Finance: Acquiring and using funds to maximise

value CHAPTER 9

Suzaan Hughes
 Planning ahead - Learning Outcomes
•Identify the goal of financial management, and explain the issues financial managers confront as they seek to achieve this goal
•Explain finance as a management task in relation to planning, organising, leading and controlling,
•Distinguish financial decisions on the various managerial levels,
•Describe the tools financial managers use to evaluate their company’s current financial condition and develop financial plans
•Evaluate the major sources of funds available to meet a firm’s short-term and long-term financial needs
•Identify the key issues involved in determining a firm’s capital structure
•Describe how financial managers acquire and manage current assets
•Explain how financial managers evaluate capital budgeting proposals to identify the best long-term investment options for their
company
•Apply the measurement and reporting of financial statements by making use of ratios,
•Explain and interpret the various financial ratios
•Determine the future value of an amount of money
•Calculate the present value of a specific amount
•Compare two projects by evaluating the net present value and making a recommendation based on the calculations
 Chapter 9 Outline
1. The function of finance in an organisation
a. Financial capital
b. Shareholder value and social responsibility
c. Risk and return
2. Identifying financial needs: evaluation and planning
a. Using ratio analysis to identify current strengths and weaknesses
b. Planning tools
 Chapter 9 Outline
3. Finding funds – what are the options
a. Sources of short term financing
b. Sources of long term financing
c. Leverage and capital structure
4. The Capital structure of the organisation
a. Managing cash
b. Managing accounts receivable
c. Managing inventories
d. Capital budgeting
e. The time value of money (Net Present Value)
Finance
Financial capital*: The funds a firm uses to acquire its assets and
finance its operations
Finance*: The functional area of business that is concerned with
finding the best sources and uses of financial capital
Goal of financial management is to maximize the value of the firm to
its owners
 Shareholder Value and
Social Responsibility
A socially responsible organisation has an
obligation to respect the needs of all
stakeholders
• Being socially responsible requires a long-
term commitment to the needs of
different stakeholders
Fiduciary duty of financial managers
• Managers should make decisions that are
most consistent with the interests of
ownership when conflicts arise
 Risk and Return: A Fundamental Trade-Off in
Financial Management
Risk: Degree of uncertainty regarding the outcome of a decision
Risk-return tradeoff
The observation that financial opportunities that offer high rates of return
are generally riskier than opportunities that offer lower rates of return
 Identifying Financial Needs:
Evaluation and Planning
Financial Ratio Analysis: Computing ratios that compare values of key accounts
listed on financial statements – to identify current strengths and weaknesses
Categories
• A liquid asset can quickly be converted into cash with little risk of loss
• Liquidity ratios: Measure the ability of a firm to obtain the cash it needs to
pay its short-term debt as they come due
• Key liquidity ratio is the current ratio, which compares current assets to
liabilities
Financial Ratio Analysis (continued)
• Asset management ratios: Measure how effectively a firm uses its assets to
generate revenues or cash (also called activity ratios)
◦ Key asset management ratios:
◦ Inventory turnover calculates how quickly a firm sells its inventory to
generate revenue
◦ Average collection period shows how long it takes for a firm to collect from
customers
Financial Ratio Analysis (continued)
• Financial leverage*: The use of debt in a firm’s capital structure
• Leverage ratios: Measure the extent to which a firm relies on debt
financing in its capital structure
• Key leverage ratio is Interest coverage, which compares a firm’s
annual earnings to its annual interest expenses
Financial Ratio Analysis (continued)
Profitability ratios: Ratios that measure the rate of return a firm is earning on
various measures of investment
◦ Provides measure of how successful the firm is at earning a profit
◦ The larger the percentage of net profit margin, the more profit a firm earns on
each dollar of revenue
◦ Key profitability ratio is net profit margin, which indicates the percentage a
firm earns on each dollar of revenue, after paying all operating expenses,
interest, and taxes
Basic Planning Tools
Budgeted income statement
A projection showing how a firm’s budgeted sales and costs will affect expected
net income (also called a pro forma income statement)
Budgeted balance sheet
• Forecasts:
• The types and amounts of assets a firm will need to implement its future
plans
• How the firm will finance the assets (pro forma balance sheet)
Basic Planning Tools (continued)
Cash budget
• Detailed forecast of future cash flows
• Helps financial managers identify when their firm is likely to experience
temporary shortages or surpluses of cash
Projecting cash flows helps financial managers determine
◦ When the firm is likely to need additional funds to meet short-term
cash shortages
◦ When surpluses of cash will be available to pay off loans or to invest in
other assets
Sources of Short-Term Financing
Trade credit
◦ Granted by sellers when they deliver goods and services to customers without
requiring immediate payment
◦ Form of spontaneous financing
Spontaneous financing*: Financing that arises during the natural course of
business without the need for special arrangements
Factor
◦ Company that provides short-term financing to firms by purchasing their
accounts receivables at a discount
Sources of Short-Term Financing (continued 1)
Short-term bank loans
◦ Line of credit: Arrangement between a firm and a bank
◦ Bank pre-approves credit up to a specified limit, provided that the firm
maintains an acceptable credit rating
Sources of Short-Term Financing (continued 2)
◦ Revolving credit agreement: Bank makes a binding commitment to provide
funds up to a specified credit limit at any time during the term of the
agreement
◦ Guaranteed line of credit
Commercial paper: Short-term promissory notes issued by large
corporations
Sources of Long-Term Financing
Direct investments from owners
◦ Investments can be obtained by selling new stock and by reinvesting earnings
◦ Retained earnings: Part of a firm’s net income that is reinvested
• Long-term debt
◦ Borrowing from banks and other lenders
◦ Issuing bonds
Sources of Long-Term Financing (continued)
Term loans
◦ Covenant*: A restriction lenders impose on borrowers as a condition of
providing long-term debt financing
Corporate bonds
◦ Corporations’ own formal IOUs, which they sell to investors
Leverage and Capital structure:

How much Debt is too much debt?

Equity and Debt Financing
Equity financing*: Funds provided by the owners of a company
◦ A company issues and sells new stock or uses retained earnings
Debt financing*: Funds provided by lenders (creditors)
◦ A company takes out a bank loan or issues and sells corporate bonds
Capital structure*: The mix of equity and debt financing a firm uses to meet its
permanent financing needs
Pros and Cons of Debt Financing
Pros
◦ Interest payments are a tax-deductible expense
◦ Firms can acquire additional funds without requiring existing stockholders to
invest more of their own money or the sale of stock to new investors
Cons
◦ Requirement to make fixed payments
◦ Creditors often impose covenants on the borrower
Pros and Cons of Equity Financing
Pros
◦ More flexible and less risky than debt financing
◦ Imposes no required payments
Cons
◦ Does not yield the same tax benefits as debt
financing
◦ Existing owners might not want a firm to issue more
stock as it may dilute their share of ownership
◦ Company that relies mainly on equity financing
forgoes the opportunity to use financial leverage
Financial Leverage and Capital Structure
Financial Leverage: Using Debt to Magnify Gains (and Losses)
Magnifies the return on the stockholders’ investment when times are good
Reduces the financial return to stockholders when times are bad
Many companies used leverage to magnify their ROEs
◦ The required interest and principal payments on debts can become a heavy burden in
an economy with low/no growth
Engaged in deleveraging
◦ Deleveraging - Replacing debt in a firm’s capital
structure with more equity
 Exhibit 9.4 How Financial Leverage Affects
the Return on Equity
Eck-Witty (Capital structure is all only equity Oze-Moore (Capital structure 20% equity, 80% debt
Equity (funds supplied by owners) $1,000,000 Equity (funds supplied by owners) $200,000
Debt (Funds obtained by borrowing) $0 Debt (Funds obtained by borrowing) $800,000

Strong Sales Weak Sales Strong Sales Weak Sales

EBITDA $160,000 $80,000 EBITDA $160,000 $80,000

Deductible debt interest 0.00 0.00 Interest 48,000 24,000

Taxable income 160,000 80,000 Taxable income 112,000 56,000

Taxes 32,000 16,000 Taxes 22,400 11,200
After-tax earnings 128,000 64,000 After-tax earnings 137,600 68,800
ROE 12.8% 6.8% ROE 68.8% 34.4%

Kelly/Williams, BUSN 12th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part. 24
Financial Leverage and Capital Structure
◦ The moral of the story: if the financial returns of leverage seem too good to be
true, through the long run they probably are

◦ Sound financial management requires keeping a level head and balancing risk
and return

◦ Dodd-Frank Act*: A law enacted in the aftermath of the financial crisis of

2008–2009 that strengthened government oversight of financial markets and
placed limitations on risky financial strategies such as heavy reliance on
leverage
 Acquiring and Managing
Current Assets: Cash
Managing Cash: Is It Possible to Have Too Much Money?
A firm’s cash refers to holdings of currency plus demand deposits
Cash equivalents: Safe and highly liquid assets that many firms list with
their cash holdings
o Commercial paper: Short-term promisory notes issued by a company
o Treasury bills: Short-term marketable IOUs issued by a government
o Money market mutual funds: Pool funds from many investors and
use these funds to purchase very safe, highly liquid securities
 Acquiring and Managing Current Assets:
Accounts Receivable and Inventories
Managing Accounts Receivable: Pay Me Now or Pay Me Later
Accounts receivable
◦ Balancing advantages of offering credit with the costs involves
setting credit terms, establishing credit standards, and deciding
on an appropriate collection policy

Firms must hold inventories to operate businesses

◦ Manufacturing firms look to keep inventories as low
as possible in an attempt to reduce costs and
improve efficiency
Capital Budgeting
Procedure a firm uses to evaluate long-term investment proposals
Evaluating Capital Budgeting Proposals
◦ Financial managers measure the benefits and costs of long-term
investment proposals in terms of the cash flows they generate
Capital Budgeting (continued)
◦ Accounting for the time value of money
◦ Time value of money: Principle that money received today is worth more than
money received in the future
◦ Cash flow’s value depends not only on the amount of cash received but also on
when it is received
Present value*: The amount of money that, if invested today at a given rate of
interest called the discount rate, would grow to become some future amount in a
specified number of time periods
◦ Compute net present value (NPV)
The Risk-Return Trade-Off Revisited: In general, projects with the potential for
high returns also carry a high degree of uncertainty and risk
Present Value and Net Present Value
Present value

• Amount of money that, if invested today at a given

rate of interest, would grow to become some future
amount in a specified number of periods
See
Net present value (NPV) additional
NPV info
on Moodle
• Sum of the present values of expected future cash
flows from an investment minus the cost of that
investment
 Tutorial homework
1. Calculate and interpret the ratios for Shoprite as outlined on the documents loaded on
Moodle
2. Calculate the Net Present Value as per the documents loaded on Moodle

Due date: 2 October