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TECHNIQUES OF

enbassey
FINANCIAL MANAGEMENT
books series

0011MH06

By

Emmanuel Nelson Bassey

(MBA; CNA; NIAFA; ACIN) enbassey


books
-ii-
BOOKS PUBLISHED BY THE SAME AUTHOR PREFACE
1. ANATOMY OF INTERNET In preparing this edition, the opportunities have been taken
2. DATA PROCESSING HAND BOOK VOL 1 to review various texts in order to keep abreast of the
3. QUESTIONS AND SUGESTED SOLUTIONS ON
DATA PROCESSING current trends in FINANCIAL MANAGEMENT.
4. INTRODUCTION TO MS WINDOWS AND BASIC
PRINCIPLES OF COMPUTING THE AIMS
5. PROJECT FORMULATION AND MANAGEMENT.
6. NEW ERA ACCOUNTING “Economic performance in a democracy will depend on
7. COMPUTER BASED ACCOUNTING markets, how they are structured, and how they function.
8. ELEMENT OF DATA BASE MANAGEMENT Markets are important because they encourage individuals
SYSTEMS.
9. ADVANCED FINANCIAL ACCOUNTING to exert their vital energies, skills, ambition and risk taking
10. ADVANCED COSTING in the economic pursuits of life. The market moderates the
11. MANAGEMENT ACCOUNTING interplay of these vital energies in a way that minimises
12. SIMPLE APPRAOCH ON FINANCIAL MANAGEMENT conflict and so ensures the prevalence of peace and
13. COMPUTER OPERATIONS AND PACKAGES
14. MONEY MANAGEMENT AND FINANCIAL stability”
INSTITUTIONS IN NIG.
15. UNDERSTADING OFFICE ADMINISTRATION The text is particularly relevant to:
16. AN INTRODUCTION TO FINANCIAL MANAGEMENT
17. BUSINESS FINANCE • Students in Colleges, Polytechnics and Universities
18. ELEMENT OF BANKING offering financial management.
19. COMPUTER AND SOCIETY • Students preparing for foundation level
20. COMPUTER SCIENCE FOR SEC.SCH. JS 1 examination of any professional examination in Nigeria in
21. COMPUTER SCIENCE FOR SEC.SCH. JS 2
22. COMPUTER SCIENCE FOR SEC.SCH. JS 3
financial management and relevant examination in
23. COMPUTER SCIENCE FOR SEC.SCH. SS 1 management science department.
24. COMPUTER SCIENCE FOR SEC.SCH. SS 2 • School leavers, dropouts, job seekers, managers
25. COMPUTER SCIENCE FOR SEC.SCH. SS 3 and others in industry, commerce, local authorities and
26. COMPUTER SCIENCE FOR PRI.SCH. VOL 1 similar organisations who wish to gain a working
27. COMPUTER SCIENCE FOR PRI.SCH. VOL 2 knowledge of how finance could be obtained and managed
28. COMPUTER SCIENCE FOR PRI.SCH. VOL 3 • The professionals and intermediates for reference
29. COMPUTER SCIENCE FOR PRI.SCH. VOL 4 purposes. This text is to give a first hand knowledge to the
prospective bankers, accountants and management
science elite; serve as a companion/references text to the

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instructors and teachers of financial management in our
schools and colleges.
It also seeks to create an avenue for professional This edition is as a result of joint efforts of a number
development in global market place. of people and many instructors, academic colleagues
and students alike. I wish to thank the many people
who have made these contributions.
THE SCOPE
The author has received continued help from a number of
colleagues through their suggestions and contributions to
The text comprehensively covers the principles, individual chapters. Joseph E. Ekpo provided enthusiastic
techniques and methods involve in obtaining and support in this edition.
managing funds, investment and performance appraisal,
risk and interpretation of account.
My thanks also go to those who assisted in the typing of
the manuscript: John Abednego Effiong, Bridget Obeda,
The value of the book is considerably enhancing by the Augustine.
instructive illustrations and examples provided by the
numerous exercises which it offers.

Thus, considering the scope and its approach, the Above all, may all glory, honour and majesty
book will be found useful as a regular textbook. be ascribed unto our MOST HIGH GOD
through JESUS CHRIST OUR LORD AND
SAVIOUR. Amen.

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-v-
Acknowledgement
……….. FOR THE STUDENTS ……… 1. Gonel Systems Limited
2 Alegbo Road, Effurun
off P.T. I. Road,
Box 527, Effurun, Delta State. Nigeria.

This book has been written specifically for you. Your 2. Blessed Concept
instructor, teacher or lecturer will help you 139 P.T.I. Road,
understand the ideas developed in the text, but ---- in Effurun, Warri. Delta State. Nigeria.
the last analysis --- it is up for you to learn.
3. C.A.C.T. PUBLISHERS
Block B, Flat 8, Masoje Estate
I have concentrated on a style and format that should PTI Road. Effurun
help you to learn and understand when you study the Delta State. Nigeria.
chapters even alone. In the classroom, you can
4. Akwa Ibom State Polytechnic
reinforce this learning and see what others have to Continuing Education Centre.
say or what questions they raise. Your lecturer can KM 1 Refinery Road. Effurun.
supplement this process through the assignments, Delta State. Nigeria.
lectures and testing. I hope the experience will be
satisfying for you. 5. c/o Sister Udeme
Association Of National Accountants Of
Nigeria,
Herbert Maculae Road, Yaba.
Lagos. Nigeria.

LOCATIONS TO-vii-
OBTAIN EN-BASSEY’S BOOK TABLE OF CONTENTS
-viii-
Books by the same author…iii Preface… iv
Acknowledgement..vi
For the students…vii
Table of contents…ix

ONE
The scenario of financial management..11
Financial management levels….17
What is financial management….20
Objectives of FM…21
Decision making…24
Functions of finance manager..26
Goals of financial management…32
Sources of funds….34
Evaluation of financial policy

TWO
Financial planning ……45
Management information for planning ..45
Business forecasting…..46
Profit and loss forecast…55
Balance sheet forecast …56
Capital structure………57
Techniques of financial analysis……62

THREE
Woking capital management….79
decision areas…81
Managing working capital ….83
Key working capital -ix-
ratios..92
Liquidity ratio………94
Working capital and operating cycle..99
Principles of working capital…104
Concepts of working capital….106
Stock control…107
Stock control method…114

FOUR
Foreign currency transaction….130
Foreign exchange market…..131
Foreign exchange market in Nigeria..132
Modern foreign exchange market….135
THE SCENARIO OF
FIVE FINANCIAL
Allocation of dividend….145
Dividend defined…….146
MANAGEMENT
Types of dividends…..148
Method of payment…150
Dividend policy……..154 Finance is the science of funds management. The
Facts about dividend policy..154 general areas of finance are business finance,
Determinants of dividend policy…172 personal finance, and public finance. Finance
includes saving money and often includes lending
SIX money. The field of finance deals with the concepts
Mergers and Acquisition…..173 of time, money and risk and how they are
Classification of mergers…………..176 interrelated. It also deals with how money is spent
Types of takeovers…………184 and budgeted.
Reconstruction and reorganisation……..190
Finance works most basically through individuals and
business organisations depositing money in a bank.
The bank then lends the money out to other
-x- individuals or corporations for consumption or
investment, and charges interest on the loans.

-11- increasingly packaged for


Loans have become
resale, meaning that an investor buys the loan (debt)
from a bank or directly from a corporation. Bonds are financial intermediary such as a bank, or buy notes
debt sold directly to investors from corporations, or bonds in the bond market. The lender receives
while that investor can then hold the debt and collect interest, the borrower pays a higher interest than the
the interest or sell the debt on a secondary market. lender receives, and the financial intermediary
Banks are the main facilitators of funding through the pockets the difference.
provision of credit, although private equity, mutual
funds, hedge funds, and other organizations have A bank aggregates the activities of many borrowers
become important as they invest in various forms of and lenders. A bank accepts deposits from lenders,
debt. Financial assets, known as investments, are on which it pays the interest. The bank then lends
financially managed with careful attention to financial these deposits to borrowers. Banks allow borrowers
risk management to control financial risk. Financial and lenders, of different sizes, to coordinate their
instruments allow many forms of securitized assets activity. Banks are thus compensators of money
to be traded on securities exchanges such as stock flows in space.
exchanges, including debt such as bonds as well as
equity in publicly-traded corporations. A specific example of corporate finance is the sale of
stock by a company to institutional investors like
Central banks act as lenders of last resort and investment banks, who in turn generally sell it to the
control the money supply, which affects the interest public. The stock gives whoever owns it part
rates charged. As money supply increases, interest ownership in that company. If you buy one share of
rates decrease. XYZ Inc, and they have 100 shares outstanding (held
by investors), you are 1/100 owner of that company.
Of course, in return for the stock, the company
receives cash, which it uses to expand its business;
The main techniques and sectors of the financial this process is known as "equity financing". Equity
industry financing mixed with the sale of bonds (or any other
debt financing) is called the company's capital
An entity whose income exceeds their expenditure structure.
can lend or invest the excess income. On the other
hand, an entity whose income is less than its Finance is used by individuals (personal finance), by
expenditure can raise capital by borrowing or selling governments (public finance), by businesses
equity claims, decreasing its expenses, or increasing (corporate finance), as well as by a wide variety of
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organizations including
its income. The lender can find a borrower, a
organizations. In general, the goals of each of the • How can one plan for a secure financial future
above activities are achieved through the use of in an environment of economic instability?
appropriate financial instruments and methodologies,
with consideration to their institutional setting. Personal financial decisions may involve paying for
education, financing durable goods such as real
Finance is one of the most important aspects of estate and cars, buying insurance, e.g. health and
business management. Without proper financial property insurance, investing and saving for
planning a new enterprise is unlikely to be retirement.
successful. Managing money (a liquid asset) is
essential to ensure a secure future, both for the Personal financial decisions may also involve paying
individual and an organization. for a loan, or debt obligations.

Personal finance Corporate finance

Questions in personal finance revolve around Managerial or corporate finance is the task of
providing the funds for a corporation's activities. For
• How much money will be needed by an small business, this is referred to as SME finance. It
individual (or by a family), and when? generally involves balancing risk and profitability,
• Where will this money come from, and how? while attempting to maximize an entity's wealth and
• How can people protect themselves against the value of its stock.
unforeseen personal events, as well as those
in the external economy? Long term funds are provided by ownership equity
• How can family assets best be transferred and long-term credit, often in the form of bonds. The
across generations (bequests and balance between these forms the company's capital
inheritance)? structure. Short-term funding or working capital is
• How does tax policy (tax subsidies or mostly provided by banks extending a line of credit.
penalties) affect personal financial decisions?
Another business decision concerning finance is
• How does credit affect an individual's financial investment, or fund management. An investment is
standing? -14- an acquisition of an asset in the hope that it will
maintain or increase its value. In investment
management – in choosing a portfolio – one has to
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decide what, how much and when to invest. To do Financial management entails planning for the
this, a company must: future of a person or a business enterprise to ensure
a positive cash flow. It includes the administration
• Identify relevant objectives and constraints: and maintenance of financial assets. Besides,
institution or individual goals, time horizon, risk financial management covers the process of
aversion and tax considerations; identifying and managing risks.
• Identify the appropriate strategy: active v.
passive – hedging strategy The primary concern of financial management is the
• Measure the portfolio performance assessment rather than the techniques of financial
quantification. A financial manager looks at the
Public finance available data to judge the performance of
enterprises. Managerial finance is an interdisciplinary
In Government circle, finance is about governments’ approach that borrows from both managerial
income and expenditure, which invariably deals with accounting and corporate finance.
a nation’s budget for the year while budgets are
statements about the ways government, plans to Some experts refer to financial management as the
obtain income (i.e. revenue) and the ways it plans to science of money management. The primary
spend such income during a particular year. It could usage of this term is in the world of financing
be a deficit budget where expenditure is greater business activities. However, financial management
than the estimated revenue and as a result is important at all levels of human existence because
government plans to save for emergency situations every entity needs to look after its finances.
or carry out capital-intensive expenditure.
A surplus budget where government expenditure
equals estimated government revenue. Financial Management: Levels
The government acquires its revenue from the
following: Broadly speaking, the process of financial
a) Indirect taxes – eg custom duties, excise, management takes place at two levels. At the
purchase tax and sales tax. INDIVIDUAL LEVEL, financial management involves
b) Direct taxes eg personal income tax, company tailoring expenses according to the financial
tax, death duties, capital gains etc. resources of an individual. Individuals with surplus
c) Miscellaneous receipts from loans, profits, cash or access to funding invest their money to make
grants and fines and royalties. up for the impact of taxation and inflation. Else, they
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spend it on discretionary items. They need to be able Strong financial management in the business arena
to take the financial decisions that are intended to requires managers to be able to:
benefit them in the long run and help them achieve
their financial goals.
1. Interpret financial reports including income
From an organisational point of view, the process of statements, Profits and Loss or P&L, cash flow
financial management is associated with financial statements and balance sheet statements
planning and financial control. Financial planning
seeks to quantify various financial resources 2. Improve the allocation of working capital within
available and plan the size and timing of business operations
expenditures. Financial control refers to monitoring
cash flow. Inflow is the amount of money coming into
3. Review and fine tune financial budgeting, and
a particular company, while outflow is a record of the
expenditure being made by the company. Managing revenue and cost forecasting
this movement of funds in relation to the budget is
essential for a business. 4. Look at the funding options for business
expansion, including both long and short term
At the CORPORATE LEVEL, the main aim of the financing
process of managing finances is to achieve the
various goals a company sets at a given point of
5. Review the financial health of the company or
time. Businesses also seek to generate substantial
amounts of profits, following a particular set of business unit using ratio analyses, such as the
financial processes. gearing ratio,
profit per employee and weighted cost of capital
Financial managers aim to boost the levels of
resources at their disposal. Besides, they control the 6. Understand the various techniques using in project
functioning on money put in by external investors. and asset valuations
Providing investors with sufficient amount of returns
on their investments is one of the goals that every
company tries to achieve. Efficient financial 7. Apply critical financial decision making techniques
management ensures that this becomes possible. to assess whether to proceed with an investment
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8. Understand valuations frameworks for businesses, Objectives of FM.
portfolios and intangible assets
Taking a commercial business as the most common
organisational structure, the key objectives of
What Is Financial Management financial management would be to:

Financial management in Nigeria economy entails • Create wealth for the business(Wealth/profit
planning, controlling, disbursement, motivation and maximization)
implementation/supervision. Without finance all the
above cannot be established and without the • Generate cash, and
services of financial management, the above cannot
be achieved. • Provide an adequate return on investment bearing
T. Lucy in his financial accounting view defined in mind the risks that the business is taking and the
“financial management as the classification and resources invested
recording of monetary transactions of any entity
in accordance with established concepts, The above could be accomplished through:
principles, accounting standards and legal end of
an accounting period” 1. Increase in profit: a firm can maximize its
value through an enhancement of its revenue.
The revenue can be enhanced through
The author of this book defined financial stepping up the volume of sales or any other
management as the organisational activities that such activities. In theory, when a firm is
involve accounting, budgeting, and cash equilibrium, its profits are said to be maximum.
management. 2. Reduction in cost: A firm should work by all
means to reduce the cost of capital and to
In a broader sense, Financial Management can be launch economy drive in its operations.
defined as “The management of the finances of a 3. Sources of funds: a firm can raise funds in
business/organisation in order to achieve various ways through several sources. The
financial objectives” risk involved in all these sources are assessed
beforehand. While the issue of capital shares
increases the ownership funds of the
corporation, the issue of debenture and
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preference shares enhance the fixed recurring • Are assets being used efficiently?
obligations of it.
• Are the businesses assets secure?
4. Minimise risks: ‘NO RISK NO GAIN’ is a
popular slogan before embarking on any • Do management act in the best interest of
course of action. A firm will have to calculate shareholders and in accordance with business rules?
different types of risks which it may confront.
(3) Financial Decision-making

Elements of financial management The key aspects of financial decision-making relate


to investment, capital budgeting financing and
There are three key elements to the process of dividends:
financial management:
• Investments must be financed in some way –
(1) Financial Planning however there are always financing alternatives that
can be considered. For example it is possible to raise
Management need to ensure that enough funding is finance from selling new shares, borrowing from
available at the right time to meet the needs of the banks or taking credit from suppliers
business. In the short term, funding may be needed
to invest in equipment and stocks, pay employees • A key financing decision is whether profits earned
and fund sales made on credit. by the business should be retained rather than
distributed to shareholders via dividends. If dividends
In the medium and long term, funding may be are too high, the business may be starved of funding
required for significant additions to the productive to reinvest in growing revenues and profits further.
capacity of the business or to make acquisitions. [

Decision-making areas
(2) Financial Control
Financial management decisions are as follows:
Financial control is a critically important activity to a. investment decisions
help the business ensure that the business is
b. financing decisions
meeting its objectives. Financial control addresses
questions such as: c. dividend decisions
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c. Dividend decisions are concerned with the
a). Investment decision are concerned with the disposal of profits. Dividend is generally paid as
investment of funds. Funds can be invested in fixed some percentage of earnings on the paid-up capital.
assets and current assets. Investment of funds in The internal profitability versus the external
fixed as long-term implications, but immediate profitability (Walter’s Approach) analysis helps in
returns can be expected from investment in current developing the pay-out rate. The part of the profit
assets such as cash, receivables and inventories. which is not paid out as dividend constitutes the
The purpose is to identify project which can be source of internal financing.
accepted using the discounted flow (DCF) technique,
using the cost of capital as the cut-off criterion and The cost of capitals acts as the nucleus in the
also to choose the projects with high net present financing decision-making. It has a two-day effect on
value (NPV) or internal rate of return (IRR) if the the investment, financing and dividend decision. It
resources are limited. The investment decisions are influences and it turn is influenced by them. As the
also subjected to risk versus analysis as future cash cost of capital is the cut –off criterion in investment
flows are subject uncertainty. decision, it lead to the acceptance of rejection of
projects. Raises or lowers the cost of capital. The
financing decision affecting the cost of capital as its
b. Financing decisions concerned with the is the weighed average of the cost different sources
financing of business activities. The are intimately of capital. The need to the raise or lower the cost of
bound with the investment decisions. The financing capital, in turn, influences the financing decisions.
decision are helpful in planning for a balanced The dividend decisions try to meet the expectations
capital structure risk, return and control are the of the investors reflected through the cost of capital.
crucial factors relevant in formulating the financing
decisions Various analytical techniques like Function of finance manager
EPS/EBIT computations leverage calculations and The manager who looks after the activities of
interest dividend coverage estimates are used in the financial management is known as the finance
process of making financing decision. manager or the controller of finance. He is the key
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team. He performs several important functions in ii). Forecasting and estimating capital
close consultation with the chief executive of the requirements.
organization. The major functions of the finance
manager are as seen below. A finance manager has to estimate and forecast the
financial requirements of a business. He should
i) formulation of objectives make estimates for both short-term and long-term
requirements of funds. Unless proper thought is
ii) forecasting and estimating capital requirements. given to the financial requirements of the business,
iii) Designing the capital structure there will be either deficiency or surplus of funds. If a
business concern has excess capital, the
iv) Determining the suitable source of finance management may become extravagant in spending.

v). Procurement of funds


iii). Designing the capital structure
vi). Investment of funds
it denotes the kinds and proportions of different
vii). Dispersal of profits securities. Thus the capital structure of a company
viii). Maintaining of proper liquidity said to be the composition of equity and preference
capital and debt capital. After estimating the financial
ix). Maintaining of relations with the outside agencies requirement, the finance manager will have to design
the kind and proportion of various sources of funds
this should be based on the analysis of cost of
i). Formulation of objectives capital, consideration of factors such as risk, return
and control conditions in money and capital market.
Formulation of financial objectives is the fundamental
function of the finance manager. These objectives iv) Determining the suitable source of finance.
should be in tune with the overall objectives of the The decision to tap various sources of finance
organisation. depend upon the capital structures designed. On the
-26- basis of it, the finance manager has to determine the
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sources from which the funds are to be raised. The dividend out of the profits of the company. A large
management can raise finance from various sources number of factors such as the trend of earning of the
such as shares, debentures, financial institutions company, the trend of market price of is shares, the
commercial banks and so on. The finance manager flow position and so on, should influence these
should analyse the pros and cons of all these decisions. Thus this is an important area of financial
sources before making a final decision. management .

v). Procurement of funds. viii). Maintaining a proper liquidity.

After estimating the capital requirements and Every organization is required to keep some liquidity
deciding about the sources of finance, the finance for meeting its day-to-day needs. Availability of cash
manager has to take necessary steps to procure the is necessary to maintain is liquidity. Cash is needed
funds. to pay off creditors, purchase stock of materials, pay
labour, and to meet-to-day expenses. The finances
vi). Investment of funds. manager has the need for liquid assets and the
The funds procured should be prudently invested in arrange them in such a way that there is no scarcity
various projects. The technique of capital budgeting of funds.
may be helpful in selecting a project. Whole taking ix). Maintaining relation with the out agencies.
investment decision the finance manger has to keep
in mind the principles of profitability, liquidity and The finance manager should establish and maintain
safety. The principle of profitability should not be the cordial business relations with outside agencies such
only criterion of investment because if the fund are as financial institution, stock exchange, tax
blocked in unsafe projects, the solvency of the authorities and so on.
company will be in danger.

vii) Dispersal of profits. Scope of financial management

The finance manger has to decide how much to 1. FM provides a conceptual and analytical
retain for internal use and how much to declare as framework for financial decision making.
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2. It covers not only acquisition of funds but also Profitability
their effective utilisation in the business as In attempting to maximize a firm's profits there is
well. always a tradeoff between profitability and risk. The
greater the risk incurred in a decision, the greater the
3. It is an analytical way of viewing the financial anticipated profit demanded. Frequently, the decision
problem of the firm. is centered on whether the return on a specific
investment is sufficient to justify the risk involved.
4. It is concerned with the solution of the three
major problem relating to the financial to
Viability
the financial operation of the firm.
Firms want to stay in business, so it should be no
surprise that one of the goals of financial
management is to guarantee financial viability. This
Goals Of Financial Management goal is often measured in terms of liquidity and
solvency.
The primary goal of financial management is the Liquidity measures the amount of resources a firm
maximization of stockholder wealth, or in other terms, has that are cash or are quickly convertible to cash to
maximization of the firm's profits. Other goals could meet the obligations the firm has in the near term.
include-maximization of sales, maximization of Generally the near-term, or current, means one year
market share, maximization of the growth rate of or less. Thus a firm is liquid if it has enough current
sales, and maximization of the market price of the resources to meet its current obligations as they
firm's stock. Managers are also concerned with their become due for payment. Solvency is the same
salaries and perks. Frequently these are tied to concept as liquidity, except it if for the long term
improved return on investments (ROI), return on rather than near term. Long-term simply means more
equity (ROE), return on assets (ROA), or return on than one year. Does the firm have enough cash
net assets (RONA). Two major goals of financial generation potential over the long term to meet the
managers are profitability and viability. The firm major cash needs that will occur over this period? A
wants to be profitable, and it wants to continue in firm must plan for adequate solvency well in advance
business. because the potentially large amounts of cash
involved may take a long period of planning to
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generate. The roots of liquidity crises that put firms Responsibilities of the financial manager
out of business often are buried in inadequate long-
term solvency planning in earlier years. 1. Safeguarding funds;
2. Controlling funds (receiving and
It is not a good idea to be too conservative and disbursement);
attempt to have maximum liquidity and solvency. 3. Controlling revenue and expenditure;
Given that the goal of the firm is to make more 4. Classifying and coding of transactions;
money now and in the future, the financial manager 5. Accounting for revenue and expenditure;
must balance the need for solvency and liquidity with 6. Budget preparation, maintenance and control
the need to supply funds for the firm to continue to 7. Financial auditing;
grow and be fully invested and therefore profitable. 8. Gathering input/output data
Every dollar kept in a liquid form (such as cash,
treasury bills, or money market funds) is a naira that 9. Operating decision making tools;
could have been invested by the firm in some longer-
term, higher yielding project or investment. 10. Developing methods and techniques for

11. evaluating effectiveness and efficiency;


The role of financial management.
12.Transmitting information;
The role of financial management can be classified
13. Ensuring that activities comply with the lows or
into five main heading:
regulations that governs the organisation;
1. Raising of funds to finance a company.
14. Ensuring that funds are expended on
2 Financial analysis of company’s operation and
15. Programmes initially planned
growth considerations.
16. Raising funds;
3. Forecasting, monitoring and control of working
17. Giving financial advice.
capital cycle.
4. Selection, appraisal and control of capital
investment.
5. Valuation of business especially in relation to
acquisition and mergers.

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SOURCES OF FUNDS Below are the main sources of funds or capital,
available to businesses to improve and manage cash
Despite all the differences among companies, there flow.
are only a few sources of funds available to all firms.
1. Owner’s Capital- As you probably know, this is
1. They make profit by selling the product for more often the only source of capital available for the sole
than it costs to produce. This is the most basic trader starting in business. The same often applies
source of funds for any company and hopefully the with partnerships, but in this case there are more
method that brings in the most money. people involved, so there should be more capital
2. Like individuals, companies can borrow money. available. This type of capital though, when invested
This can be done privately through bank loans, or it is often quickly turned into long term, fixed assets,
can be done public through a debt issue. The which cannot be readily converted into cash. If there
drawback of borrowing money is the interest that is a shortfall on a cash flow forecast, the business
must be paid to the lender . owners could invest more money in the business. For
many businesses the owner may already have all his
3. A company can generate money by selling part of or her capital invested, or may not be willing to risk
itself in the form of share to investors, which is known further investment, so this may not be the most likely
as equity funding. The benefit of this is that investors source of funding for cash flow problems.
do not require interest payments like bondholders do.
2. Shareholders’ Capital – shareholders are of
In an ideal world, a company would bring in all of its course the owners of a limited company, they invest
cash simply by selling goods and service for profit. money in the hope of capital growth, (that is the
But as the old saying goes, “you have to spend business makes profits, grows, makes more profits,
money to make money, “and just about every so as the business becomes bigger their investment
company has to raise funds at some point to will be worth), and dividend (the shareholders share
develop products and expand into new markets. of the companies profits. It is quite normal for limited
companies to issue new shares (a Rights issue), in
Now let look at this issue more critically from the
an attempt to raise capital, but this is normally for
perspective of cash flow.

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investment, funding expansion or restructuring, not withdrawal of overdraft facilities by a bank. Even so
for solving a cash flow problem! fro short term borrowing, an overdraft is often the
ideal solution, and make businesses often have a
3. Retained Profit – At the end of the trading year a rolling (on going) overdraft agreement with the bank.
business will work out its profit. All of this profit can This then is often the ideal solution for overcoming
be taken by the owners, (this would be a dividend in short term cash flow problems, e.g. funding purchase
limited company), or alternatively some or all of it of raw material whilst waiting payment on goods
could be reinvested in the company, to help the produced.
business grow and therefore make even more profit
in the future. Retained profit is show as reserves on 5. Bank Loan – this is lending by a bank to
Balance Sheet, but can take the form of any businesses. A fixed amount is lent e.g. N10,000 for
business asset, so it may not be cash flow any fixed period of time, e.g. 3 years. The bank will
charge interest on this, and the interest plus part of
Retained Profit will be allowed for and shown in
the capital, (the amount borrowed), will have to be
opening balance, if it is held as cash. pay back each month. Again the bank will only lend if
the business is credit worthy, and it may require
4. Overdraft – this is a form of loan for a bank. A
security. If security is required, this means the loan is
business becomes overdrawn when it withdraws secured against an asset of the borrower, e.g. his
more money out of its account than there is in it, this House if a Sole Trader, or an asset or the business.
leaves a negative balance on the account. This is If the load not repaid, then the bank can take
often a cheap way of borrowing money as once an possession of the asset and sell the asset to get its
overdraft has been agreed with the bank the money back! Load are normally made for capital
business can use as much as it needs at any time, investment, so they are unlikely to be used to solve
short-term cash flow problems. But if a loan is
up to the agreed overdraft limit. But, the bank will of
obtained, then this frees up other capital held by the
course, charge interest on the amount overdrawn, business, which can then used for other purposes.
and will only allow an overdraft if they believe the
business is credit worthy i.e. is very likely to pay the
money back. a bank can demand the repayment of 6. Leasing- with leasing a business has the use of
an overdraft at any time. Many businesses have an asset, but pays a monthly fee for its use and will
been forced to cease trading b because of the never own it. Think, of, someone setting up business
-36- -37-
as a Parcel Delivery Services, he could lease the van done by delaying paying bill for extra 14 days,
he needs from a leasing company. He will have to meaning there will more cash in the bank for this
pay a monthly leasing fee, say N 250, which is very period unfortunately this type of action may upset
useful if he does not wish to spend N 8,000 on businesses suppliers, after all they have their own
buying a van. This will free up capital, which can now cash flow to think of! The next time the business
be used for other purposes. A business looking ot wanted credit from a supplier they had been very
purchase equipment may decide to lease if it wishes slow in paying in the past, they may be turned down!
to improve its immediate cash flow. In the example slow payment by debtors is the problem for many
above, if the van had been purchased, the flow of businesses, and in fact the government had tried
cash out of the business would have been N 8,000, take action against this type of behaviour in several
but by leasing the flow out of the business over the budgets.
first year would be N 3,000, leaving possible N 5,000
for other assets and investment in the business. 9. Selling Assets – A business can sell assets it
Leasing also allows equipment to be updated on a owns to raise capital!! This is often a last gasp
regular basis, but it does cost more than outright measure as assets usually vitally necessary to
purchase in the long run. business activity. In some cases the business may
lease back the assets so that it still retains it use but
7. Hire Purchase - This is similar to leasing, but at this often the preserve of big business e.g. the sale
the end of the hire period the asset belongs to the and lease back of office blocks. Selling assets, and
company that hires it. E.g. a farmer could hire leasing and assets back improves cash flow in the
purchase a tractor. short term. If the cash raised from the sale of the
assets is used effectively by the business, cash flow
8. Buying on credit –this create creditors. If and profitability can also increase in the long term.
business, which sells shoes, buys on credit from
Johnson’s shoes, it may not have to pay Johnson’s 10. Debtors – if a firm is in immediately need of
for a month after delivery. This means it could sell cash it could chase its debtors for repayment. This
the shoes at a profit and have the money at the end may involve giving discount for early repayment.
of the month to it bill to Johnson’s. Extending a credit Chasing for early repayment may lease to long term
period will help short term cash floe this could be loss of trade as the debtors may buy from another
-38- -39-
business next time, but can effective method of EVALUATION OF FINANCAIL POLICY
solving short term cash flow problems. formula sheet only.
11. Factoring – for larger firms, with a turnover Average Tax Rate =
(sales) of 1,000,000 or more a year, it is possible to
let a factor manage your debtors for you. The factor Current Rate =
(a type of finance company) will pay 80 % of the
value of an invoice at the time of sale and will take Quick ratio =
responsibility for receiving payment from the debtor.
Cash ratio =
The balance of the debt will be passed on when the
money is received by the factor. There is of course a Total Debts ratio
charge for this and the amount of charge will depend
upon several issues such as, number of debtors, size = =
of debts, past bad debt history. But factoring dose
improve a businesses cash flow and it popularity Debt – to Equity Ratio=
amongst small to medium size businesses prove ROA =
many managers and owner regard this service as
goods value for money.

Time Interest Earned =


-41-=
Cash Coverage Ratio

Total Assets Turnover =

Fixed Assets Turnover =

InventoryTurnover=OR
-40-
Profit Margin (ROS)= =

ROE =

PRACTICE QUESTIONS
-43-
1. What factor has contributed to the importance

of financial management in recent years?

Return on Capital 2. Why should finance be managed?


-42-
3. A financial manager makes decisions, which

Basic Earning Power = directly affect the flow of funds in an organisation.

Discuss.
Earning per share = 4. What are the significance of financial

management?
Price - Earnings Ratio = 5. What is the role of finance in the Nigeria
Dividend pay out ratio = Dividends ÷ Net Income economy, and how can financial management

be used to further national goals?


Market value – Book Value Ratio
departments and by the central statistical office,
which performs the major task of constructing and
presenting statistics over a very wide field of
activities. The formation available from government
sources is so wide that only a few can be included for
illustration purposes.
a. National income and expenditure.
-44- b. Annual abstract of statistics.
c. Department of employment gazette.
d. Monthly digest-45-
of statistics.
e. Trade and industry.
f. Census of production.
g. Central Bank of Nigeria Quarterly Bulletin.

Financial Institutions
a. Clearing Bank Review.
b. Reviews and Statistics by Stock Exchange,
c.Finance Houses Associations etc.
d. Financial publications via the press e.g.
FINANCIAL PLANNING e.Financial Times, Business Concord, etc.

Others
MANAGEMENT INFORMATION a. National Economic Development Council.
FOR PLANNING b. National institute for Economic Review.
The main sources from which information necessary c. Employees’ Organisations.
for preliminary financial planning may be derived d. Employers’ Organisations.
from:… e. Trade associations

Government Sources Leading indicators for financial planning are:


This would embrace publications issued by specific 1. Business Times Share Index
2. Changes in Exchange Rates.
3. Index of Industrial Production. In addition, he will be concerned with the
4. Levels of Stocks of Raw Materials. presentation and interpretation of forecast to
management and the comparison of the forecast with
the actual results.
BUSINESS FORECASTING
Introduction SALES FORECAST
It is necessary to distinguish between Budget and The state of the market is the basic variable
Forecast. A forecast is concerned with ‘probable elements affecting the future of any business,
events’ while a budget relates to panned events and although in conditions of high demand, shortage of
a statement of the policy to be carried out. Complex materials, capital -47-
or capacity may determine the
-46-
or long term forecasts naturally involve range of extent to which demand can be satisfied
problems. In such a situation, the most convenient
method is to subdivide the work according to the The purpose of sales forecast
main function of the business. A sales forecast may be needed
a. To establish sale budget.
In this chapter, the forecast will be subdivided into b. To aid management decision e.g. by estimating
(a) Sales forecast the profitability of new product or by product.
(b) Output forecast c. To plan production leading over to a given period,
(c) Capital expenditure forecast to allow for cyclical and seasonal fluctuations.
(d) Trading results forecast. d. To provide studies of the market for future
(e) Cash forecast. references and for the guidance of long term
management policy rather than to aid particular
The Accountant must be ready to supply from his decisions.
record to other departmental heads details and
reliable background data as to past experience and Factors influencing the level of sales
recent trends of sale, output and capital expenditure Factors likely to influence the level of sales may be
forecast. either external or within the control of management.
He may be called upon to carry out the arithmetical The external factors likely to influence the level of
work of translating quantitative estimates into money sales are as follows
totals, and will act as a coordinator, Keeping watch or 1. Fluctuation in the size of the population
inconsistencies in figures submitted to him. and in its sex and age make up.
2. The general level of prosperity. The level of
employment and income purchasing power, the trend buildings, plant and labour?
of consumption, the rate of investment and the
psychological factors of confidence in the future.
3. The extent and severity of competition in The essence of the above questions is to be able to
the market and the probable availability of substitute find
products 1. A combination of plant and labour that can
4. The repercussion of world events, such as war, produce the forecast sales at the lowest cost;
international tensions, arms races, economic 2. The most efficient use of resources to meet a
development projects, new inventions etc. given sales programme.
5. Government policy and regulations e.g. import Factors affecting output fore-cast
restrictions. -48- a. Materials-49-
6. Social changes brought about by redistribution of 1. Quantity required
income. 2. Quality required
7. Seasonal and cyclical fluctuations. 3. Price trends
4. Availability and source of supply
5. Frequency and size of deliveries
OUTPUT FORECAST 6. The possibility of using substitutes
7. The production of buy-products
Purposes of output forecast
In order to be able to forecast output, one should be External factors, which must be considered in
able to answer the following questions forecasting turnover from export sales, are
1. How can the value of sales on forecast be 1. Restrictions imposed by exporting country
produce? 2. Restrictions imposed by the government of the
2. What normal stock level of finished goods and market countries.
work-in progress are necessary to make the 3. Restrictions imposed by trade associations and
output available at the time it is required? similar bodies set up.
3. Can seasonal sales fluctuation be absorbed by 4. The number and extent of the sources of
temporary adjustment of stock levels? competition.
4. What difficulties have to be overcome in order 5. Economic trends affecting the prosperity of
to obtain raw materials, labour and services particular markets.
5. What is the effect of expansion, contraction or 6. The necessity of satisfying markets, which have
substitution on the available or utilization of special requirement due to local conditions.
4. Statutory regulations.
Controllable factors influencing the level of 5. The influence exerted by trade unions.
sales are as follows; 6. The problems of redundancy and redeployment
1. The use of promotion aids, such as market of labour.
research, advertising, incentives to salesman
and distributors. c. Buildings, plant and equipment
2. The ability of the organization to satisfy Any projected change in the products to be
demand, which must in the short run, set the manufactured, new methods of handling materials
upper limit of sales. and of production are factors which may influence
3. The quantity of the financial products. the need for alterations or additions to buildings,
4. The level of selling-50-
prices, changes of which -51-
plant and equipment.
depend on the degree of elasticity of demand
for the product. d. Services
The following internal and external services should
Additional controllable factors to be considered in be considered.
respect of export sales are; i). Coals, gas, electricity, hydraulic power,
1. Price policy. Management may consider a compressed air, water supplies.
policy of price discrimination in certain export ii). Adequacy of internal transport.
markets, perhaps in the form of ‘dumping’ or iii). External transport by road, air and water.
selling below cost in order to establish control
over particular area.
2. Methods of distributions. Sales may be made CAPITAL EXPENDITURE FORECAST
through distributors associate selling The need for a forecast of capital expenditure arises
companies, or direct for government buying because circumstances change or can be changed.
agencies. Factors to be considered are:
1) The necessity of replacing assets as they become
b. Labour worn out or obsolete.
1. The type and availability of labour. 2) The need for more or less machinery, plant or
2. The size of the labour force at a particular period building which may be revealed by the sales and
having regards to machine, staffing etc output forecast.
3. The cost of labour, hours of work needed for 3) Any important change in capital equipment.
shift work, overtime and night work. 4) New or improved plant or machinery may become
available. Buildings and services.
(2) Changes in the prices of products sold and
discount allowed.
FORECAST OF TRADING RESULTS (3) The necessity for holding larger stocks or giving
The form and extent of trading forecasts are extended credit.
influenced by two factors: (4) Alteration in bank credit facilities.
(5) Changes in taxation.
The kind of activity under forecast and the purpose of
the forecast. Forecast may be grouped into three
broad categories. CASH FORECAST
1. Those concerned with -52-
a series of events and their -53-
The liquidity of a business depends on a correct
correlation over a comparatively short period. assessment of the factors affecting the cash forecast.
2. Those dealing only with a major change in The need to know the probable effect of future
conditions or a single event, such as the marketing events on the cash position of a company arises:
of a new product or by-product, the introduction of (1.) To ensure that sufficient cash is available for
a new process or machine or the opening of a new revenue, expenditure including cover for the ordinary
market. trading fluctuation of manufacturing stocks and
3. Those involving a survey of all the changes in selling goods.
conditions and events, which may affect a (2.) To indicate where additional finance is needed
business over a considerable period such as long and when.
plan for development over a period of, say 10 or (3.) To preserve sufficient liquidity throughout the
20 years. year to reveal surplus cash resources which may be
available for profitable investment externally of for
Period: The period covered by the trading forecast expansion of facilities.
will vary not only with the nature of the project but (4.) To provide a guide to show whether external
also with the industry, type of business or prevailing capital investment must be financed from external
market conditions. sources or from internal funds.

Preparation: In the preparation of trading results


forecast, the following consideration will have to be Factors affecting cash forecasts
taken into account. The factors that affect cash forecast are as follows:
(1) Changes in prices of materials, labour, plant.
(1) Programmes of expansion or contraction involved with the manufacturing of your
particularly with regard to fixed assets. product) and other direct costs.
(2) Increase or decrease in level of stocks, work-in- • Gross Profit - This is total cost of sales figure
progress and debtors. minus sales.
(3) Increase or decrease in value of stocks, work-in – • Overheads - This is where you would list all
progress and debtors through the effects of changing the expenses involved in running the
price levels. business, such as rent and rates, heating and
lighting, telephone, drawings and so on.
Methods of cash forecast
There are three methods of making a cash forecast: • Total Overheads - This is the total sum of the
(a) Receipts and payment basis suitable for short- above.
term forecasts. -54- -55-
(b) Profit and loss basis suitable for longer forecasts. • Miscellaneous income - This is where you
(c) Balance sheet basis mainly for long-term would put the estimate figure of any other
forecasts. income you might receive that is not from the
sale of your product. For example, interest
PROFIT AND LOSS FORECAST from money invested.
A profit forecast is the amount of profit you expect to • Net Profit - The net profit figure is the gross
make at the end of the period. The monthly profit and profit plus the miscellaneous income minus
loss forecast will consist of the following: the total overheads.

• Sales - This is the cash you receive during a BALANCE SHEET FORECAST
period of time including what you are owed, The Balance Sheet forecast is an estimate of what
minus what you were owed at the end of the your business owe and own at a particular period of
previous period. You do not include the time. It consists of the following:
amount of VAT here as you do in the cashflow
forecast. • Fixed Assets - This is items such as property,
• Cost of sales - This is the cost that you furniture, machinery, and fittings, vehicles that
estimate will vary with the level of your sales. are acquired for use in the business over a
It will include items such as purchases (such prolonged period of time.
as raw materials or items you buy to sell), • Total Fixed Assets - This is the total figure of
labour (any employees who are directly the above.
• Current Assets - These are mainly cash in There are many useful sources that can help you
hand and at the bank, stock (includes any raw draw up your forecasts, which include banks that
materials or half-finished products not yet sold) usually provide the template for forecasts. Your
and debtors (what the customers owe you). accountant can also help you to produce the
• Total Current Assets - The total sum of the forecasts.
above.
• Total Assets - The total fixed assets plus the
total current assets. CAPITAL STRUCTURE

In finance, capital structure refers to the way a


corporation finances its assets through some
combination of equity, debt, or hybrid securities. A
firm's capital structure is then the composition or
-56-
Capital and Liabilities -57- For example, a firm that
'structure' of its liabilities.
sells N20 billion in equity and N80 billion in debt is
• Capital - This would be the money used to said to be 20% equity-financed and 80% debt-
start your business. You would also put I the financed. The firm's ratio of debt to total financing,
figure for profit and loss taken from your profit 80% in this example, is referred to as the firm's
forecast. If you forecast a loss, you would leverage. In reality, capital structure may be highly
need to put this in brackets and deduct from complex and include tens of sources. Gearing Ratio
your capital. is the proportion of the capital employed of the firm
• Liabilities - The liabilities of a business may which come from outside of the business finance,
be of two types: current liabilities such as e.g. by taking a long term loan etc.
overdrafts, tax payable (including VAT) and
creditors (what you owe to your suppliers at
the end of the period) and long tem liabilities 1. Equity capital or financing is money raised by a
such as loans. business in exchange for a share of ownership in the
company. Ownership is represented by owning
The Working Capital is the value of the current shares of stock outright or having the right to convert
assets of the business less the current liabilities. The other financial instruments into stock of that private
Working Capital is essential to businesses, the lack company. Two key sources of equity capital for new
of which is a common reason for business failure.
and emerging businesses are angel investors and
venture capital firms. 3. Hybrid security: Hybrid Securities are tradable
securities possessing characteristics borrowed from
2. Debt capital is the capital that a business raises both debt and equity instruments. Their myriad forms
by taking out a loan. It is a loan made to a company make understanding and evaluating the risk / return
that is normally repaid at some future date. Debt trade-off imperative if investors are to make informed
capital differs from equity or share capital because decisions to include or exclude a component of these
subscribers to debt capital do not become part securities in their portfolios.
owners of the business, but are merely creditors, and Hybrid Securities pay a predictable (fixed or floating)
the suppliers of debt capital usually receive a rate of return or dividend for a certain period of time,
contractually fixed annual percentage return on their usually until a maturity or conversion date. At that
loan, and this is known as the coupon rate. date the holder has a number of options including
converting the securities into the underlying share or
-58- cash or more commonly-59-reset for another term. Each
Differences Between Debt and Equity Capital issuer determines the specific terms of the
Debt Capital: Debt capital is represented by funds conversion.
borrowed by a business that must be repaid over a
period of time, usually with interest. Debt financing Therefore, unlike a share the holder has a “known”
can be either short-term, with full repayment due in cash flow, and, unlike a fixed interest security, there
less than one year, or long-term, with repayment due is an option to convert to the underlying equity. More
over a period greater than one year. The lender does common examples include convertible and
not gain an ownership interest in the business and converting preference shares. Converting preference
debt obligations are typically limited to repaying the shares means that at the maturity date (or
loan with interest. Loans are often secured by some conversion date) the security converts into ordinary
or all of the assets of the company. shares whereas with a convertible preference share,
the holder has the option of redeeming to cash or
Equity Capital: Equity capital is represented by funds converting to shares.
that are raised by a business, in exchange for a
share of ownership in the company. Equity financing
allows a business to obtain funds without incurring 4. Vendor financing: A loan from one company to
debt, or without having to repay a specific amount of another which is used to buy goods from the
money at a particular time. company providing the loan. In this way, the vendor
increases sales, earns interest, and may sometimes 6. Sweat equity: The equity that is created in a
also acquire an interest in the customer. This company or some other asset as a direct result of
increases the risk profile of a company if it is carried hard work by the owner(s).
out on a large scale, since many companies do not
have the skill to conduct credit analysis. Large, Sweat equity is a term used to describe the
creditworthy buyers are unlikely to make use of this contribution made to a project by people who
arrangement, since they will be able to borrow contribute their time and effort. It can be contrasted
money at lower rates from other sources. with financial equity which is the money contributed
towards the project. It is used to refer to a form of
compensation by businesses to their owners or
5. Insurance float: In the insurance industry, "other
employees. The term is sometimes used in
people's money" is known as float. Float is such a
partnership agreements where one or more of the
valuable form of capital because not only does the
partners contributes no financial capital. In the case
insurance company -60-get to keep the investment
of a business startup, employees might, upon
income, but also the company's cost of capital is
incorporation, receive stock or stock options in return
often low or even positive. -61-
for working for below-market salaries (or in some
cases no salary at all).
The Power of Float: The source of insurance funds is
"float," which is money that doesn't belong to the firm
The term is sometimes used to describe the efforts
but that it is temporarily hold. Most of the float arises
put into a start-up company by the founders in
because
exchange for ownership shares of the company. This
concept, also called "stock for services" and
(1) premiums are paid upfront though the service
sometimes "equity compensation" or "sweet equity"
provided - insurance protection - is delivered over a
can also be seen when start-up companies use their
period that usually covers a year and;
shares of stock to entice service providers to provide
necessary corporate services in exchange for a
(2) loss events that occur today do not always result
discount or for deferring service fees until a later date
in immediately paying claims, because it sometimes
takes many years for losses to be reported,
TECHNIQUES OF FINANCIAL ANALYSIS
negotiated and settled..
Break-even analysis and ratio analysis are going to
be used here.
Break-even analysis
Break-even analysis is a technique widely used by
production management and management
accountants. It is based on categorising production
costs between those which are "variable" (costs that
change when the production output changes) and
those that are "fixed" (costs not directly related to the
volume of production).

Total variable and fixed costs are compared with


sales revenue in order to determine the level of
sales volume, sales value or production at which
the business makes neither a profit nor a loss
(the "break-even point").
-62-
The Break-Even Chart

In its simplest form, the break-even chart is a In the diagram above, the line OA represents the
graphical representation of costs at various levels of variation of income at varying levels of production
activity shown on the same chart as the variation of activity ("output"). OB represents the total fixed costs
income (or sales, revenue) with the same variation in in the business. As output increases, variable costs
activity. The point at which neither profit nor loss is are incurred, meaning
made is known as the "break-even point" and is -63- that total costs (fixed +
variable) also increase. At low levels of output, Costs
represented on the chart below by the intersection of are greater than Income. At the point of intersection,
the two lines: P, costs are exactly equal to income, and hence
neither profit nor loss is made.

Fixed Costs
Fixed costs are those business costs that are not
directly related to the level of production or output. In
other words, even if the business has a zero output
or high output, the level of fixed costs will remain
broadly the same. In the long term fixed costs can include depreciation (where it is calculated related to
alter - perhaps as a result of investment in production output - e.g. machine hours), maintenance and
capacity (e.g. adding a new factory unit) or through certain labour costs.
the growth in overheads required to support a larger,
more complex business. Semi-Variable Costs

Examples of fixed costs: Whilst the distinction between fixed and variable
- Rent and rates costs is a convenient way of categorising business
- Depreciation costs, in reality there are some costs which are fixed
- Research and development in nature but which increase when output reaches
- Marketing costs (non- revenue related) certain levels. These are largely related to the overall
- Administration costs "scale" and/or complexity of the business. For
example, when a business has relatively low levels of
Variable Costs output or sales, it may not require costs associated
with functions such as human resource management
Variable costs are those costs which vary directly or a fully-resourced finance department. However, as
with the level of output. They represent payment the scale of the business grows (e.g. output, number
output-related inputs such as raw materials, direct people employed, number and complexity of
labour, fuel and revenue-related costs such as transactions) then more resources are required. If
commission. production rises suddenly then some short-term
increase in warehousing and/or transport may be
A distinction is often made between "Direct" variable required. In these circumstances, we say that part of
costs and "Indirect"-64-
variable costs. the cost is variable -65-
and part fixed.

Direct variable costs are those which can be directly We can relate Break-Even Point to the information in
attributable to the production of a particular product our financial statements, particularly the Income
or service and allocated to a particular cost centre. Statement. The Income Statement should be
Raw materials and the wages those working on the organised into the following sections:
production line are good examples.
1. Revenue
Indirect variable costs cannot be directly attributable
to production but they do vary with output. These
The sum of all sales and other income net of returns Once you have your financial statements and data in
and sales commissions. the right format, you can easily calculate Break-Even
using the following formula as:
2. Cost of Sales (Cost of Goods Sold)
Break-Even Point = FC/(1-VC/S)
The cost of purchases that are resold (merchandise)
and/or raw materials plus the costs of labor to Where: FC = Fixed Costs
manufacture the product or convert it or install it or
deliver it or construct it on site. These costs are also
called direct or variable costs. VC = Variable Costs

3. General & Administrative Costs


(Overhead) S = Sales

These are all the costs not directly, or easily, related For illustrative purposes, let’s look at an example
to sales volume such as Advertising, Bank Charges, company, Umeh Global Ventures, had the following
Computer Expenses, Insurance, Office Wages & data from its Income Statement:
Salaries, Officer’s Compensation, Telephone,
Utilities, Depreciation, Interest, Taxes etc. These Sales = N1,000,000
costs are also called indirect or fixed costs.
Cost of Goods Sold = N 710,000

4. 1 minus 2 minus 3 = PROFIT. General & Admin = N 215,000


-66-
Note: If your Income Statement is not organised in Break-Even Point (during the period indicated by the
this fashion (called managerial accounting format), -67-
income statement) is:
you need to have a session with your accountant
and demand it be put into this format so you can Break-Even Point = FC/(1-VC/S) and
manage the business better.
VC/S = 710,000/1,000,000 = .71

1- VC/S = 1 - .71 = .29


FC/(1-VC/S) = 215,000/.29 = $741,379 = BEP This is assuming, of course, that fixed costs can be
accurately or, at least, reasonably associated with
And the company operated at N 1,000,000/741,379 = the organisers above.
135% of Break-Even during the period.
Ratio Analysis
Note that ..Break-Even can be calculated for: Ratio analysis was developed to determine the
stability of various financial aspects of a business. It
A Company shows the relationship between two figures, or two
aspects of your business. It helps you work out your
A Division business' financial weaknesses and strengths, so
that you can take appropriate action.
A Location Ratio analysis also offers a view of your business'
competitive performance in relation to similar
A Department businesses in your industry.

A Store Financial ratio analysis is the calculation and


comparison of ratios which are derived from the
A Product information in a company's financial statements. The
level and historical trends of these ratios can be used
A Product Line to make inferences about a company's financial
condition, its operations and attractiveness as an
A Service investment

A Day Financial ratios are calculated from one or more


-68- pieces of information from a company's financial
A Week statements. -69-

A Month For example, the "gross margin" is the gross profit


from operations divided by the total sales or
A Year (or any other time period) revenues of a company, expressed in percentage
terms. In isolation, a financial ratio is a useless piece
of information. In context, however, a financial ratio
can give a financial analyst an excellent picture of a • Profitability Ratios which use margin
company's situation and the trends that are analysis and show the return on sales and
developing. capital employed.
• Solvency Ratios which give a picture of a
A ratio gains utility by comparison to other data and company's ability to generate cash flow and
standards. Taking our example, a gross profit margin pay it financial obligations.
for a company of 25% is meaningless by itself. If we
know that this company's competitors have profit It is imperative to note the importance of the proper
margins of 10%, we know that it is more profitable context for ratio analysis. Like computer
than its industry peers which is quite favourable. If programming, financial ratio is governed by the
we also know that the historical trend is upwards, for GIGO law of "Garbage In...Garbage Out!" A cross
example has been increasing steadily for the last few industry comparison of the leverage of stable utility
years, this would also be a favourable sign that companies and cyclical mining companies would be
management is implementing effective business worse than useless. Examining a cyclical company's
policies and strategies. profitability ratios over less than a full commodity or
business cycle would fail to give an accurate long-
Financial ratio analysis groups the ratios into term measure of profitability. Using historical data
categories which tell us about different facets of a independent of fundamental changes in a company's
company's finances and operations. An overview of situation or prospects would predict very little about
some of the categories of ratios is given below. future trends. For example, the historical ratios of a
company that has undergone a merger or had a
• Leverage Ratios which show the extent that substantive change in its technology or market
debt is used in a company's capital structure. position would tell very little about the prospects for
this company.
• Liquidity Ratios-70-which give a picture of a
company's short term financial situation or Credit analysts, those interpreting the financial ratios
solvency. from the prospects of a lender, focus on the
• Operational Ratios which use turnover "downside" risk since -71-
they gain none of the upside
measures to show how efficient a company is from an improvement in operations. They pay great
in its operations and use of assets. attention to liquidity and leverage ratios to ascertain a
company's financial risk. Equity analysts look more to
the operational and profitability ratios, to determine Turnover 1,110,678 697,720
the future profits that will accrue to the shareholder. Cost of sales 830,126 505,738

Gross profit 280,552 191,982


Although financial ratio analysis is well-developed
and the actual ratios are well-known, practicing Operating expenses 176,960 129,359

financial analysts often develop their own measures Operating profit 66,016 41,389

for particular industries and even individual Other costs/income 6,555 -5,132
companies. Analysts will often differ drastically in Profit before interest and taxation 45,012 25,300
their conclusions from the same ratio analysis. Let's put these ratios in a table:
We will now examine profitability RATIO only.
Gross Profit Profitability Ratios for t Jefry Warehouse
Gross Profit Margin = * 100
Turnover
Ratio Name Ratio Formula 31 Mar 06 25 Mar 05
Note: Turnover = Sales
Profitability For the year ended 31
Gross Profit = Turnover - Cost of Sales
Mar 06

Net Profit Margin = Gross Profit 280,552 ÷ 1,110,678*100 25.26%


Margin
X 100 = X 100
Net Profit 45,012 ÷ 1,110,678*100 4.05%
Note: Net Profit = Gross Profit – Expenses Margin

Look and see where these figures and ratios came


Now that we know a bit about profitability ratios, let's
from: don't do anything
-73-else until you have agreed
see how to use them. Here are parts of the profit and
with what it is in this table.
loss account for the Jefry Warehouse plc; we will use
that information to-72-
calculate its gross and net profit Did you see that for the year ended 25 March 2005,

margin. we didn't give you the ratio results?

Jefry Warehouse
Well spotted! So, using the profit and loss account
Consolidated Profit and Loss Account above, calculate the gross and net profit margins for
for the year ended 31 March 2006 25 March 2005
the Jefry Warehouse for the year ended 25 March
N'000 N'000
2005, enter those ratios in the table above.
taxation

Company: Vodafone plc Tax on profit on ordinary activities -2956.0 -2140.0 -1426.0

Description: Profit on ordinary activities after


-9164.0 -15679.0 -9512.0
taxation

The COMPANY is involved principally in the


Equity minority interests -655.0 -476.0 -373.0
provision of mobile telecommunications services.
Profit for the financial period -9819.0 -16155.0 -9885.0
Consolidated Profit & Loss Account for
2003 2002 2001
the year ended
Dividends 1154.0 -1025.0 -887.0

Weeks 52 52 52
Retained profit -10973.0 -17180.0 -10772.0

Currency N million N million N million


Consolidated Balance Sheet
-75-
Turnover 30375.0 22845.0 15004.0
Fixed assets

Cost of sales -17896.0 -13446.0 -8702.0


Intangible Assets 108085.0 105944.0 108853.0
-74-
Gross Profit 12479.0 9399.0 6302.0
Tangible Assets 19574.0 18541.0 10586.0

Operating Expenses -17774.0 -21233.0 -13291.0


Investments 27030.0 28977.0 34769.0

Operating Profit -5295.0 -11834.0 -6989.0


Total Fixed Assets 154689.0 153462.0 154208.0

Other costs/income -161.0 -860.0 80.0


Current assets

Profit before interest and taxation -5456.0 -12694.0 -6909.0


Stock 365.0 513.0 316.0

Net interest receivable (payable) -752.0 -845.0 -1177.0


Debtors due within one year 7460.0 7053.0 4587.0

Profit on ordinary activities before -6208.0 -13539.0 -8086.0


Short-term investments 291.0 1792.0 13211.0 Minority interests 2863.0 2855.0 2421.0

Cash at bank and in hand 475.0 80.0 68.0 Total capital employed 131534.0 133428.0 147428.0

Total Current Assets 8591.0 9438.0 18182.0 Weighted average number of shares in
65012501146 65012501146 61334032162
issue in the period

Creditors: Amounts falling due within


-14293.0 -13455.0 -12377.0
one year

Net Current Assets (liabilities) -5702.0 -4017.0 5805.0

Total assets less current liabilities 148987.0 149445.0 160013.0

-77-- answer
Vodafone profit margin
Creditors: Amounts falling due after more
-13757.0 -13118.0 -11235.0
than one year -76-
Vodafone plc
Provisions for liabilities and charges -3696.0 -2899.0 -1350.0
Profitability 31 Mar 2002 31 Mar 2001
Net assets 131534.0 133428.0 147428.0
Gross Profit Margin 41.14% 42.00%
Capital and reserves

Net Profit Margin -55.57% -46.05%


Called-up share capital 4275.0 4273.0 4054.0

Share premium 52073.0 52044.0 48292.0

Other reserves 99770.0 99862.0 97938.0

Profit and loss account -27447.0 -25606.0 -5277.0


PRACTICE QUESTIONS
Equity shareholders' funds 128671.0 130573.0 145007.0 1. In planning for finance, what are the major sources
of information available?
2. State in detail, short, medium and long term
forecasting of capital requirement.
3. What are the various techniques available for its short-term liabilities. The goal of working capital
financial analysis? management is to ensure that the firm is able to
continue its operations and that it has sufficient cash
flow to satisfy both maturing short-term debt and
upcoming operational expenses.

Management of working capital

Management adopt a combination of policies and


techniques for the management of working capital.
-78- These policies aim at managing the current assets
-79-
(generally cash and cash equivalents, inventories
and debtors) and the short term financing, such that
cash flows and returns are acceptable.

•Cash management. Identify the cash balance


which allows for the business to meet day to day
expenses, but reduces cash holding costs.
•Inventory management. Identify the level of
inventory which allows for uninterrupted
production but reduces the investment in raw
materials - and minimizes reordering costs - and
hence increases cash flow; see Supply chain
management; Just In Time (JIT); Economic order
WORKING CAPITAL quantity (EOQ); Economic production quantity
MANAGEMENT •Debtors management. Identify the appropriate
credit policy, i.e. credit terms which will attract
customers, such that any impact on cash flows
and the cash conversion cycle will be offset by
Decisions relating to working capital and short term
increased revenue and hence Return on Capital
financing are referred to as working capital
(or vice versa); see Discounts and allowances.
management. These involve managing the
relationship between a firm's short-term assets and
•Short term financing. Identify the appropriate activities, management generally aims at a low
source of financing, given the cash conversion net count.
cycle: the inventory is ideally financed by credit
granted by the supplier; however, it may be • In this context, the most useful measure of
necessary to utilize a bank loan (or overdraft), or profitability is Return on capital (ROC). The result
to "convert debtors to cash" through "factoring". is shown as a percentage, determined by dividing
relevant income for the 12 months by capital
Working capital is directly affecting by other employed; Return on equity (ROE) shows this
management issues, such as product mix, supply result for the firm's shareholders. Firm value is
chain design and business model (for example agent enhanced when, and if, the return on capital,
vs. distributor) which results from working capital management,
exceeds the cost of capital, which results from
Decision criteria -80- capital investment decisions as above. ROC
-81-
measures are therefore useful as a management
By definition, working capital management entails tool, in that they link short-term policy with long-
short term decisions - generally, relating to the next term decision making.
one year period - which are "reversible". These
decisions are therefore not taken on the same basis
as Capital Investment Decisions (NPV or related, as
above) rather they will be based on cash flows and / Calculation
or profitability.
Current assets and current liabilities include three
• One measure of cash flow is provided by the accounts which are of special importance. These
cash conversion cycle - the net number of days accounts represent the areas of the business where
from the outlay of cash for raw material to managers have the most direct impact:
receiving payment from the customer. As a
management tool, this metric makes explicit the • accounts receivable (current asset)
inter-relatedness of decisions relating to • inventory (current assets), and
inventories, accounts receivable and payable, • accounts payable (current liability)
and cash. Because this number effectively
corresponds to the time that the firm's cash is tied The current portion of debt (payable within 12
up in operations and unavailable for other months) is critical, because it represents a short-term
claim to current assets and is often secured by long to use the cashflow to generate profits. If a business
term assets. Common types of short-term debt are is operating profitably, then it should, in theory,
bank loans and lines of credit. generate cash surpluses. If it doesn't generate
surpluses, the business will eventually run out of
An increase in working capital indicates that the cash and expire. Click here for more information
business has either increased current assets (that is about the vital distinction between profits and
received cash, or other current assets) or has cashflow.
decreased current liabilities, for example has paid
off some short-term creditors. The faster a business expands, the more cash it will
need for working capital and investment. The
Implications on M&A: The common commercial cheapest and best sources of cash exist as working
definition of working capital for the purpose of a capital right within business. Good management of
working capital adjustment in an M&A transaction (ie working capital will generate cash will help improve
for a working capital adjustment mechanism in a sale profits and reduce risks. Bear in mind that the cost of
and purchase agreement) -82-
is equal to: -83- and holding stocks can
providing credit to customers
represent a substantial proportion of a firm's total
Current Assets - Current Liabilities excluding profits.
deferred tax assets/liabilities, excess cash, surplus
assets and/or deposit balances. There are two elements in the business cycle that
absorb cash - Inventory (stocks and work-in-
Cash balance items often attract a one-for-one progress) and Receivables (debtors owing you
purchase price adjustment. money). The main sources of cash are Payables
(your creditors) and Equity and Loans.

MANAGING WORKING CAPITAL

1. Working Capital Cycle

Cash flows in a cycle into, around and out of a


business. It is the business's life blood and every
manager's primary task is to help keep it flowing and
2. Sources of Additional Working Capital

Sources of additional working capital include the


following:

• Existing cash reserves


• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans

If you have insufficient working capital and try to


increase sales, you can easily over-stretch the
financial resources of the business. This is called
Each component of working capital (namely overtrading. Early warning signs include:
inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY. When it • Pressure on existing cash
comes to managing working capital - TIME IS
MONEY. If you can get money to move faster around • Exceptional cash generating activities e.g.
the cycle (e.g. collect monies due from debtors more offering high discounts for early cash payment
quickly) or reduce the amount of money tied up (e.g. -85-
reduce inventory levels-84- relative to sales), the • Bank overdraft exceeds authorized limit
business will generate more cash or it will need to • Seeking greater overdrafts or lines of credit
borrow less money to fund working capital. As a • Part-paying suppliers or other creditors
consequence, you could reduce the cost of bank • Paying bills in cash to secure additional
interest or you'll have additional free money available supplies
to support additional sales growth or investment. • Management pre-occupation with surviving
Similarly, if you can negotiate improved terms with rather than managing
suppliers e.g. get longer credit or an increased credit • Frequent short-term emergency requests to
limit, you effectively create free finance to help fund the bank (to help pay wages, pending receipt
future sales. of a cheque).
3. Handling Receivables (Debtors) 5. Check out each customer thoroughly before
you offer credit. Use credit agencies, bank
Cashflow can be significantly enhanced if the references, industry sources etc.
amounts owing to a business are collected faster. 6. Establish credit limits for each customer... and
Every business needs to know.... who owes them stick to them.
money.... how much is owed.... how long it is 7. Continuously review these limits when you
owing.... for what it is owed. suspect tough times are coming or if operating
in a volatile sector.
Late payments erode profits and 8. Keep very close to your larger customers.
can lead to bad debts. 9. Invoice promptly and clearly.
10. Consider charging penalties on overdue
accounts.
Slow payment has a crippling effect on business, in 11. Consider accepting credit /debit cards as a
particular on small businesses who can least afford payment option.
it. If you don't manage debtors, they will begin to 12. Monitor your debtor balances and ageing
manage your business as you will gradually lose schedules, and don't let any debts get too
control due to reduced cashflow and, of course, you large or too old.
could experience an increased incidence of bad debt.
The following measures will help manage your Recognize that the longer someone owes you, the
debtors: greater the chance you will never get paid. If the
average age of your debtors is getting longer, or is
-86-
1. Have the right mental attitude to the control of already very long, you may need to look for the
credit and make sure that it gets the priority it following possible defects:
deserves. -87-
2. Establish clear credit practices as a matter of • weak credit judgement
company policy. • poor collection procedures
3. Make sure that these practices are clearly • lax enforcement of credit terms
understood by staff, suppliers and customers. • slow issue of invoices or statements
4. Be professional when accepting new • errors in invoices or statements
accounts, and especially larger ones. • customer dissatisfaction.
Debtors due over 90 days (unless within agreed • Don't feel guilty asking for money.... its yours
credit terms) should generally demand immediate and you are entitled to it.
attention. Look for the warning signs of a future bad • Make that call now. And keep asking until you
debt. For example......... get some satisfaction.
• In difficult circumstances, take what you can
• longer credit terms taken with approval, particularly now and agree terms for the remainder. It lessens
for smaller orders the problem.
• use of post-dated checks by debtors who normally • When asking for your money, be hard on the
settle within agreed terms issue - but soft on the person. Don't give the
• evidence of customers switching to additional debtor any excuses for not paying.
suppliers for the same goods. • Make it your objective is to get the money -
• new customers who are reluctant to give credit not to score points or get even.
references
• receiving part payments from debtors. 4. Managing Payables (Creditors)

Profits only come from paid sales. Creditors are a vital part of effective cash
management and should be managed carefully to
enhance the cash position.
The act of collecting money is one which most
people dislike for many reasons and therefore put on
Purchasing initiates cash outflows and an over-
the long finger because they convince themselves
zealous purchasing function can create liquidity
there is something more urgent or important that
problems. Consider the following:
demand their attention now. There is nothing more
important than getting paid for your product or
Who authorizes purchasing in your company - is it
service. A customer who does not pay is not a
tightly managed or spread among a number of (junior)
customer. Here are a few ideas that may help you in
-88-debtors:
collecting money from
people?
-89-
Are purchase quantities geared to demand forecasts?
• Develop appropriate procedures for handling
late payments.
Do you use order quantities which take account of
• Track and pursue late payers.
stock-holding and purchasing costs?
• Get external help if your own efforts fail.
Do you know the cost to the company of carrying few days while a motor factor would be much slower
stock ? as it may carry a wide range of rarely-used spare
parts in case somebody needs them.
Do you have alternative sources of supply ? If not, get
quotes from major suppliers and shop around for the Nowadays, many large manufacturers operate on a
best discounts, credit terms, and reduce dependence just-in-time (JIT) basis whereby all the components
on a single supplier. to be assembled on a particular today, arrive at the
factory early that morning, no earlier - no later. This
How many of your suppliers have a returns policy ? helps to minimize manufacturing costs as JIT stocks
take up little space, minimize stock-holding and
Are you in a position to pass on cost increases virtually eliminate the risks of obsolete or damaged
quickly through price increases to your customers ? stock. Because JIT manufacturers hold stock for a
very short time, they are able to conserve substantial
If a supplier of goods or services lets you down can cash. JIT is a good model to strive for as it embraces
you charge back the cost of the delay ? all the principles of prudent stock management.

Can you arrange (with confidence !) to have delivery The key issue for a business is to identify the fast
of supplies staggered or on a just-in-time basis ? and slow stock movers with the objectives of
establishing optimum stock levels for each category
5. Inventory Management and, thereby, minimize the cash tied up in stocks.
Factors to be considered when determining optimum
Managing inventory is a juggling act. Excessive stock levels include:
stocks can place a heavy burden on the cash
resources of a business. Insufficient stocks can result • What are the projected sales of each product?
in lost sales, delays -90-
for customers etc. • How widely -91-available are raw materials,
components etc.?
The key is to know how quickly your overall stock is • How long does it take for delivery by
moving or, put another way, how long each item of suppliers?
stock sit on shelves before being sold. Obviously, • Can you remove slow movers from your
average stock-holding periods will be influenced by product range without compromising best sellers?
the nature of the business. For example, a fresh
vegetable shop might turn over its entire stock every
Remember that stock sitting on shelves for long ordering will reduce average days.
It take you on average x days to collect
periods of time ties up money which is not working Receivables monies due to you. If your official credit
Debtors * 365/ = x terms are 45 day and it takes you 65 days...
for you. For better stock control, try the following: Ratio
Sales days why ?
(in days)
One or more large or slow debts can drag
out the average days. Effective debtor
• Review the effectiveness of existing management will minimize the days.

purchasing and inventory systems. Creditors *


On average, you pay your suppliers every x
days. If you negotiate better credit terms this
• Know the stock turn for all major items of Payables
Ratio
365/ = x will increase. If you pay earlier, say, to get a
discount this will decline. If you simply defer
inventory. (in days)
Cost of Sales days
(or Purchases)
paying your suppliers (without agreement)
this will also increase - but your reputation,
• Apply tight controls to the significant few items the quality of service and any flexibility
and simplify controls for the trivial many. provided by your suppliers may suffer.
Current Assets are assets that you can
• Sell off outdated or slow moving merchandise readily turn in to cash or will do so within 12
- it gets more difficult to sell the longer you keep it. Total Current
months in the course of business. Current
Liabilities are amount you are due to pay
• Consider having part of your product Current Assets/ = x within the coming 12 months. For example,
Ratio Total Current times 1.5 times means that you should be able to
outsourced to another manufacturer rather than Liabilities lay your hands on $1.50 for every $1.00 you
owe. Less than 1 times e.g. 0.75 means that
make it yourself. you could have liquidity problems and be
• Review your security procedures to ensure under pressure to generate sufficient cash to
meet oncoming demands.
that no stock "is going out the back door !" (Total Current
Assets - Similar to the Current Ratio but takes
=x
Quick Ratio Inventory)/ account of the fact that it may take time to
times
Total Current convert inventory into cash.
Liabilities
6. Key Working Capital Ratios
(Inventory +
Working Receivables - As % A high percentage means that working
Payables)/
Capital Ratio Sales capital needs are high relative to your sales.
The following, easily calculated, ratios are important Sales
measures of working capital utilization.

Other working capital-93-


measures include the following:

Ratio Formulae
-92-
Result Interpretation -Bad debts expressed as a percentage of sales.
Stock On average, you turn over the value of your
Turnover
Average Stock entire stock every x days. You may need to -Cost of bank loans, lines of credit, invoice
* 365/ = x break this down into product groups for
(in days)
Cost of Goods days effective stock management. discounting etc.
Sold Obsolete stock, slow moving lines will
extend overall stock turnover days. Faster
production, fewer product lines, just in time
-Debtor concentration - degree of dependency on a X : y eg 1.75: 1
limited number of customers.

Once ratios have been established for your business,


The Calcemco Warehouse is our business of choice,
it is important to track them over time and to compare
them with ratios for other comparable businesses or so here is the information to help us work out its
industry sectors. current ratio.

Consolidated Balance Sheet 31 March 25 March 2000


LIQUIDITY RATIO
Cash is the life-blood of any business, no matter how 2001
large or small. If a business has no cash and no way N'000 N'000
of getting any cash, it will have to close down. It's
that simple! Following on from this we can see that if Total Current Assets 315,528 171,160
a business has no idea of its liquidity and working
Creditors: Amounts falling due within one 222,348 173,820
capital position, it could be in serious trouble.
year
Current Assets: Current Liabilities

(Current Assets-Stocks): Current Liabilities

The two liquidity ratios, the current ratio and the acid
test ratio, are the most important ratios in almost the
whole of ratio analysis are also the simplest to use
Current Ratio For the Calcemco Warehouse
and to learn
-95-
31 March Current Assets: Current 315,528: 1.42: 1
The current ratio is also known as the working 2001 Liabilities 222,348
-94-
capital ratio and is normally presented as a real 25 March Current Assets: Current 171,160: 0.98: 1
ratio. That is, the working capital ratio looks like this: 2000 Liabilities 173,820

Current Assets: Current Liabilities =


Maths revision. How did we get 1.42: 1 for the year Creditors: Amounts falling due within one 13,455 12,377

ended 31 March 2001? All we did was to divide the year

current assets by the current liabilities and that gives


us: Fill in this table and discuss what you find:
current assets 315,528
= = 1.42 Current Ratio For Vodafone
current liabilities 222,348

31 March 2002 Current Assets: Current Liabilities _____: _____ ___: 1


so we automatically know that our ratio is 1.42: 1
31 March 2001 Current Assets: Current Liabilities _____: _____ ___: 1
The same with the year before:
current assets 171,160
= = 0.98
current liabilities 173,820

so the ratio is 0.98: 1

Work through the data for Vodafone and calculate


their current ratio for the two years for which you
have data.
-96-
Vodafone 31 March 31 March 2001
Consolidated Balance Sheet 2002 -97-answer
Vodafone Current Ratio

N’ m N’ m Current Ratio For Vodafone

31 March 2002 Current Assets: Current Liabilities 9,438: 13,455 0.70: 1


Total Current Assets 9,438 18,182

31 March 2001 Current Assets: Current Liabilities 18,182: 12,377 1.47: 1


Vodafone has done almost the exact opposite of the
Calcemco Warehouse with its current ratio. This WORKING CAPITAL AND OPERATING CYCLE
additional information might help your analysis. The operating cycle is the length of time between the
company’s outflow on raw materials, wages and
Current assets 2002 N m 2001 N m other expenditures and the inflow of cash from the
sale of goods.
Stock 513 316

Debtors due within one year 7,053 4,587 In a manufacturing business, this is the average time,

Short-term investments 1,792 13,211 that raw materials remain in stock, less the period of
Cash at bank and in hand 80 68
credit taken from suppliers, plus the time taken for
Total Current Assets 9,438 18,182
producing of the goods, plus the time the goods
Creditors: Amounts falling due within one 13,455 12,377
year
remain unfinished in inventory, plus the time taken by

Net current assets (liabilities) -4,017 5,805 customers to pay for the goods.

Vodafone has liquidated, or sold, many of its short-


-98- This is an important-99-
concept for the management of
term investments. This business has grown at a very
rapid rate and has possibly used the cash from cash or working capital because the longer the
having sold its investments to finance that expansion.
Overall, Vodafone has lost almost N10 billion of operating cycle, the more the financial resources the
working capital as it has fallen from N5.8 billion to
-N4.0. This has left Vodafone in a weak working company needs.
capital position as its creditors are large but its cash
and short-term assets balances are small by
In calculating the operating cycle, allowances should
comparison.
be made for any significant changes in the level of Debtors 24,000 25,000 24,500

Creditors 11,000 12,000 11,500


stock taking place over the period.
Sales 132,000 156,000 144,000

Illustration Purchase of raw 84,000 88,000 86,000


materials
The following figures are derived from JEMI
124,000 136,000 130,000
Cost of goods sold
manufacturing industry, compute its operating cycle

to determine the raw material turn over, period of


Working Guide
production, turn over of finished goods and credit
To arrive the mean figure ……add the figures on
taken by customer.
2001 and 2002 column, then divide the answer by
2.

1. Row materials

Period of turnover of material stock =

-100- (Average value of raw material stock)


-101-
ITEMS 2001 2002 MEAN
÷
Raw materials 16,000 18,400 17,200
(Purchase of raw material per day) =

Work in progress 12,000 13,000 12,500 Less Period of credit granted by suppliers =
inventory
(Average level of creditors)
Finished goods 10,000 14,000 12,000
inventory
÷
(Purchases of raw materials per day) = X Note: to get 236 seen above, divide the mean figure
of the raw materials purchased by 365days of the
year.
2. Period of production =
(Average value of work in progress) 2. Period of production
÷
(Average cost of goods sold per day) = X
= 35days approx.

3. Period of turnover of finished goods stock = 3. Turn-over of finished goods


Average valued of stock of finished goods
÷
(Average cost of goods sold per day) = X = 34days approx.

4. Period of credit taken by customers =


(Average value of debtors) 4. Credit taken by customer
÷ -103-
(Average value of sales per day) x Total
operating cycle = X = 62days approx.

-102- Total number of days = 155 days. Answer


Now let look at the solution to the above problem.
The operating cycle is only the time span between
1. Turn over of raw materials = production cost and cash returns; it says nothing in
itself on the working capital that will be needed over
= 73 days approx. this period.

Less credit granted by suppliers


PRINCIPLES OF WORKING CAPITAL
= 49 days approx.

73days – 49days = 24days


There are four principle of working capital · Current assets as a percentage of total assets.
management. They are being depicted as below :
· Current assets as a percentage of total sales.
(i) Principle of Risk Variation: - The goal of WC
management is to establish a suitable trade between (iv) Principle of Maturity Payment: - This principle
profitability and risk. Risk here refers to a firm's ability is concerned with planning the source of finance for
to honor its obligation as and when they become due WC. As per this principle a firm should make every
for payments. Larger investment in current assets will effort to relate maturities of its flow of internally
lead to dependence. Short term borrowings generated funds in other words it should plan its cash
increases liquidity, reduces risk and thereby inflow in such a way that it could easily cover its cash
decreases the opportunity for gain or loss On the out flows or else it will fail to meet its obligation in
other hand the reserve situation will increase risk and time.
profitability And reduce liquidity thus there is direct
relationship between risk and profitability and inverse
relationship between liquidity and risk.
CONCEPT OF WORKING CAPITAL
(ii) Principle of Cost Capital: - The various sources -105-
of raising WC finance
-104- have different cost of capital The concept of Working Capital includes Current
and the degree of risk involved. Generally higher the Assets and Current Liabilities. There are two
cost lower the risk, Lower the risk higher the cost. A concepts of Working Capital which are Gross and
sound WC management should always try to achieve Net Working Capital.
the balance between these two.
1. Gross Working Capital: Gross Working Capital
(iii) Principle of Equity Position: - This principle is refers to the firm's investment in Current Assets.
considered with planning the total investment in Current Assets are the assets, which can be
current assets. As per this principle the amount of converted into cash within an accounting year or
WC investment in each component should be operating cycle. It includes cash, short-term
adequately justified by a firms equity position Every securities, debtors (account receivables or book
rupee contributed current assets should contribute to debts), bills receivables and stock (inventory).
the net worth of the firm The level of current assets
may be measured with the help of two ratios. They 2. Net Working Capital: Net Working Capital refers
are: to the difference between Current Assets and
Current Liabilities are those claims of outsiders, be made quickly. The financial manager should have
which are expected to mature for payment within an the knowledge of sources of the working Capital
accounting year. It includes creditors or accounts funds as wheel as investment avenues where idle
payables, bills payables and outstanding expenses. funds can be temporarily invested.
Net Working Capital can be positive or negative.

The concept of Gross Working Capital focuses


STOCK CONTROL
attention on two aspects of Current Assets'
management. They are:
Managing stock effectively is important for any
a) Way of optimizing investment in Current Assets. business, because without enough stock, production
and sales will grind to a halt. Stock control involves
b) Way of financing current assets. careful planning to ensure that the business has
sufficient stock of the right quality available at the
a. Optimizing investment in Current Assets: right time.
-106-
Investment in Current Assets should be just -107-
Stock can mean different things and depends on the
adequate i.e., neither in excess nor deficit because
excess investment increases liquidity but reduces industry the firm operates in. It includes:
profitability as idle investment earns nothing and
inadequate amount of working capital can threaten • Raw materials and components from suppliers
the solvency of the firm because of its inability to • Work in progress or part finished goods made
meet its obligation. It is taken into consideration that within the business
the Working Capital needs of the firm may be • Finished goods ready to dispatch to
fluctuating with changing business activities which customers
may cause excess or shortage of Working Capital • Consumables and materials used by service
frequently and prompt management can control the businesses
imbalances.
In order to meet customer orders, product has to be
b. Way of financing Current Assets: This aspect available from stock – although some firms are able
points to the need of arranging funds to finance to arrange deliveries Just in Time, see below. If a
Company Assets. It says whenever a need for business does not have the necessary stock to meet
working Capital arises; financing arrangement should orders, this can lead to a loss of sales and a
damaged business reputation. This is sometimes The marketing department should be able to provide
called a ‘stock-out’. sales forecasts for the coming weeks or months (this
can be difficult if demand is seasonal or prone to
It is important therefore that a business either holds unexpected fluctuation) and so allow stock control
sufficient stocks to meet actual and anticipated managers to judge the type, quantity and timing of
orders, or can get stocks quickly enough to meet stocks needed.
those orders. For a high street retailer, in practice
this means having product on the shelves. It is the purchasing department’s responsibility to
order the correct quantity and quality of these inputs,
at a competitive price and from a reliable supplier
who will deliver on time.
STOCK HOLDING
As it is difficult to ensure that a business has exactly
There are three types of stock that a business can the correct amount of stock at any one time, the
hold: majority of firms will hold buffer stock. This is the
“safe” amount of stock -109-
that needs to be held to cover
Stocks of raw materials (inputs brought from unforeseen rises in demand or problems of
suppliers waiting to be used in the production reordering supplies.
process) -108-
STOCK MANAGEMENT
Work in progress (incomplete products still in the
process of being made) Good stock management by a firm will lower costs,
improve efficiency and ensure production can meet
Stocks of finished products (finished goods of fluctuations in customer demand. It will give the firm
acceptable quality waiting to be sold to customers) a competitive advantage as more efficient production
can feed through to lower prices and also customers
The aim of stock control is to minimise the cost of should always be satisfied as products will be
holding these stocks whilst ensuring that there are available on demand.
enough materials for production to continue and be
able to meet customer demand. Obtaining the correct However, poor stock control can lead to problems
balance is not easy and the stock control department associated with overstocking or stock-outs.
will work closely with the purchasing and marketing
departments.
If a business holds too much buffer stock (stock Less chance of loss of production time
held in reserve) or overestimates the level of demand because of stock outs
for its products, then it will overstock. Overstocking
increase costs for businesses as holding stocks are Can take advantage of bulk buying
an expense for firms for several reasons. economies of scale

• Increases warehouse space needed


• Higher insurance costs needed
• Higher security costs needed to prevent theft Disadvantages
• Stocks may be damaged, become obsolete or Costs of storage – rent and insurance
perish (go out of date)
Money tied up in stocks not being used
• Money spent buying the stocks could have elsewhere in the business
been better spent elsewhere
Large stocks subject to deterioration and
-110-
The opposite of an overstock is a stock-out. This theft -111-
occurs when a businesses runs out of stocks. This
can have severe consequences for the business:
The costs of holding stock include:
Loss of production (with workers still having to be
paid but no products being produced) • The opportunity cost of working capital tied
up in stock that could have been used for
Potential loss of sales or missed orders. This can another purpose
harm the reputation of the business. • Storage costs – the rent, heating, lighting and
security costs of a warehouse or additional
In these circumstances a business may choose to factory or office space
increase the amount of stock they hold in reserve • Bank interest , if the stock is financed by an
(buffer stock). There are advantages and overdraft or a loan
disadvantages of increasing the stock level. • Risk of damage to stock by fire, flood, theft
etc; most businesses would insure against
Advantages this, so there is the cost of insurance
Can meet sudden changes in demand
• Stock may become obsolete if buyer tastes Protect your stock
change in favour of new or better products
• Stock may perish or deteriorate – especially • Identify and mark expensive portable
with food products equipment (such as computers). If possible, fit
valuable stock with security tags - such as Radio
Frequency Identification tags - which will sound
TOCK SECURITY an alarm if they are moved.
• Don't leave equipment hanging around after
Keeping stock secure depends on knowing what you delivery. Put it away in a secure place, record it
have, where it is located and how much it is worth - and clear up packaging. It is a good idea to
so good records are essential. Stock that is portable, dispose of packaging securely - leaving boxes in
does not feature the business' logo, or is easy to sell view could be an advertisement to thieves.
on, is at particular risk. • Have regular stocktakes.

Thieves and shoplifters


A thief coming in from outside is an obvious threat.
Check the security around your premises to keep the Theft by staff -113-
risk to a minimum. In a shop, thieves may steal in
-112-
groups - some providing a distraction while others
Theft by employees can sometimes be a problem. To
prevent this:
take goods. Teach your staff to be alert and to
recognise behaviour like this. Set up a clear policy
• Train staff about your security systems and
and make sure staff are trained in dealing with
your disciplinary policies and procedures.
thieves.
Training about the cost of stock theft will help, as
many people aren't aware of the implications for
Offering to help a customer if you are suspicious will
company turnover and job security.
often prevent a theft. Avoid using confrontational
• Set up procedures to prevent theft. Staff with
words like 'steal' if you do have to approach a
financial responsibilities should not be in charge
suspected thief, and avoid getting into a dangerous
of stock records.
situation.
• Restrict access to warehouses, stockrooms so you need to be confident that your suppliers can
and stationery cupboards. deliver on demand. Find out more about JIT
• Regularly change staff controlling stock to
production on the Manufacturing Advisory
Service (MAS) website (registration required) -
avoid collusion or bad practice.
Opens in a new window.

These methods can be used alongside other


STOCK CONTROL METHODS processes to refine the stock control system. For
example:
There are several methods for controlling stock, all
Re-order lead time - allows for the time between
designed to provide an efficient system for deciding
placing an order and receiving it.
what, when and how much to order.
Economic Order Quantity (EOQ) - a standard
You may opt for one method or a mixture of two or
formula used to arrive at a balance between holding
more if you have various types of stock. For further
too much or too little stock. It's quite a complex
information, see the page in this guide on types of
calculation, so you may find it easier to use stock
stock.
control software. Find out about the EOQ
formula on the InventoryOps website - Opens in a
• Minimum -114-stock level - you identify a new window.
minimum stock level, and re-order when stock -115-
reaches that level. This is known as the Re-order Batch control - managing the production of goods in
Level. batches. You need to make sure that you have the
• Stock review - you have regular reviews of right number of components to cover your needs until
stock. At every review you place an order to the next batch.
return stocks to a predetermined level.
If your needs are predictable, you may order a fixed
quantity of stock every time you place an order, or
Just In Time (JIT) - this aims to reduce costs by
order at a fixed interval - say every week or month.
cutting stock to a minimum - see our guide on how to
In effect, you're placing a standing order, so you
avoid the problems of overtrading. Items are
need to keep the quantities and prices under review.
delivered when they are needed and used
immediately. There is a risk of running out of stock,
First in, first out - a system to ensure that • If a large client demands an unreasonable
perishable stock is used efficiently so that it doesn't amount of credit you may have to simply walk
deteriorate. Stock is identified by date received and away from the contract. You cannot afford to
moves on through each stage of production in strict risk running out of cash.
order. • If stage payments are delayed, you may
perhaps have to say, for example, that you will
be unable to complete the contract; this may
help with neogitations.
CONTROL OF DEBTORS
So what should you be aiming for in terms of the
Invoicing and collection credit you offer? The key objective should be to try
and shorten the period each year rather than
Commercial organisations normally give credit to lengthen it. So, for example, if you agree with your
their customers in order to encourage sales. In the clients 30 days and you collect in this, you are doing
case of charities it is less likely that you are very well!
encouraging additional sales by giving credit and
more likely that your clients will want credit and will A general rule of thumb is: agreed time plus 33%.
wish to dictate the terms on which they will pay. You need to improve your collection procedures as
Therefore, for voluntary organisations, management soon as it slips towards this point.
-116-
is more about dealing with credit than deciding on a
control policy. Reducing the cost-117-
of debtors

'It is better to have cash in your bank account than in • Send invoices promptly
your customers'!
The quicker invoices are sent the sooner they are
• If you get the money in quickly you can use it paid. The best time to send them is at the same time
for other purposes which will advance the as dispatching an order or completing a service. Do
organisation's objectives. not wait until the end of the month as this
• Giving credit costs money, even if it is only a automatically gives additional credit.
small amount of interest foregone. If you have
an overdraft, the costs rise sharply. • Send statements monthly
Some organisations pay only on statement, though When all the above fail, send a letter requesting
this is less common now, and it acts as a reminder payment within seven days. This should state that
for all debtors. you will take further measures, legal action or
withdrawal of services, if payment is not received.
• Phone the client
• Stop supplies of goods or services
When you see an invoice that has gone over your
credit terms and your statement produced no You reach a point where it is vital to stop throwing
response you should try to find out why. The best good money after bad.
person to call is not always the person who gave you
the order especially in large organisations. The • Send a Solicitor's letter
purchase (or bought) ledger clerk probably knows
most about the delay. If you have a few important By this time the relationship between you and your
clients it is often worth while getting to know the client will have broken down. Place the matter in the
name of this person and speaking directly with them. hands of your solicitor. Ask them to write to the
They sometimes have the ability to speed up organisation asking for payment before taking any
payment dramatically. other action.

• Send a reminder letter •


-119-
Take legal action
-118-
After about 60 days you should remind the client of Legal action needs careful consideration. If there is
the debt by letter asking for payment within 14 days. a dispute over the goods or services, you must have
a good case for taking legal action. Otherwise,
• Phone again hopefully, you would have been able to resolve this
issue earlier.
If the reminder letter was unsuccessful, something
may be wrong. Try to find out what and rectify the Managing bad and aged debts
situation if possible

• Send a final reminder


80% of your debts are probably from 20% of your However, some organisations may then pay at their
clients or customers, so concentrate management normal time but take the discount anyway. It will
effort on these. seldom be worthwhile to sue for the difference. All
you have then is a 2.5% reduction in your price which
An easy way of monitoring debts is to set up the the client or customer may expect to continue!
finance system to produce lists of aged debtors at
monthly intervals. Then all debts of, say, over £500 Furthermore, you have no control over whether the
(depending on the size of the organisation) or more client will take up a discount. This makes cash
than threee months old can be picked for intensive forecasting more difficult. Also, you are at the mercy
chasing. Alternatively, you could create a list of all of interest rates - a discount which is worthwhile at
debtors, the amounts and how old they are. one level of bank interest may not be advantageous
if interest rates change, but you will have your
Part of your procedure to control bad debts should be contracts and stationery printed up in advance, and
that only a senior member of staff or the project cannot immediately change them.
leader can be allowed to write off bad debts.
Similarly, the decision to sue should normally be • Wait for cheques to clear
reviewed for likely costs by the Finance manager to
assess whether it is worthwhile, and by a lawyer to If you are selling goods by mail order or catalogue,
assess the chances of success. you could consider not sending them out until
cheques have cleared.

Decreasing your debtor level


-120- •
-121-
Use merchant accounts
There are a number of tactics you can employ to
encourage early, or at least discourage late payment. It may be worth setting up the necessary merchant
accounts so that you can accept online orders with a
• Offer discounts debit or credit card - debit cards work out cheaper.

Offering (say) 2.5% discount for payment within 14 Monitoring debtor levels
days may result in early payment.
It is very easy for an organisation to allow its debtor average is the average of 12 monthly debtors
figure to creep upwards, and if there has not been figures (or perhaps four quarterly figures). If
any cash shortage crises these may not have been there are seasonal variations which mean that
noticed quickly. the December 2003 figure is abnormally low
(or high) then the December 2004 figure is
It is important to monitor the levels of debtors in also likely to be abnormally low or high.
relation to income. They should go up or down in
line with each other. The key ratio to help you 4. The result is the average number of days
monitor this is the debtor collection period. taken to collect debts, or the debtor collection
period.
How to calculate the debtor collection period

1. Determine income
CONTROL OF CASH
Ideally, this should be the Income which
involves credit. If, for example, the charity also Cash is a vital component of any profit-generating
has a shop which sells only for cash, then the organisation. An organization's assets generate
shop turnover should, if possible, be excluded revenue, which in turn generates cash inflows. These
otherwise the average number of days figures cash inflows are used for several purposes: to pay
will be lower than the ratio you wish to creditors, compensate employees, reward
monitor. shareholders, provide asset replacement, and
provide for growth.

Cash is unique because it's the single asset that is


2. Multiply by 365 readily convertible into any other type of asset.
-122- Therefore, it's also-123-
the most widely desired asset.
3. Divide by the debtor figure However, cash is also the asset that is most
susceptible to fraud and abuse. Therefore,
usually, it is adequate and easier to take the management has to ensure that adequate controls
year-end figure; however, if there are very and safeguards are in place to eliminate any
large variations in the year it is better to take unauthorized transactions with cash.
an average figure. Important point - the true
Fortunately, there are ways management can accountable for a cash shortage, they'll be motivated
safeguard the cash generated by its organization. to keep a close eye on how cash is used within their
Each of the following methods will help an departments.
organization prevent losses due to human error or
theft: Authorized Cash Disbursement. Management should
allow cash to be disbursed only through checks
• Monthly bank reconciliation issued by authorized signers, which will provide a
• Segregation of duties over cash handling method for tracking cash usage. In addition, your
• Accountability for cash shortages organization should require signatures on all checks
• Authorized cash disbursement in order for them to be valid.
• Internal audits
Internal Audits. Every organization should arrange to
Monthly Bank Reconciliation. Monthly bank have internal audits conducted on a regular basis.
reconciliation will help ensure that the amount of Whether the auditors come from an internal audit
cash generated by an organization is consistent with staff or an outside auditing firm, auditing an
bank records. In addition, an independent review of organization's accounting system can identify how
the reconciliation by management will provide an effective and accurate the operation is and whether
additional safeguard. Independent verification of or not any improvements need to be made.
bank reconciliation acts as a check to make sure the
reconciliation was done properly and ensures there is Debt Factoring and Invoice Discounting
no abuse of the organization's cash.
Financial services companies that provide
Segregation of Duties Over Cash Handling. Every businesses with debtor finance, secured against
organization must make sure that there is adequate unpaid invoices are-125-known as Factors and Invoice
-124-
segregation of duties over cash handling. Separating Discounters. Factors buy your trade debts and
the duties of cash receipts and disbursements typically will pay 80% to 85% as soon as they receive
prevents an individual from committing and a valid copy invoice. The balance, less charges, is
concealing embezzlement. paid when the customer pays. The Factor collects
the debt from your customer directly but will usually
Accountability for Cash Shortages. Management agree collection policies with you, in order to ensure
should hold supervisors accountable for cash faster customer payment without loss of goodwill.
shortages. If supervisors know that they'll be held Some Factors also provide bad debt insurance. With
invoice discounting responsibility for collection of in turnover. Conversely, where turnover is falling the
debts remains with you and the service is normally level of finance will fall. The cost of the service needs
undisclosed to customers. Payments that you receive to be weighed against the costs of in-house debt
are paid into a bank account administered by the collection and, for example, having sufficient cash to
Invoice Discounter and you are then credited with the benefit from early payment discounts from suppliers.
balance less charges. Generally, invoice discounting
is only available to businesses that already practice Generally debt finance providers are looking for
sound credit management and have the staff and 'clean' invoices where there is clear evidence of
accounting systems to generate reliable customer delivery of the goods or service and a low level of
collections. Invoice Discounters, like Factors, will disputes or credit notes. It may not be available for
typically pay 80% to 85% against valid invoices. some industries, for example contracting, where
there is a high level of retentions and variation
Cost of Factoring and Invoice Discounting orders. Providers of debt finance usually acquire your
debts with recourse to you if the debtor does not pay.
For both factoring and invoice discounting there is a This means they will reclaim the amount already
service charge, normally a proportion of turnover, advanced to you should your debtor not pay in a
and a discount charge, based on the amount of given time period. Alternatively, you may take out
finance provided. Charges will be agreed in advance insurance against non-payment by your debtors.
and form part of the factoring or invoice discounting Many factors and invoice discounters can also
agreement. For factoring the service charge is provide bad debt insurance.
-126- -127-
normally between 0.75% and 2.5% of turnover,
depending on the workload to be undertaken. The Finding a Factor or Invoice Discounter
charge for invoice discounting will usually be less, as
less work is required. The discount charge is More information and a list of providers of these
calculated on day-to-day usage of funds. It is likely to services are available from the Factors &
be comparable with normal secured bank overdraft Discounters Association.
rates.
Questions to ask when selecting a Factor
Suitability of Factoring and Invoice Discounting
• What will the service cost?
Debtor finance is most suitable for growing • How long will the agreement take to set up?
businesses; finance will grow in line with the growth
• How quickly will money be available against borrowings you can expect your bank to ask for a
invoices? "charge" over your home. This means that in the
• How quickly will you collect from customers? event you cannot repay the loan they are entitled to
force a sale on your house to recover their money.
• Who will be my day-to-day contact?
• Who will speak to my customers?
• How much notice must I give to terminate the PRACTICE QUESTIONS
agreement?
• Can you give me two or three references with 1. Preparing a written business plan is your first step
in business. If you need to raise finance from a bank
similar businesses to mine? or from outside investors, what are you expected to
• Can I factor export invoices? do?
• Are debts bought with or without recourse to 2. Write a short note on the following: (a) inventory
me? control (b) Debt factoring
• Do I have to take out insurance against bad 3. Discuss on the basic requirement of working
capital.
debts and, if so, can I choose who to buy the
insurance from? 4. The operating cycle is only the time span between
production cost and cash returns. Discuss.

Preparation and approach


-128- to bank for loan and -129-
overdraft.

With a clear business plan and cash flow forecast


you can approach your bank for a loan. The best
place to start is the bank with which you already
have a personal account as they will know your
history and be more likely to help you.

The one thing all banks are most interested in is FOREIGN CURRENCY
what security you can provide, i.e. what assets do TRANSACTION
you have that they can sell if you default on your
loan. The most obvious and by far the most common
will be your house. For all but the smallest
traded. Currency Trading is the world's largest
market consisting of almost $2 trillion in daily volume
Definition and as investors learn more and become more
interested, the market continues to rapidly grow. Not
Foreign currency is a currency other than the only is the forex market the largest market in the
reporting currency of an entity.
world, but it is also the most liquid, differentiating it
from the other markets. In addition, there is no
Foreign Currency Transactions central marketplace for the exchange of currency, but
A foreign currency transaction is a transaction which instead the trading is conducted over-the-counter.
is denominated in or requires settlement in a foreign Unlike the stock market, this decentralization of the
currency, including transactions arising when an market allows traders to choose from a number of
entity either: different dealers to make trades with and allows for
comparison of prices. Typically, the larger a dealer is
(a) buys or sells goods or services whose price is the better access they have to pricing at the largest
denominated in a foreign currency; banks in the world, and are able to pass that on to
their clients. The spot currency market is open
(b) borrows or lends funds when the amounts twenty-four hours a day, five days a week, with
payable or receivable are denominated in a foreign currencies being traded around the world in all of the
currency;
major financial centers.
(c) becomes a party to an unperformed foreign
exchange contract;-130-
or All trades that take place in the foreign exchange
market involve the buying of one currency and the
(d) otherwise acquires or disposes of assets, or selling of another currency simultaneously. This is
incurs because the value of one currency is determined by
or settles liabilities, denominated in a foreign its comparison to another currency. The first currency
currency. of a currency pair is called the "base currency," while
the second currency is called the “counter currency.”
The currency pair shows how much of the counter
currency is needed to purchase one unit of the base
FOREIGN EXCHANGE MARKET currency. Currency pairs can be thought of as a
single unit that can be bought or sold. When
The foreign exchange market or forex market as it is
purchasing a currency pair, the base currency is
often called is the market in which currencies are

-131-
being bought, while the counter currency is being foreign exchange receipts. The foreign exchange
sold. The opposite is true, when the sale of a market experienced a boom during this period and
currency pair takes place. There are four major the management of foreign exchange resources
currency pairs that are traded most often in the became necessary to ensure that shortages did not
foreign exchange market. These include the arise. However, it was not until 1982 that
EUR/USD, USD/JPY, GBP/USD, and USD/CHF. comprehensive exchange controls were applied as a
result of the foreign exchange crisis that set in that
The Foreign Exchange Market in Nigeria year. The increasing demand for foreign exchange at
a time when the supply was shrinking encouraged
The evolution of the foreign exchange market in the development of a flourishing parallel market for
Nigeria up to its present state was influenced by a foreign exchange.
number of factors such as the changing pattern of
international trade, institutional changes in the The exchange control system was unable to evolve
economy and structural shifts in production. Before an appropriate mechanism for foreign exchange
the establishment of the Central Bank of Nigeria allocation in consonance with the goal of internal
(CBN) in 1958 and the enactment of the Exchange balance. This led to the introduction of the Second-
Control Act of 1962, foreign exchange was earned by tier Foreign Exchange Market (SFEM) in September,
the private sector and held in balances abroad by 1986. Under SFEM, the determination of the Naira
commercial banks which acted as agents for local exchange rate and allocation of foreign exchange
exporters. During this period, agricultural exports were based on market forces. To enlarge the scope
contributed the bulk of foreign exchange receipts. of the Foreign Exchange Market Bureaux de Change
-132- pound was tied to the
The fact that the Nigerian were introduced in -133-
1989 for dealing in privately
British pound sterling at par, with easy convertibility, sourced foreign exchange.
delayed the development of an active foreign
exchange market. However, with the establishment As a result of volatility in rates, further reforms were
of the CBN and the subsequent centralisation of introduced in the Foreign Exchange Market in 1994.
foreign exchange authority in the Bank, the need to These included the formal pegging of the naira
develop a local foreign exchange market became exchange rate, the centralisation of foreign exchange
paramount. in the CBN, the restriction of Bureaux de Change to
buy foreign exchange as agents of the CBN, the
The increased export of crude oil in the early 1970s, reaffirmation of the illegality of the parallel market
following the sharp rise in its prices, enhanced official
and the discontinuation of open accounts and bills for exchange market helps businesses convert one
collection as means of payments sectors. currency to another.

The Foreign Exchange Market was liberalised in In a typical foreign exchange transaction a party
1995 with the introduction of an Autonomous Foreign purchases a quantity of one currency by paying a
Exchange Market (AFEM) for the sale of foreign quantity of another currency. The modern foreign
exchange to end-users by the CBN through selected exchange market started forming during the 1970s
authorised dealers at market determined exchange when countries gradually switched to floating
rate. In addition, Bureaux de Change were once exchange rates from the previous exchange rate
more accorded the status of authorized buyers and regime, which remained fixed as per the Bretton
sellers of foreign exchange. The Foreign Exchange Woods system.
Market was further liberalized in October, 1999 with
the introduction of an Inter-bank Foreign Exchange The foreign exchange market is unique because of
Market (IFEM).
•its trading volumes,
Structure of Nigeria's Foreign Exchange Market •the extreme liquidity of the market,
•its geographical dispersion,
The Nigerian foreign exchange market has witnessed •its long trading hours: 24 hours a day
except on
tremendous changes. The Second-tier Foreign weekends (from 22:00 UTC on Sunday until
Exchange Market (SFEM) was introduced in 22:00 UTC Friday),
September, 1986, the unified official market in 1987,
the autonomous Foreign Exchange Market (AFEM) •the variety of factors that affect exchange rates.
in 1995, and the -134-
Inter-bank Foreign Exchange
Market (IFEM) in 1999. •the -135-
low margins of profit compared with other
markets of fixed income (but profits can be high
due to very large trading volumes)
MODERN FOREIGN EXCHANGE MARKET •the use of leverage

The purpose of the foreign exchange market is to As such, it has been referred to as the market closest
help international trade and investment. A foreign to the ideal perfect competition, notwithstanding
market manipulation by central banks.
speculative trading every day. A large bank may
Market participants trade billions of NAIRA daily. Some of this trading is
undertaken on behalf of customers, but much is
Unlike a stock market, where all participants have conducted by proprietary desks, trading for the
access to the same prices, the foreign exchange bank's own account. Until recently, foreign exchange
market is divided into levels of access. At the top is brokers did large amounts of business, facilitating
the inter-bank market, which is made up of the interbank trading and matching anonymous
largest investment banking firms. Within the inter- counterparts for small fees. Today, however, much of
bank market, spreads, which are the difference this business has moved on to more efficient
between the bid and ask prices, are razor sharp and electronic systems. The broker squawk box lets
usually unavailable, and not known to players outside traders listen in on ongoing interbank trading and is
the inner circle. The difference between the bid and heard in most trading rooms, but turnover is
ask prices widens (from 0-1 pip to 1-2 pips for some noticeably smaller than just a few years ago.
currencies such as the EUR). This is due to volume.
If a trader can guarantee large numbers of Commercial companies
transactions for large amounts, they can demand a
smaller difference between the bid and ask price, An important part of this market comes from the
which is referred to as a better spread. The levels of financial activities of companies seeking foreign
access that make up the foreign exchange market exchange to pay for goods or services. Commercial
are determined by the size of the "line" (the amount companies often trade fairly small amounts
of money with which they are trading). The top-tier compared to those of banks or speculators, and their
inter-bank market accounts for 53% of all trades often have little short term impact on market
transactions. After that there are usually smaller rates. Nevertheless, trade flows are an important
investment banks, followed factor in the long-term direction of a currency's
-136-by large multi-national exchange rate. Some-137- multinational companies can
corporations (which need to hedge risk and pay
employees in different countries), large hedge funds, have an unpredictable impact when very large
and even some of the retail FX-metal market makers. positions are covered due to exposures that are not
widely known by other market participants.
Banks
Central banks
The interbank market caters for both the majority of
commercial turnover and large amounts of
Central banks play an important role in the foreign in the end; rather, they were solely speculating on
exchange markets. They try to control the money the movement of that particular currency. Hedge
supply, inflation, and/or interest rates and often have funds have gained a reputation for aggressive
official or unofficial target rates for their currencies. currency speculation since 1996. They control
They can use their often substantial foreign billions of dollars/naira of equity and may borrow
exchange reserves to stabilize the market. Milton billions more, and thus may overwhelm intervention
Friedman argued that the best stabilization strategy by central banks to support almost any currency, if
would be for central banks to buy when the exchange the economic fundamentals are in the hedge funds'
rate is too low, and to sell when the rate is too high— favour.
that is, to trade for a profit based on their more
precise information. Nevertheless, the effectiveness Investment management firms
of central bank "stabilizing speculation" is doubtful
because central banks do not go bankrupt if they Investment management firms (who typically manage
make large losses, like other traders would, and large accounts on behalf of customers such as
there is no convincing evidence that they do make a pension funds and endowments) use the foreign
profit trading. exchange market to facilitate transactions in foreign
securities. For example, an investment manager
The mere expectation or rumour of central bank bearing an international equity portfolio needs to
intervention might be enough to stabilize a currency, purchase and sell several pairs of foreign currencies
but aggressive intervention might be used several to pay for foreign securities purchases.
times each year in countries with a dirty float
Some investment management firms also have more
currency regime. Central banks do not always speculative specialist currency overlay operations,
achieve their objectives. The combined resources of which manage clients' currency exposures with the
the market can easily overwhelm any central bank]
-139-
aim of generating profits as well as limiting risk.
-138- Whilst the number of this type of specialist firms is
Hedge funds as speculators quite small, many have a large value of assets under
management (AUM), and hence can generate large
About 70% to 90% of the foreign exchange trades.
transactions are speculative. In other words, the
person or institution that bought or sold the currency Retail foreign exchange brokers
has no plan to actually take delivery of the currency
There are two types of retail brokers offering the physical delivery of currency to a bank account. Send
opportunity for speculative trading: retail foreign Money Home offer an in-depth comparison into the
exchange brokers and market makers. Retail traders services offered by all the major non-bank foreign
(individuals) are a small fraction of this market and exchange companies.
may only participate indirectly through brokers or
banks. Retail brokers, while largely controlled and It is estimated that in the UK, 14% of currency
regulated by the CFTC and NFA might be subject to transfers/payments are made via Foreign Exchange
foreign exchange scams. At present, the NFA and Companies.[11] These companies' selling point is
CFTC are imposing stricter requirements, particularly usually that they will offer better exchange rates or
in relation to the amount of Net Capitalization cheaper payments than the customer's bank. These
required of its members. As a result many of the companies differ from Money Transfer/Remittance
smaller, and perhaps questionable brokers are now Companies in that they generally offer higher-value
gone. It is not widely understood that retail brokers services.
and market makers typically trade against their
clients and frequently take the other side of their Money Transfer/Remittance Companies
trades. This can often create a potential conflict of
interest and give rise to some of the unpleasant Money transfer companies/remittance companies
experiences some traders have had. A move toward perform high-volume low-value transfers generally by
NDD (No Dealing Desk) and STP (Straight Through economic migrants back to their home country. In
Processing) has helped to resolve some of these 2007, the Aite Group estimated that there were $369
concerns and restore trader confidence, but caution billion of remittances (an increase of 8% on the
is still advised in ensuring that all is as it is previous year). The four largest markets (India,
presented. China, Mexico and the Philippines) receive $95
billion. The largest and best known provider is
Non-bank Foreign-140-
Exchange Companies Western Union with 345,000 agents globally.
-141-
Non-bank foreign exchange companies offer Send Money Home is an international money transfer
currency exchange and international payments to price comparison site that allows consumers access
private individuals and companies. These are also to a range of alternative products/ rates available
known as foreign exchange brokers but are distinct in when remitting (transferring) money worldwide.
that they do not offer speculative trading but currency Provides impartial and unbiased advice for those
exchange with payments. I.e., there is usually a looking to send money overseas
Trading characteristics changes in monetary flows caused by changes in
gross domestic product (GDP) growth, inflation
There is no unified or centrally cleared market for the (purchasing power parity theory), interest rates
majority of FX trades, and there is very little cross- (interest rate parity, Domestic Fisher effect,
border regulation. Due to the over-the-counter (OTC) International Fisher effect), budget and trade deficits
nature of currency markets, there are rather a or surpluses, large cross-border M&A deals and
number of interconnected marketplaces, where other macroeconomic conditions. Major news is
different currencies instruments are traded. This released publicly, often on scheduled dates, so many
implies that there is not a single exchange rate but people have access to the same news at the same
rather a number of different rates (prices), depending time. However, the large banks have an important
on what bank or market maker is trading, and where advantage; they can see their customers' order flow.
it is. In practice the rates are often very close,
otherwise they could be exploited by arbitrageurs
instantaneously. Due to London's dominance in the
market, a particular currency's quoted price is usually
the London market price. A joint venture of the
Chicago Mercantile Exchange and Reuters, called
Fxmarketspace opened in 2007 and aspired but
failed to the role of a central market clearing
mechanism.

The main trading center is London, but New York,


Tokyo, Hong Kong and Singapore are all important -143-
centers as well. -142-
Banks throughout the world
participate. Currency trading happens continuously PRACTICE QUESTIONS
throughout the day; as the Asian trading session
ends, the European session begins, followed by the
North American session and then back to the Asian 1. Explain the following terms that relate to foreign
session, excluding weekends. currency transaction. (a) Exchange rate (b)
Foreign
Fluctuations in exchange rates are usually caused by operation.
actual monetary flows as well as by expectations of 2. What are the objectives of the foreign exchange
transaction?
3. What do you understand by translation of foreign
exchange currency.
4. Explain the nature of foreign exchange system in
Nigeria. ALLOCATION OF DIVIDEND
5. The purpose of the foreign exchange market is to
help international trade and investment. How can this
be accomplished?
A taxable payment declared by a company's board of
directors and given to its shareholders out of the
company's current or retained earnings, usually
quarterly. Dividends are usually given as cash (cash
dividend), but they can also take the form of stock
(stock dividend) or other property. Dividends provide
an incentive to own stock in stable companies even if
they are not experiencing much growth. Companies
are not required to pay dividends. The companies
that offer dividends are most often companies that
have progressed beyond the growth phase, and no
-145-
longer benefit sufficiently by reinvesting their profits,
-144-
so they usually choose to pay them out to their
shareholders. also called payout.

DIVIDEND DEFINED

A distribution of a portion of a company's earnings,


decided by the board of directors, to a class of its
shareholders. The dividend is most often quoted in dividend at any time, sometimes called a
terms of the Naira amount each share receives special dividend to distinguish it from a
(dividends per share). It can also be quoted in terms regular one.
of a percent of the current market price, referred to
as dividend yield. Cooperatives, on the other hand, allocate
dividends according to members' activity, so
Dividends are payments made by a their dividends are often considered to be a
corporation to its shareholder members. It is pre-tax expense.
the portion of corporate profits paid out to
stockholders. When a corporation earns a Dividends are usually settled on a cash
profit or surplus, that money can be put to basis, as a payment from the company to
two uses: it can either be re-invested in the the shareholder. They can take other forms,
business (called retained earnings), or it such as store credits (common among retail
can be paid to the shareholders as a consumers' cooperatives) and shares in the
dividend. Many corporations retain a portion company (either newly-created shares or
of their earnings and pay the remainder as existing shares bought in the market.)
a dividend. Further, many public companies offer
dividend reinvestment plans, which
For a joint stock-146-
company, a dividend is automatically use the cash dividend to
-147-
allocated as a fixed amount per share. purchase additional shares for the
Therefore, a shareholder receives a shareholder.
dividend in proportion to their shareholding.
For the joint stock company, paying
dividends is not an expense; rather, it is the TYPES OF DIVIDENDS
division of an asset among shareholders.
Public companies usually pay dividends on 1. Cash dividends (most common) are
a fixed schedule, but may declare a those paid out in the form of a cheque.
Such dividends are a form of investment 3. Property dividends or dividends in
income and are usually taxable to the specie (Latin for "in kind") are those paid
recipient in the year they are paid. This is out in the form of assets from the issuing
the most common method of sharing corporation or another corporation, such as
corporate profits with the shareholders of a subsidiary corporation. They are relatively
the company. For each share owned, a rare and most frequently are securities of
declared amount of money is distributed. other companies owned by the issuer,
Thus, if a person owns 100 shares and the however they can take other forms, such as
cash dividend is N0.50 per share, the products and services.
person will be issued a cheque for N50
Other dividends can be used in structured
2. Stock or scrip dividends are those paid finance. Financial assets with a known
out in form of additional stock shares of the market value can be distributed as
issuing corporation, or other corporation dividends; warrants are sometimes
(such as its subsidiary corporation). They distributed in this way. For large companies
are usually issued in proportion to shares with subsidiaries, dividends can take the
owned (for example, for every 100 shares of form of shares in a subsidiary company. A
stock owned, 5% stock dividend will yield 5 common technique for "spinning off" a
extra shares). If this payment involves the
-148- company from its parent is to distribute
issue of new shares, this is very similar to a shares in the new company to the old
-149-
stock split in that it increases the total company's shareholders. The new shares
number of shares while lowering the price of can then be traded independently.
each share and does not change the market
capitalization or the total value of the shares
held.
MOTHOD OF PAYMENT
Dividends must be "declared" (approved) by and anyone who buys it on this day will
a company’s Board of Directors each time receive the dividend, whereas any holders
they are paid. For public companies, there selling the stock lose their right to the
are four important dates to remember dividend. After this date the stock becomes
regarding dividends. ex dividend.

1. The declaration date 3. The ex-dividend date

The declaration date is the day the Board The ex-dividend date is the day on which
of Directors announces its intention to pay a all shares bought and sold no longer come
dividend. On this day, a liability is created attached with the right to be paid the most
and the company records that liability on its recently declared dividend. This is an
books; it now owes the money to the important date for any company that has
stockholders. On the declaration date, the many stockholders, including those that
Board will also announce a date of record trade on exchanges, as it makes
and a payment date. reconciliation of who is to be paid the
dividend easier. Existing holders of the
stock will receive the dividend even if they
now sell the stock, whereas anyone who
now buys the stock will not receive the
-150- dividend. It is -151-
relatively common for a
2. The in-dividend date
stock's price to decrease on the ex-dividend
The in-dividend date is the last day, which date by an amount roughly equal to the
is one trading day before the ex-dividend dividend paid. This reflects the decrease in
date, where the stock is said to be cum the company's assets resulting from the
dividend ('with [including] dividend'). In declaration of the dividend. The company
other words, existing holders of the stock does not take any explicit action to adjust its
stock price; in an efficient market, buyers Dividend-reinvestment plans
and sellers will automatically price this in.
Some companies have dividend
Whenever a company announces a reinvestment plans, or DRIPs. These plans
dividend pay-out, it also announces a "Book allow shareholders to use dividends to
closure Date" which is a date on which the systematically buy small amounts of stock,
company will ideally temporarily close its usually with no commission and sometimes
books for fresh transfers of stock. Read at a slight discount. In some cases the
"Book Closure" for a better understanding. shareholder might not need to pay taxes on
these re-invested dividends, but in most
Shareholders who properly registered their cases they do.
ownership on or before the date of record,
known as stockholders of record, will Dividend reinvestment plans-in case of
receive the dividend. Shareholders who are mutual funds: When the dividend is paid in
not registered as of this date will not receive cash it will attract the dividend distribution
the dividend. Registration in most countries tax (DDT) and the same is not taxable in the
is essentially automatic for shares hands of the person, but in case of dividend
purchased before the ex-dividend date. reinvestment plan where the dividend is not
paid in cash but distributed as additional
units will not attract the DDT and the same
4. Payment -152-
date will be taxable in the hands of the person as
capital gains when-153-
he realises the gain by
The payment date is the day when the selling the units.
dividend checks will actually be mailed to
the shareholders of a company or credited
to brokerage accounts. DIVIDEND POLICY
Dividend policies are the regulations and guidelines In cases where the dividend policy is not specifically
that companies develop and implement as the defined, investors often look at the history to spot any
means of arranging to make dividend payments to trends that emerged in the past. If the dividend
shareholders. payments have been more or less constant for the
last several years, and there has been no loss in
Establishing a specific dividend policy is to the business volume, it is reasonable to assume the
advantage of both the company and the shareholder. payments will still be in the same general range as
In order to make sure the policy is workable, a before. However, if the dividend history is more
company should develop a viable policy and then run volatile, the shareholder may attempt to identify what
this policy through a number of test scenarios in factors led to the up and down movement of the
order to determine what impact the dividend policy dividends and determine if any of those factors are
would have on the operation of the business. relevant to the current dividend period.

In many cases, companies choose to explicitly state In both expressed and implied dividend policy
the provisions within the dividend policy. This is procedures, it is less common for the dividends to be
definitely to the advantage of the shareholder, as a increased. Part of the reason for that is companies
well defined policy makes it much easier to project tend to look closely at retained earnings and want to
the amount of payout profits generated for the period make sure the increased level of earnings will be
under consideration and thus be able to determine sustained over the long term. Once this upward trend
the size of the dividends that will be issued. When is deemed to be more or less permanent, the
the dividend policy is well defined and documented, it company may choose to increase dividends.
is easy for the shareholder to obtain a written copy
and thus be fully informed as to how the policy Far more common is the practice of reducing
works. dividends. This usually takes place because there is
a decrease in the company’s business volume that is
-154-
However, there are cases where the dividend policy not anticipated to-155-
be recaptured in the foreseeable
is not so well documented. When this is the case, future. At other times, the decrease may be due to
investors sometimes base their assumptions on the need to retain more cash on hand for capital
upcoming dividend payments on what has occurred expenses. In both these scenarios, companies tend
in the past. While less systematic, it is still possible to to notify the shareholders in advance that these
project a more or less accurate estimate of what the factors exist and a chance in dividends will take
dividend payout will actually be.
place in order to meet the challenge to remain
profitable. = Dividends / Stock Price

Three Schools Of Thought On Dividends

FACTS ABOUT DIVIDEND POLICY 1. If ……..

* Dividends are sticky; Firms are much more (a) there are no tax disadvantages associated
reluctant to cut dividends than increase them with dividends

(b) companies can issue stock, at no cost, to


raise equity, whenever needed

Dividends do not matter, and dividend policy


does not affect value.

2. If dividends have a tax disadvantage,

Dividends are bad, and increasing dividends


will reduce value

3. If stockholders like dividends, or dividends


operate as a signal of future prospects,
Measures of Dividend Policy
Dividends are good, and increasing dividends
* Dividend Payout : measures the percentage of will increase value
-156-pays in dividends
earnings that the company -157-

= Dividends / Earnings
2. The balanced viewpoint
* Dividend Yield : measures the return that an
investor can make from dividends alone If a company has excess cash, and few good
projects (NPV>0), returning money to time? To avoid conflict, the brokerage industry has
stockholders (dividends or stock repurchases) is set up the convention of declaring that the right to the
GOOD. dividend remains with the stock until 4 days prior to
the holder-of-record date; on the fourth day before
If a company does not have excess cash, and/or the record date the right to the dividend no longer
has several good projects (NPV>0), returning goes with the stock. This date is called the ex-
money to stockholders (dividends or stock dividend date. The ex-dividend date in this example
repurchases) is BAD. in December 11, 1984.

Payment date: The company mails the checks to the


recorded holders on January 2, 1985.
PAYMENT PROCEDURES

* Significant Dates
WHY DO FIRMS PAY DIVIDENDS?
Declaration date: The dividend is declared at a
board of directors meeting. On this date the directors The Miller-Modigliani Hypothesis: Dividends do
issue a statement similar to the following: " On not affect value
November 15, 1984, the directors of the XYZ
corporation met and declared a regular quarterly Basis: If a firm's investment policy (and hence cash
dividend of 50 cents per share, plus an extra flows) don't change, the value of the firm cannot
dividend of 25 cents per share, payable to the change with dividend policy. If we ignore personal
holders of record on December 15, payment to be taxes, investors have to be indifferent to receiving
made on January 2, 1985." either dividends or capital gains.
Holder-of-record date: At the close of the business
on the holder-of-record date, December 15, the
company closes -158-
its stock transfer books and makes * Underlying-159-
Assumptions:
up a list of the shareholders on that date. These
shareholders will receive the dividends (a) There are no tax differences between dividends
and capital gains.
Ex-dividend date: Suppose you buy 100 shares on
December 13, 1984. Will the company be notified in
(b) If companies pay too much in cash, they can
issue new stock, with no flotation costs or signaling (a) selling before the ex-dividend day, and forsaking
consequences, to replace this cash. the dividend.

(c) If companies pay too little in dividends, they do (b) selling after the ex-dividend day, and receiving
not use the excess cash for bad projects or the dividend.
acquisitions.

The cash flows from selling before then are-


* The Tax Response: Dividends are taxed more
than capital gains Pb - (Pb - P) tcg

Basis: Dividends are taxed more heavily than capital The cash flows from selling after the ex-dividend day
gains. A stockholder will therefore prefer to receive are-
capital gains over dividends.
Pa - (Pa - P) tcg + D(1-to)
Evidence: Examining ex-dividend dates should
provide us with some evidence on whether dividends Since the average investor should be indifferent
are perfect substitutes for capital gains. between selling before the ex-dividend day and
selling after the ex-dividend day -
Let Pb= Price before the stock goes ex-dividend
Pb - (Pb - P) tcg = Pa - (Pa - P) tcg + D(1-to)
Pa=Price after the stock goes ex-dividend
Moving the variables around, we arrive at the
D = Dividends declared on stock following:
-160-
to, tcg = Taxes paid on ordinary income and capital -161-
gains respectively

Assume you are all investors in a stock that you Holding other things equal, the price drop on the ex-
bought a long time ago for $P and you have the dividend day will be equal to the dollar dividend if and
choice between- only if the marginal investor in the stock faces the

-162-
same tax rate on dividends and capital gains; it will
be less than the dividend if the tax rate on dividends ( ) Buy just before the ex-dividend day, and sell after.
exceeds the tax rate on capital gains; it will be
greater than the dividend if the tax rate on dividends
is less than the tax rate on capital gains.
Example of dividend capture strategy with tax
If Pb - Pa = D then to = tcg factors: XYZ company is selling for N50 at close of
trading May 3. On May 4, XYZ goes ex-dividend; the
Pb - Pa < D then to > tcg dividend amount is N1. The price drop (from past
examination of the data) is only 90% of the dividend
Pb - Pa > D then to < tcg amount. The transactions needed by a tax-exempt
pension fund for the arbitrage are as follows:
1. Assume that the company that you are analysing
has only wealthy individual investors, and that they 1. Buy 1 million shares of XYZ stock cum-dividend at
face a marginal tax rate of 41% on ordinary income, N50/share.
and 28% on capital gains. If the company pays a
dividend of N1.00, how much would you expect the 2. Wait till stock goes ex-dividend; Sell stock for
price to drop on the ex-dividend day? N49.10/share (50 - 1* 0.90)

What will happen if the capital gains tax rate is 3. Collect dividend on stock.
lowered to 19.6%?
Net profit = - 50 million + 49.10 million + 1 million =
N0.10 million
2. Assume that you are a tax exempt investor, and
that you know that the price drop on the ex-dividend Clearly these profits have to exceed transactions
day is only 90% of the dividend. How would you costs for this to be worth it. (Transactions costs have
exploit this differential? to be less than 10 cents per share)

( ) Invest in the stock for the long term Example of dividend capture strategy even
without tax factors
( ) Sell short the day before the ex-dividend day, buy
on the ex-dividend day On May 4, 2007 Nigeria Electric Power Authority
-163-
began trading ex-dividend; the dividend amount was
N0.565. On May 3, 2007 the following transactions
were reported.
A. The bird in the hand fallacy
10:09:30 am 5,500,000 shares traded at N27.25.
Argument: Dividends now are more certain than
10:09:34 am 2,640,000 shares traded at N26.75 capital gains later. Hence dividends are more
valuable than capital gains.
10:09:37 am 2,860,000 shares traded at N26.625
Counter: The appropriate comparison should be
The first transaction represented a buy of 5.5 million between dividends today and price appreciation
shares at N27.25 by a Jakoto insurance company today. (The stock price drops on the ex-dividend
(which were then obligated to pay yields of 7-8% to day.)
their policy holders from dividend income) from a
Nigeria pension fund.

The second and third transactions represent a sell- B. The excess cash hypothesis
back by the same company to the same pension
fund of 5.5 million shares at a weighted average Argument: The firm has excess cash on its hands
price of N26.685 (These were special trades where this year, no investment projects this year and wants
the pension fund agreed to allow the Jakoto firm to to give the money back to stockholders.
collect the dividends of N0.565 on the stock).
Counter: So why does not it just repurchase stock? If
Jakoto company: was able to collect dividend income this is a one-time phenomenon, the firm has to
of N0.565*5.5 million shares= N3.1 mil consider future financing needs. Consider the cost of
issuing new stock:
Nigeria pension fund: was able to receive the N3.1
million almost 5 weeks early.
-164-
-165-
* The wrong reasons for paying dividends
Size of Issue Cost of Issue
Preferred Common An updated study of Canadian stocks arrives at
Bonds
Stock Stock similar conclusions; cash dividend shares sell at a
Under N 1 million 14.0% - 22.0% premium over stock dividend shares.
N 1 - N 1.9 million 11.0% - 16.9%
N 2- N 4.9 million 4.0% - 12.4% Premium on Cash
N 5 - N 9.9 million 2.4% 2.6% 8.1% Dividend Shares over
Company
N 10 - N 19.9 million 1.2% 1.8% 6.0%
N 20 - N 49.9 million 1.0% 1.7% 4.6% Stock Dividend Shares
> N 50 million 0.9% 1.6% 3.5% Consolidated Bathurst 19.30%
Donfasco 13.30%
Dome Petroleum 0.30%
* Are firms perverse? Some evidence that they Imperial Oil 12.10%
are not Newfoundland Light &
1.80%
Power
Some investors clearly prefer to receive dividends. Royal Trustco 17.30%
Companies with such investors have to pay Stelco 2.70%
dividends to keep them happy. TransAlta 1.10%
Average 7.54%
Citizens Utility is a company which has two classes
of stock. Class A gets a stock dividend and can be 3. Clearly some investors like dividends. What types
converted freely into Class B stock. Class B gets a of investors do you think are most likely to fall into
cash dividend and cannot be converted to Class A this category? (You can pick more than one)
stock. The stock dividend is generally 7% to 13%
greater than the cash dividend. - Wealthy investors

The study found that PB > PA by more than 10%. In - Institutional Investors
-167- -168-
other words, the cash dividend shares sold at a
premium of 10% over-166-
the capital gains shares. - Less well-off investors

An Updated Study of Canadian companies arrives at - Tax-exempt investors


similar conclusions.
* A clientele based explanation
prospects. An increase in dividends is one way to
Basis: Investors may form clienteles based upon signal good future prospects.
their tax brackets. Investors in high tax brackets may
invest in stocks which do not pay dividends and On average, at least, increases in dividends seem to
those in low tax brackets may invest in dividend be viewed as positive signals and decreases as
paying stocks. negative signals.

* Why is the positive reaction to a dividend increase


4. Assume that you run a phone company, and that more muted than the negative reaction to a dividend
you have historically paid large dividends. You are decrease?
now planning to enter the telecommunications and
media markets. Which of the following paths are you An Alternative Story...Dividends as Negative Signals
most likely to follow?
The problem with signaling stories is that an equally
( ) Courageously announce to your stockholders that compelling case can be made for increasing
you plan to cut dividends and invest in the new dividends being a negative signal, especially for
markets. young, high growth firms. There is evidence that
earnings growth declines after firms initiate
( ) Continue to pay the dividends that you used to, dividends.
and defer investment in the new markets.
Extending the effects of dividend changes on stock
( ) Continue to pay the dividends that you used to, prices - long term
make the investments in the new markets, and issue
new stock to cover the shortfall While dividend increases (decreases) tend to have a
positive (negative) effect in the short term, there
seems to be an interesting evening out of returns in
the month after the announcement.
-169-
* The Signalling Hypothesis
* The Wealth Transfer Hypothesis
Context: In a world of asymmetric information, firms
have to convince investors about their future Basis: Dividends are one of the ways stockholders
can transfer wealth from bondholders to themselves. a signaling device of future
prospects
Since bondholders anticipate this, they write 3. The market uses dividend
constraints into bond covenants and stockholders announcements as
who do not pay dividends will actually be transferring information for 43% 51% 6%
wealth to bondholders. assessing firm value.
4. Investors have different
perceptions of the relative
56% 42% 2%
riskiness of dividends and
retained earnings.
5. Investors are basically
indifferent with regard to
6% 30% 64%
returns from dividends and
capital gains.
6. A stockholder is attracted to
firms that have dividend
44% 49% 7%
policies appropriate to the
stockholders' tax environment.
7. Management should be
responsive to shareholders'
41% 49% 10%
preferences regarding
dividends.

-171-
DETERMINANTS OF DIVIDEND POLICY
-170-
* Management Beliefs about Dividend Policy A. Investment Opportunities
Statement of Management
Beliefs
Agree No Opinion Disagree Basis: Other thing remaining equal, a firm with more
1. A firm's dividend payout investment opportunities will pay a lower fraction of
ratio affects the price of the 61% 33% 6% its earnings as dividends than a stable firm.
stock
2. Dividend payments provide 52% 41% 7%

-172-
Proxy for investment opportunities: Growth rate in less likely to have a high payout ratio.
firm's assets; Capital Investment;
D. Constraints
Testable proposition: A firm with higher growth
rates in assets or earnings, and greater capital Basis: Firms which have borrowed large amounts of
investment needs will pay out a lower fraction of its debt usually have several constraints on their
earnings as dividends dividend policy and will therefore follow more
conservative dividend policies
B. Stability in earnings
Proxy for leverage: Debt ratio
Basis: Other things remaining equal, a firm with
more stable earnings will pay out a higher fraction of Testable proposition: A firm with a high debt ratio
its earnings as dividends than a firm with variable will very seldom be able to make major changes in
earnings its dividend policy because of constraints on payout.

Proxy for variability in earnings: Variance in EPS E. Signalling Incentives

Testable proposition: A firm with higher variance in Basis: Firms which are undervalued may use
EPS will have a lower dividend payout ratio dividend increases as signals to the market

C. Alternative sources of capital Proxy for undervaluation: Price/ Value ratios

Basis: Other things remaining equal, a firm which Testable proposition: As the ratio of price to value
can issue new stock or bonds at low cost (such as decreases dividend increases will become more
underwriting commissions) will be more likely to have frequent.
a high dividend payout ratio.
F. Stockholder characteristics
Proxy for cost of issue: Size of the firm
Basis: Firms which have acquired a reputation as
Testable proposition: A smaller firm will almost high dividend yield firms also acquire stockholders
invariably have a higher issuance cost than a larger who desire high dividends. Consequently they cannot
firm in issuing new stock and debt. It will therefore be suddenly shift policy.
-173-
Testable proposition: The past history of a
company's dividend policy is usually be a good
indication of what it will do in the future.

MERGERS AND ACQUISITION

The phrase mergers and acquisitions


(abbreviated M&A) refers to the aspect of
corporate strategy, corporate finance and
management dealing with the buying,
selling and combining of different
companies that can aid, finance, or help a
growing company in a given industry grow
rapidly without having to create another
business entity.

-174- ACQUISITION
-175-
An acquisition, also known as a takeover
or a buyout, is the buying of one company
(the ‘target’) by another. An acquisition may
be friendly or hostile. In the former case, the
companies cooperate in negotiations; in the

-176-
latter case, the takeover target is unwilling The terms "demerger", "spin-off" and "spin-
to be bought or the target's board has no out" are sometimes used to indicate a
prior knowledge of the offer. Acquisition situation where one company splits into two,
usually refers to a purchase of a smaller generating a second company separately
firm by a larger one. Sometimes, however, listed on a stock exchange.
a smaller firm will acquire management
control of a larger or longer established In business or economics a merger is a
company and keep its name for the combination of two companies into one
combined entity. This is known as a larger company. Such actions are
reverse takeover. Another type of commonly voluntary and involve stock swap
acquisition is reverse merger, a deal that or cash payment to the target. Stock swap
enables a private company to get publicly is often used as it allows the shareholders
listed in a short time period. A reverse of the two companies to share the risk
merger occurs when a private company involved in the deal. A merger can resemble
that has strong prospects and is eager to a takeover but result in a new company
raise financing buys a publicly listed shell name (often combining the names of the
company, usually one with no business and original companies) and in new branding; in
limited assets. Achieving acquisition some cases, terming the combination a
success has proven to be very difficult, "merger" rather than an acquisition is done
while various studies have showed that purely for political or marketing reasons.
50% of acquisitions were unsuccessful. The
CLASSIFICATIONS OF MERGERS
acquisition process is very complex, with -177-
many dimensions influencing its outcome.
1. Horizontal merger - Two companies that
MERGER are in direct competition and share similar
product lines and markets
2. Vertical merger - A customer and 6, Conglomeration - Two companies that
company or a supplier and company. (eg: have no common business areas.
an ice cream maker merges with the dairy
farm whom they previously purchased milk
from; now, the milk is 'free')
TYPES OF MERGERS
3. Market-extension merger - Two
companies that sell the same products in 1. Purchase mergers - As the name
different markets suggests, this kind of merger occurs when
one company purchases another. The
4. Cogeneric : in same industries and purchase is made with cash or through the
taking place at the same level of economic issue of some kind of debt instrument; the
activity- exploration, production or sale is taxable.
manufacturing wholesale distribution or
retail distribution to the ultimate consumer. Acquiring companies often prefer this type
of merger because it can provide them with
Cogeneric merger are of two types a tax benefit. Acquired assets can be
Horizontal merger (b) Vertical merger (eg: written-up to the actual purchase price, and
an ice cream maker in the United States the difference between the book value and
merges with an ice cream maker in the purchase price of the assets can
Canada) depreciate annually, reducing taxes payable
by the acquiring company.
-178-
5. Product-extension merger - Two
companies selling different but related -179-
2. Consolidation mergers - With this
products in the same market (eg: a cone merger, a brand new company is formed
supplier merging with an ice cream maker). and both companies are bought and
combined under the new entity. The tax
terms are the same as those of a purchase business and the buyer's stock continues to
merger. be traded.

3. Accretive mergers are those in which an In the pure sense of the term, a merger
acquiring company's earnings per share happens when two firms, often of about the
(EPS) increase. An alternative way of same size, agree to go forward as a single
calculating this is if a company with a high new company rather than remain separately
price to earnings ratio (P/E) acquires one owned and operated. This kind of action is
with a low P/E. more precisely referred to as a "merger of
equals". Both companies' stocks are
4. Dilutive mergers are the opposite of surrendered and new company stock is
above, whereby a company's EPS issued in its place.
decreases. The company will be one with a
low P/E acquiring one with a high P/E. In practice, however, actual mergers of
equals don't happen very often. Usually,
Distinction between mergers and acquisitions one company will buy another and, as part
of the deal's terms, simply allow the
Although they are often uttered in the same acquired firm to proclaim that the action is a
breath and used as though they were merger of equals, even if it is technically an
synonymous, the terms merger and acquisition. Being bought out often carries
acquisition mean slightly different things. negative connotations, therefore, by
describing the deal euphemistically as a
When one company takes over another and
merger, deal makers and top managers try
-181-
clearly establishes itself as the new owner,
to make the takeover more palatable.
the purchase is-180-
called an acquisition. From
a legal point of view, the target company A purchase deal will also be called a merger
ceases to exist, the buyer "swallows" the when both CEOs agree that joining together
is in the best interest of both of their are financed and partly by the relative size
companies. But when the deal is unfriendly of the companies. Various methods of
- that is, when the target company does not financing an M&A deal exist:
want to be purchased - it is always regarded
as an acquisition. 1. Cash

Whether a purchase is considered a merger Payment by cash. Such transactions are


or an acquisition really depends on whether usually termed acquisitions rather than
the purchase is friendly or hostile and how it mergers because the shareholders of the
is announced. In other words, the real target company are removed from the
difference lies in how the purchase is picture and the target comes under the
communicated to and received by the target (indirect) control of the bidder's
company's board of directors, employees shareholders alone.
and shareholders. It is quite normal though
for M&A deal communications to take place A cash deal would make more sense during
in a so called 'confidentiality bubble' a downward trend in the interest rates.
whereby information flows are restricted Another advantage of using cash for an
due to confidentiality agreements (Harwood, acquisition is that there tends to lesser
2005). chances of EPS dilution for the acquiring
company. But a caveat in using cash is that
it places constraints on the cash flow of the
company.
-182- 2. Financing
FINANCING M&A
-183-
Financing capital may be borrowed from a
Mergers are generally differentiated from bank, or raised by an issue of bonds.
acquisitions partly by the way in which they
Alternatively, the acquirer's stock may be • Economy of scale: This refers to the fact that
offered as consideration. Acquisitions the combined company can often reduce its fixed
costs by removing duplicate departments or
financed through debt are known as operations, lowering the costs of the company
leveraged buyouts if they take the target relative to the same revenue stream, thus
private, and the debt will often be moved increasing profit margins.
down onto the balance sheet of the • Increased revenue or market share: This
assumes that the buyer will be absorbing a major
acquired company.
competitor and thus increase its market power (by
capturing increased market share) to set prices.
3. Hybrids
• Cross-selling: For example, a bank buying a
stock broker could then sell its banking products
An acquisition can involve a combination of to the stock broker's customers, while the broker
cash and debt or of cash and stock of the can sign up the bank's customers for brokerage
purchasing entity. accounts. Or, a manufacturer can acquire and sell
complementary products.
4. Factoring • Synergy: For example, managerial economies
such as the increased opportunity of managerial
specialization. Another example are purchasing
Factoring can provide the extra to make a economies due to increased order size and
merger or sale work associated bulk-buying discounts.

MOTIVES BEHIND M&A • Taxation: A profitable company can buy a loss


maker to use the target's loss as their advantage
The dominant rationale used to explain by reducing their tax liability. In the United States
M&A activity is that acquiring firms seek and many other countries, rules are in place to
limit the ability of profitable companies to "shop"
improved financial performance. The for loss making companies, limiting the tax motive
following motives are considered to improve
-184- of an acquiring company.
financial performance: -185-
• Geographical or other diversification: This is
designed to smooth the earnings results of a
company, which over the long term smoothens industry it fails to deliver value, since it is possible
the stock price of a company, giving conservative for individual shareholders to achieve the same
investors more confidence in investing in the hedge by diversifying their portfolios at a much
company. However, this does not always deliver lower cost than those associated with a merger.
value to shareholders (see below). • Manager's hubris: manager's overconfidence
• Resource transfer: resources are unevenly about expected synergies from M&A which
distributed across firms (Barney, 1991) and the results in overpayment for the target company.
interaction of target and acquiring firm resources • Empire-building: Managers have larger
can create value through either overcoming companies to manage and hence more power.
information asymmetry or by combining scarce • Manager's compensation: In the past, certain
resources.[3] executive management teams had their payout
based on the total amount of profit of the
• Vertical integration: Vertical integration occurs company, instead of the profit per share, which
when an upstream and downstream firm merge would give the team a perverse incentive to buy
(or one acquires the other). There are several companies to increase the total profit while
reasons for this to occur. One reason is to decreasing the profit per share (which hurts the
internalise an externality problem. A common owners of the company, the shareholders);
example is of such an externality is double although some empirical studies show that
marginalization. Double marginalization occurs compensation is linked to profitability rather than
when both the upstream and downstream firms mere profits of the company.
have monopoly power, each firm reduces output
from the competitive level to the monopoly level,
creating two deadweight losses. By merging the
vertically integrated firm can collect one TAKEOVER
deadweight loss by setting the upstream firm's
output to the competitive level. This increases In business, a takeover is the purchase of
profits and consumer surplus. A merger that one company (the target) by another (the
creates a vertically integrated firm can be
profitable. acquirer, or bidder). to the acquisition of a
private company.
• Diversification: While this may hedge a
company against -186-
a downturn in an individual -187-
TYPES OF TAKEOVERS A hostile takeover allows a suitor to bypass
a target company's management unwilling
1. Friendly takeovers to agree to a merger or takeover. A
takeover is considered "hostile" if the target
Before a bidder makes an offer for another
company's board rejects the offer, but the
company, it usually first informs that
bidder continues to pursue it, or the bidder
company's board of directors. If the board
makes the offer without informing the target
feels that accepting the offer serves
company's board beforehand.
shareholders better than rejecting it, it
recommends the offer be accepted by the A hostile takeover can be conducted in
shareholders. several ways. A tender offer can be made
where the acquiring company makes a
In a private company, because the
public offer at a fixed price above the
shareholders and the board are usually the
current market price.
same people or closely connected with one
another, private acquisitions are usually The main consequence of a bid being
friendly. If the shareholders agree to sell the considered hostile is practical rather than
company, then the board is usually of the legal. If the board of the target cooperates,
same mind or sufficiently under the orders the bidder can conduct extensive due
of the shareholders to cooperate with the diligence into the affairs of the target
bidder. This point is not relevant to the UK company. It can find out exactly what it is
concept of takeovers, which always involve taking on before it makes a commitment.
the acquisition of a public company. But a hostile bidder knows about the target
only the information that is publicly
available, and so takes a greater risk. Also,
2. Hostile takeovers banks are less willing to back hostile bids
-188- -189-
with the loans that are usually needed to leveraged buyouts, and the debt will often
finance the takeover be moved down onto the balance sheet of
the acquired company. The acquired
3. Reverse takeovers company then has to pay back the debt.
This is a technique often used by private
A reverse takeover is a type of takeover
equity companies. The debt ratio of
where a private company acquires a public
financing can go as high as 80% in some
company. This is usually done at the
cases. In such a case, the acquiring
instigation of the larger, private company,
company would only need to raise 20% of
the purpose being for the private company
the purchase price.
to effectively float itself while avoiding some
of the expense and time involved in a 2. Loan note alternatives
conventional IPO.
Cash offers for public companies often
include a "loan note alternative" that allows
shareholders to take part or all of their
FINANCING A TAKEOVER consideration in loan notes rather than
1. Funding cash. This is done primarily to make the
offer more attractive in terms of taxation. A
Often a company acquiring another pays a conversion of shares into cash is counted a
specified amount for it. This money can be disposal that triggers a payment of capital
raised in a number of ways. Although the gains tax, whereas if the shares are
company may have sufficient funds converted into other securities, such as loan
available in its account, this is unusual. notes, the tax is rolled over.
More often, it will be borrowed from a bank,
or raised by an issue of bonds. Acquisitions
financed through debt are known as -191-
-190-
3. All share deals 4. Increase market share
-192-
A takeover, particularly a reverse takeover, 5. Decrease competition (from the perspective of
the acquiring company)
may be financed by an all share deal. The 6. Reduction of overcapacity in the industry
bidder does not pay money, but instead 7. Enlarge brand portfolio
issues new shares in itself to the 8. Increase in economies of scale
shareholders of the company being
acquired. In a reverse takeover the Cons:
shareholders of the company being
1. Reduced competition and choice for
acquired end up with a majority of the consumers in oligopoly markets. (Bad for
shares in, and so control of, the company consumers, although this is good for the
making the bid. The company has companies involved in the takeover)
managemental rights. 2. Likelihood of job cuts.
3. Cultural integration/conflict with new
management
4. Hidden liabilities of target entity.
5. The monetary cost to the company.
PROS AND CONS OF TAKEOVER
Takeovers also tend to substitute debt for
While perceived pros and cons of a equity. In a sense, government tax policy of
takeover differ from case to case, there are allowing for deduction of interest expenses
a few worth mentioning. but not of dividends, has essentially
provided a substantial subsidy to takeovers.
Pros:
It can punish more conservative or prudent
1. Increase in sales/revenues (e.g. Procter & management that don't allow their
Gamble takeover of Gillette) companies to leverage themselves into a
2. Venture into new businesses and markets high risk position. High leverage will lead to
3. Profitability of target company
high profits if circumstances go well, but can

-193-
lead to catastrophic failure if circumstances o How the funding and security issues are to
do not go favorably. This can create work.
substantial negative externalities for -194-
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-195-
10. Pfizer and Warner-Lambert agree to $90
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