Financial Management

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Key learning system questions

CS101625

Topics

● The finance function● The treasury function● Financial markets● Share price volatility● Efficient market hypothesis● Investor ratios● Working capital management strategies

Examination of the acquisition and deployment of financial resources

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In a large entity the finance function may be split between treasury and financial control, with both functions reporting to the chief financial officer

Financial control

Preparation of financial reports to stakeholders Preparation and control of budgets Management of pricing policies Preparation of investment appraisals Management of working capital

Balanced scorecard

Emphasises the need to provide information that addresses all relevant areas of performance in an objective and unbiased fashion

Customer satisfaction Enhancement of internal processes Financial Learning and growth

Benchmarking

Used to measure relative performance against finance functions in other entities, or between subsidiary entities

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The finance function

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Treasury is concerned with the relationship between the entity and its financial stakeholders

Main functions

Managing relationships with the banks Ensuring the entity has liquid funds and invests

surplus funds Identifying sources of funds and raising capital Managing interest rate risks Dealing in foreign exchange markets Managing foreign exchange risks

In larger entities, treasury will usually be centralised at head office, providing a service to all the various units of the entity and thereby economies of scaleTreasurers require specialist skills to be able to handle effectively e.g.:

An ever-growing range of capital instruments Hedging of foreign exchange risk Advising permissible ways of reducing overall tax

liability

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The treasury function

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Advantages of profit centre

Individual business units of the entity can be charged a market rate for services provided, making their operating costs more realistic

Treasurer is motivated to provide services effectively and economically to ensure a profit is made at the market rate e.g. managing hedging activities

Disadvantages of profit centre

Temptation to speculate, increasing exposure to risk Management time is unduly spent in arguments with

business units over charges for services Additional administrative costs may be excessive

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The treasury function

Cost centre or profit centre

Treasury activities may be accounted for simply as a cost centre, but in some entities it is treated as a business in its own right, seeking to make profit out of its activities

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Money markets

Markets for trading in relatively short-dated funds, usually less than one year. Dominated by banks and other financial institutionsEncompasses:

Inter-bank and inter-company loans Local authority debt instruments Bills of exchange Certificates of deposit Commercial paper Eurocurrency

Capital markets

Markets for trading in longer-dated securities such as shares and bonds. Examples of capital markets would be the Stock Exchange, the bond market and the Eurobond marketCapital markets have two main functions:

They provide a primary market for raising new capital, usually in the form of equity

They also allow trading in existing securities – the secondary market

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Financial markets

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Advantages of flotation

Provides more accurate valuation of the entity than previously possible

Realisation of paper profits Raise profile of entity Raise capital for future investment Employee share schemes more accessible

Disadvantages of flotation

Costly for a small entity Small entities perceived as risky, leading investors to

require higher returns Making enough shares available to market Reporting requirements more stringent Stock Exchange rules are stringent

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Financial markets

Flotation

The process of making shares available to investors by obtaining a quotation on the Stock Exchange

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Fundamental analysis

Analysis of external and internal influences upon the operations of an entity with a view to assisting in investment decisionsInformation accessed might include:

Fiscal/monetary policy Financial statements Industry trends Competitor analysis

The analysis will conclude that the share is overvalued or undervalued

Technical analysis/Chartism

The analysis of past movements in the prices of financial instrumentsChartists believe future prices can be charted and a pattern identified that can be used to predict future pricesOn the available evidence, theorists have developed the idea that the progress of a particular share is a ‘random walk’, rendering the achievement of consistently superior returns an impossibility

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Share price volatility

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Weak form

Current share price reflects all the information that could be gleaned from a study of past share prices

Semi-strong form

Current share price reflects all historical information, and all other published information

Strong form

Current share price incorporates all information, including non-published information

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Efficient market hypothesis

The hypothesis that, in an efficient market, prices fully and instantaneously reflect all available information. The main implications are:

The timing of issues of bonds or equity is not critical, as the prices quoted in the market are ‘fair’ An entity cannot mislead the markets by adopting ‘creative accounting’ techniques Share prices will reflect the net present value of the entity’s future cash flows

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Market price per share [mps]

The market price is the ex-dividend market price

Earnings per share [eps]

Net profit attributable to ordinary shareholders divided by the number of shares in issue

Price earnings ratio [P/E]

Market price per share (MPS)Earnings per share (EPS)

Earnings yield

Reciprocal of the P/E ratioEarnings per share (EPS)

Market price per share (MPS)

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Investor ratios

Remember this!

The net profit must be after deduction of interest and tax but before deduction of preference dividends

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Dividend payout rate

Dividend per share (DPS)Earnings per share (EPS)

Dividend yield

Indicates the return on capital investment relative to price

Dividend per share (DPS)Market price per share (MPS)

Dividend cover

Measures the ability of the entity to maintain the existing level of dividend

Earnings per share (EPS)Dividend per share (DPS)

Book value per share

Indicates the asset backing of the investment

Shareholders’ fundsNumber of equity shares in issue at balance sheet date

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Investor ratios

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Working capital management strategies

Investment decision

An aggressive policy involves holding low levels of stocks and cash. This minimises costs, but the entity may not be able to respond rapidly to increased demand for sales

A conservative policy involves holding higher levels of stock and cash

Financing decision

An aggressive policy involves financing part of the permanent asset base with short-term debt. This provides the highest expected return but is very risky

A conservative policy has permanent financing (long-term debt plus equity) exceeding the permanent asset base

An entity’s working capital policy is a function of two decisions: The appropriate level of investment in, and mix of current assets to be decided upon, for a set level of activity The methods of financing this investment

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Working capital management strategies

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Current ratio

Current assetsCurrent liabilities

Quick ratio

Current assets − inventoriesCurrent liabilities

Operating cycle

The length of time between the entity’s outlay on raw materials, wages and other expenditures, and the inflow of cash from the sale of goods

Shortening the operating cycle

Reduce raw materials inventories Delay payments to suppliers Reduce work in progress Reduce finished goods inventories Reduce credit given to customers

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Working capital management strategies

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First level heading

Calculation of the operating cycle

Financial Management

Working capital management strategies

Raw materials days average value of raw materials holdings=

Raw materials purchases

×365

Production days average value of work in progress Cost

=×365

of goods sold

Finished goods days average value of finished goods holdin=

ggs Cost of good sold

×365

Receivables days average receivables Credit sales

=×365

Payables days average trade payables credit puchases

=×365

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First level heading

Overtrading

The situation of operating an entity with insufficient long-term capital resources to support the current volume of business

Causes of overtrading

Over expansion is one of the main causes, hence the alternative term ‘under capitalisation’Permanent increases in working capital requirements should be financed from additional long-term capital

Symptoms of overtrading

A fall in liquidity ratios A rapid increase in revenue Increase in revenue to non-current assets ratio Increase in inventories in relation to revenues Increase in receivables Increase in short-term borrowings Decrease in cash balances Increase in gearing Profit margin decreases

Financial Management

Working capital management strategies

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