ABMF2103 Principles of Finance

Chapter 1: Introduction to Financial Management Learning outcomes At the end of this chapter you should be able to: Differentiate between accounting and finance Explain financial management Discuss the roles of financial managers in a firm Define cash, cash flow and funds Outline the various sources and applications of finance Explain the importance of cash flow management and its impact on liquidity and company survival Explain the importance of cash of sustainable growth of such organization Define cash accounting and accrual accounting Reconcile cash flow and profit Explain working capital and cash operating cycle Explain overtrading and overcapitalization

1.1

The Difference between Accounting and Finance

Accounting is a record-keeping system, which has been invented to reflect the financial operation of a firm. The record can be used periodically to produce financial statements such as Balance Sheet, Income Statement and Cash Flow Statement. These statements reflect the firms standing and performance. Finance consists of three important aspects: i. Money and capital markets. ii. Investment decisions of individuals and financial institutions as they choose securities for their investment portfolios. iii. Financial management / business finance the actual management of the firm.

Although account and finance do not involves the same aspects, they are closely related. To have a good financial management, many accounting information are required such as financial statement and financial ratio analysis. Source: OUM, Introductory Finance BDPW3103

1.2

Financial Management

Financial Management refers to how we manage money to get maximum return from investments. It is concerned with the acquisition, financing and management of assets

with some overall goals in mind. A good financial planning and management will increase the value of a firm. OUM, Introductory Finance BDPW3103 Profit Maximization vs Wealth Maximization Profit maximization Short term in nature Profit maximization, major emphasizes is on profit. mostly concerned about short term benefits. A short term horizon can fulfill objective of earning profit but may not help in creating wealth. Wealth maximization - maximizing the value of the firm through maximizing the price of the firms common stock. Long term in nature concentrate on various other aspects like increasing sales, developing goodwill, customer service, corporate responsibility for the purpose of capturing more market share which will take care of profitability. priority to value creation leads to better and true evaluation of business e.g., under wealth maximization, more importance is given to cash flows rather than profitability. The objectives of the Firm / Goals of the Corporation The most important goal of most corporations is:

Maximizing Shareholder wealth

(a)

The firms stock price is dependent on the following factors:Cash Flow The expectation that the firm will generate cash in future. Financial managers concentrate on increasing cash inflows and decreasing cash outflows. The higher the expected cash inflows and the lower the expected cash outflows, the higher the firms stock price will be. Timing of cash flow Page | 2

(b)

Refers to when the firms expect to receive cash and when they expect to pay out cash. The sooner the cash inflows and the later the cash outflows, the higher the firms stock price will be.

(c)

Risk of expected cash flows. The less certain owners and investors are about a firms expected future cash flows, the lower they will value the company. As risk increased, stock prices goes down and vice versa. Corporate Social Responsibility(CSR) welfare of their employee, customers and the communities.

1.3
i.

The Financial Managers Responsibilities

Forecasting and planning. The financial manager must interact with other executives as they look ahead and lay the plans which will shape the firms future position. Major Investment and financing decisions. A successful firm usually has rapid growth in sales, which requires investments in plant, equipment and inventory. The financial manager must help determine the optimal rate of sales growth, and he or she must help decide on the specific assets to acquire and the best way to finance these investments. For example, should the firm finance with debt or equity, and if debt is used, should it be long term or short term. Coordination and control. The financial manager must interact with other executives to insure that the firm is operated as efficiently as possible. All business decisions have financial implications, and all managers-financial and otherwise need to take this into account. For example marketing decision affect sales growth, which in turn influences investment requirement. Thus, marketing decision makers must take account of how their actions affect such factors as the availability of funds, inventory policies and plant capacity utilization. Dealing with the capital market. The financial manager must deal wit the money and capital markets. All firms affect and are affected by the general financial markets where funds are raised, where the firms securities are traded, and where its investors are either rewarded or penalized.

ii.

iii.

iv.

In summary, financial mangers make decisions regarding which assets their firms should acquire, how those assets should be financed, and how the firm should manage its existing resources. If these responsibilities are performed optimally, financial managers

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will help to maximize the values of their firms and this will also maximize the long run welfare of those who buy from or work for the company.

1.4

Define Cash, Cash Flow and Funds

Cash is very important in the running of business. A business that makes losses can last for a few years but if a business is short of cash, it will collapse in a very short period of time. Cash can be defined as money, in the form of notes and coins. It is the most liquid of assets and represents the lifeblood for growth and investment. Cash includes the followings coin and notes current accounts and short term deposits bank overdrafts and short term loans foreign currency and deposits that can be easily converted to the domestic currency Excluding long term deposits, long term borrowings, money owed by customers and stock. Cash flow is a term for receipts and payments of cash. In other words, it represents the cash movement for a particular organization. Basically, cash flow can be subdivided into two movement ie cash inflow or cash outflow. Cash Outflows can occur for the following reasons: i. Payment to suppliers for goods purchased and employee for wages and bonuses (Revenue expenditure) ii. Payments to government in term of taxes iii. Payment to suppliers of finance : Dividend payments to shareholders Interest to bondholders, banks Drawing by sole traders or partners (the regularity of these payments will vary)

iv. Payments to cover the purchase cost of non current asset such as buildings and equipment. (Capital Payment as for long term use in the business. They may be irregular) Page | 4

v. Payment for acquire investment : New businesses or takeover of companies (capital) Short term financial instruments to use surplus cash to turn a quick profit vi. Purchase of foreign currency for trading oversea

Cash Inflows can come in from various sources such as below : i. Cash received for sales: Immediately from cash customers From customers for sales made on credit (revenue receipts) ii. Cash received from providers of finance: Equity share capital invested in the business Long term loans provided by banks and other financial institutions. (Capital receipts as they are for long term investment in the business) iii. Cash received from : Sale of non current assets after their useful life. The liquidation of short term investments.

Net cash flow is the difference between the cash received in a period and the cash paid out in the same period. Funds can be defined as any arrangement that enables goods or services to be bought ie money or credit. Managing cash, cash flows and funds represents the most important aspect in business. A company needs to purchase raw materials to be used in the production of goods and services, to pay their labours, to rent factory and to acquire the necessary tools that is required. The goods purchased will then be sold to customers who will only pay some time later in the future. Due to this time lag between paying for the factors of production and receiving money from customers, the company must be able to balance the flow of cash, how to negotiate funds to finance this operation and in managing the companys cash.

1.5

Motives of Holding Cash

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i.

The transactions motive A business holds cash in order to make the payments that are necessary to keep the business going, such as wages, taxes and payments to suppliers. It the business cannot meet its financial obligations as they arise, it may cease to be a going concern. It is therefore the main motive for holding cash. The precautionary motive The second motive in which business does not find itself in financial difficulties should some unforseen expenses arise. In practice, businesses tend to cover themselves against this by arranging overdraft facilities with their banks. These do not cost businesses anything unless they are used. The speculative motive This refers to businesses holding cash in case an opportunity to invest and earn money arises. Few businesses are likely to do this in practice as they will lose money whilst waiting for an opportunity to arise.

ii.

iii.

1.6

Sources and Uses of Cash

Sources and uses of cash cover three activities in an enterprise: i. Operating activities are activities that create revenue or expenses in the entitys major line of business. The largest cash inflow from operations is the collection of cash from customers. Operating activities that create cash outflows include payments to suppliers, payment to employees ~ Day-to-day running of business. ii. Investing activities include lending money and collecting on those loans, buying and selling productive assets that are expected to generate revenues over long periods, and buying and selling securities not classified as cash equivalents. Cash inflows include sales of fixed assets such as property, plant and equipment and so on. Cash outflows include purchases of fixed assets. iii. Financing activities include borrowing and repaying money from payables (creditors), obtaining resources from owners and providing both a return on their investment and a return of their investment. The return on investment is provided in the form of dividends.

1.7

Types of Cash Transaction

i. Revenue Receipts and Revenue Payments Cash receipts and payments arising from the normal course of business:Page | 6

Revenue receipts are cash receipts from : Cash sales Payments by trade debtors Revenue payments are payments to : Trade creditors Employees for salaries and wages Business expenses such as office rental, utility bills and so on.

ii. Capital receipts and capital payments Capital receipts are receipt of long term funds from companys owner or cash from the sales of fixed assets or long term investments. E.g. the shareholders in a company might agree to put more cash into the business by subscribing for a new issue of share. Capital payments are cash payments for capital expenditure, such as the purchase of new fixed asset (equipment, motor vehicles and so on). Occasionally a business might raise new cash by obtaining a long term loan. A loan from a bank is a liability, but long term liabilities can be thought of as a capital receipt. Similarly, the repayment of a loan might be though of as capital payment. iii. Drawing of dividends and disbursements When a business makes profits, it usually pays out some of those profits to its owners: Payment out of profits to sole trader or partners in a partnership are known as drawings. Payment out of profits to the shareholders of a company are known as dividends. Businesses can pay drawings or dividends whenever they want to. However many companies pay dividends to shareholders twice each year. One dividend payment is an interim dividend, paid in the middle of the year when the profits fro the first six months are known. The second dividend payments are a final dividend, which is paid after the end of the year when the profits for the full year are known. The term of disbursement simply means a payment for : Interest on loans and overdrafts, and on other debts for which interest is payable. Taxation payable by a company out of its profits (corporation tax). iv. Exceptional receipts and payments

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The foregoing are all relatively routine transactions. They are known and they can be planned for. There is always the possibility that there will be a significant movement because of an unusual or exceptional transaction that does not fall into any of the categories describe above. Exceptional items are unusual. For example the costs of closing down part of a business. 1.8

Other Categorization of Cash Flows

Another method of categorization that might be preferred gives four groupings:1. 2. Operational cash flows derive from normal trading activities for example, cash receipts from sales, payments for supplies etc. Priority cash flows are payments for non trading cash payments that must be made to keep the company functioning and have priority over other non operational payments. These priority items are all cash outflows. They include interest payments and tax payments. Discretionary cash flows are cash payment or receipt that not necessary need to incur. For example, discretionary outflows are capital expenditures, payments for acquisitions, payout for dividend etc. Discretionary inflows are sale of non current assets e.g. sales of fixed assets, sales of investment etc. Financial cash flows arise from variations in long term capital. Financial inflows include cash from issue of shares or from new loans. Financial outflows include the repayment of a long term loan

3.

4.

When operational cash flows are insufficient, a top up of cash will be needed from discretionary or financial sources. This situations will occur especially when a company is expanding rapidly finance a large capital expenditure or acquisition or when it must repay the principal on a large debt. Operational cash flow problems are much more likely to occur when the company is making only small profit especially when the company is growing too fast and its overtrading.

1.9

Cash flow problem may arise due to the following circumstances

i. Business that is loss making If a business continually makes losses, it will eventually have cash flow problems. ii. Inflation Page | 8

In a period of rising prices, a business needs increasing amount of cash just to replace used up and worn out assets. The business can be making a profit in historical cost accounting terms, but might still be not receiving enough cash to buy replacement assets it needs iii. Growth A successful business in order to grow must be able to manage its resources carefully. As its sales increases, the growing company may need additional financing in order to employ more employees, buy additional equipments for production, purchase additional materials and to extend customers payment period. iv. Seasonal business When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times of the year. Ways to overcome cash shortages When there is a need of cash in the near future, a company may be able to take the following steps to overcome cash difficulties v. vi. vii. viii. Postponing capital expenditure Accelerating cash inflows Sell assets Negotiate for reduction in cash outflow

1.10 Profit and Cash Flow

Trading profits and cash flows are different. A company can make profits but have a net cash deficit on its trading operations; and vice versa. Profit is not cash because: i. cash may be obtained from a transaction which has nothing to do with profit or loss such as issue of shares will receive cash but nothing to do with profit. Similarly increase in bank overdraft provides a source of cash but it is not reported in the income statement. Cash may be paid for the purchase of fixed assets, but this transaction is not reflected in income statement.

ii.

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iii.

Profit is sales less the cost of sales. Operational cash flow is the difference between cash received and cash paid from trading. Cash received differs from sales because of changes in the amount of receivables. Cash paid differs from the cost of sales because of changes in the amount of inventory and payables.

: Cost of sales Negative Cash Flows A company that trades profitably should earn cash surpluses. However, a profitable company can also suffer from negative cash flows: It might spend cash on non current asset purchases(eg. purchase of building) and extra working capital investments. It might use cash to pay for business acquisitions(takes over another company). High inflation rates might force a company to increase its funding of business in money terms, even when there is no real growth in the business. Dividends might exceed cash surpluses for the year. In recession, for example, profits fall but there will be pressure from shareholders to maintain or increase the dividend.

The difference between profit and cash flow has important implications:i. If a company is profitable but short of cash, one reason could be an increase in the other elements of working capital. If a company were to seek credit from a bank to finance the growth in working capital, the bank might ask the management whether operational cash flows could be improved be squeezing working capital and: Reducing receivables Reducing inventories Taking more credit from suppliers Better control over working capital could remove the need to borrow. ii. If a company is making losses, it could try to maintain a positive operation cash flow by taking more credit (ie by increasing its payables and so reducing working capital).

1.11 Cash Accounting and Accruals Accounting

Accruals Concept Revenues and costs are recognized as they are earned or incurred, not as money is received or paid.

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Cash Accounting It is a system of accounting for costs and income on the basis of payments and cash receipts.

Finance vs Accounting View Techniques in finance generally use cash flows (cash accounting), whereas accounting generally stresses profits (accruals concept). Example: Suppose that Midland Company is in the business of refining and trading gold. At the end of the year, it sold 2500 ounces of gold for RM1 million. The company had acquired the gold for RM900,000 at the beginning of the year. The company paid cash for the gold when it was purchased. Unfortunately, it has yet to collect from the customer to whom the gold was sold. Based on accruals concept Sales Cost of Sales Profit RM1,000,000 900,000 100,000 Based on cash accounting Cash inflows Cash outflows Net cash flows RM 0 (900,000) (900,000)

By generally accepted accounting principles, the sale is recorded even though the customer has yet to pay. Midland seems to be profitable.

The perspective of corporate finance is different. It is interested in whether cash flows are being created by the operation of Midland.

Tutorial: Chapter 1 Introduction to Financial Management

1. Discuss the difference between profit maximization and wealth maximization.

2. Identify responsibilities for a financial manager in an organization. 3. Define Cash, cash flow and funds. 4. Explain Three (3) examples each for cash inflows and cash outflows.

5. What is generally understood by the following terms? i) Revenue receipts Page | 11

ii) Revenue payments iii) Capital receipts iv) Capital payments

6. Identify 3 motives for a business to hold cash. 7. It is understood that cash flow can be classified into 4 major headings that is operational cash flow, priority cash flow, discretionary cash flows and financial cash flow. You are required to explain (together with an example) in detail of each classification and to provide an example. 8. List 4 possible problems that may give rise to cash shortages and ways to overcome it.

9. In the short run, a loss making business can survive and a profitable business might not survive. Explain how far you agree with the statement above. 10. What separates cash from profits? Explain why lots of sales might not mean lots of cash.

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