TECHNIQUES OF

enbassey
FINANCIAL MANAGEMENT
books series

0011MH06

By

Emmanuel Nelson Bassey

(MBA; CNA; NIAFA; ACIN) enbassey

books
-ii-
BOOKS PUBLISHED BY THE SAME AUTHOR
1. ANATOMY OF INTERNET
2. DATA PROCESSING HAND BOOK VOL 1
3. QUESTIONS AND SUGESTED SOLUTIONS ON
DATA PROCESSING
4. INTRODUCTION TO MS WINDOWS AND BASIC
PRINCIPLES OF COMPUTING
5. PROJECT FORMULATION AND MANAGEMENT.
6. NEW ERA ACCOUNTING
7. COMPUTER BASED ACCOUNTING
8. ELEMENT OF DATA BASE MANAGEMENT
SYSTEMS.
9. ADVANCED FINANCIAL ACCOUNTING
10. ADVANCED COSTING
11. MANAGEMENT ACCOUNTING
12. SIMPLE APPRAOCH ON FINANCIAL MANAGEMENT
13. COMPUTER OPERATIONS AND PACKAGES
14. MONEY MANAGEMENT AND FINANCIAL
INSTITUTIONS IN NIG.
15. UNDERSTADING OFFICE ADMINISTRATION
16. AN INTRODUCTION TO FINANCIAL MANAGEMENT
17. BUSINESS FINANCE
18. ELEMENT OF BANKING
19. COMPUTER AND SOCIETY
20. COMPUTER SCIENCE FOR SEC.SCH. JS 1
21. COMPUTER SCIENCE FOR SEC.SCH. JS 2
22. COMPUTER SCIENCE FOR SEC.SCH. JS 3
23. COMPUTER SCIENCE FOR SEC.SCH. SS 1
24. COMPUTER SCIENCE FOR SEC.SCH. SS 2
25. COMPUTER SCIENCE FOR SEC.SCH. SS 3
26. COMPUTER SCIENCE FOR PRI.SCH. VOL 1
27. COMPUTER SCIENCE FOR PRI.SCH. VOL 2
28. COMPUTER SCIENCE FOR PRI.SCH. VOL 3
29. COMPUTER SCIENCE FOR PRI.SCH. VOL 4
-iii-
PREFACE
In preparing this edition, the opportunities have been taken
to review various texts in order to keep abreast of the
current trends in FINANCIAL MANAGEMENT.
THE AIMS
“Economic performance in a democracy will depend on
markets, how they are structured, and how they function.
Markets are important because they encourage individuals
to exert their vital energies, skills, ambition and risk taking
in the economic pursuits of life. The market moderates the
interplay of these vital energies in a way that minimises
conflict and so ensures the prevalence of peace and
stability”
The text is particularly relevant to:
• Students in Colleges, Polytechnics and Universities
offering financial management.
• Students preparing for foundation level
examination of any professional examination in Nigeria in
financial management and relevant examination in
management science department.
• School leavers, dropouts, job seekers, managers
and others in industry, commerce, local authorities and
similar organisations who wish to gain a working
knowledge of how finance could be obtained and managed
• The professionals and intermediates for reference
purposes. This text is to give a first hand knowledge to the
prospective bankers, accountants and management
science elite; serve as a companion/references text to the
-iv-
instructors and teachers of financial management in our
schools and colleges.
It also seeks to create an avenue for professional
development in global market place.
THE SCOPE
The text comprehensively covers the principles,
techniques and methods involve in obtaining and
managing funds, investment and performance appraisal,
risk and interpretation of account.
The value of the book is considerably enhancing by the
instructive illustrations and examples provided by the
numerous exercises which it offers.
Thus, considering the scope and its approach, the
book will be found useful as a regular textbook.
-v-
Acknowledgement
This edition is as a result of joint efforts of a number
of people and many instructors, academic colleagues
and students alike. I wish to thank the many people
who have made these contributions.
The author has received continued help from a number of
colleagues through their suggestions and contributions to
individual chapters. Joseph E. Ekpo provided enthusiastic
support in this edition.
My thanks also go to those who assisted in the typing of
the manuscript: John Abednego Effiong, Bridget Obeda,
Augustine.
Above all, may all glory, honour and majesty
be ascribed unto our MOST HIGH GOD
through JESUS CHRIST OUR LORD AND
SAVIOUR. Amen.
-vi-
 ……….. FOR THE STUDENTS ……… 1. Gonel Systems Limited
2 Alegbo Road, Effurun
off P.T. I. Road,
Box 527, Effurun, Delta State. Nigeria.

This book has been written specifically for you. Your 2. Blessed Concept
instructor, teacher or lecturer will help you 139 P.T.I. Road,
understand the ideas developed in the text, but ---- in Effurun, Warri. Delta State. Nigeria.
the last analysis --- it is up for you to learn.
3. C.A.C.T. PUBLISHERS
Block B, Flat 8, Masoje Estate
I have concentrated on a style and format that should PTI Road. Effurun
help you to learn and understand when you study the Delta State. Nigeria.
chapters even alone. In the classroom, you can
4. Akwa Ibom State Polytechnic
reinforce this learning and see what others have to Continuing Education Centre.
say or what questions they raise. Your lecturer can KM 1 Refinery Road. Effurun.
supplement this process through the assignments, Delta State. Nigeria.
lectures and testing. I hope the experience will be
satisfying for you. 5. c/o Sister Udeme
Association Of National Accountants Of
Nigeria,
Herbert Maculae Road, Yaba.
Lagos. Nigeria.

LOCATIONS TO-vii-
OBTAIN EN-BASSEY’S BOOK TABLE OF CONTENTS
-viii-
Books by the same author…iii Preface… iv
Acknowledgement..vi
For the students…vii
Table of contents…ix

ONE
The scenario of financial management..11
Financial management levels….17
What is financial management….20
Objectives of FM…21
Decision making…24
Functions of finance manager..26
Goals of financial management…32
Sources of funds….34
Evaluation of financial policy

TWO
Financial planning ……45
Management information for planning ..45
Business forecasting…..46
Profit and loss forecast…55
Balance sheet forecast …56
Capital structure………57
Techniques of financial analysis……62

THREE
Woking capital management….79
decision areas…81
Managing working capital ….83
Key working capital -ix-
ratios..92
Liquidity ratio………94
Working capital and operating cycle..99
Principles of working capital…104
Concepts of working capital….106
Stock control…107
Stock control method…114

FOUR
Foreign currency transaction….130
Foreign exchange market…..131
Foreign exchange market in Nigeria..132
Modern foreign exchange market….135
FIVE
Allocation of dividend….145
Dividend defined…….146
Types of dividends…..148
Method of payment…150
Dividend policy……..154
Facts about dividend policy..154
Determinants of dividend policy…172
SIX
Mergers and Acquisition…..173
Classification of mergers…………..176
Types of takeovers…………184
Reconstruction and reorganisation……..190
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THE SCENARIO OF
FINANCIAL
MANAGEMENT
Finance is the science of funds management. The
general areas of finance are business finance,
personal finance, and public finance. Finance
includes saving money and often includes lending
money. The field of finance deals with the concepts
of time, money and risk and how they are
interrelated. It also deals with how money is spent
and budgeted.
Finance works most basically through individuals and
business organisations depositing money in a bank.
The bank then lends the money out to other
individuals or corporations for consumption or
investment, and charges interest on the loans.

-11- increasingly packaged for

Loans have become
resale, meaning that an investor buys the loan (debt)
from a bank or directly from a corporation. Bonds are
debt sold directly to investors from corporations,
while that investor can then hold the debt and collect
the interest or sell the debt on a secondary market.
Banks are the main facilitators of funding through the
provision of credit, although private equity, mutual
funds, hedge funds, and other organizations have
become important as they invest in various forms of
debt. Financial assets, known as investments, are
financially managed with careful attention to financial
risk management to control financial risk. Financial
instruments allow many forms of securitized assets
to be traded on securities exchanges such as stock
exchanges, including debt such as bonds as well as
equity in publicly-traded corporations.
Central banks act as lenders of last resort and
control the money supply, which affects the interest
rates charged. As money supply increases, interest
rates decrease.
The main techniques and sectors of the financial
industry
An entity whose income exceeds their expenditure
can lend or invest the excess income. On the other
hand, an entity whose income is less than its
expenditure can raise capital by borrowing or selling
equity claims, decreasing its expenses, or increasing
-12-
its income. The lender can find a borrower, a
financial intermediary such as a bank, or buy notes
or bonds in the bond market. The lender receives
interest, the borrower pays a higher interest than the
lender receives, and the financial intermediary
pockets the difference.
A bank aggregates the activities of many borrowers
and lenders. A bank accepts deposits from lenders,
on which it pays the interest. The bank then lends
these deposits to borrowers. Banks allow borrowers
and lenders, of different sizes, to coordinate their
activity. Banks are thus compensators of money
flows in space.
A specific example of corporate finance is the sale of
stock by a company to institutional investors like
investment banks, who in turn generally sell it to the
public. The stock gives whoever owns it part
ownership in that company. If you buy one share of
XYZ Inc, and they have 100 shares outstanding (held
by investors), you are 1/100 owner of that company.
Of course, in return for the stock, the company
receives cash, which it uses to expand its business;
this process is known as "equity financing". Equity
financing mixed with the sale of bonds (or any other
debt financing) is called the company's capital
structure.
Finance is used by individuals (personal finance), by
governments (public finance), by businesses
(corporate finance), as well as by a wide variety of
-13-schools and non-profit
organizations including
organizations. In general, the goals of each of the
above activities are achieved through the use of
appropriate financial instruments and methodologies,
with consideration to their institutional setting.
Finance is one of the most important aspects of
business management. Without proper financial
planning a new enterprise is unlikely to be
successful. Managing money (a liquid asset) is
essential to ensure a secure future, both for the
individual and an organization.
Personal finance
Questions in personal finance revolve around
• How much money will be needed by an
individual (or by a family), and when?
• Where will this money come from, and how?
• How can people protect themselves against
unforeseen personal events, as well as those
in the external economy?
• How can family assets best be transferred
across generations (bequests and
inheritance)?
• How does tax policy (tax subsidies or
penalties) affect personal financial decisions?
• How does credit affect an individual's financial
standing? -14-
• How can one plan for a secure financial future
in an environment of economic instability?
Personal financial decisions may involve paying for
education, financing durable goods such as real
estate and cars, buying insurance, e.g. health and
property insurance, investing and saving for
retirement.
Personal financial decisions may also involve paying
for a loan, or debt obligations.
Corporate finance
Managerial or corporate finance is the task of
providing the funds for a corporation's activities. For
small business, this is referred to as SME finance. It
generally involves balancing risk and profitability,
while attempting to maximize an entity's wealth and
the value of its stock.
Long term funds are provided by ownership equity
and long-term credit, often in the form of bonds. The
balance between these forms the company's capital
structure. Short-term funding or working capital is
mostly provided by banks extending a line of credit.
Another business decision concerning finance is
investment, or fund management. An investment is
an acquisition of an asset in the hope that it will
maintain or increase its value. In investment
management – in choosing a portfolio – one has to
-15-
decide what, how much and when to invest. To do
this, a company must:
• Identify relevant objectives and constraints:
institution or individual goals, time horizon, risk
aversion and tax considerations;
• Identify the appropriate strategy: active v.
passive – hedging strategy
• Measure the portfolio performance
Public finance
In Government circle, finance is about governments’
income and expenditure, which invariably deals with
a nation’s budget for the year while budgets are
statements about the ways government, plans to
obtain income (i.e. revenue) and the ways it plans to
spend such income during a particular year. It could
be a deficit budget where expenditure is greater
than the estimated revenue and as a result
government plans to save for emergency situations
or carry out capital-intensive expenditure.
A surplus budget where government expenditure
equals estimated government revenue.
The government acquires its revenue from the
following:
a) Indirect taxes – eg custom duties, excise,
purchase tax and sales tax.
b) Direct taxes eg personal income tax, company
tax, death duties, capital gains etc.
c) Miscellaneous receipts from loans, profits,
grants and fines and royalties.
-16-
Financial management entails planning for the
future of a person or a business enterprise to ensure
a positive cash flow. It includes the administration
and maintenance of financial assets. Besides,
financial management covers the process of
identifying and managing risks.
The primary concern of financial management is the
assessment rather than the techniques of financial
quantification. A financial manager looks at the
available data to judge the performance of
enterprises. Managerial finance is an interdisciplinary
approach that borrows from both managerial
accounting and corporate finance.
Some experts refer to financial management as the
science of money management. The primary
usage of this term is in the world of financing
business activities. However, financial management
is important at all levels of human existence because
every entity needs to look after its finances.
Financial Management: Levels
Broadly speaking, the process of financial
management takes place at two levels. At the
INDIVIDUAL LEVEL, financial management involves
tailoring expenses according to the financial
resources of an individual. Individuals with surplus
cash or access to funding invest their money to make
up for the impact of taxation and inflation. Else, they
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spend it on discretionary items. They need to be able
to take the financial decisions that are intended to
benefit them in the long run and help them achieve
their financial goals.
From an organisational point of view, the process of
financial management is associated with financial
planning and financial control. Financial planning
seeks to quantify various financial resources
available and plan the size and timing of
expenditures. Financial control refers to monitoring
cash flow. Inflow is the amount of money coming into
a particular company, while outflow is a record of the
expenditure being made by the company. Managing
this movement of funds in relation to the budget is
essential for a business.
At the CORPORATE LEVEL, the main aim of the
process of managing finances is to achieve the
various goals a company sets at a given point of
time. Businesses also seek to generate substantial
amounts of profits, following a particular set of
financial processes.
Financial managers aim to boost the levels of
resources at their disposal. Besides, they control the
functioning on money put in by external investors.
Providing investors with sufficient amount of returns
on their investments is one of the goals that every
company tries to achieve. Efficient financial
management ensures that this becomes possible.
-18-
Strong financial management in the business arena
requires managers to be able to:
1. Interpret financial reports including income
statements, Profits and Loss or P&L, cash flow
statements and balance sheet statements
2. Improve the allocation of working capital within
business operations
3. Review and fine tune financial budgeting, and
revenue and cost forecasting
4. Look at the funding options for business
expansion, including both long and short term
financing
5. Review the financial health of the company or
business unit using ratio analyses, such as the
gearing ratio,
profit per employee and weighted cost of capital
6. Understand the various techniques using in project
and asset valuations
7. Apply critical financial decision making techniques
to assess whether to proceed with an investment
-19-
8. Understand valuations frameworks for businesses,
portfolios and intangible assets
What Is Financial Management
Financial management in Nigeria economy entails
planning, controlling, disbursement, motivation and
implementation/supervision. Without finance all the
above cannot be established and without the
services of financial management, the above cannot
be achieved.
T. Lucy in his financial accounting view defined
“financial management as the classification and
recording of monetary transactions of any entity
in accordance with established concepts,
principles, accounting standards and legal end of
an accounting period”
The author of this book defined financial
management as the organisational activities that
involve accounting, budgeting, and cash
management.
In a broader sense, Financial Management can be
defined as “The management of the finances of a
business/organisation in order to achieve
financial objectives”
-20-
Objectives of FM.
Taking a commercial business as the most common
organisational structure, the key objectives of
financial management would be to:
• Create wealth for the business(Wealth/profit
maximization)
• Generate cash, and
• Provide an adequate return on investment bearing
in mind the risks that the business is taking and the
resources invested
The above could be accomplished through:
1. Increase in profit: a firm can maximize its
value through an enhancement of its revenue.
The revenue can be enhanced through
stepping up the volume of sales or any other
such activities. In theory, when a firm is
equilibrium, its profits are said to be maximum.
2. Reduction in cost: A firm should work by all
means to reduce the cost of capital and to
launch economy drive in its operations.
3. Sources of funds: a firm can raise funds in
various ways through several sources. The
risk involved in all these sources are assessed
beforehand. While the issue of capital shares
increases the ownership funds of the
corporation, the issue of debenture and
-21-
 preference shares enhance the fixed recurring
obligations of it.
4. Minimise risks: ‘NO RISK NO GAIN’ is a
popular slogan before embarking on any
course of action. A firm will have to calculate
different types of risks which it may confront.
Elements of financial management
There are three key elements to the process of
financial management:
(1) Financial Planning
Management need to ensure that enough funding is
available at the right time to meet the needs of the
business. In the short term, funding may be needed
to invest in equipment and stocks, pay employees
and fund sales made on credit.
In the medium and long term, funding may be
required for significant additions to the productive
capacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to
help the business ensure that the business is
meeting its objectives. Financial control addresses
questions such as:
-22-
• Are assets being used efficiently?
• Are the businesses assets secure?
• Do management act in the best interest of
shareholders and in accordance with business rules?
(3) Financial Decision-making
The key aspects of financial decision-making relate
to investment, capital budgeting financing and
dividends:
• Investments must be financed in some way –
however there are always financing alternatives that
can be considered. For example it is possible to raise
finance from selling new shares, borrowing from
banks or taking credit from suppliers
• A key financing decision is whether profits earned
by the business should be retained rather than
distributed to shareholders via dividends. If dividends
are too high, the business may be starved of funding
to reinvest in growing revenues and profits further.
[
Decision-making areas
Financial management decisions are as follows:
a. investment decisions
b. financing decisions
c. dividend decisions
-23-

a). Investment decision are concerned with the
investment of funds. Funds can be invested in fixed
assets and current assets. Investment of funds in
fixed as long-term implications, but immediate
returns can be expected from investment in current
assets such as cash, receivables and inventories.
The purpose is to identify project which can be
accepted using the discounted flow (DCF) technique,
using the cost of capital as the cut-off criterion and
also to choose the projects with high net present
value (NPV) or internal rate of return (IRR) if the
resources are limited. The investment decisions are
also subjected to risk versus analysis as future cash
flows are subject uncertainty.
b. Financing decisions concerned with the
financing of business activities. The are intimately
bound with the investment decisions. The financing
decision are helpful in planning for a balanced
capital structure risk, return and control are the
crucial factors relevant in formulating the financing
decisions Various analytical techniques like
EPS/EBIT computations leverage calculations and
interest dividend coverage estimates are used in the
process of making financing decision.
-24-
c. Dividend decisions are concerned with the
disposal of profits. Dividend is generally paid as
some percentage of earnings on the paid-up capital.
The internal profitability versus the external
profitability (Walter’s Approach) analysis helps in
developing the pay-out rate. The part of the profit
which is not paid out as dividend constitutes the
source of internal financing.
The cost of capitals acts as the nucleus in the
financing decision-making. It has a two-day effect on
the investment, financing and dividend decision. It
influences and it turn is influenced by them. As the
cost of capital is the cut –off criterion in investment
decision, it lead to the acceptance of rejection of
projects. Raises or lowers the cost of capital. The
financing decision affecting the cost of capital as its
is the weighed average of the cost different sources
of capital. The need to the raise or lower the cost of
capital, in turn, influences the financing decisions.
The dividend decisions try to meet the expectations
of the investors reflected through the cost of capital.
Function of finance manager
The manager who looks after the activities of
financial management is known as the finance
manager or the controller of finance. He is the key
functionary and forms part of the top management
-25-
team. He performs several important functions in
close consultation with the chief executive of the
organization. The major functions of the finance
manager are as seen below.
i) formulation of objectives
ii) forecasting and estimating capital requirements.
iii) Designing the capital structure
iv) Determining the suitable source of finance
v). Procurement of funds
vi). Investment of funds
vii). Dispersal of profits
viii). Maintaining of proper liquidity
ix). Maintaining of relations with the outside agencies
i). Formulation of objectives
Formulation of financial objectives is the fundamental
function of the finance manager. These objectives
should be in tune with the overall objectives of the
organisation.
-26-
ii). Forecasting and estimating capital
requirements.
A finance manager has to estimate and forecast the
financial requirements of a business. He should
make estimates for both short-term and long-term
requirements of funds. Unless proper thought is
given to the financial requirements of the business,
there will be either deficiency or surplus of funds. If a
business concern has excess capital, the
management may become extravagant in spending.
iii). Designing the capital structure
it denotes the kinds and proportions of different
securities. Thus the capital structure of a company
said to be the composition of equity and preference
capital and debt capital. After estimating the financial
requirement, the finance manager will have to design
the kind and proportion of various sources of funds
this should be based on the analysis of cost of
capital, consideration of factors such as risk, return
and control conditions in money and capital market.
iv) Determining the suitable source of finance.
The decision to tap various sources of finance
depend upon the capital structures designed. On the
basis of it, the finance manager has to determine the
-27-
sources from which the funds are to be raised. The
management can raise finance from various sources
such as shares, debentures, financial institutions
commercial banks and so on. The finance manager
should analyse the pros and cons of all these
sources before making a final decision.
v). Procurement of funds.
After estimating the capital requirements and
deciding about the sources of finance, the finance
manager has to take necessary steps to procure the
funds.
vi). Investment of funds.
The funds procured should be prudently invested in
various projects. The technique of capital budgeting
may be helpful in selecting a project. Whole taking
investment decision the finance manger has to keep
in mind the principles of profitability, liquidity and
safety. The principle of profitability should not be the
only criterion of investment because if the fund are
blocked in unsafe projects, the solvency of the
company will be in danger.
vii) Dispersal of profits.
The finance manger has to decide how much to
retain for internal use and how much to declare as
-28-
dividend out of the profits of the company. A large
number of factors such as the trend of earning of the
company, the trend of market price of is shares, the
flow position and so on, should influence these
decisions. Thus this is an important area of financial
management .
viii). Maintaining a proper liquidity.
Every organization is required to keep some liquidity
for meeting its day-to-day needs. Availability of cash
is necessary to maintain is liquidity. Cash is needed
to pay off creditors, purchase stock of materials, pay
labour, and to meet-to-day expenses. The finances
manager has the need for liquid assets and the
arrange them in such a way that there is no scarcity
of funds.
ix). Maintaining relation with the out agencies.
The finance manager should establish and maintain
cordial business relations with outside agencies such
as financial institution, stock exchange, tax
authorities and so on.
Scope of financial management
1. FM provides a conceptual and analytical
framework for financial decision making.
-29-
 2. It covers not only acquisition of funds but also
their effective utilisation in the business as
well.
3. It is an analytical way of viewing the financial
problem of the firm.
4. It is concerned with the solution of the three
major problem relating to the financial to
the financial operation of the firm.
Goals Of Financial Management
The primary goal of financial management is the
maximization of stockholder wealth, or in other terms,
maximization of the firm's profits. Other goals could
include-maximization of sales, maximization of
market share, maximization of the growth rate of
sales, and maximization of the market price of the
firm's stock. Managers are also concerned with their
salaries and perks. Frequently these are tied to
improved return on investments (ROI), return on
equity (ROE), return on assets (ROA), or return on
net assets (RONA). Two major goals of financial
managers are profitability and viability. The firm
wants to be profitable, and it wants to continue in
business.
-30-
Profitability
In attempting to maximize a firm's profits there is
always a tradeoff between profitability and risk. The
greater the risk incurred in a decision, the greater the
anticipated profit demanded. Frequently, the decision
is centered on whether the return on a specific
investment is sufficient to justify the risk involved.
Viability
Firms want to stay in business, so it should be no
surprise that one of the goals of financial
management is to guarantee financial viability. This
goal is often measured in terms of liquidity and
solvency.
Liquidity measures the amount of resources a firm
has that are cash or are quickly convertible to cash to
meet the obligations the firm has in the near term.
Generally the near-term, or current, means one year
or less. Thus a firm is liquid if it has enough current
resources to meet its current obligations as they
become due for payment. Solvency is the same
concept as liquidity, except it if for the long term
rather than near term. Long-term simply means more
than one year. Does the firm have enough cash
generation potential over the long term to meet the
major cash needs that will occur over this period? A
firm must plan for adequate solvency well in advance
because the potentially large amounts of cash
involved may take a long period of planning to
-31-
generate. The roots of liquidity crises that put firms
out of business often are buried in inadequate long-
term solvency planning in earlier years.
It is not a good idea to be too conservative and
attempt to have maximum liquidity and solvency.
Given that the goal of the firm is to make more
money now and in the future, the financial manager
must balance the need for solvency and liquidity with
the need to supply funds for the firm to continue to
grow and be fully invested and therefore profitable.
Every dollar kept in a liquid form (such as cash,
treasury bills, or money market funds) is a naira that
could have been invested by the firm in some longer-
term, higher yielding project or investment.
Responsibilities of the financial manager
1. Safeguarding funds;
2. Controlling funds (receiving and
disbursement);
3. Controlling revenue and expenditure;
4. Classifying and coding of transactions;
5. Accounting for revenue and expenditure;
6. Budget preparation, maintenance and control
7. Financial auditing;
8. Gathering input/output data
9. Operating decision making tools;
10. Developing methods and techniques for

11. evaluating effectiveness and efficiency;

The role of financial management.
12.Transmitting information;
The role of financial management can be classified
13. Ensuring that activities comply with the lows or
into five main heading:
regulations that governs the organisation;
1. Raising of funds to finance a company.
14. Ensuring that funds are expended on
2 Financial analysis of company’s operation and
15. Programmes initially planned
growth considerations.
16. Raising funds;
3. Forecasting, monitoring and control of working
17. Giving financial advice.
capital cycle.
4. Selection, appraisal and control of capital
investment.
5. Valuation of business especially in relation to
acquisition and mergers.

-32-
-33-
SOURCES OF FUNDS
Despite all the differences among companies, there
are only a few sources of funds available to all firms.
1. They make profit by selling the product for more
than it costs to produce. This is the most basic
source of funds for any company and hopefully the
method that brings in the most money.
2. Like individuals, companies can borrow money.
This can be done privately through bank loans, or it
can be done public through a debt issue. The
drawback of borrowing money is the interest that
must be paid to the lender .
3. A company can generate money by selling part of
itself in the form of share to investors, which is known
as equity funding. The benefit of this is that investors
do not require interest payments like bondholders do.
In an ideal world, a company would bring in all of its
cash simply by selling goods and service for profit.
But as the old saying goes, “you have to spend
money to make money, “and just about every
company has to raise funds at some point to
develop products and expand into new markets.
Now let look at this issue more critically from the
perspective of cash flow.
-34-
Below are the main sources of funds or capital,
available to businesses to improve and manage cash
flow.
1. Owner’s Capital- As you probably know, this is
often the only source of capital available for the sole
trader starting in business. The same often applies
with partnerships, but in this case there are more
people involved, so there should be more capital
available. This type of capital though, when invested
is often quickly turned into long term, fixed assets,
which cannot be readily converted into cash. If there
is a shortfall on a cash flow forecast, the business
owners could invest more money in the business. For
many businesses the owner may already have all his
or her capital invested, or may not be willing to risk
further investment, so this may not be the most likely
source of funding for cash flow problems.
2. Shareholders’ Capital – shareholders are of
course the owners of a limited company, they invest
money in the hope of capital growth, (that is the
business makes profits, grows, makes more profits,
so as the business becomes bigger their investment
will be worth), and dividend (the shareholders share
of the companies profits. It is quite normal for limited
companies to issue new shares (a Rights issue), in
an attempt to raise capital, but this is normally for
-35-
investment, funding expansion or restructuring, not
for solving a cash flow problem!
3. Retained Profit – At the end of the trading year a
business will work out its profit. All of this profit can
be taken by the owners, (this would be a dividend in
limited company), or alternatively some or all of it
could be reinvested in the company, to help the
business grow and therefore make even more profit
in the future. Retained profit is show as reserves on
Balance Sheet, but can take the form of any
business asset, so it may not be cash flow any
Retained Profit will be allowed for and shown in
opening balance, if it is held as cash.
4. Overdraft – this is a form of loan for a bank. A
business becomes overdrawn when it withdraws
more money out of its account than there is in it, this
leaves a negative balance on the account. This is
often a cheap way of borrowing money as once an
overdraft has been agreed with the bank the
business can use as much as it needs at any time,
up to the agreed overdraft limit. But, the bank will of
course, charge interest on the amount overdrawn,
and will only allow an overdraft if they believe the
business is credit worthy i.e. is very likely to pay the
money back. a bank can demand the repayment of
an overdraft at any time. Many businesses have
been forced to cease trading b because of the
-36-
withdrawal of overdraft facilities by a bank. Even so
fro short term borrowing, an overdraft is often the
ideal solution, and make businesses often have a
rolling (on going) overdraft agreement with the bank.
This then is often the ideal solution for overcoming
short term cash flow problems, e.g. funding purchase
of raw material whilst waiting payment on goods
produced.
5. Bank Loan – this is lending by a bank to
businesses. A fixed amount is lent e.g. N10,000 for
fixed period of time, e.g. 3 years. The bank will
charge interest on this, and the interest plus part of
the capital, (the amount borrowed), will have to be
pay back each month. Again the bank will only lend if
the business is credit worthy, and it may require
security. If security is required, this means the loan is
secured against an asset of the borrower, e.g. his
House if a Sole Trader, or an asset or the business.
If the load not repaid, then the bank can take
possession of the asset and sell the asset to get its
money back! Load are normally made for capital
investment, so they are unlikely to be used to solve
short-term cash flow problems. But if a loan is
obtained, then this frees up other capital held by the
business, which can then used for other purposes.
6. Leasing- with leasing a business has the use of
an asset, but pays a monthly fee for its use and will
never own it. Think, of, someone setting up business
-37-
as a Parcel Delivery Services, he could lease the van
he needs from a leasing company. He will have to
pay a monthly leasing fee, say N 250, which is very
useful if he does not wish to spend N 8,000 on
buying a van. This will free up capital, which can now
be used for other purposes. A business looking ot
purchase equipment may decide to lease if it wishes
to improve its immediate cash flow. In the example
above, if the van had been purchased, the flow of
cash out of the business would have been N 8,000,
but by leasing the flow out of the business over the
first year would be N 3,000, leaving possible N 5,000
for other assets and investment in the business.
Leasing also allows equipment to be updated on a
regular basis, but it does cost more than outright
purchase in the long run.
7. Hire Purchase - This is similar to leasing, but at
the end of the hire period the asset belongs to the
company that hires it. E.g. a farmer could hire
purchase a tractor.
8. Buying on credit –this create creditors. If
business, which sells shoes, buys on credit from
Johnson’s shoes, it may not have to pay Johnson’s
for a month after delivery. This means it could sell
the shoes at a profit and have the money at the end
of the month to it bill to Johnson’s. Extending a credit
period will help short term cash floe this could be
-38-
done by delaying paying bill for extra 14 days,
meaning there will more cash in the bank for this
period unfortunately this type of action may upset
businesses suppliers, after all they have their own
cash flow to think of! The next time the business
wanted credit from a supplier they had been very
slow in paying in the past, they may be turned down!
slow payment by debtors is the problem for many
businesses, and in fact the government had tried
take action against this type of behaviour in several
budgets.
9. Selling Assets – A business can sell assets it
owns to raise capital!! This is often a last gasp
measure as assets usually vitally necessary to
business activity. In some cases the business may
lease back the assets so that it still retains it use but
this often the preserve of big business e.g. the sale
and lease back of office blocks. Selling assets, and
leasing and assets back improves cash flow in the
short term. If the cash raised from the sale of the
assets is used effectively by the business, cash flow
and profitability can also increase in the long term.
10. Debtors – if a firm is in immediately need of
cash it could chase its debtors for repayment. This
may involve giving discount for early repayment.
Chasing for early repayment may lease to long term
loss of trade as the debtors may buy from another
-39-
business next time, but can effective method of EVALUATION OF FINANCAIL POLICY
solving short term cash flow problems. formula sheet only.
11. Factoring – for larger firms, with a turnover Average Tax Rate =
(sales) of 1,000,000 or more a year, it is possible to
let a factor manage your debtors for you. The factor Current Rate =
(a type of finance company) will pay 80 % of the
value of an invoice at the time of sale and will take Quick ratio =
responsibility for receiving payment from the debtor.
Cash ratio =
The balance of the debt will be passed on when the
money is received by the factor. There is of course a Total Debts ratio
charge for this and the amount of charge will depend
upon several issues such as, number of debtors, size = =
of debts, past bad debt history. But factoring dose
improve a businesses cash flow and it popularity Debt – to Equity Ratio=
amongst small to medium size businesses prove ROA =
many managers and owner regard this service as
goods value for money.

Time Interest Earned =

-41-=
Cash Coverage Ratio

Total Assets Turnover =

Fixed Assets Turnover =

InventoryTurnover=OR
-40-
Profit Margin (ROS)= =

ROE =

PRACTICE QUESTIONS
-43-
1. What factor has contributed to the importance

of financial management in recent years?

Return on Capital 2. Why should finance be managed?

-42-
3. A financial manager makes decisions, which

Basic Earning Power = directly affect the flow of funds in an organisation.

Discuss.
Earning per share = 4. What are the significance of financial

management?
Price - Earnings Ratio = 5. What is the role of finance in the Nigeria
Dividend pay out ratio = Dividends ÷ Net Income economy, and how can financial management

be used to further national goals?

Market value – Book Value Ratio
 departments and by the central statistical office,
which performs the major task of constructing and
presenting statistics over a very wide field of
activities. The formation available from government
sources is so wide that only a few can be included for
illustration purposes.
a. National income and expenditure.
-44- b. Annual abstract of statistics.
c. Department of employment gazette.
d. Monthly digest-45-
of statistics.
e. Trade and industry.
f. Census of production.
g. Central Bank of Nigeria Quarterly Bulletin.

Financial Institutions
a. Clearing Bank Review.
b. Reviews and Statistics by Stock Exchange,
c.Finance Houses Associations etc.
d. Financial publications via the press e.g.
FINANCIAL PLANNING e.Financial Times, Business Concord, etc.

Others
MANAGEMENT INFORMATION a. National Economic Development Council.
FOR PLANNING b. National institute for Economic Review.
The main sources from which information necessary c. Employees’ Organisations.
for preliminary financial planning may be derived d. Employers’ Organisations.
from:… e. Trade associations

Government Sources Leading indicators for financial planning are:

This would embrace publications issued by specific 1. Business Times Share Index
2. Changes in Exchange Rates.
3. Index of Industrial Production.
4. Levels of Stocks of Raw Materials.
BUSINESS FORECASTING
Introduction
It is necessary to distinguish between Budget and
Forecast. A forecast is concerned with ‘probable
events’ while a budget relates to panned events and
a statement of the policy to be carried out. Complex
-46-
or long term forecasts naturally involve range of
problems. In such a situation, the most convenient
method is to subdivide the work according to the
main function of the business.
In this chapter, the forecast will be subdivided into
(a) Sales forecast
(b) Output forecast
(c) Capital expenditure forecast
(d) Trading results forecast.
(e) Cash forecast.
The Accountant must be ready to supply from his
record to other departmental heads details and
reliable background data as to past experience and
recent trends of sale, output and capital expenditure
forecast.
He may be called upon to carry out the arithmetical
work of translating quantitative estimates into money
totals, and will act as a coordinator, Keeping watch or
inconsistencies in figures submitted to him.
In addition, he will be concerned with the
presentation and interpretation of forecast to
management and the comparison of the forecast with
the actual results.
SALES FORECAST
The state of the market is the basic variable
elements affecting the future of any business,
although in conditions of high demand, shortage of
materials, capital -47-
or capacity may determine the
extent to which demand can be satisfied
The purpose of sales forecast
A sales forecast may be needed
a. To establish sale budget.
b. To aid management decision e.g. by estimating
the profitability of new product or by product.
c. To plan production leading over to a given period,
to allow for cyclical and seasonal fluctuations.
d. To provide studies of the market for future
references and for the guidance of long term
management policy rather than to aid particular
decisions.
Factors influencing the level of sales
Factors likely to influence the level of sales may be
either external or within the control of management.
The external factors likely to influence the level of
sales are as follows
1. Fluctuation in the size of the population
and in its sex and age make up.
2. The general level of prosperity. The level of
employment and income purchasing power, the trend
of consumption, the rate of investment and the
psychological factors of confidence in the future.
3. The extent and severity of competition in
the market and the probable availability of substitute
products
4. The repercussion of world events, such as war,
international tensions, arms races, economic
development projects, new inventions etc.
5. Government policy and regulations e.g. import
restrictions. -48-
6. Social changes brought about by redistribution of
income.
7. Seasonal and cyclical fluctuations.
OUTPUT FORECAST
Purposes of output forecast
In order to be able to forecast output, one should be
able to answer the following questions
1. How can the value of sales on forecast be
produce?
2. What normal stock level of finished goods and
work-in progress are necessary to make the
output available at the time it is required?
3. Can seasonal sales fluctuation be absorbed by
temporary adjustment of stock levels?
4. What difficulties have to be overcome in order
to obtain raw materials, labour and services
5. What is the effect of expansion, contraction or
substitution on the available or utilization of
buildings, plant and labour?
The essence of the above questions is to be able to
find
1. A combination of plant and labour that can
produce the forecast sales at the lowest cost;
2. The most efficient use of resources to meet a
given sales programme.
Factors affecting output fore-cast
a. Materials-49-
1. Quantity required
2. Quality required
3. Price trends
4. Availability and source of supply
5. Frequency and size of deliveries
6. The possibility of using substitutes
7. The production of buy-products
External factors, which must be considered in
forecasting turnover from export sales, are
1. Restrictions imposed by exporting country
2. Restrictions imposed by the government of the
market countries.
3. Restrictions imposed by trade associations and
similar bodies set up.
4. The number and extent of the sources of
competition.
5. Economic trends affecting the prosperity of
particular markets.
6. The necessity of satisfying markets, which have
special requirement due to local conditions.

Controllable factors influencing the level of
sales are as follows;
1. The use of promotion aids, such as market
research, advertising, incentives to salesman
and distributors.
2. The ability of the organization to satisfy
demand, which must in the short run, set the
upper limit of sales.
3. The quantity of the financial products.
4. The level of selling-50-
prices, changes of which
depend on the degree of elasticity of demand
for the product.
Additional controllable factors to be considered in
respect of export sales are;
1. Price policy. Management may consider a
policy of price discrimination in certain export
markets, perhaps in the form of ‘dumping’ or
selling below cost in order to establish control
over particular area.
2. Methods of distributions. Sales may be made
through distributors associate selling
companies, or direct for government buying
agencies.
b. Labour
1. The type and availability of labour.
2. The size of the labour force at a particular period
having regards to machine, staffing etc
3. The cost of labour, hours of work needed for
shift work, overtime and night work.
4. Statutory regulations.
5. The influence exerted by trade unions.
6. The problems of redundancy and redeployment
of labour.
c. Buildings, plant and equipment
Any projected change in the products to be
manufactured, new methods of handling materials
and of production are factors which may influence
the need for alterations or additions to buildings,
-51-
plant and equipment.
d. Services
The following internal and external services should
be considered.
i). Coals, gas, electricity, hydraulic power,
compressed air, water supplies.
ii). Adequacy of internal transport.
iii). External transport by road, air and water.
CAPITAL EXPENDITURE FORECAST
The need for a forecast of capital expenditure arises
because circumstances change or can be changed.
Factors to be considered are:
1) The necessity of replacing assets as they become
worn out or obsolete.
2) The need for more or less machinery, plant or
building which may be revealed by the sales and
output forecast.
3) Any important change in capital equipment.
4) New or improved plant or machinery may become
available.
FORECAST OF TRADING RESULTS
The form and extent of trading forecasts are
influenced by two factors:
The kind of activity under forecast and the purpose of
the forecast. Forecast may be grouped into three
broad categories.
1. Those concerned with -52-
a series of events and their
correlation over a comparatively short period.
2. Those dealing only with a major change in
conditions or a single event, such as the marketing
of a new product or by-product, the introduction of
a new process or machine or the opening of a new
market.
3. Those involving a survey of all the changes in
conditions and events, which may affect a
business over a considerable period such as long
plan for development over a period of, say 10 or
20 years.
Period: The period covered by the trading forecast
will vary not only with the nature of the project but
also with the industry, type of business or prevailing
market conditions.
Preparation: In the preparation of trading results
forecast, the following consideration will have to be
taken into account.
(1) Changes in prices of materials, labour, plant.
Buildings and services.
(2) Changes in the prices of products sold and
discount allowed.
(3) The necessity for holding larger stocks or giving
extended credit.
(4) Alteration in bank credit facilities.
(5) Changes in taxation.
CASH FORECAST
-53-
The liquidity of a business depends on a correct
assessment of the factors affecting the cash forecast.
The need to know the probable effect of future
events on the cash position of a company arises:
(1.) To ensure that sufficient cash is available for
revenue, expenditure including cover for the ordinary
trading fluctuation of manufacturing stocks and
selling goods.
(2.) To indicate where additional finance is needed
and when.
(3.) To preserve sufficient liquidity throughout the
year to reveal surplus cash resources which may be
available for profitable investment externally of for
expansion of facilities.
(4.) To provide a guide to show whether external
capital investment must be financed from external
sources or from internal funds.
Factors affecting cash forecasts
The factors that affect cash forecast are as follows:
(1) Programmes of expansion or contraction
particularly with regard to fixed assets.
(2) Increase or decrease in level of stocks, work-in-
progress and debtors.
(3) Increase or decrease in value of stocks, work-in –
progress and debtors through the effects of changing
price levels.
Methods of cash forecast
There are three methods of making a cash forecast:
(a) Receipts and payment basis suitable for short-
term forecasts. -54-
(b) Profit and loss basis suitable for longer forecasts.
(c) Balance sheet basis mainly for long-term
forecasts.
PROFIT AND LOSS FORECAST
A profit forecast is the amount of profit you expect to
make at the end of the period. The monthly profit and
loss forecast will consist of the following:
• Sales - This is the cash you receive during a
period of time including what you are owed,
minus what you were owed at the end of the
previous period. You do not include the
amount of VAT here as you do in the cashflow
forecast.
• Cost of sales - This is the cost that you
estimate will vary with the level of your sales.
It will include items such as purchases (such
as raw materials or items you buy to sell),
labour (any employees who are directly
involved with the manufacturing of your
product) and other direct costs.
• Gross Profit - This is total cost of sales figure
minus sales.
• Overheads - This is where you would list all
the expenses involved in running the
business, such as rent and rates, heating and
lighting, telephone, drawings and so on.
• Total Overheads - This is the total sum of the
above.
-55-
• Miscellaneous income - This is where you
would put the estimate figure of any other
income you might receive that is not from the
sale of your product. For example, interest
from money invested.
• Net Profit - The net profit figure is the gross
profit plus the miscellaneous income minus
the total overheads.
BALANCE SHEET FORECAST
The Balance Sheet forecast is an estimate of what
your business owe and own at a particular period of
time. It consists of the following:
• Fixed Assets - This is items such as property,
furniture, machinery, and fittings, vehicles that
are acquired for use in the business over a
prolonged period of time.
• Total Fixed Assets - This is the total figure of
the above.
 • Current Assets - These are mainly cash in
hand and at the bank, stock (includes any raw
materials or half-finished products not yet sold)
and debtors (what the customers owe you).
• Total Current Assets - The total sum of the
above.
• Total Assets - The total fixed assets plus the
total current assets.
-56-
Capital and Liabilities
• Capital - This would be the money used to
start your business. You would also put I the
figure for profit and loss taken from your profit
forecast. If you forecast a loss, you would
need to put this in brackets and deduct from
your capital.
• Liabilities - The liabilities of a business may
be of two types: current liabilities such as
overdrafts, tax payable (including VAT) and
creditors (what you owe to your suppliers at
the end of the period) and long tem liabilities
such as loans.
The Working Capital is the value of the current
assets of the business less the current liabilities. The
Working Capital is essential to businesses, the lack
of which is a common reason for business failure.
There are many useful sources that can help you
draw up your forecasts, which include banks that
usually provide the template for forecasts. Your
accountant can also help you to produce the
forecasts.
CAPITAL STRUCTURE
In finance, capital structure refers to the way a
corporation finances its assets through some
combination of equity, debt, or hybrid securities. A
firm's capital structure is then the composition or
-57- For example, a firm that
'structure' of its liabilities.
sells N20 billion in equity and N80 billion in debt is
said to be 20% equity-financed and 80% debt-
financed. The firm's ratio of debt to total financing,
80% in this example, is referred to as the firm's
leverage. In reality, capital structure may be highly
complex and include tens of sources. Gearing Ratio
is the proportion of the capital employed of the firm
which come from outside of the business finance,
e.g. by taking a long term loan etc.
1. Equity capital or financing is money raised by a
business in exchange for a share of ownership in the
company. Ownership is represented by owning
shares of stock outright or having the right to convert
other financial instruments into stock of that private
company. Two key sources of equity capital for new
and emerging businesses are angel investors and
venture capital firms.
2. Debt capital is the capital that a business raises
by taking out a loan. It is a loan made to a company
that is normally repaid at some future date. Debt
capital differs from equity or share capital because
subscribers to debt capital do not become part
owners of the business, but are merely creditors, and
the suppliers of debt capital usually receive a
contractually fixed annual percentage return on their
loan, and this is known as the coupon rate.
-58-
Differences Between Debt and Equity Capital
Debt Capital: Debt capital is represented by funds
borrowed by a business that must be repaid over a
period of time, usually with interest. Debt financing
can be either short-term, with full repayment due in
less than one year, or long-term, with repayment due
over a period greater than one year. The lender does
not gain an ownership interest in the business and
debt obligations are typically limited to repaying the
loan with interest. Loans are often secured by some
or all of the assets of the company.
Equity Capital: Equity capital is represented by funds
that are raised by a business, in exchange for a
share of ownership in the company. Equity financing
allows a business to obtain funds without incurring
debt, or without having to repay a specific amount of
money at a particular time.
3. Hybrid security: Hybrid Securities are tradable
securities possessing characteristics borrowed from
both debt and equity instruments. Their myriad forms
make understanding and evaluating the risk / return
trade-off imperative if investors are to make informed
decisions to include or exclude a component of these
securities in their portfolios.
Hybrid Securities pay a predictable (fixed or floating)
rate of return or dividend for a certain period of time,
usually until a maturity or conversion date. At that
date the holder has a number of options including
converting the securities into the underlying share or
cash or more commonly-59-reset for another term. Each
issuer determines the specific terms of the
conversion.
Therefore, unlike a share the holder has a “known”
cash flow, and, unlike a fixed interest security, there
is an option to convert to the underlying equity. More
common examples include convertible and
converting preference shares. Converting preference
shares means that at the maturity date (or
conversion date) the security converts into ordinary
shares whereas with a convertible preference share,
the holder has the option of redeeming to cash or
converting to shares.
4. Vendor financing: A loan from one company to
another which is used to buy goods from the
company providing the loan. In this way, the vendor
increases sales, earns interest, and may sometimes
also acquire an interest in the customer. This
increases the risk profile of a company if it is carried
out on a large scale, since many companies do not
have the skill to conduct credit analysis. Large,
creditworthy buyers are unlikely to make use of this
arrangement, since they will be able to borrow
money at lower rates from other sources.
5. Insurance float: In the insurance industry, "other
people's money" is known as float. Float is such a
valuable form of capital because not only does the
insurance company -60-get to keep the investment
income, but also the company's cost of capital is
often low or even positive.
The Power of Float: The source of insurance funds is
"float," which is money that doesn't belong to the firm
but that it is temporarily hold. Most of the float arises
because
(1) premiums are paid upfront though the service
provided - insurance protection - is delivered over a
period that usually covers a year and;
(2) loss events that occur today do not always result
in immediately paying claims, because it sometimes
takes many years for losses to be reported,
negotiated and settled..
6. Sweat equity: The equity that is created in a
company or some other asset as a direct result of
hard work by the owner(s).
Sweat equity is a term used to describe the
contribution made to a project by people who
contribute their time and effort. It can be contrasted
with financial equity which is the money contributed
towards the project. It is used to refer to a form of
compensation by businesses to their owners or
employees. The term is sometimes used in
partnership agreements where one or more of the
partners contributes no financial capital. In the case
of a business startup, employees might, upon
incorporation, receive stock or stock options in return
-61-
for working for below-market salaries (or in some
cases no salary at all).
The term is sometimes used to describe the efforts
put into a start-up company by the founders in
exchange for ownership shares of the company. This
concept, also called "stock for services" and
sometimes "equity compensation" or "sweet equity"
can also be seen when start-up companies use their
shares of stock to entice service providers to provide
necessary corporate services in exchange for a
discount or for deferring service fees until a later date
TECHNIQUES OF FINANCIAL ANALYSIS
Break-even analysis and ratio analysis are going to
be used here.
Break-even analysis
Break-even analysis is a technique widely used by
production management and management
accountants. It is based on categorising production
costs between those which are "variable" (costs that
change when the production output changes) and
those that are "fixed" (costs not directly related to the
volume of production).

Total variable and fixed costs are compared with

sales revenue in order to determine the level of
sales volume, sales value or production at which
the business makes neither a profit nor a loss
(the "break-even point").
-62-
The Break-Even Chart

In its simplest form, the break-even chart is a
graphical representation of costs at various levels of
activity shown on the same chart as the variation of
income (or sales, revenue) with the same variation in
activity. The point at which neither profit nor loss is
made is known as the "break-even point" and is
represented on the chart below by the intersection of
the two lines:
In the diagram above, the line OA represents the
variation of income at varying levels of production
activity ("output"). OB represents the total fixed costs
in the business. As output increases, variable costs
are incurred, meaning
-63- that total costs (fixed +
variable) also increase. At low levels of output, Costs
are greater than Income. At the point of intersection,
P, costs are exactly equal to income, and hence
neither profit nor loss is made.

Fixed Costs
Fixed costs are those business costs that are not
directly related to the level of production or output. In
other words, even if the business has a zero output
or high output, the level of fixed costs will remain
broadly the same. In the long term fixed costs can
alter - perhaps as a result of investment in production
capacity (e.g. adding a new factory unit) or through
the growth in overheads required to support a larger,
more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
Variable costs are those costs which vary directly
with the level of output. They represent payment
output-related inputs such as raw materials, direct
labour, fuel and revenue-related costs such as
commission.
A distinction is often made between "Direct" variable
costs and "Indirect"-64-
variable costs.
Direct variable costs are those which can be directly
attributable to the production of a particular product
or service and allocated to a particular cost centre.
Raw materials and the wages those working on the
production line are good examples.
Indirect variable costs cannot be directly attributable
to production but they do vary with output. These
include depreciation (where it is calculated related to
output - e.g. machine hours), maintenance and
certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable
costs is a convenient way of categorising business
costs, in reality there are some costs which are fixed
in nature but which increase when output reaches
certain levels. These are largely related to the overall
"scale" and/or complexity of the business. For
example, when a business has relatively low levels of
output or sales, it may not require costs associated
with functions such as human resource management
or a fully-resourced finance department. However, as
the scale of the business grows (e.g. output, number
people employed, number and complexity of
transactions) then more resources are required. If
production rises suddenly then some short-term
increase in warehousing and/or transport may be
required. In these circumstances, we say that part of
the cost is variable -65-
and part fixed.
We can relate Break-Even Point to the information in
our financial statements, particularly the Income
Statement. The Income Statement should be
organised into the following sections:
1. Revenue
The sum of all sales and other income net of returns
and sales commissions.
2. Cost of Sales (Cost of Goods Sold)
The cost of purchases that are resold (merchandise)
and/or raw materials plus the costs of labor to
manufacture the product or convert it or install it or
deliver it or construct it on site. These costs are also
called direct or variable costs.
3. General & Administrative Costs
(Overhead)
These are all the costs not directly, or easily, related
to sales volume such as Advertising, Bank Charges,
Computer Expenses, Insurance, Office Wages &
Salaries, Officer’s Compensation, Telephone,
Utilities, Depreciation, Interest, Taxes etc. These
costs are also called indirect or fixed costs.
4. 1 minus 2 minus 3 = PROFIT.
-66-
Note: If your Income Statement is not organised in
this fashion (called managerial accounting format),
you need to have a session with your accountant
and demand it be put into this format so you can
manage the business better.
Once you have your financial statements and data in
the right format, you can easily calculate Break-Even
using the following formula as:
Break-Even Point = FC/(1-VC/S)
Where: FC = Fixed Costs
VC = Variable Costs
S = Sales
For illustrative purposes, let’s look at an example
company, Umeh Global Ventures, had the following
data from its Income Statement:
Sales = N1,000,000
Cost of Goods Sold = N 710,000
General & Admin = N 215,000
Break-Even Point (during the period indicated by the
-67-
income statement) is:
Break-Even Point = FC/(1-VC/S) and
VC/S = 710,000/1,000,000 = .71
1- VC/S = 1 - .71 = .29
FC/(1-VC/S) = 215,000/.29 = $741,379 = BEP This is assuming, of course, that fixed costs can be
accurately or, at least, reasonably associated with
And the company operated at N 1,000,000/741,379 = the organisers above.
135% of Break-Even during the period.
Ratio Analysis
Note that ..Break-Even can be calculated for: Ratio analysis was developed to determine the
stability of various financial aspects of a business. It
A Company shows the relationship between two figures, or two
aspects of your business. It helps you work out your
A Division business' financial weaknesses and strengths, so
that you can take appropriate action.
A Location Ratio analysis also offers a view of your business'
competitive performance in relation to similar
A Department businesses in your industry.

A Store Financial ratio analysis is the calculation and

comparison of ratios which are derived from the
A Product information in a company's financial statements. The
level and historical trends of these ratios can be used
A Product Line to make inferences about a company's financial
condition, its operations and attractiveness as an
A Service investment

A Day Financial ratios are calculated from one or more

-68- pieces of information from a company's financial
A Week statements. -69-

A Month For example, the "gross margin" is the gross profit

from operations divided by the total sales or
A Year (or any other time period) revenues of a company, expressed in percentage
terms. In isolation, a financial ratio is a useless piece
of information. In context, however, a financial ratio
can give a financial analyst an excellent picture of a
company's situation and the trends that are
developing.
A ratio gains utility by comparison to other data and
standards. Taking our example, a gross profit margin
for a company of 25% is meaningless by itself. If we
know that this company's competitors have profit
margins of 10%, we know that it is more profitable
than its industry peers which is quite favourable. If
we also know that the historical trend is upwards, for
example has been increasing steadily for the last few
years, this would also be a favourable sign that
management is implementing effective business
policies and strategies.
Financial ratio analysis groups the ratios into
categories which tell us about different facets of a
company's finances and operations. An overview of
some of the categories of ratios is given below.
• Leverage Ratios which show the extent that
debt is used in a company's capital structure.
• Liquidity Ratios-70-which give a picture of a
company's short term financial situation or
solvency.
• Operational Ratios which use turnover
measures to show how efficient a company is
in its operations and use of assets.
• Profitability Ratios which use margin
analysis and show the return on sales and
capital employed.
• Solvency Ratios which give a picture of a
company's ability to generate cash flow and
pay it financial obligations.
It is imperative to note the importance of the proper
context for ratio analysis. Like computer
programming, financial ratio is governed by the
GIGO law of "Garbage In...Garbage Out!" A cross
industry comparison of the leverage of stable utility
companies and cyclical mining companies would be
worse than useless. Examining a cyclical company's
profitability ratios over less than a full commodity or
business cycle would fail to give an accurate long-
term measure of profitability. Using historical data
independent of fundamental changes in a company's
situation or prospects would predict very little about
future trends. For example, the historical ratios of a
company that has undergone a merger or had a
substantive change in its technology or market
position would tell very little about the prospects for
this company.
Credit analysts, those interpreting the financial ratios
from the prospects of a lender, focus on the
"downside" risk since -71-
they gain none of the upside
from an improvement in operations. They pay great
attention to liquidity and leverage ratios to ascertain a
company's financial risk. Equity analysts look more to
the operational and profitability ratios, to determine Turnover 1,110,678 697,720
the future profits that will accrue to the shareholder. Cost of sales 830,126 505,738

Gross profit 280,552 191,982

Although financial ratio analysis is well-developed
and the actual ratios are well-known, practicing Operating expenses 176,960 129,359

financial analysts often develop their own measures Operating profit 66,016 41,389

for particular industries and even individual Other costs/income 6,555 -5,132
companies. Analysts will often differ drastically in Profit before interest and taxation 45,012 25,300
their conclusions from the same ratio analysis. Let's put these ratios in a table:
We will now examine profitability RATIO only.
Gross Profit Profitability Ratios for t Jefry Warehouse
Gross Profit Margin = * 100
Turnover
Ratio Name Ratio Formula 31 Mar 06 25 Mar 05
Note: Turnover = Sales
Profitability For the year ended 31
Gross Profit = Turnover - Cost of Sales
Mar 06

Net Profit Margin = Gross Profit 280,552 ÷ 1,110,678*100 25.26%

Margin
X 100 = X 100
Net Profit 45,012 ÷ 1,110,678*100 4.05%
Note: Net Profit = Gross Profit – Expenses Margin

Look and see where these figures and ratios came

Now that we know a bit about profitability ratios, let's
from: don't do anything
-73-else until you have agreed
see how to use them. Here are parts of the profit and
with what it is in this table.
loss account for the Jefry Warehouse plc; we will use
that information to-72-
calculate its gross and net profit Did you see that for the year ended 25 March 2005,

margin. we didn't give you the ratio results?

Jefry Warehouse
Well spotted! So, using the profit and loss account
Consolidated Profit and Loss Account above, calculate the gross and net profit margins for
for the year ended 31 March 2006 25 March 2005
the Jefry Warehouse for the year ended 25 March
N'000 N'000
2005, enter those ratios in the table above.
 taxation

Company: Vodafone plc Tax on profit on ordinary activities -2956.0 -2140.0 -1426.0

Description: Profit on ordinary activities after

-9164.0 -15679.0 -9512.0
taxation

The COMPANY is involved principally in the

Equity minority interests -655.0 -476.0 -373.0
provision of mobile telecommunications services.
Profit for the financial period -9819.0 -16155.0 -9885.0
Consolidated Profit & Loss Account for
2003 2002 2001
the year ended
Dividends 1154.0 -1025.0 -887.0

Weeks 52 52 52
Retained profit -10973.0 -17180.0 -10772.0

Currency N million N million N million

Consolidated Balance Sheet
-75-
Turnover 30375.0 22845.0 15004.0
Fixed assets

Cost of sales -17896.0 -13446.0 -8702.0

Intangible Assets 108085.0 105944.0 108853.0
-74-
Gross Profit 12479.0 9399.0 6302.0
Tangible Assets 19574.0 18541.0 10586.0

Operating Expenses -17774.0 -21233.0 -13291.0

Investments 27030.0 28977.0 34769.0

Operating Profit -5295.0 -11834.0 -6989.0

Total Fixed Assets 154689.0 153462.0 154208.0

Other costs/income -161.0 -860.0 80.0

Current assets

Profit before interest and taxation -5456.0 -12694.0 -6909.0

Stock 365.0 513.0 316.0

Net interest receivable (payable) -752.0 -845.0 -1177.0

Debtors due within one year 7460.0 7053.0 4587.0

Profit on ordinary activities before -6208.0 -13539.0 -8086.0

Short-term investments 291.0 1792.0 13211.0 Minority interests 2863.0 2855.0 2421.0

Cash at bank and in hand 475.0 80.0 68.0 Total capital employed 131534.0 133428.0 147428.0

Total Current Assets 8591.0 9438.0 18182.0 Weighted average number of shares in
65012501146 65012501146 61334032162
issue in the period

Creditors: Amounts falling due within

-14293.0 -13455.0 -12377.0
one year

Net Current Assets (liabilities) -5702.0 -4017.0 5805.0

Total assets less current liabilities 148987.0 149445.0 160013.0

-77-- answer
Vodafone profit margin
Creditors: Amounts falling due after more
-13757.0 -13118.0 -11235.0
than one year -76-
Vodafone plc
Provisions for liabilities and charges -3696.0 -2899.0 -1350.0
Profitability 31 Mar 2002 31 Mar 2001
Net assets 131534.0 133428.0 147428.0
Gross Profit Margin 41.14% 42.00%
Capital and reserves

Net Profit Margin -55.57% -46.05%

Called-up share capital 4275.0 4273.0 4054.0

Share premium 52073.0 52044.0 48292.0

Other reserves 99770.0 99862.0 97938.0

Profit and loss account -27447.0 -25606.0 -5277.0

PRACTICE QUESTIONS
Equity shareholders' funds 128671.0 130573.0 145007.0 1. In planning for finance, what are the major sources
of information available?
2. State in detail, short, medium and long term
forecasting of capital requirement.
3. What are the various techniques available for
financial analysis?
-78-
WORKING CAPITAL
MANAGEMENT
Decisions relating to working capital and short term
financing are referred to as working capital
management. These involve managing the
relationship between a firm's short-term assets and
its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to
continue its operations and that it has sufficient cash
flow to satisfy both maturing short-term debt and
upcoming operational expenses.
Management of working capital
Management adopt a combination of policies and
techniques for the management of working capital.
These policies aim at managing the current assets
-79-
(generally cash and cash equivalents, inventories
and debtors) and the short term financing, such that
cash flows and returns are acceptable.
•Cash management. Identify the cash balance
which allows for the business to meet day to day
expenses, but reduces cash holding costs.
•Inventory management. Identify the level of
inventory which allows for uninterrupted
production but reduces the investment in raw
materials - and minimizes reordering costs - and
hence increases cash flow; see Supply chain
management; Just In Time (JIT); Economic order
quantity (EOQ); Economic production quantity
•Debtors management. Identify the appropriate
credit policy, i.e. credit terms which will attract
customers, such that any impact on cash flows
and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital
(or vice versa); see Discounts and allowances.
 •Short term financing. Identify the appropriate
source of financing, given the cash conversion
cycle: the inventory is ideally financed by credit
granted by the supplier; however, it may be
necessary to utilize a bank loan (or overdraft), or
to "convert debtors to cash" through "factoring".
Working capital is directly affecting by other
management issues, such as product mix, supply
chain design and business model (for example agent
vs. distributor)
Decision criteria -80-
By definition, working capital management entails
short term decisions - generally, relating to the next
one year period - which are "reversible". These
decisions are therefore not taken on the same basis
as Capital Investment Decisions (NPV or related, as
above) rather they will be based on cash flows and /
or profitability.
• One measure of cash flow is provided by the
cash conversion cycle - the net number of days
from the outlay of cash for raw material to
receiving payment from the customer. As a
management tool, this metric makes explicit the
inter-relatedness of decisions relating to
inventories, accounts receivable and payable,
and cash. Because this number effectively
corresponds to the time that the firm's cash is tied
up in operations and unavailable for other
activities, management generally aims at a low
net count.
• In this context, the most useful measure of
profitability is Return on capital (ROC). The result
is shown as a percentage, determined by dividing
relevant income for the 12 months by capital
employed; Return on equity (ROE) shows this
result for the firm's shareholders. Firm value is
enhanced when, and if, the return on capital,
which results from working capital management,
exceeds the cost of capital, which results from
capital investment decisions as above. ROC
-81-
measures are therefore useful as a management
tool, in that they link short-term policy with long-
term decision making.
Calculation
Current assets and current liabilities include three
accounts which are of special importance. These
accounts represent the areas of the business where
managers have the most direct impact:
• accounts receivable (current asset)
• inventory (current assets), and
• accounts payable (current liability)
The current portion of debt (payable within 12
months) is critical, because it represents a short-term
claim to current assets and is often secured by long
term assets. Common types of short-term debt are
bank loans and lines of credit.
An increase in working capital indicates that the
business has either increased current assets (that is
received cash, or other current assets) or has
decreased current liabilities, for example has paid
off some short-term creditors.
Implications on M&A: The common commercial
definition of working capital for the purpose of a
working capital adjustment in an M&A transaction (ie
for a working capital adjustment mechanism in a sale
and purchase agreement) -82-
is equal to:
Current Assets - Current Liabilities excluding
deferred tax assets/liabilities, excess cash, surplus
assets and/or deposit balances.
Cash balance items often attract a one-for-one
purchase price adjustment.
MANAGING WORKING CAPITAL
1. Working Capital Cycle
Cash flows in a cycle into, around and out of a
business. It is the business's life blood and every
manager's primary task is to help keep it flowing and
to use the cashflow to generate profits. If a business
is operating profitably, then it should, in theory,
generate cash surpluses. If it doesn't generate
surpluses, the business will eventually run out of
cash and expire. Click here for more information
about the vital distinction between profits and
cashflow.
The faster a business expands, the more cash it will
need for working capital and investment. The
cheapest and best sources of cash exist as working
capital right within business. Good management of
working capital will generate cash will help improve
profits and reduce risks. Bear in mind that the cost of
-83- and holding stocks can
providing credit to customers
represent a substantial proportion of a firm's total
profits.
There are two elements in the business cycle that
absorb cash - Inventory (stocks and work-in-
progress) and Receivables (debtors owing you
money). The main sources of cash are Payables
(your creditors) and Equity and Loans.

Each component of working capital (namely
inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY. When it
comes to managing working capital - TIME IS
MONEY. If you can get money to move faster around
the cycle (e.g. collect monies due from debtors more
quickly) or reduce the amount of money tied up (e.g.
reduce inventory levels-84- relative to sales), the
business will generate more cash or it will need to
borrow less money to fund working capital. As a
consequence, you could reduce the cost of bank
interest or you'll have additional free money available
to support additional sales growth or investment.
Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to help fund
future sales.
2. Sources of Additional Working Capital
Sources of additional working capital include the
following:
• Existing cash reserves
• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans
If you have insufficient working capital and try to
increase sales, you can easily over-stretch the
financial resources of the business. This is called
overtrading. Early warning signs include:
• Pressure on existing cash
• Exceptional cash generating activities e.g.
offering high discounts for early cash payment
-85-
• Bank overdraft exceeds authorized limit
• Seeking greater overdrafts or lines of credit
• Part-paying suppliers or other creditors
• Paying bills in cash to secure additional
supplies
• Management pre-occupation with surviving
rather than managing
• Frequent short-term emergency requests to
the bank (to help pay wages, pending receipt
of a cheque).
3. Handling Receivables (Debtors)
Cashflow can be significantly enhanced if the
amounts owing to a business are collected faster.
Every business needs to know.... who owes them
money.... how much is owed.... how long it is
owing.... for what it is owed.
Late payments erode profits and
can lead to bad debts.
Slow payment has a crippling effect on business, in
particular on small businesses who can least afford
it. If you don't manage debtors, they will begin to
manage your business as you will gradually lose
control due to reduced cashflow and, of course, you
could experience an increased incidence of bad debt.
The following measures will help manage your
debtors:
-86-
1. Have the right mental attitude to the control of
credit and make sure that it gets the priority it
deserves.
2. Establish clear credit practices as a matter of
company policy.
3. Make sure that these practices are clearly
understood by staff, suppliers and customers.
4. Be professional when accepting new
accounts, and especially larger ones.
5. Check out each customer thoroughly before
you offer credit. Use credit agencies, bank
references, industry sources etc.
6. Establish credit limits for each customer... and
stick to them.
7. Continuously review these limits when you
suspect tough times are coming or if operating
in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
10. Consider charging penalties on overdue
accounts.
11. Consider accepting credit /debit cards as a
payment option.
12. Monitor your debtor balances and ageing
schedules, and don't let any debts get too
large or too old.
Recognize that the longer someone owes you, the
greater the chance you will never get paid. If the
average age of your debtors is getting longer, or is
already very long, you may need to look for the
following possible defects:
-87-
• weak credit judgement
• poor collection procedures
• lax enforcement of credit terms
• slow issue of invoices or statements
• errors in invoices or statements
• customer dissatisfaction.
 Debtors due over 90 days (unless within agreed
credit terms) should generally demand immediate
attention. Look for the warning signs of a future bad
debt. For example.........
• longer credit terms taken with approval, particularly
for smaller orders
• use of post-dated checks by debtors who normally
settle within agreed terms
• evidence of customers switching to additional
suppliers for the same goods.
• new customers who are reluctant to give credit
references
• receiving part payments from debtors.
Profits only come from paid sales.
The act of collecting money is one which most
people dislike for many reasons and therefore put on
the long finger because they convince themselves
there is something more urgent or important that
demand their attention now. There is nothing more
important than getting paid for your product or
service. A customer who does not pay is not a
customer. Here are a few ideas that may help you in
-88-debtors:
collecting money from
• Develop appropriate procedures for handling
late payments.
• Track and pursue late payers.
• Get external help if your own efforts fail.
• Don't feel guilty asking for money.... its yours
and you are entitled to it.
• Make that call now. And keep asking until you
get some satisfaction.
• In difficult circumstances, take what you can
now and agree terms for the remainder. It lessens
the problem.
• When asking for your money, be hard on the
issue - but soft on the person. Don't give the
debtor any excuses for not paying.
• Make it your objective is to get the money -
not to score points or get even.
4. Managing Payables (Creditors)
Creditors are a vital part of effective cash
management and should be managed carefully to
enhance the cash position.
Purchasing initiates cash outflows and an over-
zealous purchasing function can create liquidity
problems. Consider the following:
Who authorizes purchasing in your company - is it
tightly managed or spread among a number of (junior)
people?
-89-
Are purchase quantities geared to demand forecasts?
Do you use order quantities which take account of
stock-holding and purchasing costs?
Do you know the cost to the company of carrying
stock ?
Do you have alternative sources of supply ? If not, get
quotes from major suppliers and shop around for the
best discounts, credit terms, and reduce dependence
on a single supplier.
How many of your suppliers have a returns policy ?
Are you in a position to pass on cost increases
quickly through price increases to your customers ?
If a supplier of goods or services lets you down can
you charge back the cost of the delay ?
Can you arrange (with confidence !) to have delivery
of supplies staggered or on a just-in-time basis ?
5. Inventory Management
Managing inventory is a juggling act. Excessive
stocks can place a heavy burden on the cash
resources of a business. Insufficient stocks can result
in lost sales, delays -90-
for customers etc.
The key is to know how quickly your overall stock is
moving or, put another way, how long each item of
stock sit on shelves before being sold. Obviously,
average stock-holding periods will be influenced by
the nature of the business. For example, a fresh
vegetable shop might turn over its entire stock every
few days while a motor factor would be much slower
as it may carry a wide range of rarely-used spare
parts in case somebody needs them.
Nowadays, many large manufacturers operate on a
just-in-time (JIT) basis whereby all the components
to be assembled on a particular today, arrive at the
factory early that morning, no earlier - no later. This
helps to minimize manufacturing costs as JIT stocks
take up little space, minimize stock-holding and
virtually eliminate the risks of obsolete or damaged
stock. Because JIT manufacturers hold stock for a
very short time, they are able to conserve substantial
cash. JIT is a good model to strive for as it embraces
all the principles of prudent stock management.
The key issue for a business is to identify the fast
and slow stock movers with the objectives of
establishing optimum stock levels for each category
and, thereby, minimize the cash tied up in stocks.
Factors to be considered when determining optimum
stock levels include:
• What are the projected sales of each product?
• How widely -91-available are raw materials,
components etc.?
• How long does it take for delivery by
suppliers?
• Can you remove slow movers from your
product range without compromising best sellers?
Remember that stock sitting on shelves for long ordering will reduce average days.
It take you on average x days to collect
periods of time ties up money which is not working Receivables monies due to you. If your official credit
Debtors * 365/ = x terms are 45 day and it takes you 65 days...
for you. For better stock control, try the following: Ratio
Sales days why ?
(in days)
One or more large or slow debts can drag
out the average days. Effective debtor
• Review the effectiveness of existing management will minimize the days.

purchasing and inventory systems. Creditors *

On average, you pay your suppliers every x
days. If you negotiate better credit terms this
• Know the stock turn for all major items of Payables
Ratio
365/ = x will increase. If you pay earlier, say, to get a
discount this will decline. If you simply defer
inventory. (in days)
Cost of Sales days
(or Purchases)
paying your suppliers (without agreement)
this will also increase - but your reputation,
• Apply tight controls to the significant few items the quality of service and any flexibility
and simplify controls for the trivial many. provided by your suppliers may suffer.
Current Assets are assets that you can
• Sell off outdated or slow moving merchandise readily turn in to cash or will do so within 12
- it gets more difficult to sell the longer you keep it. Total Current
months in the course of business. Current
Liabilities are amount you are due to pay
• Consider having part of your product Current Assets/ = x within the coming 12 months. For example,
Ratio Total Current times 1.5 times means that you should be able to
outsourced to another manufacturer rather than Liabilities lay your hands on $1.50 for every $1.00 you
owe. Less than 1 times e.g. 0.75 means that
make it yourself. you could have liquidity problems and be
• Review your security procedures to ensure under pressure to generate sufficient cash to
meet oncoming demands.
that no stock "is going out the back door !" (Total Current
Assets - Similar to the Current Ratio but takes
=x
Quick Ratio Inventory)/ account of the fact that it may take time to
times
Total Current convert inventory into cash.
Liabilities
6. Key Working Capital Ratios
(Inventory +
Working Receivables - As % A high percentage means that working
Payables)/
Capital Ratio Sales capital needs are high relative to your sales.
The following, easily calculated, ratios are important Sales
measures of working capital utilization.

Other working capital-93-

measures include the following:

Ratio Formulae
-92-
Result Interpretation -Bad debts expressed as a percentage of sales.
Stock On average, you turn over the value of your
Turnover
Average Stock entire stock every x days. You may need to -Cost of bank loans, lines of credit, invoice
* 365/ = x break this down into product groups for
(in days)
Cost of Goods days effective stock management. discounting etc.
Sold Obsolete stock, slow moving lines will
extend overall stock turnover days. Faster
production, fewer product lines, just in time
-Debtor concentration - degree of dependency on a X : y eg 1.75: 1
limited number of customers.

Once ratios have been established for your business,

The Calcemco Warehouse is our business of choice,
it is important to track them over time and to compare
them with ratios for other comparable businesses or so here is the information to help us work out its
industry sectors. current ratio.

Consolidated Balance Sheet 31 March 25 March 2000

LIQUIDITY RATIO
Cash is the life-blood of any business, no matter how 2001
large or small. If a business has no cash and no way N'000 N'000
of getting any cash, it will have to close down. It's
that simple! Following on from this we can see that if Total Current Assets 315,528 171,160
a business has no idea of its liquidity and working
Creditors: Amounts falling due within one 222,348 173,820
capital position, it could be in serious trouble.
year
Current Assets: Current Liabilities

(Current Assets-Stocks): Current Liabilities

The two liquidity ratios, the current ratio and the acid
test ratio, are the most important ratios in almost the
whole of ratio analysis are also the simplest to use
Current Ratio For the Calcemco Warehouse
and to learn
-95-
31 March Current Assets: Current 315,528: 1.42: 1
The current ratio is also known as the working 2001 Liabilities 222,348
-94-
capital ratio and is normally presented as a real 25 March Current Assets: Current 171,160: 0.98: 1
ratio. That is, the working capital ratio looks like this: 2000 Liabilities 173,820

Current Assets: Current Liabilities =

Maths revision. How did we get 1.42: 1 for the year Creditors: Amounts falling due within one 13,455 12,377

ended 31 March 2001? All we did was to divide the year

current assets by the current liabilities and that gives

us: Fill in this table and discuss what you find:
current assets 315,528
= = 1.42 Current Ratio For Vodafone
current liabilities 222,348

31 March 2002 Current Assets: Current Liabilities _____: _____ ___: 1

so we automatically know that our ratio is 1.42: 1
31 March 2001 Current Assets: Current Liabilities _____: _____ ___: 1
The same with the year before:
current assets 171,160
= = 0.98
current liabilities 173,820

so the ratio is 0.98: 1

Work through the data for Vodafone and calculate

their current ratio for the two years for which you
have data.
-96-
Vodafone 31 March 31 March 2001
Consolidated Balance Sheet 2002 -97-answer
Vodafone Current Ratio

N’ m N’ m Current Ratio For Vodafone

31 March 2002 Current Assets: Current Liabilities 9,438: 13,455 0.70: 1

Total Current Assets 9,438 18,182

31 March 2001 Current Assets: Current Liabilities 18,182: 12,377 1.47: 1

Vodafone has done almost the exact opposite of the
Calcemco Warehouse with its current ratio. This WORKING CAPITAL AND OPERATING CYCLE
additional information might help your analysis. The operating cycle is the length of time between the
company’s outflow on raw materials, wages and
Current assets 2002 N m 2001 N m other expenditures and the inflow of cash from the
sale of goods.
Stock 513 316

Debtors due within one year 7,053 4,587 In a manufacturing business, this is the average time,

Short-term investments 1,792 13,211 that raw materials remain in stock, less the period of
Cash at bank and in hand 80 68
credit taken from suppliers, plus the time taken for
Total Current Assets 9,438 18,182
producing of the goods, plus the time the goods
Creditors: Amounts falling due within one 13,455 12,377
year
remain unfinished in inventory, plus the time taken by

Net current assets (liabilities) -4,017 5,805 customers to pay for the goods.

Vodafone has liquidated, or sold, many of its short-

-98- This is an important-99-
concept for the management of
term investments. This business has grown at a very
rapid rate and has possibly used the cash from cash or working capital because the longer the
having sold its investments to finance that expansion.
Overall, Vodafone has lost almost N10 billion of operating cycle, the more the financial resources the
working capital as it has fallen from N5.8 billion to
-N4.0. This has left Vodafone in a weak working company needs.
capital position as its creditors are large but its cash
and short-term assets balances are small by
In calculating the operating cycle, allowances should
comparison.
be made for any significant changes in the level of Debtors 24,000 25,000 24,500

Creditors 11,000 12,000 11,500

stock taking place over the period.
Sales 132,000 156,000 144,000

Illustration Purchase of raw 84,000 88,000 86,000

materials
The following figures are derived from JEMI
124,000 136,000 130,000
Cost of goods sold
manufacturing industry, compute its operating cycle

to determine the raw material turn over, period of

Working Guide
production, turn over of finished goods and credit
To arrive the mean figure ……add the figures on
taken by customer.
2001 and 2002 column, then divide the answer by
2.

1. Row materials

Period of turnover of material stock =

-100- (Average value of raw material stock)

-101-
ITEMS 2001 2002 MEAN
÷
Raw materials 16,000 18,400 17,200
(Purchase of raw material per day) =

Work in progress 12,000 13,000 12,500 Less Period of credit granted by suppliers =
inventory
(Average level of creditors)
Finished goods 10,000 14,000 12,000
inventory
÷
(Purchases of raw materials per day) = X Note: to get 236 seen above, divide the mean figure
of the raw materials purchased by 365days of the
year.
2. Period of production =
(Average value of work in progress) 2. Period of production
÷
(Average cost of goods sold per day) = X
= 35days approx.

3. Period of turnover of finished goods stock = 3. Turn-over of finished goods

Average valued of stock of finished goods
÷
(Average cost of goods sold per day) = X = 34days approx.

4. Period of credit taken by customers =

(Average value of debtors) 4. Credit taken by customer
÷ -103-
(Average value of sales per day) x Total
operating cycle = X = 62days approx.

-102- Total number of days = 155 days. Answer

Now let look at the solution to the above problem.
1. Turn over of raw materials =
= 73 days approx.
The operating cycle is only the time span between
production cost and cash returns; it says nothing in
itself on the working capital that will be needed over
this period.

Less credit granted by suppliers

PRINCIPLES OF WORKING CAPITAL
= 49 days approx.

73days – 49days = 24days

There are four principle of working capital
management. They are being depicted as below :
(i) Principle of Risk Variation: - The goal of WC
management is to establish a suitable trade between
profitability and risk. Risk here refers to a firm's ability
to honor its obligation as and when they become due
for payments. Larger investment in current assets will
lead to dependence. Short term borrowings
increases liquidity, reduces risk and thereby
decreases the opportunity for gain or loss On the
other hand the reserve situation will increase risk and
profitability And reduce liquidity thus there is direct
relationship between risk and profitability and inverse
relationship between liquidity and risk.
(ii) Principle of Cost Capital: - The various sources
of raising WC finance
-104- have different cost of capital
and the degree of risk involved. Generally higher the
cost lower the risk, Lower the risk higher the cost. A
sound WC management should always try to achieve
the balance between these two.
(iii) Principle of Equity Position: - This principle is
considered with planning the total investment in
current assets. As per this principle the amount of
WC investment in each component should be
adequately justified by a firms equity position Every
rupee contributed current assets should contribute to
the net worth of the firm The level of current assets
may be measured with the help of two ratios. They
are:
· Current assets as a percentage of total assets.
· Current assets as a percentage of total sales.
(iv) Principle of Maturity Payment: - This principle
is concerned with planning the source of finance for
WC. As per this principle a firm should make every
effort to relate maturities of its flow of internally
generated funds in other words it should plan its cash
inflow in such a way that it could easily cover its cash
out flows or else it will fail to meet its obligation in
time.
CONCEPT OF WORKING CAPITAL
-105-
The concept of Working Capital includes Current
Assets and Current Liabilities. There are two
concepts of Working Capital which are Gross and
Net Working Capital.
1. Gross Working Capital: Gross Working Capital
refers to the firm's investment in Current Assets.
Current Assets are the assets, which can be
converted into cash within an accounting year or
operating cycle. It includes cash, short-term
securities, debtors (account receivables or book
debts), bills receivables and stock (inventory).
2. Net Working Capital: Net Working Capital refers
to the difference between Current Assets and
Current Liabilities are those claims of outsiders,
which are expected to mature for payment within an
accounting year. It includes creditors or accounts
payables, bills payables and outstanding expenses.
Net Working Capital can be positive or negative.
The concept of Gross Working Capital focuses
attention on two aspects of Current Assets'
management. They are:
a) Way of optimizing investment in Current Assets.
b) Way of financing current assets.
a. Optimizing investment in Current Assets:
-106-
Investment in Current Assets should be just
adequate i.e., neither in excess nor deficit because
excess investment increases liquidity but reduces
profitability as idle investment earns nothing and
inadequate amount of working capital can threaten
the solvency of the firm because of its inability to
meet its obligation. It is taken into consideration that
the Working Capital needs of the firm may be
fluctuating with changing business activities which
may cause excess or shortage of Working Capital
frequently and prompt management can control the
imbalances.
b. Way of financing Current Assets: This aspect
points to the need of arranging funds to finance
Company Assets. It says whenever a need for
working Capital arises; financing arrangement should
be made quickly. The financial manager should have
the knowledge of sources of the working Capital
funds as wheel as investment avenues where idle
funds can be temporarily invested.
STOCK CONTROL
Managing stock effectively is important for any
business, because without enough stock, production
and sales will grind to a halt. Stock control involves
careful planning to ensure that the business has
sufficient stock of the right quality available at the
right time.
-107-
Stock can mean different things and depends on the
industry the firm operates in. It includes:
• Raw materials and components from suppliers
• Work in progress or part finished goods made
within the business
• Finished goods ready to dispatch to
customers
• Consumables and materials used by service
businesses
In order to meet customer orders, product has to be
available from stock – although some firms are able
to arrange deliveries Just in Time, see below. If a
business does not have the necessary stock to meet
orders, this can lead to a loss of sales and a
damaged business reputation. This is sometimes
called a ‘stock-out’.
It is important therefore that a business either holds
sufficient stocks to meet actual and anticipated
orders, or can get stocks quickly enough to meet
those orders. For a high street retailer, in practice
this means having product on the shelves.
STOCK HOLDING
There are three types of stock that a business can
hold:
Stocks of raw materials (inputs brought from
suppliers waiting to be used in the production
process) -108-
Work in progress (incomplete products still in the
process of being made)
Stocks of finished products (finished goods of
acceptable quality waiting to be sold to customers)
The aim of stock control is to minimise the cost of
holding these stocks whilst ensuring that there are
enough materials for production to continue and be
able to meet customer demand. Obtaining the correct
balance is not easy and the stock control department
will work closely with the purchasing and marketing
departments.
The marketing department should be able to provide
sales forecasts for the coming weeks or months (this
can be difficult if demand is seasonal or prone to
unexpected fluctuation) and so allow stock control
managers to judge the type, quantity and timing of
stocks needed.
It is the purchasing department’s responsibility to
order the correct quantity and quality of these inputs,
at a competitive price and from a reliable supplier
who will deliver on time.
As it is difficult to ensure that a business has exactly
the correct amount of stock at any one time, the
majority of firms will hold buffer stock. This is the
“safe” amount of stock -109-
that needs to be held to cover
unforeseen rises in demand or problems of
reordering supplies.
STOCK MANAGEMENT
Good stock management by a firm will lower costs,
improve efficiency and ensure production can meet
fluctuations in customer demand. It will give the firm
a competitive advantage as more efficient production
can feed through to lower prices and also customers
should always be satisfied as products will be
available on demand.
However, poor stock control can lead to problems
associated with overstocking or stock-outs.
If a business holds too much buffer stock (stock
held in reserve) or overestimates the level of demand
for its products, then it will overstock. Overstocking
increase costs for businesses as holding stocks are
an expense for firms for several reasons.
• Increases warehouse space needed
• Higher insurance costs needed
• Higher security costs needed to prevent theft
• Stocks may be damaged, become obsolete or
perish (go out of date)
• Money spent buying the stocks could have
been better spent elsewhere
-110-
The opposite of an overstock is a stock-out. This
occurs when a businesses runs out of stocks. This
can have severe consequences for the business:
Loss of production (with workers still having to be
paid but no products being produced)
Potential loss of sales or missed orders. This can
harm the reputation of the business.
In these circumstances a business may choose to
increase the amount of stock they hold in reserve
(buffer stock). There are advantages and
disadvantages of increasing the stock level.
Advantages
Can meet sudden changes in demand
Less chance of loss of production time
because of stock outs
Can take advantage of bulk buying
economies of scale
Disadvantages
Costs of storage – rent and insurance
Money tied up in stocks not being used
elsewhere in the business
Large stocks subject to deterioration and
theft -111-
The costs of holding stock include:
• The opportunity cost of working capital tied
up in stock that could have been used for
another purpose
• Storage costs – the rent, heating, lighting and
security costs of a warehouse or additional
factory or office space
• Bank interest , if the stock is financed by an
overdraft or a loan
• Risk of damage to stock by fire, flood, theft
etc; most businesses would insure against
this, so there is the cost of insurance
 • Stock may become obsolete if buyer tastes
change in favour of new or better products
• Stock may perish or deteriorate – especially
with food products
TOCK SECURITY
Keeping stock secure depends on knowing what you
have, where it is located and how much it is worth -
so good records are essential. Stock that is portable,
does not feature the business' logo, or is easy to sell
on, is at particular risk.
Thieves and shoplifters
A thief coming in from outside is an obvious threat.
Check the security around your premises to keep the
risk to a minimum. In a shop, thieves may steal in
-112-
groups - some providing a distraction while others
take goods. Teach your staff to be alert and to
recognise behaviour like this. Set up a clear policy
and make sure staff are trained in dealing with
thieves.
Offering to help a customer if you are suspicious will
often prevent a theft. Avoid using confrontational
words like 'steal' if you do have to approach a
suspected thief, and avoid getting into a dangerous
situation.
Protect your stock
• Identify and mark expensive portable
equipment (such as computers). If possible, fit
valuable stock with security tags - such as Radio
Frequency Identification tags - which will sound
an alarm if they are moved.
• Don't leave equipment hanging around after
delivery. Put it away in a secure place, record it
and clear up packaging. It is a good idea to
dispose of packaging securely - leaving boxes in
view could be an advertisement to thieves.
• Have regular stocktakes.
Theft by staff -113-
Theft by employees can sometimes be a problem. To
prevent this:
• Train staff about your security systems and
your disciplinary policies and procedures.
Training about the cost of stock theft will help, as
many people aren't aware of the implications for
company turnover and job security.
• Set up procedures to prevent theft. Staff with
financial responsibilities should not be in charge
of stock records.
 • Restrict access to warehouses, stockrooms
and stationery cupboards.
• Regularly change staff controlling stock to
avoid collusion or bad practice.
STOCK CONTROL METHODS
There are several methods for controlling stock, all
designed to provide an efficient system for deciding
what, when and how much to order.
You may opt for one method or a mixture of two or
more if you have various types of stock. For further
information, see the page in this guide on types of
stock.
• Minimum -114-stock level - you identify a
minimum stock level, and re-order when stock
reaches that level. This is known as the Re-order
Level.
• Stock review - you have regular reviews of
stock. At every review you place an order to
return stocks to a predetermined level.
Just In Time (JIT) - this aims to reduce costs by
cutting stock to a minimum - see our guide on how to
avoid the problems of overtrading. Items are
delivered when they are needed and used
immediately. There is a risk of running out of stock,
so you need to be confident that your suppliers can
deliver on demand. Find out more about JIT
production on the Manufacturing Advisory
Service (MAS) website (registration required) -
Opens in a new window.
These methods can be used alongside other
processes to refine the stock control system. For
example:
Re-order lead time - allows for the time between
placing an order and receiving it.
Economic Order Quantity (EOQ) - a standard
formula used to arrive at a balance between holding
too much or too little stock. It's quite a complex
calculation, so you may find it easier to use stock
control software. Find out about the EOQ
formula on the InventoryOps website - Opens in a
new window.
-115-
Batch control - managing the production of goods in
batches. You need to make sure that you have the
right number of components to cover your needs until
the next batch.
If your needs are predictable, you may order a fixed
quantity of stock every time you place an order, or
order at a fixed interval - say every week or month.
In effect, you're placing a standing order, so you
need to keep the quantities and prices under review.
First in, first out - a system to ensure that
perishable stock is used efficiently so that it doesn't
deteriorate. Stock is identified by date received and
moves on through each stage of production in strict
order.
CONTROL OF DEBTORS
Invoicing and collection
Commercial organisations normally give credit to
their customers in order to encourage sales. In the
case of charities it is less likely that you are
encouraging additional sales by giving credit and
more likely that your clients will want credit and will
wish to dictate the terms on which they will pay.
Therefore, for voluntary organisations, management
-116-
is more about dealing with credit than deciding on a
control policy.
'It is better to have cash in your bank account than in
your customers'!
• If you get the money in quickly you can use it
for other purposes which will advance the
organisation's objectives.
• Giving credit costs money, even if it is only a
small amount of interest foregone. If you have
an overdraft, the costs rise sharply.
• If a large client demands an unreasonable
amount of credit you may have to simply walk
away from the contract. You cannot afford to
risk running out of cash.
• If stage payments are delayed, you may
perhaps have to say, for example, that you will
be unable to complete the contract; this may
help with neogitations.
So what should you be aiming for in terms of the
credit you offer? The key objective should be to try
and shorten the period each year rather than
lengthen it. So, for example, if you agree with your
clients 30 days and you collect in this, you are doing
very well!
A general rule of thumb is: agreed time plus 33%.
You need to improve your collection procedures as
soon as it slips towards this point.
Reducing the cost-117-
of debtors
• Send invoices promptly
The quicker invoices are sent the sooner they are
paid. The best time to send them is at the same time
as dispatching an order or completing a service. Do
not wait until the end of the month as this
automatically gives additional credit.
• Send statements monthly
Some organisations pay only on statement, though
this is less common now, and it acts as a reminder
for all debtors.
• Phone the client
When you see an invoice that has gone over your
credit terms and your statement produced no
response you should try to find out why. The best
person to call is not always the person who gave you
the order especially in large organisations. The
purchase (or bought) ledger clerk probably knows
most about the delay. If you have a few important
clients it is often worth while getting to know the
name of this person and speaking directly with them.
They sometimes have the ability to speed up
payment dramatically.
• Send a reminder letter
-118-
After about 60 days you should remind the client of
the debt by letter asking for payment within 14 days.
• Phone again
If the reminder letter was unsuccessful, something
may be wrong. Try to find out what and rectify the
situation if possible
• Send a final reminder
When all the above fail, send a letter requesting
payment within seven days. This should state that
you will take further measures, legal action or
withdrawal of services, if payment is not received.
• Stop supplies of goods or services
You reach a point where it is vital to stop throwing
good money after bad.
• Send a Solicitor's letter
By this time the relationship between you and your
client will have broken down. Place the matter in the
hands of your solicitor. Ask them to write to the
organisation asking for payment before taking any
other action.
•
-119-
Take legal action
Legal action needs careful consideration. If there is
a dispute over the goods or services, you must have
a good case for taking legal action. Otherwise,
hopefully, you would have been able to resolve this
issue earlier.
Managing bad and aged debts
80% of your debts are probably from 20% of your
clients or customers, so concentrate management
effort on these.
An easy way of monitoring debts is to set up the
finance system to produce lists of aged debtors at
monthly intervals. Then all debts of, say, over £500
(depending on the size of the organisation) or more
than threee months old can be picked for intensive
chasing. Alternatively, you could create a list of all
debtors, the amounts and how old they are.
Part of your procedure to control bad debts should be
that only a senior member of staff or the project
leader can be allowed to write off bad debts.
Similarly, the decision to sue should normally be
reviewed for likely costs by the Finance manager to
assess whether it is worthwhile, and by a lawyer to
assess the chances of success.
Decreasing your debtor level
-120-
There are a number of tactics you can employ to
encourage early, or at least discourage late payment.
• Offer discounts
Offering (say) 2.5% discount for payment within 14
days may result in early payment.
However, some organisations may then pay at their
normal time but take the discount anyway. It will
seldom be worthwhile to sue for the difference. All
you have then is a 2.5% reduction in your price which
the client or customer may expect to continue!
Furthermore, you have no control over whether the
client will take up a discount. This makes cash
forecasting more difficult. Also, you are at the mercy
of interest rates - a discount which is worthwhile at
one level of bank interest may not be advantageous
if interest rates change, but you will have your
contracts and stationery printed up in advance, and
cannot immediately change them.
• Wait for cheques to clear
If you are selling goods by mail order or catalogue,
you could consider not sending them out until
cheques have cleared.
•
-121-
Use merchant accounts
It may be worth setting up the necessary merchant
accounts so that you can accept online orders with a
debit or credit card - debit cards work out cheaper.
Monitoring debtor levels
It is very easy for an organisation to allow its debtor
figure to creep upwards, and if there has not been
any cash shortage crises these may not have been
noticed quickly.
It is important to monitor the levels of debtors in
relation to income. They should go up or down in
line with each other. The key ratio to help you
monitor this is the debtor collection period.
How to calculate the debtor collection period
1. Determine income
Ideally, this should be the Income which
involves credit. If, for example, the charity also
has a shop which sells only for cash, then the
shop turnover should, if possible, be excluded
otherwise the average number of days figures
will be lower than the ratio you wish to
monitor.
2. Multiply by 365
-122-
3. Divide by the debtor figure
usually, it is adequate and easier to take the
year-end figure; however, if there are very
large variations in the year it is better to take
an average figure. Important point - the true
average is the average of 12 monthly debtors
figures (or perhaps four quarterly figures). If
there are seasonal variations which mean that
the December 2003 figure is abnormally low
(or high) then the December 2004 figure is
also likely to be abnormally low or high.
4. The result is the average number of days
taken to collect debts, or the debtor collection
period.
CONTROL OF CASH
Cash is a vital component of any profit-generating
organisation. An organization's assets generate
revenue, which in turn generates cash inflows. These
cash inflows are used for several purposes: to pay
creditors, compensate employees, reward
shareholders, provide asset replacement, and
provide for growth.
Cash is unique because it's the single asset that is
readily convertible into any other type of asset.
Therefore, it's also-123-
the most widely desired asset.
However, cash is also the asset that is most
susceptible to fraud and abuse. Therefore,
management has to ensure that adequate controls
and safeguards are in place to eliminate any
unauthorized transactions with cash.
Fortunately, there are ways management can
safeguard the cash generated by its organization.
Each of the following methods will help an
organization prevent losses due to human error or
theft:
• Monthly bank reconciliation
• Segregation of duties over cash handling
• Accountability for cash shortages
• Authorized cash disbursement
• Internal audits
Monthly Bank Reconciliation. Monthly bank
reconciliation will help ensure that the amount of
cash generated by an organization is consistent with
bank records. In addition, an independent review of
the reconciliation by management will provide an
additional safeguard. Independent verification of
bank reconciliation acts as a check to make sure the
reconciliation was done properly and ensures there is
no abuse of the organization's cash.
Segregation of Duties Over Cash Handling. Every
organization must make sure that there is adequate
-124-
segregation of duties over cash handling. Separating
the duties of cash receipts and disbursements
prevents an individual from committing and
concealing embezzlement.
Accountability for Cash Shortages. Management
should hold supervisors accountable for cash
shortages. If supervisors know that they'll be held
accountable for a cash shortage, they'll be motivated
to keep a close eye on how cash is used within their
departments.
Authorized Cash Disbursement. Management should
allow cash to be disbursed only through checks
issued by authorized signers, which will provide a
method for tracking cash usage. In addition, your
organization should require signatures on all checks
in order for them to be valid.
Internal Audits. Every organization should arrange to
have internal audits conducted on a regular basis.
Whether the auditors come from an internal audit
staff or an outside auditing firm, auditing an
organization's accounting system can identify how
effective and accurate the operation is and whether
or not any improvements need to be made.
Debt Factoring and Invoice Discounting
Financial services companies that provide
businesses with debtor finance, secured against
unpaid invoices are-125-known as Factors and Invoice
Discounters. Factors buy your trade debts and
typically will pay 80% to 85% as soon as they receive
a valid copy invoice. The balance, less charges, is
paid when the customer pays. The Factor collects
the debt from your customer directly but will usually
agree collection policies with you, in order to ensure
faster customer payment without loss of goodwill.
Some Factors also provide bad debt insurance. With
invoice discounting responsibility for collection of
debts remains with you and the service is normally
undisclosed to customers. Payments that you receive
are paid into a bank account administered by the
Invoice Discounter and you are then credited with the
balance less charges. Generally, invoice discounting
is only available to businesses that already practice
sound credit management and have the staff and
accounting systems to generate reliable customer
collections. Invoice Discounters, like Factors, will
typically pay 80% to 85% against valid invoices.
Cost of Factoring and Invoice Discounting
For both factoring and invoice discounting there is a
service charge, normally a proportion of turnover,
and a discount charge, based on the amount of
finance provided. Charges will be agreed in advance
and form part of the factoring or invoice discounting
agreement. For factoring the service charge is
-126-
normally between 0.75% and 2.5% of turnover,
depending on the workload to be undertaken. The
charge for invoice discounting will usually be less, as
less work is required. The discount charge is
calculated on day-to-day usage of funds. It is likely to
be comparable with normal secured bank overdraft
rates.
Suitability of Factoring and Invoice Discounting
Debtor finance is most suitable for growing
businesses; finance will grow in line with the growth
in turnover. Conversely, where turnover is falling the
level of finance will fall. The cost of the service needs
to be weighed against the costs of in-house debt
collection and, for example, having sufficient cash to
benefit from early payment discounts from suppliers.
Generally debt finance providers are looking for
'clean' invoices where there is clear evidence of
delivery of the goods or service and a low level of
disputes or credit notes. It may not be available for
some industries, for example contracting, where
there is a high level of retentions and variation
orders. Providers of debt finance usually acquire your
debts with recourse to you if the debtor does not pay.
This means they will reclaim the amount already
advanced to you should your debtor not pay in a
given time period. Alternatively, you may take out
insurance against non-payment by your debtors.
Many factors and invoice discounters can also
provide bad debt insurance.
-127-
Finding a Factor or Invoice Discounter
More information and a list of providers of these
services are available from the Factors &
Discounters Association.
Questions to ask when selecting a Factor
• What will the service cost?
• How long will the agreement take to set up?
 • How quickly will money be available against
invoices?
• How quickly will you collect from customers?
• Who will be my day-to-day contact?
• Who will speak to my customers?
• How much notice must I give to terminate the
agreement?
• Can you give me two or three references with
similar businesses to mine?
• Can I factor export invoices?
• Are debts bought with or without recourse to
me?
• Do I have to take out insurance against bad
debts and, if so, can I choose who to buy the
insurance from?
borrowings you can expect your bank to ask for a
"charge" over your home. This means that in the
event you cannot repay the loan they are entitled to
force a sale on your house to recover their money.
PRACTICE QUESTIONS
1. Preparing a written business plan is your first step
in business. If you need to raise finance from a bank
or from outside investors, what are you expected to
do?
2. Write a short note on the following: (a) inventory
control (b) Debt factoring
3. Discuss on the basic requirement of working
capital.
4. The operating cycle is only the time span between
production cost and cash returns. Discuss.

Preparation and approach

-128- to bank for loan and -129-
overdraft.

With a clear business plan and cash flow forecast

you can approach your bank for a loan. The best
place to start is the bank with which you already
have a personal account as they will know your
history and be more likely to help you.

The one thing all banks are most interested in is FOREIGN CURRENCY
what security you can provide, i.e. what assets do TRANSACTION
you have that they can sell if you default on your
loan. The most obvious and by far the most common
will be your house. For all but the smallest

Definition
Foreign currency is a currency other than the
reporting currency of an entity.
Foreign Currency Transactions
A foreign currency transaction is a transaction which
is denominated in or requires settlement in a foreign
currency, including transactions arising when an
entity either:
(a) buys or sells goods or services whose price is
denominated in a foreign currency;
(b) borrows or lends funds when the amounts
payable or receivable are denominated in a foreign
currency;
(c) becomes a party to an unperformed foreign
exchange contract;-130-
or
(d) otherwise acquires or disposes of assets, or
incurs
or settles liabilities, denominated in a foreign
currency.
FOREIGN EXCHANGE MARKET
The foreign exchange market or forex market as it is
often called is the market in which currencies are
-131-
traded. Currency Trading is the world's largest
market consisting of almost $2 trillion in daily volume
and as investors learn more and become more
interested, the market continues to rapidly grow. Not
only is the forex market the largest market in the
world, but it is also the most liquid, differentiating it
from the other markets. In addition, there is no
central marketplace for the exchange of currency, but
instead the trading is conducted over-the-counter.
Unlike the stock market, this decentralization of the
market allows traders to choose from a number of
different dealers to make trades with and allows for
comparison of prices. Typically, the larger a dealer is
the better access they have to pricing at the largest
banks in the world, and are able to pass that on to
their clients. The spot currency market is open
twenty-four hours a day, five days a week, with
currencies being traded around the world in all of the
major financial centers.
All trades that take place in the foreign exchange
market involve the buying of one currency and the
selling of another currency simultaneously. This is
because the value of one currency is determined by
its comparison to another currency. The first currency
of a currency pair is called the "base currency," while
the second currency is called the “counter currency.”
The currency pair shows how much of the counter
currency is needed to purchase one unit of the base
currency. Currency pairs can be thought of as a
single unit that can be bought or sold. When
purchasing a currency pair, the base currency is
being bought, while the counter currency is being
sold. The opposite is true, when the sale of a
currency pair takes place. There are four major
currency pairs that are traded most often in the
foreign exchange market. These include the
EUR/USD, USD/JPY, GBP/USD, and USD/CHF.
The Foreign Exchange Market in Nigeria
The evolution of the foreign exchange market in
Nigeria up to its present state was influenced by a
number of factors such as the changing pattern of
international trade, institutional changes in the
economy and structural shifts in production. Before
the establishment of the Central Bank of Nigeria
(CBN) in 1958 and the enactment of the Exchange
Control Act of 1962, foreign exchange was earned by
the private sector and held in balances abroad by
commercial banks which acted as agents for local
exporters. During this period, agricultural exports
contributed the bulk of foreign exchange receipts.
-132- pound was tied to the
The fact that the Nigerian
British pound sterling at par, with easy convertibility,
delayed the development of an active foreign
exchange market. However, with the establishment
of the CBN and the subsequent centralisation of
foreign exchange authority in the Bank, the need to
develop a local foreign exchange market became
paramount.
The increased export of crude oil in the early 1970s,
following the sharp rise in its prices, enhanced official
foreign exchange receipts. The foreign exchange
market experienced a boom during this period and
the management of foreign exchange resources
became necessary to ensure that shortages did not
arise. However, it was not until 1982 that
comprehensive exchange controls were applied as a
result of the foreign exchange crisis that set in that
year. The increasing demand for foreign exchange at
a time when the supply was shrinking encouraged
the development of a flourishing parallel market for
foreign exchange.
The exchange control system was unable to evolve
an appropriate mechanism for foreign exchange
allocation in consonance with the goal of internal
balance. This led to the introduction of the Second-
tier Foreign Exchange Market (SFEM) in September,
1986. Under SFEM, the determination of the Naira
exchange rate and allocation of foreign exchange
were based on market forces. To enlarge the scope
of the Foreign Exchange Market Bureaux de Change
were introduced in -133-
1989 for dealing in privately
sourced foreign exchange.
As a result of volatility in rates, further reforms were
introduced in the Foreign Exchange Market in 1994.
These included the formal pegging of the naira
exchange rate, the centralisation of foreign exchange
in the CBN, the restriction of Bureaux de Change to
buy foreign exchange as agents of the CBN, the
reaffirmation of the illegality of the parallel market
and the discontinuation of open accounts and bills for
collection as means of payments sectors.
The Foreign Exchange Market was liberalised in
1995 with the introduction of an Autonomous Foreign
Exchange Market (AFEM) for the sale of foreign
exchange to end-users by the CBN through selected
authorised dealers at market determined exchange
rate. In addition, Bureaux de Change were once
more accorded the status of authorized buyers and
sellers of foreign exchange. The Foreign Exchange
Market was further liberalized in October, 1999 with
the introduction of an Inter-bank Foreign Exchange
Market (IFEM).
Structure of Nigeria's Foreign Exchange Market
The Nigerian foreign exchange market has witnessed
tremendous changes. The Second-tier Foreign
Exchange Market (SFEM) was introduced in
September, 1986, the unified official market in 1987,
the autonomous Foreign Exchange Market (AFEM)
in 1995, and the -134-
Inter-bank Foreign Exchange
Market (IFEM) in 1999.
MODERN FOREIGN EXCHANGE MARKET
The purpose of the foreign exchange market is to
help international trade and investment. A foreign
exchange market helps businesses convert one
currency to another.
In a typical foreign exchange transaction a party
purchases a quantity of one currency by paying a
quantity of another currency. The modern foreign
exchange market started forming during the 1970s
when countries gradually switched to floating
exchange rates from the previous exchange rate
regime, which remained fixed as per the Bretton
Woods system.
The foreign exchange market is unique because of
•its trading volumes,
•the extreme liquidity of the market,
•its geographical dispersion,
•its long trading hours: 24 hours a day
except on
weekends (from 22:00 UTC on Sunday until
22:00 UTC Friday),
•the variety of factors that affect exchange rates.
•the -135-
low margins of profit compared with other
markets of fixed income (but profits can be high
due to very large trading volumes)
•the use of leverage
As such, it has been referred to as the market closest
to the ideal perfect competition, notwithstanding
market manipulation by central banks.

Market participants
Unlike a stock market, where all participants have
access to the same prices, the foreign exchange
market is divided into levels of access. At the top is
the inter-bank market, which is made up of the
largest investment banking firms. Within the inter-
bank market, spreads, which are the difference
between the bid and ask prices, are razor sharp and
usually unavailable, and not known to players outside
the inner circle. The difference between the bid and
ask prices widens (from 0-1 pip to 1-2 pips for some
currencies such as the EUR). This is due to volume.
If a trader can guarantee large numbers of
transactions for large amounts, they can demand a
smaller difference between the bid and ask price,
which is referred to as a better spread. The levels of
access that make up the foreign exchange market
are determined by the size of the "line" (the amount
of money with which they are trading). The top-tier
inter-bank market accounts for 53% of all
transactions. After that there are usually smaller
investment banks, followed
-136-by large multi-national
corporations (which need to hedge risk and pay
employees in different countries), large hedge funds,
and even some of the retail FX-metal market makers.
Banks
The interbank market caters for both the majority of
commercial turnover and large amounts of
speculative trading every day. A large bank may
trade billions of NAIRA daily. Some of this trading is
undertaken on behalf of customers, but much is
conducted by proprietary desks, trading for the
bank's own account. Until recently, foreign exchange
brokers did large amounts of business, facilitating
interbank trading and matching anonymous
counterparts for small fees. Today, however, much of
this business has moved on to more efficient
electronic systems. The broker squawk box lets
traders listen in on ongoing interbank trading and is
heard in most trading rooms, but turnover is
noticeably smaller than just a few years ago.
Commercial companies
An important part of this market comes from the
financial activities of companies seeking foreign
exchange to pay for goods or services. Commercial
companies often trade fairly small amounts
compared to those of banks or speculators, and their
trades often have little short term impact on market
rates. Nevertheless, trade flows are an important
factor in the long-term direction of a currency's
exchange rate. Some-137- multinational companies can
have an unpredictable impact when very large
positions are covered due to exposures that are not
widely known by other market participants.
Central banks
Central banks play an important role in the foreign
exchange markets. They try to control the money
supply, inflation, and/or interest rates and often have
official or unofficial target rates for their currencies.
They can use their often substantial foreign
exchange reserves to stabilize the market. Milton
Friedman argued that the best stabilization strategy
would be for central banks to buy when the exchange
rate is too low, and to sell when the rate is too high—
that is, to trade for a profit based on their more
precise information. Nevertheless, the effectiveness
of central bank "stabilizing speculation" is doubtful
because central banks do not go bankrupt if they
make large losses, like other traders would, and
there is no convincing evidence that they do make a
profit trading.
The mere expectation or rumour of central bank
intervention might be enough to stabilize a currency,
but aggressive intervention might be used several
times each year in countries with a dirty float
currency regime. Central banks do not always
achieve their objectives. The combined resources of
the market can easily overwhelm any central bank]
-138-
Hedge funds as speculators
About 70% to 90% of the foreign exchange
transactions are speculative. In other words, the
person or institution that bought or sold the currency
has no plan to actually take delivery of the currency
in the end; rather, they were solely speculating on
the movement of that particular currency. Hedge
funds have gained a reputation for aggressive
currency speculation since 1996. They control
billions of dollars/naira of equity and may borrow
billions more, and thus may overwhelm intervention
by central banks to support almost any currency, if
the economic fundamentals are in the hedge funds'
favour.
Investment management firms
Investment management firms (who typically manage
large accounts on behalf of customers such as
pension funds and endowments) use the foreign
exchange market to facilitate transactions in foreign
securities. For example, an investment manager
bearing an international equity portfolio needs to
purchase and sell several pairs of foreign currencies
to pay for foreign securities purchases.
Some investment management firms also have more
speculative specialist currency overlay operations,
which manage clients' currency exposures with the
-139-
aim of generating profits as well as limiting risk.
Whilst the number of this type of specialist firms is
quite small, many have a large value of assets under
management (AUM), and hence can generate large
trades.
Retail foreign exchange brokers
There are two types of retail brokers offering the
opportunity for speculative trading: retail foreign
exchange brokers and market makers. Retail traders
(individuals) are a small fraction of this market and
may only participate indirectly through brokers or
banks. Retail brokers, while largely controlled and
regulated by the CFTC and NFA might be subject to
foreign exchange scams. At present, the NFA and
CFTC are imposing stricter requirements, particularly
in relation to the amount of Net Capitalization
required of its members. As a result many of the
smaller, and perhaps questionable brokers are now
gone. It is not widely understood that retail brokers
and market makers typically trade against their
clients and frequently take the other side of their
trades. This can often create a potential conflict of
interest and give rise to some of the unpleasant
experiences some traders have had. A move toward
NDD (No Dealing Desk) and STP (Straight Through
Processing) has helped to resolve some of these
concerns and restore trader confidence, but caution
is still advised in ensuring that all is as it is
presented.
Non-bank Foreign-140-
Exchange Companies
Non-bank foreign exchange companies offer
currency exchange and international payments to
private individuals and companies. These are also
known as foreign exchange brokers but are distinct in
that they do not offer speculative trading but currency
exchange with payments. I.e., there is usually a
physical delivery of currency to a bank account. Send
Money Home offer an in-depth comparison into the
services offered by all the major non-bank foreign
exchange companies.
It is estimated that in the UK, 14% of currency
transfers/payments are made via Foreign Exchange
Companies.[11] These companies' selling point is
usually that they will offer better exchange rates or
cheaper payments than the customer's bank. These
companies differ from Money Transfer/Remittance
Companies in that they generally offer higher-value
services.
Money Transfer/Remittance Companies
Money transfer companies/remittance companies
perform high-volume low-value transfers generally by
economic migrants back to their home country. In
2007, the Aite Group estimated that there were $369
billion of remittances (an increase of 8% on the
previous year). The four largest markets (India,
China, Mexico and the Philippines) receive $95
billion. The largest and best known provider is
Western Union with 345,000 agents globally.
-141-
Send Money Home is an international money transfer
price comparison site that allows consumers access
to a range of alternative products/ rates available
when remitting (transferring) money worldwide.
Provides impartial and unbiased advice for those
looking to send money overseas
Trading characteristics changes in monetary flows caused by changes in
gross domestic product (GDP) growth, inflation
There is no unified or centrally cleared market for the (purchasing power parity theory), interest rates
majority of FX trades, and there is very little cross- (interest rate parity, Domestic Fisher effect,
border regulation. Due to the over-the-counter (OTC) International Fisher effect), budget and trade deficits
nature of currency markets, there are rather a or surpluses, large cross-border M&A deals and
number of interconnected marketplaces, where other macroeconomic conditions. Major news is
different currencies instruments are traded. This released publicly, often on scheduled dates, so many
implies that there is not a single exchange rate but people have access to the same news at the same
rather a number of different rates (prices), depending time. However, the large banks have an important
on what bank or market maker is trading, and where advantage; they can see their customers' order flow.
it is. In practice the rates are often very close,
otherwise they could be exploited by arbitrageurs
instantaneously. Due to London's dominance in the
market, a particular currency's quoted price is usually
the London market price. A joint venture of the
Chicago Mercantile Exchange and Reuters, called
Fxmarketspace opened in 2007 and aspired but
failed to the role of a central market clearing
mechanism.

The main trading center is London, but New York,

Tokyo, Hong Kong and Singapore are all important -143-
centers as well. -142-
Banks throughout the world
participate. Currency trading happens continuously PRACTICE QUESTIONS
throughout the day; as the Asian trading session
ends, the European session begins, followed by the
North American session and then back to the Asian 1. Explain the following terms that relate to foreign
session, excluding weekends. currency transaction. (a) Exchange rate (b)
Foreign
Fluctuations in exchange rates are usually caused by operation.
actual monetary flows as well as by expectations of 2. What are the objectives of the foreign exchange
 transaction?
3. What do you understand by translation of foreign
exchange currency.
4. Explain the nature of foreign exchange system in
Nigeria. ALLOCATION OF DIVIDEND
5. The purpose of the foreign exchange market is to
help international trade and investment. How can this
be accomplished?
A taxable payment declared by a company's board of
directors and given to its shareholders out of the
company's current or retained earnings, usually
quarterly. Dividends are usually given as cash (cash
dividend), but they can also take the form of stock
(stock dividend) or other property. Dividends provide
an incentive to own stock in stable companies even if
they are not experiencing much growth. Companies
are not required to pay dividends. The companies
that offer dividends are most often companies that
have progressed beyond the growth phase, and no
-145-
longer benefit sufficiently by reinvesting their profits,
-144-
so they usually choose to pay them out to their
shareholders. also called payout.

DIVIDEND DEFINED

A distribution of a portion of a company's earnings,

decided by the board of directors, to a class of its
shareholders. The dividend is most often quoted in
terms of the Naira amount each share receives
(dividends per share). It can also be quoted in terms
of a percent of the current market price, referred to
as dividend yield.
Dividends are payments made by a
corporation to its shareholder members. It is
the portion of corporate profits paid out to
stockholders. When a corporation earns a
profit or surplus, that money can be put to
two uses: it can either be re-invested in the
business (called retained earnings), or it
can be paid to the shareholders as a
dividend. Many corporations retain a portion
of their earnings and pay the remainder as
a dividend.
For a joint stock-146-
company, a dividend is
allocated as a fixed amount per share.
Therefore, a shareholder receives a
dividend in proportion to their shareholding.
For the joint stock company, paying
dividends is not an expense; rather, it is the
division of an asset among shareholders.
Public companies usually pay dividends on
a fixed schedule, but may declare a
dividend at any time, sometimes called a
special dividend to distinguish it from a
regular one.
Cooperatives, on the other hand, allocate
dividends according to members' activity, so
their dividends are often considered to be a
pre-tax expense.
Dividends are usually settled on a cash
basis, as a payment from the company to
the shareholder. They can take other forms,
such as store credits (common among retail
consumers' cooperatives) and shares in the
company (either newly-created shares or
existing shares bought in the market.)
Further, many public companies offer
dividend reinvestment plans, which
automatically use the cash dividend to
-147-
purchase additional shares for the
shareholder.
TYPES OF DIVIDENDS
1. Cash dividends (most common) are
those paid out in the form of a cheque.
Such dividends are a form of investment
income and are usually taxable to the
recipient in the year they are paid. This is
the most common method of sharing
corporate profits with the shareholders of
the company. For each share owned, a
declared amount of money is distributed.
Thus, if a person owns 100 shares and the
cash dividend is N0.50 per share, the
person will be issued a cheque for N50
2. Stock or scrip dividends are those paid
out in form of additional stock shares of the
issuing corporation, or other corporation
(such as its subsidiary corporation). They
are usually issued in proportion to shares
owned (for example, for every 100 shares of
stock owned, 5% stock dividend will yield 5
extra shares). If this payment involves the
-148-
issue of new shares, this is very similar to a
stock split in that it increases the total
number of shares while lowering the price of
each share and does not change the market
capitalization or the total value of the shares
held.
3. Property dividends or dividends in
specie (Latin for "in kind") are those paid
out in the form of assets from the issuing
corporation or another corporation, such as
a subsidiary corporation. They are relatively
rare and most frequently are securities of
other companies owned by the issuer,
however they can take other forms, such as
products and services.
Other dividends can be used in structured
finance. Financial assets with a known
market value can be distributed as
dividends; warrants are sometimes
distributed in this way. For large companies
with subsidiaries, dividends can take the
form of shares in a subsidiary company. A
common technique for "spinning off" a
company from its parent is to distribute
shares in the new company to the old
-149-
company's shareholders. The new shares
can then be traded independently.
MOTHOD OF PAYMENT
Dividends must be "declared" (approved) by
a company’s Board of Directors each time
they are paid. For public companies, there
are four important dates to remember
regarding dividends.
1. The declaration date
The declaration date is the day the Board
of Directors announces its intention to pay a
dividend. On this day, a liability is created
and the company records that liability on its
books; it now owes the money to the
stockholders. On the declaration date, the
Board will also announce a date of record
and a payment date.
-150-
2. The in-dividend date
The in-dividend date is the last day, which
is one trading day before the ex-dividend
date, where the stock is said to be cum
dividend ('with [including] dividend'). In
other words, existing holders of the stock
and anyone who buys it on this day will
receive the dividend, whereas any holders
selling the stock lose their right to the
dividend. After this date the stock becomes
ex dividend.
3. The ex-dividend date
The ex-dividend date is the day on which
all shares bought and sold no longer come
attached with the right to be paid the most
recently declared dividend. This is an
important date for any company that has
many stockholders, including those that
trade on exchanges, as it makes
reconciliation of who is to be paid the
dividend easier. Existing holders of the
stock will receive the dividend even if they
now sell the stock, whereas anyone who
now buys the stock will not receive the
dividend. It is -151-
relatively common for a
stock's price to decrease on the ex-dividend
date by an amount roughly equal to the
dividend paid. This reflects the decrease in
the company's assets resulting from the
declaration of the dividend. The company
does not take any explicit action to adjust its
stock price; in an efficient market, buyers
and sellers will automatically price this in.
Whenever a company announces a
dividend pay-out, it also announces a "Book
closure Date" which is a date on which the
company will ideally temporarily close its
books for fresh transfers of stock. Read
"Book Closure" for a better understanding.
Shareholders who properly registered their
ownership on or before the date of record,
known as stockholders of record, will
receive the dividend. Shareholders who are
not registered as of this date will not receive
the dividend. Registration in most countries
is essentially automatic for shares
purchased before the ex-dividend date.
4. Payment -152-
date
The payment date is the day when the
dividend checks will actually be mailed to
the shareholders of a company or credited
to brokerage accounts.
Dividend-reinvestment plans
Some companies have dividend
reinvestment plans, or DRIPs. These plans
allow shareholders to use dividends to
systematically buy small amounts of stock,
usually with no commission and sometimes
at a slight discount. In some cases the
shareholder might not need to pay taxes on
these re-invested dividends, but in most
cases they do.
Dividend reinvestment plans-in case of
mutual funds: When the dividend is paid in
cash it will attract the dividend distribution
tax (DDT) and the same is not taxable in the
hands of the person, but in case of dividend
reinvestment plan where the dividend is not
paid in cash but distributed as additional
units will not attract the DDT and the same
will be taxable in the hands of the person as
capital gains when-153-
he realises the gain by
selling the units.
DIVIDEND POLICY
Dividend policies are the regulations and guidelines
that companies develop and implement as the
means of arranging to make dividend payments to
shareholders.
Establishing a specific dividend policy is to the
advantage of both the company and the shareholder.
In order to make sure the policy is workable, a
company should develop a viable policy and then run
this policy through a number of test scenarios in
order to determine what impact the dividend policy
would have on the operation of the business.
In many cases, companies choose to explicitly state
the provisions within the dividend policy. This is
definitely to the advantage of the shareholder, as a
well defined policy makes it much easier to project
the amount of payout profits generated for the period
under consideration and thus be able to determine
the size of the dividends that will be issued. When
the dividend policy is well defined and documented, it
is easy for the shareholder to obtain a written copy
and thus be fully informed as to how the policy
works.
-154-
However, there are cases where the dividend policy
is not so well documented. When this is the case,
investors sometimes base their assumptions on
upcoming dividend payments on what has occurred
in the past. While less systematic, it is still possible to
project a more or less accurate estimate of what the
dividend payout will actually be.
In cases where the dividend policy is not specifically
defined, investors often look at the history to spot any
trends that emerged in the past. If the dividend
payments have been more or less constant for the
last several years, and there has been no loss in
business volume, it is reasonable to assume the
payments will still be in the same general range as
before. However, if the dividend history is more
volatile, the shareholder may attempt to identify what
factors led to the up and down movement of the
dividends and determine if any of those factors are
relevant to the current dividend period.
In both expressed and implied dividend policy
procedures, it is less common for the dividends to be
increased. Part of the reason for that is companies
tend to look closely at retained earnings and want to
make sure the increased level of earnings will be
sustained over the long term. Once this upward trend
is deemed to be more or less permanent, the
company may choose to increase dividends.
Far more common is the practice of reducing
dividends. This usually takes place because there is
a decrease in the company’s business volume that is
not anticipated to-155-
be recaptured in the foreseeable
future. At other times, the decrease may be due to
the need to retain more cash on hand for capital
expenses. In both these scenarios, companies tend
to notify the shareholders in advance that these
factors exist and a chance in dividends will take
place in order to meet the challenge to remain
profitable. = Dividends / Stock Price

Three Schools Of Thought On Dividends

FACTS ABOUT DIVIDEND POLICY 1. If ……..

* Dividends are sticky; Firms are much more (a) there are no tax disadvantages associated
reluctant to cut dividends than increase them with dividends

(b) companies can issue stock, at no cost, to

raise equity, whenever needed

Dividends do not matter, and dividend policy

does not affect value.

2. If dividends have a tax disadvantage,

Dividends are bad, and increasing dividends

will reduce value

3. If stockholders like dividends, or dividends

operate as a signal of future prospects,
Measures of Dividend Policy
Dividends are good, and increasing dividends
* Dividend Payout : measures the percentage of will increase value
-156-pays in dividends
earnings that the company -157-

= Dividends / Earnings
2. The balanced viewpoint
* Dividend Yield : measures the return that an
investor can make from dividends alone If a company has excess cash, and few good
 projects (NPV>0), returning money to
stockholders (dividends or stock repurchases) is
GOOD.
If a company does not have excess cash, and/or
has several good projects (NPV>0), returning
money to stockholders (dividends or stock
repurchases) is BAD.
PAYMENT PROCEDURES
* Significant Dates
Declaration date: The dividend is declared at a
board of directors meeting. On this date the directors
issue a statement similar to the following: " On
November 15, 1984, the directors of the XYZ
corporation met and declared a regular quarterly
dividend of 50 cents per share, plus an extra
dividend of 25 cents per share, payable to the
holders of record on December 15, payment to be
made on January 2, 1985."
Holder-of-record date: At the close of the business
on the holder-of-record date, December 15, the
company closes -158-
its stock transfer books and makes
up a list of the shareholders on that date. These
shareholders will receive the dividends
Ex-dividend date: Suppose you buy 100 shares on
December 13, 1984. Will the company be notified in
time? To avoid conflict, the brokerage industry has
set up the convention of declaring that the right to the
dividend remains with the stock until 4 days prior to
the holder-of-record date; on the fourth day before
the record date the right to the dividend no longer
goes with the stock. This date is called the ex-
dividend date. The ex-dividend date in this example
in December 11, 1984.
Payment date: The company mails the checks to the
recorded holders on January 2, 1985.
WHY DO FIRMS PAY DIVIDENDS?
The Miller-Modigliani Hypothesis: Dividends do
not affect value
Basis: If a firm's investment policy (and hence cash
flows) don't change, the value of the firm cannot
change with dividend policy. If we ignore personal
taxes, investors have to be indifferent to receiving
either dividends or capital gains.
* Underlying-159-
Assumptions:
(a) There are no tax differences between dividends
and capital gains.
(b) If companies pay too much in cash, they can
issue new stock, with no flotation costs or signaling
consequences, to replace this cash.
(c) If companies pay too little in dividends, they do
not use the excess cash for bad projects or
acquisitions.
* The Tax Response: Dividends are taxed more
than capital gains
Basis: Dividends are taxed more heavily than capital
gains. A stockholder will therefore prefer to receive
capital gains over dividends.
Evidence: Examining ex-dividend dates should
provide us with some evidence on whether dividends
are perfect substitutes for capital gains.
Let Pb= Price before the stock goes ex-dividend
Pa=Price after the stock goes ex-dividend
D = Dividends declared on stock
-160-
to, tcg = Taxes paid on ordinary income and capital
gains respectively
Assume you are all investors in a stock that you
bought a long time ago for $P and you have the
choice between-
(a) selling before the ex-dividend day, and forsaking
the dividend.
(b) selling after the ex-dividend day, and receiving
the dividend.
The cash flows from selling before then are-
Pb - (Pb - P) tcg
The cash flows from selling after the ex-dividend day
are-
Pa - (Pa - P) tcg + D(1-to)
Since the average investor should be indifferent
between selling before the ex-dividend day and
selling after the ex-dividend day -
Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to)
Moving the variables around, we arrive at the
following:
-161-
Holding other things equal, the price drop on the ex-
dividend day will be equal to the dollar dividend if and
only if the marginal investor in the stock faces the
-162-
same tax rate on dividends and capital gains; it will
be less than the dividend if the tax rate on dividends
exceeds the tax rate on capital gains; it will be
greater than the dividend if the tax rate on dividends
is less than the tax rate on capital gains.
If Pb - Pa = D then to = tcg
Pb - Pa < D then to > tcg
Pb - Pa > D then to < tcg
1. Assume that the company that you are analysing
has only wealthy individual investors, and that they
face a marginal tax rate of 41% on ordinary income,
and 28% on capital gains. If the company pays a
dividend of N1.00, how much would you expect the
price to drop on the ex-dividend day?
What will happen if the capital gains tax rate is
lowered to 19.6%?
2. Assume that you are a tax exempt investor, and
that you know that the price drop on the ex-dividend
day is only 90% of the dividend. How would you
exploit this differential?
( ) Invest in the stock for the long term
( ) Sell short the day before the ex-dividend day, buy
on the ex-dividend day
( ) Buy just before the ex-dividend day, and sell after.
Example of dividend capture strategy with tax
factors: XYZ company is selling for N50 at close of
trading May 3. On May 4, XYZ goes ex-dividend; the
dividend amount is N1. The price drop (from past
examination of the data) is only 90% of the dividend
amount. The transactions needed by a tax-exempt
pension fund for the arbitrage are as follows:
1. Buy 1 million shares of XYZ stock cum-dividend at
N50/share.
2. Wait till stock goes ex-dividend; Sell stock for
N49.10/share (50 - 1* 0.90)
3. Collect dividend on stock.
Net profit = - 50 million + 49.10 million + 1 million =
N0.10 million
Clearly these profits have to exceed transactions
costs for this to be worth it. (Transactions costs have
to be less than 10 cents per share)
Example of dividend capture strategy even
without tax factors
On May 4, 2007 Nigeria Electric Power Authority
-163-
began trading ex-dividend; the dividend amount was
N0.565. On May 3, 2007 the following transactions
were reported.
A. The bird in the hand fallacy
10:09:30 am 5,500,000 shares traded at N27.25.
Argument: Dividends now are more certain than
10:09:34 am 2,640,000 shares traded at N26.75 capital gains later. Hence dividends are more
valuable than capital gains.
10:09:37 am 2,860,000 shares traded at N26.625
Counter: The appropriate comparison should be
The first transaction represented a buy of 5.5 million between dividends today and price appreciation
shares at N27.25 by a Jakoto insurance company today. (The stock price drops on the ex-dividend
(which were then obligated to pay yields of 7-8% to day.)
their policy holders from dividend income) from a
Nigeria pension fund.

The second and third transactions represent a sell-
back by the same company to the same pension
fund of 5.5 million shares at a weighted average
price of N26.685 (These were special trades where
the pension fund agreed to allow the Jakoto firm to
collect the dividends of N0.565 on the stock).
Jakoto company: was able to collect dividend income
of N0.565*5.5 million shares= N3.1 mil
Nigeria pension fund: was able to receive the N3.1
million almost 5 weeks early.
-164-
* The wrong reasons for paying dividends
B. The excess cash hypothesis
Argument: The firm has excess cash on its hands
this year, no investment projects this year and wants
to give the money back to stockholders.
Counter: So why does not it just repurchase stock? If
this is a one-time phenomenon, the firm has to
consider future financing needs. Consider the cost of
issuing new stock:
-165-
Size of Issue Cost of Issue
 Preferred Common An updated study of Canadian stocks arrives at
Bonds
Stock Stock similar conclusions; cash dividend shares sell at a
Under N 1 million 14.0% - 22.0% premium over stock dividend shares.
N 1 - N 1.9 million 11.0% - 16.9%
N 2- N 4.9 million 4.0% - 12.4% Premium on Cash
N 5 - N 9.9 million 2.4% 2.6% 8.1% Dividend Shares over
Company
N 10 - N 19.9 million 1.2% 1.8% 6.0%
N 20 - N 49.9 million 1.0% 1.7% 4.6% Stock Dividend Shares
> N 50 million 0.9% 1.6% 3.5% Consolidated Bathurst 19.30%
Donfasco 13.30%
Dome Petroleum 0.30%
* Are firms perverse? Some evidence that they Imperial Oil 12.10%
are not Newfoundland Light &
1.80%
Power
Some investors clearly prefer to receive dividends. Royal Trustco 17.30%
Companies with such investors have to pay Stelco 2.70%
dividends to keep them happy. TransAlta 1.10%
Average 7.54%
Citizens Utility is a company which has two classes
of stock. Class A gets a stock dividend and can be 3. Clearly some investors like dividends. What types
converted freely into Class B stock. Class B gets a of investors do you think are most likely to fall into
cash dividend and cannot be converted to Class A this category? (You can pick more than one)
stock. The stock dividend is generally 7% to 13%
greater than the cash dividend. - Wealthy investors

The study found that PB > PA by more than 10%. In - Institutional Investors
-167- -168-
other words, the cash dividend shares sold at a
premium of 10% over-166-
the capital gains shares. - Less well-off investors

An Updated Study of Canadian companies arrives at - Tax-exempt investors

similar conclusions.
* A clientele based explanation

Basis: Investors may form clienteles based upon
their tax brackets. Investors in high tax brackets may
invest in stocks which do not pay dividends and
those in low tax brackets may invest in dividend
paying stocks.
4. Assume that you run a phone company, and that
you have historically paid large dividends. You are
now planning to enter the telecommunications and
media markets. Which of the following paths are you
most likely to follow?
( ) Courageously announce to your stockholders that
you plan to cut dividends and invest in the new
markets.
( ) Continue to pay the dividends that you used to,
and defer investment in the new markets.
( ) Continue to pay the dividends that you used to,
make the investments in the new markets, and issue
new stock to cover the shortfall
* The Signalling Hypothesis
Context: In a world of asymmetric information, firms
have to convince investors about their future
prospects. An increase in dividends is one way to
signal good future prospects.
On average, at least, increases in dividends seem to
be viewed as positive signals and decreases as
negative signals.
* Why is the positive reaction to a dividend increase
more muted than the negative reaction to a dividend
decrease?
An Alternative Story...Dividends as Negative Signals
The problem with signaling stories is that an equally
compelling case can be made for increasing
dividends being a negative signal, especially for
young, high growth firms. There is evidence that
earnings growth declines after firms initiate
dividends.
Extending the effects of dividend changes on stock
prices - long term
While dividend increases (decreases) tend to have a
positive (negative) effect in the short term, there
seems to be an interesting evening out of returns in
the month after the announcement.
-169-
* The Wealth Transfer Hypothesis
Basis: Dividends are one of the ways stockholders
can transfer wealth from bondholders to themselves. a signaling device of future
prospects
Since bondholders anticipate this, they write 3. The market uses dividend
constraints into bond covenants and stockholders announcements as
who do not pay dividends will actually be transferring information for 43% 51% 6%
wealth to bondholders. assessing firm value.
4. Investors have different
perceptions of the relative
56% 42% 2%
riskiness of dividends and
retained earnings.
5. Investors are basically
indifferent with regard to
6% 30% 64%
returns from dividends and
capital gains.
6. A stockholder is attracted to
firms that have dividend
44% 49% 7%
policies appropriate to the
stockholders' tax environment.
7. Management should be
responsive to shareholders'
41% 49% 10%
preferences regarding
dividends.

-171-
DETERMINANTS OF DIVIDEND POLICY
-170-
* Management Beliefs about Dividend Policy A. Investment Opportunities
Statement of Management
Beliefs
Agree No Opinion Disagree Basis: Other thing remaining equal, a firm with more
1. A firm's dividend payout investment opportunities will pay a lower fraction of
ratio affects the price of the 61% 33% 6% its earnings as dividends than a stable firm.
stock
2. Dividend payments provide 52% 41% 7%

-172-
Proxy for investment opportunities: Growth rate in
firm's assets; Capital Investment;
Testable proposition: A firm with higher growth
rates in assets or earnings, and greater capital
investment needs will pay out a lower fraction of its
earnings as dividends
B. Stability in earnings
Basis: Other things remaining equal, a firm with
more stable earnings will pay out a higher fraction of
its earnings as dividends than a firm with variable
earnings
Proxy for variability in earnings: Variance in EPS
Testable proposition: A firm with higher variance in
EPS will have a lower dividend payout ratio
C. Alternative sources of capital
Basis: Other things remaining equal, a firm which
can issue new stock or bonds at low cost (such as
underwriting commissions) will be more likely to have
a high dividend payout ratio.
Proxy for cost of issue: Size of the firm
Testable proposition: A smaller firm will almost
invariably have a higher issuance cost than a larger
firm in issuing new stock and debt. It will therefore be
less likely to have a high payout ratio.
D. Constraints
Basis: Firms which have borrowed large amounts of
debt usually have several constraints on their
dividend policy and will therefore follow more
conservative dividend policies
Proxy for leverage: Debt ratio
Testable proposition: A firm with a high debt ratio
will very seldom be able to make major changes in
its dividend policy because of constraints on payout.
E. Signalling Incentives
Basis: Firms which are undervalued may use
dividend increases as signals to the market
Proxy for undervaluation: Price/ Value ratios
Testable proposition: As the ratio of price to value
decreases dividend increases will become more
frequent.
F. Stockholder characteristics
Basis: Firms which have acquired a reputation as
high dividend yield firms also acquire stockholders
who desire high dividends. Consequently they cannot
suddenly shift policy.
-173-
Testable proposition: The past history of a
company's dividend policy is usually be a good
indication of what it will do in the future.

MERGERS AND ACQUISITION

The phrase mergers and acquisitions

(abbreviated M&A) refers to the aspect of
corporate strategy, corporate finance and
management dealing with the buying,
selling and combining of different
companies that can aid, finance, or help a
growing company in a given industry grow
rapidly without having to create another
business entity.

-174- ACQUISITION
-175-
An acquisition, also known as a takeover
or a buyout, is the buying of one company
(the ‘target’) by another. An acquisition may
be friendly or hostile. In the former case, the
companies cooperate in negotiations; in the

-176-
latter case, the takeover target is unwilling
to be bought or the target's board has no
prior knowledge of the offer. Acquisition
usually refers to a purchase of a smaller
firm by a larger one. Sometimes, however,
a smaller firm will acquire management
control of a larger or longer established
company and keep its name for the
combined entity. This is known as a
reverse takeover. Another type of
acquisition is reverse merger, a deal that
enables a private company to get publicly
listed in a short time period. A reverse
merger occurs when a private company
that has strong prospects and is eager to
raise financing buys a publicly listed shell
company, usually one with no business and
limited assets. Achieving acquisition
success has proven to be very difficult,
while various studies have showed that
50% of acquisitions were unsuccessful. The
acquisition process is very complex, with
many dimensions influencing its outcome.
MERGER
The terms "demerger", "spin-off" and "spin-
out" are sometimes used to indicate a
situation where one company splits into two,
generating a second company separately
listed on a stock exchange.
In business or economics a merger is a
combination of two companies into one
larger company. Such actions are
commonly voluntary and involve stock swap
or cash payment to the target. Stock swap
is often used as it allows the shareholders
of the two companies to share the risk
involved in the deal. A merger can resemble
a takeover but result in a new company
name (often combining the names of the
original companies) and in new branding; in
some cases, terming the combination a
"merger" rather than an acquisition is done
purely for political or marketing reasons.
CLASSIFICATIONS OF MERGERS
-177-
1. Horizontal merger - Two companies that
are in direct competition and share similar
product lines and markets
2. Vertical merger - A customer and
company or a supplier and company. (eg:
an ice cream maker merges with the dairy
farm whom they previously purchased milk
from; now, the milk is 'free')
3. Market-extension merger - Two
companies that sell the same products in
different markets
4. Cogeneric : in same industries and
taking place at the same level of economic
activity- exploration, production or
manufacturing wholesale distribution or
retail distribution to the ultimate consumer.
Cogeneric merger are of two types
Horizontal merger (b) Vertical merger (eg:
an ice cream maker in the United States
merges with an ice cream maker in
Canada)
-178-
5. Product-extension merger - Two
companies selling different but related
products in the same market (eg: a cone
supplier merging with an ice cream maker).
6, Conglomeration - Two companies that
have no common business areas.
TYPES OF MERGERS
1. Purchase mergers - As the name
suggests, this kind of merger occurs when
one company purchases another. The
purchase is made with cash or through the
issue of some kind of debt instrument; the
sale is taxable.
Acquiring companies often prefer this type
of merger because it can provide them with
a tax benefit. Acquired assets can be
written-up to the actual purchase price, and
the difference between the book value and
the purchase price of the assets can
depreciate annually, reducing taxes payable
by the acquiring company.
-179-
2. Consolidation mergers - With this
merger, a brand new company is formed
and both companies are bought and
combined under the new entity. The tax
terms are the same as those of a purchase
merger.
3. Accretive mergers are those in which an
acquiring company's earnings per share
(EPS) increase. An alternative way of
calculating this is if a company with a high
price to earnings ratio (P/E) acquires one
with a low P/E.
4. Dilutive mergers are the opposite of
above, whereby a company's EPS
decreases. The company will be one with a
low P/E acquiring one with a high P/E.
Distinction between mergers and acquisitions
Although they are often uttered in the same
breath and used as though they were
synonymous, the terms merger and
acquisition mean slightly different things.
When one company takes over another and
clearly establishes itself as the new owner,
the purchase is-180-
called an acquisition. From
a legal point of view, the target company
ceases to exist, the buyer "swallows" the
business and the buyer's stock continues to
be traded.
In the pure sense of the term, a merger
happens when two firms, often of about the
same size, agree to go forward as a single
new company rather than remain separately
owned and operated. This kind of action is
more precisely referred to as a "merger of
equals". Both companies' stocks are
surrendered and new company stock is
issued in its place.
In practice, however, actual mergers of
equals don't happen very often. Usually,
one company will buy another and, as part
of the deal's terms, simply allow the
acquired firm to proclaim that the action is a
merger of equals, even if it is technically an
acquisition. Being bought out often carries
negative connotations, therefore, by
describing the deal euphemistically as a
merger, deal makers and top managers try
-181-
to make the takeover more palatable.
A purchase deal will also be called a merger
when both CEOs agree that joining together
is in the best interest of both of their
companies. But when the deal is unfriendly
- that is, when the target company does not
want to be purchased - it is always regarded
as an acquisition.
Whether a purchase is considered a merger
or an acquisition really depends on whether
the purchase is friendly or hostile and how it
is announced. In other words, the real
difference lies in how the purchase is
communicated to and received by the target
company's board of directors, employees
and shareholders. It is quite normal though
for M&A deal communications to take place
in a so called 'confidentiality bubble'
whereby information flows are restricted
due to confidentiality agreements (Harwood,
2005).
-182-
FINANCING M&A
Mergers are generally differentiated from
acquisitions partly by the way in which they
are financed and partly by the relative size
of the companies. Various methods of
financing an M&A deal exist:
1. Cash
Payment by cash. Such transactions are
usually termed acquisitions rather than
mergers because the shareholders of the
target company are removed from the
picture and the target comes under the
(indirect) control of the bidder's
shareholders alone.
A cash deal would make more sense during
a downward trend in the interest rates.
Another advantage of using cash for an
acquisition is that there tends to lesser
chances of EPS dilution for the acquiring
company. But a caveat in using cash is that
it places constraints on the cash flow of the
company.
2. Financing
-183-
Financing capital may be borrowed from a
bank, or raised by an issue of bonds.
Alternatively, the acquirer's stock may be
offered as consideration. Acquisitions
financed through debt are known as
leveraged buyouts if they take the target
private, and the debt will often be moved
down onto the balance sheet of the
acquired company.
3. Hybrids
An acquisition can involve a combination of
cash and debt or of cash and stock of the
purchasing entity.
4. Factoring
Factoring can provide the extra to make a
merger or sale work
MOTIVES BEHIND M&A
The dominant rationale used to explain
M&A activity is that acquiring firms seek
improved financial performance. The
following motives are considered to improve
-184-
financial performance:
• Economy of scale: This refers to the fact that
the combined company can often reduce its fixed
costs by removing duplicate departments or
operations, lowering the costs of the company
relative to the same revenue stream, thus
increasing profit margins.
• Increased revenue or market share: This
assumes that the buyer will be absorbing a major
competitor and thus increase its market power (by
capturing increased market share) to set prices.
• Cross-selling: For example, a bank buying a
stock broker could then sell its banking products
to the stock broker's customers, while the broker
can sign up the bank's customers for brokerage
accounts. Or, a manufacturer can acquire and sell
complementary products.
• Synergy: For example, managerial economies
such as the increased opportunity of managerial
specialization. Another example are purchasing
economies due to increased order size and
associated bulk-buying discounts.
• Taxation: A profitable company can buy a loss
maker to use the target's loss as their advantage
by reducing their tax liability. In the United States
and many other countries, rules are in place to
limit the ability of profitable companies to "shop"
for loss making companies, limiting the tax motive
of an acquiring company.
-185-
• Geographical or other diversification: This is
designed to smooth the earnings results of a
company, which over the long term smoothens
the stock price of a company, giving conservative
investors more confidence in investing in the
company. However, this does not always deliver
value to shareholders (see below).
• Resource transfer: resources are unevenly
distributed across firms (Barney, 1991) and the
interaction of target and acquiring firm resources
can create value through either overcoming
information asymmetry or by combining scarce
resources.[3]
• Vertical integration: Vertical integration occurs
when an upstream and downstream firm merge
(or one acquires the other). There are several
reasons for this to occur. One reason is to
internalise an externality problem. A common
example is of such an externality is double
marginalization. Double marginalization occurs
when both the upstream and downstream firms
have monopoly power, each firm reduces output
from the competitive level to the monopoly level,
creating two deadweight losses. By merging the
vertically integrated firm can collect one
deadweight loss by setting the upstream firm's
output to the competitive level. This increases
profits and consumer surplus. A merger that
creates a vertically integrated firm can be
profitable.
• Diversification: While this may hedge a
company against -186-
a downturn in an individual
industry it fails to deliver value, since it is possible
for individual shareholders to achieve the same
hedge by diversifying their portfolios at a much
lower cost than those associated with a merger.
• Manager's hubris: manager's overconfidence
about expected synergies from M&A which
results in overpayment for the target company.
• Empire-building: Managers have larger
companies to manage and hence more power.
• Manager's compensation: In the past, certain
executive management teams had their payout
based on the total amount of profit of the
company, instead of the profit per share, which
would give the team a perverse incentive to buy
companies to increase the total profit while
decreasing the profit per share (which hurts the
owners of the company, the shareholders);
although some empirical studies show that
compensation is linked to profitability rather than
mere profits of the company.
TAKEOVER
In business, a takeover is the purchase of
one company (the target) by another (the
acquirer, or bidder). to the acquisition of a
private company.
-187-
TYPES OF TAKEOVERS
1. Friendly takeovers
Before a bidder makes an offer for another
company, it usually first informs that
company's board of directors. If the board
feels that accepting the offer serves
shareholders better than rejecting it, it
recommends the offer be accepted by the
shareholders.
In a private company, because the
shareholders and the board are usually the
same people or closely connected with one
another, private acquisitions are usually
friendly. If the shareholders agree to sell the
company, then the board is usually of the
same mind or sufficiently under the orders
of the shareholders to cooperate with the
bidder. This point is not relevant to the UK
concept of takeovers, which always involve
the acquisition of a public company.
2. Hostile takeovers
-188-
A hostile takeover allows a suitor to bypass
a target company's management unwilling
to agree to a merger or takeover. A
takeover is considered "hostile" if the target
company's board rejects the offer, but the
bidder continues to pursue it, or the bidder
makes the offer without informing the target
company's board beforehand.
A hostile takeover can be conducted in
several ways. A tender offer can be made
where the acquiring company makes a
public offer at a fixed price above the
current market price.
The main consequence of a bid being
considered hostile is practical rather than
legal. If the board of the target cooperates,
the bidder can conduct extensive due
diligence into the affairs of the target
company. It can find out exactly what it is
taking on before it makes a commitment.
But a hostile bidder knows about the target
only the information that is publicly
available, and so takes a greater risk. Also,
banks are less willing to back hostile bids
-189-
with the loans that are usually needed to
finance the takeover
3. Reverse takeovers
A reverse takeover is a type of takeover
where a private company acquires a public
company. This is usually done at the
instigation of the larger, private company,
the purpose being for the private company
to effectively float itself while avoiding some
of the expense and time involved in a
conventional IPO.
FINANCING A TAKEOVER
1. Funding
Often a company acquiring another pays a
specified amount for it. This money can be
raised in a number of ways. Although the
company may have sufficient funds
available in its account, this is unusual.
More often, it will be borrowed from a bank,
or raised by an issue of bonds. Acquisitions
financed through debt are known as
-190-
leveraged buyouts, and the debt will often
be moved down onto the balance sheet of
the acquired company. The acquired
company then has to pay back the debt.
This is a technique often used by private
equity companies. The debt ratio of
financing can go as high as 80% in some
cases. In such a case, the acquiring
company would only need to raise 20% of
the purchase price.
2. Loan note alternatives
Cash offers for public companies often
include a "loan note alternative" that allows
shareholders to take part or all of their
consideration in loan notes rather than
cash. This is done primarily to make the
offer more attractive in terms of taxation. A
conversion of shares into cash is counted a
disposal that triggers a payment of capital
gains tax, whereas if the shares are
converted into other securities, such as loan
notes, the tax is rolled over.
-191-
3. All share deals
A takeover, particularly a reverse takeover,
may be financed by an all share deal. The
bidder does not pay money, but instead
issues new shares in itself to the
shareholders of the company being
acquired. In a reverse takeover the
shareholders of the company being
acquired end up with a majority of the
shares in, and so control of, the company
making the bid. The company has
managemental rights.
PROS AND CONS OF TAKEOVER
While perceived pros and cons of a
takeover differ from case to case, there are
a few worth mentioning.
Pros:
1. Increase in sales/revenues (e.g. Procter &
Gamble takeover of Gillette)
2. Venture into new businesses and markets
3. Profitability of target company
4. Increase market share
-192-
5. Decrease competition (from the perspective of
the acquiring company)
6. Reduction of overcapacity in the industry
7. Enlarge brand portfolio
8. Increase in economies of scale
Cons:
1. Reduced competition and choice for
consumers in oligopoly markets. (Bad for
consumers, although this is good for the
companies involved in the takeover)
2. Likelihood of job cuts.
3. Cultural integration/conflict with new
management
4. Hidden liabilities of target entity.
5. The monetary cost to the company.
Takeovers also tend to substitute debt for
equity. In a sense, government tax policy of
allowing for deduction of interest expenses
but not of dividends, has essentially
provided a substantial subsidy to takeovers.
It can punish more conservative or prudent
management that don't allow their
companies to leverage themselves into a
high risk position. High leverage will lead to
high profits if circumstances go well, but can
-193-
lead to catastrophic failure if circumstances o How the funding and security issues are to
do not go favorably. This can create work.
substantial negative externalities for -194-
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