LEARNING UNIT 4

The financial function and financial management The time value of money

•Concerned with the flow of funds •combined effect of both interest and time
• Acquisition of funds (financing)
• Application of funds for the acquisition of assets approached perspectives:
(investment) • calculation of the future value of some given present value
• Administration, and reporting, financial matters. • calculation of the present value of some expected future
amount
Performs following tasks:
• Financial analysis, reporting, planning and control
• Management of the acquisition of funds
• Management of the application of funds

Profit
• Favourable difference between the income earned during
a specific period and the cost incurred to earn that income

Costs
• Monetary value sacrificed in the production of goods Present value of a single amount (SIMPLE INTEREST)
and/or services produced for the purpose of resale
• Costs can be subdivided: • the monetary amount which can be invested today at a
• Direct cost given interest rate (i) per period in order to grow to the
• Indirect cost same future amount after n periods
• Overhead expenses • Discounting process -reciprocal of the compounding
• Fixed costs process
• Variable cost

Future value of a single amount (COMPOUND INTEREST)

• Future value of an initial investment or principle is

determined by means of compounding
• Amount of interest earned in each successive period is
added to the amount of the investment at the end of the
preceding period
• Interest is earned on capital and interest

Objective of financial management

•Long term objective -to increase the value of the business

accomplished by:
• Investing in assets that will add value to the business
Cost–volume–profit relationships
• Keeping the cost of capital as low as possible
•Profitability is determined by the unit selling price of a
•Short term financial objective - to ensure the profitability,
product, the cost of the product and the level of activity of
liquidity and solvency of the business.
the business
•Change in one of these three components = change in the
Fundamental principles of financial management
total profit earned
•Each of these components have to be viewed in
• The risk-return principle
conjunction with one another
• The cost-benefit principle
• The time value of money principle
Break-even point is reached, where total costs are equal to
total income.

Financial markets

• channels which holders of surplus funds make funds

available to those who require additional finance
• Financial institutions act as intermediaries on financial
markets between savers and those with a shortage of funds
Financial analysis, planning and control. • Financial intermediation is the process in which financial
institutions pool funds from savers and make these funds
• monitors the general financial position of a business and available to those requiring finance
to limit the risk of financial failure of the business as far as
possible Primary and secondary markets
• tools disposal to conduct financial analyses: [PPR] • Savers receive assets in the form of financial claims against
• statement of Financial Performance the institution to which money was made available
• statement of Financial Position • New issues of financial claims -as issues of the primary
• Financial ratios market
• Trading in securities after they have been issued takes
Financial ratios place in the secondary market
• tradability of securities ensures that savers with surplus
• gives the relationship between two items (or groups of funds continue to invest
items) in the financial statements
• Serves as a performance criterion to point out potential Money and capital markets
strengths and weaknesses of the business • Money market -market for financial instruments with a
short-term maturity
Liquidity ratios • Funds are borrowed and lent for periods of one day or for
a few months
• Indicate the ability of a business to meet its short-term • Funds required for long-term investment are raised and
obligations as they become due without curtailing or ceasing traded by investors on the capital market:
normal activities • the Johannesburg Securities Exchange (JSE)
• Long-term investment transactions can be done privately

Types of institutions [PSLPP]

Financial institutions:
Deposit-taking institutions
• Private-sector bank (FNB, Standard Bank)
Non-deposit taking institutions:
• Short-term insurers (Outsurance, Santam)
Solvency ratios • Life assurers (Old Mutual and Sanlam)
• Pension funds
Indicate the ability of a business to repay its debts from the • Provident funds
sale of the assets on cessation of its activities.
Short-term financing

Trade credit

• Occurs mainly in the form of suppliers’ credit

• Prompt payment is often secured in the form of rebates
Advantages of trade credit: Important characteristics of the ordinary share:
• Readily available to businesses that pay their suppliers
regularly • Liability of ordinary shareholders is limited to the amount
• informal of share capital they contributed to the business
• more flexible than other forms of short-term financing • No certainty that money paid for shares will be recouped
• Ordinary shares in listed company are tradable on stock
Accruals exchange
• Ordinary shareholders are owners of the business and
• source of spontaneous finance usually have full control of it
• Accrued wages - money that a business owes its • Business has no legal obligation to reward ordinary
employees (wages or salaries) shareholders for their investment in shares
• Accrued tax - form of financing which is determined by the • Share capital is available to the business for an unlimited
amount of tax payable and the frequency with which it is period
paid
Preference-shareholders’ capital
Bank overdrafts
Two types of preference shares:
• Overdraft facility allows the business to make payments • Ordinary preference share
from a cheque account in excess of the balance in the • Cumulative preference share
account
• Bridges the gap between cash income and cash expenses Characteristics of preference shares:
• Interest charged on overdraft is negotiable and is related • Have a preferential claim over ordinary shares on profit
to the borrower’s risk profile after tax
• Interest is charged daily on the outstanding balance • Have a preferential claim over ordinary shares on the
assets of the business in the case of liquidation
Debtor finance • The term of availability is unlimited
• Authority can vary between full voting rights and no voting
Involves the sale of debtors to a debtor-financing company: rights at all
• Invoice discounting is the sale of existing debtors and
future credit sales to a debtor financing company Financial planning and control
• Factoring is similar to invoice discounting, except the
financer undertakes to administer and control the collection •Integral part of the strategic planning of the business
of debt •Done in most businesses or organisations by means of
budgets
Long-term financing •A budget is a formal written plan of future action
expressed in monetary terms
Shareholders’ interest
An integrated budgeting system
• Shareholders’ interest in a company is subdivided into
owners’ equity and preference shareholders’ capital Operating budgets
• Owners’ equity consists of funds made directly available • Cost budgets
by the legal owners in the form of share capital • Income budgets
• Preference-shareholder capital falls between debentures • Profit plan or profit budget
and ordinary shares in terms of risk
Financial budgets
Owners’ equity • Capital expenditure budget
• The cash budget
• Ordinary shareholders are true owners of a business • Financing budget
• The budgeted statement of financial position
Two types of ordinary shares:
• Par value shares
• Non-par value shares

• A co-owner of the business, the ordinary shareholder, has

a claim to profits
Traditional budgeting
• Using the actual income and expenditure of the previous
year as a basis and making adjustments for expected
changes in circumstances.

Zero-base budgeting
• Enables the business to look at its activities and priorities
afresh on an annual basis because historical results are not
taken as a basis for the next budgeting period The management of debtors

Asset management: The management of current assets • Debtors arise when a business sells on credit.
• Credit granted to individuals is referred to as consumer
•Current assets include items such as cash, marketable credit
securities, debtors, and inventory • Credit extended to businesses is known as trade credit
•Current assets are needed to ensure the smooth and
continuous functioning of the business. Three most important facets of the management of debtor
accounts are:
The management of cash and marketable securities
• The credit policy
Costs of holding cash: • The credit terms
• Loss of interest • The collection policy
• Loss of purchasing power.
The credit policy
Costs of little or no cash: • Credit policy contains information on how decisions are
• Loss of goodwill made about who to grant credit to and how much
• Loss of opportunities
• Inability to claim discounts The four Cs of credit:
• Cost of borrowing • Character: The customer's willingness to pay
• Capacity: The customer's ability to pay
Marketable securities • Capital: The customer's financial resources
• Conditions: Current economic or business conditions.
• Investment instruments on which a business earns a fixed
interest income The collection policy
• guidelines for collection of debtor accounts that have not
Three reasons to have a certain amount of cash available: been paid by due dates
• The transaction motive • Costs of granting credit include the following:
• The precautionary motive • Loss of interest
• The speculative motive • Costs associated with determining customer’s
creditworthiness
The cash budget. • Administration and record-keeping costs
• Bad debts
• Determining the cash needs of a business is crucially
important The management of stock (inventory)
• Cash budget is a detailed plan of future cash flows for a
specific period Conflict between profit objective and operating objective
Costs of holding stock:
Composed of three elements: • Lost interest
• Cash receipts • Storage cost
• Cash disbursements • Insurance costs
• Net changes in cash • Obsolescence

The cash cycle indicates the time it takes to complete: Costs of holding little or no stocks:
• The loss of customer goodwill
• Investing cash in raw materials • Production interruption dislocation
• Converting the raw materials to finished products • Loss of flexibility
• Selling the finished products on credit • Re-order costs
• Ending the cycle by collecting cash
Long-term investment decisions and capital budgeting The application of NPV involves:

•Capital investment involves the use of funds of a business • Forecasting the three components of project cash flows as
to acquire fixed assets, such as land, the benefits of which accurately as possible
accrue over periods longer than one year • Deciding on an appropriate discounting rate
• Calculating the present values of the three project cash
Importance of capital investment projects: flow components for a project
• Relative magnitude of the amounts involved • Accepting all projects with a positive NPV and rejecting all
• Long-term nature of capital investment decisions those with a negative NPV, in accordance with NPV decision
• Strategic nature of capital investment projects criteria

The evaluation of investment projects Decision criteria for the NPV

• Basic principle underlying the evaluation of investment
decision-making is cost benefit analysis – cost of each • Accept all independent projects with a positive NPV (NPV
project is compared to its benefits > 0)
• Reject all independent projects with a negative NPV (NPV
Two additional factors require further consideration when < 0)
comparing benefits and costs: • Projects with NPV = 0 make no contribution to value and
• Benefits and costs occur at different times are usually rejected
• Costs and benefits are accounting concepts that do not
necessarily reflect the timing and number of payments to Risk and uncertainty
the business
• Risk is defined as any deviation from the expected
Cash-flow concepts outcome
• Cash flow represents cash transactions • Risks may or may not occur
• Uncertainty describes a situation where the managers are
Three cash-flow components used for capital budgeting: simply unable to identify the various deviations and are
• Initial investment unable to assess the likelihood of their occurrence
• Expected annual cash flows over the life of the project
• Expected terminal cash flow, related to the termination of Sources of financing for small businesses
the project. • Personal funds
• Loans from relatives and friends
`Annual net cash flows are calculated as the earnings before • Trade credit
interest and tax, plus any non-cash cost items such as • Mortgage loans
depreciation minus cash outflows for particular year • Small-business loans
• Taking in partners
Concepts to understand: • Selling capital shares
• Initial investment (C0)
• Annual net cash flows (CFt)
• Life of the project (n)
• Terminal cash flow (TCF)

The net present value method

The formula used to calculate NPV is:

NPV = present value of net cash inflows – initial investment