Financial Management study notes

1. FINANCIAL MANAGEMENT
Introduction
Financial management is a process which brings together planning, accounting, auditing,
budgeting, reporting and production of the project with the aim of managing the resources and
achieving the objectives of the project. This is the fundamental ingredient for the success of a
project. That is why policies and activities of the project require financial management.
In this course, students are provided with financial skills theory and management of capital,
profits and investments. This course gives an understandings of financial statements, recognitions
and matching of expenses and income, financial projections, audit requirements, working capital;
management ratio analysis reporting and disclosures for outside users, oversight and
accountability and regulatory responsibilities.
The way in which a company finances its assets has an effect on the return on owners’ capital and
the overall cost of capital. Gearing up the capital structure together with tax allowances on
interest payments can enhance the return on shareholders’ funds but carry risks if taken too far.
Capital is invested either in fixed assets or in working capital. Both the raising of capital and its
use affect the share price of a private- sector company through the impact on reported profit.
Capital is not free. The owners of firms and financial institutions require a return on their
investments in the company. In turn the company must earn a return of assets at least equal to this
cost of capital. To do otherwise will not satisfy the providers of that capital and will make the
raising of future capital more difficult, if not impossible. Firms need to set a minimum required
rate of return against which the profitability of proposed new investments is measured. This
required rate must at least be equal to the cost of the different types of capital used in the
business.
The are two main source of new capital for new investments. Firms can either barrow the money,
usually form a financial institution, or they can obtain it from the owners. In this latter case, new
equity capital can be obtained in one of two ways.
Companies occasionally sell new shares to existing shareholders on a rights’ issue. This may be
unpopular as it tends to depress the existing hare price on the stock exchange. The other way
companies obtain new capital for the owners is by not paying out all the profit earned as
dividends. By this means companies are assured of the extra capital they need and they save the
expense of issuing new shares. Most firms use a mix of borrowed and owners’ capital and the
relationship between the two is known as capital gearing. Accompany is said to be highly geared
when it has a large amount of borrowed capital relative to owners’ capital. It is lowly geared

2. when the proportion of borrowed capital is small. Strictly speaking, gearing is the use of any prior
charge capital including preference shares.
Low gearing High gearing
Owners Capital (Share capital + Retained Profits) 90% 50%
Borrowed Capital 10% 50%
Total Capital 100% 100%
Cost of borrowed capital
The rate of interest which has to be paid on new loans to get them taken up by investors at par can
be regarded as the cost of borrowed capital. Such rates of interest vary over time in sympathy
with interest rates obtainable on alternatives investments. They vary slightly according to the size
of the loan and the degree of risk attached to the particular firm. An alternative approach can be
used to find the current cost of borrowing for a firm which has existing quoted loans or
debentures. If the fixed rate of interest on such loans is less than the current going rate, these
securities will have a market price of less than the par value of the stock. This means investors
will obtain an annual return from the interest payments and a capital gain on the eventual
repayment of the stock at par.
The cost of equity capital
The equity of a company is its risk capital, embracing ordinary share capital and retained profits
which can be regarded as having the same cost. Companies retained profits to short-circuit paying
out all profits with one hand while asking shareholders to buy new hares with the other. There is
clearly a saving in administrative costs and professional fees by returning profits, so this
alternative will be slightly cheaper in practice. When put simply, the cost of equity is the return
shareholders expect the company to earn in their money. It is their estimation, often not
scientifically calculated of the rate of return which will be obtained both from future dividends
and an increased share value. Unfortunately, simple concepts are not always so easy to apply in
practice and the cost of capital is a favorite battlefield for academics with no one agreed solution.
It is possible to calculate the cost of equity as the discounted cash flow yield achieved from the
estimated future dividends and the increased share value at a future point of time. An alternative
approach is to take the current dividend yield for a company and add the expected annual growth.
For example F. J. Management Ltd currently pay a net dividends of 10p on each ordinary share
which is quoted at ₤2 on the stock exchange. Growth of profits and dividends has averaged 15%
over the few years. The cost of equity for FJ . Management Ltd can be calculated as:
Current net Dividend x100%+15%

3. Cost of Equity Capital = Current Market Price
= 10p x 100% +15%
£2
= £0.1 x 100% +15%
£2
= 5% + 15%
= 20%
Managing the working capital
The capital of a company is employed is two distinct areas. Some of it goes to provide the
permanent or fixed assests, such as buildings, plant and vehicles. The remainder goes to provide
the working capital necessitated by having to pay for the cost of goods and sevices before
recovering the money form customers.
Fixed Assets (Buildings, Plant, Vehicles)
Capital Employed
(Shareholders’ funds, Working Capital (Stocks, debtors, cash less creditors)
Loans, debentures etc.)
The employment of capital. Figure 1.2

4. Working capital is the value of all the current assets less the value of the current liabilities. It
therefore includes the cost of stocks of raw materials, work- in- progress and finished goods
together with the amount owned by customers less the amount owed to suppliers
Working Capital = Stock + Debtors + Cash - Creditors
The key to managing working capital successfully is to find the right balance between liquidity
and profitability. A firm needs to be liquid enough to pay the wages and other bills when
required, but on the other hand it needs to carry sufficient stocks so that production is not
excessively disrupted nor customers dissatisfied with stock-outs! Both these requirements can be
met given unlimited working capital but much of it would be idle for long periods of time. This
means that profit would be lost due to the extra holding costs of large stocks and the interest cost
of the capital involved. Therefore we have to strike a balance between profitability and liquidity
recognizing that they pull in opposite directions
Management of debtors and creditors
Apart from retail shops, most companies sell on credit so their managers must decide whom to
sell to, on what terms ans how to follow up late payments. When another firm applies for credits
as a potential customer, it would be rash to agree credit without checking on credit worthiness.
Checks should include talking to other suppliers who have been quoted as trade references and
checking bank references. Unfortunately the latter may say little more than the length of time the
account has been operated. A copy of the clients annual accounts can be requested and checked
thoroughly using ratio analysis techniques to look at the profitability, liquidity and debt capacity.
Having decided whom to sell to, a firm must now decide the terms of sale being the length of the
credit period and whether to offer cash discounts for early payment. The length of credit period is
often settled by the normal terms for that particular industry, firms compete with one another for
custom andit would be difficult for one firm to impose a shorter credit period than its competitors,
unless it had some compensating advantages.
Cash discounts are a way of stimulating early payments, thereby reducing the amount of working
capital required. If a cash discount of 2% is offered for payment of invoice within two weeks, this
may persuade customers to accept instead of taking a further four weeks’ credit. A discount of
2% for four weeks is equivalent to an annual rate of 26%. If credit customers would have taken a
further six weeks to pay after the expiry of the discount period then the 2% discount is equivalent
to an annual rate of 17%.
Early payment induced by not having to borrow so much capital. Some firms offer a tapering
discount/penalty scheme where the cash discount redures in steps as the normal credit period
shortens, but after that a stepped penalty is added to the invoice value according to the lateness of
payment. An example is:
Payment within 2 weeks of invoice date 3% discount

5. Payment within 4 weeks of invoice date 2% discount
Payment within 6 weeks of invoice date 1% discount
Payment after 6 weeks of invoice date 1% penalty
Payment after 8 weeks of invoice date 2% penalty
If payment is not forth coming in the stipulated time a reminder letter should be sent followed by
a more strongly worded letter about a fortnight later. Should payment still not received,
consideration should be given to terminate supplies and instituting legal action and the customer
informed accordingly.
Management of stocks
When looking at the current ratio, it is assumed that stocks represent half of current assets. There
are three possible kinds of stocks raw materials, work in progress and finished goods. In
manufacturing industry all three types are likely to be present unless the product is a customers’
one off specification, when completed work is not usually held in stock. In service industries
physical stocks are not so prevalent but work in progress in the form of wages, salaries and
overheads may be very significant. In an ideal situation firms would need no stocks. Raw
materials would be delivered daily; production would be completed the same day and the finished
goods would immediately be sold and delivered to customers. This situation is most unusual in
practice because firms buy in bulk to reduce the unit cost of purchases and to hold some of the
stock as an insurance against non-delivery. Production is not completed in some industries.
To ensure that production is never halted for lack of materials or component parts and that
customers are never dissatisfied, might entail holding very large stocks.
MANAGING THE WORKING CAPITAL
The capital of accompany is employed in two distinct areas. Some of it goes to provide the
permanent or fixed assets such as buildings, plant and vehicles. The remainder goes to provide
the working capital necessitated by having to pay for the cost of goods and services before
recovering the money form customers.
Working capital is the value of all the current assets less the value of the current liabilities. It
therefore includes the cost of stocks of raw materials, work in progress and finished goods
together with the amount owned by customer less the amount owned to supplies.
The key to managing working capital successfully is to find the right balance between
profitability and liquidity. A firm needs to be liquid enough to pay the wages and other bills when
required, but on the other hand it needs to carry sufficient stocks so that production is not unduly
disrupted nor customers dissatisfied with stock outs: both these requirements can be met given
unlimited working capital but much of it would be idle for long periods of time.

6. Having looked at working capital requirements, let us now look at how each constituent part is
best managed.
The management of cash
There two key instruments for managing cash- the cash budget and the forecast flow statement.
The former is the more detailed statement showing all the cash receipts and payments for the
coming year broken down into monthly intervals.
When compiling a cash budget it is essential to allow for the time lags on transactions. If a firm
finds that credit customers take an average of eight weeks to settle their account, then sales that
takes place in month one will appear as a cash inflow in month three. Similarly, purchases will
not be paid for in the month of purchase but in a later month depending on the credit period
obtained from suppliers. Note the absence of depreciation which is not a expense. The other
instrument which helps to manage cash is the forecast cash flow statement. It might be thought
that it is similar to the cash budget but there are important distinctions. A cash flow statement is a
summary of the detailed cash transactions. The first entry, for example, shows the cash flow from
operating activities of which profit is the main constituent item. The cash budget, however details
the individual items of income and expenditure as they are paid not when they were initially
incurred. The cash flow statement is therefore very useful in identifying the causes of the change
in the liquid position. It highlights changes in stocks and debtors and in the level of investing
activities or new financing for example which are not obvious from the cash budget which
records the actual receipts and payments of cash.
Armed with these two statements we should now know the size, duration, and causes of potential
surpluses or deficits of cash. Short-term cash surpluses of a few months duration should be
invested short term to earn more profit while being capable of being turned back into cash when
required. The taking of cash discounts for early payment to suppliers may be advisable if the
annual rate of interest so earned exceeds that available on financial investments. If a surplus is
disclosed that is expected to continue in later years, though must be given to using this in the
expansion or diversification of the existing business or in the acquisition of new businesses.
Forecast cash deficits obviously pose more of a problem than cash surplus. A short term deficit
lasting only a few months will be disclosed in a cash budget and explained in the forecast sources
and application of funds. If the cause is a seasonal increase in stocks and debtors then the
evidence of these statements will usually persuade the bank managers to extend overdraft
facilities. Failing this a firm may have trim stocks, re-negotiate credit term, defer capital
expenditure and somehow level the peak cash outflows.
Long term cash deficits are caused by a move to an increased volume of business, large capital
expenditure programmes or simply the effects of inflation which require more cash to finance the
same activities. Such events have to be met by introducing new long term capital. This may take a
form of right s issue of new shares or a loan or debenture repayable over a number of years or in a
lump sum on redemption. Sale and leaseback of valuable premises may be a one- off way of
releasing funds for other uses but the rent will reduce profits in much the same way as would
interest do on a loan,

7. INVESTMENT:
In the business environment, Capital investment is the important step. Investment appraisal is
concerned with decisions about whether, when and how to spent money on capital projects. Such
decisions are important for the companies involved because too often large sums of money are
committed in an irreversible decision, with no certain knowledge of the size of future benefits.
Suppose a printing firm is considering buying a binding machine for $20,000 which reduce
labour costs on this activity by $6,000 per annum for each of the five years the is expected to last.
What the management of the firm has to consider is whether a return of $6,000 per annum for
five years justifies the initial investment of $20,000.
The essence of all investment appraisals is to measure the worthwhileness of proposals to spent
money by comparing the benefits with costs. If this measurement is done badly, it can hamper a
firm’s growth and employment prospects for years to come, and may lead to an inability to attract
new investors. Financial institutions finance firms with capital in the expectation of a reasonable
rate of return. If a firm invests those finances in projects which do not yield a reasonable return
then investors will be wary of that company in the future.
Types of Investment situation:
There are a number of basic situation where an appraisal takes place.
• Expansion – assessing the worthwhileness of expanding existing product lines requiring
additional investment in buildings, plant, stocks, debtors etc.
• New product/diversification – assessing the viability of the more risky investment in
totally new products.
• Cost saving – assessing the profitability of a cost-saving scheme; for example, when an
investment in a new machine automates an existing manual process.
• Replacement – deciding whether and when to replace an old machine with a new one to
save operating costs or reduce wastage.
• Financing – comparing the cost of purchasing an asset outright with the alternative cost
of leasing.
All the above investment situations have the common approach. In each case we must decide
whether the benefits we get from initial investment are sufficient to justify the original capital
outlay.
Investment Appraisal Methods
1. Present Value:

8. Suppose $1 was invested one year ago at the interest rate of 10% p.a. after a year the sum has
grown from $1 to $1.1. If the same amount was invested two years ago it would have grown to
$1.21 with first year’s interest re-invested. Compound interest measures the future value of
money invested sometime in the past. It is equally possible to look at money in the reverse
direction, namely, the present value of money receivable at a future point in time. The present
value of future sum of money is the equivalent sum how that would leave the recipient in
difference between the two amounts. The present value or equivalent sum to $1 receivable in one
year’s time is that amount which, if invested for one year, would accumulate to $1 in one year’s
time.
Example
Table 1 shows the present value factors compared with the compound interest factors at the same
interest rate.
Present Value of $1 Receivable
In a future year with interest at 10%
Future value of $1 with compound
interest at 10%
Year 0 (now) 1.000 1.000
1 0.909 1.100
2 0.826 1.210
3 0.751 1.331
Using a 10% rate of interest R1 receivable in one year’s time has an equivalent value now of
R0.909 because R0.909 for one year at 10% will accumulate to R1. the relationship between the
factors is that one is the reciprocal of the other for the same year. For example, for year 3
1
0.751 = 1.331
2. True rate of return

9. The profitability of an investment should be measured by the size of the profit earned on the
capital invested. This is what the rate of return method attempts to do without perfect success. An
ideal method will not rely on averages but will relate these two factors of profit and capital
employed to each other in every individual year of the investments’ life. A useful analogy can be
made with a building-society a sum of money each year. Part of this sum is taken as interest to
service the capital outstanding leaving the remainder as a capital repayment to reduce the capital
balance. The profitability of the investment from the society’s viewpoint can be measured by the
rate of the interest payment assuming that the yearly capitals have paid off the mortgage.
Table 2 sets the yearly cash flows of a typical building-society mortgage of R20.000 repayable
over ten years with interest at 12% p.a. on the reducing balance. The small surplus remaining at
the end of ten year is negligible given the size of the annual cash flows. This building society is
getting a true return of 12% pa on the reducing capital balance of the mortgage.
Annual Cash-
Flow : $
Interest Payment at
12% p.a.
Capital
Repayment
Capital Outstanding
Balance
Year 0 -20,000
1 + 3,540 2,400 1,140 20,000
2 + 3,540 2,263 1,277 18,860
3 + 3,540 2,110 1,430 17,583
4 + 3,540 1,938 1,602 16,153
5 + 3,540 1,746 1,794 14,551
6 + 3,540 1,531 2,009 12,757
7 + 3,540 1,290 2,250 10,748
8 + 3,540 1,020 2,520 8,498
9 + 3,540 717 2,823 5,978
10 + 3,540 379 3,161 3,155
6 (Surplus)
The true rate of profitability is 12%. This can be proved using the simpler present value approach
as in table 3 (below). To do this the cash flows are tabulated yearly and brought back
(discounted) to their present value by the use of present value factors. In effect, interest I
deducted for the waiting time involved. The remaining cash is therefore available to repay the

10. original investment. The profitability of the investment is measured by the maximum rate of
interest which can be deducted, while leaving enough cash to repay the investment. This rate of
interest is the same 12% as found in Table 2. the surplus of R3 is negligible given the size of the
annual cash flows. The effect of using present value (PV) factors on the future cash flows us ti
take interest than 12% was applied in Table 3, then not all the capital would be repaid over the ten
year life. If a lower rate of interest than 12 was used the capital repayments would be viable, but
what rate of return they can expect on a project. To answer this question the NPV method is taken
a stage further. The annual cash flows are discounted at a high trial rate of interest at FJ
Management Ltd. Such trial is an educated guess but a high rather than lower rate is chosen
because of the NPV surplus which previously occurred.
Assuming a trial rate of 30% was chosen, and then the annual cash flows can be discounted by
the present value factors at 30% as shown below:
Table 5
Annual Cash Flow
$
PV Factor at
30%
PV
$ $
Year 0 - 150,000 1.000 -150,000
1 +60,000 0.769 +46,140
2 +60,000 0.592 +35,520
3 +60,000 0.455 +27,300
4 +60,000 0.350 +21,000
5 +40,000 0.269 +10,760
6 +20,000 0.207 + 4,140
+144,860
NPV $5,140
As there is a deficit net present value of R5.140 the rate of return is less than 30%. This is
because too much interest has to be deducted to allow all the capital to be repaid. If instead of
going to an estimated trial rate of 30% the annual cash flows had been repeatedly discounted at
1% intervals from the 20% required rate, then a zero net present value would have been found at
about 28%. This is the true of return of the project and is known as the discounted cash flow yield

11. (DCF). In other words, the DCF yield is the solution rate of interest which when used to discount
annual cash flows on a project, gives an NPV of zero. The DCF yield is also known as IRR.
Interpolation
The NPV calculation at 20% and 30% yield a surplus of R28.060 and a deficit of R5.140
respectively. By interpolation which can be proved by calculation:
28,060 x (30% - 20%)
20% + 28,060 + 5,140 = 28.5%
Another method of interpolation takes the form of a simple graph with the rate of interest on the
vertical axis and the NPV on the horizontal axis. The NPVs from the trial at the company’s
required rate are then plotted against their respective interest rates and the two plots joined by a
straight line. The approximate DCF yield is where the straight line intersects the vertical axes at
zero NPV. It is possible to calculate the DCF yield to one or more decimal places. Although one
decimal may be justifiable there is usually no case for further precision. This is because the basic
data on which the calculations are performed are only estimates of future events. Some managers
may have access to calculations or computers which can rapidly the question of a project’s rate of
profitability though interpolation is an obvious shortcut.
CONCLUSION:
Having explained the Financial Management and what it involves, I conclude by Risk
Assessment in financial statements. Risk management is of utmost importance and must be
highly considered in business entity.
CHECKLIST
“Risk Assessment” Do Financial Statements Capture Risk?
Have We Been &Where Are We Going?
Valuation Basics, Accounting-based Valuation, Multiples Analysis
Cash Flow Analysis, Refresher on Financial Statements
Detecting Accounting Manipulations.

12. Part 1 of Project (Cash Flow Projections/Earnings Quality Analysis)
Risk Assessment (Credit), Cost of Capital Calculations
Risk and Analyzing Accounting Trading Strategies
Mergers and Acquisitions, and Stock Options.
– Off Balance Sheet Activities, Pension Plans, International Accounting and Valuation
Financial Statement Analysis –Risk Assessment
• Common-Size Financial Statements (cross-sectional analysis)
– E.g. deflate all financial numbers by total assets
• Trend Financial Statements (time-series analysis)
– Compare growth rates over time
Financial Ratio Analysis
– Profitability ratios, short-term liquidity ratios, long-term solvency ratios
Accounts Receivable Turnover
Measures how soon sales will be become cash:
Accounts Receivable Turnover = Net Sales on Account
Average Accounts Receivable
Perhaps a more intuitive measures of the rate at which A/R are being collected is the day’s
receivable outstanding:
Days Receivable Outstanding = 365 / Accounts Receivable Turnover

13. Inventory Turnover Ratio
This ratio measures how quickly inventory is being sold.
Inventory Turnover = Cost of Goods Sold
Average Inventory
Perhaps a more intuitive measure of the rate at which inventory is being sold is the days inventory
held:
Days Inventory Held = 365/Inventory turnover
Fixed Asset Turnover
Measures the relations between sales and the investment in property, plant, and equipment.
How efficiently is the firm using its fixed assets to generate sales?
Fixed asset turnover = Sales
Average fixed assets
Accounts Payable Turnover
Measures how quickly a firm is paying its
Suppliers.
Accounts Payable = Purchases
Turnover Av. Accounts Payable
Also can be expressed as:
Days Payable Outstanding = 365/ (Accounts Payable Turnover Rate)
Analysis of Short-Term Liquidity
•Sheds light on a firm’s ability to pay for obligations that come due during its operating
cycle (e.g., wages, purchases of inventory).

14. • Commonly used measures of short-term debt paying ability include:
- Current Ratio
- Quick Ratio
- Operating Cash Flow to Current Liabilities Ratio
Current Ratio
Current Ratio = Current Assets
Current Liabilities
This ratio matches the amount of cash and other current assets that will become cash
within one year against the obligations that come due in the next year.
Basic rule of thumb: A minimum current ratio of 1.0.
Quick Ratio
A variation of the current ratio is the quick ratio or acid test ratio.
Quick Ratio = Cash + Mkt Securities + AR = CA-Inv
Current Liabilities CL
Include in the numerator only those current assets that the firm could convert quickly into
cash
Operating Cash Flow to Current Liabilities Ratio
• Another measure a firm’s short-term liquidity.

15. – The advantage is that it is based on cash flow AFTER the funding needs for working
capital (i.e., accounts receivables and inventory) been made.
Operating Cash Flow
Average Current Liabilities
Long-Term Solvency Ratios
Measure a firm’s ability to meet interest and principal payments on long-term debt (and
similar obligations, like long-term leases) when they come due.
Obviously, the best indicator for assessing long-term solvency risk is a firm's ability to
generate earnings over a period of years.
Long-Term Solvency Ratios
Long-Term = Long-Term Debt
Debt Ratio Long-Term Debt +
Shareholders Equity
Debt/Equity = Long-Term Debt
Ratio Shareholders’ Equity
Liabilities/Assets = Total Liabilities
Ratio Total Assets
Interest Coverage Ratio
Measures how many times a firm’s net income before interest expense and income taxes
exceeds its interest expense.
Net Income + Interest Expense + Income Tax Expense+ Minority Interest in Earnings
Interest Expense

16. Interest coverage ratios less than 2.0 suggest a risky situation.
Summary of Risk Assessment using Financial Information
. Analysis of a particular firm’s financial ratios over a period of years allows one to track
historical trends and variability in the ratios over time.
. Key is compare with industry benchmarks.
. An important part of the analyst’s job is to use financial ratios to identify aspects of the
firm that warrant deeper investigation.
BIBLIOGRAPHY
Eugene F. Brigham and Michael C. Ehrhardt (2005).
Financial Management – Theory and Practice. Published by: Thomson Corporation, USA.