DPB5043 BUSINESS FINANCE SESI DIS 2019Present BUSINESS FINANCE exposes tHe STUDENTS ON THE 2} CONCEPTS OF FINANCE AND TECHNIQUES USED TO MANAGETHE %%,® XQ FINANCIAL PLANNING OF AN ORGANIZATION. e THE THEORIES AND CONCEPTS OF BASIC FINANCIAL ARE DISCUSSED AS J A BENCHMARK AND INPUT FOR CONSIDERATION, IN ORDER TO MAKE 3 ° SHORT AND LONG TERM FINANCIAL DECISIONS FROM THE ee ASPECT OF FINANCING AND INVESTMENT. APART FROM THAT, ORGANIZATIONS ¢ \\\\\c)\8 \)/A\L%5)5 1S USED TO AN ALIA? Tilt ORGANIZNTION’S FINANCIAL POSITION.INTEGRATE THE THEORIES AND CONCEPTS OF BASIC FINANCIAL. (C5, PLO1) “2, ANALYZE ORGANIZATION’S FINANCIAL POSITION USING APPROPRIATE METHODS AND TECHNIQUES. (C4, PLO1) 3. DEMONSTRATE AND PRACTICE INDEPENDENT ACQUISITION OF NEW w KNOWLEDGE FOR LIFE-LONG LEARNING IN ) ACCOMPLISHING PROBLEM SCENARIO. (C3, PLO1) (A2, PLO6) i i hd Presenter 3CHAPTER 1 FINANCIAL MANAGEMENT (CLO1) GGL os hdBasic of Financial Management? Imagine that you were to start your own business. No matter the type of business, you would have to answer the following three questions in some form or another. 1. What long term investment you take on? That is, what lines of business will you be in and what sorts of buildings, machinery and equipment will you need? 2. Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money? 3. How will you manage your everyday financial activities such as collecting from customers and paying suppliers? Financial management is concern with the management of all matters associated with the cash flow of an organization both short-term and long term. How the company uses its funds typically by buying non-current assets and funding its working capital and where the funds came from typically from the shareholders (equity) or by borrowing money from third parties (loans/debt).In addition to ongoing involvement in financial analysis and planning, the financial manager’s primary activities are (a) making investment decisions and (b) making financing decision. a) Investment decisions — Determine both the mix and the type of assets held by the firm. b) Financing decisions - Determine both the mix and the type of financing used by the firm. Goals/ Objectives of the Firm The owners of the firm are normally distinct from its managers. Actions of the financial manager should be taken to achieve the objectives of the firm’s owners, its stockholders. The financial managers need to know the objectives of the firm’s owners. 1. Maximize profits 2. Maximize shareholders wealthSome people believe that the firms objective is always to maximize profit To achieve this goal, the financial manager would take only those actions that were expected to make major contribution to the firm’s overall profits. For each alternative being considered, the financial manager would select the one that is expected to result in the highest monetary return. Earnings per share (EPS) commonly used to measure profits, which represent the amount earned during the period on behalf of each outstanding share of common stock. Profit maximization is not a reasonable goal because it ignores (i) the timing of returns, (ii) cash flows available to stockholder and (iii) risk.The wealth of the owners is measured by the share price of the stock, which in turn is based on the timing of returns (cash flows and their risk. When considering each financial decision alternative or possible action in terms of its effect on the share price of the firm’s stock, financial managers should accept only those actions that are expected to increase share price. Because share price represents the owner’s wealth in the firm, maximizing share price will maximize owner wealth.Making decisions on financial management is usually done by a financial manager. The main task of the financial manager is to determine how financial resources are obtained and used effectively and efficiently to achieve the objectives of the company that is to maximize profits of the company or increase shareholders’ wealth. Among the most common activities undertaken by financial managers are: i) Forecasting and planning: Financial managers must be able to forecast the company’s future performance. Forecasting is made based on the company’s past and present performance as well as other factors such as economic performance, customer’s preference and the future demand for their products. Based on the forecasts and interaction with other executives, the financial manager will lay plans, which will shape the company’s future position.ii) Investment and financing decisions Based on the forecasts and the plans, financial managers will be able to do the following tasks : e Determine sales growth rates ; e Determine what specific assets to purchase ; e Determine the best method of financing those assets, whether to use debt (long term / short term) or to use equity (common stock /preferred stock). iii) Coordination and control Financial manager have to interact with other departments within the organization. This is necessary because the decisions of other departments might affect investment decisions. For example, the company has decided to increase sales promotion activities (marketing decision). This will usually result in an increase in sales. The increase in sales would subsequently require an increase in the production capacity that will then influence the investment requirements.iv) Dealing with financial markets As financial managers, they will have to deal with money markets and capital markets. The financial manager has to obtain financing either through the money market or capital market. He may have to decide on investing excess or idle fund in the financial markets. He will also have to foster relationships with creditors (for example -— bank loan officers), stockholders, investors and governmental regulatory bodies.10 PRINCIPLES THAT FORM THE FOUNDATION OF FINANCIAL MANAGEMENT * We won't take additional risk unless we expect to be compensated with additional return * a dollar received today is worth more than a dollar received in the future. * in measuring value, we will use cash flows rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest.10 PRINCIPLES THAT FORM THE FOUNDATION OF FINANCIAL MANAGEMENT teu) Ure aii me) Sheed) et ey it’s only what changes that count. In making business decisions, we will concern ourselves with what happens as a result of that decision. it’s hard to find exceptionally profitable projects and economic changes makes the market more competitive The markets are quick and the prices are right. Government policy for the benefits of the country may results in tax bias in certain business10 PRINCIPLES THAT FORM THE FOUNDATION OF FINANCIAL MANAGEMENT * The agency problem is the result of the separation between the decision makers and the owners of the firm. As a result managers may make decisions that are not in line with the goal of maximization of shareholders wealth. Utw.\(uta edd uid since some risk can be diversified away and some cannot. The process of diversification can be reduce risk, and as a result, measuring projects or an assets risk is very difficult means doing the right thing. Ethical dilemmas are everywhere in finance. Ethical behavior is important in financial management. Unfortunately, precisely how we define what is and what is not ethical behavior is sometimes difficult.CHAPTER 2 RISK AND RETURN (CLO1) & @ ©All investors want a return or profit from each of their investments without having to experience high risk. However, the returns and risks are directly related to each other where a higher risk is associated with a higher return that will be obtained and vice versa. Consideration should be taken into account in determining the risks and returns of an investment. This topic will emphasize the risks and returns for investors that invest in common stock markets. Types of investor: Generally, investors can be divided into three types: 1. Risk free: This type of investor, try to avoid investing in high-risk investments such as investments in stocks. They are more interested in investing in the investment that has a very low risk, such as Amanah Saham Bumiputera (ASB), Premium Savings Certificates, or any investment guaranteed by the government. 2. Risk adverse: These types of investors will try to avoid investing in a risky market, but tend to prefer low-risk investments even lower returns. They are always careful to environmental conditions that affect the stock market. 3. Risk Take These types of investors like to invest in high-risk market, they think the higher the risk of an investment, the higher the potential returns available. Investors do not have the constraints of funds to invest. Reducing risk by diversifying Diversification mean to spread an investment over a range of investment instruments in order to minimize the risk of losing all the investment should one investment go bad. Diversification would tend to reduce or eliminate riskWhat is Return ? Return, in finance, simply means the reward for investing. Return consists of periodic cash payments or current income and capital gains (losses) or increase (decrease) in market value. The periodic cash payments maybe in the form of interest or dividends. In other words, return can be referred to as total income obtained on an investment plus any changes in market prices (usually shown in %). Classification of Return: Return in finance simply means the reward for investing, Return consists of periodic cash payments of current income and capital gain (losses) or increases (decreases) in market value actual return that has been earned @ obtained. realized return is historical in nature risk free rate of refurn- reward for deferring consumption. required rate of return for riskless investments such as investment in government securities realized return classification Of return risk premium- additional return that we anticipate for assuming risk. as level of risk increase, we would demand an additional expected return the return is anticipated or expected . expected benefit or earnings that the investment would generate. target return that the firm may desireReturn can be expressed either as percentage or in RM value. But it is best to present return as percentage because it would give a better understanding of how much income is obtained from each RM that is invested. - Typically, the indicator most often used to measure the level of return is by using the expected return @ Computing Expected Return ( ) Generally, expected return can be defined as the average results based on all probability and possible yield or rate of return expected from an asset. Expected rate of return (2) = SRP R = the possible return P = probability to occur Example 1: Growing 14 25 36 Stable 30 12 20 30 Down 50 10 VF 28 Based on the example above, you are required to calculate the expected rate of return for investments in Stock A, B and C. >| o tl} >! a WExample 2: Growing 1870 3000 Stable 40 2500 1700 2500 Declines 30 1800 1450 2000 Based on the example above, you are required to calculate the expected rate of return for investments in Stock A, B and C. RA= >| o tl pl a IWhat is Risk ? Risk can be referred to as uncertainty or stability in the expected return to be received from an investment. In the financial dictionary, risk is defined as a chance of a monetary loss. If a project has a greater probability of loss, then it is viewed as more risky than projects that have a lesser probability of loss. TYPES OF RISK a) Systematic Ris! - Referring to the risks affecting mostly the stock market. It is also known as "market risk". An example of this risk is inflation, changes in foreign exchange rates and changes in tax rates. - The risk is also known as the risk that cannot be avoided. Risk cannot be reduced by “diversification”. b) Non Systematic Risk: - Referring to the risk that does not affect the market but only affects the firm. - Example: shortage of raw materials, new competitors producing the same products, change of management and labour strike. - This risk can be minimized or eliminated through “diversification”.The indicators often use to measure the risks of an investment are known as Standard Deviation (6) and coefficient variation (CV). Standard Deviation (6): The standard deviation is used to measure the distribution of results that may occur around the expected value. The higher the standard deviation, the higher the returns will be obtained and the higher the risk to be faced. Standard Deviation (6) = V 5 (R - 8)? x P R ‘ate of return may occur R = expected rate of return P = probability Example 3: Growing 14 25 Stable 30 ny 20 30 Down 50 10 15 28 Calculate the risk for stock above? Example 4: Based on the question in example 2, calculate the risk of each stock?Coefficient of variation is a standardized measure of a risk per unit of expected return. It is the ratio of the standard deviation to the expected return. Thus, it is said to be measure of relative risk. Coefficient of variation (CV) provides @ meaningful basis for a comparison when the expected return and the standard deviation of alternative investments are not the same. Variation coefficient (CV) = Standard Deviation (6 ) Expected rate of return (R ) From example 3 and example 4, calculate the CV for the shares. ** RELATIONSHIP BETWEEN RISK AND RETURN All investments have risk, but some investments are riskier than others — there’s a greater chance you could lose some or all of your money. In general, higher-risk investments offer higher potential returns, and lower-risk investments offer lower returns.CHAPTER 3 FINANCIAL ANALYSIS (CLO2) oe Learning Objectives 4%FINANCIAL ANALYSIS Introduction A firm operates from year to year and at the end of its financial year, the management shareholders, creditors, potential investor, government and other parties would be interested in its performance. They are concerned about whether the company is making any profits or whether the company is able to increase its profits compared to previous year. What is financial analysis? Financial analysis is the assessments of a firm's past, present, expected future financial performance. The analysis is made based on the firm’s financial statement. It involves looking at historical performance. Financial analysis helps an individual to check whether a business is doing better this year than it was last year, or whether it is doing better or worse than other companies in the same industry. Objective of financial analysis The main objective of financial analysis is to identify the firm's strengths and weaknesses. It is necessary for a firm to identify its strengths so that it can capitalize on these strength and corrective actions to improve its weaknesses. Types of financial statement A) Statement of Comprehensive Income B) Statement of Financial Positions C) Cash Flow Statement D) Notes to accountFINANCIAL ANALYSIS The principal tools of financial analysis are financial ratio. Ratios are mathematical aids for evaluation and comparison of _ financial performance. Financial ratios are computed based on the firm’s financial statement. They are used to summarize the information in a company’s financial statement in assessing its financial health. Objective of ratio analysis |. To standardize financial information for comparison purposes 2. To evaluate current operations of the company 3. To compare present performance with past performance 4. To compare with other firms or industry standards 5. To assess the efficiency of operation 6. To assess the risk of operations Types of comparison 1. Internal comparison 2. External comparison Internal comparison Internal comparison is an analysis based on comparisons of similar ratios for the same firm. It compares present ratios past and expected future ratios. The objective of internal comparison to analyze the financial condition and performance of the firm over time.FINANCIAL ANALYSIS External comparison External comparison involves comparison of ratios of a firm with ratios of a firm with ratios of other firms in a similar industry. This is also called inter-firm comparison @ cross sectional analysis. For example a firm may want to analyze its performance relative to its competitor to know its standing in the industry. External comparison is important as it will enable the company to identify its strength and weaknesses as compared to its competitors. The company will be able to improve its performance Users of financial statement 1, Shareholder/owner These users are interested in the profits earned, financial health performance and potential growth of the company. They want to ensure that they get good returns from their investment. They want to know whether there is an increase in the value of their shares. They need to get these statements to identify the firm's strength and weaknesses for remedial action and future planning. 2. Managers Managers are hired by owners to manage the business on their behalf. They have to ensure that they manage the business effectively and efficiently so that owner’s wealth is maximized. 3. Creditors /lenders Creditors consist of those who supply goods and services on a credit basis as well as bank providing loans to companies. Supplier wants to ensure that they are able to get timely payment. Banks are interested not only in the firm's profitability but also its ability to repay loans.FINANCIAL ANALYSIS Users of financial statement A. Current and future employees Employees are part of the company and feel that their contribute to the firm's profitability. They need the financial statement to determine the monetary benefits that they can obtain from the firm. 5, Prospective investor They need to analyze the firm’s financial statement to assess profitability, stability, growth potential and financial health. They also want to assess the efficiency of management before deciding whether to invest in the firm. 6. Customers Customer would want to ensure that the company can deliver not only the goods ordered. They want to ensure the company provide after sale customer service 7. Government Various government ministries and department require financial statement to a firm's declaration and payment of taxes and utilities and make expansion plans for the economy.FINANCIAL RATIO Types Of Financial Ratio » Liquidity ratios > Efficiency ratios » Leverage ratios » Market ratios 1 . LIQUIDITY RATIO = Shows a firm’s ability to meet its short term financial obligation. Company has the resources to pay its the higher creditor when current asset liquidity the payments are due current liabilities easier it is T for the Unit = 1x company to pay its creditor on time Indicates whether current asset — inventory = prepaid expenses current liabilities eG firm has enough current asset to cover its current its liabilities without Unit = 1x selling inventory2. EFFICIENCY RATIO ~ MEASURE HOW EFFECTIVELY THE FIRM IS MANAGING ITS ASSET IN GENERATING SALES. | SHOW US THE FIRM’S EFFICIENCY IN COLLECTING DEBT Lee a PRN PT cuit) Pwr Peery Pouce CA | or a CPCI assets Ug Ratio indicates how many times the stock is sold and replaced in a year Ratio indicates the number of days taken by a firm to collect its account receivable Ratios measure the firm's in utilizing its plant, and efficiency property, equipment in generating sales Ratio generating a volume sales with the given indicates is higher amount of assets costs of good sold T closing stock Unit = 1x account receivable annual credit sales | Xx 360 days Unit = 10 days sales 1 net fixes assets Unit = 1x sales 1 total assets Unit = 1x The the faster stock higher ratio is being sold The shorter the ACP, the faster debtor paying their account are3. LEVERAGE RATIOS eee A) Debt ratio es Cie lce) on aes tg oT) ace) Measure the level of debt of borrowings in a firm. Measure the percentage of borrowings used compare with total equity. Measures the firm’s ability to cover its interest charges out of operating profits total debt total assets Unit = % total debt total equity Unit = 1x EBIT interest expense (current liability +long term liability) L e es The lower the better, minimum debt of borrowing The lower the better, minimum debt of borrowing The higher the ratio the higher is the firm’s ability to fulfill interest obligation4. PROFITABILITY RATIOS MEASURE HOW EFFECTIVELY THE FIRM USES ITS ASSETS TO MAKE PROFITS Types of ratio | __Definition | Formula | Indicator] 1S) SS i) It shows the efficiency of The higher Peietial the company in gross profit the better. controlling its cost of sales T Ratio tells us goods sold about company’s pricing policy Operating profit is. ©) rir) derived after deducting EBIT Pa all costs and expenses sales f excluding interest and tax The higher the _ better, the higher the profitability =) 9) 55 This ratiois not usefulfor "et income available to} of the eri companies making losses —Co™monstockholder = company sales The higher ID) Retum on Warners the et income available to the ROA due peed management’s ability to common stockholder to efficiency make profits from the total asset 1 in asset firm's investment in asset utilization The higher (3) Gy Gn) Measures the profit net income available to the ROE Pray earned by common common stockholder 1 better the stockholder total equity return for shareholder5. MARKET RATIOS ALSO CALLED INVESTORS RATIO. RELATE A FIRM'S STOCK PRICE TO ITS EARNINGS AND BOOK VALUE PER | SHARE Lea i Metis Profit earned per net income available to BI unit of issued share ___common stockholder ____ 1 Market no. of ordinary shares issued , value will be high the Seveeytlce It indicate the | firms _ stock a ordinary dividend 7 Arts amount of dividend ————______ price will : no.of ordinary shares issued | received by increase ordinary shareholder ©)pividend) ITT the ee Pac} proportion of ——_—_—_—_—— tT The higher ; ° Earnings per share ° earnings that is P/E ratio distribution high growth dividend to potential shareholder and low risk It compares the Dyas current. market Sue | price with earnings to establish whether a stock is overvalued @ undervalued market price per share Earnings per share =i) Indicates dividend Nor] per share received by the shareholder with the current market share price latest annual dividends current market share priceEXAMPLE I : You are required to make an analysis of Melati Sdn Bhd financial position and present your analysis in a report. Financial statements of the company are presented below: Required: 1. Compute the ratios for Melati Sdn Bhd for the year ended 2019 2. Comment on the company’s profitability and debt management for 2019 as compared to the industry average Melati Sdn Bhd Income statement for the year ended 31 December 2019 350,000 (250,000) 100,000 25,000 5,000 15,000 (45,000) 55,000 (16,500) 38,500Melati Sdn Bhd Balance sheet as at 31 December 2019 Assets Cash Marketable Securities Account Receivable Inventory Prepaid Rent Net Property, Plant And Equipment Liabilities And Stockholder Equity Accounts Payable Notes Payable Accruals Long Term Debts Common Stockholder Equity Industry Average Current Ratio Quick Ratio Debt Ratio Times Interest Earned Average Collection Period Inventory Turnover Total Asset Turnover Return On Assets Net Profit Margins Gross Profit Margin RM 8,500 3,600 19,000 46,500 550 145,000 223,150 27,500 6,500 2,500 75,000 111,650 223,150 2009 1.8x 0.9x 50% 10x 20 days 7x 1.4x 8.40% 10.50% 27%LIMITATION OF FINANCIAL RATIO Comparison with industry averages is difficult for conglomerates. If a firm in various kinds of businesses or has many divisions in different industries, its industry category is often difficult to identify. 2. Average performance as shown in the industry average may not be desirable. It could be better for a firm to make comparison with market leader. 3. Seasonal factors can also distort ratios. Year-end values may not be representative. Certain account balances may increase or decrease. Sales are usually higher during festive due to seasonal factor. Such changes may distort the value of the ratio before and after such seasons significantly different. 4. Inflation distorts the firm’s financial statement. It will cause the recorded value to be different from true value. 5. It is sometime difficult to conclude whether a ratio is good or bad. For example a high liquidity ratio may indicate that a company is financially sound therefore efficient in the firm’s working capital management. High liquidity ratios may indicate overstocking and difficulty in collecting account receivable on time 6. Itis also difficult to conclude whether a firms overall performance is good or bad. This is because most ratios by themselves are not highly meaningful. For example some ratios may be good while others are bad.CHAPTER 4 WORKING CAPITAL MANAGEMENT (CLO3)WORKING CAPITAL POLICY & MANAGEMENT “yO _ =INTRODUCTION WORKING CAPITAL MANAGEMENT Managing the firm’s working capital, that is it current assets and current liabilities, is one of the financial manager’s function as working capital represents a_ significant proportion of total assets. Current assets comprise mainly inventory, accounts receivable, marketable securities and cash while current liabilities comprise mainly accounts payable, accruals, creditors for expenses and bank overdraft. WORKING CAPITAL POLICY refers to the firm’s investment in current assets such as cash, debtors and stocks. Working capital is obtained by subtracting the total current assets by current liabilities. For a firm to be liquid, or solvent it is imperative that net current assets are positive. In management, the company must ensure that there are appropriate levels of working capital in order to obtain high profits or returns from investments over the potential risks encountered. The higher the level of working capital, the lower the returns earned and at the same time facing low risk. WHY? This is because companies do not make full use of liquid assets held to generate revenue for the company. For example, high levels of working capital may be due to the high level of cash and stock in a company. Returns obtained would be doubled if the cash is invested in a profitable investment instruments such as the purchase of shares, purchase of new assets to enhance the ability of the firm or others. While a high stock holding will only harm the company because it is better if the stock is sold to customers.INTRODUCTION WORKING CAPITAL MANAGEMENT IMPORTANCE OF WORKING CAPITAL MANAGEMENT Normally, a substantial proportion of total assets of the firm is made of current assets. Therefore it must be managed properly. Company must maintain a proper level of working capital so that it is not compelled to bankruptcy when a company's total current assets were lower than current liabilities. Each current asset is to be managed efficiently and effectively to achieve the suitable level of liquidity and not to maintain any current assets at a level that is too high. Working capital levels are the most important items and generally accepted in the evaluation of firm performance. It is used as an indication of the company's ability to meet liabilities claims. Cash is the most important component in the level of current assets of the company. Inaccuracies in the forecast cash inflows and outflows will cause problems in the management firm handling the firm daily. Factor affecting working capital level Type of Business - Manufacturing and retail firms have higher working capital requirements, especially in the form of inventory, as compared with service organization Volume of sales - A higher level of sales will require a higher level of working capital Seasonality - Peak seasons, for example festive seasons, require a higher level of working capital Length of operating and cash cycle - A longer operating and cash cycle increases the level of working capital whereas a shorter cycle will lower it.INTRODUCTION WORKING CAPITAL MANAGEMENT THE RISK-RETURN TRADE-OFF IN WORKING CAPITAL MANAGEMENT "The risk-return trade-off in managing a firm’s working capital is related to a trade-off between the firm's liquidity and profitability. "A firm can increase its investment in working capital by increasing its investment in current assets (This in turn increase firms liquidity). Example : Increase inventory and cash, firm more liquid (able to pay bills on time). "However, this may not result in an increase in the firm’s returns, if profits remain unchanged. "Therefore the financial manager has to determine a balance between liquidity and profitability which is contribute positively to the firm’s value. =Therefore the financial manager in considering the risk return trade off in general should only take on additional risk when an additional return is expected. We can now see that the risk return trade off involves an increased risk of insolvency versus increased profitability.CASH — MANAGEMENT AND MARKETABLE SECURITIES wO if 0CASH MANAGEMENT Cash or money itself are in the form of currency and current accounts. Current account is known more formally as a demand in the bank. The bank pays money out of the current account to another person when the owner of the account issues cheque. Cash is considered the most liquid asset of a company, which is non- earning asset. It means that by holding cash we cannot earn any interest or return on it. But the company still need cash to pay bills, purchase goods, make payment on interest, pay salaries/wages and so on. Even though cash it self does not earn any return, a firm must have cash in hand to run the business efficiently. Cash management is mainly concerned with maintaining liquidity of a firm so as to minimize the risk of insolvency. A company becomes insolvent when it is unable to meet its maturing liabilities on time because it lacks the necessary liquidity to make prompt payment on its current debt obligations. Objectives of Cash Management 1. Carrying minimum amount of cash: a company attempts to carry the minimum amount so that it does not have a lot of cash in hand since it does not earn any return. So a firm must minimize idle cash balances. 2. Have enough cash to make payment.: to make sure a company can make the payment during the operation of the business without running out of cash.CASH MANAGEMENT Motives for holding cash by British economist John Maynard Keynes are: 1. The transaction motive : cash balances held are for the purpose of meeting cash need in term of the ordinary course of doing business. Ex. buying inventories, pay bills etc. 2. The precautionary motive : Cash balances act as a buffer for unexpected needs that may arise. 3. The speculative motive : Cash balances are held for potential profit-making situations such as bargain purchase opportunities that might arise and attractive interest rates. Cash planning - Cash budget to forecast cash inflow and outflow. Also referred to as cash budget. Management of cash receipts and payments - Float Refers to funds that have been paid for, but are as yet not useable. 3 components — mail, processing and clearing float Mail — length of time between the mailing of payments and its receipt Processing — time between receiving of a payment and its deposits into the firm’s account Clearing float — time between the deposit of payment into the firm’s account and when the fund can be used (time ‘or cheque to clear)CASH MANAGEMENT Methods to speed up collection and slow down payments: 1. Reducing collection time — this will reduce customer float time which will shortened the average collection period and cash conversion cycle. 2. Increasing payment time — delay payment to supplier, must be use carefully as longer payments period may cause a strain in relationship with supplier. 3. Concentration of cash — transfer mechanism selected/choose by the firm to concentrate deposits into one bank. 4. Zero-balance account - allows a firm to keep all of its operating cash in an interest earning account. It allows the firm to maximize the use of float on each cheque without altering the float time of payment to its suppliers. The Efficient Management of Cash Since the objective of a company is to run the business effectively without running out of cash, a company must keep the minimum cash balance. By keeping the minimum cash balance, it will allow the company to invest in various alternatives and to repay debts when they are due. Therefore the efficient cash management requires the following steps: 1. Determine minimum operating Cash (MOC) Most companies need to have minimum cash balance in operate their business. This amount of cash is called Minimum Operating Cash (MOC). MOC balances and safety stock of cash are influenced by the firm's production and sales techniques and also by its procedures for collecting sales receipts and payment on purchase. In other hand, cash balance are influence by the firm’s operating cycle and cash cycle. If @ company can manage these cycles efficiently, then the financial manager of that company can maintain a minimum level of cash investment and contribute toward maximization of share value.CASH MANAGEMENT 2. Defining Operating Cycle (OC) Operating cycle is an average time period to acquire inventory, process it and sell the finished product until to the point when cash is collected from the sale of it. 3. Defining Cash Cycle (CC) Most of the time a company is able to purchase raw materials on credit. The time its takes to pay for these inputs is called the average payment period. The ability to purchase raw materials on credits allows the firm to offset the length of time resources that are tied up in the operating cycle. So cash cycle refers to an average time between ‘cash out’ for inventory and ‘cash in’ from collection on sales. In other words, cash cycle is an average time the company is without cash.MARKETABLE SECURITIES Are assets that be converted into cash quickly. Ex. Treasury bills, commercial papers, negotiable certificates of deposit and money market mutual fund. Rationale for holding marketable securities CAs a substitute to cash. When cash outflow exceeds cash inflows at any point in time, a firm will sell the marketable securities. OAs a temporary investment: held as temporary investment for the purpose of meeting the known financial requirements. Ex: to pay tax. Selection criteria for marketable securities 1. Financial risk/ default risk — this is the risk of the borrower not being able to pay interest/ principle on the security traded. 2. Interest rate risk — Financial instruments with longer terms to maturity are more sensitive to changes in interest rate and therefore have higher interest rate risk 3. Inflation risk — inflation will reduce purchasing power and those financial instruments whose returns rise with inflation will experience lower inflation risk, whereas those financial instruments whose returns fall with inflation , will experienced higher inflation risk. 4. Marketable/ liquidity — financial instrument which can be sold immediately at a price close to their market price are more marketable and liquid as compared to those that cannot be sold immediately. 5. Rates of return/yield — the return on marketable securities are dependent on the four factors described above. The higher the risk, the higher the return. However it must be said that safety/ liquidity should not be sacrificed for higher returns.MARKETABLE SECURITIES Types of marketable securities 1. Malaysian Treasury Bills (MTB) — MTB are short-term securities issued by the Government of Malaysia to raise short-term funds for Government's working capital. Bills are sold at discount through competitive auction, facilitated by Bank Negara Malaysia, with original maturities of 3-month, 6- month, and 1-year. The redemption will be made at par. MTB are issued on weekly basis and the auction will be held one day before the issue date. The successful bidders will be determined according to the most competitive yield offered. Normal auction day is Thursday and the result of successful bidders will be announced one day after. MTB are tradable on yield basis (discounted rate) based on bands of remaining tenure (e.g., Band 4= 68 to 91 days to maturity). The standard trading amount is RM5 million, and it is actively traded in the secondary market. 2. Malaysian Islamic Treasury Bills (MITB) — are issued to allow Islamic banks to hold liquid papers that meet their statutory liquidity requirements. 3. Promissory Note — A promissory note is a financial instrument that contains a written promise by one party (the note's issuer or maker) to pay another party (the note's payee) a definite sum of money, either on demand or at a specified future date. It is an unconditional promise to pay a specific amount to bearer or to the order of a named of person, on demand or on a specific date. It is a written promise by a maker to pay money to the payee.MARKETABLE SECURITIES Types of marketable securities 4. Bill of Exchange — A bill of exchange is a written order once used primarily in international trade that binds one party to pay a fixed sum of money to another party on demand or at a predetermined date. Bills of exchange are similar to checks and promissory notes—they can be drawn by individuals or banks and are generally transferable by endorsements. A bill of exchange transaction can involve up to three parties. The drawee is the party that pays the sum specified by the bill of exchange. The payee is the one who receives that sum. The drawer is the party that obliges the drawee to pay the payee. The drawer and the payee are the same entity unless the drawer transfers the bill of exchange to a third-party payee. 5. Negotiable Instrument of Deposit (NID) : also known as Negotiable Certificate of Deposit (NCD) are deposit certificates used in the wholesale money market that are regularly purchased and traded by institutional investors and high-net-worth individuals in the stock market. A negotiable CD is one that can be bought and sold on a secondary market. The bank that issues the original certificate sets the face amount and interest to be paid. In general, the longer the term, the higher the interest rate. Negotiable CDs mature over relatively short periods, from two weeks up to a year. At maturity, the holder of the CD receives the face amount from the issuer and the CD expires. If the bank restricts the DPB50113 BUSINESS FINANCE | fiedahusain CD so that it can't be transferred by the holder, and sets a penalty for the return of principal before maturity, then the CD is non-negotiable.MARKETABLE SECURITIES Types of marketable securities 6. Banker’s Acceptance : A bankers acceptance ( BA , aka bill of exchange) is a commercial bank draft requiring the bank to pay the holder of the instrument a specified amount on a specified date, which is typically 90 days from the date of issue, but can range from 1 to 180 days. A banker's acceptance is an instrument representing a promised future payment by a bank. The payment is accepted and guaranteed by the bank as a time draft to be drawn on a deposit. The draft specifies the amount of funds, the date of the payment (or maturity), and the entity to which the payment is owed. 7. Commercial Paper: Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of rarely more than 270 days. Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet short-term debt obligations (for example, payroll) and is backed only by an issuing bank or company promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized credit rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value and generally carries lower interest repayment rates than bonds due to the shorter maturities of commercial paper. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution pays. Interest rates fluctuate with market conditions but are typically lower than banks' rates.MARKETABLE SECURITIES Types of marketable securities 8. Repurchase Agreement (Repo): A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price.INVENTORY MANAGEMENT i Pres' Am” cas.Inventory is defined as a stock or store of goods. »These goods are maintained on hand at or near a business's location so that the firm may meet demand and fulfil its reason for existence. If the firm is a retail establishment, a customer may look elsewhere to have his or her needs satisfied if the firm does not have the required item in stock when the customer arrives. >\f the firm is a manufacturer, it must maintain some inventory of raw materials and work-in process in order to keep the factory running. In addition, it must maintain some supply of finished goods in order to meet demand. » Sometimes, a firm may keep larger inventory than is necessary to meet demand and keep the factory running under current conditions of demand. If the firm exists in a volatile environment where demand is dynamic (i.e., rises and falls quickly), an on-hand inventory could be maintained as a buffer against unexpected changes in demand. This buffer inventory also can serve to protect the firm if a supplier fails to deliver at the required time, or if the supplier's quality is found to be substandard upon inspection, either of which would otherwise leave the firm without the necessary raw materials. » Other reasons for maintaining an unnecessarily large inventory include buying to take advantage of quantity discounts (i.e., the firm saves by buying in bulk), or ordering more in advanceInventory types can be grouped into 3 classifications:- 1. Raw material Raw materials are inventory items that are used in the manufacturer's conversion process to produce components, subassemblies, or finished products. These inventory items may be commodities or extracted materials that the firm or its subsidiary has produced or extracted. "They also may be objects or elements that the firm has purchased from outside the organization. Even if the item is partially assembled or is considered a finished good to the supplier, the purchaser may classify it as a raw material if his or her firm had no input into its production. "Generally, raw materials are used in the manufacture of components. These components are then incorporated into the final product or become part of a subassembly. 2. Work-in-process Work-in-process (WIP) is made up of all the materials, parts (components), assemblies, and subassemblies that are being processed or are waiting to be processed within the system. “This generally includes all material—from raw material that has been released for initial processing up to material that has been completely processed and is awaiting final inspection and acceptance before inclusion in finished goods. “Any item that has a parent but is not a raw material is considered to be work-in- process 3. Finished goods “Finished good is a completed part that is ready for a customer order. Therefore, finished goods inventory is the stock of completed products. These goods have been inspected and have passed final inspection requirements so that they can be transferred out of work-in-process and into finished goods inventory. “From this point, ished goods can be sold directly to their final user, sold to retailers, sold to wholesalers, sent to distribution centers, or held in a of a customer order.WHY KEEP INVENTORY Why would a firm hold more inventory than is currently necessary to ensure the firm's operation? The following is a list of reasons for maintaining what would appear to be "excess" inventory. — danvary February March = April «= May June (Wemenay = 50 50 0) 100 200 200 (Predte ~—100 100 100 100 100 100 a 50 100 200 200 100 0 Table 1 : Inventory requirementsMEET DEMAND. In order for a retailer to stay in business, it must have the products that the customer wants on hand when the customer wants them. If not, the retailer will have to back-order the product. If the customer can get the good from some other source, he or she may choose to do so rather than electing to allow the original retailer to meet demand later (through back-order). Hence, in many instances, if a good is not in inventory, a sale is lost forever. KEEP OPERATIONS RUNNING. A manufacturer must have certain purchased items (raw materials, components, or subassemblies) in order to manufacture its product. Running out of only one item can prevent a manufacturer from completing the production of its finished goods. LEAD TIME. Lead time is the time that elapses between the placing of an order (either a purchase order or a production order issued to the shop or the factory floor) and actually receiving the goods ordered. If a supplier (an external firm or an internal department or plant) cannot supply the required goods on demand, then the client firm must keep an inventory of the needed goods. The longer the lead time, the larger the quantity of goods the firm must carry in inventory. A just-in-time (JIT) manufacturing firm, such as Nissan in Smyrna, Tennessee, can maintain extremely low levels of inventory. Nissan takes delivery on truck seats as many as 18 times per day. However, steel factory may have a lead time of up to three months. That means that a firm that uses steel produced at the factory must place orders at least three months in advance of their need. In order to keep their operations running in the meantime, on-hand inventory of three months’ steel requirements would be necessary.HEDGE. Inventory can also be used as a hedge against price increases and inflation. Salesmen routinely call purchasing agents shortly before a price increase goes into effect. This gives the buyer a chance to purchase material, in excess of current need, at a price that is lower than it would be if the buyer waited until after the price increase occurs. QUANTITY DISCOUNT. Often firms are given a price discount when purchasing large quantities of a good. This also frequently results in inventory in excess of what is currently needed to meet demand. However, if the discount is sufficient to offset the extra holding cost incurred as a result of the excess inventory, the decision to buy the large quantity is justified. SMOOTHING REQUIREMENTS. Sometimes inventory is used to smooth demand requirements in a market where demand is somewhat erratic. Consider the demand forecast and production schedule outlined in Table 1. Notice how the use of inventory has allowed the firm to maintain a steady rate of output (thus avoiding the cost of hiring and training new personnel), while building up inventory in anticipation of an increase in demand. In fact, this is often called anticipation inventory. In essence, the use of inventory has allowed the firm to move demand requirements to earlier periods, thus smoothing the demand.IMPORTANCE OF INVENTORY CONTROL The main goal of the inventory management is to minimize costs that are directly involved in the company. Balancing up the stock value is necessary for companies in order to maximize return on sales, thus providing good valve to return on assets. 1. Companies should avoid excessive stocking because it will adversely affect the company itself because the real level of sales cannot be made. 2. The first step in the management of inventory is to identify all the costs involved in purchasing and handling of inventory. This is to ensure that companies are operating at minimum cost. 3. The costs involved are: a) Carrying Cost - cost arising starting from the stock began to be in store until it is sold. - Example : cost of warehousing, storage costs b) Ordering Cost - Costs involved in the process of getting goods from suppliers. SAFETY STOCK REASONS FOR KEEPING SAFETY STOCK “Supplier may deliver their product late or not at all “The warehouse may be on strike “SA number of items at the warehouse may be of poor quality and replacements are still on order “SA competitor may be sold out on a product, which is increasing the demand for your products “Random demand (in reality, random events occur.) “Machinery breakdown “Unexpected increase in demandFactors Determine The Level Of Safety Stock: i. There is uncertainty in the demand level or lead time for the product; it serves as an insurance against stock outs. ji, Lack of Inventory If companies do not want to be in a situation where customer demand is not met, then the amount of safety stock that must be retained by the company should be improved to avoid losing sales. Inventory carrying costs if companies have to pay a high carrying cost, then the total safety stock should be reduced. With these reductions, will lower the average inventory and inventory carrying costs can be further reduced. CALCULATION RELATED TO INVENTORY 1 Total In ry cost (TIC) TIC = TCC + TOC ** TCC — TOTAL CARRYING COST, TOC — TOTAL ORDER COST DETERMINATION OF TOTAL CARRYING STOCK (TCC) TCC is dependent on the average stock, the percentage of cost savings and price for the stock. In other words, the calculation of the TCC are as follows: TCC=CXPXA C = the percentage of cost savings P = purchase price of the stock A= the average stockIf a company requires S units of goods X, per year, and orders Q in the same amount of N times a year, then: Quantity ordered each time is, Q= S/N Stock Average, A=Q/2 or A= min level + max level 2 min level = safety stock ; max level = min level + Q EXAMPLE: If Company A requires 300,000 units of goods X per year, and orders made 6 times a year, calculate the level of Q and average stock. If the unit price of items X is RM3.00 with the percentage of the cost savings is 11.25%, CALCULATE TCC DETERMINATION OF TOTAL ORDERING STOCK (TOC) Costs orders are fixed, it does not depend on the quantity ordered. TOC=O*N~ or Demand @ Sales X O Q O = order cost for each order ; N = number of each order per year EXAMPLE: If the cost of each purchase is RM150 and the company needs 300,000 units a year with stocks of goods X is an average of 30,000 units, N = 6. Calculate the TOCDETERMINATION OF ANNUAL STOCK PRICES (TIC - TOTAL INVENTORY COST) TIC = TCC + TOC TIC DETERMINATION WITH SAFETY STOCK: Safety Stock: + Stocks that exist to avoid the problem of loss of sales when the customer requests can not be met. - It is also kept to meet any requirements in the event of delay in receiving order from the supplier. = In other words, the safety stock is required when there is uncertainty between the point of order and delivery time. - If there is safety stock. It will affect the TCC and TIC: A=Q/2 + Safety Stocks EXAMPLE: Abu Lahab & Co. sells container to its customers. Company is expected to sell 260,000 units of containers next year. The cost per unit is RM6.20. Cost savings are estimated at 20% of the value of the container. Ordering cost is RM100 for each order. Calculate TIC for the company if the safety stock required is 1,000 units.Economic order quantity is the level of inventory that minimizes the total inventory holding / carrying costs and ordering costs. ECONOMIC ORDER QUANTITY MODEL (EOQ) Used to determine the minimum inventory cost. This is done through determining the total quantity of each order made to ensure that the total cost incurred is minimal. FOQ =V2XOXD@S € EXAMPLE: A company would like to know the amount should be ordered to minimize the inventory cost. Sales made for one year is 12,000 units. The percentage of carrying costs is 30% of the purchase value. The purchase price is RM12.00 per unit and the ordering cost is RM130 per order. Calculate: a) EOQ b) Number of orders ¢) TIC d) TIC if the safety stock required is 1,500 units.