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Business Management

FINANCIAL MANAGEMENT
Financial Management  part of a business that is concerned with planning and manageing
funds in order to achieve the business’s objective

Functions of financial Management
The financial management department has 3 main functions
1) Analysing the financial position of the business
2) Managing the assets of the business
3) Managing the liabilities of the business
- Accurate financial analysis and efficient management of the assets and liabilities of
the business will ensure that it has reasonable liquidity and profitability to function

Analysing the financial position of a business
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This means finding how healthy the business is by measuring and checking its
liquidity and profitability
...
A business has a liquidity crisis if it cannot pay its debts
and liabilities such as wages, taxes and salaries because of a lack of cash
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The businesses
profitability is its ability to make more income than the total costs, by using its assets
productively hence productivity means the amount of success of a business
operation
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Managing the liabilities of a business
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When managing the liabilities of a business, the financial manager must decide on
how best to arrange the assets, this means considering the most useful mix of short
and long-term financing as well as the individual sources or short-term and longterm funds to be used
...

Example of long-term liabilities include mortgages, long-term bank loans, leases and
any other needs to pay money to a creditor after more than 1 year
Short term funds are also known as current liabilities and these are amounts
owning to creditors that are due within one year
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Core principle of financial management
Sound financial management decisions are based on the following 3 core principles
1) The cost-benefit principle
2) The risk-return principle
3) The time-value-of-money principle

1) The cost-benefit principle
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In any decisions made, the benefits should always be more than the costs
Hence sound financial making means that we analyse the total costs and total
benefits of any financial decisions we take
We use the cost-benefit principle to be clear about our objectives, to work out the
total costs and benefits of different choices, to determine standards to measure
choices and then decide on the best course of action to take
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Judging risk is part of any decision
making process
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The
same applies with the risk-return principle, the return should always be greater than
the risk taken
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If that business instead invests that money into fixed-assets then
the business will not earn any interest

Analysing financial statements
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Financial statement give a written summary of the financial activities of a business
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Primary financial statements include the balance sheet and the income statement

Balance sheet
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The Balance sheet is a listing, at a specific moment in time, of all the assets and
liabilities of the business and how these net assets (TOTAL ASSETS – TOTAL
LIABILITIES) were financed i
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by owners’ equity and/or profits
...


ASSETS = OWNER’S EQUITY + LIABILITIES
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The accounting equation is also known as the “balance sheet equation”
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To see whether the business is operating at a profit or loss, the sales revenue earned
is matched with the expenses paid to get that revenue
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The ratio should be clear, direct and understandable relationship between the two
variables and should express a relationship that is meaningful
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Financial ratios are grouped into broad categories of business performance
Liquidity ratios
Current ratio
Quick ratio

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Asset Management ratios
Inventory turnover
Average collection period
Total asset turnover

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Debt-Management ratios
Debt ratios
Gearing ratios
Interest coverage ratios

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Profitability Ratios
Gross profit margin
Profit Margin
Return on total asset
Return on equity

Liquidity Ratios
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Liquidity is the ability of a business to honour its short term financial commitments
continuously and on time
...

Chronic illiquidity (opposite of liquidity) can lead to liquidation (selling off the
business to pay its debts
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1) The current ratio
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The Current ratio shows the relationship between the value of a business’s current
assets and the amount of its current liabilities
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The Quick ratio/acid test ratio is calculated with the following formulae

Quick Ratio = Current assets - Inventory
Current liabilities

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A quick ratio of at least 1:1 is the norm
Although the quick ratio is always less than the current ratio, a quick ratio that is too
low relative to the current ratio may indicate that inventories are higher that they
should be
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- The higher the turnover the better, because the more times inventory can be turned
over in an operating cycle, the greater the profit
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An excessively high inventory turnover could lead to stock shortages, which could
stop the production line or mean the loss of potential sale
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3) Total asset turnover
- The Total asset turnover shows how efficiently the business is using its assets to
create sales
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As a rule, the higher the asset turnover, the better the assets have been used and
the more financially efficient the business operations are
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A business must be able to assure people that lend
capital to it that its total assets can cover its total liabilities
Financial Leverage means the use of debt financing in the business
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Financial Risk is the risk of not being able to meet the interest payment obligations
on debt finance
However any additional risk promises additional returns, i
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if you can earn more on
the borrowed finds than you pay in interest, the result is that the return on owner’s
capital is magnified
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These debt management ratios include the debt ratio, the gearing ratio and the
interest coverage ratio
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2) The gearing ratio
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The gearing ratio is the owners’ equity divided by the total debt as shown below

Gearing ratio = Owners equity
Total debt
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The larger the ratio, the better and a minimum gearing ratio of 1:1 is normally
advised
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3) Interest coverage ratio
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The interest coverage ratio measures the number of times a business can pay its
interest commitments from its profit before taxes and interest
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Failure to meet the interest expenses could lead to legal action, and eventually
insolvency (bankruptcy)

Interest coverage ratio =

PBIT
Interest

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PBIT  Profit Before Interest and Taxes
It is measured in times
A value of between 3 & 5 is normally recommended
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They show how effectively the available capital
has been used in the activities of the business
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These ratios are concerned with the implications of changes in financial risk for
owner’s returns
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It indicates the amount of funds available to pay the firm’s expenses other than its
cost of sales
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2) The Profit Margin
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The Profit Margin is net profits after all expenses to sales
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To increase the profit margin, management of a company would have to increase
revenue or decrease expenses
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The ratio is calculated by dividing the profits after tax by total assets
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4) Return on equity (ROE)
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The Return on equity (ROE) measures the profitability of own capital and is
influenced largely by how much borrowed capital the business uses
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Return on Equity = Profit after Taxes
Owners’ equity
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It is measured as a percentage
If the ROE is less than the rate of return on an alternative risk-free investment, it
would not be worthwhile for the owners to continue investing their capital in the
business
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To do this, you must get a benchmark (standard), which is normally based on either
previous performance or on how other businesses in the same industry perform (or
both)
The ratio procedure is as follows:
1) Calculate a ratio
2) Compare it with last year’s ratio to see if there’s a trend
3) Compare it with those of other firms in the same industry to judge strengths and
weaknesses of your business
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Fixed Costs
A Fixed cost is a cost that is not affected by increase or decrease in the volumes of
output
...

The variable cost per unit is the same amount for each unit produced
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Variable costs, which change with the level of business activity

R costs

Level of activity
Semi variable costs

R cost
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Level of activity

The break-even point
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The Break-even point is the level of activity where a business is making neither a
profit nor a loss
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Critical elements of Break-even analysis are:
1) Selling price per unit
2) The costs (fixed and variable)
3) The level of activity of the business (volume of sales)

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A change in one of the above results in a change in the total profit of the business
...

The business will make a profit on sales above the break-even point and will suffer a
loss if sales are below the break-even point
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 Elements making up the variable-unit cost and total fixed costs are not constant
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 Break-even analysis does not consider qualitative factors such as customer ideas,
competitors, or the availability of cash
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These elements need to be continuously measured, calculated and managed to
ensure that the objectives of the business are being achieved
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1) Trade credit
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Trade credit is an arrangement that allows the business to pay the suppliers of a
product only after 30, 60 or 90 days
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2) Bank credit
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Bank credit in the form of a bank overdraft is not linked to a particular transaction,
but is valid for a certain maximum amount
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Overdrafts may be regarded as a relatively cheap form of finance, with the interest
rate charged depending on how good the applicant’s credit rating is
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Unused overdraft facilities represent a useful ready supply of funds which can be
called upon before the business has to look for further capital
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3) Factoring of trade receivables
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A business can sell off its trade receivables to a financing institution as they arise and
the institution then takes over the risk of non-payment and is responsible for debt
collections
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Factoring is a very expensive source of finance
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The credit and collection function, and all the expenses associated with this function,
are assumed by the factor
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Factors provide important information concerning product prices, market conditions
and finance – areas which many firms are unable to research because of a lack of
funds and skills
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Long-term financing
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Long term financing is a capital that you need over a long period, in other words for
a period of more than 1 year
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Long-term funds consist of owners’ equity, and long-term liabilities (debt funding)
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Long term financing decisions involve choosing the type and combination of finance
available at the lowest possible cost (interest rate or opportunity cost) to the
business
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The financial power of the business will influence the debt versus equity decision
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1) Equity funding
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Equity funding is also known as “shareholder funds” or “owners interest”
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In the case of a company, it is the share capital and retained earnings and is referred
to as the equity
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Shareholders also have a proportional interest in the net-assets of the business in
the case of liquidation
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Part of the ordinary shareholders equity consists of the profits that could be
distributed but which have been retained in the firm
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If the profits are retained, they represent an immediate source of finance
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2) Long-term bank loans
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Bank loans are the chief source of long-term borrowed funds, particularly for smaller
businesses
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In assessing a prospective borrower, the bank manager will evaluate the solvency,
liquidity and profitability of the deal to be financed, chiefly looking at the degree of
risk involved in the loan request
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3) Financial leases
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A Financial lease is a contract agreement between a lessee (asset user) and lessor
(asset owner)
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Business Management

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Financial leases are normally used to finance vehicles and equipment and they give
the lessee the chance to own the asset at the end of the lease
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The cash Budget
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A cash budget is a statement of estimated future cash receipts and payments,
showing the forecast cash balance of the business at certain intervals
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Banks are more likely to grant a business loan under favourable terms if the loan
request is supported by a methodical cash budget
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A monthly cash budget helps to show estimated cash balances at the end of each
month, which may show up likely short-term cash shortfalls or reveal if large sums of
excess cash are lying idle and could be invested to earn a return in the short term

Preparing a cash budget
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There are 3 separate parts to the cash budget, namely estimated cash receipts,
estimated cash payments and the balance
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Cash payments include cash purchases, payments to creditors, rent, wages and
salaries, tax paid, interest paid, lease payments, loan repayments and assets
purchases for cash
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The difference between the monthly cash receipts and cash payments if the cash
flow for the month
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(TOTAL CASH RECEIPTS – TOTAL CASH PAYMENTS) + BEGINNING CASH = ENDING
CASH BALANCE

TOTAL CASH RECEIPTS – TOTAL CASH PAYMENTS = NET CASH FLOW
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NET CASH FLOW + BEGINNING CASH = ENDING CASH BALANCE

Managing trade receivables & inventories
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Both trade receivables and inventories represent large investments in current assets
and should be carefully managed
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Managing trade receivables starts with the decision to give credit to customers,
credit is given in order to attract and maintain customers, because credit sales
increases total revenue
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Here the greater the size of the
trade receivable and the longer the collection period, the higher the investment
needed and the grater the cost
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Reaching this goal involves 3 critical aspects:
1) Credit policy
2) Credit terms
3) Collection policy

1) Credit policy
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The Credit policy spells out conditions that will determine which customers should
get credit and how much
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2) Capacity  the customers’ ability to pay
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4) Conditions  current economic or business conditions
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Credit agencies provide credit
ratings and credit assessments on individuals and businesses
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These
terms include the length of time given to customers to pay, and cash discounts
offered for prompt payment
Here management should consider the following:
What are the usual terms of trade in the industry?
What is the cost to the business of offering cash discounts for prompt payment?
Are the terms of trade clear on the invoice?

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Credit terms can be indicated, for example, 2/10 net 30 days
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If not, the account must be settled within 30 days
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3) Collection Policy
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The Collection policy refers to the collection methods used to collect trade
receivables once they become due
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Credit can be checked by using the average collection period, and by aging trade
receivables
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The average collection period is calculated by using the following equation:

Average collection period = debtors
÷ 365
Credit sales
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“Aging trade receivables” means breaking down the receivables on a month by
month basis in order to show the balances that have been outstanding for a specific
period of time
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A number of credit-collection techniques ranging from letters to legal action may be
used
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 Letters may be sent out after a number of days to remind customers to pay
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 A salesperson/collection person can be sent to deal with the customer in order
to collect payment
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Legal
action is a costly and lengthy process and could result in the customer’s
liquidation and therefore under-recovery of cash
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The overall objective of inventory management is to minimise the investment in
inventories (to meet the profit objective) without interrupting the production line,
which could result in a loss of sales (endangering the operating objective)
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The critical factors that determine inventory holding levels are:
 Ordering costs  administrative costs of placing orders with suppliers
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 Holding costs  interest costs of short-term borrowing that are used to fund
inventories
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 The level of demand  as indicated in the sales/production forecast, this must
be co-ordinated with the purchases of inventory
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The following points are indicators of good practice regarding inventory control:
 Use a good inventory system  use a modern inventory reporting system will
provide accurate and timely management information on inventory movements
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Identify slow moving items  the inventory reporting system must highlight the
slow-moving inventory items so that steps can be taken to dispose of these items
before they become obsolete
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Comparison of budgeted and actual sales is therefore
critical
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