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Business Finance- Lecturer Notes

BUSINESS ADMINISTRATION (Kampala International University)

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BUSINESS FINANCE

INTRODUCTION
Business concern needs finance to meet their requirements in the economic world.
Any
kind of business activity depends on the finance. Hence, it is called as lifeblood of
business
organization. Whether the business concerns are big or small, they need finance to
fulfill
their business activities.

In the modern world, all the activities are concerned with the economic activities
and very particular to earning profit through any venture or activities. The entire
business activities are directly related with making profit. (According to the
economics concept of factors of production, rent given to landlord, wage given to
labour, interest given to capital and profit given to shareholders or proprietors), a
business concern needs finance to meet all the requirements. Hence finance may
be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the
main aim of any kind of economic activity.

MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the provision
of money at the time when it is needed. Finance function is the procurement of
funds and their effective utilization in business concerns.
The concept of finance includes capital, funds, money, and amount. But each word
is having unique meaning. Studying and understanding the concept of finance
become an important part of the business concern.
DEFINITION OF BUSINESS FINANCE
According to the Wheeler, “Business finance is that business activity which
concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise

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According to the Guthumann and Dougall, “Business finance can broadly be

defined as the activity concerned with planning, raising, controlling, administering
of the funds used in the business”.
In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in
nonfinancial fields of industry”.

Corporate finance is concerned with budgeting, financial forecasting, cash

management, credit administration, investment analysis and fund procurement of
the business concern and the business concern needs to adopt modern technology
and application suitable to the global environment. ”.

TYPES OF FINANCE
Finance is one of the important and integral part of business concerns,
hence, it plays a major role in every part of the business activities. It is used
in all the area of the activities under the different names.

Finance can be classified into two major parts:

Finance

Private finance public finance

Individual
Finance Partnership Business Central State
Government Semi
Government
Government
Finance

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Finance

DEFINITION OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is concerned

with the duties of the financial managers in the business firm.

The term financial management has been defined by Solomon, “It is concerned
with the efficient use of an important economic resource namely, capital funds”.
The most popular and acceptable definition of financial management as given by
S.C.Kuchal is that “Financial Management deals with procurement of funds and
their effective utilization in the business”.
Thus, Financial Management is mainly concerned with the effective funds
management in the business. In simple words, Financial Management as practiced
by business firms can be called as Corporation Finance or Business Finance.

 The task of financial management is therefore to assist, advise and support management
in the four important areas of decision making i.e. investment, financing, working capital
and dividend decisions.

 Financial management is the area of business management, devoted to a judicious use of

capital and a careful selection of sources of capital, in order to enable a spending unit to
move in the direction of reaching its goals.

Financial Management is concerned with the acquisition, financing, and management of assets with
some overall goal in mind. There are mainly two major roles in financial management i.e.

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 Raising of funds
 Allocation of funds/utilization.

Raising of funds

Funds can be raised from owners of the business (equity) and from outsiders (debt). When funds are
raised from equity or debt, you create what is known as the financing mix e.g. 70% equity: 30% debt.
This financing mix will determine the financing risk. Financing risk is the possible variability in return as a
result of the method of financing used by the firm. It involves repayment of fixed financing obligations
that come in form of interest and debt redemption i.e. payment of principal. Financial risk is the
additional risk a shareholder bears when a company uses debt in addition to equity financing.
Companies that issue more debt instruments would have higher financial risk than companies financed
mostly or entirely by equity.

Allocation of funds

The allocation of funds determines the asset mix of the firm. The asset mix defines the nature of the
firm which in turn shapes the business risk. Business risk will vary with the nature of the business e.g. a
service firm and manufacturing firm will not have the same business risk. Business risk is defined as the
variability in return as a result of the nature of the business that thefirm is undertaking.
Business risk associated with the unique circumstances of a particular company, as they might affect the
price of that company's securities.

Business risk and financing risk show the importance of the finance function and therefore decisions
made in finance are strategic.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management,
which is directly related with various functional departments like personnel,
marketing and production. Financial management covers wide area with
multidimensional approaches. The followingare the important scope of
financial management.
1. Financial Management and Economics

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Economic concepts like micro and macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro
environmental factors are closely associated with the functions of financial
manager. Financial management also uses the economic equations like money
value discount factor, economic order quantity etc. Financial economics is one of
the emerging area, which provides immense opportunities to finance, and
economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern.
Hence, we can easily understand the relationship between the financial
management and accounting. In the olden periods, both financial management and
accounting are treated as a same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance manager
to take decisions. But nowadays financial management and accounting discipline
are separate and interrelated.
3. Financial Management or Mathematics
Modern approaches of the financial management applied large number of
mathematical and statistical tools and techniques. They are also called as
econometrics. Economic order quantity, discount factor, time value of money,
present value of money, cost of capital, capital structure theories, dividend theories,
ratio analysis and working capital analysis are used as mathematical and statistical
tools and techniques in the field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which
helps to multiple the money into profit. Profit of the concern depends upon the
production performance. Production performance needs finance, because
production department requires raw material, machinery, wages, operating
expenses
etc. These expenditures are decided and estimated by the financial department and
the finance manager allocates the appropriate finance to production department.
The financial manager must be aware of the operational process and finance
required for each process of production activities.
5. Financial Management and Marketing

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Produced goods are sold in the market with innovative and modern approaches. For
this, the marketing department needs finance to meet their requirements. Introduction
to Financial Management
The financial manager or finance department is responsible to allocate the
adequate finance to the marketing department. Hence, marketing and financial
managementare interrelated and depends on each other.
6. Financial Management and Human Resource
Financial management is also related with human resource department,
which provides manpower to all the functional areas of the management.
Financial manager should carefully evaluate the requirement of manpower to
each department and allocate the finance to the human resource department as
wages, salary, remuneration, commission, bonus, pension and other monetary
benefits to the human resource department. Hence, financial management is
directly
related with human resource management.
OBJECTIVES OF FINANCIAL MANAGEMENT

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the
earningcapacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized
in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

THE OBJECTIVE OF A FIRM

1. Maximization of profits: This objective requires a firm to maximize its revenue as it minimizes its
costs.

This objective is generally criticized in financial management because

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i) The definition of profit is vague – Economists define profit differently from accountants
therefore, as a financial manager, the objective becomes elusive.
ii) Profit maximization ignores the concept of time value of money.
iii) The objective is in conflict with interests of other stakeholders e.g. employees, suppliers,
consumers, etc.

There has been a re-focus of what the objective of the firm should be and therefore overcoming the
weaknesses of profit maximization. Financial managers now focus on the objective of wealth
maximization.

2. Wealth maximization – Wealth is the net cash flow expected from all the assets in which
resources of the firm have been invested; these cash flows have to be discounted to their
present worth using a discount rate that takes into account all stakeholders interests in the
business.

Wealth max. = Σ Ai _ _ I0

i=1 (1 + K)^i

Wealth maximization = Discounted Cash inflows – Outflows.

Ai – cash flow invested in period i

K - discount rate/factor

I0 - initial cash flow

i - period over which a firm is expected to acquire resources and invest.

Note: i) Cash flows are different from profits.

ii) Wealth maximization focuses on cash flows and not accounting profits

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Other Objectives of the firm:

3. Maximization of market share.

4. Maximization of earnings per share

5. Maximization of employee welfare

6. Social responsibility. (Read)

FUNCTIONS OF FINANCE MANAGE

Finance function is one of the major parts of business organization, which involves
the permanent, and continuous process of the business concern. Finance is one of
the interrelated functions which deal with personal function, marketing function,
production function and research and development activities of the business
concern. At present, every business concern concentrates more on the field of
finance because, it is a very emerging part which reflects the entire operational and
profit ability position of the concern. Deciding the proper financial function is the
essential and ultimate goal of the business organization. Finance manager is one of
the important role players in the field of finance function.
He must have entire knowledge in the area of accounting, finance, economics and
management. His position is highly critical and analytical to solve various problems
related to finance. A person who deals finance related activities may be called
finance manager. Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate
the financial requirement of the business concern. He should estimate, how
much finances required to acquire fixed assets and forecast the amount needed
to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate
how the finance is mobilized and where it will be available. It is also highly critical in
nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and
consider the reasonable and stable return from the investment. He must be well
versed in the field of capital budgeting techniques to determine the effective
utilization of investment. The finance manager must concentrate to principles of
safety, liquidity and profitability while investing capital.
4. Cash Management

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Present days cash management plays a major role in the area of finance because
proper cash management is not only essential for effective utilization of cash but it
also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing,
production, personnel, system, research, development, etc. Finance manager should
have sound knowledge not only in finance related area but also well versed in other
areas. He must maintain a good relationship with all the functional departments of
the business organization.

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of business organization. It needs to meet the requirement
of the business concern. Each and every business concern must maintain adequate
amount of finance for their smooth running of the business concern and also
maintain the business carefully to achieve the goal of the business concern. The
business goal can be achieved only with the help of effective management of
finance. We can’t neglect the importance of finance at any time at and at any
situation. Some of the importance of the financial
management is as follows:
Financial Planning
Financial management helps to determine the financial requirement of the business
concern
and leads to take financial planning of the concern. Financial planning is an
important part
of the business concern, which helps to promotion of an enterprise.
Acquisition of Funds
Financial management involves the acquisition of required finance to the business
concern.
Acquiring needed funds play a major part of the financial management, which
involve
possible source of finance at minimum cost.
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the
business concern. When the finance manager uses the funds properly, they can
reduce the cost of capital and increase the value of the firm.

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Financial Decision
Financial management helps to take sound financial decision in the business
concern. Financial decision will affect the entire business operation of the concern.
Because there is direct relationship with various department functions such as
marketing, production personnel, etc.
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper
utilization of funds by the business concern. Financial management helps to
improve the profitability position of the concern with the help of strong financial
control devices such as budgetary control, ratio analysis and cost volume profit
analysis.
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the
investors and the business concern. Ultimate aim of any business concern will
achieve the maximum profit and higher profitability leads to maximize the wealth of
the investors as well as the nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings.
Nowadays financial management is also popularly known as business finance or
corporate finances. The business concern or corporate sectors cannot function
without the importance of the financial management.
 Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs and profits
and future programmes and policies of a concern. Estimations have to be made in an adequate
manner which increases earning capacity of enterprise.
 Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis. This
will depend upon the proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties.
 Choice of sources of funds: For additional funds to be procured, a company has many
choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

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Choice of factor will depend on relative merits and demerits of each source and period of
financing.
 Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
 Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
b. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.

 Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of
enough stock, purchase of raw materials, etc.
 Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc.

MODEL QUESTIONS
1. What is finance? Define business finance.
2. Explain the types of finance.
3. Discuss the objectives of financial management.
4. Critically evaluate various approaches to the financial management.
5. Explain the scope of financial management.
6. Discuss the role of financial manager.
7. Explain the importance of financial management.

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COST OF CAPITAL
3.1 Introduction

It is defined as the minimum rate of return that a firm must generate from an investment to
justify the commitment of funds in such an investment.

It is also referred to as the hurdle rate reflecting the fact that any investment must realize such a
rate of return if it’s to be feasible.

Crucial decisions in financial management are often made with refine in the cost of capital e.g.:

• In the capital budgeting decision the cost of capital is reflected in the investors IRR
which is then used to discount the investments cash flow so as to derive its NPV.

• The IRR is compared with the required rate of return in order to determine if the
investment project is feasible or not.

• The profitability index PI also relates to the present value of inflows to that of out flows
which present values are partly affected by the required rate of return.

Categories of cost of capital

They are:

• Specific cost of capital

• Over all or weighted cost of capital

• Historical cost of capital

• Future or marginal cost of capital

Specific cost of capital

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It refers to the required rate of return on an investment for a specific financial asset hence there is
the specific cost of the debt, the specific cost of preference share capital, specific cost of ordinary
share capital.

Overall or weighted cost of capital

It is the cost of capital for the aggregate pool of funds used in the firm.

Historical cost of capital

It refers to the cost of funds already being utilized in the business. These funds were raised
sometimes in the past hence the cost if just historical.

Future/marginal cost of capital

This is the cost of capital funds yet to be raised by the firm which is being planned for. It is
determined by conditions relating to the future when these funds will be raised because it is the
cost of additional funds to be raised in future it is also referred to as marginal cost of capital.

Determination of specific cost of capital

Cost of debt capital

It is the required rate of return on the investment by the lenders of funds. It is obtained by
determining the discount rate which equates the present value of the debt to the present value of
the interest and principle payment on the debt.

Bo = int1 + int 2 +………….. intn + Bn

(I + kd) (I +kd) 2 (1 +kd) n

Bo = Present value of Bond

Kd = Discount rate

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When debt instruments are issued at values other than the par value, in this cost the debt (kd) is
determined as follows:

Kd = int +1/n (Fo-Po)

½ (Fo+ Po)

Int-period interests

N-years to maturity of the bond

Fo- face value of the bond

Po- price at which bond is issued.

Cost of preference share capital

The cost of preference share capital is the rate of dividends that the investors require in order to
purchase these shares since most preference shares have no maturity date, the cost of preference
share is determined as follows

Kp. = Div P

Po

Div p – Dividend per share

Po – Price of preference share

Kp. – cost of preference share

Cost of Equity share

To determine the cost of equity is slightly more difficult because the dividends on ordinary share
capital are not definite. They fluctuate depending on the availability of earnings and the
proyalities of BOD this makes it difficult to estimate the periodic dividends; however Gordon
model can be still used to determine the cost of equity.

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Po = Div 1 + Div2 + ………. + Div n.

(1 + Ke) 1 (1+ Ke) 2 (1+Ke) n

= n Divt

t=1(1+Ke)t

Where Po= is market value of ordinary shares at the time of issue.

Div t, refers to dividend per share expected to period t.

K e refers to cost of equity being sought.

T- Time period ranging from period (I – x) since the ordinary shares are held for ever as long as
the business exists.

To determine cost of equity (Ke) requires estimate of future dividends expected by investors.

Approach: it’s normally easier and more realistic to estimate the dividends of any share (Div1)
and then assume that these dividends will grow at given rate.

Dividends are normally assumed to grow at a constant rate over the future period.

Once the initial dividends and the growth rate have been defined, then the cost of equity is
determined by the following formula.

Ke = Div +g

Po

Ke - cost of equity

Div 1- Dividend in period one

Po – price of the share

g- Growth rate

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3.2 Weighted cost of capital

This is the cost of funds that the firm intends to employ. It is more relevant in evaluating new
investments whose financing is yet to be procured. The process of determining the marginal cost
of capital is the same as that of historical weighted cost of capital. Except that the rights in case
of marginal cost are the expected proportions of the new funds and the specific costs related to
those new funds.

The weighted cost of capital (Ko) is the firms over all cost of capital.

It’s a combination of costs of all the individual sources of funds for the firm or it’s a combination
of the cost of all the individual sources of funds for the firm or it’s a combined total cost of funds
of the funds.

It can be the historical cost of funds or cost of funds to be raised.

Determination of the average cost of capital

Determining of Ko involves the following: 3 steps

• Determine the specific costs of capital for the different categories of funds used in
financing the firm.

• Determine the weight or proportion of each source of funds in the entire capital structure.

• Multiplying the cost of each source of funds by its weight to determine the weighted cost
of each source and then summing these up to obtain the over all cost of capital

Ko = ∑w k Wi- weight of each source

Ki – cost of specific source of each fund.

Byansi ltd currently has a total capital of 100m/= composed of the ff.

Amount proportion

20% long term bank loan - 40m 0.40

10% preference shares - 10 m 1.10

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Common shares - 30m 0.30

Retained earnings - 20 m 0.20

100m 1.00

Additional information:

The business anticipates that dividends on ordinary shares would be 5000/= per share and the
market value of the share is 22.000/= per share, the dividends are expected to grow at rate of 6%
per year for ever and the co is in 30% tax bracket.

Required: determine the weighted average cost of capital of the firm.

Ki = kd (I –T) = 20% (1-0.3) = 14%

0.20 (0.7) = 0.14

= 14%

Long term bank loan amount proportion Ki Wiki

* 20% 40m 0.40 x 0.14= 0.056

* 10% preference shares 10m 0.10 x 0.10 = 0.010

Common shares 30m 0.30 x 0.287= 0.0861

Retained earnings 20m 0.20 x 0.287= 0.0574

100 1.00 ∑wiki 0.2095

NB:

i) This cost of capital is historical

ii) When raising funds to finance new invests this cost may not be appropriate as the
required rate of return because conditions may change.

iii) Weighted average cost of capital (WACC) assumes that all invests have the same risk
level and should be evaluated using a uniform required rate of return.

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iv) The weighted average cost of capital even if its historical still serves as an important
planning tool in finance decisions. By providing an insight into the present cost of capital for the
firm.

Qn. Βx = P 1.20

Market rate of return = 18%

Return on bond security 8%

ER: = Rf + (Rm – Rf) Bx

= 0.08 + (0.18 - 0.08) 1.20

= 0.08 + (0.1) 1.20

= 0.08 + 1.20

= 0.2

= 20%

3.3 Capital Asset Pricing Model (CAPM)

The CAPM is used in portfolio management to determine the required rate of return given the
risk of the equity share capital.

ER: = Rf + (Rm – Rf) Bx

Where ER1 – is the expected rate of return of share i.e. cost of equity.

Rf. = Risk free rate of return i.e. return on government securities.

Rm – Market rate of return

Bx – Beta coefficient showing risk less of the asset compared to the market port folio:

Illustration

A firm is interested in investing in a project whose average risk as indicated by Beta (Bx). 1.80
And has a market rate of return of 16%. If government bonds presently earn a risk less rate of
return of 6% find the cost of capital for the project.

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ER: = Rf + (Rm –Rf) Bx =

6% + (16% -6%) 1.80

= 0.06 + (0.16 – 0.06) 1.80

0.06 + (0.1) 1.80

0.06 + 0.18

= 0.24

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MANAGEMENT OF WORKING CAPITAL

Introduction

This concerns management of the current assets maintained by an organization for

the day to day running of the business, these assets includes;

• Cash
• Accounts receivables
• Financial securities
• Prepayments
• Inventory

Working capital is also known as net working capital which is the financing metric
that represents operating liquidity available to the business. Together with fixed
assets, working capital is considered to be part of the operating capital.

Working capital management is entirely concerned with to decisions relating to

working capital and short term financing, it involves managing the relationship
between the firm’s short term assets and short term liabilities.
It also involves taking decisions relating to the level of current assets that business
should maintain and lastly how to raise funds to boost the working capital.
It is also primarily concerned with liquidity and safety, and then on maximizing
profits and ensures a competitive advantage and often creates an increase in
shareholder value.

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Net working capital is determined by deducting the current liabilities from the
current assets, and if CA’s are less than CL’s, then the business entity has a working
capital deficiency (deficit).
If a business empire has got negative working capital it may lack necessary funds
for growth and these happens when the CL are greater than the CA, and this
becomes difficult for the business to meet its obligations
A company may have high levels of fixed assets but if it lucks sufficient capital it
may fail to make use of this fixed assets, in other words with out working capital
these fixed assets would be idle.

5.2 Determinants of the working capital in the business

• The size of the firm- big business require more working capital as compared
to small medium sized businesses
• Length of the cash cycle- this is the time it takes from acquisition of inputs,
making finished products up to selling, and collection of proceeds.
• The longer the cash cycle, the more working capital will be needed as daily
collections cannot be relied on to meet short term obligations
• The stability of sales and revenues- if the sales are unpredictable, higher
levels of working capital will be needed to cater for uncertainty.
• The nature of the business- retail shops must carry a variety of stock to
satisfy its customers.
• Seasonal sales
• A number of companies experience seasonal and cyclic fluctuations which
affect the working capital requirement.
• Manufacturing cycle.
• This comprises of the purchase and use of raw materials and conversion into
finished products.
• Availability of credit from suppliers
• Price changes

The importance of maintaining sufficient working capital

• Working capital is considered to be the life blood of a firm.

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• A company may have a high value of fixed assets but if it lacks sufficient
working capital it may fail to make use of its fixed assets.
• Without working capital, the fixed assets (e.g. plant, equipments, furniture,
machinery, buildings and vehicles) of an organization would be idle.
• Adequate working capital is required to ensure that a firm is able to continue
its operations un interrupted
• To pay maturing short-term debt
• Maintaining good company image
• To take care of unforeseen financial difficulties that may arise.
• To support the day-to-day financial operations of an organization, including:
• Purchase of stock,
• Payment of salaries, wages and other business expenses, monthly bills
• Financing of credit sales.
• Raising credit standing of a business because of:
• Better terms on goods bought e.g. ability to obtain cash discounts,
• Favorable rates of interest etc

• Poor working capital leads to:

• Financial pressure on a company,
• Increased borrowing,
• Late payment to creditors-all of which result in a lower credit rating.
• Lower credit rating means banks charge a higher interest rate, which can cost
a company a lot of money over time.

The need effective working capital management

• Effective working capital management will ensure that the business has
enough current assets (liquidity) to meet its obligations, without having to
frequently sacrifice business opportunities.
• When a business can predict its future cash flows with relative accuracy, it
can maintain minimal excess cash reserves.

Level of working capital

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• It is crucial to retain right level of working capital.

• A financial manager is required to decide the appropriate amount of working
capital
• The manager has to trade off between profitability and liquidity (risk)
• When a firm maintains high levels of working capital, it is able to pay its
obligation when they fall due
• This enhances liquidity and reduces the risk of insolvency
• Liquidity- measures the ability of a business to pay its debts as they fall due.
• It is a useful indicator of the short-term financial stability of a business.
• The high level of liquidity involves keeping large amounts of current assets
which become idle as they are not employed to generate a return.
• This would jeopardize the profitability position of the firm

5.3 Management of Receivables

Accounts receivables are also known as trade debtors. Trade debtors arise from a
firm selling its products and services on credit and expect to collect, in the near
future.
The customers from whom receivables are to be collected are called Trade Debtors.

Implication of receivables

• Receivables involve the element of risk which should be carefully analyzed –

cash sales do not involve risk
• Economic value – the value of the goods passes immediately after the sale
• It implies futurity – the buyer will pay in future
• The interval between the date of sale and the date of payment has to be
financed out of working capital – this may necessitate the firm to get funds from
banks or other sources, hence receivables represent an investment.

The justification for investment in receivables

• Trade credit is a marketing tool.

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• The firm can use it for launching new products

• For gaining market share.
• For coping with competition. The higher the competition, the more the credit
granted by the firm. Trade credit helps to protect a firm sale from competition.
• Building customer loyalty and good will credit sales help to create loyal
customers who will always buy from the organization during times of economic
instability.
• Buyers status
• Large/buyers demand credit purchases because of bulk purchases and higher
bargaining power. Companies prefer extending credit to bulk buyers because
collection costs tend to be lower.
• Some buyers can not operate without credit e.g. Government.
• Industrial practice – it may a practice in a certain industry to extend credit to
customers. So all new entrants to the industry find it inevitable to offer credit.
• Reduction in inventory levels of the company
• Acts as a bridge for moving of goods through production and distribution
stages to customers.
• It increases bargaining power of the firm.

Costs of selling on credit

• Collection costs, these include:
 Postage costs, incurred through sending reminders( letters informing the
client of his debt position
 Telephone, calls made on demand
 News papers, publishing of debtors in journals
 Legal costs, arising out of engaging company lawyers.
 Debt collectors
• Bad debts losses i.e. failure by some customers to honor their credit
obligations
• Administration costs these include:
 Processing of credit sales costs
 Supervising and investigating receivables
 Costs of customer analysis
 Production and selling costs

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• Damaged relationships
• Opportunity costs
• Tying up of funds in receivables

Factors that determine the level of receivables maintained

• The of credit sales is a function of total sales. Total sales depend on:
 Market share
 Intensity of competition
 Economic conditions-
• Collection period
• Credit policy.

The credit policy, these are procedures and policies that the company puts in place
to when dealing in trade credit and it’s evident that when a firm adopts a lenient
credit policy, it tends to increase sales, however this may increase costs associated
with credit sales.
Therefore a credit policy is a set of guidelines designed to minimize costs associated
with credit while maximizing the benefits in order for a firm to arrive at an optimum
credit policy, it should analyze the contribution of additional sales resulting from a
lenient policy and the associated costs.

Elements of the credit policy

There are 3 important elements to be considered in coming up with a credit
policy:-
• Credit standards
• Credit terms
• Collection procedures

Credit standards, these are criteria which a firm follows in selection of customers to
whom credit is to be extended and they affect the quality of customers. Managers
should be in position to determine:
 The time it takes to collect credit sales (average collection period)

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 The default rate which is proportion of uncollected receivables. It is also

known as bad debts losses ratio.
 Default risk (This is likelihood that the customer will fail to pay the credit
obligation)
Therefore, a firm may have tight credit standards (– i.e. selling only to the most
reliable or financially strong customers). This may minimize bad debts but the firm
may not expand sales.
The choice of optimum credit standards involves a trade off between incremental
return and incremental costs.

Criteria for vetting credit customers

To minimize the credit risk the manager should vet customers using the 5Cs
• Character -Marital status, Level of Education, Contact ,Occupational stability,
Historical back ground
• Capacity
• Condition
• Capital
• Collateral

• Character, this concerned with the customer’s willingness to pay. The

following aspects can be used to asses the customers character, they include:
o Bank reference
o Marital status
o Level of Education
o Contact
o Occupational stability
o Historical back ground
• Capacity, this is the ability of the customer to pay the credit, capacity can be
analyzed using the following sources:
• Previous experience
• Trade reference
• Bank reference
• Amount and purpose of credit

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• Financial statements i.e. Balance sheet, income statement, forecasted cash

flow statements and duration a customer has been in business.

• Condition, this refers to prevailing economic, social, political conditions.

These affect customer ability to pay.
• Capital, need to analyze the customers’ working capital position and trends.
• Collateral
This refers to the security offered by the customer
Credit terms
These refer to conditions under which a firm grants credit to customers, they
include:
• Credit period, this stipulates the length of time for which credit is extended.
• Cash discount, this is what is offered to customers in form of a reduction in
payment. So as to induce them to repay their credit obligations within a specified
period which is less than the normal credit? It is used as tool to increase sales and
accelerate collections from customers.
5.5 Collection procedures
This is a set of collection efforts intended to accelerate collection from slow-payers
and reducing bad debts losses.
The following steps can be taken:
(a) Reminders
(i) Sending credit notes
(ii) Sending letters
(iii) Making personal contacts
(b) Resorting to legal measures.
(c) Insuring debtors – here the business insures its debtors with an insurance
firm which will pay bad debts.
(d) (d) engaging a debt collector
(e) Factoring is a financial transaction whereby a business sells its accounts
receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange
for immediate money with which to finance continued business. Factoring differs
from a bank loan, the emphasis is on the value of the receivables , not the firm’s
credit worthiness
(f) Write off.

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5.6 Management of Cash

Financial managers actively attempt to keep cash (non-earning asset) to a
minimum. It is critical to have sufficient cash to assuage emergencies and steps to
improve overall profitability of a firm through minimizing cash balances thus have
accurate knowledge of when cash moves in and out of the firm.

Cash management policy

Cash being the most liquid short term asset normally held as money, efficient
management is therefore very essential because cash is the basic input in
production, with out cash labor force will not be motivated to perform, procurement
process will not be effected, and other resource in puts. In relation to this guidelines
should be established by the business to ensure that the cash resource are
efficiently and effectively put to use which involves management of cash inflows
and outflows.

Reasons for Holding Cash

• Transactions balances
– Payments towards planned expenses.
• Compensative balances for banks
– Compensate a bank for services provided rather than paying directly for
them.
• Precautionary needs and emergency purposes.

Cash planning, a process of making decisions which will define how cash resources
can be put to use, it defines what has and should be achieved in the future. It is a
means of ensuring that the organizations cash objectives are accomplished as when
desired.
Planning is future oriented and it’s necessary for facilitating control and to
determine targets that have to be achieved.
Under the planning process we use tools or techniques such as, Cash Budget, which
is a statement of the monetary terms.

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It is a coordinate and comprehensive plan expressed in financial terms for the

operation and resource organization for a specific period in the future. It must be
comprehensive, financially quantified and has a time element. Therefore a cash
budget is a detailed budget of cash in flows and outflows incorporating both
revenue and capital items.
It is prepared by showing estimated cash flows in form of receipts and payments

Example 1
Given below is information, which relates to HLC General Traders Ltd. you are
required to prepare a month-by-month cash budget for the first half of 2002 and to
append such brief comments as you consider might be helpful to management.
(a) The company’s only product sells a unit U Shs 40,000/- and has a variable
cost of U abs 26,000/= per unit made up as follows: materials 20,000/=, labour U
Shs 4,000/- and overheads U Shs 2,000/=
(b) Fixed costs of U Shs 6,000,000/= per month are paid on the 281) of each
month.
(c) Quantities sold/to be sold on credit.
Nov 01 Dec 01 Jan 02 Feb 02 Mar 02 Apr 02 May 02
Jun 02
1,000 1,200 1,400 1,600 1,800 2,000 2,200 2, 600

(d) Production quantities

Nov 01 Dec 01 Jan 02 Feb 02 Mar 02 Apr 02 May 02

Jun 02
1,200 1,400 1,600 2,000 2,400 2,600 2,400 2,200
(e) Cash sates at a discount of 5% expected on average 100 units per month.
(f) Customers are expected to settle their accounts by the end of the second
month following sale.
(g) Suppliers of materials are paid two months after’ the material is used in
production.
(h) Wages are paid in the same month as they are incurred.
(i) 70% of the variable overhead is paid in the month of production, the
remainder in the following month.

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(j) Corporation tax of U shs 18,000,000/- is to be paid in April 2002.

(k) A new delivery vehicle is to be bought in December 01. It costs U shs
8,000,000/- and is to be paid for in Feb 2002. The old vehicle was sold for U shs
600,000/-, the buyer undertaking to pay in January 2002.
(l) The company is expected to be U shs 3,000,000/- overdrawn at the bank at
31st December 2001.
(m) No increases or decreases in raw materials, work in progress or finished
goods are planned over the period.
(n) No price increases or cost increases are expected in the period
Solution: HLC General Traders Ltd - Cash Budget For January to June
2062

Jan Shs.
000 Feb Shs.
000 Mar Shs.
000 Apr Shs.
000 May Shs.
000 Jun Shs.
000 Total Shs.
000
Receipts
Credit Sales

40,000

48,000

56,000

64,000

72,000

80,000

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360,000
Cash Sales 3,800 3,800 3,800 3,800 3,800 3,800 22,800
Sale of Vehicle 600 - - - - - -
44,400 51,800 59,800 67,800 75,800 83,800
383,400

Payments
Jan Shs.
000 Feb Shs.
000 Mar Shs.
000 Apr Shs.
000 May Shs.
000 Jun Shs.
000 Total Shs.
000
Materials 24.000 28.000 32.000 40.000 48.000
52.000 224.000
Labour 6.400 8.000 9.600 10.400 9.600 8.800 52.800
Variable overhead 3.080 3.760 4.500 5.080 4.920 4.520 25.920
Fixed Costs 6.000 6.000 6.000 6.000 6.000 6.000 36.000
Corporation tax 18.000 18.000
Purchase of Vehicles
8.000 8.000
39.480 53.760 52.160 79.480 68.520 71.320
364.720

Receipts – Less:
Jan Shs.
000 Feb Shs.
000 Mar Shs.
000 Apr Shs.
000 May Shs.

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000 Jun Shs.

000 Total Shs.
000
Payments 4.920 (1.960) 7.640 (11.680) 7.580 12.480 18.680
Balance b/f (3.000) 1.920 (40) 7.600 3.200 3.200 (3.000)
Balance c/f 1.920 (40) 7.600 (4.080) 15.680 15.680 15.680

Working
Variable overhead

Dec 01 Shs. Jan 02 Shs. Feb 02 Shs. Mar 02 Shs. Apr 02

000 May 02 Shs. June 02
Shs.
Variable overhead production cost 70% 2.800 3.200 4.000 4.800 5.200 4.800

3.360 4.400

3.080
Paid Month 30% in Following Month 2.400
840
3.080 2.800
960
3.760 3.360
1.200
4.560 3.640
1.440
5.080
1.560
4920
1.440
4.520

Comments

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a) There will be a small overdraft at the end of January 2002, but a much larger
one at the end of April 2002. It may be possible to delay payments to suppliers for
longer that two months or to reduce purchases of materials or reduce the volume of
productivity by running down existing stock levels.

b) If neither of these courses is possible, the company may need to negotiate

overdraft facilities with its banks.

c) The cash deficit is only temporary and by the end of June 2002 there will be a
comfortable surplus. The use to which this cash will be put should ideally be
planned in advance.

5.7 Cash Cycle

The lengthy of time it takes to convert cash into raw materials, work in progress, to
finished products that are ready for disposal so as a return in form of cash is
realized and the cycle continues and under this ensure that cash inflows and
outflows are synchronized for transaction purposes. Under this tools like cash
budgets are used to track cash flows and ensuing balances.
• Cash flow relies on:
– Payment pattern of customers.
– Speed at which suppliers and creditors process checks.
– Efficiency of the banking system.

• Cash-generating process is continuous although the cash flow may be

unpredictable and uneven and are driven by sales and influenced by:
– Type of customers.
– Customers’ geographical location.
– Product being sold.
– Industry.

Expanded Cash Flow Cycle

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• Financial managers must pay close attention to the percentage of sales

generated:
– By cash.
– By outside credit cards.
– By the company’s own credit terms

• Account receivable is collected or the credit card company advances

payment.
– Used for various payments such as interest to lenders, dividends to
stockholders, taxes to the government etc.
– Used to invest in marketable securities.
• Therefore when there is a need for cash a firm can:
– Sell the marketable securities.
– Borrow funds from short-term lenders
– Collection & Disbursement

• Primary concern to the financial manager is the management of Cash inflows

which are still affected by collection mechanisms and Payment outflow. There are
various measures that are put in place to control the collection and disbursement of
cash with in business organizations, they include;

Float

• Difference between firm’s recorded amount and amount credited to the firm
by a bank.
– Arises due to time delays in mailing, processing and clearing checks through
the banking system.
– Can be managed to some extent by combining disbursements and collection
strategies.
– Main challenge: the physical presentation of the check to the issuing bank.
• Factors that help in reducing float:

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– Ease of credit and debit cards payments and on-line banking for customers.
– Wire transfers for corporations.
– Rise of Internet commerce.
–
Improving collections

• Setting up multiple collection centers at different locations.

• Adopt lockbox system for expeditious check clearance at lower costs.

Extending disbursements

• General trend speed up processing of incoming checks while slowing down

payment procedures. Extended disbursement float - allows companies to hold onto
their cash balances for as long as possible.

Cash Management Net Work

Electronic Funds Transfer

Funds are moved between computer terminals without the use of a ‘check’,
automated clearinghouses (ACH) that transfers information between financial
institutions and between accounts using computer tape and Central clearing
facilities include:
• National Automated Clearinghouse Association (NACHA)
• Federal Reserve system
• Electronic Payment Network
• VISA
• International EFT

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Carried out through Society for Worldwide Interbank Financial Telecommunications

(SWIFT) which uses a proprietary secure messaging system each message is
encrypted and every money transaction is authenticated by a code, using smart
card technology and assumes financial liability for the accuracy, completeness, and
confidentiality of transaction.
International cash management

• Factors differentiating international cash management from domestic based

systems:
– Differing payment methods and or higher popularity of electronic funds
transfer.
– Subject to international boundaries, time zone differences, currency
fluctuations, and interest rate changes.
– Differing banking systems, and check clearing processes.
– Differing account balance management, and information reporting systems.
– Cultural, tax, and accounting differences
• Financial managers try to keep as much cash as possible in a country with a
strong currency and vice versa.
• Sweep account:
– Allows companies to maintain zero balances.
– Excess cash is swept into an interest-earning account.

5.8 Management of Inventory

Inventory refers to, the stock of any item or resources used in an organization. An
inventory system is the set of policies and controls that monitor levels of inventory
and determine what level should be maintained, when stork should be replenished
and how large order should be.
In finance inventory refers to items that contribute to or become part of a firms
product output or in service inventory refers to the tangible goods to be sold and
the supplies necessary to administer the Service.

Inventory has three basic categories that is,

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• Raw materials
• Work in progress, which reflects partially finished products
• Finished goods, which are ready for sale.
It’s evident that the amount of inventory is affected by sales, production, and
economic conditions. Inventory is the least of liquid assets that provides the highest
yield. When maintaining maximum Level production, efficiency in manpower and
machinery usage is vital.
Inventory position can be protected in an environment of price instability by:
– Taking moderate inventory positions (by not committing at a single price).
– Hedging with a futures contract to sell at a stipulated price some months
from now.
– Rapid price movements in inventory may also have a major impact on the
reported income of the firm.
Inventory control techniques
• Two-Bin System - Two containers of inventory; reorder when the first is empty
• Universal Bar Code -Bar c ode printed on a label that has information about
the item to which it is attached

Functions of Inventory
• To meet anticipated demand
• To smooth production requirements
• To decouple operations
• To protect against stock-outs
• To take advantage of order cycles
• To hedge against price increases
• To permit operations
• To take advantage of quantity discounts

Costs associated with management of Inventory

• Carrying costs
– Interest on funds tied up in inventory.
– Cost of warehouse space, insurance premiums and material handling
expenses.

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– Implicit cost associated with the risk of obsolescence and perish-ability.

• Ordering costs
– Cost of ordering.
– Cost of processing inventory into stock
• Lead time: time interval between ordering and receiving the order
• Holding (Carrying) Costs: cost to carry an item in inventory for a length of
time, usually a year
• Ordering costs: costs of ordering and receiving inventory
• Shortage costs: when demand exceeds supply
Approaches to the inventory management
a) ABC Analysis
Classifying inventory according to some measure of importance and allocating
control efforts accordingly,
A - Very important
B - Mod, Important
C - Least important
b) The economic order quantity approach (EOQ) refers to the order size that
minimizes total annual cost, economic production model and quantity discount
model.
Assumptions of EOQ
• Only one product is involved
• Annual demand requirements known
• Demand is even throughout the year
• Lead time does riot vary
• Each order is received in a single delivery
• There are no quantity discounts

The Inventory Cycle

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Total Ordering Costs = (Number of orders) X (Ordering Costs per Order)

Number of Orders =
Total Ordering Costs =
Total Carrying Costs (CC) =
Total Carrying Costs =
Total Inventory Costs

Or

• Reorder Point -When the quantity on hand of an item drops to this amount,
the item is reordered
• Safety Stock - Stock that is held in excess of expected demand due to
variable demand rate and/or lead time.
• Service Level - Probability that demand will not exceed supply during lead
time.
Determinants or reorder point
• The rate of demand

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• The lead time

• Demand and/or lead time variability
• Stock out risk (safety stock)

Determining Optimum Inventory in

Just In Time approach (JIT)

• Basic requirements for JIT are that there must be quality production that
continually satisfies customer requirements, close ties between suppliers,
manufactures, and customers, minimization of the level of inventory.
• Cost Savings from lower inventory, on average, JIT has reduced inventory to
sales ratio by 10% over the last decade

Advantage of JIT
• Reduction in space due to reduced warehouse space requirement.
• Reduced construction and overhead expenses for utilities and manpower.

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• Better technology with the development of electronic data interchanges

systems (EDI).
• Reduction in costs from quality control.
• Elimination of waste and Integration costs.

In conclusion working capital management is concerned with the management of

short term assets of the business such as cash, inventory, receivables and payables
and when doing this financial mangers need to be versed or exposed to the
business environment in order to affect their duties.

Review Questions
1. What happens when a company has a low working capital?
2. What is the importance of maintaining sufficient working capital?
3. Discuss the different approaches used in inventory management
4. The management of HLC ltd has requested you to analyze their financial
information below and prepare their cash budget for the of May 2007 to April 2008
and they have provided you with the following information that;
A. Returns of 100,000 were to be earned for the months of May to October and
180,000 for November to April 2008.
B. Sales for Feb, March and April were 80,000 respectively
C. Division of sale between cash and credit is as follows 30% for cash and the
balance being credit.
D. Credit collection pattern is 30% after one month and 70% after two months.
E. Bad debts were nil throughout.
F. Other anticipated receipts are sale of a machine in July at 90,000/= and
6,000 interest on securities in September.
G. Estimated purchases of materials are 80,000/= for the months of May to July
and 100, 000/= for the remaining months and payments are made one month after
the purchase.
H. Wages and salaries are expected to be 40,000/= per month.
I. Manufacturing expenses are expected to be 30,000/= per month.
J. General administration and selling expenses is to be 10,000/= per month.

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K. Dividend payments of 25,000/= and tax payment of 30,000 are scheduled for
October.
L. A machine worth 100,000/= is planned to be purchased in June.
M. The cash balance as on Jan was 20,000/= and the minimum cash balance
required by the firm is 20,000/=
Required to prepare cash forecast for HLC showing the surplus and deficit in relation
to the minimum cash balance

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