end of the period. The monthly profit andloss forecast will consist of the following:
Sales - This is the cash you receive during aperiod of time including what you are owed,minus what you were owed at the end of theprevious period. You do not include theamount of VAT here as you do in the cashflowforecast.
Cost of sales - This is the cost that youestimate will vary with the level of your sales.It will include items such as purchases (suchas raw materials or items you buy to sell),labour (any employees who are directly
involved with the manufacturing of yourproduct) and other direct costs.
Gross Profit - This is total cost of sales figureminus sales.
Overheads - This is where you would list all
the expenses involved in running thebusiness, such as rent and rates, heating andlighting, telephone, drawings and so on.
Total Overheads - This is the total sum of theabove.
Miscellaneous income - This is where youwould put the estimate figure of any otherincome you might receive that is not from thesale of your product. For example, interest
from money invested. Net Profit - The net profit figure is the gross
profit plus the miscellaneous income minusthe total overheads.
BALANCE SHEET FORECASTThe Balance Sheet forecast is an estimate of whatyour business owe and own at a particular period oftime. It consists of the following:
Fixed Assets - This is items such as property,furniture, machinery, and fittings, vehicles thatare acquired for use in the business over aprolonged period of time. Total Fixed Assets - This is the total figure ofthe above.
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Current Assets - These are mainly cash inhand and at the bank, stock (includes any rawmaterials or half-finished products not yet sold)and debtors (what the customers owe you). Total Current Assets - The total sum of the
above. Total Assets - The total fixed assets plus thetotal current assets.
Capital and Liabilities
Capital - This would be the money used to
start your business. You would also put I thefigure for profit and loss taken from your profitforecast. If you forecast a loss, you wouldneed to put this in brackets and deduct fromyour capital.
Liabilities - The liabilities of a business maybe of two types: current liabilities such asoverdrafts, tax payable (including VAT) andcreditors (what you owe to your suppliers atthe end of the period) and long tem liabilitiessuch as loans.
The Working Capital is the value of the currentassets of the business less the current liabilities. TheWorking Capital is essential to businesses, the lackof which is a common reason for business failure.
There are many useful sources that can help youdraw up your forecasts, which include banks thatusually provide the template for forecasts. Youraccountant can also help you to produce theforecasts.
CAPITAL STRUCTURE
In finance, capital structure refers to the way acorporation finances its assets through somecombination of equity, debt, or hybrid securities. Afirm's capital structure is then the composition or'structure' of its liabilities. For example, a firm thatsells N20 billion in equity and N80 billion in debt issaid to be 20% equity-financed and 80% debt-
financed. The firm's ratio of debt to total financing,80% in this example, is referred to as the firm'sleverage. In reality, capital structure may be highlycomplex and include tens of sources. Gearing Ratiois the proportion of the capital employed of the firmwhich come from outside of the business finance,e.g. by taking a long term loan etc.
1. Equity capitalor financing is money raised by abusiness in exchange for a share of ownership in the
company. Ownership is represented by owningshares of stock outright or having the right to convertother financial instruments into stock of that privatecompany. Two key sources of equity capital for new
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and emerging businesses are angel investors andventure capital firms.
2. Debt capital is the capital that a business raisesby taking out a loan. It is a loan made to a company
that is normally repaid at some future date. Debtcapital differs from equity orshare capital becausesubscribers to debt capital do not become partowners of the business, but are merely creditors, andthe suppliers of debt capital usually receive acontractually fixed annual percentage return on theirloan, and this is known as the coupon rate.
Differences Between Debt and Equity Capital
Debt Capital: Debt capital is represented by fundsborrowed by a business that must be repaid over aperiod of time, usually with interest. Debt financingcan be either short-term, with full repayment due inless than one year, or long-term, with repayment dueover a period greater than one year. The lender doesnot gain an ownership interest in the business anddebt obligations are typically limited to repaying theloan with interest. Loans are often secured by someor all of the assets of the company.
Equity Capital: Equity capital is represented by fundsthat are raised by a business, in exchange for ashare of ownership in the company. Equity financingallows a business to obtain funds without incurringdebt, or without having to repay a specific amount ofmoney at a particular time.
3. Hybrid security: Hybrid Securities are tradablesecurities possessing characteristics borrowed fromboth debt and equity instruments. Their myriad formsmake understanding and evaluating the risk / return
trade-off imperative if investors are to make informeddecisions to include or exclude a component of thesesecurities in their portfolios.Hybrid Securities pay a predictable (fixed or floating)rate of return or dividend for a certain period of time,usually until a maturity or conversion date. At thatdate the holder has a number of options includingconverting the securities into the underlying share orcash or more commonly reset for another term. Eachissuer determines the specific terms of theconversion.
Therefore, unlike a share the holder has a knowncash flow, and, unlike a fixed interest security, thereis an option to convert to the underlying equity. Morecommon examples include convertible andconverting preference shares. Converting preferenceshares means that at the maturity date (orconversion date) the security converts into ordinaryshares whereas with a convertible preference share,the holder has the option of redeeming to cash or
converting to shares.
4. Vendor financing: A loan from one company toanother which is used to buy goods from thecompany providing the loan. In this way, the vendor
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increases sales, earns interest, and may sometimesalso acquire an interest in the customer. Thisincreases the riskprofile of a company if it is carriedout on a large scale, since many companies do nothave the skill to conduct credit analysis. Large,
creditworthybuyers are unlikely to make use of thisarrangement, since they will be able to borrowmoney at lowerrates from othersources.
5. Insurance float: In the insurance industry, "otherpeople's money" is known as float. Float is such avaluable form of capital because not only does theinsurance company get to keep the investmentincome, but also the company's cost of capital isoften low or even positive.
The Power of Float:The source of insurance funds is"float," which is money that doesn't belong to the firmbut that it is temporarily hold. Most of the float arisesbecause
(1) premiums are paid upfront though the serviceprovided - insurance protection - is delivered over aperiod that usually covers a year and;
(2) loss events that occur today do not always result
in immediately paying claims, because it sometimestakes many years for losses to be reported,negotiated and settled..
6. Sweat equity: The equity that is created in acompany or some other asset as a direct result ofhard work by the owner(s).
Sweat equity is a term used to describe the
contribution made to a project by people whocontribute their time and effort. It can be contrastedwith financial equity which is the money contributedtowards the project. It is used to refer to a form ofcompensation by businesses to their owners oremployees. The term is sometimes used inpartnership agreements where one or more of thepartners contributes no financial capital. In the caseof a business startup, employees might, uponincorporation, receive stock orstock options in returnfor working for below-market salaries (or in some
cases no salary at all).
The term is sometimes used to describe the effortsput into a start-up company by the founders inexchange for ownership shares of the company. Thisconcept, also called "stock for services" andsometimes "equity compensation" or "sweet equity"can also be seen when start-up companies use theirshares of stock to entice service providers to providenecessary corporate services in exchange for adiscount or for deferring service fees until a later date
TECHNIQUES OF FINANCIAL ANALYSISBreak-even analysis and ratio analysis are going tobe used here.
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Break-even analysisBreak-even analysis is a technique widely used byproduction management and managementaccountants. It is based on categorising productioncosts between those which are "variable" (costs that
change when the production output changes) andthose that are "fixed" (costs not directly related to thevolume of production).
Total variable and fixed costs are compared withsales revenue in order to determine the level ofsales volume, sales value or production at whichthe business makes neither a profit nor a loss(the "break-even point").
The Break-Even Chart
In its simplest form, the break-even chart is agraphical representation of costs at various levels ofactivity shown on the same chart as the variation ofincome (or sales, revenue) with the same variation inactivity. The point at which neither profit nor loss ismade is known as the "break-even point" and isrepresented on the chart below by the intersection ofthe two lines:
In the diagram above, the line OA represents thevariation of income at varying levels of productionactivity ("output"). OB represents the total fixed costsin the business. As output increases, variable costsare incurred, meaning that total costs (fixed +variable) also increase. At low levels of output, Costsare greater than Income. At the point of intersection,P, costs are exactly equal to income, and henceneither profit nor loss is made.
Fixed CostsFixed costs are those business costs that are notdirectly related to the level of production or output. Inother words, even if the business has a zero outputor high output, the level of fixed costs will remain
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The sum of all sales and other income net of returnsand sales commissions.
2. Cost of Sales (Cost of Goods Sold)
The cost of purchases that are resold (merchandise)and/or raw materials plus the costs of labor tomanufacture the product or convert it or install it ordeliver it or construct it on site. These costs are alsocalled directorvariable costs.
3. General & Administrative Costs(Overhead)
These are all the costs not directly, or easily, relatedto sales volume such as Advertising, Bank Charges,
Computer Expenses, Insurance, Office Wages &Salaries, Officers Compensation, Telephone,Utilities, Depreciation, Interest, Taxes etc. Thesecosts are also called indirectorfixedcosts.
4. 1 minus 2 minus 3 = PROFIT.
Note: If your Income Statement is notorganised inthis fashion (called managerial accounting format),you need to have a session with your accountant
and demand it be put into this format so you canmanage the business better.
Once you have your financial statements and data inthe right format, you can easily calculate Break-Evenusing the following formula as:
Break-Even Point = FC/(1-VC/S)
Where: FC = Fixed Costs
VC = Variable Costs
S = Sales
For illustrative purposes, lets look at an examplecompany, Umeh Global Ventures, had the following
data from its Income Statement:
Sales = N1,000,000
Cost of Goods Sold = N 710,000
General & Admin = N 215,000
Break-Even Point (during theperiod indicated by theincome statement) is:
Break-Even Point = FC/(1-VC/S) and
VC/S = 710,000/1,000,000 = .71
1- VC/S = 1 - .71 = .29
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FC/(1-VC/S) = 215,000/.29 = $741,379 = BEP
And the company operated at N 1,000,000/741,379 =135% of Break-Even during the period.
Note that ..Break-Even can be calculated for:
A Company
A Division
A Location
A Department
A Store
A Product
A Product Line
A Service
A Day
A Week
A Month
A Year (or any other time period)
This is assuming, of course, that fixed costs can beaccurately or, at least, reasonably associated withthe organisers above.
Ratio Analysis
Ratio analysis was developed to determine thestability of various financial aspects of a business. Itshows the relationship between two figures, or twoaspects of your business. It helps you work out yourbusiness' financial weaknesses and strengths, sothat you can take appropriate action.Ratio analysis also offers a view of your business'competitive performance in relation to similarbusinesses in your industry.
Financial ratio analysis is the calculation and
comparison of ratios which are derived from theinformation in a company's financial statements. Thelevel and historical trends of these ratios can be usedto make inferences about a company's financialcondition, its operations and attractiveness as aninvestment
Financial ratios are calculated from one or morepieces of information from a company's financialstatements.
For example, the "gross margin" is the gross profitfrom operations divided by the total sales orrevenues of a company, expressed in percentageterms. In isolation, a financial ratio is a useless pieceof information. In context, however, a financial ratio
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can give a financial analyst an excellent picture of acompany's situation and the trends that aredeveloping.
A ratio gains utility by comparison to other data and
standards. Taking our example, a gross profit marginfor a company of 25% is meaningless by itself. If weknow that this company's competitors have profitmargins of 10%, we know that it is more profitablethan its industry peers which is quite favourable. Ifwe also know that the historical trend is upwards, forexample has been increasing steadily for the last fewyears, this would also be a favourable sign thatmanagement is implementing effective businesspolicies and strategies.
Financial ratio analysis groups the ratios intocategories which tell us about different facets of acompany's finances and operations. An overview ofsome of the categories of ratios is given below.
Leverage Ratios which show the extent thatdebt is used in a company's capital structure.
Liquidity Ratios which give a picture of acompany's short term financial situation orsolvency.
Operational Ratios which use turnovermeasures to show how efficient a company isin its operations and use of assets.
Profitability Ratios which use marginanalysis and show the return on sales andcapital employed.
Solvency Ratios which give a picture of acompany's ability to generate cash flow and
pay it financial obligations.
It is imperative to note the importance of the propercontext for ratio analysis. Like computerprogramming, financial ratio is governed by theGIGO law of "Garbage In...Garbage Out!" A crossindustry comparison of the leverage of stable utilitycompanies and cyclical mining companies would beworse than useless. Examining a cyclical company'sprofitability ratios over less than a full commodity orbusiness cycle would fail to give an accurate long-
term measure of profitability. Using historical dataindependent of fundamental changes in a company'ssituation or prospects would predict very little aboutfuture trends. For example, the historical ratios of acompany that has undergone a merger or had asubstantive change in its technology or marketposition would tell very little about the prospects forthis company.
Credit analysts, those interpreting the financial ratiosfrom the prospects of a lender, focus on the
"downside" risk since they gain none of the upsidefrom an improvement in operations. They pay greatattention to liquidity and leverage ratios to ascertain acompany's financial risk. Equity analysts look more to
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the operational and profitability ratios, to determinethe future profits that will accrue to the shareholder.
Although financial ratio analysis is well-developedand the actual ratios are well-known, practicing
financial analysts often develop their own measuresfor particular industries and even individualcompanies. Analysts will often differ drastically intheir conclusions from the same ratio analysis.We will now examine profitability RATIO only.
Gross Profit Margin =Gross Profit
* 100Turnover
Note: Turnover = Sales
Gross Profit = Turnover - Cost of Sales
Net Profit Margin =
X 100 = X 100
Note: Net Profit = Gross Profit Expenses
Now that we know a bit about profitability ratios, let's
see how to use them. Here are parts of the profit and
loss account for the Jefry Warehouse plc; we will use
that information to calculate its gross and net profit
margin.
Jefry Warehouse
Consolidated Profit and Loss Account
for the year ended 31 March 2006 25 March 2005
N'000 N'000
Turnover 1,110,678 697,720
Cost of sales 830,126 505,738
Gross profit 280,552 191,982
Operating expenses 176,960 129,359
Operating profit 66,016 41,389
Other costs/income 6,555 -5,132
Profit before interest and taxation 45,012 25,300
Let's put these ratios in a table:
Profitability Ratios for t Jefry Warehouse
Ratio Name Ratio Formula 31 Mar 06 25 Mar 05
Profitability For the year ended 31
Mar 06
Gross Profit
Margin
280,552 1,110,678*100 25.26%
Net Profit
Margin
45,012 1,110,678*100 4.05%
Look and see where these figures and ratios came
from: don't do anything else until you have agreed
with what it is in this table.
Did you see that for the year ended 25 March 2005,
we didn't give you the ratio results?
Well spotted! So, using the profit and loss account
above, calculate the gross and net profit margins for
the Jefry Warehouse for the year ended 25 March
2005, enter those ratios in the table above.
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Company: Vodafone plc
Description:
The COMPANY is involved principally in theprovision of mobile telecommunications services.
Consolidated Profit & Loss Account for
the year ended2003 2002 2001
Weeks 52 52 52
Currency N million N million N million
Turnover 30375.0 22845.0 15004.0
Cost of sales -17896.0 -13446.0 -8702.0
Gross Profit 12479.0 9399.0 6302.0
Operating Expenses -17774.0 -21233.0 -13291.0
Operating Profit -5295.0 -11834.0 -6989.0
Other costs/income -161.0 -860.0 80.0
Profit before interest and taxation -5456.0 -12694.0 -6909.0
Net interest receivable (payable) -752.0 -845.0 -1177.0
Profi t on ord inary activi ties before - 6208.0 - 13539.0 - 8086 .0
taxation
Tax on profit on ordinary activities -2956.0 -2140.0 -1426.0
Profit on ordinary activities after
taxation-9164.0 -15679.0 -9512.0
Equity minority interests -655.0 -476.0 -373.0
Profit for the financial period -9819.0 -16155.0 -9885.0
Dividends 1154.0 -1025.0 -887.0
Retained profit -10973.0 -17180.0 -10772.0
Consolidated Balance Sheet
Fixed assets
Intangible Assets 108085.0 105944.0 108853.0
Tangible Assets 19574.0 18541.0 10586.0
Investments 27030.0 28977.0 34769.0
Total Fixed Assets 154689.0 153462.0 154208.0
Current assets
Stock 365.0 513.0 316.0
Debtors due within one year 7460.0 7053.0 4587.0
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Short-term investments 291.0 1792.0 13211.0
Cash at bank and in hand 475.0 80.0 68.0
Total Current Assets 8591.0 9438.0 18182.0
Creditors: Amounts falling due within
one year-14293.0 -13455.0 -12377.0
Net Current Assets (liabilities) -5702.0 -4017.0 5805.0
Total assets less current liabilities 148987.0 149445.0 160013.0
Creditors: Amounts falling due after more
than one year-13757.0 -13118.0 -11235.0
Provisions for liabilities and charges -3696.0 -2899.0 -1350.0
Net assets 131534.0 133428.0 147428.0
Capital and reserves
Called-up share capital 4275.0 4273.0 4054.0
Share premium 52073.0 52044.0 48292.0
Other reserves 99770.0 99862.0 97938.0
Profit and loss account -27447.0 -25606.0 -5277.0
Equity shareholders' funds 128671.0 130573.0 145007.0
Minority interests 2863.0 2855.0 2421.0
Total capital employed 131534.0 133428.0 147428.0
Weighted average number of shares in
issue in the period65012501146 65012501146 61334032162
Vodafone profit margin - answer
Vodafone plc
Profitability 31 Mar 2002 31 Mar 2001
Gross Profit Margin 41.14% 42.00%
Net Profit Margin -55.57% -46.05%
PRACTICE QUESTIONS1. In planning for finance, what are the major sourcesof information available?2. State in detail, short, medium and long termforecasting of capital requirement.
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3. What are the various techniques available forfinancial analysis?
WORKING CAPITAL
MANAGEMENT
Decisions relating to working capital and short termfinancing are referred to as working capitalmanagement. These involve managing therelationship between a firm's short-term assets and
its short-term liabilities. The goal of working capitalmanagement is to ensure that the firm is able tocontinue its operations and that it has sufficient cashflow to satisfy both maturing short-term debt andupcoming operational expenses.
Management of working capital
Management adopt a combination of policies andtechniques for the management of working capital.These policies aim at managing the current assets(generally cash and cash equivalents, inventoriesand debtors) and the short term financing, such thatcash flows and returns are acceptab