LECTURE-1

NATURE AND SCOPE OF FINANCE

Introduction to Finance

Finance is a branch of economics concerned with resource allocation as well as resource

management, acquisition and investment.

Simply, finance deals with matters related to money and the market. It is the science of the
management of money and other assets.

The scope of financial management can be summarized into two broad parts, namely:
 Managerial functions
 Routine functions

Managerial Functions

These are the most important functions of the finance manager since they affect the value of
the firm. These functions require the technical expertise of the finance manager. They include
the following:

1. Investment
This refers to the allocation of the company’s resources to projects available.

2. Financing
This involves determining the sources of finance available to the company and to ensure that
the company utilizes these resources in the most optimal manner. The sources of finance
available to the company can be categorized into two;

a. Long-term sources of finance

These sources of finance are available for a period of more than five years e.g. long-term debt
and equity.

b. Short-term sources of finance

These are funds available for a period of less than one year; for example, creditors and accruals.

3. Dividend policy
This function is also known as the profit allocation function. Dividends are profits which are
distributed to the shareholders as a reward for investing in the company.

The dividend policy decision affects the investment function because retained earnings are an

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internal source of finance. Therefore, a high dividend payout ratio will lead to low retained
earnings and hence more external borrowing for investment purposes and vice versa.

Routine Functions

These functions do not require the technical knowledge or expertise of the finance manager.
These functions support the managerial functions and are normally delegated to junior staff in
the finance department. They include:

 Implementing the internal controls of finance department.

 Receiving and paying cash.
 Issuing cash receipts.
 Safeguarding important financial documents.

Goals of the Firm

Firms, just like individuals, operate with specific goals. Without goals the firm will not be able
to achieve much. These goals include:
 Financial goals
 Non-financial goals

1. Financial Goals

a. Profit maximization
Profit can generally be defined as the difference between sales and expenses.
For a firm to increase its profitability, it should either:
 Increase its sales and hold its expenses constant. This may entail increasing the selling
price per unit. The other possibility of increasing sales quantity is not guaranteed since it
depends on market demand that the business may not have any influence on.
 Reduce its expenses and hold its sales constant. This may entail reducing the expenses
per unit while maintaining the selling price.

However, these two strategies may not be sustainable in the long run because increasing the
selling price implies overcharging the customers whereas reducing the expenses may involve
underpaying the workers.

b. Wealth maximization
The benefits received by the shareholders will either be in form of dividends received each year
or capital gains or losses. When these two are added up and expressed in present value terms,
they give the theoretical value of a share.

This goal will involve investing in projects which will yield positive net present value. Any
course of action which yields a positive net present value will maximize wealth and vice versa.

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Advantages of wealth maximization objective
i) It takes into account the concept of the time value of money. This is done by calculating
the present value of all the expected future benefits.
ii) It considers the risks and uncertainties associated with a given cash flow by discounting
the cash flows.
iii) It is a long-term goal which is consistent with the going concern concept of the firm.

Disadvantages
i) It ignores the welfare of other interested parties in the firm as it focuses only on the
shareholders.
ii) It is a subjective goal since it uses future cash flows which are uncertain.

2. Non-Financial Goals
These goals limit the ability of the company to achieve its financial goals. However, the
company still pursues them because it has to interact with other parties in its environment. Non-
financial goals are the social responsibilities of the firm and include the following:
i) Corporate responsibility to employees e.g. fair remuneration, promotion, good
retirement benefits and a conducive working environment.
ii) Corporate responsibility to the government e.g. prompts payment of taxes and abiding
by the laid down rules and regulations e.g. respecting covid-19 curfew obligations on
staff
iii) Corporate responsibility to the community e.g. pollution controls, employment of its
members, taking part in community development programmes and adhering to business
ethics.

Stakeholders in a firm and their interests

An organization's stakeholders are the individuals or entities that influence or have an interest
in the firm’s actions and decisions. The major stakeholders in a company include;

 Shareholders
 The government
 Employees
 Customers
 Creditors/bondholders
 The community

TOPIC-2: SOURCES OF FINANCE FOR ORGANIZATION

There are different sources from which a firm can raise funds. These sources may be classified
into the following two categories:

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  Internal and external sources
 Long-term and short-term sources

Internal sources of finance are generated within the business. They include:
 Retained earnings.
 Provisions e.g. provision for depreciation and provision for taxation.
 Sale and lease back.

External sources of finance are obtained from owners or creditors. They include:
 Ordinary share capital.
 Preference share capital.
 Debentures.
 Trade credit.
 Hire purchase.
 Loan from banks and other financial institutions.

Long-term financial sources provide funds that may be used usually for more than five years.
On the other hand, short-term sources provide funds that may be used for between one to three
years.

Long-Term Sources

a. Share capital

Share capital may include:

 Ordinary share capital
 Preference share capital

Ordinary Share Capital

Ordinary share capital or equity is contributed by the real owners of a limited company. It is
not redeemable and as such it is a permanent source of finance. Ordinary shares carry voting
rights and control of the affairs of the company is exercised by the holders of these shares.

The ordinary shareholders bear the greatest part of the risk of a company’s operations. If the
profits for the year are low, the ordinary shareholders will suffer the most as they will only be
paid their dividends after payment of interest on loans, taxation and preference dividend have
been cleared. Similarly, in case the company has to wind up the ordinary shareholders will be
the last to be paid.

Advantages of ordinary shares

i. There are no fixed charges attached to ordinary shares because the payment of dividends is
not a legal obligation.
ii. They carry no fixed maturity date thus can be used permanently.
iii. They can be sold more easily than debentures because they give voting power to the
investors.
iv. They can raise large amounts in particular if the company is quoted on the stock exchange.

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v. The market prices of ordinary shares help to measure how financially sound a company is.

Preference Shares
Preference share capital is contributed by the preference shareholders. Preference shares do not
carry voting power and holders do not exercise any control on the affairs of the company. They
carry the prior right to fixed dividend from profits and to preferential payments before ordinary
shareholders in the event of winding up. Preference shares may be:

Cumulative
The shareholders receive full payment of dividends in arrears before any other shareholders are
paid.

Non-cumulative
The shareholders receive a fixed dividend when sufficient profits are available.

Participating
The shareholders receive a fixed dividend and participate in surplus profits with ordinary
shareholders at a specific rate.

Redeemable
The preference shares may be redeemed at a specific date fixed at the time of issue.

Non-redeemable
These shares are not to be redeemed by the issuing company except in the event of liquidation.

Convertible
These can be converted into ordinary shares at a specific conversion ratio after a specific period.

Non-convertible
These cannot be converted into ordinary shares.

Advantages of preference shares

A. From the view point of the issuer
i) Obligation to pay a fixed rate of dividend is not binding.
ii) Voting power is not affected.
iii) If redeemable, they are more flexible than debentures.

B. From the viewpoint of the investor

i) Provides a reasonably steady income.
ii) There is preference over ordinary shares in liquidation.

Disadvantages of preference shares

A. From the viewpoint of the issuer
i) Preference dividends are not allowable for tax purposes.
ii) Cost of issue is higher than for debentures.

B. From the viewpoint of the investor

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 i) There’s no legally enforceable right to dividends
ii) These cannot be secured against assets.

Debenture or Long-Term Loans

A debenture may be defined as the written acknowledgement of a debt incurred by a limited

company. Debentures are capital raised by a company for which interest is paid usually half-
yearly at a fixed rate. Debentures may be secured or unsecured.

Types of debentures

i) Naked or unsecured debentures

These do not give any form of security and are a mere acknowledgement of a debt due from a
third party. These are considered as unsecured creditors.

ii) Secured debentures

These debentures are secured against the assets of a company. These may have floating or fixed
charges. A fixed charge gives a mortgage of specific assets and a floating charge gives a charge
over the general assets of the company in the present or future.

iii) Redeemable debentures

These debentures are redeemable after a specific period. Meaning the borrower pays off the
debt owing to the provider of finance.

iv) Irredeemable debentures

These debentures are normally redeemable at the option of the company only or in the event
of winding up of the company.

v. Convertible debentures
These can be converted into ordinary shares at the option of the holder and under specific terms
and conditions.

vi. Subordinated debentures

These are debentures which are subordinated to the other loans previously issued. These are
normally issued on the basis of the terms of the debentures previously issued and to which they
are subordinated. They carry no security and rank last in claims after all classes of creditors,
except trade creditors.

Advantages of loan capital/debentures

i) Cost of debt is limited.
ii) Interest payment is deductible for tax purposes.
iii) Control of the company is not shared.

Disadvantages of loan capital/debentures

i) Debt interest is a fixed charge.

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 ii) The date of maturity is fixed.
iii) Funds can be raised within certain limits only.

Long-term debt is encouraged under the following conditions:

a) When sales and earnings are stable.
b) Profit margins are high.
c) A rise in profit or the general price level is expected. i.e. when inflation is anticipated
d) The existing debt is relatively low.

Retained earnings and provisions

A part of profits which belongs to the ordinary shareholders may not be paid to them in the
period they are earned. These undistributed profits are known as retained earnings.

Advantages of retained earnings

These are the cheapest and painless methods of raising additional capital because they do not
involve any cost.
i) The retained earnings are the only sources of finance if a firm in unable to raise long-
term loans due to insufficient assets being available as security.
ii) These earnings must be used when external borrowing carries too high interest rates.
iii) They do not affect the control of the company.

Disadvantages of retained earnings

i) High retained earnings are possible only when dividends are declared at a low rate. The
fall in dividends results in the fall of share prices.
ii) Investors who buy shares to get more income are not happy when there are high retained
earnings.
iii) If the retained earnings are invested carelessly, the company’s profitability will be
affected adversely.

In addition to the retained profits, the following provisions also provide funds for the business.
Provision for depreciation
Depreciation is charged to the profit and loss account but it does not involve any cash payment.
The provision for depreciation leaves cash at the disposal of the business which can be used or
utilized for further expansion of the business.

Provision for taxation

A company must pay corporation tax which is usually a fixed percentage of profit earned for a
year. There is always a time lag between the time profits are made and the time the tax must
be paid over to the government. During this period, these funds can be utilized for expansion
of the business.

Mortgage

Companies can access loans for long periods by mortgaging their assets with a financial
institution. Insurance companies, pension funds and finance companies are the main
mortgagees. The mortgagor agrees to deposit the title to the assets with the mortgagee. The

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loans obtained by the mortgage are to be repaid through installments over a specific period of
time.

Advantages of mortgages
i) It is a long-term source of finance and is used to acquire fixed assets.
ii) The interest on mortgages is allowable for tax purposes.
iii) The debt is repayable in installments which is convenient for the borrower and can be
repaid out of income generated by the additional assets.
iv) It is a flexible source of finance.

Disadvantages of mortgage
i) The cost of the debt is too high.
ii) The repayment of debt is legally binding and the failure to repay may force the
mortgagor to go into receivership.
iii) The source is available only to the companies which own freehold properties.
iv) The formalities involved are too complicated and it can delay the procurement of the
debt.

Sale and lease back

A company which owns its own premises or fixed assets can obtain finance by selling the
property to another entity e.g. an insurance company for immediate cash and rent it back.

Advantages of sale and lease back

i) Hire charges of the lease is an allowable expense for tax purposes.
ii) The finances obtained can be used to expand the operations of the company.
iii) It does not entail the risk of receivership.

Disadvantages of sale and lease back

i) The firm loses an asset which is certain to appreciate with inflation.
ii) There is a reduction in the company’s future borrowing power as the property that could
be used as a security is already sold.
iii) There is less freedom to modify the premises sold and leased back.
iv) The finance is limited to the value of the asset leased so it may not be enough for the
company to expand its operations.

Short Term Sources of Finance

Bank credit
Commercial banks give short-term loans. These loans are given in the form of overdrafts. The
rate of interest of the overdraft is comparatively high. The main advantage of the overdraft is
that interest is charged only on that part of facility which has actually been used.

The main disadvantage is that money is repayable on demand.

Trade credit

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The use of credit from suppliers is a major source of finance. It is a particularly important
source for fast growing firms. Trade credit is a cheap source of short-term finance. It is also
easy to obtain and is a flexible source of finance. The only caution a company must exercise is
to avoid over trade credit financing as it will result to over trading.

The main disadvantage of trade credit is the loss of cash discount.

Factoring
Factoring refers selling debts for immediate cash to a factor who charges a commission. When
the factor receives each batch of invoices from his client he pays about 80% of its value in cash
immediately. Factoring can result in savings to management in the form of bad debts, losses,
salary costs, telephone etc.

Invoice discounting
Invoice discounting is almost similar to factoring. Whereas factoring is defined as the selling
of debts, invoice discounting is the assignment of debts.

Invoice discounting is characterized by the fact that the lender not only has lien on the debts
but also has recourse to the borrower (seller) if the firm or person that bought the goods does
not pay. In this case the loss is borne by the selling firm, invoice discounting firms act as the
agent of the seller.

Difference between factoring and invoice discounting

Factoring
 Factoring provides many value added
services such as full sales ledger and
collections service
 A factoring company takes on the
responsibility for the collection of
invoices
Invoice discounting
 Does not include services such as full
sales ledger and collections service
 Under an invoice discounting facility
the actual business takes on the
responsibility for the collection of
invoices

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  A business sells its invoices to a third
party and then the factoring company
control the sales ledger and collects
the debts.
 The customer is aware of the fact
that the invoices have been factored.
 Under a factoring agreement a
business sell and completely assigns
the entire rights to the submitted
invoice.
 Under a factoring facility the
customer is aware that there is a third
party involved and so the customer
may feel uncomfortable
 Under a factoring facility the
customer pays the factoring company
direct.
 Invoice discounting is an alternative
way of drawing money against your
invoices. However, the business
retains control over the
administration of your sales ledger.
 The customer is not aware of the
fact that the invoices have been
discounted.
 Under a invoice discounting facility
you do assign or sell the invoice you
just raise funds against a invoice or
batch of invoices
 Under an invoice discounting facility
the whole process can be kept
confidential thus avoiding an
embarrassment
 Under an invoice discounting the
customer pays the company as
normal

Advantages of factoring and invoice discounting

i) These methods are flexible.
ii) A larger volume of invoices is generated with an increase in sales.
iii) Invoices provide a security

Disadvantages of factoring and invoice discounting

i) It is inconvenient and expensive when invoices are numerous and relatively small in
value
ii) The firm is using a high liquid asset as security.

Factoring and invoice discounting are also known as financing of trade debtors.

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