Part One

1. An overview of financial management

1.1. Introduction
In recent years, the changing in regulatory and economic environments coupled with the globalization
of business activities have increased, the complexity as well as the importance of the financial
management. As a result, the financial management function has become more demanding and complex
to achieve organizational goal.
Moreover, finance is regarded as the life blood of a business enterprise. In modern money oriented
economy, finance is one of the basic foundations of all kinds of economic activities. It is the master key
which provides access to all the sources being employed in manufacturing, merchandising and all
business activities. It has rightly been said that business needs money to make more money by using
effective and efficient management decisions related to finance management.

1.2. Meaning of finance

Finance is one of basic economic resources that expressed/ measured by monetary term/value
(money). On other way finance may be defined as the art and science of managing money.
That means, finance mainly involves in rising of funds and their effective utilization keeping in view
of the over all objectives of the firm. Business finance refers to the business activity which is
concerned with the acquisition and conservation of capital funds in meeting financial needs and over
all objectives of a business enterprise. In a broad sense finance includes the determination of what
has to be paid for raising the money on the best terms available and utilizing the available funds to
the best possible way.

1.3. Business finance/Financing

Business finance /Financing can be broadly defined as “the activity concerned with planning,
raising, investing/using controlling, and administering of funds used in business” Guttmann and
Dongall
The major areas of finance business finance are: (1) financial services and (2) managerial
finance/corporate finance/financial management.

1.4. Meaning /concepts of financial management

Financing mainly involves rising of funds and their effective utilization keeping in view of the over all
objectives of the firm. This requires great caution and wisdom on the part of management.

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The management makes use of financial techniques, devices… etc for administering the financial
affaires of the firm in the most effective and efficient way.
Therefore financial management means, the entire total managerial efforts devoted to the management
of finance. Thus financial management is mainly concerned with proper management of funds. The
finance manager must see that the funds are procured in a manner that the risk, cost and control
consideration are properly balanced in a given situation and there is optimum utilization of funds.
1.5. Definition of Financial management
Financial management in a management activity concerned with the management decision that results
in the acquisition and financing of long term and short term fund/ credit for the firm. As such it deals
with the situation that requires selection of specific assets as well as the problem of size and growth of
an enterprise. The analysis of the decision is based on the expected inflows and outflows of funds and
their effects on managerial objectives.
Financial management is “concerned with the decision regarding acquisition, financing and
management of assets with the overall objectives of profit maximization and wealth maximization” …
Van Horne

1.6. Importance of Financial management

In every organization, where funds are involved sound financial management is necessary. Sound
financial management is essential in both profit non-profit organizations for the following benefits:
o Financial management helps in maintaining the effective development of funds in fixed assets and
working capital investment.
o Financial management also helps in ascertaining how the company would perform in the future. It
helps to know whether the firm will generate enough funds to meet its various obligations like its
repayments of the various instalments due on loans, and redemption of other liabilities.
o Sound financial management helps in profit planning, capital spending, measuring costs,
controlling inventories, account receivables …etc.
o Besides, financial management essentially helps in optimizing the output of the firm from a given
input of funds.
1.7. Scope Financial management
The scope of financial management increased with the introduction of capital budgeting techniques. In
the modern dynamic environment capital investment and financing decision become more risky than
ever before, this has enlarged the scope of finance.

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 Financial management is concerned with both acquisition of fund and their optimum allocation. Fund
requirement decision is one of the most important decisions and that has to be taken by taking into
accounting both the long term and working capital requirements.
Financial management also assists in taking financing decision, investment decision which involves the
evaluation of different capital investment proposal and selection of the best course action, keeping in
view the over all objectives of the enterprise and dividend decision.

Generally the scope and functions of financial management is divided, for purposes of exposition, into
two broad categories:

(a) The Traditional Approach, and

(b) The Modem Approach.

Traditional Approach

The scope of the finance function was treated by the traditional approach in the narrow sense of
procurement of funds by corporate enterprise to meet their financing needs. The term 'procurement' was
used in a broad sense so as to include the whole activities of raising funds externally. Thus defined, the
field of study dealing with finance was treated as encompassing three interrelated aspects of raising and
administering resources from outside:

(i) the institutional arrangement in the form of financial institutions which comprise the organization
of the capital market;
(ii) the financial instruments through which funds are raised from the capital markets and the related
aspects of practices and the procedural aspects of capital markets;
(iii) the legal and accounting relationships between a firm and its sources of funds.

The weaknesses of the traditional approach fall into two broad categories: (i) those relating to the treatment
of various topics and the emphasis attached to them; and (ii) those relating to the basic conceptual and
analytical framework of the definitions and scope of the finance function.

Modern Approach

The modern approach views the term financial management in a broad sense and provides a conceptual
and analytical framework for financial decision making. According to it, the finance function covers
both acquisitions of funds as well as their allocations. Thus, apart from the issues involved in acquiring
external funds, the main concern of financial management is the efficient and wise allocation of funds to
various uses. Defined in a broad sense, it is viewed as an integral part of overall management.

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The new approach is an analytical way of viewing the financial problems of a firm. The main contents
of this approach are: What is the total volume of funds an enterprise should commit? What specific
assets should an enterprise acquire? How should the funds required be financed? Alternatively, the
principal contents of the modem approach to financial management can be said to be:
(i) How large should an enterprise be, and how fast should it grow?
(ii) In what form should it hold assets?
(iii) What should be the composition of its liabilities?

The three questions posed above cover between them the major' financial problems of a firm. In other
words, the financial management, according to the new approach, is concerned with the solution of
three major problems relating to the financial operations of a firm, corresponding to the three questions
of investment, financing and dividend decisions. Thus, financial management in modern sense of a firm
can be broken down into three major decisions as functions of finance:
(i) The investment decision, (ii) the financing decision, and (iii) Management decision

1.8. Goals of financial management

The primary objective of any firm is to make the profit. Even before this, the firm has to reach a no
profit and no loss /break even/ position. Once the firm starts earning the profit, the next step is to
increase the profit. Since there is a limit to increase a profit, maximization of the profit will be the aim
of the managers.
Creation of more and more value to shares of shareholders (owners) is the next objective. This is
possible through the efficient management of profit by dividing it between dividend and investment
/retained earnings.
Acquiring wealth will have a positive impact on the increase in profit and hence, maximizing the wealth
of shareholders will be the ultimate goal of any firm. In addition the social responsibility of the firm can
not be ignored. To summarize the goals of financial management of business firms are profit
maximization and wealth maximization to the shareholders and protecting the interest of stakeholders
and being socially responsible.

1.9. Functions of financial management

Financial management has three major functional areas:
 Investment decision – It is the process of determining the total amount of assets needed to be
held by the firm.

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 It is decided about the size and composition of assets of the firm, i,e. what type of assets and
how much of each type. Disinvestment decision is also important for uneconomical and non
functioning assets to be reduced, eliminated or replaced. It involves activities such as: Financial
forecasting, cash budgeting and capital budgeting.
 Financing decision – It is the process of determining sources of finance and acquisition of
funds. It involves the decision on the composition of sources of fund, management of short term
and long term funds, cost of capital and analysis of leverage.
 Asset management decision – It is the process of efficient management of assets. It involves
analyzing the financial position of the firm in terms of various ratio analyses.

FINANCE –FINANCE AND RELATED DISCIPLINE

Finance and Accounting

The relationship between finance and accounting, conceptually speaking, has two dimensions:

i) they are closely related to the extent that accounting is an important input in financial decision
making;

(ii) there are key differences in viewpoints between them. .

Accounting function is a necessary input into the finance function. That is, accounting is a sub function
of finance. Accounting generates information/data relating to operations/activities of the firm. The end-
product of accounting constitutes financial statements such as the balance sheet, the income statement
(profit and loss account) and the statement of changes in financial position/ sources and uses of funds
statement/cash flow statement. The information contained in these statements and reports assists
financial managers in assessing the past performance and future directions of the firm and in meeting
legal obligations, such as payment of taxes and so on. Thus, accounting and finance are functionally
closely related.

These functions are closely related and generally overlap; indeed, financial management and accounting
are often not easily distinguishable. In small firms the controller often carries out the finance function
and in large firms many accountants are intimately involved in various finance activities.

But there are two key differences between finance and accounting. The first difference relates to the
treatment of funds, while the second relates to decision making.

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Treatment of Funds - The viewpoint of accounting relating to the funds of the firm is different from
that of finance. The measurement of funds (income and expenses) in accounting is based on the accrual
principle/system. For instance, revenue is recognized at the point of sale and not when collected.
Similarly, expenses are recognized when they are incurred rather than when actually paid. The accrual-
based accounting data do not reflect fully the financial circumstances of the firm. A firm may be quite
profitable in the accounting sense in that it has earned profit (sales less expenses) but it may not be able
to meet current obligations owing to shortage of liquidity. due to uncollectable receivables, for instance.
Such a firm will not survive regardless of its levels of profits.

The viewpoint of finance relating to the treatment of funds is based on cash flows. The revenues are
recognized only when actually received in cash (Le. cash inflow) and expenses are recognized on actual
payment (Le. cash outflow). This is so because the financial manager is concerned with maintaining
solvency of the firm by providing the cash flows necessary to satisfy its obligations and acquiring and
financing the assets needed to achieve the goals of the firm. Thus, cash flow-based returns help
financial managers avoid insolvency and achieve the desired financial goals.

Obviously, the firm is quite profitable in accounting sense, it is a financial failure in, terms of actual
cash flows resulting from uncollected receivables. Regardless of its profits, the firm would not survive
due to inadequate cash inflows to meet its obligations.

Decision Making --Finance and accounting also differ in respect of their purposes. The purpose of
accounting is collection and presentation of financial data. It provides consistently developed and easily
interpreted data on the past, present and future operations of the firm. The financial manager uses such
data for financial decision making. It does not mean that accountants never make decisions or financial
managers never collect data. But the primary focus of the functions of accountants is on collection and
presentation of data while the financial manager's major responsibility relates to financial planning,
controlling and decision making. Thus, in a sense, finance begins where accounting ends.

Finance and Other Related Disciplines

Apart from economics and accounting, finance also draws-for its day-to-day decisions-on supportive
disciplines such as marketing, production and quantitative methods. For instance, financial managers
should consider the impact of new product development and promotion plans made in marketing area
since their plans will require capital outlays and have an impact on the projected cash flows. Similarly,
changes in the production process may necessitate capital expenditures which the financial managers
must evaluate and finance. And, finally, the tools of analysis developed in the quantitative methods area
are helpful in analyzing complex financial management problems.

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 Part Two
Financial analysis and planning
2.1. Financial analysis
Most of the time the result of operation of a firm expressed in the form of a profit and loss account and
financial position of a firm expressed in the form of income statement and balance sheet. This may not
be sufficient if one wishes to further information to answer the following questions that need financial
analysis:
 Whether the firm is solvent or not?
 What is the trend of the business?
 What is the profitability of the firm?
 Is the financial position of the firm sound?
 What is the status of the firm? …

Definition of the terms

 Financial analysis - refers different types of interpretation and inferences based on financial data
expressed in the financial statements of the firm by using ratio analysis.
 Ratio analysis – is a process of computation, comparison and interpretation of ratios of figures in
financial statements.
 Ratio- is a quantitative relation ship between two or more related items expressed one as so many
times of the other.
 The ratio between two items a and b is expressed as a : b or a/b
 Ratio is a pure number with out an suffixes or unit
 Ratio can be expressed in three forms:
 Pure ratio – example, when the ratio between a and b expressed as a : b
 Rate or times ratio – example, when the ratio between 6 and 4 expressed as 1 ½
 Percentage ratio – example, percentage of profit to sales when profit is birr 10,000 for sales
of birr 50,000 profit ratio is 20%
 Accounting ratio – is the ratio expressed out of the figures presented in the financial statements of
the concern.
2.1.1. The need for financial analysis /ratio analysis
The need for ration analysis depends on the purpose for it is applied or the requirement of the
stakeholders /users.

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 Some of the common advantages /importance of ratio analysis include the followings: i.e. ratio analysis
is very important for:
a) Measurement of trend – trend is the symptom of the direction in which the company is moving.
b) Measurement of performance / profitability- Example, the level of profit from total sales.
c) Measurement of health of the organization – it refers the ability of the company to generate funds
from its assets and liquidity position of the firm.
d) Measurement of efficiency – the efficiency of the firm can be measured by efficient utilization of
resources, productivity, and output to input ratio.
e) Measurement of comparison- refers comparison of two or more companies, growth rate, market
share and others.
f) Measurement of solvency – that is the ability of the firm to payoff its liabilities from its current
assets.
g) Measure of better communication – ratio is easy for communication in business information.

Limitations of ratio analysis – ratio analysis has the following limitations:

 It shows quantitative relationships only
 It is dependant on the figures in financial statements
 It is not reflect current value, it shows past data relationship
Source of financial data for ratio analysis
The main sources of financial data for ratio analysis are financial statements.
Example- Balance sheet, Income statement, Cash flows statement and retained earnings statement for
different types of ratio analysis.

Steps in ratio analysis

In ratio analysis the following steps to be followed:
1. Proper arrangements of data - depending up on the requirement for calculation of specific ratio
2. Classification and calculation of ratio – based on the underlying factors or requirements
3. Explanation, interpretation and comment – about the result of the computed ratio
4. Deriving the data from the ratios – some times the financial statements may have to be constructed
from the given ratio and relevant information available based on defined terms.

Classification and calculation of ratio

Several ratios can be calculated according to the requirements of the users. The followings are some
broad categories of ratio:

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  Based on financial statement ratio can be classified as:
 Balance sheet ratio some times called financial ratio
 Income statement ratio - i.e. focus on operating ratio
 Balance sheet and Income statement ratio – composite ratio
 Based on purpose or functions - ratio can be classified as: liquidity ratio, solvency ratio,
profitability ratio, activity ratio, leverage ratio etc…
 Based on the requirement of users - ratio can be prepared as per the requirements of
management, shareholders, creditors, government, prospective investors etc ….
 Based on the importance - ratio can be classified as: primary ratio, secondary ratio, performance
ratio, growth ratio etc…

Generally for the purpose of this study the following common classification of ratios are very important
for financial analysis and decision making to all stakeholders /users.
1. Profitability ratio – helps to measure the ability of the firm to increase its profit. It includes:
- Gross profit ratio - Return on investment ratio (ROI)
- Net profit ratio - Return on equity ratio (ROE)
2. Liquidity ratio – helps to measure the ability of the firm to pay the current liability out of
current assets. It includes:
- Current ratio - Working capital ratio
- Quick ratio - Stock ratio
3. Debt utilization ratio – helps to measure the extent to which the borrowed funds/debts are
utilized in the firm. It includes:
- Debt to equity ratio - Debt to total asset ratio
- Long term debt to equity ratio
4. Asset utilization ratio- helps to determine the extent of the use of assets to generate revenue. It
some times called activity ratio, efficiency ratio, or asset turnover ratio. It includes:
- A/R turnover ratio
- Average collection period
- Inventory turnover ratio

 Illustration- will be given in class

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2.2 Financial planning & forecasting
Financial planning process
The financial planning process can be divided in to the following six steps:

1. Preparation of Projected financial statements, and use the projection to analyze the effects of
the operating plan on projected profit and financial ratio. The projected financial statement can
also be used to monitor operations after the plan has been finalized and put in to effect.
2. Determine the fund needed to support the future (five) years plan. This includes fund for plant
assets, equipment as well as for inventories, research and development and advertising
campaigns.
3. Forecast funds available over the next years (5 years). This involves estimating the funds to be
generated internally as well as those to be obtained from external sources.
4. Establish and maintained a system of controls to govern the allocation & use of funds within the
firm. In essence, this involves making sure the basic plan is carried out properly.
5. Develop procedures for adjusting the basic plan of the economic forecast upon which the plan
was based do not materialized that is “Feedback loop” that triggers modifications to the financial
plan.
6. Establish a performance based management compensation system. It is critically important that
firms reward managers for Ding what stockholder want them to maximize share price.
Financial forecasting
Forecasting- is systematic estimation /predicting / events will be occurred in the future period.
Financial Fore casting – refers systematic prediction/estimation of future cash inflow and outflow of a
firm.
Cash inflows /outflows form /for operating, Financing and investing activities of a company in future
period.
Significance of financial forecasting- Financial forecasting is very important for:
 Cash management decision; - it helps to determine the amount of fund needed in the future (Quantity
of money & time) and to use the idle cash.
 Budgeting decision – budgeting provide a way to have control over financial affairs ( i.e. maximum
limit for spending )
 Financial management – to increase profit & to reduce risks
 Financing decision – Financial forecasting act as an evidence for getting of loan from financial
institutions.

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Approaches /methods for financial forecasting – there are different methods for financial forecasting:
Example:-
 Trend analysis – based on past information and the following assumptions / concepts
o No change concept
o Consideration seasonal factors /proportional change
 Ration analysis – example, turnover ratio, gross profit ratio and other ratios…
 Preparation of Forecasted Financial statement by percentage of sales method
 AFN- Formula method
 Statistical techniques - Example: Linear regression, probability and others

 See the illustration

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 Part Three

Management of Cash and Inventory

Cash and other assets
Cash is medium exchange that bank will accept for deposit & immediately credit the depositor account balance
and ready for payment. The management of cash covers the management of all the following Cash and other
cash equivalent assets:
 Coin & paper currency
 checks
 Bank draft
 Money order
 Credit card
 CPO ( certificate of payment order)
1.1 Meanings cash management
Cash management refers the management activities concerned with, the formulation of policies &
programs for inflows & outflows of cash & controlling of their implementation. It is very important
to reduce the risks of handling of excess idle cash & shortage of cash in business operation.

In general the main central focuses of cash management are forecasting & controlling of cash needed &
cash available throughout the operation of business firms.

Nature of cash
Cash needs special & sound management because of the following particular natures/features, which distinguish
cash from all other assets.
 Cash is the most liquid asset of all assets
 cash a means of acquiring all goods & services in all economic & business activities
 Cash the most easily /readily transferable & miss appropriate able asset
1.2 motives for holding & management of cash
As it indicated above cash is the very important assets for all business activities & also it has its own
particular nature.
In general, business firm & individuals have primary motives for holding of cash
a. Transaction motive- the principal motive for holding of cash is to enable the firm to conduct its
ordinary day to day business activities (purchasing, payments, sales …) in the line of business
where billing are predictable , cash inflows can be scheduled & balanced with the need for cash
out flows.

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 b. Precautionary motive: - the precaution motive for holding of cash related to the predictability of
cash inflow and out flows. It depends on the ability of flexibility of the firm to borrow additional
cash on short notice against cash needed for emergencies.
c. Speculative motives: - it is the motive to take market cost advantages opportunities. Most
companies sometimes hold cash to buy securities/ goods when their prices are exceptionally
attractive for sale with profit in the future period.
d. Compensating balance requirement: - compensating balance represent the minimum levels that
the firm agrees to maintain in its account with the bank. This is commercial banking system that
performs many functions for business firm.

1.3 objectives of cash management

The Management of cash target to achieve the following very important objectives:
a. To ensure the availability of adequate cash for business activates of the firm
b. To prevent misappropriation & loss of cash
c. To invest any idle /excess cash in short term or long term investment as per the financial need
of the firm to earn more return
d. To ensure effective & efficient utilization of cash in the organization.

1.4 Cash management strategies techniques

Cash management is a function usually carried out by the form’s treasurer. Commonly cash
budget /forecasted cash flow statement/ is the primary tool used in the cash management process for
planning & controlling of cash. To attain the maximum cash availability and earn maximum return
on idle funds, business firms follow the strategy of collecting of amount due as soon as possible,
while paying amounts owed as late as possible and still maintaining the firm credit standing.
Cash management techniques/strategies include the followings:
a. Cash flow synchronization/ balancing/- this technique depends on effective forecasting of
inflow & outflow of cash. It focuses on the periodic arrangement of the amount of cash available
/inflow/ with the amount of cash required/payments. When the amount of cash receipts coincide
with the amount of cash required per period/day, by confident cash flow forecasting business
firms can reduce the amount idle cash on hand, decrease bank loans, lower interest
expense/capital cost that result in high profit .
b. Using float – i.e. Cash cycle management strategy

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 Float is defined as the difference b/n the balance shown in a firm’s check book and the balance
on the bank’s record. Cash float can be managed by average cash cycle/period management
strategy.
AV cash cycle = (AV. A/R collection period + AV. Inventory period) – AV. A/P period
In other way,
AV cash cycle = ( E+F+B+C+D)-B
Where , E= A/R period /customer payment period or credit period granted to customers
F = customer mail time/ collection float time
(B + C + D) Av. Inventory period which has three components
B = AV. A/P payment period
C = A/P disbursement time/ disbursement Float
D = inventory holding period (that include the period RM, FG and WIP inventories)

Example- Assume that , the average credit purchase period of ABC company is 15 days and
the time gap b/n the date on which a check mailed to the vender & the date on which company’s
account is reduced takes 3 days from the total given inventory period of 50 days. on the other
hand the credit sales period of the company is 30 days & the mail time of customers till the
deposit or check clearance take 5 days.

Required :- Compute AV. Cash cycle period of the company

Given: E = 30 days F= 5 days B=15days C = 3 days
D= 50-(15+3) = 32 days
Solution : Av. Cash cycle = ( E+F+B+C+D) -B
= (30 + 5 +15 + 3 + 32) - 15 = 70 days

C. Accelerating receipts: - business firm used different techniques to collect A/R faster, since
credit transactions are began. For example: lock box services, pre authorized debit &
concentration banking and others …
d. Disbursement control – Accelerated collections represent one side of cash management and
controlling of fund outflow/payment is the other side of the same coin. Efficient cash
management can result only if both inflows and outflows are effectively managed;
Disbursement can be controlled by different techniques;
For example: payable centralization, zero balance accounts, controlled disbursement accounts…

Setting of target cash balance

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 There are two methods/model approaches for setting and controlling of target cash balance.
A. The Baumol’s model. This model is used to determine the optional cash balance that a business
needs to maintain, so that it could minimize the cost of holding idle cash and the cost of raising
cash through sales of securities and / borrowing.
According to the assumptions of the model; the optimal cash balance that a business firm needs
to maintain can be calculated by:
C* = 2(F) (T)
(k)

Where: C* = optimal amount of cash to be raised by selling of marketable securities or borrowing

C*/2 = optional Av. cash balance
F = fixed cost of making a securities trade/borrowing
K = opportunity cost of holding cash
T= total amount of net new cash needed for transaction over entire period
 Total costs of cash balance consists of cash holding/opportunity cost plus and transaction cost
i.e. total cost of capital = ( (C*/2) (k)) + ((T/C) x F)

Example - Assume that, the firm’s net new cash need per week is birr 100,000 (i.e. total cash needed =
52 x 100,000), where fixed costs of making securities trade or borrowing is birr 150, and opportunities
cost of holding cash estimated to 15 %.

Required – compute the optimal cash balance need per period

CX =
(2 x 150) (52,000,000
0.15 Birr 101,980
This means , the firm should raise birr 101,980 by selling of securities or borrowing when cash balance
approaches to zero, to build cash balance back to birr 101 ,980 .

B) The miller and Orr model

This model sets higher and lower control limits, H and L respectively and target cash balance Z. As per
this model, when the cash balance reaches H, then H - Z birr transferred from cash to marketable
securities similarly, when the cash balance hits L, then Z – L birr are transferred from marketable
securities to cash. The lower limit L, can be set by management of the firm depending on the risk of
cash short fall, access of borrowing and the consequences of a cash shortfall.

According to this model , target cash balance can be calculated by:

Z= 3F∂2 1/3

4k +L

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 H= 3Z – 2L
Av. Cash balance = 4z – L
3
Where : Z = target cash balance
H = upper limit of cash balance
L = lower limit of cash L
F = Fixed transaction cost
K = Cash holding opportunity cost on a daily basis
∂2 = variance of daily cash flows

Example - Suppose that, the fixed transaction cost of a firm estimated to birr 150, the opportunity cost
per year estimated to 15% (that is daily opportunity cost K =0.00039) and the standard deviation ( ∂ ) of
daily net cash flows is birr 1,000 (i.e. the daily variance of cash flows are ∂ 2 is equal to birr 1000,000)
where the lower limit of cash balance of the firm is zero.

Required - Compute, Z, H, and Av/ cash balance of the firm

Given: F = birr 150 K = 0.00039 ∂2 = birr 1,000,000 L=0
Solution
1/3
Z = 3X150 X 1000,00 + 0 = 3 288,461,500,000 = birr 6607
4X 0.00039

H = (3 x 6607) – 0 = 19,821

Av/Cash balance 4 x 6607 – 0 = 8809

3

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 Management of Inventory
Meaning and importance of inventory
Inventory refers the physical stock items/goods which kept for the purpose of future production or use,
or sales. That may include raw material items, office supplies, and work in process, finished goods and
merchandise goods.

Purpose of holding of inventories

Inventory items are very essential for smooth running of business operation of a firm. That means,
holding of large number of inventory items has its own benefits such as: smooth production activity,
cost saving obtained during bulky purchase, market opportunities to fill customers’ sales order on time.

On the other hand, holding of large quantity of inventory items, result in high inventory related costs.
Thus, management of inventory in directly concerned about the determination of reasonable quantity of
inventories to be hold at reasonable/minimum inventory related costs. It means inventory management
can be focused on the balancing of the benefit of holding of inventories with inventories related costs.

Inventory related costs

There are different types of costs which are directly related with holding and purchasing of inventory
items other than purchasing cost of the inventories. Such inventories related costs include:
a. Inventory ordering cost – It represent all costs of placing and receiving of purchase order and
sales order of inventory items.
b. Inventory carrying cost- It constitutes all costs of holding all inventory items for a given period
of time. For example it includes :
- Storage and handling costs it include: cost of warehouse, salary of warehouse employees….
- Capital cost of fund invested in the inventories
- Deterioration and obsolescence costs
- Insurance and tax costs due to handling of inventory items
- Stock out cost – i.e. cost incurred when the firm is unable to fill orders because of the demand
of the item is greater than the available supplies
- Opportunity costs …
Based on the above types of inventories costs total inventories related cost can be determined by:
Total inventories related cost = Annual inventories carrying cost + Annual ordering cost

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 Function of Inventory Management
One of the very important functions of inventory management is determination of Economic Order
Quantity of inventory items. Economic Order Quantity is the quantity /size of inventory that optimizes
the reasonable quantity of inventory items and their benefit with inventory related costs. The inventory
order size that minimizes the overall cost of inventory is referred to as EOQ (Economic order quantity).

EOQ of inventory can be determined by EOQ formula based on the following assumptions:
 The demand rate usage per day/year is constant for indefinite period of time
 The lead time is constant and known (the duration form order date to delivery/receiving of
materials)
 No stock out is allowed
 Materials are ordered /produced in batch and placed in to inventory all at one time
 The inventory item is single
 Specific cost structure is used as follows:
 Item cost is assumed constant
 No discounts are given for large purchase
 Carrying cost of inventory depends linearly on average inventory level
 There is a fixed ordering cost for each batch/ lot of order

Based on the above assumptions:

EOQ = 2DS = Q*
H

Total inventory related cost = (Tc) = Q*(H) + D (S)

2 Q*
Where: D = Annual demand Q = Order quantity
H= unit holding cost of inventory per year S = inventory order cost per order
D/Q* = Number of order per year Q*/2 = Average inventor level per year

Example- Assume that The manager of ABS- company is trying to develop inventory ordering level for
X- item. After careful consideration the manager has estimated that the annual inventory holding cost per
unit is birr 8, and inventory ordering cost per order is estimated to birr 16, where the annual demand/usage
of the item – X is approximately 2500 units.
Required –
A. Calculate Economic order quantity of the firm (EOQ)
B. Calculate total inventory related costs

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 C. Number of order per year
D. Calculate lead time of inventory order

Given: D = 2500units H = birr 8 S = birr 16

A, EOQ = Q* = 2DS = 2 x 2500 x 16 = 100 units

H 8

B, Tc = Q*(H) + D (S) = 100 (8) + 2500 (16) = 400 + 400 = birr 800
2 Q* 2 100

C, Number of orders per year = D = 2500 units = 25 times per year

Q* 100 units

D, Lead time of inventory order = Av. Number days in the year = 360 days = 14.4 days = 15 days
Number of the orders per year 25

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 Part Four
Capital budgeting decision: (principles and techniques)

Capital budgeting is the process of planning or allocation of resources in terms of monitory value
(money) for capital investment. Capital budgeting decision a decision about capital structure of capital
investment. Such types of decision involve the analysis of initial capital investment and the return from
that investment.

Importance of capital budgeting decision

Capital budgeting decisions are important and critical decision due to the following reasons:
 Capital budgeting decisions involves substantial amount of fund. It is therefore necessary for a firm
to make such decisions after a thoughtful consideration so as to result in the profitable use of its
scarce resources. The hasty and incorrect decisions would not only result into huge losses but may
also account for the failure of the firm.
 Capital budgeting decision has its own effect over a long period of time. Capital budgeting decision
is not only affects the future benefits and costs of the firm but also influences the rate and direction
of growth of the firm.
 Capital budgeting decisions are irreversible. Once they are taken, the firm may not be in a position
to reverse them back. This is because, as it is difficult to find a buyer for the second-hand capital
items.
 Capital budgeting decisions are complex. The capital investment decisions involve an assessment
of future events, which in fact is difficult to predict. Further it is quite difficult to estimate in
quantitative terms all the benefits or the costs relating to a particular investment decision.

Capital budgeting techniques

The decision on capital investments (projects) which require heavy investments need the consideration
of financial and non- financial factors.
In this course capital budgeting techniques focused on the analysis of financial factors. Financial factors
analysis /evaluation mainly based on the amount of cash outflow for the investment and the cash
inflows /return from the investment.
Cash outflows - refers initial net investment of fixed assets and working capital
Cash inflows – refers series future incomes or net savings of operating costs. That includes operational
cash inflows and terminal cash inflows from disposal of book values of fixed assets release of ending
working capital.

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There are different types of capital budgeting techniques /project appraisal criteria/

1. Pay Back Period (PBP) - It refers the length of time to recover the initial investment cost. That is
the number of years with in which the initial investment is recovered.
There are two cases:
When cash inflows exactly equal to the initial investment
When cash inflows do not exactly equal to the initial investment

Case I example: to evaluate the investment in two projects (project Q and Project R)
Year Project Q Project R
Initial investment 0 Birr (10,000) ……….. Birr (10,000) cash outflows
Cash inflows 1 2000 6000
2 8000 3000
3 0 1000
Total Cash inflows ………… ……..10,000 ……………….. 10,000

From the above data

Project Q initial investment is recovered in two years
Project R initial investment is recovered in three years
Therefore project Q can be selected by PBP technique evaluation, because it’s initial investment is
recovered with in shorter period than project R.
Case II example:
Initial investment 0 Birr (20,000) ……….. Birr (20,000) cash outflows
Cash inflows 1 5000 7000
2 8000 6000
3 5000 5000
4 4000 1000
5 0 4000
Total Cash inflows ………… ……..22,000 ……………….. 23,000
Science, the total cash inflows do not equal to the initial investment, the exact time (PBP) is decided by
the following interpretation:
For project Q, the exact PBP =

3 years + Return required in next period = 3 years + 2000 = 3.5 years

Return 4000

For project R, the exact PBP =

4 years + Return required in next period
Return available

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 = 4 years + 1000 = 4.25 years
4000

Therefore project Q is selected by PBP technique, because it’s initial investment is recovered with in
shorter period than project R.

2. Accrual Accounting Rate of Return (AARR) or

Average Rate of Return (ARR)

AARR = Average cash inflows - Average depreciation X 100

Total Initial investment

ARR = Average operating income - Average depreciation

Total initial investment

Example, Total initial investment of project A and B is equal to 20,000.00 for each of them with no any
salvage value of fixed assets at termination period of the projects.

Initial investment 0 Birr (20,000) ……….. Birr (20,000) cash outflows

Cash inflows 1 11,000 1,000
2 11,000 1,000
3 2,000 1,000
4 2,000 25,000
Total Cash inflows ………… ……..26,000 ……………….. 28,000
From the above data, we can compute:
- Average operating income for project A = 26,000 = 6,500
4
- Average operating income for project B = 28,000 = 7,000
4
- Average depreciation = 20,000 = 5, 000
4

For project A, AARR = 6,500 – 5000 X 100 = 1,500 X 100 = 7.5%

20,000

For project B, AARR = 7,000 – 5000 X 100 = 2,000 X 100 = 10%

20,000
Therefore Project B to be selected by AARR technique, because it has greater AARR than project A.

3. Net Present Value (NPV)

According to net present value technique a project is selected /feasible if NPV is greater than zero.
NPV = Present Value of total cash inflows - Net initial investment
Net initial investment = (Fixed asset investment + Working capital) – Disposal values of - book value of
fixed assets

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Example – The following information belongs to MM project investment in 2009:
 Initial fixed assets investment birr 390,000 and working capital investment is birr 9,000.
 Income from disposal of book value of fixed assets at liquidation time of the project is birr 20,000.
 The life period of the project is five years.
 The annual net cash an inflow of the project is birr 100,000 per year for five years.
 Required rate of return (RRR) is 8% per year that is the discounting factor for computation of
present value of cash inflows.

Required - Find the NPV of MM project investment

1st compute present value of cash inflows as follow:
Year annual net cash inflows DF at 8% Present value of cash inflows
1 100,000 0.926 92,600
2 100,000 0.857 85,700
3 100,000 0.794 79, 400
4 100,000 0.735 73,500
5 100,000 0.681 68,100
Total PV. Of cash inflows…………………….. 399,300

Therefore NPV = Total PV - Net initial investment

= 399,300 – 379,000 = 20,300
Exercise- In the same problem above if the annual cash inflow is birr 80,000 per year find NPV.
Internal Rate of Return (IRR )

4. IRR is the rate which discounts a project’s cash flows to NPV of zero. This means IRR is the rate
at which the sum of discounted cash flows equal to net initial investment.
IRR can be calculated by trial and error or the following formula:
IRR = Lower rate + NPV at lower rate X (higher rate - lower rate)
PV at lower rate - PV at higher rate

Where: lower rate is any rate lower than RRR

Higher rate is any rate higher than RRR

5. Profitability index – that is calculated as follows, PI = PV of cash inflows

Net initial investment cost

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