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FIA-Paper FFM

Foundations in Financial

Management

For exams in 2015

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ExPress Notes FIA – Foundations of Financial Management

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Contents

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1. Cash receipts and payments 7

2. Cash balances 12

3. Working capital management 17

4. Credit granting 23

5. Debt collection 26

6. Sources of finance 29

7. Short-term decisions 37

8. Capital investments 44

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Chapter 1

Cash Receipts and Payments

KEY KNOWLEDGE

Cash and Cash Flow

Cash comprises both cash and bank deposits payable on demand and also cash equivalents

which are defined as “short-term, highly liquid investments that are readily convertible to

known amounts of cash and which are subject to an insignificant risk of changes in value”. The amount of cash held by a business at a point in time is found in the balance sheet

under “current assets”.

Cash flow refers to the movement of cash in and out of a business over a period of time.

This information is found in a statement of cash flows, which is a primary financial

statement. Such a statement is useful in that it is structured to show the extent to which a

company is able to generate net cash from its operating activities and how such net cash is

used in investing and/or financing activities.

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Examples of cash receipts and payments include:

Operating: cash flow from trading activities, e.g. cash received from customers, cash

paid to suppliers and to employees;

Financing: Cash paid on interest;

Taxation: Actual cash paid during the year;

Investing: Cash flows on purchase or sale of non-current assets;

Financing: Cash flows on raising or redeeming long-term finance, such as shares or

debentures; dividends can also be included here.

Cash flow accounting

The relationship between cash flow accounting and accounting for income and expenditure

lies in the use of accruals and decisions as to the capitalisation of expenditures. Cash flow

accounting dispenses with the “matching” principle in financial accounting.

As the cash flow statement is derived from the income statement and the balance sheet,

adjustments need to be made to remove the effects of accrual accounting so that the cash

movements can be made more transparent.

Importance of cash flow management

Planning, tracking and collecting cash are all important because cash PAYS THE BILLS.

The failure to pay bills puts a company in danger of bankruptcy.

What begins as a condition of illiquidity can evolve into insolvency.

Cash flow is vital to going concern and commercial success, regardless of profitability.

Having enough cash on hand is therefore critical in being able to settle obligations when

they fall due (both planned and unforeseen); however, holding too much cash in a business

is costly. There is a trade-off between liquidity and profitability.

Determining the “optimal” amount of cash to hold becomes the challenge facing managers. Cash management functions are typically handled by treasury, and include:

Collecting cash from customers (as soon as possible);

Disbursing cash to suppliers (as late as practically possible);

Investing short-term cash surpluses in low-risk interest-bearing investments (such as

Treasury bills) in order to generate additional income for the company;

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KEY KNOWLEDGE

Cash budgets

A cash budget is an estimate of the receipt and payments of cash in and out of the business

for a defined future period based on existing conditions and operating assumptions.

By understanding the nature and timing of cash receipts and expenditures, management is

better able to influence them and plan/budget for the future. The purpose is to ensure that

the company has sufficient cash on-hand to avoid missing disbursements when they fall

due.

There are statistical techniques which assist management in planning cash levels.

Cash budget/forecast

Businesses should develop their cash budget/forecast formats in a way which best reflects

the type of business conducted and transactions generated. Such tools serve as a

mechanism for monitoring and control.

KEY KNOWLEDGE

Cash forecasting

A cash forecast format/structure is shown below, in this case covering 6 months. Both

operating and non-operating cash flows are included.

The bottom of the table shows opening and closing cash balances.

Cash Budget Jan Feb Mar Apr May June

$ $ $ $ $ $

Receipts

Credit sales

Cash sales

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Equipment disposal

Total

Payments

Materials

Labour

Variable Overheads

Fixed Costs

Equipment acquisition

Overdraft Interest

Current account interest

Income tax

Total

Net cash m-o-m variance

Cash balance at month-end

Completing the table above requires forecast assumptions relating to volume of

production/sales as well as prices and costs.

EXAMPLE

Unit Selling Price (on credit) $/unit payment terms given to credit customers:

Unit Selling Price (cash) $/unit discount granted to cash customers

Unit Variable Cost:

Material $/unit payment terms taken from suppliers:

Labour $/unit paid in the month

Overheads $/unit

Fixed Costs $/month

< Actual Forecast > Sales/Production volumes Nov Dec Jan Feb Mar Apr May June Total

actuals/forecast

Production (units)

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Credit sales (units)

Cash sales (units)

Capex forecast New equipment acquisition

Old equipment sale

Inventory levels required +/- planned

Bank interest at % pa Bank interest at % pa

KEY KNOWLEDGE

Sensitivity of variables

Preparing cash forecasts requires assumptions, and assumptions are exposed to uncertainty.

This means that the actual amount of cash received or disbursed may vary from that budgeted.

Budgeting processes therefore include the testing of assumptions for sensitivity. If, for example, wage levels rise by 10% (instead of 5%), then what effect will this have on the

level of cash? Same question with regard to materials (and overheads and prices, etc.).

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Chapter 2

Cash Balances

KEY KNOWLEDGE

Investing and financing

Cash surpluses and deficits occur as a result in timing differences between the receipt of

cash and the necessity to settle obligations punctually. If a deficit results, then the company

should have overdraft faciltities in place with a bank.

If deficits prove to be longer-term in nature, then the company should consider short-term

borrowing, or possibly, longer-term forms of finance if the deficit is expected to persist.

In the event of surpluses, these can be invested (e.g. T-bills mentioned earlier); other types

of investments include:

Bank deposits DEM

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Money- market deposits

Certificates of deposit

Government bonds

Local authority stock

KEY KNOWLEDGE

Optimum liquidity levels

Cash management models Holding too much cash is sub-optimal. A business with permanently excessive balances (not

required for operating purposes) should be paid out to shareholders.

Two techniques for monitoring the optimal level of cash are discussed below.

Baumol model

This model was developed several decades ago. One can think of:

cash as inventory;

selling marketable securities transactions as ordering costs;

Interest rate, representing the opportunity cost of holding cash

By determining the following:

N = the total annual amount of cash required

F = the cost of each securities transaction (sale)

i = the annual interest rate obtainable on the investment in securities

then

Z = the amount of cash that needs to be raised per transaction

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The optimal level of Z = √2NF / i

The main drawback of the Baumol method is that it makes the simplified (and unrealistic)

assumption that cash disbursements are constant and predictable.

Miller-Orr

A second method addresses the issue of optimal cash balances and attempts to improve on

the drawback of the Baumol model.

Miller-Orr is based on statistically tracking the variability of net daily cash flows; this is

denoted as

V = Variability of net daily cash flows (variance or sigma squared)

The other variables are:

F = Cost of each securities transaction;

k = Interest rate per day on marketable securities; and

LL = Lower cash limit, which needs to be established by management

Based on the above, the cash balance return point (R) is

________ R = 3√3xFxV/4k + LL

The level R is the cash balance which must be restored when either the upper limit (UL) or

lower limit (LL) have been reached.

Once R is known, then the upper cash limit, or UL, is calculated thus:

UL = 3 R – 2(LL)

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KEY KNOWLEDGE

Working capital needs and funding strategies

The level of working capital required in a business depends on the industry it operates in,

the length of its working capital cycle and the range of funding options open to it. Retaining

flexibility is a key requirement. While overdraft financing is expensive, it does permit

spontaneous drawdowns and rapid repayments.

Funding strategies are guided by the following considerations:

Temporary cash shortages can be funded short-term, while

Permanent shortages should be funded long-term

The “matching principle” can be applied to the assets being financed:

Fixed assets are generally funded long-term, along with the permanent portion of

current assets (e.g. buffer stocks);

Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal

upswings in inventories / receivables)

Cash surpluses, on the other hand, can be dealt with based on whether they are:

Short-term: in this case they may be invested in short-term, low-risk, liquid

investments (e.g. Treasury bills or marketable securities);

Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc.

KEY KNOWLEDGE

Liquidity ratios

The relationship between current assets and current liabilities is used as a measure of

liquidity in the firm:

Current ratio = Current assets Current liabilities DE

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· FIA-Paper FFM Foundations in Financial ... We are very pleased that you have downloaded a copy of our ExPress notes for this paper ... question …