Managing financial resources and desicions
- Finance as a source.
- Finance as a resource.
How to start a business, develop & expand without source of funds?
This is the 1st question which you will get to your mind when you going to startup a business, develop or expand, as business management student we have to identify what are the source of finance to start up, develop or expand a business.
Then the 2nd step would be to recognize the method of obtaining them & identify what source of finance should use on what purposes.
In terms of market capitalisation, John Keells Holdings PLC is the largest listed conglomerate on the Colombo Stock Exchange. Other measures tell a similar tale; our group companies manage the largest number of hotel rooms in Sri Lanka, own the country's largest privately-owned transportation business and hold leading positions in Sri Lanka's key industries: tea, food and beverage manufacture and distribution, logistics, real estate, banking and information technology. Our investment in Sri Lanka is so deep and widely diversified that our stock price is sometimes used by international financial analysts as a benchmark of the country's economy.
For over 130 years, we have remained proudly independent, forcefully committed to private ownership and private dividends, and relying on foresight, expertise and integrity for success and growth. Having a significant portion of our shares held by foreign investors, our Group has also partnered with some of the world's finest business establishments, from DHL to American Airlines, from IBM to Toshiba, and from Thomas Cook to Kuoni. For emerging-market investors and those seeking a business partner in Sri Lanka, John Keells is an option that simply cannot be ignored.
Building businesses that are leaders in the region.
We are passionate about :
- Changing constantly, re-inventing and evolving
- Striving to get things right the first time
- Doing the right things always
- Constantly raising the bar
- Fostering a great place to work
- Building strong relationships based on openness and trust
Source Of Finance
The assets of a business are financed from a variety of sources, which can be categorized into either:
- Short-term, medium-term and long term,
- Internal source of finance & External source of finance.
Source of finance is the most crucial point when it's come to the point of starting up a business, development & expansion of the business as I mention above.
Short- term finance is finance repayable within 12months.
- Bank overdrafts and short-term loans
- Trade credit
- Bill finance
- Acceptance credits
- Commercial paper
Medium-term finance is finance provided for a period of between 1 and about 5years
- Bank Loans.
- Lease finance and hire purchase finance.
Long term sources of finance are those that are needed over a longer period of time generally over a year.
- Owner's capital.
- Long-term debt.
Source of Finance
Internal Source of Finance
These are the sources of finance that come from the business assets or activities.
If I explain it in simple terms it is the profit that the organization kept and not spent, such as use within the business to help with buying new machinery, vehicles, and computers etc, helps us to run the day to day business.
Sale of Assets
Business balance sheets usually have several fixed assets on them. A fixed asset is anything that is not used up in the production of the good or service concerned - land, buildings, fixtures and fittings, machinery, vehicles and so on. At times, one or more of these fixed assets may be surplus to requirements and can be sold.
Alternatively, a business may desperately need to find some cash so it decides to stop offering certain products or services and because of that can sell some of its fixed assets. Hence, by selling fixed assets, business can use them as a source of finance. Selling its fixed assets, therefore, has an effect on the potential capacity of the business - the amount it can produce.
This is the short-term capital or finance that a business keeps. Working capital is the money used to pay for the everyday trading activities carried out by the business - stationery needs, staff salaries and wages, rent, energy bills, payments for supplies and so on. Working capital is defined as:
Working capital = current assets - current liabilities
Current assets are short term sources of finance such as stocks, debtors and cash - the amount of cash and cash equivalents - the business has at any one time. Cash is cash in hand and deposits payable on demand (e.g. current accounts). Cash equivalents are short term and highly liquid investments which are easily and immediately convertible into cash.
Current liabilities are short term requirements for cash including trade creditors, expense creditors, tax owing, dividends owing - the amount of money the business owes to other people/groups/businesses at any one time that needs to be repaid within the next month or so.
External Source of Finance
This is finance that comes from outside the business. It involves the business owing money to outside individual or institution. There are two main external sources.
- Ownership Capital.
- Non Ownership Capital.
In this context, 'owners' refers to those people/institutions who are shareholders. Sole traders and partnerships do-not have shareholders - the individual or the partners are the owners of the business but do not hold shares. Shares are units of investment in a limited company, whether it is a public or private limited company. Shares are generally broken down into two categories:
Ordinary shares are also known as equity shares and they are the most common form of share. An ordinary share gives the right to its owner to share in the profits of the company (dividends) and to vote at general meetings of the company.
Since the profits of companies can vary wildly from year to year, so can the dividends paid to ordinary shareholders. In bad years, dividends may be nothing whereas in good years they may be substantial. Some businesses may choose to pay out a dividend even if it has had a difficult trading year and has made a loss! (How do you think this is possible and why might a business choose to do this?)
Ordinary shareholders can vote on all of the issues raised at a general meeting of the company including:
- Appointment of directors and auditors
- Whether to accept the dividend proposed
- Changes to the company's constitution (memorandum and articles of association)
Preference shares offer their owners preferences over ordinary shareholders. There are two major differences between ordinary and preference shares:
- Preference shareholders are often entitled to a fixed dividend even when ordinary shareholders are not.
- Preference shareholders cannot normally vote at general meetings.
Whilst the following sources of finance are important, they are not classed as Ownership Capital - Debenture holders are not shareholders, nor are banks who lend money or creditors. Only shareholders are owners of the company.
Debentures are loans that are usually secured and are said to have either fixed or floating charges with them.
A secured debenture is one that is specifically tied to the financing of a particular asset such as a building or a machine. Then, just like a mortgage for a private house, the debenture holder has a legal interest in that asset and the company cannot dispose of it unless the debenture holder agrees. If the debenture is for land and/or buildings it can be called a mortgage debenture.
Debenture holders have the right to receive their interest payments before any dividend is payable to shareholders and, most importantly, even if a company makes a loss, it still has to pay its interest charges.
If the business fails, the debenture holders will be preferential creditors and will be entitled to the repayment of some or all of their money before the shareholders receives anything.
The term debenture is a strictly legal term but there are other forms of loan or loan stock. A loan is for a fixed amount with a fixed repayment schedule and may appear on a balance sheet with a specific name telling the reader exactly what the loan is and its main details.
Many companies have the need for external finance but not necessarily on a long-term basis. A company might have small cash flow problems from time to time but such problems don't call for the need for a formal long-term loan. Under these circumstances, a company will often go to its bank and arrange an overdraft. Bank overdrafts are given on current accounts and the good point is that the interest payable on them is calculated on a daily basis. So if the company borrows only a small amount, it only pays a little bit of interest.
Hire Purchase is a method of acquiring assets without having to invest the full amount in buying them. Typically, a hire purchase agreement allows the hire purchaser sole use of an asset for a period after which they have the right to buy them, often for a small or nominal amount. The benefit of this system is that companies gain immediate use of the asset without having to pay a large amount for it or without having to borrow a large amount.
Lines of Credit from Creditors
This source of finance really belongs under the heading of working capital management since it refers to short term credit. By a 'line of credit' we mean that a creditor, such as a supplier of raw materials, will allow us to buy goods now and pay for them later. Why do we include lines of credit as a source of finance? Well, if we manage our creditors carefully we can use the line of credit they provide for us to finance other parts of our business
Grants can be an attractive aspect of a company's financing structure. If a company has a specific issue that it wants or needs to deal with then it could find that there are grants available from local councils and other bodies that will help to pay for it.
Factoring allows you to raise finance based on the value of your outstanding invoices. Factoring also gives you the opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems. Once you have set up a factoring arrangement with a Factor, it works this way:
Once you make a sale, you invoice your customer and send a copy of the invoice to the factor and most factoring arrangements require you to factor all your sales. The factor pays you a set proportion of the invoice value within a pre-arranged time - typically, most factors offer you 80-85% of an invoice's value within 24 hours.
The major advantage of factoring is that you receive the majority of the cash from debtors within 24 hours rather than a week, three weeks or even longer
Leasing is a contract between the leasing company, the lesser, and the customer (the lessee). The leasing company buys and owns the asset that the lessee requires. The customer hires the asset from the leasing company and pays rental over a pre-determined period for the use of the asset. There are two types of leases:
- Finance Leases
- Operating Leases
Under a finance lease the rental covers virtually all of the costs of the asset therefore the value of the rental is equal to or greater than 90% of the cost of the asset. The leasing company claims writing down allowances, whilst the customer can claim both tax relief and VAT on rentals paid.
The lease will not run for the full life of the asset and the lessee will not be liable for its full value. The lesser or the original manufacturer or supplier will assume the residual risk. This type of lease is normally only used when the asset has a probable resale value, for instance, aircraft or vehicles.
Identify the monetary policy and the financial market
- Monetary Policy.
- Financial Market.
Core objective of the monetary policy is economic & price stability of a country, which is managed by central bank of a country. , i.e. actions to influence cost and availability of money, to attain this objective. The Monetary Law Act (MLA), the legislation under which the Central Bank has been established and operates, has provided a wide range of instruments for monetary management. At present, the monetary policy framework of the country places greater reliance on market based policy instruments and the use of market forces to achieve the desired objectives.
Financial market is a mechanism that allows people to buy and sell financial securities such as stokes & bonds
- Organizations that facilitate the trade in financial products. I.e. Stock exchanges facilitate the trade in stocks, bonds and warrants.
- The coming together of buyers and sellers to trade financial products. i.e. stocks and shares are traded between buyers and sellers in a number of ways including: the use of stock exchanges; directly between buyers and sellers etc.
- In academia, students of finance will use both meanings but students of economics will only use the second meaning. Financial markets can be domestic or they can be international.
John Keells - Source of Finance 2008/2009
The Sources of finance statistically for Financial Year 2008/2009
- Internal Source of Finance
- External Source of Finance
Analyze the Statistical data of John Keells Holdings 2008/2009.
Internal Source of Finance
- Revenue Reserves
- Profit on sale of property, plant & equipment
Internal Source of Finance 2008
Internal Source of Finance 2009
Evaluation of Internal Source of Finance in 2008/2009
External Source of Finance
- Stated Capital
- Interest bearing borrowings
- Bank overdrafts
- Short time borrowings
External Source of Finance 2009
Evaluation of External Source of Finance
Appropriate Source of Finance for a Business Project
The relationship between risk & return this concept states that an investor or a company takes on more risk only if a high return is offered in compensation. Return refers to the financial rewards gained as a result making investment.
The time value of money - is a concept in corporate finance & it's relevant to both companies & investors. In a wider context it is relevant to anyone expecting to pay or receive money over a period of time.
The Role of a Financial Manager
The role of the financial manager as the person central to a company financing, investment decisions.
- Maximization of profits
- Maximization of sales
- Social Responsibility
How is Shareholder Wealth Maximized?
NPV = Net Present Value
SHW = Shareholder Wealth Maximized
While managers should make decisions that consistent with the objectives of maximizing
The Concept of capital structure, which is the rate of return required on invested funds, plays an important role in corporate finance theory and practice. A companies cost of capital used as the discount rate in the investment appraisal process when using techniques such as net present value and internal rate of return refers to financial rewards gained as a result of making an investment.
Key points for cost of capital.
- Equity Capital
- Debt capital
Capital raised from owners. Equity capial goes under long-term source of finance, This is different from debt capital which is money raised by incurring debt through the issuance of debentures & other types of bonds. Owners can choose to sell equity in the company, in the form of stocks, to investors. This is usually done through a direct offering to the public through an underwriter like an investment bank. Equity capital is used to get companies off the ground.
Capital issued through the issuance of bonds. Although most of the time the capital raised is money, it could be could be other values as well. The capital raised must be paid back to those who finance the debt. Both private companies and government can raise debt capital this way.
If we assume that a company is rational, it will seek raise capital by the cheapest & most efficient methods, thereby minimizing its average cost of capital. This will have the effects of increasing the net present value of the companies projects & hence its market value. For a company to try to minimize its average cost of capital, it's first requires information on the cost associated with the different sources of finance available to it.
We consider the impact of gearing on the cost capital of a company. The advantage to equity holders of using debt arises from tax shield on debt, that is, the benefit to share holders deriving from the treatment of debt for tax as being deductible in arriving at an entity's taxable profits. High gearing means that debt represents a high proportion of the financing of entities assets.
Second, It needs to know how to combine these different sources of finance in order to reach its optimal capital structure.
The main disadvantage of increasing debt is that additional intrest payable reduces the earnings available to share holders, thereby increasing the risk of their investment & consequently increasing the cost of capital, as new investors to compensate for the increased financial risk.
If you are still doubtful as to why increasing debt increase risk, you must appreciate that debt has priority & also that coupon ratesv of debt must be met. Thus if an entity hits bad times & profits fall significantly losses ensure, there may be little if any return for shareholders. Clearly, therefore, the level of an entities gearing can affect both earnings per share & dividend policy decisions.
Capital gearing is concerned with the level of debt in a companies capital structure.
Weighted Average Cost of Capital
The WACC assumes that when a company raises finance, the cash raised is added in to a pool of funds when a potential investment project is identified, the project is assumed to be financed from the pool, rather than from any specific fund raising operation. If the mix of equity, debt & preference shares within the pool of funds is assumed to remain constant over time, the discount rate to apply in appraising the project would be the cost of the pool of funds, that is, the weighted average cost of capital. The WACC can be found by calculating the cost of each long term source of finance weighted by the proportions of finance used.
Finance as Resource
Cost of different source of finance
Share capital (Dividends in cash)
- Dividend Cost
- Dividends are as significant a source of income as a salary is for an employee.
- The cost of providing share holders or owners with information about the performance of the business. This is considerable in the case of a PLC
- It includes the cost of financial reports, audit fees & administrative cost of complying with legal & stock exchange requirements for disclosure of information to shareholders
- If funds are not needed immediately there may be a cost associated with investing them (bank charges, commission, adviser's fees) until they are wanted for use in the operation of the business.
- Financial & non financial costs arise from the relationship between the borrower & the lender. The lender will require the borrower to provide it with regular information about the performance of the business, and this will have a cost as well as creating the uncomfortable feeling of being watched
- Opportunity Cost
Government grants may appear to be without cost. However there may be well opportunity cost associated with eligibility for a grant. Being based in a certain region for example, may deprive a business of certain sales opportunities. There will also be certain administrative costs to cover applying for the grant & filling in forms on a regular basis to reassure the grant giving authority that the business is still eligible to receive it.
- A business sales are only generated by incurring costs such as wages, rent, materials, electricity and so on
- Business have to pay tax on their earnings
- Dividends are a cost of retained earnings as well as a cost of share capital. If dividends are not paid, shareholders goodwill will be lost.
- Opportunity Cost
Importance of Financial Planning
- The financial manager will need to plan ensure that enough funding is available at the right time to meet the needs of the organization for short, medium & long term capital.
- In the short term, funds may be needed to pay for purchases of stocks, or to smooth out changes in debtors, creditors & cash the financial manager is here ensuring that working capital requirements are met.
- In the medium or long term, the organization may have planned purchases of fixed assets such as plant & equipment, for which the financial manager must ensure that funding, is available.
Overtrading happens when a business tries to do too much too quickly with too little long term capital, so that it is trying to support too large a volume of trade with the capital resources as its disposal. Even if an overtrading business operates at a profit, it could easily run into series trouble because it is short of money. Such liquidity troubles stem from the fact that it does not have enough capital to provide the cash to pay its debts as they fall due.
Other causes of overtrading are as follows
- When a business repays a loan, it often replaces the old loan with a new one. However, a business might repay a loan without replacing it, with the consequences that it has less long term capital finance its current level of operations.
- A business might be profitable, but in a period of inflation, it's retained profits might be insufficient to pay for replacement fixed assets & stoks , which now cost more hence of inflation. The business would then rely increasingly on credit & eventually find it self unable to support its current volume of trading with a capital base that has fallen in real terms.
Symptoms of Overtrading
- There is a rapid increase in turnover
- There is a rapid increase in the volume of current assets & possibly also fixed assets. The rate at which stock & debtors are turned in to cash might slow down, in which case the rate of increases in stocks & debtors would be even greater that the rate of increase in sales.
- There is only a small increase in proprietors capital (perhaps through retained profit) most of the increase in assets is financed by the following methods of credit.
- Trade Credit
- A bank overdraft
Management of Debtors
- Formulating a credit policy
- The debt collection policy
- Discount policies
- Credit Control
The Management of Creditors
- Trade Credit
- Other Creditors
Management of Stocks
- Stock Cost
The Management of Cash
Cash Flow Problems
- Making Losses
- Seasonal Business
Methods of Easing Cash Shortages
Postponing capital expenditure.
- Accelerating cash inflows which would otherwise be expected in a latter period.
- Reversing pas investment decision by selling assets previously acquired.
- Negotiating a reduction in cash outflows, so as to postpone or even reduce payments.
- Large companies rely heavily on the financial & currency markets. These markets are volatile, with interest rates & foreign exchange rates changing continually & by significant amounts. To manage cash & currency efficiently, many large companies have set up a separate treasury department.
- A treasury department, even in a very large organization, is likely to be quite small, with perhaps a staff of three to six qualified accountants, bankers or corporate treasures working under the treasure. In some cases, where the company or organization handles very large amounts of cash or foreign currency dealings & often has large cash surplus the treasury department might a little bigger.
The Value of Having a Specialist Treasury Department
The following are advantages of having a centralized specialist
- Centralized management
Avoids having a mix of cash surpluses & overdrafts in different localized bank accounts.
- Facilities bulk cash flows, so that lower bank charges can be negotiated.
- Large volumes of cash are available to invest giving better short term investment opportunities.
- Any borrowings can be arranged in bulk, at lower interest rates than for small borrowings, & perhaps on the Eurocurrency.
- A specialist treasury department will employ experts with knowledge of dealing in forward contracts.
Information Needs of Different Decision Makers
What is Decision Making?
- Decision making is the process of sufficiently reducing uncertainty and doubt about alternatives to allow a reasonable choice to be made from among them.
- This definition stresses the information gathering function of decision making.
- It should be noted here that uncertainty is reduced rather than eliminated.
- Very few decisions are made with absolute certainty because complete knowledge about all the alternatives is seldom possible. Thus, every decision involves a certain amount of risk.
The Decision Making Process
- Define and clarify the issue.
- Gather all the facts and understand their causes.
- Think about or brainstorm possible options and solutions.
- Consider and compare the pros and cons of each option - consult if necessary
- Select the best option and implement it.
- Explain your decision to those involved and affected, and follow up to ensure proper and effective implementation.
- In order to make decisions we need information.
The Importance of Financial Information
- Financial information is the Heart of Business Management.
- There are significant inseparable relationship between Finance and every other organizational activity.
- Almost all business activities directly or indirectly involve the acquisition of use of funds.
E.g. Buying a new machine replacing an old machine to improve capacity -it needs funds.
- The finance function of raising and using the money has a significant effect on other functions.
- If a company is in a good financial position, it can expand all business activities words achieving organizational goals.
Sources of Financial Information
- Financial reports provide information in numbers ,words and pictures about the financial performance of organization.
- Financial statements, income tax filings
- Cash flow and financial position of a venture. ...
Impact on The Finance on Finance Statement
The impact of financial are mainly forced through the double entry system of the changes made in assets, liabilities, profit loss and equity.
These transactions would effect on the financial statements as trade proft & loss account balance sheet, cash flow statement etc,
- Increase the inflow of the cash flow statement.
- The value which the asset was sold.
- Reflects a profit, it would indicate in other revenue as gain from sales of equity & increase the amount.
- If reflects as a loss this would be deducted from the revenue.
- The value of the
Cost of Capital
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