OVERVIEW OF FINANCIAL MANAGEMENT
Finance is called “The science of money”. It studies the principles and the methods of obtaining control of money from those who have saved it, and of administering it by those into whose control it passes.
Involves the task of raising funds required by the firm at the most favorable terms.
It’s the study of how best to raise funds needed by the business and allocation of the utilized and the distribution of returns generated.
The above definition will therefore cover the four financial management functions namely;
- Financing function
- Investing function
- Dividend function
- Liquidity function
The finance management is responsible for making projections of the firms’ future financial needs. He has to determine the companies fixed capital needs in the short, medium and long-term as well as the working capital needs.
He has to ensure that the finance is provided in the most appropriate form and for the purpose for which it is required at the lowest possible cost to the company.
He needs to be well equipped with the requirement of financial markets.
THE FINANCING DECISION
The financing decision is concerned with capital – mix (Financing – mix) or Capital Structure of a firm. The term Capital Structure refers to the proportion of debentures capital (debt) and equity share capital. Financing decision of a firm relates to the financing – mix. This must be decided taking into account the cost of capital, risk and return to the shareholders. Employment of debt capital implies a higher return to the shareholders and also the financial risk. There is a conflict between return and risk in the financing decisions of a firm. So, the Finance Manager has to bring a trade – off between risk and return by maintaining a proper balance between debt capital and equity share capital. On the other hand, it is also the responsibility of the Finance Manager to determine an appropriate Capital Structure.
Determining Sources of Funds:
The Finance Manager has to choose sources of funds. He may issue different types of securities and debentures. He may borrow from a number of financial institutions and the public. When a firm is new and small and little known in financial circles, the Finance Manager faces a great challenge in raising funds. Even when he has a choice in selecting sources of funds, that choice should be exercised with great care and caution.
FINANCIAL INSTITUTIONS AND MARKETS
A market can be defined as an organizational device, which brings together buyers and sellers. A financial market is a market for funds. It brings together the parties willing to trade in a commodity, which constitutes funds. The respective parties in financial markets are known as demanders of funds (borrowers) and suppliers of funds (lenders) who come together to trade so as to meet financial needs. The level of economic development of any country will be affected by the ability of the financial markets to move surplus funds from certain economic units, which constitutes individuals and corporate bodies to other economic units in need of additional funds. Financial market can be divided into six categories: –
- Primary and secondary market
- Money and the capital market
- Over-the counter and organized market
- Derivatives market
- Mortgage market
- Forex market
Primary and secondary market
Primary financial markets are those markets where there is transfer of new financial instruments. Financial instruments constitute assets, which are used in the financial markets. They consists of cash, shares and debt capital both long term and short-term e.g. commercial paper.
TIME VALUE OF MONEY
This concept attempts to explain the difference in value of money over time and individuals or investors would prefer current cash to future cash (preference for money).
Reasons for time preference for money
- Availability of investment opportunities: money received at present can be invested to earn extra returns in future
- Uncertainty: money is preferred at present due to uncertainty of its availability in future.
- Declining purchasing power of money: value of money will decline due to inflation and other micro-economic factors e.g. inflation, interest rates.
- Transactive motive: individuals/firms may require money at present to take a dug of cash discounts which may be available at present and not in future.
- To meet urgency of current needs: money is required at present to meet immediate needs of the firms and individuals e.g. money to buy food, raw materials for production.
Definition of key terms
- Compounding: Is the process of determining future value of money that one possesses at present. It’s the present value of money expressed into tomorrow’s value
- Discounting: the process of determining present value of money given the future value of money.
- Annuities/annuity: this is a constant amount of money renewed or paid out over a specific period of time e.g. payment of salary to an employee.
- Non-annuity/single amount/Lump sum: represents an amount spent or renewed and which isn’t constant over duration of time.
Valuation is the process of determining the true price or worth of securities or business. This is carried out by financial experts or analysts.
Reasons for valuation of securities in business
- Determine the price at which securities can be sold or acquired.
- To facilitate such securities being used as collateral in securing a loan e.g shares.
- In determining the purchase consideration in times of business combinations e.g mergers and take – over.
- Where the company wishes to go public and intend to issue shares or debentures through the stock market.
- When a company wishes to sell part of business holding in a subsidiary.
Definition of key terms
- Book value – The values of an asset/security as recorded in the financial statements of a business. For fixed assets book value is the figure net of account depreciation to date while for financial assets it’s represented by the par value of shares/debentures.
- Replacement value – This is the amount that a company or business is ready to spend if it were to replace its existing assets in their current conditions.
- Liquidation value – Amount that company/business would realize if it sells its assets upon liquidation.
- Going concern value – Amount a company/business will realize if it were sold as an operating business.
- Market value – Price at which an asset /security is currently selling at or can be bought at in the market.
True value /intrinsic value /theoretical value / fair value /Actual value: This is the value of a security arrived after discounting the sum totals of future cash benefits
COST OF CAPITAL
Refers to the minimum required rate of return of a given security. It’s the return that a security (ordinary share, preference share or even debenture) must promise for it to become acceptable to investors. It’s a cost to the company since the company has to pay return to the investors for the capital provided to the company
Significance of cost of capital
- It is useful in long term investment decisions so as to determine which project should be undertaken. The techniques used to make this decision include net present value and IRR.
- It is also used in capital structure decisions to determine the mix of various components in the capital structure. The cost of capital of each component is determined.
- Used for performance appraisal. A high cost of capital is an indicator of high risk attached to the firm usually attributed to the performance of the management of a firm.
- In making lease or buy decisions. In lease or buy decisions the cost of debt is used as the discounting rate.
Factors influencing firms cost of capital
What are the elements in the business environment that cause a company’s weighted cost of capital to be high or low? We identify four primary factors : general economic conditions, the marketability of the firm’s securities (market conditions), operating and financing conditions within the company, and the amount of financing needed for new investments.
CAPITAL BUDGETING DECISIONS
One of the important aspects of Financial Management is proper decision making in respect of investment of funds. Successful operation of any business depends upon the investment of resources in such a way as to bring in benefits or best possible returns from any investment. An investment can be simply defined as an expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its
equivalent in some future time period or periods. An appraisal of investment proposals is necessary to ensure that the investment of resources will bring in desired benefits in future. If the financial resources were in abundance, it would be possible to accept several investment proposals which satisfy the norms of approval or acceptability. Since resources are limited a choice has to be made among the various investment proposals by evaluating their comparative merit. It is apparent that some techniques should be followed for making appraisal of investment proposals. Capital Budgeting is one of the appraising techniques of investment decisions. Capital Budgeting is defined as the firm’s decision to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years. It should be remembered that the investment proposal is common both for fixed assets and current assets.
Capital budgeting decision may be defined as “Firms decisions to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years.”
The firm’s investment decision would generally include:-
- Replacement of long term assets
Types of capital budgeting decisions
- Mutually exclusive decisions/projects
Are projects that serve the same purpose and compete with each other in terms of resources i.e. if one project is undertaken then others will have to be excluded.
- Independent projects
Are projects that serve different purposes and don’t compete for resources. Therefore, they can be undertaken subject to availability of funds.
- Dependent/contingent projects/decisions
Are those projects that depend on each other thus when one is undertaken then the other will have to be undertaken.
- Divisible and indivisible projects
Divisible – Are those which generate income before they are complete
Indivisible – Don’t generate income before they are complete.
- Outright acquisition projects
It involves purchase of a new long term assets for the first time
Usually done to meet the changing need of an enterprise
- Expansion and diversification projects
Involves expanding of existing facilities which have become inadequate due to diversification into new areas of operation.
- Replacement and modernization projects
Involves replacing an existing asset which has become technologically outdated in order to modernize operations of the business
FINANCIAL ANALYSIS AND FORECASTING
Objectives of ratio analysis
- To determine whether the operations are carried out efficiently, i.e. minimizing costs
- To determine whether profitability is being achieved and maintained.
- To determine whether the company is in too much debt i.e. solvency
- To ascertain whether the company has enough working capital i.e. liquidity
- As a comparison of performance with other firms and departments
- A means of estimating future performance through budgets.
Advantages of ratio analysis
- It enables the company to analyze whether it is earning profits
- It enables managers to take remedial measures to reduce costs
- It gives a guidance to managers when formulating future plans
- Comparison of performance enables the company to analyze how well it is operating
- Solvency ratios guide managers when deciding whether to acquire external finance.
- It enables users to understand more the financial statements
Limitations of ratio analysis
- The past cannot be a precise forecast for the future
- Interpretation of ratio analysis is difficult and may require expert opinion.
- Analysis are usually based on the past year’s results only which may not be adequate
- The figure on which ratios are based may not be reliable
WORKING CAPITAL MANAGEMENT
Working capital refers to the portion of capital which is employed in the business to run it on a day to day basis. Working capital management are the policies and procedures relating to management of cash, inventory and debtors or simply current assets.
Components of working capital
There are 2 components of working capital;
- Current assets
- Current liabilities
Gross working capital
Represents the sum of all current assets only
Net working capital
Represents the difference between the total Current asset and Current liabilities
Negative working capital
Represents the excess of current liabilities over current assets
Positive working capital
Represents the excess of current assets over current liabilities
Dividends are part of earnings which are distributed to ordinary shareholders for investing in the company. This decision is important to the company because of two main reasons:-
- Provides a solution to the dividend puzzle i.e. does payment of dividend increase or decrease value of the firm.
- It is part of company’s financing strategy – payment of high dividends means low retained earnings and hence need for more debt capital in the capital structure.
Dividend policy decisions
- When should the company pay dividends?
- How much should the company pay?
- How should the firm pay dividends?
- Why should the company pay dividends?
a) When should the firm pay dividends?
A company can pay dividends twice in the course of the year i.e. interim and final or once in a year i.e. final dividend.
The question whether to pay interim or final dividend will depend on:-
- Liquidity positions
- Expectation of shareholders
- Need for cash for financing purposes
b) How much dividend to pay?
There are four different dividend policies which influence the amount of dividend/per share a company can pay:
INTRODUCTION TO RISK AND RETURN
Risk is defined as the uncertainty about the actual return that will earn on an investment. When one invest, expects some particular return, but there is a risk that he ends up with a different return when he terminates the investment. The more the difference between the expected and the actual the more is the risk. It is not sensible to talk about the investment returns without talking about the risk, because the investment decision involves a trade-off between the two, return and risk.
Factors influencing risk
The following makes financial assets risky. Business failure, market fluctuations, changes in the interest rate inflation in the economy, fluctuations in exchange rates changes in the political situation etc. Based on the factors affecting the risk the risk can be understood in following manners
Interest rate risk: The variability in a security return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes
generally affect securities inversely, that is other things being equal, security price move inversely to interest rate.
Market risk: The variability in returns resulting from fluctuations in overall market that is, the agree get stock market is referred to as market risk. Market
risk includes a wide range of factors exogenous to securities themselves, like recession, wars, structural changes in the economy, and changes in consumer
preference. The risk of going down with the market movement is known as market risk.
Inflation risk: Inflation in the economy also influences the risk inherent in investment. It may also result in the return from investment not matching the
rate of increase in general price level (inflation). The change in the inflation rate also changes the consumption pattern and hence investment return carries an
additional risk. This risk is related to interest rate risk, since interest rate generally rises as inflation increases, because lenders demands additional
inflation premium to compensate for the loss of purchasing power.
Business risk: The changes that take place in an industry and the environment causes risk for the company in earning the operational revenue creates business
risk. For example the traditional telephone industry faces major changes today in the rapidly changing telecommunication industry and the mobile phones. When
a company fails to earn through its operations due to changes in the business situations leading to erosion of capital, there by faces the business risk.
History of Islamic finance
The financial industry has historically played an important role in the economy of every society. Banks mobilize funds from investors and apply them to investments in trade and business. The history of banking is long and varied, with the financial system as we know it today directly descending from Florentine bankers of the 14th – 17th century. However, even before the invention of money, people used to deposit valuables such as grain, cattle and agricultural implements and, at a later stage, precious metals such as gold for safekeeping with religious temples.
Around the 5th century BC, the ancient Greeks started to include investments in their banking operations. Temples still offered safe-keeping, but other entities started to offer financial transactions including loans, deposits, exchange of currency and validation of coins. Financial services were typically offered against the payment of a flat fee or, for investments, against a share of the profit.
The views of philosophers and theologians on interest have always ranged from an absolute prohibition to the prohibition of usurious or excess interest only, with a bias towards the absolute prohibition of any form of interest. The first foreign exchange contract in 1156 AD was not just executed to facilitate the exchange of one currency for another at a forward date, but also because profits from time differences in a foreign exchange contract were not covered by canon laws against usury.
In a time when financial contracts were largely governed by Christian beliefs prohibiting interest on the basis that it would be a sin to pay back more or less than what was lent, this was a major advantage.
Time value of money
- James intends to deposit 2.4m in a bank paying an annual interest rate of 6% compounded quarterly.
Compute his bank balance amount of interest he will earn after 6 years.
- A bank has offered to you an annuity of 1.8M shillings for 10 years. If you invest Sh. 12M today what rates of return would you earn?
- A firm purchased a land at Ksh. 800,000 by making a down payment of Ksh.150,000 and remainder in equal installments of Ksh. 150,000 for 6 years. What’s the rate of interest.
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