COCM 1202 FINANCIAL MANAGEMENT 1.docx

COCM 1202 FINANCIAL MANAGEMENT I (45 CONTACT HOURS) Course purpose To equip learners with sound financial knowledge and skills necessary for effective financial decision making. Learning outcomes At the end of this course students should be able to: Identify and evaluate Sources of financing for organizations Recognize the principles and concepts of financial management Solve problems related to time value of money and cost of capital Course description The nature and scope of finance; Sources and uses of funds , functions of finance, financial objectives of firms, risk-return trade-off. Financial management: Financial analysis, planning and control, management of working capital, agency theory, Sources of funds; internal and external sources. Teaching Methodologies LecturersGroup work/ discussions. Instructional Materials These will include; tablets, smart board, flipcharts, videos, LCD projector& computers. Course Assessment CATs, Assignments, 30% End of semester examination 70% TOTAL 100% Course Text Books Pandey, I.M. (2009). Financial management. 9thEd. ISBN-13:978-8125916581 Ross S, Westerfield, J., & Jordan, F. (2008). Corporate finance, 8th ed. McGraw- Hill, Irwin. ISBN-13:978-0078034770 Berk ,J., DeMarzo,P.,(2013) Corporate Finance 3rd Ed. ISBN-13:978-0132992473 Reference Text Books Schall, L.,& Haley, C. (2008). Introduction to financial management. McGraw- Hill. ISBN-13:978-0070551176 Brigham ,F.E. ,Ehrhardt, C.M.,(2010) Financial Management :Theory and Practice ISBN-13:978-1439078099 Course Journals Journal of finance .ISSN:1540-6261 Journal of accounting and finance .ISSN:0810-5391 Journal of banking and finance. ISSN:0378-4266 Reference Journals Journal of Investment and Portfolio Management Journal of Finance &Economics. ISSN:0304-405X Journal of Financial &Quantitative Analysis. ISSN :0022-1090 COCM 1202: FINANCIAL MANAGEMENT (45 LECTURE HOURS) COURSE PURPOSE To equip the students with knowledge that enables them to understand and appreciate financial decision making process, empowering them to explain and predict the impact of financing, investing, risk management, dividend and liquidity decisions. COURSE OBJECTIVES At the end of this course students should be able to: Identify and Evaluate sources of long term, medium term and long term sources of finance. Recognize the principles and concepts of the three main decision making areas of finance i.e. investing, financing and asset management Solve problems relating to time value of money. COURSE OUTLINE LESSON 1: INTRODUCTION TO FINANCIAL MANAGEMENT LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…) LESSON 3: SOURCES OF FINANCE LESSON 4: SOURCES OF FINANCE (CONT…) LESSON 5: WORKING CAPITAL MANAGEMENT LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…) LESSON 7: FINANCIAL STATEMENT ANALYSIS LESSON 1: INTRODUCTION TO FINANCIAL MANAGEMENT 1.1Definition of financial management Financial Management is that specialised function of general management which is related to the procurement of finance and its effective utilisation for the achievement of common goal of the organisation. It includes each and every aspect of financial activity in the business. Financial Management has been defined differently by different scholars. A few of the definitions are being reproduced below:- “Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.”- Weston and Brigam. “Financial Management is the application of the planning and control functions to the finance function.”- Howard and Upton. “Financial Management is the operational activity of a business that is responsible for obtaining and effectively, utilizing the funds necessary for efficient operations.”- Joseph and Massie. From the above definitions, it is clear that financial management is that specialised activity which is responsible for obtaining and affectively utilizing the funds for the efficient functioning of the business and, therefor, it includes financial planning, financial administration and financial control. Financial Management is a discipline concerned with the generation and allocation of scarce resources (usually fund) to the most efficient user within the firm (the competing projects) through a market pricing system (the required rate of return). A firm requires resources in form of funds raised from investors. The funds must be allocated within the organization to projects which will yield the highest return. We shall refer to this definition as we go through the subject. 1.2 Required Rate of Return (Ri) The required rate of return (Ri) is the minimum rate of return that a project must generate if it has to receive funds. It’s therefore the opportunity cost of capital or returns expected from the second best alternative. In general, Required Rate of Return = Risk free rate + Risk premium Risk free is compensation for time and is made up of the real rate of return (Ri)and the inflation premium (IRp). The risk premium is compensation for risk of financial actions reflecting: The riskiness of the securities caused by term to maturity The security marketability or liquidity The effect of exchange rate fluctuations on the security, etc. The required rate of return can therefore be expressed as follows: Rj = Rr + IR∞ + DR∞ + MR∞ + LR∞ + ER∞ +SR∞ + OR∞ Where: Rr is the real rate of return that compensate investors for giving up the use of their funds in an inflation free and risk free market. IRp is the Inflation Risk Premium which compensates the investor for the decrease in purchasing power of money caused by inflation. DRp is the Default Risk Premium which compensates the investor for the possibility that users of funds would be unable to repay the debts. MRp is the Maturity Risk Premium which compensates for the term to maturity LRp is the Liquidity Risk Premium which compensates the investor for the possibility that the securities given are not easily marketable (or convertible to cash) ERp is the Exchange Risk Premium which compensates the investors for the fluctuation in exchange rate. This is mainly important if the funds are denominated in foreign currencies. SRp is the Soverign Risk Premium which compensates the investors for the possibility of political instability in the country in which the funds have been provided. ORp is the Other Risk Premium e.g the type of product, the type of market, etc. Distinction between Financial Accounting and Financial Management Financial Accounting Financial Management It is a statutory requirement It is carried out according to the General Accepted Acoounting Principles (GAAP) It deals with historical transactions It is both for internal and external users It deals with recording financial transactions in a systematic manner for a particular period Where finacial accounting ends financial management starts It is not a statutory requirement It is just conducted according to the management decisions It deals with future planning It is for internal users i.e management It deals with the procurement and allocation of fianancial resources finacial accounting comes before financial management 1.3 Scope of finance functions. The functions of Financial Manager can broadly be divided into two. The Routine functions and the Managerial Functions. 1.3.1Managerial Finance Functions Require skillful planning control and execution of financial activities. There are four important managerial finance functions. These are: Investment of Long-term asset-mix decisions These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among investment projects. They refer to the firm’s decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects. Investment proposals are evaluated in terms of both risk and expected return.Investment decisions also relates to recommitting funds when an old asset becomes less productive. This is referred to as replacement decision. Financing decisions Financing decision refers to the decision on the sources of funds to finance investment projects. The finance manager must decide the proportion of equity and debt. The mix of debt and equity affects the firm’s cost of financing as well as the financial risk. This will further be discussed under the risk return trade off. Division of earnings decision The finance manager must decide whether the firm should distribute all profits to the shareholder, retain them, or distribute a portion and retain a portion. The earnings must also be distributed to other providers of funds such as preference shareholder, and debt providers of fund such as preference shareholders and debt providers. The firm’s divided policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend – payout ratio so as to maximize the value of the firm. Liquidity decision The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due. It can also be referred as current assets management. Investment in current assets affects the firm’s liquidity, profitability and risk. The more current assets a firm has, the more liquid it is. This implies that the firm has a lower risk of becoming insolvent but sine current assets are non- earning assets the profitability of the firm will be low. The converse will hold true. The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient not unnecessary funds are invested in current assets. 1.3.2 Routine functions For the effective execution of the managerial finance functions, routine functions have to be performed. These decision concern procedures and systems and involve a lot of paper work and time. In most cases these decisions are delegated to junior staff in the organization. Some of the important routine functions are: Supervision of cash receipts and payments Safeguarding of cash balance Custody and safeguarding of important documents Record keeping and reporting The finance manager will be involved with the managerial functions while the routing functions will carried out by junior staff in the firm . He must however ,supervise the activities of the junior staff . 1.4 objectives of a business entity Any business firm would have certain objectives which it aims at achieving .The major goal of a firm are : Profit maximization Shareholder wealth maximization Social responsibility Business ethics Growth 1.4.1 Profit maximization Traditionally, this was considered to be the major goal of the firm. Profit maximization refers to achieving the highest possible profits during the year. This could be achieved by either increasing sales revenue or by reducing expenses. Note that: Profit = Revenue – Expenses The sales revenue can be increased by either increasing the sales volume or the selling price. It should be noted however, that maximizing sales revenue may at the same time result to increasing the firm's expenses. The pricing mechanism will however, help the firm to determine which goods and services to provide so as to maximize profits of the firm. The profit maximization goal has been criticized because of the following: (a) It ignores time value of money (b) It ignores risk and uncertainties (c) it is vague (d) it ignores other participants in the firm rather than the shareholders 1.4.2 Shareholders' wealth maximization Shareholders' wealth maximization refers to maximization of the net present value of every decision made in the firm. Net present value is equal to the difference between the present value of benefits received from a decision and the present value of the cost of the decision. A financial action with a positive net present value will maximize the wealth of the shareholders, while a decision with a negative net present value will reduce the wealth of the shareholders. Under this goal, a firm will only take those decisions that result in a positive net present value. Shareholder wealth maximization helps to solve the problems with profit maximization. This is because, the goal: i. considers time value of money by discounting the expected future cashflows to the present. ii. it recognises risk by using a discount rate (which is a measure of risk) to discount the cashflows to the present. 1.4.3 Social responsibility The firm must decide whether to operate strictly in their shareholders' best interests or be responsible to their employers, their customers, and the community in which they operate. The firm may be involved in activities which do not directly benefit the shareholders, but which will improve the business environment. This has a long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized. 1.4.4 Business Ethics Related to the issue of social responsibility is the question of business ethics. Ethics are defined as the "standards of conduct or moral behaviour". It can be thought of as the company's attitude toward its stakeholders, that is, its employees, customers, suppliers, community in general, creditors, and shareholders. High standards of ethical behaviour demand that a firm treat each of these constituents in a fair and honest manner. A firm's commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to: i. Product safety and quality ii. Fair employment practices iii. Fair marketing and selling practices iv. The use of confidential information for personal gain Illegal political involvement bribery or illegal payments to obtain business 1.4.5 Growth This is a major objective of small companies which may even invest in projects with negative NPV so as to increase their size and enjoy economies of scale in the future. LESSON 2: INTRODUCTION TO FINANCIAL MANAGEMENT (CONT…) 1.5 AGENCY THEORY An agency relationship may be defined as a contract under which one or more people (the principals) hire another person (the agent) to perform some services on their behalf, and delegate some decision making authority to that agent. Within the financial management framework, agency relationship exists between: Shareholders and Managers Debt holders and Shareholders Shareholders and the government Shareholders and auditors 1.5.1 Shareholders versus Managers A Limited Liability company is owned by the shareholders but in most cases is managed by a board of directors appointed by the shareholders. This is because: There are very many shareholders who cannot effectively manage the firm all at the same time. Shareholders may lack the skills required to manage the firm. Shareholders may lack the required time. Conflict of interest usually occur between managers and shareholders in the following ways: Managers may not work hard to maximize shareholders wealth if they perceive that they will not share in the benefit of their labour. Managers may award themselves huge salaries and other benefits more than what a shareholder would consider reasonable Managers may maximize leisure time at the expense of working hard. Manager may undertake projects with different risks than what shareholders would consider reasonable. Manager may undertake projects that improve their image at the expense of profitability. Where management buy out is threatened. ‘Management buy out’ occurs where management of companies buy the shares not owned by them and therefore make the company a private one. Solutions to this Conflict In general, to ensure that managers act to the best interest of shareholders, the firm will: Incur Agency Costs in the form of: Monitoring expenses such as audit fee; Expenditures to structure the organization so that the possibility of undesirable management behaviour would be limited. (This is the cost of internal control) Opportunity cost associated with loss of profitable opportunities resulting from structure not permit manager to take action on a timely basis as would be the case if manager were also owners. This is the cost of delaying decision. The Shareholder may offer the management profit-based remuneration. This remuneration includes: An offer of shares so that managers become owners. Share options: (Option to buy shares at a fixed price at a future date). Profit-based salaries e.g. bonus Threat of firing: Shareholders have the power to appoint and dismiss managers which is exercised at every Annual General Meeting (AGM). The threat of firing therefore motivates managers to make good decisions. Threat of Acquisition or Takeover: If managers do not make good decisions then the value of the company would decrease making it easier to be acquired especially if the predator (acquiring) company beliefs that the firm can be turned round. 1.5.2 Debt holders versus Shareholders A second agency problem arises because of potential conflict between stockholders and creditors. Creditors lend funds to the firm at rates that are based on: i. Riskiness of the firm's existing assets ii. Expectations concerning the riskiness of future assets additions iii. The firm's existing capital structure iv. Expectations concerning future capital structure changes. These are the factors that determine the riskiness of the firm's cashflows and hence the safety of its debt issue. Shareholders (acting through management) may make decisions which will cause the firm's risk to change. This will affect the value of debt. The firm may increase the level of debt to boost profits. This will reduce the value of old debt because it increases the risk of the firm. Creditors will protect themselves against the above problems through: Insisting on restrictive covenants to be incorporated in the debt contract. These covenants may restrict: The company’s asset base The company’s ability to acquire additional debts The company’s ability to pay future dividend and management remuneration. The management ability to make future decision (control related covenants) if creditors perceive that shareholders are trying to take advantage of them in unethical ways, they will either refuse to deal further with the firm or else will require a much higher than normal rate of interest to compensate for the risks of such possible exploitations. It therefore follows that shareholders wealth maximization require fair play with creditors. This is because shareholders wealth depends on continued access to capital markets which depends on fair play by shareholders as far as creditor's interests are concerned. 1.5.3 Shareholders and the government The shareholders operate in an environment using the license given by the government. The government expects the shareholders to conduct their business in a manner which is beneficial to the government and the society at large. The government in this agency relationship is the principal and the company is the agent. The company has to collect and remit the taxes to the government. The government on the other hand creates a conducive investment environment for the company and then shares in the profits of the company in form of taxes. The shareholders may take some actions which may conflict the interest of the government as the principal. These may include; The company may involve itself in illegal business activities The shareholders may not create a clear picture of the earnings or the profits it generates in order to minimize its tax liability.(tax evasion) The business may not response to social responsibility activities initiated by the government The company fails to ensure the safety of its employees. It may also produce sub standard products and services that may cause health concerns to their consumers. The shareholders may avoid certain types of investment that the government covets. Solutions to this agency problem The government may incur costs associated with statutory audit, it may also order investigations under the company’s act, the government may also issue VAT refund audits and back duty investigation costs to recover taxes evaded in the past. The government may insure incentives in the form of capital allowances in some given areas and locations. Legislations: the government issues a regulatory framework that governs the operations of the company and provides protection to employees and customers and the society at large.ie laws regarding environmental protection, employee safety and minimum wages and salaries for workers. The government encourages the spirit of social responsibility on the activities of the company. The government may also lobby for the directorship in the companies that it may have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc 1.5.4 Shareholders and auditors Auditors are appointed by shareholders to monitor the performance of management. They are expected to give an opinion as to the true and fair view of the company’s financial position as reflected in the financial statements that managers prepare. The agency conflict arises if auditors collude with management to give an unqualified opinion (claim that the financial statements show a true and fair view of the financial position of the firm) when in fact they should have given a qualified opinion (that the financial statements do not show a true and fair view). The resolution of this conflict could be through legal action, removal from office, use of disciplinary actions provided for by regulatory bodies such as ICPAK. 1.6 CORPORATE GOVERNANCE 1.6.1 Definition of corporate governance Corporate governance can be defined in various ways, for example: The Private Sector Corporate Governance Trust (PSCGT) states that corporate governance, “Refers to the manner in which the power of the corporation is exercised in the stewardship of the corporation total portfolio of assets and resources with the objective of maintaining and increasing shareholders value through the context of its corporate vision” (PSCGT, 1999) The Cadbury Report (1992) defines corporate governance as the system by which companies are directed and controlled. The Capital Market Authority (CMA) in year 2000 defined corporate governance as the process and structures used to direct and manage business affairs of the company towards enhancing prosperity and corporate accounting with the ultimate objective of realizing shareholders long-term value while taking into account the interests of other stakeholders. 1.6.2 Rationale for corporate governance The organization of the world economy (especially in current years) has seen corporate governance gain prominence mainly because: Institutional investors, as they seek to invest funds in the global economy, insist on high standard of Corporate Governance in the companies they invest in. Public attention attracted by corporate scandals and collapses has forced stakeholders to carefully consider corporate governance issues. Corporate governance is therefore important as it is concerned with: Profitability and efficiency of the firm. Long-term competitiveness of firms in the global economy. The relationship among firm’s stakeholders 1.6.3 Principles of corporate governance There are 22 principles of Corporate Governance as given by the Common Wealth Association of Corporate Governance (CACG) in1999 and the Private Sector Corporate Governance Trust (PSCGT) in 1999 also. The first ten principles are summarized below. 1. The authority and duties of members (shareholders) Members and shareholders shall jointly and severally protect, preserve and actively exercise the supreme authority of the corporation in general meeting (AGM). They have a duty to exercise that supreme authority to: Ensure that only competent and reliable persons who can add value are elected or appointed to the board of directors (BOD). Ensure that the BOD is constantly held accountable and responsible for the efficient and effective governance of the corporation so as to achieve corporate objective, prospering and sustainability. Change the composition of the BOD that does not perform to expectation or in accordance with mandate of the corporation 2. Leadership Every corporation should be headed by an effective BOD, which should exercise leadership, enterprise, integrity and judgements in directing the corporation so as to achieve continuing prosperity and to act in the best interest of the enterprise in a manner based on transparency, accountability and responsibility. 3. Appointments to the BOD It should be through a well managed and effective process to ensure that a balanced mix of proficient individuals is made and that each director appointed is able to add value and bring independent judgment on the decision making process. 4. Strategy and Values The BOD should determine the purpose and values of the corporation, determine strategy to achieve that purpose and implement its values in order to ensure that the corporation survives and thrives and that procedures and values that protect the assets and reputation of the corporation are put in place. 5. Structure and organization The BOD should ensure that a proper management structure is in place and make sure that the structure functions to maintain corporate integrity, reputation and responsibility. 6. Corporate Performance, Viability & Financial Sustainability The BOD should monitor and evaluate the implementation of strategies, policies and management performance criteria and the plans of the organization. In addition, the BOD should constantly revise the viability and financial sustainability of the enterprise and must do so at least once in a year. 7. Corporate compliance The BOD should ensure that corporation complies with all relevant laws, regulations, governance practices, accounting and auditing standards. 8. Corporate Communication The BOD should ensure that corporation communicates with all its stakeholders effectively. 9. Accountability to Members The BOD should serve legitimately all members and account to them fully. 10. Responsibility to stakeholders The BOD should identify the firm’s internal and external stakeholders and agree on a policy (ies) determining how the firm should relate to and with them, increasing wealth, jobs and sustainability of a financially sound corporation while ensuring that the rights of the stakeholders are respected, recognized and protected. 1.7 Self Review Questions Define the term Agency relationship as it applies in Co-operatives and describe its structure. Discuss FIVE goals of financial Management and their applications in Co-operatives State FIVE shortcomings of profit maximization objective. Outline FIVE areas of conflict between managers and shareholders and the solutions to counter the conflict. Discuss authority and duties of members as a principle of corporate governance. In what ways is wealth maximization objective superior to the profit maximization objective? Explain. Outline FOUR functions of the Financial Manager. Briefly discuss the following principles of corporate governance. Authority and duties of members Strategy and Values Internal Control procedures Structure and organization What roles should the financial manager play in the modern Co-operative set up? Explain the key issues to be considered by a Financial Manager in the day to day operating of saving and credit Co-operative. Discuss the merits of the notion that the Financial Manager’s aim is to maximize the value of the firm in light of the views expressed under agency theory. State FIVE shortcomings of profit maximization objective. Outline FIVE areas of conflict between managers and shareholders and the solutions to counter the conflict. Discuss authority and duties of members as a principle of corporate governance LESSON 3: SOURCES OF FINANCE Sources from which a firm may obtain its funds to finance its operations can be classified in four different way as this include : 1. Classification according to the duration over which the funds will be retained. These sources include (a) long term sources of funds- They are refundable after a long period of time i.e. after 12 years (b)Short term sources of funds These funds are refundable after a short period of time i.e. a period of 3 years (c) Permanent sources of funds These funds are not refundable as long as the business remains a going concern for example ordinary share capital 2. Classification according to origin These sources include;- External sources of funds -They are raised from outside the organization Internal sources of fund-These are funds that are raised from within the firm 3. Classification according to the relationship between the firm and parties providing the funds These sources include:- Common equity capital -These are funds provided by the real owners of the business i.e. ordinary share capital; it is the total of the ordinary capital and the reserves Quasi capital these are funds that are provided by the preference shareholders Debt finance -They are funds provided by the creditors i.e. debentures 4. Classification to the rate of return These sources include:- Capital with affixed rate of return -This is capital that is paid a certain prespecified rate of return each year i.e. preference capital and long term debts Capital with a variable rate of return-This is capital that is paid a different rate o0f return each year depending on the firm’s performance. 5. A business may obtain funds from various sources which may be either: Long term sources which are repaid after a long period of time. Short term sources which are repaid after a short period even less than a year. Sources of Finance 1. Equity finance This is finance from the owners of the company (shareholders).it is generally made up of ordinary share capital and reserves (both revenue and capital reserves) Ordinary share capital The true owners of business forms are the ordinary shareholders. Sometimes referred to as residual owners, they receive what is left after satisfaction of all other claims. The ordinary share capital is raised by the shareholders through the purchase of common shares through the capital markets. This form of long term capital is only accessible to limited companies who have met the requirements of the capital market authority for listing before floating the shares. Features of ordinary share capital. Ownership The ordinary shares of a firm may be owned privately (family) or publicly with shares being traded in the stock exchange. Par value The par value of an ordinary share is relatively useless value, established in the firm’s corporate charter (memorandum). It is generally very low- Sh.5or less. Pre-emptive rights Allow shareholders to maintain their proportionate ownership in the corporation when new shares are issued. The feature maintains voting control and protects against dilution. Rights offering The firm grants rights to its shareholders to purchase additional shares at a price below market price, in direct proportion to their existing holding. Authorized, outstanding and issued shares Authorized shares are the number of shares of common stock that the firm’s charter (articles) allows without further shareholders’ approval. Outstanding shares is the number of shares held by the public Issued shares are the number of share that has been put in circulation; they represent the sum of outstanding and treasury stock. Treasury stock is the number of shares of outstanding stock that have been repurchased by the firm (not allowed by the Companies Act of Kenya Laws). Dividends The payment of corporate dividends is at the discretion of the Board of Directors. Dividends are paid usually semi- annually (interim and final dividends). Dividends can be paid in cash, stock (bonus issues) and merchandise. Voting rights Generally each ordinary share entitled the holder to one vote at the Annual General Meeting for the election of directors and on special issues. Shareholders can either vote in person or in proxy i.e. appoint a representative to vote on his behalf .Shareholders can vote through two main systems, Majority voting system. Cumulative system. Majority voting system Under this system , shareholders receive a vote for every share held. Decisions to be made must therefore be supported by over 50% of the votes in a company .Under this system any shareholder or group pf shareholders owning more than 50% of the company’s shares will make all the decisions. The minority shareholders have no say. Cumulative voting system. Under this system, shareholders receive one vote for every share held times the number of similar decisions to be made. This system is appropriate for making decisions that are similar and is mainly used in the election of directors. Example. Assume that there are 10,000 shares outstanding and you own 1001v shares .Their are 9 directors to be elected and therefore you would have (1001×9)= 9009 votes .How many directors can you elect. A.1001 shares = 1001×9 =9009 B. 10,000 – 1001 = 8999 × 9 = 80,991 Share holder A has 9009 votes and with 9 directors to be elected , there is no way for the owners of the remaining shares to exclude A from electing a person to one of the top 9 positions. The majority shareholder would control 8999 shares thus thus entitling them to 80991 votes .The 80991 vote cannot be spread thinly enough over the nine candidates to stop shareholder A from electing one director. The number of shares required to elect a give number of directors is given as follows. R= d (n) + 1 Nd + 1 Where, R- Number of shares required to elect a desired number of directors. d- Number of directors shareholders desire to elect. n- Total number of common shares outstanding. Nd- Total number of directors to be elected. Example A company will elect 6 directors and their ae 100,000 shares entitled to vote, Required. If a group desires to elect two directors, how many shares must they have. Shareholder A owns 10,000 shares, shareholder B owns 40,000 shares how many directors can each elect. Solution. R =2 (100,000) + 1 6+1 =28571.6 + 1=28573 A. 10,000= d (100,000) +1 6+1 10,000=14285.7d + 1 d= 9999/14285.7 d=0.7 Therefore zero directors. B. 40,000=d (100,000) + 1 6+1 d=2 Therefore 2 directors. Advantages of equity financing accruing to shareholders Shares can be used as security for loans. Providers of these funds can participate in the supernormal earnings of the firm The shares are easily transferable Return in form of a share price appreciation (capital gain) and dividends. The following rights of ordinary shareholders can be viewed as advantages: Rights of ordinary shareholders. Right to vote-shareholders have the right to vote on a number of issues in a company such as election of directors, changes in the Memorandum of Association and Articles of Association. Shareholders can vote either in person or by proxy that is, by appointing someone to represent them and vote on their behalf. Pre-emptive rights- Allow shareholders to maintain their proportionate ownership in the corporation when new shares are issued. The feature maintains voting control and protects against dilution. Right to appoint another auditor Right to approve dividend payments Right to approve merger acquisition Right to residual assets claim Disadvantages accruing to shareholders The ordinary share dividend is not an allowable deduction for tax purposes The dividend is paid after claims for other providers of capital are satisfied Ordinary shares carry the highest risk because of the uncertainty of return(company has the discretion to declare dividend or not)and incase of liquidation the holders have a residual claim on assets Advantages of using ordinary share capital to a company It is a permanent source of capital hence facilitates long term projects Use of equity lowers the gearing level hence a company has a broader borrowing capacity The shareholders may provide valuable ideas to the company’s operation A company is not legally obliged to pay dividend especially if it is facing financial difficulty these funds would serve better if retained. It enables a company to get the opinion of the public through the movement in share prices. This source can be raised in very large amounts It does not require any collateral as security. The funds are provided without conditions hence are flexible. Disadvantages of using ordinary share capital to a company The floatation costs are higher than those of debt It is only accessible to companies that have fulfilled the capital markets authority requirements It can lead to dilution of ownership of control of the firm by the shareholders Since the dividend payment is not tax allowable then the company does not enjoy a tax saving The cost of this source of fund(dividend) is perpetual as ordinary shares are not redeemable securities The firm has to follow set guidelines on disclosure and publishing of financial statements. Methods of issuing common shares Through a public issue Private placement Through a rights issue Employee stock option plans (ESOP) Bonus issue Public issue Ordinary shares are offered to the general public. The issuing company engages an investment banker who will undertake the issue. The investment will set the securities issue price and will sell the shares to the investors. The issuing firm can enter into an arrangement with the investment banker where the investment banker will underwrite shares, that is, buy any shares not taken up by the public. Private placement Under this method securities are sold to a few, usually chosen investors mainly institutional investors. The advantages of this method is that the firm gets to decide who will take up there shares, it can be used as part of strategic partnership, it will also lead to less floatation cost as no advertisement is necessary. It also takes less time to raise funds through a private placement than a public issue which involves a number of requirements to be fulfilled. A major disadvantage is that the share is not as liquid-transferability is made difficult. Rights issue This is an option offered to already existing shareholders to buy common shares of the company at a price (subscription price) which is less than the market price. The subscription price is set a lower price than the market price so as to make it attractive for the existing shareholders to buy the common shares; also it acts as a safeguard against any reduction in share price in the market. When a rights issue is declared every outstanding share receives one right however, a shareholder needs to have a number of rights in order to buy one new share. A rights issue involves selling of common shares to existing shareholders of the company on a prorata basis. Shares becoming available on account of non-exercise of rights are allotted to shareholders who have applied for additional shares on a pro-rata basis. Any balance of shares can be sold in the open market. When rights are issued the shareholder has three options available: (a) He can exercise the rights and therefore buy the new shares (b) He can sell the rights in the market (c) He can ignore the rights The number of rights required to buy one new share can be given by the following formula N = So S Where So is the number of existing shares S is the number of new shares to be sold N is the number of rights required to buy one new share The ex-right price of shares can be given by: Px = So Po + S Ps So + S Where: Px is the ex-right price of shares Po is the cum-right price (current market prices of shares) So is the number of existing shares S is the number of new shares Ps is the subscription price of rights It can also be given by: Px = Ps + (Po - Ps) N N + 1 Rights have value and the value of each right can be given by the following formulae: R = Px - Ps N Where R is the theoretical value of rights Px, Ps and N have previously been defined. It can also be given by: R = Po - Px or R = Po - Ps N + 1 Note: All the above formulae give the same value and the student should use whichever is most convenient. Illustration: XYZ Ltd has 900,000 shares outstanding at current market price of Sh 130 per share. The company needs Sh 22,500,000 to finance its proposed expansion. The board of directors has decided to issue rights for raising the required funds. The subscription price has been fixed at Sh 75 per share. Required: (a) How many rights are required to purchase one new share? (b) What is the price of one share after the rights issue (Ex-right price)? (c) Compute the theoretical value of each right (d) Consider the effect of the rights issue on the shareholders' wealth under the three options available to the shareholders (Assume he owns 3 shares and has Sh 75 cash on hand). Solution: (a) To compute the number of rights required to buy one new share, we must first compute the number of new shares to be issued. No. of shares = Desired funds Subscription price = 22,500,000 75 = 300,000 shares N = So So = 900,000 shares S S = 300,000 shares N = 900,000 = 3 300,000 Therefore a shareholder will require 3 rights to buy one new share in the company. Notes The shareholder will receive one right for each share held and therefore a total of 900,000 rights will be issued by the company. (b) The price of the shares after the rights issue will be lower than the price before the rights issue because the new shares are usually sold at a price which is below the market price. Px = Ps + (Po - Ps) N N + 1 Ps = 75 Po = 130 N = 3 Px = 75 + (130 - 75) 3/4 = Sh 116.25 After the rights issue the price of the shares would fall from Sh 130 to Sh 116.25. However, in an inefficient market, this may not be the case. (c) Value of each right R = Po - Ps = 130 - 75 N + 1 3 + 1 = Sh 13.75 Each right will therefore have a theoretical value of Sh 13.75. (d) To consider the effects of the rights issue on the shareholders wealth, we need to consider the current wealth of the shareholder. Current Wealth Sh Wealth in the company (3 x 130) 390 Cash in hand 75 Total Wealth 465 Option 1 - Exercise the rights Sh Wealth in the company 4 x 116.25 465 Cash in hand (75 - 75) 0 Total Wealth 465 Therefore, the wealth remains constant if the shareholder exercises the rights and buys the new shares. Option 2 - Sell the rights at their theoretical value Sh Wealth in the company 3 x 116.25 348.75 Cash in hand - previous 75 From sale of rights 3 x 13.75 41.25 116.25 Total Wealth 465.00 The wealth also remains constant if the shareholder sells the rights at their theoretical value. Option 3 - Ignore the rights Sh Wealth in the company 3 x 116.25 348.75 Cash in hand 75.00 Total Wealth 423.75 The wealth declines by Sh 41.25 from Sh 465 to Sh 423.75 if the shareholder ignores the rights. The shareholder should therefore never ignore a rights issue because his wealth will decline. Note: In an inefficient capital market the announcement of the rights issue may carry additional information not yet known by the market and therefore the share price may increase or decrease depending on the informational content of the rights issue. The major advantage of a rights issue is that the shareholders maintain their proportionate ownership of the company. Bonus issue This is an issue of additional shares to existing shareholders in lieu of a cash dividend. Companies may choose a bonus issue if it wants to give dividends but not in the form of cash so as to retain the cash say for investment, it is not taxable as cash dividends would be taxed. A bonus issue is expected to have no effect on the shareholders wealth and may have the following benefits, Tax benefit –If a company declares such an issue. It Is not taxable as in the case of Cash dividends .The share holder can therefore sale the new shares in the market to make capital gain which is not taxable. It can result into conservation of cash especially if a company is facing financial constrains. If the market is inefficient, a bonus issue maybe regarded as signaling important information and may result in an increase in the share price because a bonus issue is interpreted to mean high profits. Increase in future dividends .This occurs especially if a company follows a policy of paying a constant mount of dividends per share and continues with this policy even after the bonus issue. 2. Term loan Medium term & long term loans are obtained from commercial banks and other financial institutions. This funds are mainly used to finance major expansions or profit financing. Features of term loans Direct negotiation – A firm negotiates a term loan directly with a bank of financial institution. I.e. a private placement. Security – term loans are usually secured specifically by the assets acquired using the funds. (Primary security). This is said to create a fixed charge on the company’s assets. A fixed charge can also be referred to as specific charge. Restrictive covenant – financial institutions usually restrict the firms so as to safeguard their funds. They do this by way of restrictive covenants which include asset based covenant, cashflow, liability etc. Convertibility – they are usually not convertible to common shares unless under special cases. E.g. a financial institution may agree to restructure the firms capital structure. Repayment schedule – this indicates the time schedule for payment of interest and principle. It may occur. Where interest & principle are paid on equal periodic instalments. Where principles is paid on equal periodic instalments & interest on the outstanding balance of the loan. Example A company negotiates a Sh.30 million loan at 14% pa from a financial institution. Acquired; prepare the loan prepayment schedule assuming that: (i) Interest & principle paid in 8 equal year end installment’s (ii) Principle is paid in 8 equal instalments i) 30,000,000 = A x PVIFA 14% 8 years 30,000,000 = 4.6389A A = 6,46,050.0378 Schedule of Repayment Year Bal. b/d Instalment Interest 14% Principle Bal b/d 1 30,000,000 6,467,050 4,200,000 2,267,050 27,732,950 2. 27,732,950 6,467,050 3,882,613 2584437 25148513 3. 25148513 6,467,050 3520792 2946258 22202254.8 4. 22202255 6,467,050 3108316 3358734.3 18843521 5. 18843521 6,467,050 2638093 3828957 15014564 6. 150145639 6,467,050 2102039 4365011 10649553 7. 10649553 6,467,050 1490937.4 4976112.6 5673440.4 8. 56734404 6,467,050 794282 5672768.4 672.1 8 equal principle – 30n/8 = 3,750,000 YR Bal b/d inst. Int. primar Year Bal. b/d Instalment Interest 14% Principle Bal b/d 1 30,000,000 7950000 4200000 3750000 26250000 2. 26250000 7425000 3675000 3750000 22500000 3. 22500000 6900000 3150000 3750000 18750000 4. 18750000 6375000 2625000 3750000 15000000 5. 150000000 5850000 2100000 3750000 11250000 6. 11250000 5325000 1575000 3750000 7500000 7. 7500000 4800000 1050000 3750000 3750000 8. 3750000 4275000 525000 3750000 0 3. Preference shares (quasi-equity) Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders. Characteristics of preference shares They have a fixed dividend Dividends can be paid in arrears They can be converted to ordinary shares They have a claim on assets before the ordinary shareholders Types of preference shares Redeemable verses Irredeemable Cumulative verses non- cumulative Participative verses non-participative Convertible verse non-convertible From the company's point of view, preference shares are advantageous in that:  Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures).  Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not.  Unless they are redeemable, issuing preference shares will lower the company's gearing. Redeemable preference shares are normally treated as debt when gearing is calculated.  The issue of preference shares does not restrict the company's borrowing power, at least in the sense that preference share capital is not secured against assets in the business.  The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders. However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks. For the investor, preference shares are less attractive than loan stock because:  they cannot be secured on the company's assets  the dividend yield traditionally offered on preference dividends has been much too low to provide an attractive investment compared with the interest yields on loan stock in view of the additional risk involved. 4. Venture capital Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term 'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme. The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk. A venture capital organisation will not want to retain its investment in a business indefinitely, and when it considers putting money into a business venture, it will also consider its "exit", that is, how it will be able to pull out of the business eventually (after five to seven years, say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American Corporation Services Ltd. When a company's directors look for help from a venture capital institution, they must recognise that:  the institution will want an equity stake in the company  it will need convincing that the company can be successful  it may want to have a representative appointed to the company's board, to look after its interests. The directors of the company must then contact venture capital organisations, to try and find one or more which would be willing to offer finance. A venture capital organisation will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management: a) a business plan b) details of how much finance is needed and how it will be used c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecast d) details of the management team, with evidence of a wide range of management skills e) details of major shareholders f) details of the company's current banking arrangements and any other sources of finance g) any sales literature or publicity material that the company has issued. A high percentage of requests for venture capital are rejected on an initial screening, and only a small percentage of all requests survive both this screening and further investigation and result in actual investments. Venture capital is a form of investment in new and risky small enterprises which is required to get them started. Venture capitalists are therefore investment specialist who raises pools of capital to fund new ventures which are likely to become public companies in return for an ownership interest. They therefore buy part of the stools of the company at a low price in anticipation that when the company goes public, they would sale the shares at a high price and make considerable capital gains, venture capitalists also provide managerial skills to the firm examples of venture capitalists are: Pension funds, insurance companies and also individuals. Since the goal of venture capital is to make a profit, they will only invest in that have a potential for growth. Constraints in the development of a venture capital market in Kenya. The few promoters of venture capital are risk averse and therefore are discouraged by the level of risk, the length of investment and the liquidity of investment. The nature of firms in Kenya is such that they are privately owned and therefore do not dillusion of ownership through use of venture capital. The poor infrastructure in the country also discourages venture capitalists. They are not enough incentives for the development of venture capital and the government is discriminative against venture capital. The tax laws favour debt over equity. There is a general shortage of venture capitalists. Importance of venture capital market in small and medium scale business development Venture capitalists provide the much needed finance to tour small businesses which lack access to capital markets due to their size. Small medium scale businesses may lack managerial skills. Venture capitalists sere as active partners through involvement in this businesses and therefore provide marketing and planning skills as the also want to see their investments succeed. Venture capitalists encourage tree spirit of entrepreneurship therefore small businesses are encouraged to see their ideas through as they know they will get start up capital. Venture capitalists provide improved technology so that small and medium scale business are in line with changes in technology and are therefore able to compete with other firms of the same level. LESSON 4: SOURCES OF FINANCE (CONT…) 5. Lease financing This is an agreement where the right repossession and enjoyment of an asset is transferred for a definite period of time. The person transferring the right i.e. the owner of the asset is referred to as leasor. The recipient of the asset is the lessee. A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases". Operating leases Operating leases are rental agreements between the lessor and the lessee whereby: a) the lessor supplies the equipment to the lessee b) the lessor is responsible for servicing and maintaining the leased equipment c) the period of the lease is fairly short, less than the economic life of the asset, so that at the end of the lease agreement, the lessor can either i) lease the equipment to someone else, and obtain a good rent for it, or ii) sell the equipment secondhand. Finance leases Finance leases are lease agreements between the user of the leased asset (the lessee) and a provider of finance (the lessor) for most, or all, of the asset's expected useful life. Suppose that a company decides to obtain a company car and finance the acquisition by means of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the company. The company will take possession of the car from the car dealer, and make regular payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of the lease. Other important characteristics of a finance lease: a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not involved in this at all. b) The lease has a primary period, which covers all or most of the economic life of the asset. At the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset would be worn out. The lessor must, therefore, ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment. c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the lessor. Requirements of a Long Term lease The present value of lease rentals must be greater than 90% the year value of the asset. 75% of the assets life is the lease term. It is non-cell unsalable Maintenance costs, insurance and taxes are paid by the lessee. According to terms of payment Net lease This is on in which the leasee pays all or a substantial part of the maintenance cost. It is therefore where the lessee pays for all the expenses except taxes, insurances and exterior repairs. Flat Lease This is one which opts for periodic payment for use of the asset over the term of the lease. Such a lease is usually made for such periods of time since inflation can easily erode the buying power of the fixed rentals. Step Up lease This provides for the fixed payments to be adjusted periodically. This adjustments can be made either b new rentals taking effect after the passages of a certain period of time or by periodically adjusting the fixed payments for inflation. The term of a stepup lease is usually longer than a flat lease. Percentage lease This is where the lessee is required to pay a fixed basic percentage rate and a designated percentage of sales volume. The percentage factor acts as an inflation gauge as well as a means of Keeping lease rentals in line with the market conditions. Escalator lease This calls for an increase in taxes insurance and operating costs to be paid for the lessee. Sandwich lease This refers to a multiple lease in which the lessee in turn sub-lease to a sub-lessee who in turn sub-leases to another sub-lessee. Example: A the original owner of an asset leases to B. B executes a sub-lease to C who then sub-leases to D. This is a sandwich lease between B & C, B being the sandwich lessor and C the sandwich lessee. Advantages of lease To avoid the risk of ownership. When a firm purchases an asset, it has to bear the risk of obsolescence especially if the asset is vulnerable to technological changes e.g. computers. Avoidance of investment outlay. Leasing enables a firm to make full use of an asset without making an immediate investment in the form of initial cash outflow. Increased flexibility. A St. lease is a cancelable lease especially when the asset is needed for a short period of time e.g. during construction, equipment can be leased on a seasonal basis after which the lease can be cancelled. Lease charges are tax allowable expenses. This therefore reduces the tax liability. 6. Hire purchase This is arrangement whereby a company acquires an asset on making a down payment or deposit and paying the balance over a period of time in installments. This source of finance is more expensive than a bank loan and companies that use this source need guarantors since it does not require security or collateral. The company hiring the asset will be required to honour the terms of the agreement which means that any term in violated, the selling firm may repossess the asset. This is therefore finance in kind and the hirer will not get title to the asset until he clears the final installment and any charges thereof. Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the owner of the goods. Hire purchase agreements usually involve a finance house. i) The supplier sells the goods to the finance house. ii) The supplier delivers the goods to the customer who will eventually purchase them. iii) The hire purchase arrangement exists between the finance house and the customer. The finance house will always insist that the hirer should pay a deposit towards the purchase price. The size of the deposit will depend on the finance company's policy and its assessment of the hirer. This is in contrast to a finance lease, where the lessee might not be required to make any large initial payment. An industrial or commercial business can use hire purchase as a source of finance. With industrial hire purchase, a business customer obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by businesses on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery. 7.Mortgages A Mortgage can be defined as a pledge of security over property or an interest therein created by a formal written agreement for the repayment of monetary debt. Minimum mortgage requirements All mortgages should be in writing. All parties must have contractual capacity. Interest in the property being mortgaged should be specific e.g. rental income lease hold etc. A description of true loan or obligation secured by the mortgage should appear in the mortgage agreement. A legal description of the mortgage must be included in the documents. The mortgage must be signed by the mortgagor The mortgage must be acknowledged and delivered to the mortgagee. 8.Debentures A debenture is a long-term promissory note used to raise debt funds. The firm promises to pay periodic interest and principal at maturity. Ideally, a debenture is a long-term bond that is not secured by a pledge of a specific property. However, like other general creditors claims, its secured by a pledge of a specific property not otherwise pledged. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. Debentures with a floating rate of interest These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile. Security Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge. a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and buildings. The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent. b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular asset. Features of debenture (a) Interest rate The interest rate on a debenture is fixed and known. It is called the contractual or coupon interest rate. It indicates the percentage of the par value that will be paid out annually (or semi-annually) in form of interest. The interest must be paid whether the firm makes profit or not. However, debenture interest is tax deductible on the part of the company. (b) Maturity Debentures are usually issued for a specific period of time. The maturity of a debenture indicates the length of time the debenture remains outstanding before the company redeems it. However, there are debentures that have no maturity period. (c) Redemption The redemption of debentures can be accomplished either through a sinking fund or call provision. A sinking fund is cash set aside periodically for retiring the debentures. The fund is placed under the control of the trustee who redeems the debenture either by purchasing them in the market or calling them in an acceptable manner. The advantage of a sinking fund is that it reduces the amount required to redeem the remaining debt at maturity. Particularly when the firm faces temporary financial difficulties at the time of debt maturity, the repayment of huge amount of principal could endanger the firm's financial viability. Call provisions enable the company to redeem debentures at a specific price before the maturity date. The call price is usually higher than the par value, the difference being a call premium. (d) Security Debentures are either secured or unsecured. A secured debenture is secured by a claim on the company's specific assets. When debentures are not protected by any security, they are known as unsecured or naked debentures. (e) Convertibility A convertible debenture is one which can be converted, fully or partly into shares at a specified price at a given date. Debentures without a conversion feature are called non-convertible or straight debentures. (f) Yield We can distinguish two types of yield: the current yield and the yield to maturity. The current yield on a debenture is the ratio of the annual interest payment to the debentures market price. Current yield = Annual interest Market price The yield to maturity takes into account the payments of interest and principal over the life of the debenture. It is an internal rate of return on the debenture and is given by the following formula. 1 Where C is the annual interest M is the maturity value = Face Value P is the current market value n is the number of periods to maturity Claim on Assets and Income Debentures have a claim on the company's earnings prior to that of the shareholders since their interest has to be paid before paying any dividend to preference and common shareholders. In case of liquidation, the debenture holders have a claim on assets prior to that of shareholders. The secured debentures will have priority over the unsecured debentures Types of debentures Subordinated debentures Redeemable debentures Irredeemable debentures Advantages of debentures It involves less cost to the firm than the equity financing because: i. Investors consider debentures as a relatively less risky investment alternative and therefore require a lower rate of return. ii. Interest payments are tax deductible. iii. The floatation costs on debentures is usually lower than floatation costs on common shares. (b) Debenture holders do not have voting rights and therefore, debenture issue does not cause dilution of ownership. (c) Debenture holders do not participate in extraordinary earnings of the company. Thus their payments are limited to interest. (d) During periods of high inflation, debenture issue benefits the company. Its obligations of paying interest and principal, which remain fixed, decline in real terms. Disadvantage of debentures (a) Debentures issue results in legal obligation of paying interest and principal, which, if not paid can force the company into liquidation. (b) Debenture issue increases the firm's financial leverage and reduces its ability to borrow in future. (c) Debentures must be paid at maturity and therefore at some point, it involves substantial cash outflows. (d) Debentures may contain restrictive covenants which may limit the firm's operating flexibility in future 9. Retained earnings For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows: a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash. b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. c) The use of retained earnings as opposed to new shares or debentures avoids issue costs. d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares. Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods. A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors. 10. Franchising Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn. Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for architect's work, establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's turnover. Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost. The advantages of franchises to the franchisor are as follows:  The capital outlay needed to expand the business is reduced substantially.  The image of the business is improved because the franchisees will be motivated to achieve good results and will have the authority to take whatever action they think fit to improve the results. The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed number of years (including stock and premises, although premises might be leased from the franchisor) together with the backing of a large organisation's marketing effort and experience. The franchisee is able to avoid some of the mistakes of many small businesses, because the franchisor has already learned from its own past mistakes and developed a scheme that works. Self Assessment Questions QUESTION ONE (a) Differentiate the following:- Participative and non-participative preference shares. Subordinated and naked debentures invoice discounting and factoring (b) List the functions of a factor QUESTION TWO Maendeleo Ltd has 900,000 shares outstanding the current price is Ksh. 130. The company needs cash, Ksh 22,500,000 to finance a new project. The Board of directors have decided to declare rights issue at a subscription price of Ksh. 85. Required: Compute the number of rights required to buy one share. Compute the Ex-rights price of the shares of the rights. Compute the theoretical value of each right. QUESTION THREE State and explain any FIVE sources of external finance to a Co-operative Society, giving two advantages and two disadvantages of each. QUESTION FOUR ABC ltd is incorporated under the companies Act with a total of 100, 000 0rdianry shares outstanding and eligible to vote at all the AGMs. The Company is controlled by 5 directors who are usually electe3d at every AGM. Mr. King has approached you for advice on the following issues:- He bought 25,000 ordinary shares from the company and therefore wants to know the number of directors he can elect. He has a friend who to indirectly control the company by electing single handedly 3 directors and wishes to know the number of shares he must buy at the stock market so as to elect the directors, Advise him. QUESTION FIVE As a finance manager of Kasuku products ltd, you decide to raise sufficient capital in the next five years to enable your company to expand. You decide to raise the capital by combining both internal and external opportunities Required:- (a)Explain the major internal sources of capital to an organisation (b) In details, explain the main disadvantages of sourcing funds externally. .(20Mks) QUESTION SIX State and explain any FIVE sources of external finance to a Co-operative Society, giving two advantages and two disadvantages of each. QUESTION SEVEN (i) Maendeloeo Ltd has 900,000 shares outstanding the current price is kshs. 130. The company needs cash, ksh 22,500,000 to finance a new project. The Board of directors have share decided to declare rights issue at a subscription price of ksh. 85. Required: Compute the number of rights required to buy one share. Compute the Ex-rights price of the shares of the rights. Compute the theoretical value of each right. LESSON 5: WORKING CAPITAL MANAGEMENT 5.1 Introduction Working capital is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Working Capital = Current Assets Net Working Capital = Current Assets − Current Liabilities A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. By definition, working capital management entails short term decisions - generally, relating to the next one year period - which is "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability. One measure of cash flow is provided by the cash conversion cycle - the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Approaches used to finance current assets Matching or hedging approach Conservative approach Aggressive approach a) Matching Approach This approach is sometimes referred to as the hedging approach. Under this approach, the firm adopts a financial plan which involves the matching of the expected life of assets with the expected life of the source of funds raised to finance assets. The firm, therefore, uses long term funds to finance permanent assets and short-term funds to finance temporary assets. Permanent assets refer to fixed assets and permanent current assets. This approach can be shown by the following diagram. b) Conservative Approach An exact matching of asset life with the life of the funds used to finance the asset may not be possible. A firm that follows the conservative approach depends more on long-term funds for financing needs. The firm, therefore, finances its permanent assets and a part of its temporary assets with long-term funds. This approach is illustrated by the following diagram. Risk-Return trade-off of the three approaches: It should be noted that short-term funds are cheaper than long-term funds. (Some sources of short-term funds such as accruals are cost-free). However, short-term funds must be repaid within the year and therefore they are highly risky. With this in mind, we can consider the risk-return trade off of the three approaches. The conservative approach is a low return-low risk approach. This is because the approach uses more of long-term funds which are now more expensive than short-term funds. These funds however, are not to be repaid within the year and are therefore less risky. The aggressive approach on the other hand is a highly risky approach. However it is also a high return approach the reason being that it relies more on short-term funds that are less costly but riskier. The matching approach is in between because it matches the life of the asset and the life of the funds financing the assets. DETERMINANTS OF WORKING CAPITAL NEEDS There are several factors which determine the firm’s working capital needs. These factors are comprehensively covered by A Textbook of Business Finance by Manasseh (Pages 403 – 406). They however include: a) Nature and size of the business. b) Firm’s manufacturing cycle c) Business fluctuations d) Production policy e) Firm’s credit policy f) Availability of credit g) Growth and expansion activities. Factors which determine working capital needs of a firm (1) Availability of Credit: The amount of credit that a firm can obtain, as also the length of the credit period significantly affects the working capital requirement. The greater the prospects of getting credit, the smaller will be its requirement of working capital because it can easily purchase raw materials and other requirements on credit. Creditworthiness can also the interpreted to mean that the firm can function smoothly even with a smaller amount of working capital if it is assured that it can obtain loans from the bank immediately and easily. The firm does not need then to keep a wide margin of safety. (2) Growth and Expansion: The working capital requirements increase with growth and expansion of business. Hence planning of the working capital requirements and its procurement must go hand in hand with the planning of the growth and expansion of the firm. The implementation of the production plan that aims at the growth or expansion of the unit necessitates more of fixed capital and working capital both. Even the expansion of the volume of sales increases the requirements of working capital. Of course, it is difficult to establish a quantitative relationship between them. An important point to be noted is that the requirements of working capital emerge before the growth or expansion actually takes place. (3) Profit and its Distribution: The net profit of a firm is a good index of the resources available to it to meet its capital requirements. But, from the viewpoint of working capital requirement, it is the profit in the form of cash which is important, and not the net profit. The profit available in the form of cash is called cash profit and it can be assessed by adding or deducting non-cash items from the net profit of the firm. The larger the amount of cash profit, the greater will be the possibility of acquiring working capital. But, in fact the entire amount of cash profit may not be available to meet working capital needs. The portion of cash profit which is available for this purpose depends on the profit distribution policy. The policies with regard to distribution of dividends, ploughing back of profit and tax payments will determine the portion of cash profit which the firm can use to meet its working capital needs. Even depreciation policy can influence the amount of cash available, as depreciation of capital assets is deductible item of expenditure and it reduces tax liability. (4) Price Level Fluctuations: A general statement may be made that with price rise, a firm will require more funds to purchase its current assets. In other words, the requirements of working capital will increase with the rise in prices. But all firms may not be affected equally. The prices of all current assets never go up to the same extent. Price of some current assets rise less rapidly than those of the others. Hence for the firms which use such current assets, the working capital need will increase by a smaller amount. Besides, if it is possible to pass on the burden of high prices of raw materials to the customers by raising the prices of final product, then also there will be no increase in working capital requirements. (5) Operating Efficiency: If a firm is efficient, it can use its resources economically, and thereby it can reduce cost and earn more profit. Thus, the working capital requirement can be reduced by more efficient use of the current assets. Importance of working capital management The finance manager should understand the management of working capital because of the following reasons: a) Time devoted to working capital management A large portion of a financial manager’s time is devoted to the day to day operations of the firm and therefore, so much time is spent on working capital decisions. b) Investment in current assets Current assets represent more than half of the total assets of many business firms. These investments tend to be relatively volatile and can easily be misappropriated by the firm’s employees. The finance manager should therefore properly manage these assets. c) Importance to small firms A small firm may minimise its investments in fixed assets by renting or leasing plant and equipment, but there is no way it can avoid investment in current assets. A small firm also has relatively limited access to long term capital markets and therefore must rely heavily on short-term funds. d) Relationship between sales and current assets The relationship between sales volume and the various current asset items is direct and close. Changes in current assets directly affects the level of sales. The finance management must therefore keep watch on changes in working capital items. LESSON 6: WORKING CAPITAL MANAGEMENT (CONT…) 1.0 Cash management. It helps to identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Cash Cycle refers to the amount of time that elapses from the point when the firm makes a cash outlay to purchase raw materials to the point when cash is collected from the sale of finished goods produced using those raw materials. Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a year. Illustration XYZ Ltd. currently purchases all its raw materials on credit and sells its merchandise on credit. The credit terms extended to the firm currently requires payment within thirty days of a purchase while the firm currently requires its customers to pay within sixty days of a sale. However, the firm on average takes 35 days to pay its accounts payable and the average collection period is 70 days. On average, 85 days elapse between the point a raw material is purchased and the point the finished goods are sold. Required Determine the cash conversion cycle and the cash turnover. Solution The following chart can help further understand the question: Inventory Conversion period (85 days) Receivable collection Payable deferral Period (35 days) Period (70 days) Collection of receivables Sale of Finished goods Payment for the raw materials Purchase of raw materials Cash conversion cycle = 85 + 70 - 35 = 120 The cash conversion cycle is given by the following formula: Cash conversion = Inventory conversion + Receivable collection – Payable deferral Cycle period period period For our example: Cash conversion cycle = 85 + 70 – 35 = 120 days Cash turnover = 360 Cash conversion cycle = = 3 times Note also that cash conversion cycle can be given by the following formulae: Cash conversion cycle = NB: In this chapter we shall assume that a year has 360 days. Setting the optimal cash balance Cash is often called a non-earning asset because holding cash rather than a revenue-generating asset involves a cost in form of foregone interest. The firm should therefore hold the cash balance that will enable it to meet its scheduled payments as they fall due and provide a margin for safety. There are several methods used to determine the optimal cash balance. These are: a) The Cash Budget The Cash Budget shows the firm’s projected cash inflows and outflows over some specified period. This method has already been discussed in other earlier courses. The student should however revise the cash budget. Working capital requirements of a business should be monitored at all times to ensure that there are sufficient funds available to meet short-term expenses. The cash budget is basically a detailed plan that shows all expected sources and uses of cash. The cash budget has the following six main sections: Beginning Cash Balance - contains the last period's closing cash balance. Cash collections - includes all expected cash receipts (all sources of cash for the period considered, mainly sales) Cash disbursements - lists all planned cash outflows for the period, excluding interest payments on short-term loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list (e.g. depreciation, amortization, etc.) Cash excess or deficiency - a function of the cash needs and cash available. Cash needs are determined by the total cash disbursements plus the minimum cash balance required by company policy. If total cash available is less than cash needs, a deficiency exists. Financing - discloses the planned borrowings and repayments, including interest. Ending Cash balance - simply reveals the planned ending cash balance. Reasons for keeping cash Cash is usually referred to as the "king" in finance, as it is the most liquid asset. The transaction motive refers to the money kept available to pay expenses. The precautionary motive refers to the money kept aside for unforeseen expenses. The speculative motive refers to the money kept aside to take advantage of suddenly arising opportunities. Advantages of sufficient cash Current liabilities may be catered for meeting the current obligations of the company Cash discounts are given for cash payments. Production is kept moving Surplus cash may be invested on a short-term basis. The business is able to pay its accounts in a timely manner, allowing for easily obtained credit. Liquidity Quick upfront pay. b) Baumol’s Model The Baumol’s model is an application of the EOQ inventory model to cash management. Its assumptions are: The firm uses cash at a steady predictable rate The cash outflows from operations also occurs at a steady rate The cash net outflows also occur at a steady rate. Under these assumptions the following model can be stated: Where: C* is the optimal amount of cash to be raised by selling marketable securities or by borrowing. b is the fixed cost of making a securities trade or of borrowing T is the total annual cash requirements i is the opportunity cost of holding cash (equals the interest rate on marketable securities or the cost of borrowing) The total cost of holding the cash balance is equal to holding or carrying cost plus transaction costs and is given by the following formulae: Illustration ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on marketable securities is 12% and every time the company sells marketable securities, it incurs a cost of Shs.20. Required a) Determine the optimal amount of marketable securities to be converted into cash every time the company makes the transfer. b) Determine the total number of transfers from marketable securities to cash per year. c) Determine the total cost of maintaining the cash balance per year. d) Determine the firm’s average cash balance. Solution a) Where: b = Shs.20 T = 52 x 20,000 = Shs.520,000 i = 12% Therefore the optimal amount of marketable securities to be converted to cash every time a sale is made is Sh.13,166. b) Total no. of transfers = = = 39.5 ≈ 40 times c) = = 790 + 790 = Shs.1,580 Therefore the total cost of maintaining the above cash balance is Sh.1,580. d) The firm’s average cash balance = ½C = = Shs.6,583 c) Miller-Orr Model Unlike the Baumol’s Model, Miller-Orr Model is a stochastic (probabilistic) model which makes the more realistic assumption of uncertainty in cash flows. Merton Miller and Daniel Orr assumed that the distribution of daily net cash flows is approximately normal. Each day, the net cash flow could be the expected value of some higher or lower value drawn from a normal distribution. Thus, the daily net cash follows a trendless random walk. From the graph below, the Miller-Orr Model sets higher and lower control units, H and L respectively, and a target cash balance, Z. When the cash balance reaches H (such as point A) then H-Z shillings are transferred from cash to marketable securities. Similarly, when the cash balance hits L (at point B) then Z-L shillings are transferred from marketable securities cash. The Lower Limit is usually set by management. The target balance is given by the following formula: and the highest limit, H, is given by: H = 3Z - 2L The average cash balance = Where: Z = target cash balance H = Upper Limit L = Lower Limit b = Fixed transaction costs i = Opportunity cost on daily basis δ² = variance of net daily cash flows Illustration XYZ’s management has set the minimum cash balance to be equal to Sh.10,000. The standard deviation of daily cash flow is Sh.2,500 and the interest rate on marketable securities is 9% p.a. The transaction cost for each sale or purchase of securities is Sh.20. Required Calculate the target cash balance Calculate the upper limit Calculate the average cash balance Calculate the spread Solution a) = = 7,211 + 10,000 = Sh.17,211 b) H = 3Z – 2L = 3 x 17,211 – 2(10,000) = Shs.31,633 c) Average cash balance = = d) The spread = H – L = 31,633 – 10,000 = Shs.21,633 Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422 (31,633 – 17,211) in marketable securities and if the balance falls to Shs.10,000, the firm should sell Shs.7,211(17,211 – 10,000) of marketable securities. Other Methods Other methods used to set the target cash balance are The Stone Model and Monte Carlo simulation. However, these models are beyond the scope of this manual. Cash management techniques The basic strategies that should be employed by the business firm in managing its cash are: i) To pay account payables as late as possible without damaging the firm’s credit rating. The firm should however take advantage of any favourable cash discounts offered. ii) Turnover inventory as quickly as possible, but avoid stockouts which might result in loss of sales or shutting down the ‘production line’. iii) Collect accounts receivable as quickly as possible without losing future sales because of high pressure collection techniques. The firm may use cash discounts to accomplish this objective. In addition to the above strategies the firm should ensure that customer payments are converted into spendable form as quickly as possible. This may be done either through: a) Concentration Banking b) Lock-box system. Concentration Banking Firms with regional sales outlets can designate certain of these as regional collection centre. Customers within these areas are required to remit their payments to these sales offices, which deposit these receipts in local banks. Funds in the local bank account in excess of a specified limit are then transferred (by wire) to the firms major or concentration bank. Concentration banking reduces the amount of time that elapses between the customer’s mailing of a payment and the firm’s receipt of such payment. b) Lock-box system. In a lock-box system, the customer sends the payments to a post office box. The post office box is emptied by the firm’s bank at least once or twice each business day. The bank opens the payment envelope, deposits the cheques in the firm’s account and sends a deposit slip indicating the payment received to the firm. This system reduces the customer’s mailing time and the time it takes to process the cheques received. 2.0 Inventory management. It helps to identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity Manufacturing firms have three major types of inventories: Raw materials Work-in-progress Finished goods inventory The firm must determine the optimal level of inventory to be held so as to minimize the inventory relevant cost. BASIC EOQ MODEL The basic inventory decision model is Economic Order Quantity (EOQ) model. This model is given by the following equation: Where: Q is the economic order quantity D is the annual demand in units Co is the cost of placing and receiving an order Cn is the cost of holding inventories per unit per order The total cost of operating the economic order quantity is given by total ordering cost plus total holding costs. TC = ½QCn + Where: Total holding cost = ½QCn Total ordering cost = The holding costs include: Cost of tied up capital Storage costs Insurance costs Obsolescence costs The ordering costs include: Cost of placing orders such as telephone and clerical costs Shipping and handling costs Under this model, the firm is assumed to place an order of Q quantity and use this quantity until it reaches the reorder level (the level at which an order should be placed). The reorder level is given by the following formulae: Where: R is the reorder level D is the annual demand L is the lead time in days EOQ ASSUMPTIONS The basic EOQ model makes the following assumptions: i) The demand is known and constant over the year ii) The ordering cost is constant per order and certain iii) The holding cost is constant per unit per year iv) The purchase cost is constant (Thus no quantity discount) v) Back orders are not allowed. Illustration ABC Ltd requires 2,000 units of a component in its manufacturing process in the coming year which costs Sh.50 each. The items are available locally and the leadtime in one week. Each order costs Sh.50 to prepare and process while the holding cost is Shs.15 per unit per year for storage plus 10% opportunity cost of capital. Required a) How many units should be ordered each time an order is placed to minimize inventory costs? b) What is the reorder level? c) How many orders will be placed per year? d) Determine the total relevant costs. Suggested Solution: a) Where: D = 2,000 units Co = Sh.50 Cn = Sh.15 + 10% x 50 = Sh.20 L = 7 days b) R = = = 39 units c) No. of orders = = = 20 orders d) TC = ½QCn + = ½(100)(20) + = 1,000 + 1,000 = Sh.2,000 Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is received. 3.0 Debtors’ management. It helps Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances. In order to keep current customers and attract new ones, most firms find it necessary to offer credit. Accounts receivable represents the extension of credit on an open account by a firm to its customers. Accounts receivable management begins with the decision on whether or not to grant credit. The total amount of receivables outstanding at any given time is determined by: a) The volume of credit sales b) The average length of time between sales and collections. Accounts receivables = Credit sales per day x Length of collection period The average collection period depends on: a) Credit standards which is the maximum risk of acceptable credit accounts b) Credit period which is the length of time for which credit is granted c) Discount given for early payments d) The firm’s collection policy. a) Credit standards A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy tends to sell on credit to customers on a very liberal terms and credit is granted for a longer period. A firm following a stringent credit policy on the other hand, sell on credit on a highly selective basis only to those customers who have proven credit worthiness and who are financially strong. A lenient credit policy will result in increased sales and therefore increased contribution margin. However, these will also result in increased costs such as: Increased bad debt losses Opportunity cost of tied up capital in receivables Increased cost of carrying out credit analysis Increased collection cost Increased discount costs to encourage early payments The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal, the evaluation of investment in receivables should involve the following steps: Estimation of incremental operating profits from increased sales Estimation of incremental investment in account receivable Estimation of incremental costs Comparison of incremental profits with incremental costs b) Credit terms Credit terms involve both the length of the credit period and the discount given. The terms 2/10, n/30 means that a 2% discount is given if the bill is paid before the tenth day after the date of invoice otherwise the net amount should be paid by the 30th day. In considering the credit terms to offer the firm should look at the profitability caused by longer credit and discount period or a higher rate of discount against increased cost. c) Discounts Varying the discount involves an attempt to speed up the payment of receivables. It can also result in reduced bad debt losses. d) Collection policy The firm’s collection policy may also affect our analysis. The higher the cost of collecting account receivables the lower the bad debt losses. The firm must therefore consider whether the reduction in bad debt is more than the increase in collection costs. As saturation point increased expenditure in collection efforts does not result in reduced bad debt and therefore the firm should not spend more after reaching this point. Evaluation of the credit applicant After establishing the terms of sale to be offered, the firm must evaluate individual applicants and consider the possibilities of bad debt or slow payments. This is referred to as credit analysis and can be done by using information derived from: a) The applicant’s financial statement b) Credit ratings and reports from experts c) Banks d) Other firms e) The company’s own experience Application of discriminant analysis to the selection of applicants Discriminative analysis is a statistical model that can be used to accept or reject a prospective credit customer. The discriminant analysis is similar to regression analysis but it assumed that the observations come from two different universal sets (in credit analysis, the good and bad customers). To illustrate let us assume that two factors are important in evaluating a credit applicant the quick ratio and net worth to total assets ratio. The discriminant function will be of the form. ft = a1(X1) + a2(X2) Where: X1 is quick ratio X2 is the network to total assets a1 and a2 are parameters The parameters can be computed by the use of the following equations: a1 = Szz dx – Sxzdz Sxx Sxx – Sxz² a2 = Szz dx – Sxzdz Szz Sxx – Sxz² Where: Sxx represents the variances of X1 Szz represents the variances of X2 Sxz is the covariance of variables of X1 and X2 dx is the difference between the average of X1’s bad accounts and X2’s good accounts dz represents the difference between the average of X’s bad accounts and X’s good accounts. The next step is to determine the minimum cut-off value of the function below at which credit will not be given. This value is referred to as the discriminant value and is denoted by f*. Once the discriminant function has been developed it can then be used to analyse credit applicants. The important assumption here is that new credit applicants will have the same characteristics as the ones used to develop the mode. More than two variables can be used to determine the discriminant function. In such a case the discriminant function will be of the form. ft = a1x1 + a2x2 + … + anxn Self Assessment Questions QUESTION ONE The management of Beardy Limited has ascertained that the company will require ksh. 2,500,000 in cash for transaction purposes during the coming financial year. The interest rate on the marketable securities is currently 10% per annum and is expected to remain constant over the next one year. The cost of converting securities to cash is ksh. 50 per transaction. Required: Using the Baumol cash management model, determine the following: (i) Optimal cash size (ii) Average cash balance (iii) Cash turnover (iv) Total cost of managing the optimal cash balance QUESTION TWO PKG Ltd maintains a minimum cash balance of Ksh. 500,000.00. The deviation of the company’s daily cash changes is ksh. 200,000.00. the annual interest rate is 14%. The transaction cost of buying and selling securities is kshs. 150.00 per transaction. Required: Using Miller-Orr cash management model, determine the following: (i) Upper cash limit (ii) Average cash balance (iii) Spread QUESTION THREE Mutongoi Ltd in Matuu requires 500,000 units of a component each year at a cost of ksh. 100 each. The items are obtained from Machakos and therefore it takes 3 days from the time or ordering to the time of delivery. Each order costs the company ksh. 300 to process while hoarding cost per annum is ksh 200 plus 15% opportunity cost of capital. To operate prudently the company is safe with 2000 units. Required: (i) Economic order quantity (ii) Reorder level (iii) Total relevant cost QUESTION FOUR (a) Differentiate between Hedging approach and conservative approach under management of working capital. (b) Explain four importance of working capital management. ( c) Define overcapitalization and outline the indicators of overcapitalization. (d) Explain the determinants of working capital requirements. QUESTION FIVE Ukaguzi Ltd has a total annual sales of 3,000,000. its discounted interest rate is 15 % p.a . it is considering to factor its debtor where the factor charges a service fees of 1.2% of debtors factored. 12% reserve is required by the factor. Ukaguzi limited has a credit policy of 72 days. Required: (i) the amount Ukaguzi will receive from the factor. (ii) The percentage annual cost (a) Reserve (b) Service charges © Interest charges p.a (d) Interest charges for 72 days QUESTION SIX Discuss the THREE approaches used to finance current assets. State and explain any FOUR importance of working capital management. Jitihidi wholesalers had total sales of sh. 3 million in the year ended 2008. its average collection period is 27 days. Due to unforeseen liquidity problems, it pledged its debtors and was charged interest at 18% p.a. The interest was discounted. Some of the goods were damaged and therefore the factor charged 6% reserve. Required: Calculate the amount that was advanced to the firm. QUESTION SEVEN (a) Maintain only “Enough” Levels of inventory in your business. Discuss FIVE Costs that would be avoided by maintaining “Enough” inventory level (b) Credit sales is a strategy used by traders to mitigate the effects of high competition. Discuss the FIVE Cs of a good debtor LESSON 7: FINANCIAL STATEMENT ANALYSIS Definition Financial analysis is a process by which finance identifies the company’s financial performances by comparing the entities in the balance sheet and those in the profit and loss account (P&L). This is so because balance sheet entities are usually responsible for those to be found in the P&L i.e. assets shown in the balance sheet are responsible for sales, revenue and expenses to be found in the P&L. This analysis is important to various parties with a financial stake in the company. These include: 1. Shareholders – Actual owners are interested in the company’s both short and long term survival. For this reason they will use ratio’s such as: a) Profitability ratios – which seek to establish viability. b) Dividend ratios – which seek to establish return to owners in form of dividends. The common ratios include earning yield (E/Y), Dividend pay out ratio (DPO), dividend yield, Price earning ratio, all of which will measure return to owner. 2. Creditors (trade) – these are interested in the company’s ability to meet their short-term obligations as and when they fall due. For this reason they will use ratios such as: a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by acid test ratio. b) Current ratio – which is a measure of company’s quantity of current assets against current liabilities. 3. Long term lenders – These include finances through loans, mortgages and debenture holders. These have both short and long term interest in the company and its ability to pay not only interest on debt but also principal as and when it falls due. These parties are interested in the following: a) Liquidity ratios – used to assess short-term liability to meet current obligations. b) Profitability ratios – used to ascertain whether the company can pay its principal back. c) Gearing ratio – used to gauge the company’s risk in the investment. d) Investment coverage ratio – shows the company’s safety as regards the payment of interest to the lenders of the debt. 4. Directors and management of company – They will therefore be interest in: a) Efficiency of the company in generating profits. b) The company’s viability from the investor’s point of view and the company’s ability to generate sufficient returns to investors. c) Gearing ratio to gauge the safety and risk associated with the company. 5. Potential investors – these parties are interested in a company in total both on short and long term basis in particular the company’s ability to generate acceptable return on their money. Therefore, they will use: a) Dividend ratios b) Return ratios c) Gearing ratios 6. Government – The Government is interested mostly in utility companies (e.g. KPLC, KPTC) and those that will provide public services – in this case the government will be interested in their survival and thus ability to provide those services. It may be interested in taxation derived from these companies which is used for development. Government may also be interested in employment level and as such it will use those ratios that can enable it to achieve such objectives of particular importance are: a) Profitability ratios b) Return ratios 7. Competitors – These are interested in the company’s performance from the market share point of view and will use the ratios that enable them to ascertain company’s competitive strength e.g. profitability ratios, sales and returns ratio etc. 8. General public – Customers and potential customers – These are interested in the ability of the company to provide good services both in the short and long run. To gauge the company’s ability to provide goods and services on short and long term basis. We have: Returns ratio Sales ratio YARD STICK USED IN RATIO ANALYSIS 1. Past performance of the company The company’s past performance (past ratio) is used to measure or gauge the company’s performance and in particular the change in performance whether good (favourable), better, same or even worse than the past. Such comparison is then used to interpret the company’s performance bearing in mind the factors that influenced the present and past performances. 2. Average industry ratios These are useful as they indicate the average performance of various companies in a given industry i.e. it gives the minimum performance of a number of companies in a given industry. These ratios are useful in so far as to enable the analyst to make a reasonable comparison of the company’s performance vis-à-vis other companies in the same industry. However, for this yardstick to be useful the term average should include those companies which are not extremely. I.e. very strong and very weak companies – which should be excluded to arrive at industry average figures. 3. Ratio of successful companies Useful if the company can get figures of competitors who are leading in the market so as to enable it to gauge its performance against better performance. However this information is difficult to obtain and sometimes it calls for private investigators e.g. Private Eyes Ltd. 4. Ratio of budgeted performance These are compared with actual performance ratios and investigations are made of any unfavorable variance which should be explained. Classification of Ratios Ratios are broadly classified into 5 categories: 1. Liquidity ratios 2. Turnover ratios 3. Gearing ratios 4. Profitability ratios 5. Growth and valuation ratios 1. Liquidity Ratios Also called working capital ratios. They indicate ability of the firm to meet its short term maturing financial obligation/current liabilities as and when they fall due. The ratios are concerned with current assets and current liabilities. They include: a) Current ratio = Current Assets Current liabilities This ratio indicates the No. of times the current liabilities can be paid from current assets before this assets are exhausted. The most recommended ratio is 2.0 i.e. the current asset must at least be twice as high as current liabilities b) Quick/acid test ratios = Current Asset - Stock Current liabilities Is a more refined current ratio which exclude amount of stock of the firm. Stocks are excluded for two basic reasons. i) They are valued on historical cost basis ii) They may not be converted into cash very quickly The ratio therefore indicates the ability of the firm to pay its current liabilities from the more liquid assets of the firm. c) Cash ratio = Cash in hand/bank + short term marketable securities Current liabilities This is a refinement of the acid test ratio indicating the ability of the firm to meet its current liabilities from its most liquid resources. Short term marketable securities refers to short term investment of the firm which can be converted into cash within a very short period e.g commercial paper and treasury bills. d) Net working capital Ratio = Networking Capital x 100 Net Assets Where Net Assets or Capital employed = Total Assets – Current liability This ratio indicates the proportions of total net assets which is liquid enough to meet the current liabilities of the firm. It is expressed in % term. 2. Turnover Ratios/efficiency/asset management ratio Turnover ratio indicate the efficiency with which the firm utilised the asset or resources at its disposal to generate sales revenue or turnover. This ratio includes: a) Stock/inventory turnover = Cost of Sales Average stock The ratio indicate number of times the stock was turned into sales in a year i.e how many times did the ‘buy-sell’ process occur during the year. The higher the stock turnover, the better the firm and more likely the higher the sales. b) Stock holding period = 365 days Stock turnover = 365 x Average stock i.e 365 Cost of sales Stock turnover The ratio indicates number of days the stock was held in the warehouse before being sold. The higher the stock turnover, the lower the stock holding period and vice versa. c) Debtors/accounts receiver turnover = Annual credit sales Average debtor The ratio indicate the number of times/frequency with which credit customers or debtors were turned into sale i.e the number of times they come to buy on credit per year after paying their dues to the firm. The higher the debtors turnover the better the firm indicating that customers came to buy on credit many times thus they paid within a short period. d) Debtors collection period = 365 Debtors turnover or 365 x Average debtors Annual credit sales This refers to credit period that was granted to the debtors on the period within which they were supposed to pay their dues to the firm. The shorter the collection period/credit period the higher the debtors turnover and vice versa. If no opening debtors are given use the closing debtors to represent average debtors. e) Creditors/accounts payable turnover = Annual credit purchases Average creditors The firm buy goods on credit from suppliers. The ratio indicate number of times p.a. the firm bought goods on credit after paying the suppliers. If the creditors turnover is high, this indicates that the payment was made within a short period of time. f) Creditors payment period = 365 Creditors turnover = 365 x Average creditors Annual credit purchases The ratio indicate the credit period granted by the suppliers i.e. the period within which the firm should pay its liabilities to the suppliers. The shorter the period the higher the creditors turnover and vice-versa. g) Fixed asset turnover = Annual Sales Fixed Assets This ratio indicate the efficiency with which, the fixed assets were utilised to generate sales revenue e.g. a ratio of 1.4 means one shilling of fixed assets was utilised to generate Sh.1.4 of sales. h) Total asset turnover = Annual sales Total assets The ratio indicate amount of sales revenue generated from utilisation of one shilling of total asset. The Concept of Working Capital/Cash Operating Cycle Working capital cycle refers to period that elapses between the payment for raw materials bought on credit (cash outflows) and the receipts of cash from finished goods sold on credit (cash inflows). The working capital cycle will involve the following: a) Purchase of raw materials on credit from suppliers b) Payment of raw materials after the lapse of credit period c) Conversion of raw materials into finished goods d) Sale of finished goods to creditors e) Receipt of cash from debtors. This can be illustrated using a diagram as follows: Raw material stock conversion period Creditors Payment Period Debtors Collection Period A B C D Purchase of Payment of Finished goods Receipts of Raw materials raw materials sold on credit cash goods On credit cash outflow sold on credit Cash inflows Working Capital Cycle Working capital cycle = Stock conversion + debtors collection – Creditors payment From the diagram the working capital cycle of a period will be determined as follows: Stock conversion period + Debtors collection period – Creditors payment period Note A lengthy working capital cycle is an indicator of poor management of stock and debtors reflecting low turnover of stock and debtors and lengthy stockholding period and debtors collection period. The working capital cycle can be reduced in any of the following ways: 1. Negotiate for a longer credit period with the suppliers 2. Reduce the stock conversion period or manufacturing period. 3. Reduce the debtors collection period by granting short crediting period. This can be achieved through offering discounts to customers to encourage them to pay earlier. 4. Holding fast moving goods to ensure high turnover. 5. Timely delivery of raw materials by suppliers especially if any delay in delivery will lengthen the raw materials holding period. 3. Gearing/Leverage/Capital Structure Ratio The ratio indicate the extent in which the firm has borrowed fixed charge capital to finance the acquisition of the assets or resources of the firm. The two basic gearing ratios are: a) Debt/equity ratio = Fixed charge capital Equity (net worth) This ratio indicate the amount of fixed charge capital in the capital structure of the firm for every one shilling of owners capital or equity e.g a ratio of 0.78 means for every Sh.1 of equity there is Sh.0.78 fixed charge capital. b) Fixed charge to total capital ratio = Fixed charge capital x 100 Total capital employed Where total capital employed = Fixed charge capital + equity relative to total capital employed by the firm e.g a ratio of 0.38 means that, 38% of the capital employed is fixed charge capital. Other leverage or gearing ratios are a) Debt ratio = Total debts Total assets Where total debt = fixed charge capital + liabilities. The ratio indicate the proportion of total assets that has been financed using long term and current liabilities e.g a debt ratio of 0.45 mean 45% of total asset has been financed with debt while the remaining 55% was financed with owners equity/capital. b) Times interest earned ratio = Operating profit (earning before interest and tax Interest Charges TIER also called interest coverage ratio. This ratio indicate the number of times interest charges can be paid from operating profit. The higher the TIER, the better the firm indicating that either the firm has high operating profits or its interest charges are low. If TIER is high due to low interest charges, this indicates low level of gearing/debt capital of the firm. 4. Profitability Ratio This ratio indicate the performance of the firm in relation to its ability to derive returns or profit from investment or from sale of goods i.e profit margin or sales. 1. Profitability in relation to sales The ratio indicate the ability of the firm to control its cost of sales, operating and financing expenses. They include: a) Gross profit margin = Gross profit x 100 Sales The ratio indicate the ability of the firm to control cost of sales expenses e.g gross profit margin of 40% means 60% of sales revenue was taken up by cost of sales while 40% was the gross profit. b) Operating profit margin = Operating profit/Earning before interest & tax Sales The ratio indicates ability of the firm to control its operating expenses such as distribution cost, salaries and wages, travelling, telephone and electricity charges etc. e.g a ratio of 20% means: i) 80% of sales relate to both operating and cost of sales expenses ii) 20% of sales remained as operating margin profit c) Net profit margin = Net profit x 100 (earning after tax) + interest Sales This ratio indicates the ability of the firm to control financing expenses in particular interest charges e.g. Net profit margin of 10% indicate that: i) 90% of sales were taken up by cost of sales, operating and financing expenses ii) 10% remained as net profits. 2. Profitability in relation to investment a) Return on Investment (ROI) = Net profit x 100 or return on total asset (ROTA) Total asset The ratio indicate the return on profit from investment of Sh.1 in total assets e.g a ratio of 20% means Sh.10 of total asset generated Sh.2 of net profit. b) Return on equity (ROE) = Net profit x 100 or Return on net worth (RONW) equity or Return on shareholders equity (ROSE) The ratio indicate the return of profitability for every one shilling of equity capital contributed by the shareholders e.g a ratio of 25% means one shilling of equity generates Sh.0.25 profit attributable to ordinary shareholders. c) Return on capital employed ROCE = Net profit x 100 or Return on net asset (RONA) Net Asset (Capital employed) This ratio indicate the returns of profitability for every one shilling of capital employed in the firm. 5. The Growth and Valuation Ratio This ratio indicates the growth potential of the firm in addition to determining the value of the firm and investment made by various investors. They include the following: a) Earnings per share EPS = Earnings to Ordinary shareholders No. of ordinary shares This ratio indicate earnings power of the firm i.e how much earnings or profits are attributed to every share held by an investor. The higher the ratio the better the firm. b) Earnings yield (EY) = Earnings per share x 100 Market price per share The market price per share (MPS) is the price at which new shares can be bought from the stock market. These ratios therefore indicate the returns or earnings for every one shilling invested in the firm. c) Dividends per share (DPS) = Dividend paid No. of ordinary shares - This indicates the cash dividend received for every share held by an investor. If all the earnings attributable to ordinary shareholders were paid out as dividend, then EPS = DPS. d) Dividend Yield (DY) = Dividend per share x 100 Market price per share Or Dividend paid Market value of equity Where market value of equity = No. of shares x MPS This ratio indicates the cash dividend returns for every one shilling invested in the firm. e) Price earnings (P/E) = Market price per share (MPS) Ratio Earning per share OR = Market value of equity Earning to Ord. Shareholders P/E ratio is a reciprocal of earning yield (EY). The MPS is the price at which a new share can be bought i.e investment per share. The EPS is the annual income/earnings from each share. PE therefore indicate the payback period i.e number of years it will take to recover MPS from the annual earnings per share of the firm. f) Dividend cover = EPS = Earning to ordinary shares DPS Dividend paid This indicate the number of times dividend can be paid from earnings to ordinary shareholders. The higher the DPS the lower the dividend cover and vice-versa e.g consider the following two firms X and Y X Y EPS 12/= 12/= DPS 3/= 5/= Dividend cover 12 = 4 12 = 2.4 times 3 5 g) Dividend pay out ratio = DPS x 100 = Dividend paid EPS Earning to ordinary shareholder This is the reciprocal of dividend cover. It indicates the proportion of earnings that was paid out as dividend e.g a payout ratio of 40% means 60% of earnings were retained while 40% was paid out as dividend, therefore retention ratio = 1 – dividend payout ratio h) Book value per share = Networth Equity (BVPS) No. of ordinary shares This is also called liquidity ratio which indicates the amount attributable to each share if the firm was liquidated and all asset sold at their book value. The ratio is based on the residual amount which would remain after paying all liabilities from the sales proceeds of the assets. i) Market to book value per share = MPS BVPS This ratio indicates the amount of goodwill attached to the firm i.e the price in excess of the sales value of the assets of the firm. If the ratio is greater 1(MBVPS >1) this indicate a positive goodwill while if less than 1 a –ve goodwill. Uses/Application of Ratios Ratios are used in the following ways by managers in various firms. 1. Evaluating the efficiency of assets utilisation to generate sales revenue i.e turnover ratio. 2. Evaluating the ability of the firm to meet its short term financial obligation as and when they fall due (liquidity ratios). 3. To carry out industrial analysis i.e compare the firm’s performance with the average industrial performance of the firm with that of individual competitors in the same industry. 4. For cross sectional analysis i.e compare the performance of the firm with that of individual competitors in the same industry. 5. For trend/time series analysis i.e evaluate the performance of the firm over time. 6. To establish the extent which the assets of the firm has been financed by fixed charge capital i.e use of gearing ratio 7. To predict the bankruptcy of the firm i.e use of selected ratios to determine the overall ratio usually called Z-score. The Z-score when compared with a pre-determined acceptable a Z-score will indicate the probability of the bankruptcy of the firm in future. Limitations of Ratios Ratios have the following weaknesses: 1. They ignore the size of the firm being compared e.g in cross-sectional analysis, the firm being compared might be of different size, technology and product diversification. 2. Effect of inflation: Ratio ignores the effect of inflation in performance e.g increase in sales might be due to increase in selling price caused by inflationary pressure in the economy. 3. Ratios ignore qualitative or non-quantifiable aspects of the firm e.g important assets such as corporate image, efficient management team, customer loyalty, quality of product, technological innovation etc are not captured in ratio analysis. 4. Ratios are computed only at one point in time i.e they are subject to frequent changes after computation e.g liquidity ratios will constantly change as the cash, debtors and stock level changes. 5. Monopolistic firms It is difficult to carry out industrial and cross-sectional analysis for monopolistic firms since they do not have competitors and they are the only firms in the whole industry e.g Telkom-Kenya, East Africa Brewery etc. 6. Historical Data – Ratios are computed in historical information or financial statement thus may be irrelevant in future decision-making of 7. Computation and interpretation Generally some ratios do not have an acceptable standard of computation. This may differ from one industry to another. E.g the return on investment may be computed as: Return on investment = EBIT or EAT Total assets Total assets 8. Different accounting policies – Different firms in the same industry use different accounting policies e.g methods of depreciation and stock valuation. This makes comparison difficult. Financial Forecasting Financial forecasting refers to determination of financial requirements of the firm in advance. This requires financial planning using budgets. The financial planning and forecasting will also determined the activities the firm should undertake in order to achieve its financial targets. Financial forecasting is important in the following ways: 1. Facilitate financial planning i.e determination of cash surplus or deficit that are likely to occur in future. 2. Facilitate control of expenditure. This will minimise wastage of financial resources in order to achieve financial targets. 3. It avoids surprise to the managers e.g any cash deficit is known well in advance thus the firm can plan for sources of short term funds such as bank drafts or short term loans. 4. Motivation to the employees – Financial forecasting using budgets and targets will enhance unity of purpose and objectives among employees who are determined to achieve the set target. Methods/Techniques of Financial Forecasting 1. Use of Cash Budgets A cash budget is a financial statement indicating: a) Sources of revenue and capital cash inflows b) How the inflows are expended to meets revenue and capital expenditure of the firm. c) Any anticipated cash deficit/surplus at any point during forecasting period. 2. Regression Analysis This is a statistical method which involves identification of dependant and independent variable to form a regression equation *y = a + bx) on which forecasting will be based. 3. Percentage of Sales Method This method involves expressing various balance sheet items that are directly related to sales as a percentage of sales. It involves the following steps: i) Identify various balance sheet items that are directly with sales this items include: a) Net fixed asset – If the current production capacity of the firm is full an increase in sales will require acquisition of new assets e.g. machinery to increase production. b) Current Asset – An increase in sales due to increased production will lead to increase in stock of raw materials, finished goods and work in progress. Increased credit sales will increase debtors while more cash will be required to buy more raw materials in cash. c) Current liabilities – Increased sales will lead to purchase of more raw materials d) Retained earnings – This will increase with sales if and only if, the firm is operating profitability and all net profits are not paid out as dividend. Note The increase in sales does not require an increase in ordinary share capital, preference share capital and debentures since long term capital is used to finance long term project. ii) Express the various balance sheet items varying with sales as percentage of sales e.g. assume for year 2002 stock and net fixed assets amount to Sh.12M and 18M respectively sales amount to Sh.40M. Therefore stock as percentage of sales” Stock = Fixed asset = iii) Determine the increase in total asset as a result of increase in sales e.g suppose sales increases from Sh.40 M to Sh.60 M during year 2003. The additional stock and net fixed asset required would be determined as follows: Increase in stock = % of sales x increase in sales = 30% (60 – 40) = Sh.6M Increase in fixed asset = % of sales x increase in sales = 45%(60 – 40) = Sh.9 M iv) Determine the total increase in assets which will be financed by: a) Spontaneous source of finance i.e increase in current liabilities Where Increase = % of sales x increase in sales b) Retained earnings for the forecasting period Retained earnings = Net profit – Dividend paid Net profit margin = Net profit Sales Therefore: Net profit = Net profit margin (%) x sales Note Generally Net profit margin is called after tax return on sales. Out of the total assets that are required as a result of increase in sales, the financing will come from the two sources identified. Any amount that cannot be met from the two sources will be borrowed externally on short term basis which will be a current liability. Assumptions underlying % of sales method The fundamental assumption underlying the use of % of sales method is that, there is no inflation in the economy i.e the increase in sales is caused by increase in production and not increase in selling price. Other assumptions include: 1. The firm is operating at full or 100% capacity. Therefore the increase in production will require acquisition of new fixed assets. 2. The firm will not issue new ordinary shares or debenture or preference shares thus this capital will remain constant during the forecasting period. 3. The relationship between balance sheet item and sales i.e balance sheet items as % of sales will be maintained during forecasting period. 4. The after tax, profit on sale or net profit margin will be achieved and shall remain constant during the forecasting period. Illustration The following is the balance sheet of XYZ Ltd as at 31st December 2002: Net fixed asset Current assets Financed by: Ordinary share capital Retained earnings 10% debentures Trade creditors Accrued expenses Sh.’000’ 300 100 400 100 70 150 50 30 400 Additional Information 1. The sales for year 2002 amounted to Sh.500,000. The sales will increase by 15% during year 2003 and 10% during year 2004. 2. The after tax return on sales is 12% which shall be maintained in future. 3. The company’s dividend payout ratio is 80%. This will be maintained during forecasting period. 4. Any additional financing from external sources will be affected through the issue of commercial paper by company. Required a) Determine the amount of external finance for 2 years upto 31st December 2004. b) Prepare a proforma balance as at 31 December 2004 Solution Identify various items in balance sheet directly with sales: Fixed Asset Current Asset Trade creditors Accrued expenses Net fixed assets = 300M x 100 = 60% 500M Current Assets = 100M x 100 = 20% 500M Trade creditors = 50 x 100 = 10% 500 Accrued expenses = 30 x 100 = 6% 500 c) Compute the increase in sales over the 2 years. Year 2002 sales = Year 2003 sales = Increase in sales in 2003-03-26= 632.5 – 500 = 132.5M d) Compute the amount of external requirement of the firm over the 2 years of forecasting period. i) Increase in F. Assets = % of sales x increase in sales = 60% x 132.5 = 79.5M ii) Increase in C. Assets = % of sales x increase in sales = 20% of 132.5 = 26.5M Total additional investment/asset required 106M Interpretation For the company to earn increase in sales of 132.5M it will have to acquire additional assets costing 106M. Sh.’000’ Additional investment/asset required 106,000 Less: Spontaneous source of finance Increase in creditors = % of sales x increase in sales = 132,500 x 10% (13,250) Increase in accrued expenses = % of sales x increase in sales = 132,500 x 6% (7,950) Less: Retained earnings during 2 years of operation (initial sources) Net profit for 2003 = Net profit margin x sales of 2003 = 12% of 575,000 = 69,000 Less: Dividend payable 80% of 69,000 = 55,200 (13,800) Net profit for 2004 = Net profit margin x sales of 2004 = 12% of 632,500 = 75,900 Less: dividend payable 80% of 75,900 = 60,720 (15,180) External financial needs (commercial paper) 55,820 Proforma Balance Sheet This refers to the projected balance sheet at the end of forecasting period. The items in the proforma balance which vary with sales would be determined in any of the following two ways: i) % of sales x sales at last year of forecasting (2004); or ii) Balance sheet item before forecasting plus increase in balance sheet item as a result of increase in sales. Proforma balance sheet as at 31st December 2004 Net fixed assets 60% x 632.5 or 300 + 79.5 Current Assets 20% x 632.5 or 100 + 26.5 Ordinary shares (will remain constant) Retained earning 70 + 13.8 + 15.18 10% debenture (remain constant) Trade creditor 10% x 632.5 or 50 + 13.25 Accrued expenses 6% x 632.5 or 30 + 7.95 External borrowing – commercial Shs. 379.50 126.50 506.00 100.00 98.98 150.00 63.25 37.95 55.82 506.00 REINFORCING QUESTIONS QUESTION ONE An extract from the finance statements of Kenyango Fisheries Ltd is shown below: Issued share capital: 150,000 ordinary shares of Sh.10 each fully paid 10% loan stock 1999 Share premium Revenue Reserve Capital employed Shs. 1,500,000 2,000,000 1,500,000 7,000,000 12,000,000 The profits after 30% tax is Sh.600,000. However, interest charge has not been deducted. Ordinary dividend payout ratio is 40%. The current market value of ordinary shares Shs.36 Required a) Return on capital employed b) Earnings per share c) Price earnings ratio d) Book value per share e) Gearing ratio f) Market to book value per share QUESTION TWO The following financial statements relate to the ABC Company: Assets Shs. Liabilities & Net worth Shs. Cash Debtors Stock Total current assets Net fixed assets 28,500 270,000 649,500 948,800 285,750 1,233,750 Trade creditors Notes payable (9%) Other current liabilities Long term debt (10%) Net worth 116,250 54,000 100,500 300,000 663,000 1,233,750 Income Statement for the year ended 31 March 1995 Sales Less cost of sales Gross profit Selling and administration expenses Earning before interest and tax Interest expense Estimated taxation (40%) Earnings after interest and tax Shs. 1,972,500 1,368,000 604,500 498,750 105,750 34,500 71,250 28,500 42,750 Required a) Calculate: i) Inventory turnover ratio; (3 marks) ii) Times interest earned ratio; (3 marks) iii) Total assets turnover; (3 marks) iv) Net profit margin (3 marks) (Note: Round your ratios to one decimal place) b) The ABC Company operates in an industry whose norms are as follows: Ratio Industry Norm Inventory turnover 6.2 times Times interest earned ratio 5.3 times Total assets turnover 2.2 times Net profit margin 3% Required Comment on the revelation made by the ratios you have computed in part (a) above when compared with the industry average. QUESTION THREE The following information has been extracted from the published accounts of Pesa Corporation Limited, a company quoted on the Nairobi Stock Exchange. Shs. Net profit after tax and interest 990,000 Less: dividends for the period 740,000 Transfer to reserves 250,000 Accumulated reserves brought forward 810,000 Reserves carried forward 1,060,000 Share capital (Sh.10 par value) Sh.8,000,000 Mar02ket price per share now 12% Required a) What is meant by a company quoted on the Nairobi Stock Exchange? (6 marks) b) Calculate for Pesa Corposation Limited the following ratios and indicate the importance of each to Miss Hisa, a Shareholder: i) Earnings per share. (4 marks) ii) Price earnings ratio (4 marks) iii) Dividend yield (4 marks) iv) Dividend cover (4 marks) (Total: 22 marks) QUESTION FOUR The executive director of Pesa Ltd has circulated the following information as part of board paper: Pesa Ltd. Financial Performance for the year ended 31 March: 1999 1998 i) ii) iii) iv) Return on investment Gross profit on sales Number of days credit given Administrative cost of sales 12% 25% 30 days 7% 10% 20% 45 days 10% Required a) Brief report on each of the above 4 ratios indicating the reservation, if any, you may have or judging them as improvement in performance. b) Tajiri Ltd has sales of Sh.20,000,000 in 1998. Beginning and closing stock was Sh.800,000 and Sh.2,200,000 respectively. G.P. margin is usually 25% of sales. Required i) Stock turnover ratio ii) Number of days stock held iii) Brief explanation on how the ratio computed in (i) above can be improved and financial Consequences of such action. 125