CIFA – INTRODUCTION TO FINANCE AND INVESTMENTS REVISED KASNEB STUDY TEXT

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IFI sample

 

INTRODUCTION

Finance is called “The science of money”. It studies the principles and the methods of obtaining control of money from those who have saved it, and of administering it those into whose control it passes.

Involves the task of raising funds required the firm at the most favorable terms.

It’s the study of how best to raise funds needed the business and allocation of the utilized and the distribution of returns generated.

The above definition will therefore cover the four financial management functions namely;

  1. Financing function
  2. Investing function
  3. Dividend function
  4. Liquidity function

 

Financing function

The finance management is responsible for making projections of the firms’ future financial needs. He has to determine the companies fixed capital needs in the short, medium and long-term as well as the working capital needs.

He has to ensure that the finance is provided in the most appropriate form and for the purpose for which it is required at the lowest possible cost to the company.

He needs to be well equipped with the requirement of financial markets.

 

Investing function

The finance manager has to ensure that the funds raised are allocated to the most efficient and most productive uses so as to fulfill the company’s objective of maximizing shareholders wealth.

Liquidity function

The finance manager has additional responsibility of advising on the quantity and timing of funds since cash receipts and distribution don’t always consider.

He should ensure that the firms’ financial resources are well managed by;

  1. Ensure that there is proper management of working capital.
  2. Maintain optimal level of investments in each of the working capital items investments (stocks), debtors, opportunity costs in order to efficiently with deal cash shortage or surplus.

 

Dividend function

Involves allocation of profits available for distribution

Appropriate of earnings attributable to shareholders i.e. profit after interest and tax and preference dividend is paid out as cash dividend and the other proportion is to be retained for re-investment.

 

FINANCIAL DECISION-MAKING PROCESS

Managers and business owners must weigh financial considerations with every major decision they make for their firm. Whether the decision involves capital expansion, hedging assets or acquiring major equipment or merging with another firm, solid financial analysis will provide the assurance that the decision is made with the best information available. There are six factors to consider.

 The Opportunity

Financial analysis begins with a thorough description of the project being undertaken. This narrative includes background of the project, the current status and how you intend to complete the project. If, for example, you are planning to expand your business building a new facility, you should explain why you have outgrown your current location, why the proposed addition will solve your problem and how long it will take to become operational.

Accounting Considerations

Your analysis will include pro forma balance sheets, income statements and projected cash flow — with and without the expansion. This will be necessary to convince investors that you have thought through details and can justify the expense of the project being undertaken.

 

Financial Considerations

Financial considerations include the details regarding the cost of the project, what working capital is required and the sources of any funds that you do not already control. If you plan to borrow funds, then weigh the cost and terms of each potential lender — venture capitalist, bank or private investor. Determine what collateral is required and if there are any special terms and conditions.

 

Risk Factors

Assessing risk factors is essential. Many risks cannot be avoided. Fire, accidents on the job, business interruptions and non-performance a contractor are just a few of the risks you may encounter. Some require insurance; others you may self-insure. In any case, you must assess probabilities and present alternatives. Market risks and some risks of operations are uninsurable. If there is an environmental impact, then that too must be factored into your risk analysis.

 

ROI Forecast

While the forecast is implied in your pro forma financial statements, you need to address the return on investment, presenting best-case, likely case and worst-case scenarios. Since it is impossible to project business conditions with absolute certainty, offering a range of forecasts will provide assurance to investors that even with the worst case the project will have an acceptable return.

 

Legal Issues

Whatever project you are contemplating, there will be legal considerations. A physical expansion will raise environmental issues. The purchase of major equipment will require contractual agreements. There are federal, state and local ordinances and regulations that must be followed, and tax considerations that must be met at all levels.

 

RELATIONSHIP BETWEEN ACCOUNTING AND FINANCE

Finance can be defined as the art and science of managing money. Virtually all individuals and organization earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets and instruments involved in the transfer of money among and between individuals, business and governments. Finance, in another word, can be defined as the management of the flows of money through an organization, whether it be a corporation, school, bank, or government agency. Finance concerns itself with the actual flows of money as well as any claims against money. Finance is regarded as the life-blood of the business unit. This function involves planning, procurement and effective utilization of the funds of the business.

Accounting is the methodical or precise recording, reporting, and assessment of financial deals and transactions of a business. Accounting also involves the preparation of statements or declarations concerning assets, liabilities, and outcomes of operations of a business.

 

Relationship Between Finance and Accounting

Finance can be defined as the art and science of managing money. Virtually all individuals and organization earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets and instruments involved in the transfer of money among and between individuals, business and governments. Finance, in another word, can be defined as the management of the flows of money through an organization, whether it be a corporation, school, bank, or government agency. Finance concerns itself with the actual flows of money as well as any claims against money. Finance is regarded as the life-blood of the business unit. This function involves planning, procurement and effective utilization of the funds of the business.

Accounting is the methodical or precise recording, reporting, and assessment of financial deals and transactions of a business. Accounting also involves the preparation of statements or declarations concerning assets, liabilities, and outcomes of operations of a business.

 

Relationship Between The Two

Finance concerns with accounting because financial accounting is one branch of accounting. Accounting relates to booking of the historical transaction of an organization and it leads to preparation of financial status of the company stating that asset and what liabilities are held the entity as on the day when relevant period like a year ends i.e. Balance Sheet.

Financial status is concluded from the accounting records (i.e. balance sheet, profit and loss account). Account keeps the record of the organization’s income, expenditure, asset liabilities and evaluating those transactions finance makes the decision for investment like where to invest? How much funds to invest? Etc. In a short form we can say that where account ends of keeping records, finance starts the work evaluating them.

Finance is connected with accounting. The accounting process produces one of the essential raw materials needed to make financial decisions, financial data. Accounting is a tool for handling only the financial aspects of business operations. It is geared to the financial ends of business only because these are measurable on the scale of money values. The distinction between financial management and management accounting is semantic one, but the gap between the two is rapidly closing. Financial management, however, has the broader meaning of planning and control of all activities financial means, while management accounting originally meant the internal management of finance. The accountant devotes his attention to the collection and presentation of financial data. The financial officer evaluates the accountant statements, develops additional data and arrives at decisions based on his analysis. As a matter of fact, sound financial management is a matter of good accounting.

Accounting and Finance is a very important function of any business either for profit making or for non-profit making institutions. It provides an avenue where a business analyses its operations in terms of what they own, what comes and what goes out.

 

Goals of a firm

This can be divided into 2:

  1. Financial goals
  2. Non-financial goals

Profit maximization goals

The main aim of economic activity is earning profits

A business concern also functions mainly for the purpose of earning profit

Profit maximization however, is a traditional and narrow approach which aims at maximizing the profits of the business concern.

Favorable arguments for profit maximization (advantages)

The following points are important in the profit objective of the entity.

  1. Main aim is to make profit
  2. Profit is the economic measure of efficient business operation
  3. Profit is the main source of finance
  4. Profit reduces risk of business concern
  5. Profitability meets the social needs.

Unfavorable arguments for profit maximization (disadvantages)

  1. Leads to exploitation of workers and consumers
  2. Creates immoral practices such as corrupt practice and unfair trade
  3. Leads to inequality among shareholders
  4. Profit maximization is vague in the sense that it doesn’t specify the profit at the expense of his profitability.

 

Wealth Maximization:

Wealth Maximization is considered as the appropriate objective of an enterprise. When the firms maximize the stock holder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. Wealth maximization is the single substitute for a stock holder’s utility.

 

A Stock holder’s wealth is shown by:

Stock holder’s wealth = No. of shares owned x Current stock price per share. The higher the stock price per share, the greater will be the stock holder’s wealth.

Arguments in favour of Wealth Maximization:

  1. Due to wealth maximization, the short-term money lenders get their payments in time.
  2. The long-time lenders too get a fixed rate of interest on their investments.
  3. The employees share in the wealth gets increased.
  4. The various resources are put to economical and efficient use.

Argument against Wealth Maximization:

  1. It is socially undesirable.
  2. It is not a descriptive idea.
  3. Only stock holders wealth maximization does not lead to firm’s wealth maximization.
  4. The objective of wealth maximization is endangered when ownership and management are separated.

In spite of the arguments against wealth maximization, it is the most appropriative objective of a firm.

 

Non- financial goals

Are also known as corporate social responsibility (CSR) goals.

CSR goals can be defined as making a positive effort to help the society i.e. is the managerial responsibility to take actions that protect and promotes the welfare of the various stakeholders of the firm and not just shareholders.

Is organization’s responsibility to improve the overall welfare of society avoiding harmful practices. This has a long-term advantage to the firm and therefore in the long run the stakeholders’ wealth will be maximized.

Area of social responsibility 

Social responsibility may extend from the stakeholders towards;

Employees

  1. Paying fair salaries and wage
  2. Providing conducive working environment
  3. Offer opportunities for growth and development e.g. training
  4. Involve them in decision making

 

Customers

  1. Charging fair prices
  2. Providing relevant information pertaining commodity
  3. Offer good quality products and services
  4. Offer opportunities for growth and development e.g. training
  5. Be honest with weight measurements
  6. Regular supply of goods and services

 

  1. Suppliers/creditors
  2. Prompt payment
  3. Give accurate financial statements
  4. Negotiations should be done

 

Government

  1. Pay taxes promptly
  2. Refrain from engaging in unlawful practices
  3. Provide accurate information when applying for permits

 

Community

  1. Taking care of the environment
  2. Employing people within the community
  3. Giving bursaries to needy students
  4. Contributing to construction of schools and hospitals for less privileged

 

ROLES OF A FINANCE MANAGER

Financial managers perform data analysis and advise senior managers on profit-maximizing ideas. Financial managers are responsible for the financial health of an organization. They produce financial reports, direct investment activities, and develop strategies and plans for the long-term financial goals of their organization. Financial managers typically:

  • Prepare financial statements, business activity reports, and forecasts,
  • Monitor financial details to ensure that legal requirements are met,
  • Supervise employees who do financial reporting and budgeting,
  • Review company financial reports and seek ways to reduce costs,
  • Analyze market trends to find opportunities for expansion or for acquiring other companies,
  • Help management make financial decisions.

 

The role of the financial manager, particularly in business, is changing in response to technological advances that have significantly reduced the amount of time it takes to produce financial reports. Financial managers’ main responsibility used to be monitoring a company’s finances, but they now do more data analysis and advise senior managers on ideas to maximize profits. They often work on teams, acting as business advisors to top executives.

Financial managers also do tasks that are specific to their organization or industry. For example, government financial managers must be experts on government appropriations and budgeting processes, and healthcare financial managers must know about issues in healthcare finance. Moreover, financial managers must be aware of special tax laws and regulations that affect their industry.

 

 AGENCY THEORY CONCEPT, CONFLICT AND RESOLUTION IN A FIRM

Agency is a relationship that occurs between a principal and an agent. It arises when the principal hires an agent to perform some tasks on behalf of him.

In financial theory, the agency concept arises due to separation between the ownership of the business and management of business.

The ownership is rested in the hands of shareholders while the management of the business is left in the hands of the managers.

Shareholders, as owners can’t manage the business because of;

  1. Geographical distances hence lack of time
  2. Lack of relevant technical skills to manage the firm
  3. May be too many to manage a simple firm

An agency conflict arises due to the divergence of interest of principal (shareholders) and agent (manager).

 

Types of agency relationship

Shareholder (principal) versus management (agents)

In modern time, there is a significant separation between ownership and management of the firm. The owners provide funds and other resources and expect the management to put this to the best use. The management undertakes the day to day operations of the firm since they have the technical skills and expertise.

An agency problem presents itself whenever there is divergence of interest between the shareholder and management.

The following are some of the decisions management which would result in conflict with shareholders;

Sources of conflict between management and shareholders

  1. Managements may use corporate resources for personal use
  2. Managements may take holidays and spend huge sum of company money.
  3. Creative accounting – involves manipulation of finances
  4. Empire building – managers may organize for mergers beneficial to themselves and not shareholders.
  5. Failure to declare dividend for no good reason.

 

Resolution of conflicts

  1. Performance based remuneration

This involves remunerating managements for actions they take that maximizes shareholders wealth. Managements could be given bonuses, commission for superior performance in certain periods.

  1. Incurring agency cost

Agency costs are those incurred shareholders in trying to cut management behaviour and action and therefore minimize agency conflicts.

Types of agency costs

  1. Monitoring cost- arise as a result of mechanism put in place to ensure interest of shareholders are met. These include; cost of hiring auditors.
  2. Boding assurance – insurance taken for managers who engage in harmful practice.
  3. Opportunity cost- costs incurred either because of the benefit foregone for not investing in a riskier but more profitable investment or due to the delay when procedures have to be followed.
  4. Restructuring cost – Are costs incurred in changing an organization structure so as to prevent undesirable management activities.
    1. Direct intervention shareholders

These may be done in the following ways;

  1. Making recommendations to the management on how the firm should be run
  2. Threat of firing
    1. Use of corporate governance principles which specify the manner in which organizations are acted and managed. The duties and rights of all stakeholders are outlined.
    2. Threat of hostile takeover (sell the business)

This may be arranged shareholders to lock out managements who aren’t responsible

 

Creditors/suppliers/lenders (principals) versus shareholders/management (agents)

In this relationship the shareholders (agents) are expected to manage the credit funds provided the creditors. The shareholders manage these funds through management

The following actions shareholders through management could lead to conflict between them and creditors.

  1. Shareholders could invest in very risky projects
  2. Dividend payment to shareholders could be very high
  3. Default on interest payment
  4. Shareholders could organize mergers which aren’t beneficial to creditors
  5. Shareholders could acquire additional debt that increases the financial risk of the firm.
  6. Manipulation of financial statements so as to mislead creditors
  7. Shareholders could dispose of assets which are security for credit given

 

 Reduction of above conflicts

  1. Restrictive covenants: these are covenants/agreements entered into between the firm and creditors to protect the creditor’s interest.

Types of restrictive covenants

  1. Asset based covenants: states that the minimum asset base to be maintained the firm.
  2. Liability based covenants: this limits the firm’s ability to incur more debts
  3. Cash flow-based covenants: this states the minimum working capital to be held the firm
  4. It may also restrict amount of dividends to be paid in future.
  5. Control based covenants: these limits management ability to make various decisions e.g. providers of debt capital may require to be represented in the board meetings.
  6. Callability provision – this provision will provide that the borrower will have to pay the debt before the expiry of the maturity period if there is breach of terms and conditions of the bond covenant.
  7. The lenders may sue the company
  8. Incurring agency costs such as hiring external auditors
  9. Use of corporate governance principles so as to minimize the conflict

 

Shareholders (principals) versus external auditors (agents)

Auditors are appointed shareholders to monitor the performance of management

They are expected to give an opinion as to the true and fair view of the company’s financial position and performance as reflected in the finances that managers prepare.

Causes of conflict/problem

  1. When auditors collude with management in the performance of duty wherethe independence is compromised.
  2. Demanding very high audit fees which reduces the firms profit even when the company has a strong internal control system existing.
  3. Issuing unqualified reports which might be misleading to shareholders thus exposing them to investment loss.
  4. Failure to apply to professional care and due diligence in performance of audit work.

 

Resolution to conflicts

  1. Disciplinary actions such as;-
  2. Suspension of an auditor from practice
  3. Cancellation and withdrawal of practicing certificate
  4. Fines and penalties
  5. Shareholders can sue the auditors
  6. Shareholders can remove auditors from office at the time of AGM
  7. Shareholders can appoint audit committees to avoid collusion between management and audit department.
  8. Shareholders can appoint persons of integrity to fill the vacant position
  9. Fair remuneration of auditors can also minimize chances of conflict.

 

Shareholders versus government

The shareholders operate in environment using the license given the government.

The government expects the shareholders to conduct their business in a manner which is beneficial to the government and society at large.

The government in this relationship is the principal and the company is the agent.

 

Causes of conflicts

Shareholders may take some actions which may conflict the interest of the government as the principal. E.g.

  1. Company may involve itself in illegal business activities
  2. Shareholders may not create a clear picture of the earnings or profit it generates in order to evade taxes.
  3. The business may not respond to CSR activities initiated government
  4. Company may fail to ensure the safety of employees.
  5. Shareholder may avoid certain types of investments that the government proposes.

 

Resolutions to conflicts

  1. Government should give guidelines on minimum disclosure requirements for shareholder in order to eliminate tax evasion.
  2. Government may issue incentives inform of capital allowances in some given areas and locations.
  3. The government may encourage the spirit of CSR on the activities of the company
  4. Government may seek for directorship in some companies.

 

Head office and subsidiary/branch

Companies have diverse operations set up in different geographical locations. The headquarter acts as the principal and the subsidiary as an agent thus creating an agency relationship.

The subsidiary management may pursue its own goals at the expense of overall corporate goals. This will lead to sub-optimisation and conflict of interest with the headquarter.

This conflict can be resolved in the following ways:

  1. Frequent transfer of managers
  2. Adopt global strategic planning to ensure commonality of vision
  3. Having a voluntary code of ethical practices to guide the branch managers
  4. An elaborate performance reporting system providing a 2-way feedback mechanism.
  5. Performance contracts with managers with commensurate compensation package for the same.
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