Financial Management /Management Studies

Discuss ideas of value, investment, risk, return and profit. Examples include sale of an apple, sale of an egg versus sale of a chicken.

Financial Management:

Assisting the achievement of the overall aims of the company through:

The provision of finance where and when required, in a manner and at a cost that provides an acceptable level of risk to the business, i.e., the financing decision.

The investigation and evaluation of investment opportunities open to the business, i.e. the investment decision.

These both focus on the future of the company.

Aside: another financial management function, Management Accounting, reports and records the activities of the business.

Techniques generally assume the maximisation of owners wealth (rather than profit), i.e., maximisation of owners return on investment. Profits are short term concepts, wealth is along term concept. Debate: is wealth a bad thing? Maximisation of wealth implies efficient use of resources. Aside: managers may not have ownership, hence may pursue own agendas.

Page 1 of 12

Sources of Finance - Credit

Sources of finance:

General notes:

As mentioned, job of financial manager is to have the correct amount of money in place at the correct time. Each type of source of finance has effects the business in the following ways: risk, income and control.

Financial risk: The chance that the business will be unable to pay back the interest / capital combination required of it. (Different to business risk, i.e., the risk that the products will sell at a loss, or will not sell at all).

Income risk: Pertains to the cost of funds. Examples of zero cost funds: accounts payable, government grants. Examples of funds imparting cost: share issues (payment of dividends), loans (payment of interest). Consider also the life of the cost of the funds, e.g., the length of a loan.

Control risk: Affects of funds over management ownership or control. New share may have voting rights, implying dilution of control. Bank loans may restrict the sale of assets.

Job of financial manager: Maximise income / value, while minimising risk and loss of control. Very difficult job, but larger business will have greater availability of sources.

Page 2 of 12

Sources of Finance - Credit

(Aside: Privatisation of British Rail: Government could get cheapest loans (seen as low risk by banks), and did not require return on investment in normal sense. Private industry has the twofold problem of more expensive loans and the requirement to increase shareholder value. This increase in funds must be fully financed by increases in efficiency).

Short term sources of finance: Will generally have a higher rate of interest than long term sources, as the lender will not have all his capital employed in the long term, and this loss must be made up by a higher short term rate.

Spontaneous sources of finance:

These arise during the normal course of business and are termed non negotiated. Free, insofar as no interest is usually charged.

Trade Credit

Some invoices are now invoked encouraging early payment of dues by discounting a certain percentage of the invoice for payment within a certain number of days. For example, an invoice terms may be stated as 2/10 net 30, meaning that a 2% discount will be awarded if the invoice is paid within 10 days of its date, but the full amount will be charged thereafter. In any event, the invoice must be paid within 30 days. (See notes on compound interest here)

Page 3 of 12

Sources of Finance - Credit

Costs of leaning on the trade: Higher goods prices Eventual COD only

Trade credit available depends on: The proportion of raw materials in the product (design consultancy: no trade credit) The credit terms of the supplier The purchasing policies of the company.

Aside: Retail trade: Cash received immediately for sale of goods (except for credit cards: Ref. Aldi company, Parnell St), may lean on suppliers for 90+ days. This yields 90/365 x annual turnover available at little or no cost for investment in bank, capital equipment, etc.

Accrued Expenses:

Achieving services (ESB, gas, phone, internet, banking etc.), but paying for them a number of weeks or months in arrears. Similar for wages, salaries, rent, etc., i.e., have use of workers, plant, buildings immediately, but do not have to pay for a month.

Page 4 of 12

Sources of Finance - Credit

Taxation.

Under current legislation, businesses act as tax collectors for the state. This has implications for sources of finances in two areas, VAT and income tax.

VAT is charged on all invoices, but returned to the state every four months. In fact, the last payment date is 19 days after the two month accounting period. VAT is returnable to the state on all invoices issued within the two month period, up to and including those issued on the last day. Thus the average time period before VAT is due is one month plus 19 days, assuming equispaced payments are made.

Income tax and PRSI is deducted weekly, bi-weekly and monthly from employees. Some companies delay remitting this to the state, and use the delay as a source of finance.

Corporation tax, (tax on the income of a corporation) falls due six months after the accounting period during which the taxable profits are accrued. This in effect means that the corporation can have a six month zero interest loan every year.

Negotiated Sources of Finance.

Bill of exchange: used in time of tight credit. Unconditional order in writing, from one person to another, requiring the addressee to pay a specified sum on a specified date, to a specified person, or the bearer. (Example: A

Page 5 of 12

Sources of Finance - Credit

postdated cheque, exchanged for less that its face value). The addressee (buyer) accepts the bill by writing accepted across it, and signing it. The due date is usually 30, 60, 90 or 180 days. The holder of the bill can sell it to a bank at a discounted rate.

Commercial Paper: IOUs or promissory notes of large firms, usually to be repaid in up to six months. These notes are sold on the open market, and may be bought by other companies that have excess cash and require an investment opportunity. For the issuers of the notes, this is often an easier and cheaper way to raise cash than going to the banks because: The interest rate is below the overdraft rate It is a simple and cheap negotiating procedure There is status and prestige associated with being able to borrow with this method (i.e., the company is recognised as a good investment risk). Problems include: Difficulty in extending credit over the time agreed time.

The two main types of commercial paper that are in use in Ireland are: Government guaranteed notes issued by Semi-State bodies Bank guaranteed notes issued by large Irish companies.

Advantages to borrower: Notes can be issued at Dublin Interbank Offered Rate (DIBOR)+0.15%, whereas a straight loan could be DIBOR + 0.375%. Advantage to lender: No DIRT is payable on the gains that the lender makes on the paper. As DIRT is deducted at source, hence contributing to cash flow difficulties, the lender is often happy to negotiate a lower rate of return in order to avoid the DIRT.

Page 6 of 12

Sources of Finance - Credit

Acceptance Credits A bank issues a letter of credit to the management of the company in question, stating that it will honor bills of exchange for certain amounts for a certain period of time. (Example: The bank will accept and cash cheques up to a value of Ir1000 in any given month for a year). Post dated cheques or bills of exchange can then be sold to other banks at a discount, for immediate cash. Note; this leaves the borrower open to a twofold penalty: firstly the discounted value of the cheque, and secondly the interest rate on the credit extended by the issuing bank.

Bank Overdraft

Widely used in business (and domestically). Intended for short term capital needs, and are negotiated and require the lenders authority to use. They have no time limit for repayment, i.e., they are not term loans, although they may require the account to be in credit for 30 days a year. Banks prefer short term inherently self liquidating loan, e.g., a loan for Christmas stock for a retailer. However, many companies use short tem loan facilities invest the cash in medium term investments such as plant and machinery, therefore causing difficulties if and when the loan is called in.

Advantages include: They are tied to the underlying interest rate Interest is charged on a daily basis on outstanding amounts Interest is tax deductible.

Page 7 of 12

Sources of Finance - Credit

Disadvantages include:

A mortgage or lien on property may be required. This is especially difficult if the mortgage is floating, i.e., every asset is part of the mortgage. Implies clearance from bank required before securing other loan on any asset.

May be called in at any time May require formal or personal guarantees: This seriously undermines the concept of limited liability.

Will require a sound relationship with the bank.

The overdraft must be negotiated, and therefore a coherent cash requirement and management plan must be available to the bank, to ensure that the cash is being used for short term needs, and that cash will be available to repay the overdraft. As the bank is taking a risk in lending the money, it recognises different categories of risk, and charges appropriate rates. If a bank expects one loan in 100 to become illiquid per year, the cost of that capital loss must be borne by the other borrowers in that risk group. Borrower risk category and example rates are as follows:

Category AAA

Borrower Type State, local authorities, public companies, schools, churches etc

Typical Rate 8.75%

AA A

Large private firms Small firms, personal borrowers

10.5% 13.0%

Page 8 of 12

Sources of Finance - Credit

Inventory Financing: As inventory has value, it can be used for collateral for short term loans. Called stock loans. Depending upon the liquidity of the stock, a lender may extend a loan equal to a certain percentage of the stock value. Some stock or work in progress may be so specialised as to be valueless until the product is completed. (Aside: Mellor problem: SMT machine versus car: loan issues).

Factoring A Factor will offer four main services: Take over the debt collection functions of the client Offer insurance against bad debts Pay agreed percentages of invoices on agreed dates May pay cash in advance of invoice payment. In order to protect confidentiality, the factoring service may open a company that sounds like the client company, i.e., Joe Bloggs and Sons (Sales) Limited. Cost of factoring includes: Interest charges, (about 4% above AA rates) Insurance (against bad debt) charges Service charge to cover debt collection etc.

Benefits: Allow accurate cash flow forecasting and allow access to cash Pay suppliers more promptly, enhancing credit reputation Obtain cash and quantity discounts

Page 9 of 12

Sources of Finance - Credit

Cope with seasonal demands for cash Finance a higher level of sales Saving on management time previously spent chasing accounts

Problems involved in debt factoring Business may be seen as financially weak

Accounts receivable financing. In this case a bank may issue a loan on the basis of a certain percentage (50% to 80%) of accounts receivable. The bank will audit the debtor account, and will forward a loan based on the estimated risk of the larger accounts. The difference between this and debt factoring is that it a loan, and when the account is paid to the company from the debtor, the entire value of the loan plus interest is paid to the bank.

Insurance premium loans. Used to finance insurance cover for the company. Paid back to the lender over 6 2 monthly payments. Spreads the cost of the loan, and reduces drain on the available cash.

Note: A fundamental principle of financing is to match the life of the finance with the life of the asset. This will prevent the loan having to be repaid, long after the asset is valueless. Thus, short term financing is used only for expected variances in current assets, e.g., inventory.

Page 10 of 12

Sources of Finance - Credit

Medium Term Sources of finance. Used to finance plant and machinery, and projects of payback periods of between three and five years. Principle instruments are leasing, hire purchase and term loans.

Leasing: Examples: Hertz cars, Xerox copiers, Specialist electronic equipment, etc. To lease is to gain access to and to use an asset without ever gaining title to it. 4 ways to arrange a lease Maker to user: Controls use of equipment and may have an inbuilt maintenance contract. User to User: A number of individual users purchase machines and lease them to each other. Leasing company to user: Specialised company purchases equipment and leases it users. Widespread in Ireland, examples are office equipment and cars. Finance house to user: A user chooses a piece of equipment required for use. A bank will purchase the equipment, and lease it to the user. Two main types of leases: Operating leases: The lessee (the company or person that is paying to use the equipment) can cancel the lease prior to its expiration. The lessor provides service, maintenance and insurance.

Page 11 of 12

Sources of Finance - Credit

The total sum of payments in one leasing contract may not cover the cost of the asset Therefore the leasing company will have to find subsequent lessees for the asset.

Financial leases. The lease cannot be cancelled prior to its expiry date. The lessor may or may not provide service, maintenance or insurance. The payment stream from the lessee fully covers the cost of the asset.

A typical lease agreement covers: The life of the lease The timing and amount of repayments Agreements on renewing the lease or the purchasing of the asset at the end of the lease period Arrangements concerning maintenance, repairs, etc. Direct lease versus Sale and lease back. Direct: user chooses asset and financial institution purchases the asset and leases it to the lessee. Sale and lease back: The financial institution purchases an asset belonging to the prospective lessee and lease it back to him / her. The advantage is access to cash for the lessee, via the sale, and the continuing use of the asset. Lease payments are tax deductible. However, before deciding to lease a piece of equipment, the prospective lessee should perform a purchase or lease analysis, in order to determine the most cost and tax effective method of access to the asset.

Page 12 of 12

Sources of Finance - Credit