Financial Management Concepts Chapter 14-15 PDF

**CHAPTER 14** **Financial management** Johan Marx and Raphael Mpofu **The purpose of this chapter** This chapter explains what financial management entails and illustrates financial decisionmaking. **Learning outcomes** On completion of this chapter you should be able to: describe and appl...

**CHAPTER 14** **Financial management** Johan Marx and Raphael Mpofu **The purpose of this chapter** This chapter explains what financial management entails and illustrates financial decisionmaking. **Learning outcomes** On completion of this chapter you should be able to: describe and apply the fundamental principles of financial management determine the break-even point of a business organisation calculate the present and future value of amounts analyse and interpret the financial statements of a business organisation understand the financial planning process manage the current assets of a business evaluate investment decisions find financing for a business. 14.1Introduction Financial management is the art and science of obtaining enough finance for a business at the lowest cost, investing in assets earning a return greater than the cost of capital, and managing the profitability, liquidity and solvency of the business. In financial management, we start by answering the following questions: Which long-term investments should we take on as a business? That is, which lines of business should we be in and what sorts of buildings, machinery and equipment do we need? Where will we get the long-term financing to pay for these investments? This could mean bringing in other owners or borrowing the money needed. How will we manage the everyday financial activities such as collecting from customers and paying suppliers? In other words, the financial management decisions will be around the following: 1.Capital budgeting: That is, the business's long-term investment, the process of planning and managing a business's long-term investments, so called capital budgeting, and which investment opportunities exist for the business. It should be noted that the size, timing and risk of future cash flows are the most important questions to be answered under this part of financial management. 2.Capital structure: That is, the ways in which the business obtains and manages the long-term financing it needs to support its long-term investments. This includes the mixture of debt and equity that a business uses to finance its operations. Questions involve where and how to get the financing, and the expenses associated with raising long-term financing. Choosing lenders and different types of debt financing are among the most important issues to be addressed. The financial manager needs to ask and ponder the following issues: internal financing, that is, reinvesting in the business's internal projects; debt (bonds), which have a fixed claim regardless of the business's performance; equity (shares), which has a residual or ownership claim and may receive cash flows left over after debt has been paid; and hybrid securities, such as preference shares, convertible debt, etc. 3.Working capital management: This is related to the short-term assets of the business, such as inventory, and short-term liabilities, such as money owed to suppliers. Questions that should be addressed here are how much cash and inventory a business should keep in hand, and whether it should sell on credit and, if so, under which terms, how a business can obtain short-term financing, purchase on credit or borrow in the short term and pay cash, identify sources of funding short-term expenses, and so on. 4.Finally, financial managers need to worry about how to return the proceeds from the business's investments to shareholders. Questions are related to: (a) paying dividends (note that this increases the need for external capital) and (b) retaining earnings to invest in new projects. This demonstrates to shareholders that the company cares for its welfare and maximises the market value of the business. In the introductory chapters of this book, the financial function was identified as one of the functional management areas in a business. In this chapter, the nature and meaning of the financial function and its management -- in other words, financial management -- will be explained. Thereafter, the relationship between financial management, the other functional management areas, related subject disciplines and the environment will be shown. An introduction to a few basic concepts and techniques used by financial management will then follow. The goal and fundamental principles of financial management, including financial analysis, planning and control, will be explained. The chapter also explains how to finance a business and how to evaluate investment decisions. 14.2The financial function and financial management A business must have the necessary assets such as land, buildings, machinery, vehicles, equipment, raw materials and trade inventories at its disposal if it is to function efficiently. In addition, business organisations need further resources (such as management acumen and labour) and services (such as a power supply and communication facilities). A business needs funds, also called **capital**, to obtain the required assets, resources and services. The people or institutions (including the owners) who make funds available to the business lose the right to use those funds in the short or long term, and they also run the risk of losing those funds, or a portion thereof, should the business fail. As a result, suppliers of funds expect compensation for the funds they make available to the business (and also a repayment of funds lent to the business) when it starts to generate funds through the sale of the products or services it produces. Hence, there is a continual flow of funds to and from the business. (See Figure 14.13 on page 533.) The **financial function** is concerned with this flow of funds. In particular, it is concerned with the acquisition of funds (known as **financing)**, the application of funds for the acquisition of assets (known as **investment)**, and the administration of and reporting on financial matters (known as **accounting).** Financial management is responsible for the efficient management of all facets of the financial function. Within the broad framework of the strategies and plans of the business, its aim is to make the highest possible contribution to the objectives through the performance of the following tasks: Financial analysis, reporting, planning and control; Management of the application of funds, also known as the management of the asset structure; and Management of the acquisition of funds, also known as the management of the financing or capital structure. Financial management cannot function in isolation. Besides the interdependence between the functional management areas (without production and marketing, for example, no funds will be generated, and vice versa), financial management should also depend on other related subject disciplines, such as accounting and economics, if it wants to be efficient. As a subsystem of the business, the financial function, and therefore its management, is also influenced by environmental factors. The relationship between financial management, the other functional management areas, related subject disciplines and the environment is illustrated in Figure 14.1. The case study that follows provides an illustration of how financial management is applied in a real-life situation. **Figure 14.1:** The relationship between financial management, other functional management areas, related disciplines and the environment **CASE STUDY:** Financial management in action Imagine that you own 20 000 shares of a retail firm listed on the JSE. You bought these shares at R5,20 each two years ago, but the price has subsequently declined to R1,90 each. Other firms in the same sector have seen increases in their profitability and share prices. The annual general meeting (AGM) is scheduled to take place in six weeks' time. From the firm's financial statements, you have determined the information shown in Table 14.1. **Table 14.1:** Information determined from the firm's financial statements **Ratio** 1:1The economic outlook is positive, interest rates are expected to decline, consumer spending is on the increase and inflation is below 3 per cent. However, the top management seems to be divided about the issues facing the firm. 1.What can management do to improve the firm's profitability? 2.What can the investors (shareholders) do to improve matters? **Answers** 1.The actions management could consider for improving the firm's profitability are summarised in Table 14.2. 2.An ordinary shareholder of a public company is entitled to vote at the annual general meeting of the company. The shareholder can improve matters by attending the AGM, and by nominating and voting for new members of the board of directors. If the shareholder cannot attend the meeting himself or herself, he or she can complete a proxy form and nominate someone who will be attending the meeting to vote in a particular manner on his or her behalf. Selling your shares will cause a loss of at least R3,30 per share or a total of R66 000 (R3,30 × 20 000 shares) before any transaction costs are taken into account. It might be worth engaging management and exerting pressure to implement a turnaround strategy that includes the actions described in Table 14.2. **Table 14.2:** Actions management could consider for improving a firm's profitability **Ratio** **Suggestions** **Gross profit margin** 1.Increase sales by means of more effective marketing and/or by relaxing the credit standards (increasing credit sales). 2.Reduce the cost of products sold by buying products at a lower cost from another supplier, stocking products with a faster turnover rate and/or reconsidering products with slow turnover rates. **Net profit margin** 1.Increase sales by means of more effective marketing and/or relaxing the credit standards (increasing credit sales). 2.Reduce the operating expenses and/or improve productivity by means of, inter alia, performance management systems, training and more effective use of technology. **Return on assets** 1.Increase sales by means of more effective marketing and/or relaxing the credit standards (increasing credit sales) while decreasing expenses or using existing capacity more effectively. 2.Review assets (disinvest non-core business units, use outsourcing and/or improve productivity). **Return on equity** 1.Increase sales by means of more effective marketing, consider relaxing the credit standards (increase credit sales) during periods of positive economic growth and reducing the cost of products sold. Reduce operating expenses and improve productivity. 2.Reduce equity (buy back shares and cancel them), borrow to do so (increase the debt ratio). **Earnings per share** 1.Improve profitability (as indicated above) by increasing sales and reducing expenses. 2.Reduce the number of shares (buy back shares and cancel or consolidate shares). Replace this financing with debt financing. 14.3Concepts in financial management As in any field of study, it is necessary to describe certain concepts in financial management to present the subject in a meaningful manner. 14.3.1The statement of financial position The **statement of financial position** allows the viewer to have an overall grasp of the financial position of a business. It may be diagrammatically represented, as in Figure 14.2. The information in Figure 14.2 is largely self-explanatory. The **asset side** reflects all the possessions of the business, together with their respective values as at the date on which the statement was prepared, and therefore shows the mutual coherence between these possessions. These assets represent the **asset structure** of the business. Assets are normally divided into two broad categories in the statement of financial position: 1.**Non-current assets**, such as land, buildings, machinery, vehicles and other equipment that will be used in a business for more than a year. 2.**Current assets** such as cash in the bank, as well as other possessions of the business that will be converted into cash within one year during the normal course of business, such as marketable securities, debtors and all inventories. **Figure 14.2:** A diagrammatic representation of the statement of financial position The values at which the assets are recorded in the statement of financial position differ according to the objectives for drawing up the statement of financial position. For this reason, it is essential that the statement of financial position should provide an indication of the values at which the assets have been recorded, for example, cost, cost less depreciation or cost plus appreciation. The **liability** or claims side of the statement of financial position reflects the nature and extent of the interests in the assets. In other words, it reflects the mutual coherence of the claims of the persons or institutions that provided funds (capital) for the 'purchase' of the assets. Therefore, the liability side of the statement of financial position shows the **financing** or **capital structure** of the business as at the statement of financial position date. The liability side of the statement of financial position is usually subdivided on the basis of the following two criteria: 1.The term for which the funds have been made available. 2.The source from which the funds have been obtained. Therefore, the owners' equity and liability side of a company's statement of financial position will contain the following details: **Long-term funds**. This is also known as non-current liabilities and comprises shareholders' interest and long-term debt. **Shareholders' interest** is owners' equity (made up of ordinary share capital, reserves, undistributed or retained profits) and, in some instances, preference-share capital. **Long-term debt** is usually made up of debentures, mortgage bonds, secured loans and long-term credit. **Short-term funds**. These are also referred to as current liabilities. They represent all debts or credit that are normally repayable within one year. Examples of these funds are bank overdrafts and trade creditors. The favourable difference between the current assets and the current liabilities represents the net working capital or that portion of the current assets that has been financed from long-term funds. The shareholders' interest on the liability side of the statement of financial position of businesses that do not have ordinary or preference shareholders (for example, sole proprietorships, partnerships and close corporations) is replaced by a capital account that reflects the owners' interest in the business. 14.3.2Capital Capital can be described as the accrued power of disposal over the products and services used by a business to generate a monetary return or profit. Stated differently, the capital of a business may briefly be described as the monetary value of the assets of the business at a specific time. A business needs capital for investment in fixed assets (referred to as the **need for** **fixed capital)** and capital for investment in current assets (referred to as the **need for** **working capital).** A business has a permanent need for a certain minimum portion of working capital. The remaining need for working capital will vary according to factors such as seasonal influences and contingencies that result in an increase or decrease in production activities. 14.3.3Income The **income** of a business consists primarily of receipts resulting from the sale of its products and/or services. The extent of these receipts for a given period will depend on the quantity of products and/or services sold within that period, and the unit price for which they were sold. Income = Units sold × Price per unit The income of the business can also be obtained from other sources, such as interest earned on investments. However, this income will not be taken into account in the discussions that follow. 14.3.4Costs **Costs** can be regarded as the monetary value sacrificed in the production of products and/ or services produced for the purpose of resale. Costs are further subdivided according to certain criteria; hence the business has direct costs, indirect costs, overhead expenses, fixed costs and variable costs. The subdivision of total costs into fixed and variable costs is of particular importance for decision-making purposes. Thus, the remainder of this section will be devoted to this aspect. A further subdivision will be introduced in the discussion of the statement of financial performance in Section 14.3.6. **Fixed cost** is that portion of total cost that remains unchanged (within the boundaries of a fixed production capacity) regardless of an increase or decrease in the quantity of products and/or services produced. By way of illustration, consider a bakery who is able to bake 1 800 loaves of bread every day. However demand increased and the bakery will have to buy one more oven at R200 000. The firm will borrow money from the bank in order to finance the oven. In this way, a new production capacity is created, which gives rise to a new fixed-cost component.Total fixed costs as part of total costs for a particular period and capacity can be represented graphically as in Figure 14.3. **Example: Costs** In a manufacturing firm, cost will consist of used material, rent for premises and a building, depreciation of equipment, wages and salaries for all employees, payment for electricity and communication services, and so on. **Figure 14.3:** A graphical representation of total fixed costs Total fixed costs are constant, irrespective of the volume produced. Therefore, the fixed costs per unit produced will decrease with an increase in the quantity produced, as illustrated in Figure 14.4. **Figure 14.4:** A graphical representation of fixed costs per unit **Variable cost** is that portion of the total costs that changes according to a change in the volume produced. Some variable cost items, such as manufacturing material costs, can be regarded as pure variable costs because they change in direct proportion to a change in the volume produced. Other variable cost items contain a fixed-cost component, such as the fixed telephone rental. In this instance, there is not a pure linear relationship between these variable cost items and the volume produced. Therefore, these costs are referred to as **semi-variable costs**. Since these semi-variable costs do not have any substantial effect on the principle of fixed and variable costs, a pure linear relationship can, for purposes of illustration, be assumed between total variable costs and volume produced, as represented in Figure 14.5. **Figure 14.5:** A graphical representation of total variable costs The **variable costs per unit** produced remain more or less constant irrespective of the quantity produced. This point is illustrated in Figure 14.6. **Figure 14.6:** A graphical representation of variable costs per unit The **total costs** involved in the production of a specific number of products produced in a particular period consist of the total fixed costs and the total variable costs incurred in the production of those products. Figure 14.7 graphically illustrates how total costs are arrived at.**Figure 14.7:** A graphical representation of total costs To summarise, it may be stated that the total costs of the business comprise a fixed and a variable component, each of which has a specific relationship with the volume of production. These relationships have a specific influence on the profit made by businesses, as discussed in Section 14.5. 14.3.5Profit **Profit** is regarded as the favourable difference between the income earned during a specific period and the **cost** incurred to earn that income. A **loss** results when the cost exceeds the income. Profit or loss = Income -- Cost or Profit or loss = (Price × Units sold) -- Cost Although the above comparison applies in general, various profit concepts in the different stages of the profit-determining process may be identified in the statement of financial performance. 14.3.6The statement of financial performance The statement of financial performance, one of the annual financial statements of a business, furnishes details about the manner in which the profit or loss for a particular period was arrived at and how it has been distributed. Figure 14.8 represents, in diagrammatic form, the statement of financial performance of a manufacturing business in company form. A numerical example of a statement of financial performance of such a business appears in Section 14.7.1.1, while certain profit concepts are also further highlighted in Figure 14.8. Note that the statement of financial performance of a sole proprietorship, a partnership and a close corporation will, in essence, differ solely in the division of the net profit. The information in Figure 14.8 is largely self-explanatory. \*Appears in the liability side of the statement of financial position -- see section 14.3.1 **Figure 14.8:** A diagrammatic representation of the statement of financial performance Note that accountants sometimes use certain terms associated with statements of financial performance interchangeably, for example: sales/turnover operating profit/earnings before interest and tax (EBIT) profit/earnings; and net profit/earnings after tax/net income. 14.4Objective and fundamental principles of financial management 1 The long-term objective should be to increase the value of the business. This may be accomplished by: investing in assets that will add value to the business; and keeping the cost of capital of the business as low as possible. The short-term financial objective should be to ensure the profitability, liquidity and solvency of the business. Profitability is the ability of the business to generate income that will exceed cost. In order to maximise profit, a firm has to maximise revenue from sales while limiting expenses to the essential. Liquidity is the ability of the business to satisfy its short-term obligations as they become due. In other words, it is the business's ability to pay the trade creditors by the due dates. Liquidity can be improved by accelerating cash inflows (collecting accounts receivable as fast as possible or making cash sales only) and paying creditors as late as possible. Solvency is the extent to which the assets of the business exceed its liabilities. Solvency differs from liquidity in that liquidity pertains to the settlement of short-term liabilities, while solvency pertains to long-term liabilities such as debentures and mortgage loans. Financial management is based on three principles: the risk--return principle, the cost--benefit principle and the time value of money principle. 14.4.1The risk--return principle Risk is the probability that the actual result of a decision may deviate from the planned end result, with an associated financial loss or waste of funds. Risk differs from uncertainty in that in the case of the latter, there is no probability or measure of the chances that an event will take place, whereas risk is measurable by means of statistical techniques. Similar to the cost--benefit principle, the **risk--return** principle is a trade-off between risk and return. The greater the risk, the greater the required rate of return will be. 14.4.2The cost--benefit principle Decision-making, which is based on the cost of resources only, will not necessarily lead to the most economic utilisation of resources. Sound financial decision-making requires making an analysis of the total cost and the total benefits, and ensuring that the benefits always exceed the cost. One application of the cost--benefit principle is illustrated in Section 14.5 when the cost--volume--profit relationship is explained. 14.4.3The time value of money principle The **time value of money** principle means a person could increase the value of any amount of money by earning interest. If, however, the amount is invested in inventory, equipment, vehicles and so on, then the amount cannot earn interest. This ties up with the previous two principles. From a cost--benefit point of view, the investor has to earn a greater return on the investment in inventory, equipment and vehicles than on the best alternative type of investment. Equally, from a risk--return point of view, the return must compensate adequately for any risk incurred. The time value of money principle will be illustrated in Section 14.6. Applying the concept Decision time Someone who invests R500 000 in a business sacrifices the opportunity of earning interest on the amount because it could have been invested in a fixed deposit with less risk to earn 10 per cent interest. The business must earn a return greater than 10 per cent in order to increase the wealth of the owner.14.5Cost--volume--profit relationships The concepts of costs, fixed costs, variable costs, income and profits, among other things, were explained in Section 14.3. In essence, the profitability of a business is determined by the unit selling price of its product, the costs (fixed and variable) of the product and the level of the activity of the business (the volume of production and sales). A change in any one of these three components will result in a change in the total profit made by the business. The components therefore have to be viewed in conjunction with one another and not in isolation. The underlying connection can be explained by means of a simplified numerical example in which only the volume of production and sales changes. The calculation in the example is referred to as a **break-even analysis**, where the breakeven point is reached when total costs are equal to total income. At the break-even point, no profit or loss is realised. The break-even point in a specific case can be calculated by using the following formula: N in the formula is the number of units (volume) where no profit or loss is made. The term (SP -- V) is referred to as the marginal income or variable profit. **Example:** Estimating the profitability Sales price (SP) R12 per unit Variable cost (V) R8 per unit Total fixed cost (FC) R100 00 per annum Number of units manufactured and sold: N = 30 000 (case 1) N = 40 000 (case 2) Profit = P From P = income -- cost it follows that P = (N × SP) -- \[(N × V) + FC\] Where Where The break-even analysis can also be done with the aid of a graph, as in Figure 14.9. The break-even point is reached when the total income and total cost curves intersect -- in other words, at a sales and production volume of OY where the total costs and total income equal OX. In the event of any change in the income as a result of a change in the selling price or a change in variable costs and/or fixed costs, the slope and point of intersection of the curves will change. The new break-even point is then to be obtained accordingly. The profit or loss at any sales volume can also be obtained. These values are the vertical differences between the total-cost and the total-income curves. From the above examples, it is apparent that the production and sales volumes, the unit selling price, and the fixed and variable costs together have an important effect on the profitability of a business. In practice, this type of analysis is carried out especially in the determination of the minimum size at establishment of a business manufacturing and marketing only one product, and also where the feasibility of potential expansion is concerned. A business that provides more than one product will have to make use of a budgeted statement of financial performance in order to determine its break-even point. **Figure 14.9:** A graphical representation of a breakeven analysis **Example:** Determining the break-even units 14.6The time value of money 14.6.1Introduction to the time value of money Section 14.2 stated that all businesses require capital. As is evident from the following discussion, the payment or remuneration for the use of money or capital is fundamental to the financial structure of any free-market society. It should be kept in mind in the investment and financing decisions of a business that interest has to be paid for the use of capital. Also, funds or capital are normally required and used for either shorter or longer periods, and the use of capital therefore has a time implication. Consequently, the purpose of this discussion is to explain the concept of the **time** **value of money** -- the combined effect of both interest and time -- in the context of financial decision-making. Critical thinking The time value of money influences the way people approach cash flow, as will be illustrated here. What would you choose if you were faced by the choice of receiving a gift of R10 000 in cash today or the same amount a year from now? Obviously, you would choose to be given the R10 000 today. Why? The R10 000 received today can be invested to earn interest, resulting in a larger amount after one year, purely because of the time value of money. The person who wishes to donate the money may not be able or willing to donate the money a year from now. To wait causes risk and uncertainty. During times of inflation, the real purchasing power of R10 000 will decline as time goes by. In principle, the time value of money bears a direct relation to the opportunity of earning interest on an investment. This is the opportunity rate of return on an investment. The opportunity to earn interest in the interim period is foregone if an amount is expected at some point in time in the future rather than being received immediately. The time value of money can be approached from two different perspectives. On the one hand, the calculation of the **future value** of some given present value or amount is possible, as is, on the other hand, the calculation of the **present value** of some expected future amount. The processes for the calculation of future values **(compounding)** and for the calculation of present values **(discounting)** proceed in opposite directions, as indicated in Figure 14.10. **Figure 14.10:** The relationship between present value and future value 14.6.2The future value of a single amount The future value of an initial investment or principal is determined by means of **compounding**. This means that the amount of interest earned in each successive period is added to the amount of the investment at the end of the preceding period. Interest in the period immediately following is consequently calculated on a larger amount consisting of capital and interest. Interest is therefore earned on capital and interest in each successive period. The formula for calculating the future value of an original investment is: FV *n* = PV (1+i) *n* Where: PV is the original investment or present value of the investment. FV *n* is the future value of the investment after *n* periods. *i* is the interest rate per period expressed as a decimal number. *n* is the number of discrete periods over which the investment extends. In fact, these symbols also appear on financial calculators. The factor (1 + i) *n* in the formula is known as the **future-value factor** (FVF) or **compound-interest factor** of a single amount. The process for future-value calculation is illustrated in Figure 14.11. The future value of an original investment can also be calculated by using tables. An extract from these tables follows. The example below for a three-year investment at an interest rate of 5 per cent per annum is calculated as follows with the aid of Table 14.3 on page 527: The result is identical to the one obtained by using the formula. Bear in mind that the future-value factor (1 + i) *n* is an exponential function, which means that the initial amount will grow exponentially over time.The higher the interest rate, the faster the future value will grow for any given investment period as a result of the compounding effect. Consequently, interest is earned on interest in each successive period. The concept of the compound interest rate as a growth rate is of vital importance in financial management. The values of any of the four variables in the equation for the calculation of the future value can be determined if the values of the remaining three variables are known. **Example** What is the future value of R100 invested for one year at an interest rate of 5 per cent per annum? And if the investment term is 3 years? **Figure 14.11:** Process for future-value calculation **Table 14.3:** Extract from a table used to calculate future value of an original investment 14.6.3Present value 14.6.3.1The present value of a single amount The present value is also based on the principle that the value of money is, among other things, affected by the timing of receipts or disbursements, as in the case of the future value. If it is accepted that a rand today is worth more than a rand expected at some future date, what would the present value be now of an amount expected in future? The answer to this question revolves around the following: Investment opportunities available to the investor or recipient; and The future point in time at which the money is expected. An amount of R105 that is expected one year from now will have a present value of R100, provided the opportunity exists to invest the R100 today (time *t* 0 ) at an interest rate of 5 per cent per annum. The interest rate, which is used for discounting the future value of R105 one year from now to a present value of R100, reflects the time value of money and is the key to the present-value approach. This interest rate or opportunity rate of return is the rate of interest that could be earned on alternative investments with similar risks if the money had been available for investment now. Stated differently, it is the rate of return that would be foregone by not utilising the investment opportunity. The process of discounting is explained by means of the time line in Figure 14.12.**Figure 14.12:** Process for calculating the present value of a single amount The **discounting process** is the reciprocal of the compounding process. Consequently, the formula for the calculation of the present value of a future single amount is: The factor is known as the **present-value factor** or **discounting factor** for a future single amount. Tables have also been compiled for the calculation of present values. An extract from these tables follows. **Example:** Calculating present values What is the present value of R105 expected to be one year from now if the investor's opportunity cost (discount rate) is 5 per cent per annum? What is the present value of R115,76 invested under the same circumstances and expected in three years' time? **Table 14.4:** Extract from a table used to calculate present values In the example on this page, the present value of R115,76 expected three years from now is calculated as follows, with the aid of Table 14.4, at an opportunity rate of return or discounting rate of 5 per cent. The present value of a single amount is, accordingly, defined as follows: The **present value (PV)** is the amount that can be invested today at a given interest rate *i* per period in order to grow to the same future amount after *n* periods. As illustrated in the example on page 528, as long as the opportunity for investment at 5 per cent per annum exists, the investor should be indifferent to a choice between R100 today or R115,76 in three years' time. Closer investigation of the preceding discounting factors reveals that the values of these factors decrease progressively as *i* or *n*, or both, increase. The exceptionally high decrease in the discounting factor with relatively high interest rates and long time periods means the following: The higher the interest rate is, the smaller the present value of a given future amount will be. The further in the future an amount is expected, the smaller its present value at a given interest rate will be. Interestingly, the present-value factor PVF 10,10 = 0,3855 implies that the present value of R1,00 expected in ten years is only 38,55 cents today, if the R1,00 could have been invested today at 10 per cent for ten years. If an investment opportunity at 15 per cent should exist (which is not unrealistic), the present value of R1,00 expected ten years from now is only 24,72 cents (PVF 15,10 = 0,2472). Put differently, this also means that the value or purchasing power of R1,00 will decline to 24,72 cents over the next ten years if the average annual inflation rate is to be 15 per cent a year over this period. The present-value factors and the future-value factors (as well as the tables for these factors) are based on the assumption that any funds generated in any period over the total duration of the investment or project (such as annual interest receipts) are reinvested at the same interest rate for the remainder of the total investment period. The values of any one of the four variables in the equation for the calculation of the future value can be determined provided that the values of the three remaining variables are known. **Example** 14.6.3.2The present value of an uneven cash-flow stream The determination of the present value of a series of unequal cash-flow amounts is approached in the same way as one would approach a single amount, irrespective of the total duration or the number of time periods involved. As in all applications of the time value of money, the timing of the cash receipts or disbursements is of crucial importance. This is evident from the following example of the calculation of the present value of an uneven cash-flow stream at an interest rate or discounting rate of 10 per cent. The appropriate discounting factors are found in Table 14.4. This brief overview of the present-value approach is deemed sufficient for the purposes of this discussion. However, in practice, interest on savings accounts and deposits are often calculated biannually, quarterly, monthly, weekly and even daily. This could apply to both future-value and present-value applications, and is known as intra-year compounding and discounting. 14.6.4Concluding remarks The principles and application of compounding and the time value of money as a basis for the determination of present values as well as future values have been explained in this section. The present-value approach is an indispensable aid in financial management, particularly for a large business and listed company, where the majority of investment and financing decisions are taken in accordance with the goal of the maximisation of the value of the business. Even for small business organisations, a basic knowledge of compound-interest methodology and unsophisticated discounted cash flow applications could be invaluable for capital investment decisions. The most important implications of time value of money are as follows: Inflow must be accelerated. (Encourage debtors to pay their accounts as soon as possible.) Outflow should be delayed without damaging the firm's credit record. (Pay creditors as late as possible.) Manage inventory as optimally as possible because it represents capital that does not earn a return before it is sold. 14.7Financial analysis, planning and control 2 In Section 14.2, effective financial analysis, planning and control were identified as tasks of financial management. In this section, a short review of these related tasks is given. 14.7.1Financial analysis Financial analysis is necessary to monitor the general financial position of a business and, in the process, to limit the risk of financial failure of the business as far as possible. Financial analyses will reveal certain trends, as well as the financial strengths and weaknesses of the business so that corrective measures, if necessary, can be taken in time. To help it with its financial analyses, financial management have the following important aids at their disposal: The statement of financial performance; The statement of financial position; and Financial ratios. The sections that follow will focus on the various statements and the calculation of certain financial ratios. 14.7.1.1The statement of financial performance The statement of financial performance has already been described in Section 14.3.6 and diagrammatically represented in Figure 14.8. Consequently, a numerical example of a manufacturing company's abridged statement of financial performance (see Table 14.5) will suffice for the purposes of this section. 14.7.1.2The statement of financial position The statement of financial position of a company and the most important statement of financial position items have already been discussed in Section 14.3.1 and represented diagrammatically in Figure 14.2. Thus, a numerical example of a company's statement of financial position will suffice for the purposes of this section (see Table 14.6). **Table 14.5:** An example of an abridged statement of financial performance (rand values) 14.7.1.3The flow of funds in a business A business has to make optimum use of its limited funds to achieve its objectives. It is therefore necessary to conduct an analysis of how the capital of the business is employed and supplied. This analysis involves the flow of funds in the business. The flow of funds of a firm is a continuous process and, following on from the previous explanations of the statement of financial position and statement of financial performance, can be represented as in Figure 14.13. The following points are apparent from **Table 14.6:** An example of a company statement of financial position Figure 14.13: The business obtains funds in the financial market and utilises these funds at a cost to produce products and/or services. The business sells these products and/ or services at a price higher than the production costs and therefore shows an operating profit. Interest is paid to the suppliers of loan capital from the operating profit. This means an outflow of funds from the business. The profit remaining after the interest has been paid is taxable. This means a further outflow of funds from the business. The profit remaining after tax can be applied to preference and ordinary shareholders' dividends (outflow of funds), reserves and undistributed profits, resulting in a reinvestment in the production process. It is clear from Figure 14.13 that there is a continuous flow of funds to and from the business. If the sales value of the products and/or services produced by the business exceeds the costs incurred in the production of those products and/or services, including the depreciation on equipment, the business will show a profit. A portion of the profit, after payment of interest and tax, is normally distributed among the preference and ordinary shareholders in the form of dividends. The remaining profit is reinvested in the business. The reinvestment leads to an increase in the available funds of the business. **Figure 14.13:** A simplified diagrammatical representation of the flow of funds of a business 14.7.1.4Financial ratios As mentioned earlier, financial ratios are one of the aids that financial management can employ in the process of effective financial analysis and control. A financial ratio gives the relationship between two items (or groups of items) in the financial statements (especially the statement of financial performance and the statement of financial position). It also serves as a performance criterion to point out potential strengths and weaknesses of the business. However, it must be emphasised that financial ratios do not identify the reasons for the strengths and weaknesses. They only indicate symptoms that need to be further diagnosed by financial management. The financial ratios of a business are used by the following interested parties: **Financial management**, with a view to internal control, planning and decision making; The **suppliers of borrowed capital**, to evaluate the ability of the business to pay its debt and interest; **Investment analysts**, to evaluate the business as an investment opportunity; and **Labour unions**, with a view to salary negotiations. Financial ratios as such have little, if any, usage value, and must be viewed against certain significant standards or norms to give them usage value. Three types of comparisons are significant in this regard: 1.A comparison of the current financial ratios of the business with the corresponding ratios of the past and/ or expected future ratios with a view to revealing a tendency.2.A comparison of the financial ratios of the business with those of other similar businesses. 3.A comparison of the financial ratios of the business with the norms for the particular industry as a whole. There are many different kinds of financial ratios and various classification methods. In this section, only a few kinds are mentioned without paying attention to their respective merits. The calculations of the various ratios are explained by using the information given in the previous statement of financial performance (see Table 14.5 on page 531) and statement of financial position (see Table 14.6 on page 532). **LIQUIDITY RATIOS** **Liquidity ratios** provide an indication of the ability of a business to meet its short-term obligations as they become due without curtailing or ceasing its normal activities. Providers of loan capital are interested in liquidity ratios because they give an indication of the degree to which a business can meet its debt obligations fully and punctually in the normal course of events. Two liquidity ratios are of importance: the current ratio and the acid-test ratio. **THE CURRENT RATIO** The **current ratio** reflects the relationship between the value of the current assets and the extent of the current liabilities of a business. Using the figures of ABC Limited contained in Table 14.6 on page 532 results in a current ratio of 2,2:1, calculated as follows: This means that the business had R2,20 of current assets available for each R1 of its current liabilities (short-term obligations). The smaller the ratio is, the greater the possibility that the business will not be able to meet its debt obligations fully and punctually without curtailing or ceasing its normal activities. Traditionally, a current ratio of 2:1 is recommended. **THE ACID-TEST RATIO** Since inventory cannot always be readily converted into cash in the short term, it may be misleading to evaluate the liquidity position of a business simply on the basis of the current ratio. The **acid-test ratio** should therefore be used in combination with the current ratio as a criterion for evaluating liquidity. Using the figures of ABC Limited contained in Table 14.6 on page 532 results in an acid test ratio of 1,4:1, calculated as follows: This shows that for each rand's worth of current liabilities, the business had R1,40 of current assets, excluding inventory. As in the case of the current ratio, a larger ratio reflects a healthier liquidity position than a smaller ratio. Normally, a minimum acid test ratio of 1:1 is recommended.Liquidity ratios should be evaluated with caution. The **nature** and **condition** of the current assets and the 'correctness' of the **values** at which they were recorded in the statement of financial position can cause the actual liquidity position to differ radically from that which is reflected by the liquidity ratios. Although it is important for a business to be liquid, it is also possible to be excessively liquid. A current ratio of, for example, 5:1 could be an indication that the firm is carrying too much inventory, selling too much on credit, collecting accounts receivable too slowly and/or has too much cash on hand. An acid-test ratio of, for example, 3:1 could be an indication that the firm is selling too much on credit, collecting accounts receivable too slowly and/or has too much cash on hand. In such a case, funds are not being used optimally, but are confined to unproductive use in current assets. It is therefore important to realise that one should not strive without restriction towards an improvement in the liquidity ratios. **SOLVENCY RATIOS** **Solvency ratios** indicate the ability of a business to repay its debts from the sale of the assets on cessation of its activities. Capital lenders usually show strong interest in solvency ratios because these indicate the risk level of an investment in the business. Seen from another angle, it gives the business an indication of the extent to which it will have access to additional loan capital and the extent of its risk in its current financing. There are two particularly important solvency ratios: the debt ratio and the gearing ratio. **THE DEBT RATIO** The **debt ratio** may be calculated using the following equation: Where total assets = non-current assets + current assets Using the figures of ABC Limited contained in Table 14.6 on page 532 results in a debt ratio of 37 per cent, calculated as follows: This means that 37 per cent of the assets were financed by debt (including preference shares if they are callable). A lower percentage reflects a more favourable position than a higher percentage, and a maximum debt ratio of 50 per cent is normally required. **THE GEARING RATIO** The **gearing ratio** may be calculated using the following equation: Using the figures of ABC Limited contained in Table 14.6 on page 532 results in a gearing ratio of 1,7:1, calculated as follows: This indicates that for each R1 of debt (including preference shares), the business had R1,70 of owners' equity. A larger ratio once again reflects a more favourable situation than a smaller ratio, and a minimum gearing ratio of 1:1 is normally required.The following aspects concerning solvency ratios need to be emphasised: The solvency ratios illustrate the same situation as seen from different angles. To evaluate the solvency situation of a business, it is therefore necessary to use only one of these ratios. Solvency ratios should not simply be accepted at face value. What constitutes a safe ratio for a particular business depends on various factors such as the risks to which it is subject, the nature of the assets and the degree to which creditors will be accommodating in emergency situations. **PROFITABILITY, RATE OF RETURN OR YIELD RATIOS** Firms strive to achieve the greatest possible profitability. They therefore also wish to achieve the greatest profitability ratios. To achieve this, they must maximise their income and limit cost (expenses) to the essential. Sound profitability not only enables the firm to survive financially, but it also enables the firm to obtain financing relatively easier. The share prices of listed companies normally increase in reaction to announcements of good profitability figures. **GROSS PROFIT MARGIN** The **gross profit margin** may be found by: The gross profit margin indicates how profitable sales have been. The gross profit also gives an indication of the mark-up percentage used by a firm. A firm with a gross profit margin of 50 per cent uses (on average) a mark-up of 100 per cent, as will be illustrated here. Assume sales equal R200 and the cost of products sold equals R100. This yields a gross profit of R100 and a gross profit margin of 50 per cent: Using the figures of ABC Limited contained in Table 14.5 on page 531 and Table 14.6 on page 532 results in a gross profit margin of 25 per cent: Firms prefer to achieve the greatest possible gross profit margin. In the case of ABC Ltd, the 25 per cent gross profit margin indicates that the firm uses a mark-up percentage of approximately 33 per cent. In other words, products manufactured or bought at, for example, R100 are sold at R133: A firm aiming to improve its gross profit margin will have to improve its marketing efforts in order to increase sales whilst simultaneously reducing the cost of products sold. The firm could, for example, reconsider aspects of the marketing instruments (product, price, promotion and distribution) and make suitable adjustments, which would in turn require adjustments to the manufacturing process (if it is a manufacturing firm) and/ or procurement. Firms intent on reducing cost should, however, do so with care in order not to sacrifice quality and alienate clients in the process. In this respect, firms normally prefer to improve product features (including quality) in order to justify a price increase.**NET PROFIT MARGIN** The **net profit margin** gives an indication of the overall profitability of the firm and management's ability to control revenue and expenses. Net profit margin may be found by: Using the figures of ABC Limited contained in Table 14.5 on page 531 and Table 14.6 on page 532 results in a net profit margin of 7,57%: In order to improve profitability, management needs to consider the measures already suggested for improving the gross profit margin and focus on operating expenses. Productivity will have to be evaluated and, if necessary, will have to be improved. Firms could calculate annually or quarterly the percentage of sales each operating expense (for example, salaries) constitutes. Management can compare these figures with those of previous years in order to identify deviations. **RETURN ON INVESTMENT (ROI)** This ratio may be computed as follows: Using the figures of ABC Limited contained in Table 14.5 on page 531 and Table 14.6 on page 532 results in a return on investment (after tax) of 16,8 per cent, calculated as follows: Return on investment A firm wishing to improve its return on investment needs to consider the same measures as those proposed in respect of the gross profit margin and net profit margin. Since the total capital (capital employed) is equal to the total assets (employment of capital), the firm needs to investigate whether it could function with less capital and/or improve the productivity (if possible) of its assets. A firm can reduce its capital by paying off long-term loans more quickly (especially during periods of rising interest rates), by paying greater dividends (if the profitability and cash flow permit it), or a portion of the firm's shares could be repurchased and cancelled. The firm also needs to review its core business. Parts of the firm that cannot be regarded as core business can be sold (for example, company houses that are let to employees). **RETURN ON OWNERS' EQUITY (ROE)** The **return on owners' equity** may be calculated using the following equation: Using the figures of ABC Limited contained in Table 14.5 on page 531 and Table 14.6 on page 532 results in a return on owners' equity of 26,7 per cent, calculated as follows: An increase in ROE can be achieved by means of an increase in the net profit margin, asset turnover and financial leverage. Financial leverage can be attained by using more long-term borrowed funds and less ordinary-share capital. A firm could, for example, borrow money in order to buy back its own ordinary shares and cancel the shares that have been bought back. Such an approach can be applied relatively safely during periods of declining interest rates, but is risky during periods of rising interest rates. So far, liquidity, solvency and profitability ratios have been described. As described earlier, normally an increase in profitability of a listed company leads to an increase in the share price of such a firm. Since the long-term goal of the firm is to increase the value of the firm, management should focus on earning the highest possible return and keeping the cost of capital as low as possible. 14.7.1.5Concluding remarks The preceding explanation offered a brief survey of the financial- analysis task of financial management. From the explanation, it is apparent that the statement of financial performance, statement of financial position and financial ratios are important aids in the performance of this task. In the section that follows, the focus is on financial planning and control. 14.7.2Financial planning and control Financial planning forms an integral part of the strategic planning of a firm. Top management has to formulate the vision and mission for the firm, analyse the strengths and weaknesses of the firm, and identify opportunities and threats in the external environment. The probability of successfully implementing the strategy that top management has decided on depends on the extent to which the firm has suitable human and financial resources at its disposal, or can attract such resources. Financial planning and control are done in most business organisations by means of budgets. A budget can be seen as a formal written plan of future action, expressed in monetary terms and sometimes also in physical terms, to implement the strategy of the business and to achieve the goals with limited resources. As such, budgets are also used for control purposes. Control is done by comparing the actual results with the planned (budgeted) results periodically or on a continuous basis. In this way, deviations are identified, and corrective action can be taken in time. This section provides a brief overview of the following issues: The focal points of budgets in the control system of a manufacturing business. An integrated budgeting system for a manufacturing business. Zero-base budgeting. Critical thinking The link between profitability and share prices Will the share price of a company (listed on a securities exchange) increase if the firm's profitability increases? Normally, yes. Keep in mind, however, that a good company is not necessarily a good investment. The reason for this is that those who have superior information anticipate the improved profitability of the firm better than the uninformed investor. Once the information about improved profitability is announced in the media, the share price would already reflect such information. An investor buying these shares at that point in time would be buying a fully priced or overpriced share and will not necessarily achieve a high rate of return from the investment. 14.7.2.1The focal points of budgets in a control systemControl systems are devised to ensure that a specified strategic business function or activity (for example, manufacturing or sales) is carried out properly. Consequently, control systems should focus on, and budgets should be devised for, various responsibility centres in a business. A responsibility centre can be described as any organisational or functional unit in a business that is headed by a manager responsible for the activities of that unit. All responsibility centres use resources (inputs or costs) to produce something (outputs or income). Typically, responsibility is assigned to income, cost (expense), profit and/or investment centres: In the case of an **income centre**, outputs are measured in monetary terms, though the size of these outputs is not directly compared with the input costs. The sales department of a business is an example of such an income centre. The effectiveness of the centre is not measured in terms of how much the income (units sold × selling prices) exceeds the cost of the centre (for example, salaries and rent). Instead, budgets in the form of sales quotas are prepared and the budgeted figures are compared with actual sales. This provides a useful picture of the effectiveness of individual sales personnel or of the centre itself. In the case of a **cost centre**, inputs are measured in monetary terms, though outputs are not. The reason for this is that the primary purpose of such a centre is not the generation of income. Good examples of cost centres are the maintenance, research and administrative departments of a business. Consequently, budgets should be developed only for the input portion of these centres' operations. In the case of a **profit centre**, performance is measured by the monetary difference between income (outputs) and costs (inputs). A profit centre is created whenever an organisational unit is given the responsibility of earning a profit. In this case, budgets should be developed in such a way that provision is made for the planning and control of inputs and outputs. In the case of an **investment centre**, the monetary value of inputs and outputs is again measured, but the profit is also assessed in terms of the assets (investment) employed to produce this profit. It should be clear that any profit centre can also be considered as an investment centre because its activities require some form of capital investment. However, if the capital investment is relatively small or if its manager/s have no control over the capital investment, it is more appropriate from a planning and control point of view (and thus also from a budgeting point of view) to treat it as a profit centre. 14.7.2.2An integrated budgeting system for a manufacturing business In essence, an integrated budgeting system for a manufacturing business consists of two main types of budget: 1.Operating budgets 2.Financial budgets. Figure 14.14 shows the operating and financial components of an integrated budgeting system of a manufacturing business diagrammatically. **Operating budgets** parallel three of the responsibility centres discussed earlier: 1.**Cost budgets**. There are two types of cost budgets: manufacturing-cost budgets and discretionary-cost budgets. Manufacturing-cost budgets are used where outputs can be measured accurately. These budgets usually describe the material and labour costs involved in each production item, as well as the estimated overhead costs. These budgets are designed to measure efficiency. If the budget is exceeded, it means that manufacturing costs were higher than they should have been. Discretionary-cost budgets are used for cost centres in which output cannot be measured accurately (for example, administration and research). Discretionary cost budgets are not used to assess efficiency because performance standards for discretionary expenses are difficult to devise. **Figure 14.14:** The operating and financial components of an integrated budgeting system **Source:** Marx, J. 2019. *Finance for non-financial managers*. Revised third edition. Pretoria: Van Schaik, p. 73\. Reprinted by permission of Van Schaik Publishers. 2.**Income budgets**. These budgets are developed to measure marketing and sales effectiveness. They consist of the expected sales quantity multiplied by the expected unit selling price of each product. The income budget is the most critical part of a profit budget, yet it is also one of the most uncertain because it is based on projected future sales. 3.**The profit plan or profit budget**. This budget combines cost and income budgets, and is used by managers who have responsibility for both the expenses and income of their units. Such managers frequently head an entire division or business. **Financial budgets**, which are used by financial management for the execution of the financial planning and control task, consist of capital expenditure, cash, financing and balance-sheet budgets. These budgets, prepared from information contained in the operating budgets, integrate the financial planning of the business with its operational planning. Financial budgets serve three major purposes: 1.They verify the viability of the operational planning (operating budgets). 2.They reveal the financial actions that the business must take to make the execution of its operating budgets possible. 3.They indicate how the operating plans of the business will affect its future financial actions and condition. If these future actions and conditions are undesirable (for example, over-borrowing to finance additional facilities), appropriate changes in the operating plans may be required. The **capital expenditure budget** indicates the expected (budgeted) future capital investment in physical facilities (buildings, equipment and so on) to maintain its present capacity or expand the future productive capacity. The **cash budget** indicates: the extent, time and sources of expected cash inflows; the extent, time and purposes of expected cash outflows; and the expected availability of cash in comparison with the expected need for it. The **financing budget** is developed to assure the business of the availability of funds to meet the budgeted shortfalls of receipts (income) relative to payments (expenses) in the short term, and to schedule medium-term and long-term borrowing or financing. The financing budget is therefore developed in conjunction with the cash budget to provide the business with the funds it needs at the times it needs them. The **budgeted statement of financial position** brings together all the other budgets to project how the financial position of the business will look at the end of the budget period if actual results conform to planned results. An analysis of the statement of financial position budget may suggest problems (for example, a poor solvency situation owing to over-borrowing) or opportunities (for example, excessive liquidity, creating the opportunity to expand) that will require alterations to the other budgets. 14.7.2.3Traditional budgeting Traditional budgeting involves using the actual income and expenditure of the previous year as a basis and making adjustments for expected changes in circumstances. The projected sales serve as the point of departure for the budgeting process. Information must be gathered in order to determine which factors will lead to an increase or decline in sales, as well as factors that will influence cost. Examples of these are inflation, interest rates, exchange rates, wage demands, the actions of competitors and changes to tax legislation. Applying the concept What to expect in tough times Retail firms (for example, Edgars) can expect that during times of inflation accompanied by increases in interest rates, the firm's sales could decline, bad debts could increase, the collection of debt could slow down and/or the cost of collecting outstanding debt could increase (as a result of follow-up work). At the same time, the firm has to pay more interest on its loans, pay increased rent on hired retail space and face wage demands. The opposite can be expected during times of declining inflation and interest rates. The firm's plans and budgets are usually negotiated and finalised during a time consuming process. A lack of insight into, and commitment to the firm's strategy can cause managers to pursue the interests of their own departments only during this phase, instead of thinking enterprise-wide. Such behaviour leads to suboptimum budgets. One of the disadvantages of the traditional budgeting approach is that some managers continue the same activities year after year without critically re-evaluating priorities and possible changes in the external and internal environments. This managerial challenge can be handled using zero-base budgeting. 14.7.2.4Zero-base budgeting In contrast with traditional budgeting, zero-base budgeting enables the business to look at its activities and priorities afresh on an annual basis. In this case, historical results are not taken as a basis for the next budgeting period. Instead, each manager has to justify anew his or her entire budget request. In theory, zero-base budgeting leads to a better prioritisation of resource allocations and more efficient businesses. In practice, however, it may generate undue amounts of paperwork, and demoralise managers and other employees who are expected to justify their activities and expenses and, in essence, therefore, their existence, on an annual basis. Critical thinking **The budget dilemma** Is it better for a manager at the middle management level to exceed his or her cost budget at the end of a financial year, or is it better to have funds to spare? Both are problematic. Exceeding a cost budget could be interpreted as a lack of planning and control on the part of the manager (although there might be valid reasons for exceeding the budget -- for example, an increase in activity). Funds to spare are sometimes regarded by middle management as proof to the top management of how sparingly it has used the firm's resources under its control. However, surplus funds at the end of the financial year may also indicate that the manager intentionally overestimated costs to create the impression that his or her budget is managed well. It may, however, be an indication that the manager did not achieve all the objectives that had been set at the beginning of the year. Unspent funds at the end of a financial year may also result in a reduction of the manager's budget for the following year. 14.8Asset management: The management of current assets Current assets include items such as cash, marketable securities, debtors and inventory. These items are needed to ensure the continuous and smooth functioning of the business. Cash, for example, is needed to pay bills that are not perfectly matched by current cash inflows, while an adequate supply of raw materials is required to sustain the manufacturing process. Sales may be influenced by the credit the business is prepared to allow. Current assets are therefore a necessary and significant component of the total assets of the business. Table 14.7 shows current assets to total assets of Edcon, Sasol, Shoprite and Pick n Pay. Figure 14.15 shows that the ratio of current to total assets may vary from company to company. Retailers such as Shoprite and Pick 'n Pay have a large ratio of current to total assets compared to, say, Sasol, which is listed under the JSE Oil and Gas Exploration and Production sector, and produces fuels and chemicals for the chemical industry. Shoprite and Pick n Pay's large ratio of current to total assets occurs because most of the assets of retail stores are in the form of inventory (current assets). Their main business is trading in inventory, not manufacturing. The chemical industry, in contrast, has large investments in plant and other fixed assets. In managing current assets, management should always keep in mind the consequences of having too much or too little invested in them. Two factors play a role: cost and risk. An over-investment in current assets means a low degree of risk, in that more-than adequate amounts of cash are available to pay bills when they fall due, or sales are amply supported by more-than-sufficient levels of inventory. However, over-investment causes profits to be less than the maximum, firstly because of the cost associated with the capital invested in additional current assets, and secondly because of income foregone that could have been earned elsewhere (the so-called **opportunity cost** of capital). The funds invested in excess inventory could, for example, have been invested in a short-term deposit earning interest at the prevailing interest rate. An underinvestment in current assets, however, increases the risk of cash and inventory shortages, and the costs associated with these shortages, but it also decreases the opportunity cost. For example, a business that is short of cash may have to pay high interest rates to obtain funds on short notice, while a shortage of inventory may result in a loss of sales, or even mean that the business has to buy inventory from competitors at high prices to keep customers satisfied. The optimal level of investment in current assets is a trade-off between the costs and the risks involved. As can be seen from the graph in Figure 14.15, companies differ in their holdings of current assets as a percentage of total assets. Some differences are due to the type of industry. For example, it is evident that Sasol and Edcon have a very low percentage of current assets compared to Shoprite and Pick n Pay. Sasol is in the petroleum and related industries, while Edcon is mostly in clothing retail, with companies such as Edgars, Jet and CNA. Pick n Pay and Shoprite are predominantly supermarket retailers and have a slightly higher holding of current assets than Edcon and Sasol. In previous years, Pick n Pay differed from Shoprite in its holdings but they are very similar for 2017\. This can be attributed to Pick n Pay's new broader diversification of businesses, which is similar to that of Shoprite. **Table 14.7:** Current assets to total assets for selected South African companies in 2017 **COMPANY** **2017 CURRENT ASSETS** **2017 TOTAL ASSETS** EDCON 3175 20928 SASOL 16786 115728 SHOPRITE 24643 40533 PICK n PAY 8786 14707 **Figure 14.15:** The ratio of current assets to total assets for selected South African companies (2017) **Sources:** Edcon. *Annual report 2017*. Available at http://www.edcon.co.za. \[Accessed 03 December 2018\]; Pick n Pay. *Annual report 2017*. Available at https://quotes.wsj.com/ZA/PIK/financials/annual/balance sheet. \[Accessed 03 December 2018\]; Sasol. *Annual report 2017*. Available at https://quotes.wsj.com/ZA/SOL/financials/annual/balance-sheet. \[Accessed 03 December 2018\]; Shoprite. *Annual report 2017*. Available at https://quotes.wsj.com/ZA/SHP/financials/annual/balance-sheet. \[Accessed 03 December 2018\]. 14.8.1The management of cash and marketable securities Cash is the money (currency and coin) the business has on hand in petty-cash drawers, in cash registers, and in current and savings accounts with financial institutions. The costs of holding cash are: **Loss of interest**. Cash in the form of notes and coins, and even money in a current account at a bank, earns no interest. **Loss of purchasing power**. During a period of inflation, there is an erosion in the value of money. This becomes even more serious if no interest is earned on that money. The costs of little or no cash are: **Loss of goodwill**. Failure to meet financial obligations on time due to cash shortages will seriously affect the relationship between the company and its employees, creditors and suppliers of raw materials and services. **Loss of opportunities**. Cash shortages will make it impossible to react quickly to a lucrative business opportunity. **Inability to claim discounts**. Discounts for prompt and early payment are very advantageous in percentage terms. Cash shortages may preclude the claiming of such discounts. **Cost of borrowing**. Shortages of cash may force a business to raise money at short notice at expensive rates. Marketable securities are investment instruments on which a business earns a fixed interest income. They can easily be converted into cash and are therefore also referred to as near-cash assets. An example of a marketable security is a short-term treasury bill issued by the government. There are three reasons for a business having a certain amount of cash available: 1.**The transaction motive**. The transaction motive exists primarily because receipts and disbursements are not fully synchronised. Expenses must often be paid before any cash income has been received. The business needs to have sufficient cash available to meet normal current expenditures such as the payment of wages, salaries, rent and creditors. 2.**The precautionary motive**. The precautionary motive entails the keeping of cash, in addition to that prompted by the transaction motive, for contingencies. Contingencies are unexpected events such as a large debtor defaulting on its account or employees making an unexpected wage demand that may strain the financial position of the business. These funds are usually held in the form of marketable securities or money-market funds that can easily be converted into cash. 3.**The speculative motive**. The speculative motive implies that the business must be able to capitalise on good opportunities such as unexpected bargains and bulk purchases. Additional funds for this purpose are usually also held in the form of marketable securities. A competitor may, for example, be declared insolvent and its inventory sold at bargain prices. The business can capitalise on this opportunity only if it has extra cash available to take advantage of the opportunity. Cash management is essential for obtaining the optimal trade-off between the liquidity risk and the cost of being too liquid. This is achieved by focusing on the **cash** **budget** and the **cash cycle**. These two aspects of cash management will now be considered in more detail. 14.8.1.1The cash budget Determining the cash needs of a business is an important aspect of cash management. Unutilised cash surpluses or cash shortages result in the cost and risk of the cash investment increasing unnecessarily. Cash-flow problems have been advanced as the primary cause of the demise of several financial institutions, for example, African Bank Limited. Kirkinis, the CEO and shareholder of ABIL, was enthusiastic in his idea that unsecured lending was the saviour in the lives of poorer people. In a column published in the Financial Mail, Kirkinis wrote that 'unsecured loans enable countless ordinary South Africans to build their homes, educate their children and provide for themselves and their families when faced with unforeseen life events, like the death of a loved one'. CNBC Africa reported in one of its broadcasts that they had information in their possession that the models being used by ABIL to determine provisions for non performing loans were not robust, citing that ABIL would only declare a loan non performing after three missed monthly payments. They further alleged that ABIL's lending criteria were not stringent enough. In May 2013, Kirkinis told CNBC Africa that ABIL had seen an increase in advances even though new loans granted had decreased, indicating an increase in average loan size. It is quite clear that regardless of the extent of the truth in this story, the reality was that giving more money to people who can't afford to pay you back cannot possibly be a sustainable business model because eventually you will run out of cash and foreclose due to cash flow challenges. The cash budget facilitates the planning and control of cash. Its purpose is to identify future cash shortages and cash surpluses. The cash budget is therefore a detailed plan of future cash flows for a specific period. It is composed of the following three elements: 1.**Cash receipts**. These originate from cash sales, collections from credit sales and other sources such as cash injections in the form of, for example, bank loans. 2.**Cash disbursements**. These are broadly categorised as cash paid for purchases of merchandise, raw materials and operating expenses such as salaries. 3.**Net changes in cash**. These represent the difference between cash receipts and cash disbursements. The cash budget serves as a basis for determining the cash needs of a business and indicates when bridging finance will be required. The example that follows shows how the cash budget is used to determine cash needs. It is clear that the cash budget can be used to identify temporary cash shortages and that this information can be used to arrange bridging finance timeously. It also indicates excess liquidity. This information can also be used to plan temporary investments in marketable securities. The cash budget for Save Retailers in the box that follows shows, for example, that bridging finance will have to be arranged for April and May, and that arrangements will have to be made to invest the cash surplus that will arise during June. Applying the concept The cash budget For Save Retailers there is a 30-day collection period on debtors, which means that there is a lag of 30 days between a credit sale and the receipt of cash. Consequently, cash collections in any month equal the credit sales one month prior. Purchases on credit must also be paid within 30 days. **Table 14.8:** Save Retailers Although one assumes that profit equals an amount held in cash, this is almost never the case. Even a profitable business may not be able to continue its operations owing to a cash shortage. The shortage arises despite growing sales and the accumulation of profits. 14.8.1.2The cash cycle The cash cycle in a manufacturing business, as illustrated in Figure 14.16, indicates the time it takes to complete the following cycle: Investing cash in raw materials Converting the raw materials to finished products Selling the finished products on credit Ending the cycle by collecting cash. **Figure 14.16:** The cash cycle in a businessWholesalers and retailers are not involved in the second step, but are rather concerned with directly converting cash into inventory. Businesses that offer no credit have no conversion from debtors to cash. As a rule, cash is available only after money has been collected from debtors. The cash cycle is a continuous process. It should be clear that the demand for cash can be greatly reduced if the cycle is speeded up. This is achieved by rapid cash collections and by proper management of debtors and stock (inventory). 14.8.2The management of debtors Debtors arise when a business sells on credit to its clients. Debtors have to settle their accounts in a given period (usually within 30 or 60 days after date of purchase). Credit may be extended to either an individual or a business. Credit granted to an individual is referred to as consumer credit. Credit extended to a business is known as trade credit. Debtor accounts represent a considerable portion of the investment in current assets in most businesses and obviously demand efficient management. Credit sales increase total sales and income. As pointed out in the management of cash, debtor accounts have to be recovered as soon as feasible to keep the cash requirements of the business as low as possible. Once again, an optimal balance has to be struck between the amount of credit sales (the higher the credit sales, the higher the income and, it is hoped, the profitability) and the size of debtor accounts (the greater the size of debtor accounts and the longer the collection period, the higher the investment and cash needs of the business will be, and the lower the profitability). In any business, the three most important facets of the management of debtor accounts are as follows: 1.The credit policy 2.The credit terms 3.The collection policy. The **credit policy** contains directives according to which it is decided whether credit should be granted to clients and, if so, how much. Essentially, this involves an evaluation of the creditworthiness of debtors based on realistic credit standards. Realistic credit standards revolve around the four Cs of credit: 1.**Character** -- the customer's willingness to pay 2.**Capacity** -- the customer's ability to pay 3.**Capital** -- the customer's financial resources 4.**Conditions** -- current economic or business conditions. These four general characteristics are assessed from sources such as financial statements, the customer's bank and credit agencies. Credit agencies specialise in providing credit ratings and credit reports on individual businesses. **Credit terms** define the credit period and any discount offered for early payment. They are usually stated as 'net *t*' or '*d/t*1, *n/t*'. The first (*t*) denotes that payment is due within *t* days from when the goods are received. The second (*d/t*1, *n/t*) allows a discount of d% if payment is made within t1 days; otherwise the full amount is due within *t* days. For example, '3/10, n/30' means that a 3 per cent discount can be taken from the invoice amount if payment is made within 10 days; otherwise, full payment is due within 30 days. The **collection policy** concerns the guidelines for the collection of debtor accounts that have not been paid by due dates. The collection policy may be applied rigorously or less rigorously, depending on circumstances. The level of **bad debts** is often regarded as a criterion of the effectiveness of credit and collection policies.The costs of granting credit include the following: **Loss of interest**. Granting credit is similar to granting interest-free loans. This means that interest is lost on the amount of credit advanced to trade debtors. **Costs associated with determining the customer's creditworthiness**. The procedure to determine the creditworthiness of a customer costs money, but fortunately this cost only needs to be incurred once. After the initial screening procedure, the company reassesses the customer on its own experience of the customer's track record of payment. **Administration and record-keeping costs**. Most companies that grant credit find it necessary to employ people to administer and collect trade debts. **Bad debts**. Unless a company adopts an extremely cautious credit-granting policy, it is almost inevitable that some trade debts will not be paid. Although this risk can be insured against, it still remains a cost to the company. The costs mentioned above must be considered against the loss of goodwill if credit is denied in a competitive market where customers may obtain the same products on credit terms elsewhere. Saying 'no' to a customer may be an easy answer, but your competitors may gain a profitable sale. This is not the way to increase turnover and profit. **Source:** Posner, M. 1990. *Successful credit control*. New York: BSP Professional Books, p. 1. 14.8.3The management of stock (inventory) The concept 'inventory stock' includes raw and auxiliary materials, work in progress, semi-finished products, trading stock and so on, and, like debtors, represents a considerable portion of the investment in working capital. In inventory management, there is once again a conflict between the profit objective (to keep the lowest possible supply of stock, and to keep stock turnover as high as possible, in order to minimise the investment in stock, as well as attendant cash needs) and the operating objective (to keep as much stock as possible to ensure that the business is never without, and to ensure that production interruptions and therefore loss of sales never occur). It is once again the task of financial management to combine the relevant variables in the framework of a sound purchasing and inventory policy optimally in order to increase profitability without subjecting the business to unnecessary risks. The costs of holding inventory stock are as follows: **Lost interest**. This refers to the interest that could have been earned on the money that is tied up in holding inventory stock. **Storage cost**. This cost includes the rent of space occupied by the inventory stock and the cost of employing people to guard and manage the stock. **Insurance costs**. Holding inventory stock exposes the business to risk of fire and theft of the stock. Insurance will provide cover against these losses, but this will involve an additional cost in the form of premiums that have to be paid to the insurance company. **Obsolescence**. Stocks can become obsolete. For example, they may go out of fashion. Thus, apparently perfectly good inventory stock may be of little more value than scrap. The costs of holding little or no inventory stocks are as follows: **The loss of customer goodwill**. Failure to be able to supply a customer owing to insufficient stock may mean the loss of not only that particular order, but of other orders as well. **Production interruption dislocation**. Running out of stock can be very costly for certain types of companies. For example, a motor manufacturer that runs out of a major body section has no choice but to stop production. **Loss of flexibility**. Additional stock-holding creates a safety margin whereby mishaps of various descriptions can be accommodated without major and costly repercussions. Without these buffer inventory levels, the company loses this flexibility. **Re-order costs**. A company existing on little or no stock will be forced to place a large number of small orders with short intervals between each order. Each order gives rise to costs, including the cost of placing the order and the cost of physically receiving the goods. Critical thinking Determining cash flow It is crucial that businesses estimate their expected cash flows as accurately as possible. A company collects R1 million per month in October, November and December. The company's cash payments represented 85 per cent of October's receipts, 120 per cent of November's receipts and 95 per cent of December's receipts. On 1 October, the company had a cash balance of R100 000, which also represented its minimum operating needs. 1.Which of the following methods would be used to forecast this company's cash position? a.Distribution b.Percentage of sales c.Time series d.Receipts and disbursements 2.Which of the following represents the company's ending cash position for November? a.(R200 000) b.(R50 000) c.R50 000 d.R100 000 3.In addition to short-term investments, which of the following provides liquidity reserve? i.Long-term investments ii.Unused short-term borrowing iii.Unused long-term borrowing a.i only b.ii only c.ii and iii only d.i, ii and iii 14.8.4Concluding remarks The discussion of the asset side of the statement of financial position has given only a brief overview of the management of current assets. Only a few fundamental financial implications have been discussed to show how complex the management of current assets is.14.9Asset management: Long-term investment decisions and capital budgeting 14.9.1The nature of capital investments Capital investment involves the use of funds of a business to acquire fixed assets such as land, buildings and equipment, the benefits of which accrue over periods longer than one year. Long-term investment decisions determine the type, size and composition of a business's fixed assets, as well as the amount of permanent working capital required for the implementation and continued operation of capital-investment projects. The importance of capital investments and the capital-investment decision-making process cannot be over-emphasised. Table 14.9 gives the three major capital-expenditure projects in South Africa with estimated completion dates after 2012. **Table 14.9:** Three major capital-expenditure projects The success of large businesses ultimately depends on their ability to identify capital investment opportunities that will maximise shareholders' wealth. Conversely, examples abound of business failures because businesses failed to identify opportunities or invested in unprofitable projects. The importance of capital-investment projects is reflected by the following three factors: 1.**The relative magnitude of the amounts involved**. The amounts involved in capital investment are much larger than those relating to, for example, decisions about the amount of credit to be extended or purchasing inventory. 2.**The long-term nature of capital-investment decisions**. The benefits from capital-investment projects may accrue in periods varying from two or three years to as much as 30 or 40 years. 3.**The strategic nature of capital investment projects**. Investment decisions of a strategic nature, such as the development of an entirely new product, the application of a new technology, the decision to diversify internationally or the decision to embark on rendering a strategic service could have a profound effect on the future development of a business. For example, Honda's decision to branch out from motorcycles to passenger vehicles entirely changed the strategic direction of the company. 14.9.2The evaluation of investment projects The basic principle underlying the evaluation of investment decision-making is cost-- benefit analysis, in which the cost of each project is compared to its benefits. Projects in which benefits exceed the costs add value to the business and increase stakeholders' wealth. Two additional factors require further consideration when comparing benefits and costs. Firstly, benefits and costs occur at different times. Any comparison of benefits and costs should therefore take the time value of money (discussed earlier in this chapter) into account. Secondly, 'cost' and 'benefits' (income) are accounting concepts that do not necessarily reflect the timing and amounts of payments to the business. The concept 'cash flow', which minimises accounting ambiguities associated with concepts relating to income and costs, is therefore used instead. 14.9.2.1Cash-flow concepts 2 Cash flow represents cash transactions. The net effect of cash revenues (sources of cash) and cash expenses (uses of cash) is the net cash flow. Net cash flow = Cash revenues -- Cash expenses Table 14.10 provides examples of transactions that result in cash inflows (sources of cash) and cash outflows (uses of cash). **Table 14.10:** Examples of the sources and uses of cash **Sources of cash** **Uses of cash** A decrease in assets An increase in assets An increase in liabilities A decrease in liabilities Cash sales Investment income Dividend payments to shareholders Cash flow differs from profit shown on the statement of financial performance in that the latter also includes non-cash costs such as depreciation. **Figure 14.17:** Profit and cash flow for ABC Litho Printers As shown in the representation of the cash flow for ABC Litho in Figure 14.17, the net cash flow is the difference between cash income and cash expenditures. If the net cash flow is positive, it means an inflow of cash and it is referred to as a net cash inflow. However, cash expenditures can also exceed cash income. This results in a negative cash flow and it is then referred to as net cash outflow. The following three cash-flow components are distinguished for capital-budgeting purposes: 1.**The initial investment**. This is the money paid at the beginning of a project for the acquisition of equipment or the purchase of a production plant. The net cash flow during this phase is negative and represents a net cash outflow. **Example: Depreciation** Assume that a printing business, ABC Litho Printing, buys a printing machine that will last for ten years. The business spends a large sum of money to acquire the machine, but will not spend any significant amounts until the end of the tenth year, when the machine has to be replaced.It does not make sense to assume that the business makes profits during years one to nine and then incurs a large loss in year ten when it has to replace the machine. The machine will be used for the entire period, and not only in year ten. The net profit of the business is adjusted for the use of the machine in years one to nine by deducting depreciation from income. The amount of depreciation is determined by depreciation rules laid down by the tax authorities, as tax is levied on profits after depreciation has been deducted. However, the cash-flow amount the business has available for reinvestment is equal to the profit after tax plus the depreciation. This amount is the net cash flow into the business. 2.**The expected annual cash flows over the life of the project**. The annual net cash flow can be positive or negative. The net cash flow is positive when cash income exceeds cash disbursements. This represents a cash inflow for the business. The opposite is true when cash disbursements exceed income. This may happen, for example, when expensive refurbishing is required after a number of years of operation and cash income is insufficient to cover these cash expenses. 3.**The expected terminal cash flow, related to the termination of the project**. This terminal net cash flow is usually positive. The plant is sold, and cash income exceeds cash expenses. It may happen, however, that the cost of cleaning up a site is so high that the terminal net cash flow is negative. Think, for example, of a nuclear power plant where the terminal value of the plant is low because of its limited use, but where the cost of disposing of the enriched uranium is very high. The **magnitude of the expected net cash flows** of a project and **the timing of these** **cash flows** are crucial in the evaluation of investment proposals on the basis of the present value or discounted cash-flow approach, where the **net cash flow (the cash** **inflow minus cash outflow) can occur during a specific period or at a specific time.** For evaluation purposes, it is therefore imperative to approach potential projects in a future-oriented time framework and to present the expected cash-flow stream of a potential project on a time line, as illustrated in Figure 14.18. The annual **net cash flows** are normally calculated as the profit after interest and tax, plus any non-cash cost items such as depreciation minus the cash outflows for the particular year. The **initial investment** (C 0 ) is the net cash outflow at the commencement of the project at time *t* 0 , usually for the acquisition of fixed assets and required current assets. The **annual net cash flows** (operating cash flows) (CF *t* ) are the net operating profit after tax (NOPAT) plus depreciation. A positive net cash flow means that the cash inflow exceeds the cash outflow. A negative net cash flow implies the opposite. **Figure 14.18:** A time line for project Y The **life of the project** (n periods or years), also referred to as the economic life of the project, is determined by the effects of physical, technological and economic factors. The **terminal cash flow** (TCF) is the expected net cash flow after tax, which is related to the termination of the project, such as the sale of its assets and the recovery of the working capital that was initially required. Depending on circumstances, the terminal net cash flow can again be positive or negative if it occurs only at the end of the final year of the life of the project life. This is indicated by TCF. 14.9.2.2The net present value (NPV) and internal rate of return (IRR) methods 3 NPV and IRR are **discounted cash-flow** (DCF) methods. They involve discounting estimated future cash flows to their present values, and take the magnitude and timing of cash flows into account. The NPV is the difference between the present value of all net cash inflows (after tax) and the present value of all cash outflows (usually the initial investment) directly related to the project. The formula for the calculation of NPV is as follows: The application of NPV involves: forecasting the three components of project cash flows (the initial investment, the annual net cash flows and the terminal cash flow) as accurately as possible; deciding on an appropriate discounting rate; calculating the present values of the above three project cash-flow components for a project determining the NP