ABC OF FINANCIAL MANAGEMENT A LECTURE DELIVERED AT

ABC OF FINANCIAL MANAGEMENT A LECTURE DELIVERED AT THE STRATEGIC RE-POSITIONING FOR OPTIMUM PERFORMANCE FOR BABCOCK INVESTMENT GROUP HELD ON WEDNESDAY, FEBRUARY 12, 2014 AT THE BABCOCK UNIVERSITY GUEST HOUSE ILISHAN REMO BY Prof. Sunday A. Owolabi {Ph. D} Professor of Accounting/Associate Vice President, Financial Administration Babcock University Ilishan-Remo, Ogun State

Introduction Financial management can be defined as the management of finances of a business in order to achieve the objectives of the business. Finance is important to any kind of business activity. It involves both planning and control of financial resources of a business. A firm needs to plan to ensure that enough funding is available at the right time to meet the needs of the organization while at the same time ensuring that the funds are efficiently utilized in such a way that the target objectives are being achieved. Note that the following is mandatory in any organization.

A. Key financial functions must be performed in any kind of organization. B. The main functions of financial managers are to plan for, acquire, and utilize funds to make the maximum contribution to the efficient operation of the organization. C. Financial markets continuously determine the valuation of business firms, and in doing so, assess the managerial performance.

Financial Objectives/Goals of the Firm A. The goal of financial management is to maximize shareholder wealth. 1. When examining profits, management should concentrate on earnings per share rather than on total corporate profits 2. The time value of money should also be considered. 3. Risk should also be evaluated. 4. Recognizing all these factors, managers should seek to maximize the value of the firm’s common stock, as the price of the stock reflects the market’s evaluation of the factors a. To maximize is to seek the best possible outcome b. To satisfice is to settle for any acceptable alternative B. Measures of wealth are more operational and usable than measure of utility C. Social responsibility 1. Level of obligation is difficult to ascertain 2. Mandatory government agency controls may be necessary to uniformly apply any cost increasing programs.

Non Financial Objectives i. To seek growth ii. To seek diversification iii. To survive autonomously iv. To improve productivity v. To give the highest quality service to customers vi. To maintain a contended workforce vii. To be a market leader viii. To be technical in their field ix. To acknowledge their social responsibilities

Forms of Business Organization Basis Types of Business Organization Sole proprietorship Partnership Limited companies Control The owner has exclusive control over the business Each share represents a voting right in the company in the election of the board of directors who will in turn appoint top management Ease of transfer of ownership Ownership interest are not easily transferable General partners have exclusive control over management of operations of a firm. However, limited partners have some voting rights The capitals of partnership are subject to substantial restrictions on transferability. There is usually no established trading for partnership Liability Sole traders are personally liable for the obligations of the firm Shareholders are not personally liable for obligations of the company Taxation Sole trading firms are not taxable. a sole trader now has to pay personal income tax in respect of profits derived from the sole proprietor’s business Sole proprietorships have limited life Limited partners are not liable for obligations of partnerships. General partners may have unlimited liability. Partnerships are not taxable. Partners pay taxes on distributed shares of partnership Partnership have limited life Companies have perpetual life Have a wider scope in raising additional funds. Can issue long term financial securities in terms of shares, debentures etc. Companies have flexibility in the choice of dividend payout and reinvestment of earnings Continuity of Existence Ability to raise additional funds Have limited scope in raising additional funds. Cannot issue long term financial securities Have limited scope in raising additional funds. Cannot issue long tern financial securities Distribution of earnings A sole proprietor has flexibility in the manner in the distribution of the earnings of the business All net cash flows from a partnership are distributed to partners. Partnerships are prohibited from reinventing partnership cash flows Share can be exchange without liquidation of the company. Ordinary shares, can be listed on the stock exchange and easily marketable Corporations have double taxation: corporate income is taxable, and dividends to shareholders are also taxable.

FINANCE FUNCTIONS • • It may be difficult to separate the finance functions from production, marketing and other functions, but the functions themselves can be readily identified. The functions of raising funds, investing them in assets and distributing returns earned from assets to shareholders are respectively known as financing decision, investment decision and dividend decision. A firm attempts to balance cash inflows and outflows while performing theses functions. This is called liquidity decision, and we may add it to the list of important finance decisions or functions. Thus finance functions include: Long-term asset-mix or investment decision Capital-mix or financing decision Profit allocation or dividend decision Sort-term asset-mix or liquidity decision. A firm performs finance functions simultaneously and continuously in the normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skillful planning, control and execution of a firm’s activities

Financial management and Financial Objectives Maximizing the wealth of the shareholders generally implies maximizing profits consistent with long term stability. It is often found that the greatest short term gains must be sacrificed in the interest of the company’s longer term prospects. In the context of this overall objectives, there are three main types of decisions facing financial managers: • investment decision; • financing decision; • dividend decisions.

Investment decisions Capital resource planning is defined as the process of evaluating and selecting long term assets to meet strategies Investment decisions involve committing funds to: a. internal investment projects and the withdrawal from such projects should they turn out to be unprofitable; b. external investment decisions, involving the takeover of another company, or a merger; c. disinvestment decisions, involving the sell-off of a part of the business, such as an unwanted subsidiary company.

Financing decisions Capital funding planning is the process of selecting suitable funds to finance long term assets and working capital. The assets of a company must be finances, by share capital and reserves, long term liabilities or by short term liabilities. When a company is growing, it will need additional finance from one or more of these sources. The financial manager must know: a. where additional funds can be obtained from, and at what cost; b. the effect on a company’s profitability and value of using any particular source of funds; c. the effect on financial risk of using any particular source of funds.

A company ought to be profitable, but it must be ‘liquid’ too – i. e. is must always have access to enough cash to make its payments to creditors and employees etc when they fall due. Financing decisions therefore include cash management, and negotiating bank overdraft. Dividend decisions Ordinary shareholders expect to earn dividends, and the value of a company’s shares will be related to the amount of dividends that a company has been paying, and also prospects of what the dividends might be in the future.

Dividend decisions are also directly related to financing decisions, since retained profits are the most important source of new funds to companies. What a company pays as dividends out of profits cannot be retained in the business to finance future growth, and what profits are retained represent a withholding of dividends. Financial Procedures and Systems For the effective execution of the finance functions, certain other functions have to be routinely performed. They concern procedures and systems and involve a lot of paper work and time. They do not require specialized skills of finance. Some of the important routine finance function are:

• supervision of cash receipts and payments and safeguarding of cash balances • custody and safeguarding of securities, insurance policies and other valuable papers • taking care of the mechanical details of new outside financing • record keeping and reporting. The finance manager in the modern enterprises is mainly involved in the managerial finance functions. Financial manager’s involvement in the routine functions is confined to setting up of rules of procedures, selecting forms to be used, establishing standards for the employment of competent personnel and to check up the performance to see that the rules are observed and that the forms are properly used.

FINANCIAL MANAGEMENT AND LONG TERM SURVIVAL OF THE FIRM i Working capital management The term working capital refers to the capital available for running the day to day operations of an organization. It is defined as current assets less current liabilities. Current assets include mainly cash, debtors and stock while current liabilities include mainly creditors. Working capital management refers to the management of all aspects of current assets and current liabilities.

Nature of working capital decisions Working capital management involves the management of current assets (cash, debtors and cash) and current liabilities (creditors). An important consideration in working capital management is determining the amount of investment in working capital and how working capital should be financed. It has been argued that given that because of the permanent nature of a large proportion of current assets, it is prudent to fund some current assets with long-term finance. The question is to what extent will permanent current assets be financed with long-term finance? The possible options are:

A Maturity Matching Approach – All fixed assets should be funded with long term finance (debt and equity) – All permanent current assets should be funded with long term finance – All fluctuating current assets should be funded with short term finance • B Aggressive Approach – All fixed assets should be funded with long term finance (debt and equity) – All permanent current assets should be partly funded with long term finance and partly short term finance – All fluctuating current assets should be funded with short term finance

C Conservative Approach – All fixed assets should be funded with long term finance (debt and equity) – All permanent current assets should be funded with long term finance – All fluctuating current assets should be partly funded with long term finance and partly with short term fiancé Financing fixed assets with short term finance appears imprudent. The final choice in financing working capital is managerial judgment. Management must balance the requirement for a higher return by using short-term debts to finance current assets against the risk of illiquidity that can result in insolvency. Thus, the decision on working capital financing varies with management’s attitude toward risk.

Investment in working capital The volume of working capital or net current assets required will depend on the nature of the company’s business. For example, some companies (e. g. , manufacturing) may require more stocks than other companies (e. g. , service industry). As a company expands or grows and its output increase, the volume of its working capital or net current assets will also increase. The volume of net current assets will also depend on policies adopted by a company for managing individual current asset items. A company with no stock, no debtors and no creditors will have little or no investment in working capital. This would result in few sales and therefore little profit.

The symptoms of overcapitalization include high working capital turnover (sales/working capital), high liquidity ratios (a current ratio in excess of 2: 1 or a quick ratio in excess of 1: 1), low stock turnover, high average collection period and low creditors’ payment period. A good management should watch signal to see whether they are out of line

iii Working capital and overtrading Overtrading occurs if a business is trying to support large volume of trading with little long term capital at its disposal. An overtrading business might be a profitable going concern but it could easily run into a serious problem because of illiquidity. The illiquidity stem from the fact that it does not have enough capital to provide cash to pay its debt as they fall due. Thus, an overtrading business runs the risk of liquidation. The symptoms of overtrading include:

i. A rapid growth in turnover ii. High stock turnover and low average collection period iii. A rapid growth in current and fixed assets iv. Low liquidity ratios v. Liquidity deficits vi. Creditors’ payment period is getting higher vii. Bank overdraft reaches or exceeds the limit of the facilities agreed with the bank. viii. Proportion of total assets financed by credit will increase while the proportion financed with equity capital decline.

An overtrading could be caused by the following: i. Repayment of long-term loans without refinancing ii. Inflation, which increases the amount of funds needed to finance current assets. The solution to an overtrading situation if it arises is to inject more equity capital and better control of stock and debtors.

iv Working capital and cash operating cycle The cash operating cycle is the period that takes place between payments for raw material purchases and the eventual payment for the goods made from the raw materials by the company’s customers. This implies that the cash operating cycle average collection period plus the length of time stocks are held less the creditors’ payment period. The longer the operating cycle of a business the higher will be the investment in working capital.

CONCLUSION Financial management is a managerial decision making process. Risk is an important factor in finance and it tends to be related to return. The theory of company finance is based on the assumption that the objective of the firm is to maximize shareholders’ wealth. Financial decision making which includes investment, financing and dividend decisions ought to be evaluated in the context of this objective. The main functions of financial managers are to plan for, acquire and use funds for the maximum benefit of an organization.

The organization of the financial management function will differ from firm to firm. It will depend on factors such as nature of the business, the size of the firm, financing operations, skills of the firm’s financial officers and the financial philosophy of the firm.

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