Professional Documents
Culture Documents
TABLE OF CONTENT
CHAPTER ONE
INTRODUCTION
In this chapter you will learn what financial management is and why the financial management
of construction companies is different from financial management of most other companies.
“A construction manager is like an Olympic decathlon athlete who must show great
competence in a multitude of areas ranging from design of construction operations to labor
relations.”*
Notwithstanding the multi-faceted nature of construction management, construction
professionals are forced to focus heavily on the technical side of their work. Each project is a
unique technological and organizational puzzle. A construction manager is in a race against time
and money to reach targets relating to cost and required completion deadlines. Surprisingly,
business objectives such as making a profit often take a back seat to the complex interplay of
technology and organization. Bringing a project in on time and at bid price is like landing a jet
fighter on an aircraft carrier in heavy seas.
Financial and business issues are often foreign to the interests of the field personnel who are
locked in combat, on a day-by-day basis, with the solution of practice-oriented problems in the
field. It is almost as if making a profit is a secondary issue—a necessary evil. And yet, without
profit, businesses fail. Small mistakes in judging the financial landscape often lead to big losses.
LEARNING OUTCOMES
When you have completed this chapter, you should be able to:
◼ Explain accounting and financial management in construction
◼ Discuss the role of the finance function within a business.
◼ Explain construction financial management different from the financial
management of other companies?
◼ Identify and discuss possible objectives for a business and explain the advantages
of the shareholder wealth maximization objective.
◼ Explain how risk, ethical considerations, and the needs of other stakeholders
influence the pursuit of shareholder wealth maximization.
◼ Describe the agency problem and explain how it may be managed.
❖ Investments: This area of finance focuses on the behavior of financial markets and the
pricing of securities. An investment manager’s tasks, for example, may include valuing
common stocks, selecting securities for a pension fund, or measuring a portfolio’s
performance.
❖ Financial institutions: This area of finance deals with banks and other firms that
specialize in bringing the suppliers of funds together with the users of funds. For
example, a manager of a bank may make decisions regarding granting loans, managing
cash balances, setting interest rates on loans, and dealing with government regulations.
Financial management concerns all the decisions involving money that a company must take
every day. Some financial choices, such as deciding to stop building condominiums in order to
free up resources, can have a substantial impact on a company. Others may be of much smaller
scope, such as deciding to take advantage of vendor discounts available by paying invoices in a
timely fashion. Regardless of size or impact, financial decisions can be made using a rational
analysis of relevant factors just on the basis of intuition. A main proposition of this book is that
rational and informed decisions will prevail in the long run over intuitive but uninformed
choices.
Financial management finds its way into almost every corner of human activity (think of how
many things in life involve money). It would be nearly impossible to address all the issues within
its scope. Taxes, for example, are of relevance for almost everyone. Computing a project’s profit
to date, however, is much more relevant for a construction professional than to a stock trader.
Optimizing a stock portfolio, on the other hand, is of little direct significance in construction, but
it is of utmost importance for a stock trader.
Consequently, this book—like any other specialty-focused book—is a subset of all the topics that
we could address in financial management. Its topics are not only a collection of standard areas
found in most construction oriented financial textbooks but are also a selection of what, in the
judgment of the authors, will be useful to you throughout your career. As a construction
professional, you need to know accounting fundamentals, project-related financial matters, and
company-level financial issues. Each one of these three areas has a substantial impact on your
ability to succeed in your career. Let us take a bird’s-eye view of these topics with some
attention to the issues that they comprise.
Financial accounting involves the capture of information regarding the purchase and sale of
effort and products (e.g., TV sets, bicycles, real estate, construction of concrete footers, etc.).
The information of interest is the revenue derived from sale and the expense involved in
producing work and products for sale. The history of accounting is as old as commerce in
society. It led to early forms of mathematics so that a system of measures could be used to keep
track of value and the transfer of value between individuals.
Businesses exist to produce a profit, and accounting allows for the determination of whether a
profit or loss is occurring because of the activities of a given business activity. Records of
purchase and sale offer interesting insights into the operations of society from the time of ancient
civilizations up to the present day.
Accounting is founded upon the acquiring, storing, and analyzing of financial information. This
implies extensive record-keeping and data management. The data captured by accounting
systems, when properly displayed and analyzed, tell us something about the financial position or
health of a business entity.
1.2. Construction Accounting Different from Other Business Sectors*
Worldwide construction is the largest economic sector of the global economy. Construction
ranks number three in the amount of economic activity contributed to the gross national product
(GNP) of Ethiopia. The largest Ethiopia industry that focuses on the production of a physical
product as opposed to the provision of a service (e.g., the health care industry.) The dollar
volume of the industry is on the order of one trillion (1,000 billion) dollars annually. The process
of realizing a constructed facility such as a road, bridge, or building, however, is quite different
from what is involved in manufacturing an automobile, a computer, or a cell phone.
Construction accounting is a specialized type of accounting that is tailored to accurately reflect
the unique nature of the construction business. It is a subset of project accounting, and Generally
Accepted Accounting Principles (GAAP) still apply to those who must comply with those
standards. However, just as the industry is unique, so are some aspects of construction
accounting? There are some key variations between construction accounting and accounting for
other types of businesses. These arise from industry characteristics like these:
◼ Construction work is project-based, production is often decentralized to one or more job
sites and projects may have long-term production cycles.
◼ Most of the revenue generated by construction firms falls under Standards Codification
606 (ASC 606), which sets standards around how revenue from contracts and project-
related expenses are recognized.
◼ Job costing for both direct and indirect costs is central to construction accounting. It’s
especially challenging because construction job sites are decentralized, and the projects
can take a long time to complete.
1.3. Purpose of Construction Accounting system
Construction accounting systems, which will help you manage the accounting systems and use
accounting information to manage a company.
Accounting for Financial Resources: Financial managers are responsible for accounting or
tracking how the company’s financial resources are used, including the following:
✓ Making sure that project and general overhead costs are accurately tracked through the
accounting system.
✓ Ensuring that a proper construction accounting system has been set up and is functioning
properly.
✓ Projecting the costs at completion for the individual projects and ensuring that unbilled
committed costs that the company has committed to pay but have not received a bill for
are included in these projections.
✓ Determining whether the individual projects are over- or under billed.
✓ Making sure that the needed financial statements have been prepared.
✓ Reviewing the financial statements to ensure that the company’s financial structure is in
line with the rest of the industry and trying to identify potential financial problems before
they become a crisis.
Construction accounting systems include the software, hardware, and personnel necessary to
operate a construction accounting system.
Construction accounting systems serve four purposes.
➢ First, the accounting system processes the cash receipts (collecting payments) and
disbursements (paying bills) for the company. The accounting system should ensure that
revenues are billed and collected in a timely fashion and that timely payments are made only
for bona fide expenses incurred by the company. Failure to collect revenues or careless
payment of bills can quickly deplete the cash reserves of a company and, if left unchecked,
can bankrupt a company.
➢ Second, the accounting system collects and reports the data needed to prepare company
financial statements that are used to report the financial status of the company to shareholders
and lending institutions. These reports are needed to assure shareholders and lending
institutions that the company is solvent and is wisely managing its financial assets.
➢ Third, the accounting system collects and reports the data needed to prepare income taxes,
employment taxes, and other documents required by the government. Failure to pay taxes and
file other required documents—such as W-2s and 1099s—on time results in the assessment of
penalties.
➢ Fourth, the accounting system collects and provides the data needed to manage the finances of
the company, including data for the company as a whole, each project, and each piece of
heavy equipment. To successfully manage the company’s financial resources, the accounting
system must provide this data quickly enough for management to analyze the data and make
corrections in a timely manner. Accounting systems that fail to do this are simply reporting
costs.
➢ Cost reporting is where the accounting system provides management with the accounting data
after the opportunity has passed for management to respond to and correct the problems
indicated by the data. When companies wait to enter the cost of their purchases until the bills
are received, management does not know if they are under or over budget until the bills are
entered, at which time the materials purchased have been delivered to the project and may
have been consumed. The extreme case of cost reporting is where companies only look at the
costs and profit for each project after the project is finished.
➢ Cost reporting is typified by the accounting reports showing where a company has been
financial without allowing management to proactively respond to the data. Cost control is
where the accounting system provides management with the accounting data in time for
management to analyze the data and make corrections promptly. Companies that enter
material purchase orders and subcontracts, along with their associated costs, into their
accounting system as committed costs before issuing the purchase order or subcontract allow
management time to address cost overruns before ordering the materials or work.
➢ Committed costs are those costs that the company has committed to pay and can be identified
before a bill is received for the costs. For example, when a contractor signs a fixed-price
subcontract he or she has committed to pay the subcontractor a fixed price once the work has
been completed and, short of any change orders, knows what the work is going to cost.
➢ Accounting systems that track committed costs give management time to identify the cause of
the overrun early on, identify possible solutions, and take corrective action. Cost control is
typified by identifying problems early and giving management a chance to proactively address
the problem. A lot of money can be saved by addressing pervasive problems such as excessive
waste early in the project.
➢ Key components of accounting systems:
1. The accounting system must have a strong job cost and equipment tracking system. The
accounting system should update and report costs, including committed costs and
estimated costs at completion every week. Having timely, up-to-date costs for the
project and the equipment is a must if management is going to manage costs and identify
problems early.
2. The accounting system must utilize the principle of management by exception. It can be
easy for managers to get lost in the volumes of data generated by the accounting system.
The accounting system should provide reports that allow management to quickly
identify problem areas and address the problems. For example, as soon as bills are
entered into the accounting system, management should get a report detailing all bills
that exceed the amount of their purchase order or subcontract. Problems that are buried
in volumes of accounting data are often never addressed because management seldom
has time to pour through all of the data to find the problems or if they are found they are
often found too late for management to address the problem. Providing reports that flag
transactions that fall outside the acceptable limits is a necessity if management is going
to control costs. By having reports that flag items that fall outside acceptable limits,
management can make addressing these items a priority.
3. Accounting procedures need to be established to ensure that things do not fall through the
cracks. These procedures should include things such as who can issue purchase orders
and what to do when a bill is received for a purchase order that has not been issued. The
procedures should also identify the acceptable limits for different types of transactions.
Procedures ensure that the accounting is handled in a consistent manner and give
management confidence in the data that it is using to manage the company.
4. The data must be easily and quickly available to management and other employees who
are directly responsible for controlling costs. It does little good to collect cost data for
use in controlling costs if the data cannot be accessed. Where possible the reports should
be automatically prepared by the accounting software. This eliminates the time and
effort needed to prepare the reports manually.
Additionally, frontline supervisors who are responsible for control costs should readily have
access to their costs. Holding supervisors responsible for costs at the end of a job while not
giving them access to their costs throughout the project denies them the opportunity to
proactively control costs. The accounting system for many construction companies consists of
three different ledgers: the general ledger, the job cost ledger, and the equipment ledger. The
general ledger tracks financial data for the entire company and is used to prepare the company’s
financial statements and income taxes. The job cost ledger is used to track the financial data for
each of the construction projects. The equipment ledger is used to track financial data for heavy
equipment and vehicles. All construction companies should have a general ledger and a job cost
ledger. Companies with lots of heavy equipment or vehicles should have an equipment ledger.
Construction accounting is a unique form of bookkeeping and financial management. It's
designed specially to help contractors track each job and how it affects the company as a whole.
While it draws on all the same basic principles of general accounting, it also has several
important and distinct features. Construction accounting software provides real-time visibility
into key metrics such as labor hours, material usage and contract pricing. These tools help
managers decide how much to bid and what type of contracts to pursue.
1.4. Functions of Financial Management
Put simply, the finance function within a business exists to help managers to manage. To
understand how the finance function can achieve this, we must first be clear about what
managers do. One way of describing the role of managers is to classify their activities into the
following categories:
I. Strategic management: This involves developing objectives for a business and then
formulating a strategy (long-term plan) to achieve them. Deciding on an appropriate
strategy will involve identifying and evaluating the various options available. The option
chosen should be the one that offers the greatest potential for achieving the objectives
developed.
II. Operations management: To ensure that things go according to plan, managers must
exert day-to-day control over the various business functions. Where events do not
conform to earlier plans, appropriate decisions and actions must be taken.
III. Risk management: The risks faced by a business must be identified and properly
managed. These risks, which may be many and varied, arise from the nature of business
operations and from how the business is financed.
They are interrelated, and overlaps arise between them. When considering a particular strategy,
for example, managers must also make a careful assessment of the risks involved and how these
risks may be managed. Similarly, when making operational decisions, managers must try to
ensure they fit within the strategic (long-term) plan that has been formulated.
The finance function is concerned with helping managers in each of the three areas identified.
This is achieved by undertaking various key tasks, which are set out in Figure 1.1 and described
below.
I. Financial planning. It is vitally important for managers to assess the potential impact of
proposals on future fi nancial performance and position. They can more readily evaluate
the implications of their decisions if they are provided with projected financial statements
(such as projected cash fl ow statements and projected income statements) and with other
estimates of financial outcomes.
II. Investment project appraisal. Investment in new long-term projects can have a
profound effect on the future prospects of a business. By carrying out appraisals of the
profi tability and riskiness of investment project proposals, managers can make informed
decisions about whether to accept or reject them. Financial appraisals can also help to
prioritise those investment projects that have been accepted.
III. Financing decisions. Investment projects and other business activities have to be
financed. Various sources of fi nance are available, each with their own characteristics
and costs, which will need to be identifi ed and evaluated. When selecting an appropriate
source, consideration must be given to the overall financial structure of a business. An
appropriate balance must be struck between long-term and shortterm sources of fi nance
and between the fi nancing contribution of shareholders and that of lenders. Not all of the
finance required may come from external sources: some may be internally generated. An
important source of internally-generated finance is profits, and the extent to which these
are reinvested by a business, rather than distributed to the owners, requires careful
consideration.
IV. Capital market operations. New fi nance may be raised through the capital markets,
such as through a stock exchange or banks. Managers will often need advice on how
finance can be raised through these markets, how securities (shares and loan capital) are
priced and how the markets may react to proposed investment and financing plans.
V. Financial control. Once plans are implemented, managers must ensure that things stay
on course. Regular reporting of information on actual outcomes, such as the profitability
of investment projects, levels of working capital and cash flows, is required as a basis for
monitoring performance and, where necessary, taking corrective action.
2. Proper Utilization of Funds: Raising funds is important, more than that is its proper
utilization. If proper utilization of funds were not made, there would be no revenue
generation. Benefits should always exceed cost of funds so that the organization can be
profitable. Beneficial projects only are to be undertaken.
3. Increasing Profitability: Profitability is necessary for every organization. The planning and
control functions of finance aim at increasing profitability of the firm. To achieve
profitability, the cost of funds should be low. Idle funds do not yield any return but incur
cost. So, the organization should avoid idle funds. The finance function also requires
matching of cost and returns of funds. If funds are used efficiently, profitability gets a boost.
4. Maximizing Firm’s Value: The ultimate aim of the finance function is maximizing the
value of the firm, which is reflected in the wealth maximization of shareholders. The market
value of the equity shares is an indicator of wealth maximization.
1.5. Types of Finance
Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the areas of the activities under the
different names.
Finance can be classified into two major parts:
I. Functions leading to liquidity: This means that the firm has adequate cash on hand to meet its
obligations at all times. Stated another way, the firm can pay all its bills when due and have
sufficient cash to take unanticipated Discounts for large cash purchases.
In seeking sufficient liquidity to carry out the firm’s activities, the financial manger
performs the following:
• Forecasting cash flows. Successful day-to day operations require the firm to pay its bills
promptly. This is a matter of matching cash inflows against cash outflows.
• Raising funds. The firm receives finance from a variety of resources. The financial manager
must identify the amount of funds available from each source and the periods when they will
be needed. Then the manager must take steps to ensure that the funds will actually be
available and committed to the firm.
• Managing the flow of internal funds. In a large firm, the financial manager should control
and manage the flow of cash within the different bank accounts for various operating
divisions. A manager can achieve a high degree of liquidity and reduce costs associated with
short-term borrowing by continuously checking the cash level in each bank account and
monitor the timely transfer of cash.
II. Functions leading to profitability: In seeking profits for the firm, the financial manager shall
provide specific input into the decision-making process based on financial training and actions.
Some of his specific functions are the following:
• Cost Control. Firms require detailed cost accounting systems to monitor expenditures in the
operational areas of the firm. Because of supervising the accounting and reporting functions,
the financial manager is in a position to monitor and measure the amounts of money spent or
committed by the company.
• Pricing. Important decisions by the firm involve pricing established for products, product
lines and services. Determination of the appropriate price should be a joint decision of
marketing and finance. E.g. Reasonable and fair preparation of engineering cost estimates for
projects using the cost break down of activities is important for a firm to achieve
profitability. The financial manager can supply important information about costs, changes in
cost, risk and profit margin in pricing decisions.
• Forecasting Profits. The financial manager is usually responsible for gathering and analyzing
the relevant cost and sales data and forecast profit levels. Before funds are committed to new
projects, the expected profits must be determined and evaluated. Will the profits justify the
initial expenditures?
• Measuring risk-return of a proposal. Every time when a firm invests, it must make risk-return
decisions. Is the level of return offered by the project adequate for the level of risk therein?
III. Managing Assets: Assets are the resources by which the firm is able to conduct business. The
term asset includes buildings, machinery, vehicles, inventory, money and other resources
owned by the firm. A firm’s asset must be carefully managed and a number of decisions must
be made concerning their use. The decision-making role crosses liquidity and profitability
lines. Converting idle equipment to cash improves liquidity, reducing costs improves
profitability.
1.6. Forms of Business Enterprise
Financial management is not restricted to large corporations: It is necessary in all forms and sizes
of businesses. The three major forms of business organization are the sole proprietorship, the
partnership, and the corporation. These three forms differ in a number of factors, of which
those most important to financial decision-making are:
❖ The way the firm is taxed.
❖ The degree of control owners may exert on decisions.
❖ The liability of the owners.
❖ The ease of transferring ownership interests.
❖ The ability to raise additional funds.
❖ The longevity of the business.
A. Sole Proprietorships
The simplest and most common form of business enterprise is the sole proprietorship, a business
owned and controlled by one person, the proprietor. Because there are very few legal
requirements to establish and run a sole proprietorship, this form of business is chosen by many
individuals who are starting up a particular business enterprise. The sole proprietor carries on a
business for his or her benefit, without the participation of other persons except employees. The
proprietor receives all income from the business and alone decides whether to reinvest the profits
in the business or use them for personal expenses.
A proprietor is liable for all the debts of the business; in fact, it is the proprietor who incurs the
debts of the business. If there are insufficient business assets to pay a business debt, the
proprietor must pay the debt out of his or her assets. If more funds are needed to operate or
expand the business than are generated by business operations, the owner either contributes his
or her assets to the business or borrows. For most sole proprietorships, banks are the primary
source of borrowed funds. However, there are limits to how much banks will lend a sole
proprietorship, most of which are relatively small.
For tax purposes, the sole proprietor reports income from the business on his or her personal
income tax return. Business income is treated as the proprietor’s income.
The assets of a sole proprietorship may also be sold to some other firm, at which time the sole
proprietorship ceases to exist. Or the life of a sole proprietorship ends with the life of the
proprietor, although the assets of the business may pass to the proprietor’s heirs.
B. Partnerships
A partnership is an agreement between two or more persons to operate a business. A partnership
is similar to a sole proprietorship except instead of one proprietor, there is more than one. The
fact that there is more than one proprietor introduces some issues:
❖ Who has a say in the day-to-day operations of the business?
❖ Who is liable (that is, financially responsible) for the debts of the business?
❖ How is the income distributed among the owners?
❖ How is the income taxed?
Some of these issues are resolved with the partnership agreement; others are resolved by laws.
The partnership agreement describes how profits and losses are to be shared among the partners,
and it details their responsibilities in the management of the business. Most partnerships are
general partnerships, consisting only of general partners who participate fully in the
management of the business, share in its profits and losses, and are responsible for its liabilities.
Each general partner is personally and individually liable for the debts of the business, even if
those debts were contracted by other partners.
A limited partnership consists of at least one general partner and one limited partner. Limited
partners invest in the business but do not participate in its management. A limited partner’s share
in the profits and losses of the business is limited by the partnership agreement. In addition, a
limited partner is not liable for the debts incurred by the business beyond his or her initial
investment.
A partnership is not taxed as a separate entity. Instead, each partner reports his or her share of the
business profit or loss on his or her personal income tax return. Each partner’s share is taxed as if
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CONSTRUCTION FINANCIAL MAMAGEMENT MODULE
it were from a sole proprietorship. The life of a partnership may be limited by the partnership
agreement. For example, the partners may agree that the partnership is to exist only for a
specified number of years or only for the duration of a specific business transaction. The
partnership must be terminated when any one of the partners dies, no matter what is specified in
the partnership agreement. Partnership interests cannot be passed to heirs; at the death of any
partner, the partnership is dissolved and perhaps renegotiated.
One of the drawbacks of partnerships is that a partner’s interest in the business cannot be sold
without the consent of the other partners. So, a partner who needs to sell his or her interest
because of, say, personal financial needs may not be able to do so.1 another drawback is the
partnership’s limited access to new funds. Short of selling part of their ownership interest, the
partners can raise money only by borrowing from banks, and here too there is a limit to what a
bank will lend a (usually small) partnership.
In certain businesses including accounting, law, architecture, and physician’s services firms are
commonly organized as partnerships. The use of this business form may be attributed primarily
to state laws, regulations of the industry, and certifying organizations meant to keep practitioners
in those fields from limiting their liability.
C. Corporations
A corporation is a legal entity created under state laws through the process of incorporation. The
corporation is an organization capable of entering into contracts and carrying out business under
its own name, separate from its owners.
To become a corporation, state laws generally require that a firm must do the following:
1. File articles of incorporation,
2. Adopt a set of bylaws, and
3. Form a board of directors.
The articles of incorporation specify the legal name of the corporation, its place of business, and
the nature of its business. This certificate gives “life” to a corporation in the sense that it
represents a contract between the corporation and its owners. This contract authorizes the
corporation to issue units of ownership, called shares, and specifies the rights of the owners, the
shareholders. The bylaws are the rules of governance for the corporation.
The bylaws define the rights and obligations of officers, members of the board of directors, and
shareholders. In most large corporations, it is not possible for each owner to participate in
monitoring the management of the business. Generally, it is believed that the greater the
DBU; Department of Construction Technology & Management 19
CONSTRUCTION FINANCIAL MAMAGEMENT MODULE
proportion of outside directors, the greater the board’s independence from the management of the
company.
Unlike the sole proprietorship and partnership, the corporation is a taxable entity. It files its own
income tax return and pays taxes on its income. That income is determined according to special
provisions of the federal and state tax codes and is subject to corporate tax rates different from
personal income tax rates. If the board of directors decides to distribute cash to the owners, that
money is paid out of income left over after the corporate income tax has been paid. The amount
of that cash payment, or dividend, must also be included in the taxable income of the owners (the
shareholders). Therefore, a portion of the corporation’s income (the portion paid out to owners)
is subject to double taxation: once as corporate income and once as the individual owner’s
income.
The dividend declared by the directors of a corporation is distributed to owners in proportion to
the numbers of shares of ownership they hold. If Owner A has twice as many shares as Owner B,
he or she will receive twice as much money. The ownership of a corporation, also referred to as
stock or equity, is represented as shares of stock. A corporation that has just a few owners who
exert complete control over the decisions of the corporation is referred to as a close corporation
or a closely-held corporation.
A corporation whose ownership shares are sold outside of a closed group of owners is referred to
as a public corporation or a publicly-held corporation. Mars Inc., producer of M&M candies and
other confectionery products, is a closely-held corporation; Hershey Foods, also a producer of
candy products among other things, is a publicly-held corporation.
The shares of public corporations are freely traded in securities markets, such as the New York
Stock Exchange. Hence, the ownership of a publicly-held corporation is more easily transferred
than the ownership of a proprietorship, a partnership, or a closely-held corporation.
3. Income from the business is taxed once, at the individual taxpayer level.
Disadvantages
1. The proprietor is liable for all debts of the business (unlimited liability).
2. The proprietorship has a limited life.
3. There is limited access to additional funds.
B. General Partnership
Advantages
1. Partners receive income according to terms in partnership agreement.
2. Income from business is taxed once as the partners’ personal income.
3. Decision-making rests with the general partners only.
Disadvantages
1. Each partner is liable for all the debts of the partnership.
2. The partnership’s life is determined by agreement or the life of the partners.
3. There is limited access to additional funds.
C. Corporation
Advantages
1. The firm has perpetual life.
2. Owners are not liable for the debts of the firm; the most that owners can lose is their
initial investment.
3. The firm can raise funds by selling additional ownership interest.
4. Income is distributed in proportion to ownership interest.
Disadvantages
1. Income paid to owners is subjected to double taxation.
2. Ownership and management are separated in larger organizations.
❖ How and where the money to pay for the proposed capital investment will be raised?
That is, what will be the equity and debt mix in the financing plan?
❖ How the day-to-day financial activities are handled like collecting the receivables and
paying the suppliers?
In the modern society, Financial Management goes beyond answering those fundamental
questions. It assumes the responsibility of dealing with the problems and decisions associated
with managing the firm’s assets that has made it an exciting and challenging area in managing
large organizations. Financial decision making is primarily concerned with developing the skills
needed to make correct decisions in a fast moving and technologically complex corporate
environment. Some of these issues include:
❖ Which new proposals for employing capital should be accepted by the firm?
❖ What steps can be taken to increase the value of the firm’s common stock?
❖ How much working capital will be needed to support and expand the company’s operation?
❖ Where should the firm go to raise the short and long-term capital demand and how much will it cost?
❖ Should a firm declare a cash dividend on its common stock and if so, how much a dividend should be
declared?
Finance is a specialized functional field of business administration. The term finance can be
defined as the management of the flows of money through an organization, whether it to be a
corporation or non-corporate business or government agency. Finance concerns itself with the
actual flow of money as well as any claims against money.
The flow of funds within a corporation is basically a continuous process, particularly if the
corporation has been in business for a period of time. Fig 1-1 illustrates a typical cash flow
diagram with the focal point being the reservoir of cash. One could see the following as inflow
and outflow of cash.
❖ Cash is raised through equity, debt or through investment by other corporations,
❖ Cash inflow includes net credit sales, net cash sales and sales of assets,
❖ Cash is disbursed through purchase of materials, fixed assets, expenses as wages and
salaries to workmen,
❖ Cash is repaid to stockholders in form of dividends, creditors in the form of loan repayment
and also to other corporation’s stocks or bonds. If total cash inflow exceeds all costs
(including depreciations) for a given period, then there is a profit for that particular period, if
not there is a loss.
Cash
Investment
Collections
Personal Expenses
Fixed Wages, Benefits
Raw Materials Net Credit Net Cash
Assets & Operating Exp. Sales Sales
Sales
Depreciation Expense
Labor Expense
progress payments, but in addition sources from his own reserve or other important ready-made
sources of finance should be available in different forms.
Access to finance is one of the major constraints for the market entry and growth of construction
companies tendering for projects in developing countries. There must be different alternative
financial mechanisms for the contractor to choose for the procurement of these basic resources in
facilitating construction projects, mainly for the three most significant and basic resources (i.e.
material, equipment, and labor).
Construction works require the following major financial demands from the proposal of the
project at the tender stage to the final completion of the project from the contractor’s perspective.
I. Financial demand for tender
II. Financial demand for contracting
III. Financial demand for inputs (Resources)
IV. Financial demand for supervision
V. Financial demand for payment processing
I. Financing During Tendering and Contracting
The need for financing at the time of tendering and contracting is mainly for bond and insurance
requirements and an important partner for the contractors is bond and insurance requirements
and an important partner for the contractors is insurance and bond companies. The relationship
between the two is dependent upon confidence. The performance of the contractor on projects
enhances the relationship that exists between the contractor and the insurance and Bond
Company. This source of finance mainly covers the financial demand of the contractor for bid
bond, performance bond, advance payment bond, and different insurance requirements.
Construction works in our country demands the domestic contractor to provide performance
bond of 10% from banks and 15-30% from insurance companies. Since both institutions are
established to provide surety service the need for varying percentage might not be necessary,
hence there had been strong claims on this issue and a limit of 10% from insurance or bank has
become acceptable recently. The regulation which limits the requirement of bid security from
banks only has also been revised very recently to include provision of bid bond from insurance
companies to be acceptable.
II. Financing For Material Purchase
Based on the pre-defined terms and specification, materials for construction project would be
purchased in two major financing mechanisms, cash purchase and credit from suppliers. Both
mechanisms involve selection of the minimum material price as per the given description. It is
also common for material purchase by credit suppliers might add some additional cost
considering the time in which the payment would be released depending upon the duration of
payment & their agreement. The access of getting payment for materials delivered to the site
from suppliers on credit basis is also a prominent feature of construction projects that would able
the contractor to estimate the duration in which the credit purchase would be delayed.
Generally, it is accepted that the credit facilities furnished by materials suppliers to construction
contractors form an intrinsic element of working capital for those ‘borrowing’ organizations. The
amount of ‘free’ credit that can be obtained by a contractor relates directly to potential
profitability and, subsequently, to an enhanced probability of contractor survival. ‘Free’ credit in
this sense is defined as that quantity of finance obtained from materials suppliers that are not
directly ‘charged’ to debtors for the use of such service.
III. Financing for equipment
Equipment resources play a major role in any construction activity. The costs associated with the
construction equipment can be broken down into two major categories; ownership cost (fixed
cost) and operational cost (variable cost). Ownership costs include depreciation, insurance,
interest charges in addition to the basic equipment cost. Operational costs occur only during the
period of operation and during routine and unscheduled maintenance.
Heavy construction such as roads, water works, power plants, etc. involve an intensive
equipment operation, and for contractors who work such construction require a considerable
amount of money tied up in fixed equipment assets. On the other hand, building and industrial
construction requires skilled labor for replacement and installation and therefore don’t involve
intensive equipment. The equipment is required to move materials and manpower to the point of
installation and support assembly process. Although, heavy equipment pieces are important, the
building and industrial contractors tend to have less of their capital tied up in equipment.
Because of the variability of equipment needs from project to project, the building contractor
relies heavily on the rental of equipment. The heavy construction contractor (general contractor)
because of the repetitive use of many major equipment units often finds it more cost effective to
own this equipment.
Finance Individuals, Institutional Purchase and sale of Means of raising finance for
Securities investors stocks and bonds. institutional investors. Means of
achieving profit for individuals.
International Individuals, businesses and Through Means of collecting foreign
Finance governments involved in International currency.
international transactions transactions
Institutional Banks, Insurance Individual savers Finance function of the economy
Finance companies, and pension through capital formation.
funds and credit unions.
Financial Management:
• Studies financial problems in individual firms,
• Seeks sources of low-cost funds
• Seeks profitable business activities.
Debt versus Equity financial securities, a means for raising finance for a corporation.
I. Debt Security. It arises when a firm borrows money from creditors. The firm incurs
liability to repay the amount of money borrowed in some future maturity date.
II. Equity Security. It represents ownership claim in the firm. People who purchase equity
securities are entitled to rights and conditions that are different from those of firm’s
creditors.
The three forms of financial securities:
a) Bond (Loan): a security representing a long-term promise to pay a certain sum of
money at a certain time or over the course of the loan, with a fixed rate of interest
payable to the holder of the bond. Two forms of bond: Secured bond and unsecured
bond.
❖ Secured bond: Denote borrowings of the firm against which specific collateral
have been provided. E.g., Mortgage bond: secured by a piece of property or
building
❖ Unsecured bond: Borrowings of the firm against which no specific security has
been provided. e.g., Advance payment, inter-corporate borrowings, unsecured
loan from banks based on the good reputation with the firm.
IV. Profit maximization objectives help to reduce the risk of the business.
Profit maximization has several weaknesses.
i) It is vague: Profit in the short run may be quite different from profits in the long
run. If a firm continues to operate a piece of machinery without proper
maintenance, it may lower this year’s operating expenditure and increase profits.
But the firm will pay the short run saving in future years, when the machine is no
longer capable of operating due to prior neglect.
ii) It leaves consideration of timing and duration undefined. There is no guide for
comparing profit now with profit in future or for comparing profit streams of
different durations.
iii) It overlooks future aspects.
• Some businesses have placed a high value on the growth of sales and are
willing to accept lower profits to gain stability of the market sales,
• Other businesses recognize diversifying their activities into different products
that strengthen the firm but a short-term decline in profits.
• Other firms use a portion of their profits to achieve social goals or to make
contributions to society.
Maximization of Wealth
The second frequently encountered goal of a firm is to maximize the value of the firm in the long
run. The maximization of wealth is linked with the long-term profits of the firm. Wealth
maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern.
Wealth maximization is also known as value maximization or net present worth maximization.
This objective is a universally accepted concept in the field of business.
A firm who is maximizing wealth must do the following.
i. Avoid high levels of risk: Projects that promise exceptionally high profits with relatively
high degrees of risk should be avoided.
ii. Pay consistent dividend: By paying consistent dividends, the firm helps attract investors
seeking cash income, which maintains the market value of the stocks and keep up its
present value.
iii. Seek growth in sales. As a firm increases its sales and develops new markets for
products, it protects itself against economic recessions, changes in consumer preferences
or other reductions in demand for the firm’s products. However profit may decrease from
the additional cost required for promotion and secure attraction of various customers.
iv. Maintain market price of stock. A company’s manager can take a number of positive
steps to maintain the market price of the stock at reasonable level by
➢ taking time to explain company’s actions
➢ encourage individuals to invest in the firm
➢ seek sound investments, the firm will appear to be a wise investment choice over the
long-term1.4 Functions of Financial Management
Chief Finance
Officer
Treasurer Controller
Portfolio Internal
Manager Auditor
CHAPTER TWO
2. FINANCING DECISIONS
Management acceptance of proposal is based not only on the feasibility of the proposals itself in
terms of technical criteria, but on the status of the corporation relative to profitability and risk.
Projects require the acquisition and utilization of manpower, raw material, and fixed assets, such
as real state, facilities and capital equipment. The availability of these resources is dependent on
the current cash position of the corporation and the ability to acquire additional sources of
funding for project support. Thus part of the investment and financing decisions, management
should:
• Review the corporation’s profitability and cash position
• Forecast future cash needs,
• Determine possible methods of attaining additional funds through short-term and/or
long-term financing.
In this chapter, we will examine short and long-term financing sources and the corresponding
decisions to raise financial need of firms.
2.1. Short-term financing
Short-term financing usually includes loans that mature within a year or less. Such loans are
frequently used to raise temporary funds to cover seasonal or cyclic business peak or special
finding needs involving a short time frame. Sort-term loans are generally self-liquidating, in that
the assets acquired with the borrowed money should be easily convertible to cash with a high
degree of certainty.
Long-term financing
Total requirements Decision level
for funds
Fund
(Birr)
Time (Years)
unsecured form of financing since no specific assets are pledged as collateral for
the liability.
• Accruals are short-term liabilities that arise when services are received but
payment has not yet been made. Examples:
◼ Sub-contract works for excavation, masonry works etc.
◼ Salaries/wages payable
◼ Taxes payable
Employees work for 2 weeks or months before receiving a paycheck. These form
unsecured short-term financing for the firm.
• Advance Payment: It is a common practice to pay an advance payment for
delivery engineering services upon signing of contract agreement. Contract
stipulations require that an advance payment amounting to 10-30 % of the
contract price to be paid to firm delivering the services. This is deemed to
alleviate the firm’s high financial requirement in connection with site
mobilization at the commencement of the contract works.
• Advance for purchase of materials/ Material on site. Pursuant to the terms of
any international contracts, the contractor is paid after accomplishing and
reaching a certain minimal amount of construction activities/works which are
certified through measurement by the Engineer. Furthermore to alleviate the cash
demand of the contractor, he will be paid for the raw material on site including
any transportation cost rendered for consignment to the site. Sometimes, in order
to minimize the time delay arising from cash shortage and assist in expediting the
work progress, Client’s are involved in the purchase of materials or transfer the
cash to suppliers for the purchase of materials and the corresponding price will be
deducted from the successive payment to be due to the contractor.
ii) Unsecured Interest-Bearing Sources:
A stable and profitable firm can borrow funds from short-term sources at competitive
rates of interest.
• Self-Liquidating Bank Loans. The bank provides finance for an activity that
will generate cash to pay off the loan. Short-term bank loans are generally tied in
to the prime rate plus a premium to reflect the degree of financial risk against the
borrower. Three kinds of unsecured short-term bank loans are commonly used:
◼ Single payment note: lending a business customer with as lump sum
repayable with interest in a single payment and at a specified
maturity, usually 30 to 90 days.
◼ Unsecured Overdraft Facility/ Line of Credit: An agreement between
Bank and Firm where by the bank agrees to make available upon
demand up to a stipulated amount of unsecured short-term funds, if the
bank has the funds available. It is normally established as one year and
the interest rate is expressed as prime plus some fixed percentage.
◼ Revolving Credit Agreement: Extended Lines of Credit to avoid the
need to reexamine the credit worthiness of a customer each time a small
loan is required.
• Non-bank short-term sources
◼ Commercial Paper/ Bond (Treasury bond): These consist of promissory
notes with maturities of few days say 270 days. Commercial paper is
purchased by other firms that are seeking marketable securities to provide
a return on temporarily idle funds. Individuals, commercial banks,
insurance companies, pension funds and other institutions also purchase
the commercial notes.
◼ Private Loans: A short-term unsecured loan may be obtainable from a
wealthy shareholder, a major supplier, or any other party interested in
assisting the firm through a short-term difficulty. This kind of
arrangement generally occurs when a temporary liquidity problem
endangers the firm’s operation and their stock in the company is in
danger.
iii) Secured Short-term Sources
A secured loan occurs when the borrower pledges a specific asset, called collateral,
to back a loan. The collateral may be in the form of:
• Warehouse receipt loan: it is a form of short-term financing that is secured by a
pledge of inventory controlled by the lender. The lender which may be a
Advantages: Establishing a working relationship with a bank that can result in advice and
financial expertise from the bank’s officer.
Disadvantages: The need to reveal confidential information and the restrictions that may be
imposed as part of the loan agreement.
Insurance Companies: A number of life insurance companies make term-loans to business
firms but concentrate on low risk loans to large and very strong companies only.
Advantage: Insurance company term loans are the longer terms and higher amounts of money as
compared to commercial bank financing.
Disadvantage: slightly higher interest rates are charged and the fact that only the most
creditworthy business can borrow from insurance companies.
Pension Funds: A minor source of intermediate-term financing is the employee pension funds
that make secured loans to businesses. These loans are frequently secured by mortgages on
property and have terms and conditions similar to loans made by life insurance companies.
Equipment Manufacturers: Manufacturers of industrial equipment make loans to assist in the
purchase of fixed assets. The loans may require the firm to make a down payment of 10-30
percent, and the assets must be pledged and mortgaged to secure the loan.
2.3. Long-Term Financing
Long-term financing usually refers to the borrowing of money for a long period of time in order
to invest in fixed assets relatively permanent in nature with long life. Equity and debt represent
the two broad sources of finance for a business firm. Equity capital refers to ownership money
acquired through the sale of common stocks, preferred stock and retained earnings. Debt refers
to borrowed money acquired from term loans and sale of bonds.
Key difference between equity and debt are:
• Debt investors are entitled to a contractual set of cash flows (interest and
principal) whereas equity investors have a claim of residual cash flows of the
firm after it has satisfied all other claims and liabilities.
• Interest paid to debt investors represents a tax-deductible expense whereas
dividend paid to equity investors has to come out of profit after tax.
• Debt has a fixed maturity whereas equity ordinarily has infinite life.
• Equity investors enjoy the prerogative to control the affairs of the firm whereas
debt investors play a passive role- of course they often impose certain restrictions
on the way the firm is run to protect their interests.
Equity Capital
i) Common Stock: Represents ownership capital as equity shareholders collectively
own the company. They enjoy the rewards and bear the risks of ownership. However,
their liability, unlike the liability of sole proprietors and general partners, is limited to
their capital contributions.
Rights and Position of Equity Shareholders:
• Right to income: The equal investors have a residual claim to the income of the
firm. The income left after satisfying the claims of all other investors belong to
the equity shareholders. This income is simply equal to profit after tax minus
preferred dividend.
• Right to Control: Equity shareholders as owners of the firm elect the board of
directors and have the right to vote on every resolution placed before the
company.
• Pre-emptive Right: It enables existing equity shareholders to maintain their
proportional ownership by purchasing the additional equity shares issued by the
firm.
• Right in Liquidation: In the event of liquidation, claims of all others –
bondholders, secured and unsecured lenders, preferred stock – are prior to the
claim of equity shareholders.
Advantages to the firm:
• There is no compulsion to pay dividends, if the firm has insufficiency of cash,
• Equity capital has no maturity date and hence the firm has no obligation to redeem.
• It enhances the creditworthiness of the company. The larger the equity base, the greater
the ability of the firm to raise debt finance on favorable terms.
Disadvantages to the firm:
• Sale of equity shares to outsiders dilutes the control of existing owners,
• The cost of equity capital is high. The rate of return required by equity shareholders is
generally higher than the rate of return required by other investors,
• Equity dividends are paid out of profit after tax, whereas interest payments are tax
deductible expenses.
ii) Preferred Stock: represents hybrid form of financing. It resembles equity in the
following ways,
• Dividend is payable only out of distributable profits
• Preference dividend is not an obligatory payment,
• Preference dividend is not a tax-deductible payment
• It is an expensive source of financing.
Preferred Stock is similar to debt in several ways:
• Preference shareholders do not enjoy the right to vote,
• The claim of preference shareholders is prior to the claim of equity shareholders,
iii) Retained Earnings:
Depreciation charges and retained earnings represent the internal sources of finance
available to a firm. If we assume that depreciation charges are used for replacing worn-
out plant and equipment, retained earnings represent the only internal source of financing
expansion and growth. Companies retain 30-80% of profit after tax for financing growth.
It is referred as internal equity since it retained through a sacrifice made by equity
shareholders.
Advantages to the firm:
• Retained earnings are readily available. Low-cost to the firm,
• No dilution of control when a firm relies on retained earnings,
• The stock market generally views the equity issue with skepticism. Retained
earnings, however, do not carry any negative connotation.
Disadvantage to the firm:
• The amount that can be raised by way of retained earnings may be limited,
because companies pursue a stable dividend policy,
• The opportunity cost of retained earnings is quite high. The cost foregone by
equity shareholders is quite high, by not paying dividend.
Long-Term Debt
public. It is commonly known that public finance is mostly funded for nonprofit corporation to
give social, cultural and political services.
Finance securities: Means of raising finance from individuals, institutional investors and
corporate bodies through purchase and sale of stocks and bonds for achieving profit and
maximizing wealth of the project.
Financial securities raise finance through debt and equity security:
I. Debt security; it arises when a firm borrows money from creditors. This firm incurs
liability to repay the amount of money borrowed in some future maturity date. Generally;
◼ There's relatively less loss of ownership through warrants.
◼ It's a less-expensive financing option: it costs more than senior bank debt but less
than equity.
◼ The loan must be repaid and includes interest charges, but the interest is tax
deductible.
◼ The company needs to provide security on the loan, perhaps even personal
guarantees.
◼ It's unlikely there'll be management advisors, but financial disciplines and
controls may be imposed by the lender.
II. Equity security; it represents ownership claim in the firm. People who purchase equity
securities are entitled to rights and conditions that are different from this firm’s creditor.
Equity financing is generally recommended for a business that's experiencing very high
growth with high investment risk. Mostly
✓ There's a distinct loss of ownership.
✓ It's the most expensive financing option with the cost of capital.
✓ The capital stays in the business for the long term; dividends are taxable.
✓ The valuation of the company is a huge issue in landing the capital.
✓ Investors will want a say in how the business is run and may elect to take seat(s) on the
board of directors.
Institutional finance
These are banks, insurance companies, and pension funds and credit unions. These
institutions deposit from individual savers and provide for different projects which can
fulfill the requirement of the financial institutions; generally these financial institutions
provide finance for construction projects in different ways, either in the form of loan or
assistance fund.
❖ Term loan
➢ Short term finance; usually includes loans that mature within a year or less. Such loans
are frequently used to raise temporary funds to cover seasonal or cyclic business peak.
Short term loans are generally self-liquidating in that the assets acquired with the
borrowed money should be easily convertible to cash with high degree of certainty.
Short-term finance can be acquired from;
Unsecured interest free sources like accounts payable, accruals and advance
payment.
Unsecured interest-bearing sources like self-liquidating bank loans, none-bank
short term sources.
Secured short tern sources.
➢ Intermediate-term financing; this type of term loan matures between one and five year
period. This fund can be obtained from;
• Banks
• insurance companies
• pension fund
• equipment manufacturers
➢ Long-term financing; usually refers to the borrowing of money for greater than five year
and can be acquired from Equity & debt.
Fund assistance
Fund assistance obtained from different organizations for constructing public infrastructures.
These can be obtained from different government and non-government organization.
External sources of finance are mainly used by large projects to minimize cash flow problems.
Covering this negative cash balance in the most beneficial or cost effective fashion is the project
finance problem. A contractor would receive periodic payment from the owner as construction
proceeds. However, a contractor also may have a negative cash balance due to delays in payment
and retain age of profit or cost reimbursements on the part of the owner. Contractors who are
engaged in large projects often own substantial assets and can make use of other form of
financing, unless the construction project faced to cash shortage. At that time the contractor
needs to balance the negative cash flow by looking for external source. Like:
➢ Advance payment; it is a common practice to pay an advance payment for delivery
engineering services up on signing of contract agreement. Contract stipulations require
that an advance payment amounting to10-30%of the contract price to be paid to firm
delivering the services. This is deemed to alleviate the firm’s high financial requirements
in connection with site mobilization at the commencement of the contract works.
➢ Long term loans; long term financing usually refers to the borrowing of money for long
period of time in order to invest in fixed assets relatively permanent in nature with long
life. Equity and debt represents the two broad sources of finance for business firm. Equity
capital refers to ownership money acquired through the sale of common stocks, preferred
stock and retained earnings. Debt refers to borrowed money acquired from term loans and
sale of bonds.
➢ Assistance fund; it is donated from non-governmental organization (NGO) and other
external bodies for assisting public infrastructures.
➢ Bridge financing; in bridge financing large loans for short terms are given out, using a
secured future income as guarantee. Bridge financing is often used in the agricultural
sector to bridge the period from investment in the crop until harvest. Contractors on
labor-based public work programs can use the construction contract as guarantee to
obtain bridge financing. Experience shows however, that banks are disinclined to provide
bridge finance to contractors when the contracting agency is a public entity. Work
contracts as such do not guarantee work payment, which ultimately depends on the
performance of the contractor and the administrative procedures of the contracting
agencies.
Banks will generally require collateral or third party guarantees as compensation for the
perceived higher risk involved in lending to small contractors. In these situations a contracting
agency can facilitate contractor’s access guarantees. For a contracting agency there are three
different possible ways to stand guarantee for a contractor: guaranteeing work, guaranteeing
work payments or guaranteeing loans.
b) Internal Sources of Finance
It is easy to see that payment must be made for funds secured from external sources. When
money is borrowed, either on a short term or a long term bases, interest is paid. Because the
financial managers of some companies consider internal sources to be cost less, they exhibit a
strong preference for this source. It is an error to consider internal sources as free. It is generally
accepted that internal funds are a less costly source than most if not all sources external funds.
Particularly for smaller projects internal funds are more attractive than external funds because
the cost of internal funds is generally smaller and the variety of sources is limited for smaller
Accounts payable, wages payable, retained earnings, depreciation allowance and accrued taxes
are the main internal sources of funds that can be used by contractors in minimizing cash flow
problems of projects.
1. Depreciation allowance.
2. Accounts payable
3. Wage payable
4. Retained earning
5. Accrued tax
1. Depreciation Allowance
The primary purpose of depreciation allowance is to reflect the expense resulting from the
wearing out of assets, such as machinery and buildings. The depreciation allowance preserve
apportion of the excess of gross income over expenses, so that fixed assets, ones having worn
out, may be replaced. When a machine or building must be replaced, it does not follow that it
will be replaced with a newer model of the same machine or a newer building of the same
construction and dimensions, since the requirements and technology of the business are likely to
have in the meantime. The new assets may differ considerably in design, operation, and
construction. During the life time of some machines technology may have changed so rapidly
that the old machines are retired without being replaced. In any case it is difficult to determine
when a fixed asset is acquired how long it will be used in the enterprise and what will be the cost
of replacing it at the end of its useful life.
2. Accounts Payable
These are short term of financing a firm and they arise spontaneously from daily activities of the
firm. These sources do not have interest charges associated with them.
➢ Accounts payable are created when the firm purchases raw materials, supplies or goods
for using them in construction or renting on credit terms without signing a formal note
for the liability. These on open account or credit invoice are for most firms the largest
single source of short-term financing. Payables represent unsecured form of financing
since no specific assets are pledged as collateral for the liability.
➢ Accruals are short-term liabilities that arise when services are received but payments
have not yet been made. These includes like subcontracting.
➢ Advance payment: it is common practice to pay an advanced payment for delivery
engineering services upon signing of contract agreement. Contracts stipulations require
that an advance payment amounting to 10 to 30% of contract price to be paid to the firm
delivering the service. This is deemed to alleviate the projects high financial requirement
with site mobilization at the commencement of the contract works.
➢ Advance for the purchase of material/ material on site: pursuant to the terms of any
international contract, the contractor is paid after accomplishing and reaching a certain
minimal amount of construction activities or works which are certified through
measurements by the engineer. Furthermore to alleviate the cash demand of contractor,
he will be paid for the raw material on site including any transportation cost rendered for
consignment to the site. Sometimes, in order to minimize the time delay arising from cash
shortage and assist in expediting work progress, clients are involved in the purchase of
materials or transfer the cash to the suppliers for the purchase of materials and the
corresponding price will be deducted from the successive payment to be due to the
contractor.
3. Wages Payable
Accrued wages represent the money a business owes to its employee. Accrued wages
build up between pay days and fall to zero again at the end of pay period, when employee
receive their pay check. A company can increase the average amount of accrued wages
by lengthening the period between pay days. Changing from a two week pay cycle to four
week cycle would effectively double a firm’s average level of accrued wages. Also, a
company can decrease accrued expenses by delaying payment of sales commissions and
bonuses. Legal and practical consideration; however, limit the extent to which a company
can increase accrued wages in this manner.
4. Retained Earning
Retained earnings represent the only internal source of financing expansion and growth.
Companies retain 30-80% of profit after tax for financing growth. It is referred as internal equity
since it retained through a sacrifice made by equity shareholders.
Retained earnings are readily available, low-cost to the firm, no dilution of control when a firm
relies on retained earnings, and the stock market generally views the equity issue with
skepticism. But retained earnings, however, do not carry any negative connection. In fact, the
opportunity cost of retained earnings is quite high.
Retained profits are by far the most important source of new long-term finance (internal or
external) for UK businesses.
• Retained profits are not a free source of finance, as investors will require returns similar
to those from ordinary shares.
• Internal sources of short-term finance include tighter control of trade receivables,
reducing inventories levels and delaying payments to trade payables.
5. Accrued Tax
The amount of accrued taxes and interest a firm may accumulate is also determined by
the frequency with which these expenses must be paid. For example, corporate income
tax payment normally are due quarterly, and a firm can use accrued taxes as a source of
fund between these payment dates, of course, a firm has no control over the frequency of
these tax payments, so the amount of financing provided by these sources depend solely
on the amount of the payment themselves.
statements. The most common financial statements that are important to making financial
prediction include:
✓ Income statement. Sometimes called a profit and loss account, an income statement
reveals the company’s expenses and revenues during a particular period and shows how
the business transforms those revenues into net profit or net income.
✓ Cash flow statement. Also known as a statement of cash flow, a financial statement
shows how changes in income and balance sheet accounts affect cash and cash
equivalents, and breaks down its analysis into investing, operating, and financing
activities.
✓ Pro-forma balance sheet. A pro forma balance sheet and a historical balance sheet are
similar, but a pro forma balance sheet contains running balances for the liabilities, assets,
and equity we estimate the business will have in the future and represents a projection.
Accounts receivable and current cash assets are the first two items on a pro-forma
balance sheet.
Financial forecasting is the process of analyzing what happened in the past, what is happening
now, and using that information to determine what is going to happen in the future. Businesses
use financial forecasting as a tool for planning and adapting to uncertainty by more effectively
predicting risks, opportunities and challenges that the business could encounter.
By engaging in a thorough process, enterprises can generate financial plans that estimate their
projected expenses, income, and other organization-specific macroeconomic factors affecting
financial forecasting. A strong forecast includes short- and long-term outlooks on contingencies
for costs not currently viewed as necessary and other conditions that might possibly affect
revenues. Effective financial forecasts rely on detailed models, skilled experts, strong business
partnerships and connections and tools for information gathering such as financial forecasting
software.
Financial forecasts fluctuate with business trends and other factors, and this is in part why
financial forecasting is more accurate in the short term than in the long term.
A financial forecast should include:
• Prior results weighted against current realities, considering the historical accuracy of data
sources and other assumptions critically
• A forward-facing timeframe, either set or rolling
• Full assessment of all macroeconomic risks including major, sudden global events such
as pandemic, wars, or natural disasters
• Best-case and worst-case revenue scenarios and key business assumptions
• Best-case and worst-case anticipated expenses
• Worst-case unanticipated costs, such as from disasters, data loss, or cyber attacks
• Internal risk assessment for threats such as insider attacks
• Connecting the business to “why” this forecast matters and is relevant
Financial forecast accuracy is frequently a critical factor in an organization’s ability to survive
unforeseen events.
Organizations have many, varied reasons to conduct financial forecasting. For that reason, there
are several types of financial forecast:
❖ Historical financial forecast. A historical forecast uses data from past financial
statements including balance sheets, cash flow statements, and income statements to
project future growth. This is an easy approach and the most common set of documents
finance teams use to engage the business.
❖ Sales forecasting. Predicts the amounts of products or services a business will sell during
a projected fiscal period using one of two sales forecasting methodologies: bottom-up
forecasting or top-down forecasting. Sales forecasting is useful for budgeting, allocating
and managing resources more efficiently, and streamlining planning production cycles.
Additionally, this is one of the most important forecasts that finance uses to connect and
collaborate inside the business.
❖ Cash flow forecasting. Based on factors such as expenses and income, cash flow
forecasting involves estimating cash flow in and out of the business across a defined
fiscal period. Although cash flow financial forecasting is more accurate over the short
term, it has several applications, including budgeting and identifying immediate funding
needs.
There are four basic financial forecast models that are quantitative: straight line or run rates,
moving average, simple linear regression and multiple linear regressions. All rely on large
quantities of historical data that can be measured and statistically controlled and rendered to
identify trends and patterns.
Financial forecasting methods may also be qualitative. These techniques rely on data that is
mission critical for businesses but cannot be measured objectively, such as evolving customer
preferences, and new technologies such as machine learning and predictive modeling algorithms.
What’s the right method or combo of methods for your business? That’s based on a number of
considerations.
Financial forecast examples of quantitative methods are:
• Pro-forma financial statements that use data from previous years such as expected
variable and fixed costs and sales figures to make forecasts.
• Time series analysis identifies trends and can be highly accurate, especially over the
short term.
• Scenario method identifies cause-effect relationships of relevant variables.
Qualitative forecasts are more likely to be used when little or no historical data is available.
Some examples of qualitative forecasting methods are:
Business knowledge. As always key personnel and other experts can provide a
financial forecast.
Consumer research. Market research among consumers might include data collected
via emails, interviews, phone calls, questionnaires, sample tests, texts, or more, all
used to generate forecasts.
Scenario forecasts. The forecaster generates various outcomes for different scenarios
and results based on them, and management selects the most likely outcome.
Key assumption forecasts. Taking a set of key assumptions in the business to discuss
with key business partners to test and validate potential outcomes.
The key steps in how to create a financial forecast for business include the following:
1. Define assumptions
Define assumptions that will impact the forecast to create common goals for the process:
• What is the financial forecast timeframe?
• What is the forecasting policy objective? For example, a conservative forecast might
build in expenditures for contingencies and underestimate revenues, reducing the risk of an
actual shortfall but making it harder to balance the budget. A more objective forecast might
aim for accuracy, estimating expenditures and revenues as accurately as possible, increasing
the risk of an actual shortfall but making it easier to balance the budget.
Defining the purpose of the financial forecast is essential to selecting the right factors and metrics
to consider. Financial forecasts afford insight into the future, from several weeks to several years,
although most companies forecast for one fiscal year at a time.
2. Gather information and insights from the business
To support the forecasting process, use business conversations and statistical data as well as the
forecaster’s expertise and accumulated judgment to forecast financial results, build quantitative
models, and document results throughout the financial forecasting process. Gather any relevant
historical data and records that impact financial decisions and the fiscal environment, including
those concerning: income, costs, equity, expenses, investments, liabilities, risks, and revenue.
Business trends, analysis and information should be a collaborative process with finance and the
business. The finance team conducts analysis and examination of historical data and relevant
economic conditions for consistent patterns or trends and evidence in several areas:
3. Select methods
Select the right quantitative and/or qualitative forecasting methods. Three basic forecasting
models to consider include:
• Extrapolation predicts future behavior using historical revenue data to project forward
trends.
• Regression analysis, also called regression econometrics, is a statistical procedure that
determines the relationship between independent and dependent variables to predict
future revenues or expenditures.
• Hybrid forecasting combines quantitative forecasting methods with knowledge-based
forecasting.
4. Implementation methods
Implement the forecast using the various forecasting methods described above. Develop a range
of possible forecast ranges or outcomes based on various scenarios.
5. Use forecasts appropriately
The purpose of a forecast is to inform decision-making, so any compelling, functional financial
forecast must achieve several goals.
Financial accuracy and credibility is central, and any financial forecast should be transparent and
open around key drivers, assumptions and potential outcomes connected to business processes
and tactics. Such as:
1. Describe why and how actual financial data and results might be lower or higher than the
forecast due to forces acting on expenditures or revenues?
2. Discuss possible tactics for how to improve financial forecasting accuracy and stay
within acceptable accuracy tolerances for forecasts?
Link the financial forecast to organizational decision-making and the planning and budgeting
process to lend a long-term perspective to the financial planning policy.
The difference between financial planning and forecasting is that a financial plan is a concrete,
step-by-step process for executing the financial forecast. A financial forecast is a projection or
estimate of likely future expenses and revenue or income, while a financial plan sets forth the
steps needed to cover future expenses and generate future income. A financial plan lays out the
process for making use of assets such as available capital to meet organizational goals for profit
or growth based on the financial forecast. A financial forecast in a business plan lays out how to
apply resources to generate optimal revenues.
Organizations use both financial forecasting and budgeting as tools. Budgeting establishes where
management hopes the company will go, and financial forecasting confirms progress toward the
goals. Budgeting serves as a baseline for comparison for actual results and expected performance
metrics. Typically covering one year, budgets include expected cash flows and debt reduction,
estimates of revenues and expenses, and a point of comparison for actual results to calculate
variance from financial forecasts. Financial forecasting examines historical data to estimate a
company’s future financial outcomes and looks at how actual performance and changes are
guiding future outcomes. It is updated routinely, when there is a change in inventory, operations,
and/or business plan.
A management team can use financial forecasting over both the short-term and long-term and
take immediate action based on the forecasts or use it to develop its business plan.
Financial forecasting is a process through which organizations can shape realistic expectations
surrounding future results and prepare for what’s ahead. In contrast, financial modeling uses the
assumptions from a financial forecast and financial statements to build a predictive financial
model. Businesses use these financial models to budget, attain financing, invest, and otherwise
make sound business and financial decisions. Financial modeling allows organizations to
summarize a range of variables and financial information that affect the business. Additionally,
financial models can be shared with the business in order to conduct their own forecast based on
changing key assumptions, drivers or variables. Financial models are the tools which financial
forecasts are communicated and built upon.
How can financial forecasting benefit an organization? Beyond the practical advantages of
financial forecasting we’ve already covered, the financial forecast process offers several other
benefits:
➢ Helps establish realistic goals;
➢ Forms a foundation for budgeting decisions;
➢ Prepare the organization for best- and worst-case scenarios including unforeseen future
expenses;
➢ Prepare businesses for demand fluctuations as well as forces that influence costs of goods
sold;
➢ Prepare organizations for predictable changes like new tax brackets;
➢ Prevent events from blindsiding leaders and hurting performance;
➢ Provide a gauge for management making financial decisions;
➢ Raise awareness of and establish controls for a broad range of external and internal
variables with short- and long-term impacts
➢ Reduces financial risk more generally to improve the organization.
➢ Increase business partnership and collaboration to how forecasts drive business
outcomes.
➢ Provide a strategic overview of key assumptions and drivers that help navigate
uncertainty and change
➢ Avenue for finance to work together with accounting and business partners to go further
together
There is no real downside to financial forecasting other than the need to do it and the cost to
achieve it.
Preparing, analyzing, and forecasting financial statements falls to the finance team, in close
partnership with the business. Together, this partnership should inform the leaders and
management teams inside and outside the company. Forecasting absolutely needs to be a united
team project.
A variety of financial forecasting tools and techniques exist for forecasting future financial
returns and measuring performance. Anything that helps analyze and process current internal
business and external economic information might be considered a tool for financial forecasting.
Home-based or other small businesses might not use financial forecasting tools as often as
enterprise-class organizations, but the advent of financial forecasting software and platforms
have made these tools more available. Creating financial forecasts is more complex than it used
to be, thanks in part to the availability of so much real-time data and better tools. For example,
fraud detection, buying patterns, machine learning, customer segmentation, real-time stock
market information, and other details add complexity as they open up more possibilities.
When it comes to how to forecast a company’s financials, there’s no one right way. However,
spending any time conducting financial forecasting reveals that pouring over massive amounts of
historical data can be exhausting. And spending all of the budget and time on historical data and
linear analysis generates financial forecasts that are frequently doomed to irrelevance thanks to
changes in consumer behavior or market volatility.
To best prepare for unforeseen situations, engage in ongoing financial forecasting with a
continuous planning platform. This allows for more effective scenario analyses that consider
unexpected, worst-case market scenarios and other external factors. It also ensures data
integration so your financial and non-financial data doesn’t get locked in data silos. Plan full
offers a centralized platform that finance and the business can communicate; collaborate to drive
clear and concise business outcomes through a unified and easy to use action oriented platform.
A powerful FP&A platform with financial forecasting software, Plan full supports continuous
financial forecasting and other financial planning without consuming excess time. Respond to
uncertainties and market shifts much faster with the data at your fingertips. A full financial
forecast consists of three parts: Balance Sheet, Cash Flow Statement, and Income Statement.
These are "pro forma" documents, or documents that are based on assumptions or projections.
The objectives of financial forecasting are to analyze past, current, and future fiscal data and
conditions to shape strategic decisions and policy.
The purpose of the financial forecast
The purpose of the financial forecast is to evaluate current and future fiscal conditions to
guide policy and programmatic decisions. A financial forecast is a fiscal management tool that
presents estimated information based on past, current, and projected financial conditions.
CHAPTER THREE
In this chapter we shall consider the analysis and interpretation of the financial statements. We
shall see how financial (or accounting) ratios can help in assessing the financial health of a
business. We shall also consider the problems that are encountered when applying this technique.
Financial ratios can be used to examine various aspects of financial position and performance
and are widely used for planning and control purposes. They can be very helpful to managers in
a wide variety of decision areas, such as profit planning, working-capital management, financial
structure and dividend policy.
LEARNING OUTCOMES
When you have completed this chapter, you should be able to:
◼ Explain how business plans are developed and the role that projected financial statements
play in this process.
◼ Prepare projected financial statements for a business and interpret their significance for
decision-making purposes.
◼ Discuss the strengths and weaknesses of each of the main methods of preparing projected
financial statements.
◼ Explain how projected financial statements may take into account the problems of risk
and uncertainty.
◼ Identify the major categories of ratios that can be used for analysis purposes.
◼ Calculate key ratios for assessing the financial performance and position of a business
and explain the significance of the ratios calculated.
◼ Discuss the use of ratios in helping to predict financial failure.
◼ Discuss the limitations of ratios as a tool of financial analysis.
• Marketable Securities: stocks or bonds of other firms that the firm has purchased.
• Receivables: Cash to be gained after the making of sales on credit. ( Work in
progress)
• Inventories: goods held by the firm for eventual resale. This includes raw
materials and goods tied up in the production process.
ii) LIABILITIES: These are debts of the firm. They represent sources of assets since the
firm either
Borrows the money or makes use of certain assets that have not yet been paid for. There
exist two forms of liabilities: current liabilities and long-term liabilities.
a) Current Liabilities: debts of the firm that must be paid during the current accounting
period. This Includes:
• Accounts payable: when a firm purchases credit,
• Short-term notes payable: promissory notes that mature in one year,
• Other payables: accruals (wages payable), tax liabilities.
b) Long-Term Liabilities: liabilities that will not be paid off during the next year. This
includes the long- Term secured and unsecured financing which covers mortgage and notes
where a building or other fixed assets are pledged as specific collateral for debts.
iii) EQUITY: Ownership rights in the company and includes: Preferred Stock, Common
Stock, Contributed capital in excess and retained earnings.
(Please refer to samples of balance sheets prepared by some of the local contractors)
3.1.2 The Income Statement
The income statement is a report of a firm’s activities during a given accounting period. Firms
often publish income statements showing the results of each quarter and the full accounting year.
It shows the revenues and expenses of the firm, the effect of interest and taxes and the net
income for the period. It may be called as the pit-and-loss statement or the statement of earnings.
The balance sheet offers a view of the firm at a moment in time, whereas the income statement
summarizes the profitability of operations over some time. It is an accounting device designated
to show stockholders and creditors whether the firm is making money. It can also be used as a
tool to identify the factors that affect the degree of profitability.
It includes cost accounting of:
• Net sales or construction income or work execution in monetary terms.
Working-Capital Pool
(All current accounts)
Marketable
Securities Cash Accounts Receivables
Inventory
Figure 3.1.3: Sources and uses of funds and the working capital pool.
The difference between sources and uses is shown as an increase or decrease in net working
capital. The pool is a measure of net working capital. If the firm has more funds coming in than
going out, net working capital increases.
Sample on Flow-Of-Funds
2022 2023
Source of funds
Net Income from operations Birr 148,262 Birr 127,065
Noncash expenses 107,296 92,297
Total funds from operations 255,558 219,362
Proceeds from long-term borrowing 92,621 41,831
Sales of property 6,101 1,499
Sales of common stock 2,112 1,804
Total sources of Funds Birr 356,392 Birr 264,497
Application of funds
Expenditures for property and equipment Birr 234,511 Birr 174,408
Miscellaneous investments 4,728 3,215
Payments of cash dividends 50,924 48,107
Funds held for plant construction 975 45,378
Total application of funds Birr 291,138 Birr 271,108
Increase (decrease) in net working capital Birr 65,254 Birr (6,611)
3.2. Financial Analysis
If properly analyzed and interpreted, financial statements can provide valuable insights into a
form’s performance. Analysis of financial statements is of interest to:
• Lenders (short-term as well as long-term)
• Investors,
• Security analysts,
• Managers, public and others.
Financial statements analysis is helpful in assessing:
• Corporate excellence,
• Judging creditworthiness,
• Forecasting bond ratings,
• Gross profit margin Gross Profit This ratio shows the margin left
after meeting
Income production costs. It measures the
efficiency
of production and pricing.
• Return on capital employed Net profit A measure of how efficiently
the capital is
Current assets employed. A key indicator of the
profitability of a
Firm. Firms that are efficiently using
their
Assets have a relatively high return.
Less efficient firms have a lower
return.
• Return on equity Net profit Profit indicator to shareholders.
The ratio
Total equity indicates the degree to which the
firm is able
To convert equity to generate net
profit that eventually can be claimed
by shareholders.
Turnover
• Debtors’ Turnover Net credit sales indicates the efficiency of credit management.
Accounts receivables (debtors) the higher the ratio, the more
efficient the
Credit management by the firm.
EXERCISES
1. Threads Limited manufactures nuts and bolts, which are sold to industrial users. The
abbreviated financial statements for 2010 and 2011 are as follows:
Income statements for the year ended 30 June
2022 (in 1000 birr) 2023(in 1000 birr)
Revenue 1,180 1,200
Cost of sales (680) (750)
Gross profit 500 450
Operating expenses (200) (208)
CHAPTER FOUR
4. INVESTMENT POLICY
4.1. INTRODUCTION
In this chapter we shall look at how businesses can make decisions involving investments in new
plant, machinery, buildings and other long-term assets. In making these decisions, businesses
should be trying to pursue their key financial objective, which is to maximize the wealth of the
owners (shareholders). Investment appraisal is a very important area for businesses; expensive
and far-reaching consequences can flow from bad investment decisions.
LEARNING OUTCOMES
When you have completed this chapter, you should be able to:
◼ Explain the nature and importance of investment decision making.
◼ Identify and discuss the four main investment appraisal methods found in practice.
◼ Use each method to reach a decision on a particular investment opportunity.
◼ Explain the key stages in the investment decision making process.
4.2. INVESTMENT POLICY
Investment (capital budgeting) may be defined as the decision-making process by which firms or
promoters evaluate the purchase of fixed assets, including buildings, machinery, and equipment.
Investment policy describes the firm’s formal planning process for the acquisition and
investment of capital and results in a capital budget for expenditure of money to purchase fixed
assets.
Significance of investment
• Substantial expenditure,
• Long Periods,
• Implied sales forecasts.
• Investment appraisal
• Planning horizon/ decision regarding return on investments.
4.3. The Time Value of Money
Money has time a value. If one is given the choice to receive 100 birr today or 100 birr next year.
The individual will choose 100 birr today. This is because money has value.
Simple Interest
PV
Periods
Eg. If the firm is due to receive Birr 550,000 in 2 years at a time when money is worth 10
percent compounded annually. What is the present value?
PV = FV / (1+r)n ‘
r’ here designates a discount rate.
PV= Birr 454,545
4.3.2. Present Value of an Uneven Series
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CONSTRUCTION FINANCIAL MAMAGEMENT MODULE
In financial analysis, one often comes across uneven cash flow streams. The present value of the
cash flow stream –uneven or even- may be calculated as follows:
n
A1 A2 An AT
PVn = +
(1 + r ) (1 + r )2
+ ... + =
(1 + r ) t =1 (1 + r )t
n
1 1
PVn = A 1 −
r (1 + r )
n
If a firm is due to receive Birr 400,000 annually for three years with an annual discount rate of
10 percent. What is the present value?
PV = 400,000 (1/0.1) (1-1/ (1.1)3 = Birr 994,741
4.3.4. Future Value of an Annuity
(1 + r )n − 1
FVn = A
r
4.4. Investment Appraisal
The decision-making processes of determining the economic analysis and financial viability of
capital investments under conditions of certainty. Financial viability analysis values investment
proposals toward meeting the profitability and/or wealth maximization targets of firms or
individuals. However economic analysis, in addition, values the social and economic costs and
benefits of an investment proposal pursuant to local or national development plan. Often firms
and governments have more investment opportunities than financial resources. Investment
analysts should look to the available evaluation methods to distinguish among the competing
proposals and develop a ranking procedure that will determine the method of allocation of capital
funds.
A wide range of methodologies has been suggested to judge the worthwhileness of investment
projects. The important investment evaluations from simple to more complex methods are the
following.
• Payback Period,
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Cost-Benefit Analysis
• Cost-effective analysis
• Multi-Criteria analysis
• Linear Programming ( e.g. Simplex Methods)
• Dynamic Programming (e.g. Combinatorial Problems).
Under this section, we deal only with the top four evaluation techniques.
4.4.1 The Payback Period
The payback period is the length of time required to recover the initial cash outlay on the project.
According to the payback criterion, the shorter the payback period, the more desirable the project
would be. Firms using this criterion generally specify the maximum acceptable payback period.
If this is ‘n’ years, projects with a payback period of ‘n’ years or less are deemed worthwhile and
projects with a payback period exceeding ‘n’ years are considered unworthy.
Example of Payback Period:
Year Cash Flow Discounting Present Value
Cumulative net
(Birr) Factor (10%) cash
0 -10,000 1.000 -10,000 -10,000
1 3,000 0.909 2,727 - 7,273
2 3,000 0.826 2,478 -4,795
3 4,000 0.751 3,004 -1,791
4 4,000 0.683 2,732 941
5 5,000 0.621 3,105
6 2,000 0.565 3,130
Looking at the above simple example, the payback period is between 3 and 4 years.
The payback period seems to provide the following advantages:
• Quite simple and readily understood,
• It is a rough and ready method for dealing with risks. It favors projects that generate
substantial cash inflows in earlier years. If risk tends to increase in the future, the
payback period may help screen risky projects.
• Since it emphasizes earlier cash flows, it may be a sensible method of evaluation for
firms pressed with problems of liquidity.
Major shortcoming:
• It ignores cash flows beyond the payback period. This leads to discrimination against
projects which generate substantial cash inflows in later years. Hence the payback period
is a measure of the project’s capital recovery, not profitability.
4.4.2 The Net Present Value (NPV)
The net present value of a project is the sum of the present values of all the cash flows both
positive and negative that are expected to occur over the life of the project.
n n
NPV = Bt (1 + r ) − Ct (1 + r )
−t −t
t =1 t =1
Expected Return
Business Risk
Risk less
Degree of Risk
To illustrate the net present value assessment of projects, consider the following cash flow
streams.
Year Benefit (Birr) Cost (Birr)
0 - 1,000,000
1 200,000 -
2 200,000 -
3 300,000 -
4 300,000 -
5 350,000 -
200,000 200,000 300,000 300,000 350,000 1,000,000
NPV = + + + + −
(1.1)1 (1.1)2 (1.1)3 (1.1)4 (1.1)5 (1.1)0
NPV = Birr 5,273. The net present value is shown positive with firm’s required return
accounting 10% to compensate the e for time and risk.
Application:
For investments of large size with longer project life whose future conditions are certain or
future potential risks associated with the project market and finance are predictable. It is useful
for comparing mutually exclusive projects of equivalent size when potentially higher return or
profitability is a concern.
4.4.3 The Internal Rate of Return (IRR)
The internal rate of return method calculates the actual rate of return provided by a specific
stream of net cash benefits compared to a specific net cash outlay. It uses a trial-and-error
approach to find the discount factor that equates the original investment to the net cash benefits.
In other words, it is the internal discount rate that equates NPV with zero.
n n
B (1 + r ) = C (1 + r )
−t −t
t t
t =1 t =1
The idea is to find ‘r’ that equates benefits with cost outlay. Investment projects that yield a
higher internal rate of return as compared with the required rate of return by the firm will be
accepted and those that fail to meet this acceptance criterion will be rejected.
NPV
IRR
Discount Rates
B (1 + r )
t
−1
CBR = t =1
n
C (1 + r )
t =1
t
−1
When CBR is greater than 1.0, the project accepted and if it is less than 1.0, the project is
rejected. This criterion measures the benefit out of the project per unit of the cost outlay. It can
discriminate better between large and small investments. The cost-benefit ratio may rank projects
correctly in the order of decreasing efficient use of capital.
4.5. Capital Budgeting on Contract Investment:
Cash flow budgeting, monitoring and control are a natural progression in the functioning of a
construction company. Cash, while being a resource in its own right, is also how other resources
are acquired. The provision of cash in the desired amounts, and at the right time, is one of the
most important aspects of managing a construction company.
The majority of cash flows experienced by a construction company occur as a result of the
contractual and credit arrangements existing on a series of contracts in any trading period. Every
contract carried out by a construction company requires an initial investment which will not be
recovered until sometime in the future. The sources of finance needed to carry out contracts can
be divided into two distinct classifications:
• Internal Sources: generated from the company’s operations with in the contract, which
are most of the time ‘locked up’ in a contract from the following two factors:
◼ stage payments as a requirement of the contract itself,
◼ During disagreements that might be a case for many contracts.
• External Sources: costing a market interest rate measured by risks perceived by the
lenders. This cost is prepared by the head office.
The important aspect of a construction company, in the establishment of corporate budget
planning and monitoring, is to consider the profitability at the end of the day and evaluate and
monitor with the one anticipated at the time the tender was prepared. The two distinct concepts
that affect a company’s profitability:
• The company’s desired return on capital employed (ROCE) and its ability to maintain
market share,
• The mark-up on contract costs required to achieve the desired ROCE and its effect on
tender success rates.
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CONSTRUCTION FINANCIAL MAMAGEMENT MODULE
Required
ROCE………………………………………………..20%
ROCE = Birr 66,000 (20% of Birr 330,000)
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CONSTRUCTION FINANCIAL MAMAGEMENT MODULE
Since company cash flow represents a series of aggregated cash flows generated by contracts,
The ROCE shall be collected from the cash flows of the individual contracts through the
inclusion of a Mark-up.
Mark-up (Head Office) = Administrative Expenses + ROC mark-up initiative expenses (Head
Office Expenditure) can be identified within a company’s accounts by items such as rent,
telephone charges, electric bills, office equipment hire charges, payment to staff directors etc.
Often it is established in relation to the total turnover planned in the trading year. If the company
mentioned above is planning for a total turnover of Birr 2,200,000 in the planning year, one can
assume a 10% fee as administrative expenses.
Administrative expense: Birr 220,000
Mark-up = 220,000+ 66,000 =Birr 286,000
This contribution has to be earned from the respective contract investment.
Turnover = ∑ Production Cost of Contract + Mark-up,
Where, Production Cost = Direct cost + Site Overhead Cost
∑ Production Cost of Contract = 2,200,000- 286, 000 = Birr 1,914,000.
This refers to a cost incurred at the site to produce the end deliverables.
Mark-up at individual projects = Birr 286,000/ Birr 1,914,000 = 15%
Managements or quantity surveyors need to add 15% to the estimated costs (Direct cost + site
overhead costs) in order to turn an estimate into a tender, so that general overheads, risks, and
profit are covered.
4.5.2. The corporate Budget
The corporate budget is the starting point for setting up a monitoring and reporting system. It
also becomes the reference point at the end of a financial year, against which the measurement of
financial performance and the achievement of planned objectives are made. The production of
this budget will be a rolling exercise, looking back at past performance and taking advice from
staff. However, the important element of a corporate budget is that the company has to prepare
cash flow at the corporate level (head office cash flow) to maintain and secure its commitment to
a set of objectives for a given period.
The gross and net cash demand in the planning period has to be collected from the individual
contracts. The administrative expenses should also be identified such that the planner can
establish the entire cash flow expenses, define financing sources at a low cost to the corporate,
and the right timing for funding the respective contracts.
Cash Inflow
Time in Months
Information on the first five columns can be driven from the cost break down prepared during
estimates.
The last two columns are taken from the tender values.
* Production Cost (Direct Cost + Site Overhead Cost)
** Tender Sum (The price at which the contractor is awarded the contract)
*** Contracts Mark-up by the corporate (Aggregated contract mark-up will cover the
administrative expenses and ROCE of the company)
b) The operational Budget:
Once the contract budget is established, the contract manager should produce the operational
budget on monthly basis using the contract work program. It is worta h noting that the
statements produced at this level have two primary functions:
• To provide managers with cost data on a monthly basis,
• To enable managers at each level to take decisions or implement corrective actions when
necessary.
The project manager has to identify the reasons behind why the contract might be under or over-
valued:
• Additional order of the client, work change
• Omission of the original work,
• Design errors , omissions or mistakes of the quantity surveyor
• Contractors default by, not maintaining quality of work,
• Unforeseen Circumstances, etc.
Once a variation has occurred it is important that it is first identified. Agreement that it must
be the nature of the work must be sought and from this a valuation must be made to ensure
that payment is issued to adequately maintain cash flow in a contract.
Monitoring and Control at Site Level
The final control aspects to consider are control and reporting at site level. At site level, the site
engineer is interested in the cost efficiency of each individual activity. The concern is for
comparison of resource costs, labor, materials and plant included in the estimates for cost units,
with those actually incurred and recorded on labor allocation sheets, material invoices and plant
returns.
Table 4: Site Manager’s Control Statement
CHAPTER SUMMARY
The main points of this chapter may be summarized as follows:
◼ Accounting rate of return (ARR) is the average accounting profit from the project
expressed as a percentage of the average investment.
◼ Decision rule – projects with an ARR above a defined minimum are acceptable; the
greater the ARR, the more attractive the project becomes.
◼ Conclusion on ARR:
➢ Does not relate directly to shareholders’ wealth – can lead to illogical conclusions;
➢ Takes almost no account of the timing of cash flows;
➢ Ignores some relevant information and may take account of some that is irrelevant;
➢ Relatively simple to use;
➢ Much inferior to NPV.
◼ Payback period (PP) is the length of time that it takes for the cash outflow for the initial
investment to be repaid out of resulting cash inflows.
◼ Decision rule – projects with a PP up to a defined maximum period are acceptable; the
shorter the PP, the more attractive the project.
◼ Conclusion on PP:
➢ Does not relate to shareholders’ wealth,
➢ Ignores inflows after the payback date;
➢ Takes little account of the timing of cash flows;
➢ Ignores much relevant information;
➢ Does not always provide clear signals and can be impractical to use;
➢ Much inferior to NPV, but it is easy to understand and can offer a liquidity
➢ Insight, which might be the reason for its widespread use.
◼ Net present value (NPV) is the sum of the discounted values of the net cash flows
from the investment.
◼ Money has a time value.
◼ Decision rule – all positive NPV investments enhance shareholders’ wealth; the greater
the NPV, the greater the enhancement and the greater the attractiveness of the project.
◼ PV of a cash flow = cash flow × 1/ (1 + r) n, assuming a constant cost of capital.
◼ Discounting brings cash flows at different points in time to a common valuation basis
(their present value), which enables them to be directly compared.
◼ Conclusion on NPV:
➢ Relates directly to shareholders’ wealth objective;
➢ Takes account of the timing of cash flows;
➢ Takes all relevant information into account;
➢ Provides clear signals and is practical to use.
◼ Internal rate of return (IRR) is the discount rate that, when applied to the cash flows of a
project, causes it to have a zero NPV.
◼ Represents the average percentage return on the investment, taking account of the fact
that cash may be flowing in and out of the project at various points in its life.
◼ Decision rule – projects that have an IRR greater than the cost of capital are acceptable;
the greater the IRR, the more attractive the project.
◼ Cannot normally be calculated directly; a trial and error approach is usually necessary.
◼ Conclusion on IRR:
➢ Does not relate directly to shareholders’ wealth. Usually gives the same signals as
NPV but can mislead where there are competing projects of different size;
➢ Takes account of the timing of cash flows;
➢ Takes all relevant information into account;
➢ Problems of multiple IRRs when there are unconventional cash flows;
➢ Inferior to NPV.
Use of appraisal methods in practice:
◼ All four methods identified are widely used;
◼ The discounting methods (NPV and IRR) show a steady increase in usage over time;
◼ Many businesses use more than one method;
◼ Larger businesses seem to be more sophisticated in their choice and use of appraisal
methods than smaller ones.
Managing investment projects
◼ Determine investment funds available – dealing, if necessary, with capital rationing
problems.
◼ Identify profitable project opportunities.
CHAPTER FIVE
If current assets are more than current liabilities, net working capital is positive. A negative
working capital occurs when the current liabilities exceed the current assets. Treatment of Bank
overdraft/cash credit account: Bank overdraft/cash credit account is treated as current liability as
the sanction of the bank is for one year. It is a different matter bank renews these facilities
continuously, at the request of the borrower, on submission of the required data and particulars.
Some authors treat bank overdraft/cash credit accounts as permanent borrowing, not as current
liability, as the funds remain with the firm, continuously. As already discussed in the ratio
analysis, in detail, we consider bank overdraft/cash credit account, as a current liability as the
firm has to repay, at the end of one year, as the official written sanction of the bank is available
for one year, only.
Gross and Net working capital not exclusive: The two concepts of gross and net working capital
are not exclusive. It means both have equal significance or importance from the management’s
viewpoint. The gross working capital concept is a financial or going concern concept while net
working capital is an accounting concept of working capital. A finance manager must consider
both aspects, as they provide different interpretations.
Gross Working Capital Concept: Gross working capital requires consideration from two angles:
(A) How to optimize investment in current assets?
There are two danger points in respect of working capital, excessive or inadequate investment in
current assets. Both are equally dangerous. The basic objective of working capital management
is to manage a firm’s current assets and current liabilities, in such a way, that working capital is
maintained, at a satisfactory level. Then, what is a satisfactory level? The working capital should
be neither more nor less, but just adequate. Cash is tied to current assets and funds involve costs.
If investment in current assets is excessive, profitability will be greatly affected. If investment in
current assets is inadequate, the firm experiences difficulty, in meeting the current obligations, as
and when they fall due. Inadequate working capital threatens the solvency of the firm, due to the
inability to pay current obligations, in time. Both profitability and solvency are equally
important. So, the management should be prompt to initiate the necessary action to keep working
capital, adequate to the changing needs of business.
Moreover, different components of working capital are to be balanced. If the inventory level is
too high in the total current assets, due to slow-moving stocks, it does not provide any cushion in
the form of liquidity. Similar is the case with the high proportion of accounts receivable, which
are difficult to recover. If cash and bank balances are more in total current assets, they are idle
and do not contribute to profitability. So, it is important to maintain the proper level of current
assets, in aggregate, as well as their proportion.
(B) How should current assets be financed?
The second aspect is arranging funds for financing current assets. Working capital requirements
are not static. The requirement keeps on changing. If business increases, more working capital is
needed. If the business shrinks, idle funds arise. Thus, the finance manager should have adequate
knowledge to tap the different sources of working capital funds, at short notice, as well as
investment avenues, where idle funds may be, temporarily, invested.
Net Working Capital Concept: Current assets are financed by current liabilities, to a large extent.
The balance amount of working capital, not financed by current assets, is financed from the long-
term sources of the firm. Long-term sources are shareholders’ funds and long-term borrowings.
Net working capital, the excess of current assets over current liabilities, measures the firm’s
liquidity.
This also gives an idea about the buffer available to current liabilities. It indicates the margin of
protection available to the short-term creditors. Net working capital gives more assurance to the
creditors. So, creditors look for higher net working capital for their safety and promptness in
payments. In all, net working capital indicates the financial soundness of the firm. So, to the
finance manager, the net working capital concept is also important to send signals of safety to
creditors.
(C) Importance of Working Capital
Cash inflows and outflows are never synchronized. Cash inflows occur with the realization of
current assets, such as stock and debtors. Their realizations are highly unpredictable as the
inflows depend on outsiders’ actions. Outflows are related to the payments to creditors, bills
payable, and outstanding expenses. They are more predictable and controllable as they depend
on the behavior of the firm. However efficient the finance manager may be, the certainty of both
cash inflows and outflows cannot be predicted, with total accuracy. To meet the gap between the
cash inflows and outflows, working capital is needed. The more these cash flows are predictable,
the lesser amount is needed for working capital. If these cash flows are uncertain, a higher
amount of working capital is essential for the enterprise.
Working capital Level: It is a conventional rule to maintain a level of current assets twice the
level of current liabilities. In other words, the current ratio should be 2:1. However, this is only a
crude rule. It all depends on the quality of current assets. If the current assets are realizable and
qualitative, even a lesser current ratio may be adequate and the firm may not experience any
difficulty in meeting current obligations. If the current assets consist of more slowly moving
stocks and more time-taking debtors, even a higher ratio may not put the firm at ease for making
the payments, in time. The mix of current assets is more important than its mere quantity.
Working capital should be a judicious mix: Working capital should be a judicious mix of long-
term and short-term funds for financing its current assets. The permanent component of current
assets should be financed by long-term sources such as equity share capital, preference share
capital, debentures, long-term loans, and retained earnings. Each firm should decide on the mix
of short-term and long-term funds, depending on their availability and the risk the firm is
prepared to assume. There is no hard and fast rule for deciding the exact quantum of working
capital as the requirements of business fluctuate. Similarly, there is no specific rule on how the
current assets are to be financed. But, one thing is clear, there should be a proper judicious mix
and whatever funds are raised, they should be put to productive use.
5.3. NEED FOR WORKING CAPITAL
Every enterprise is not fortunate enough to conduct its total business with cash sales. Credit sales
are common in, almost, every form of business. To support credit sales, working capital is
needed in the form of current assets. Working capital is required to carry on day-to-day business
activities. While every firm requires working capital, its quantum differs from business to
business, dependent on the nature of the activity the business is engaged in. A retail firm may
require a lower amount of working capital, while a wholesale firm needs more. Similarly, where
the gestation period is long for production, the manufacturing firm requires more amount of
working capital. It needs no further emphasis that the requirement of working capital is vital for
every business, more so, when the objective of each firm is wealth maximization. The amount of
working capital depends on the operating cycle, involved in the conversion of sales into cash or
the total period needed for bringing cash into cash again as cash is the starting for business while
cash, again, is the end point of the transaction.
The operating cycle is the length of period required to convert sales, after the acquisition of the
resources such as materials, power, etc., into cash. The operating cycle of a manufacturing firm,
typically, involves three phases:
• Acquisition of Resources such as raw material, labour, power and fuel etc.
• Manufacture of the Product which includes conversion of raw material into work in process
into finished products.
• Sale of the product either for cash or credit sales. Credit sales result into debtors or accounts
receivable.
The operating cycle can be presented in a pictorial form
postpone payments for services such as wages, rent, etc., and the period is known as the
payables deferral period. The difference between the gross operating cycle and the
payables deferral period is known as the Net operating cycle. When cash sales are
involved, the length of the operating cycle is short as there is no debtors’ conversion
period.
Estimation of Working Capital with Operating Cycle: With the operating cycle method,
working capital can be calculated in the form of the length of the operating cycle i.e. number of
days. As depreciation is a non-cash expense, depreciation is to be excluded from the expenses to
compute the cash operating cycle. The actual operating cycle would be compared with the
anticipated operating cycle to evaluate the performance of working capital management. If the
net operating cycle increases, the requirement of working capital would increase and vice versa.
The method of calculation of the operating cycle is as under:
Inventory Conversion Period (ICP) is the sum of raw materials Conversion Period (RMCP),
work-in-process Conversion Period (WIPCP), and Finished Goods Conversion Period (FGCP).
Net Operating Cycle is the difference between the gross operating cycle and payables deferral
period.
Average is calculated by averaging the total of opening and closing balance of the raw materials
stock, held by the firm
that seeks proper policies for managing current assets and liabilities and practical techniques for
maximizing the benefits from managing working capital.
5.4.1. Characteristics of Current Assets
In the management of working capital, two characteristics of current assets must be borne in
mind: Short life span, Swift transformation into other asset forms.
Current assets have a short life span. Cash balances may be held idle for a week or two, accounts
receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to 100
days. The life span of current assets depend upon the time required in the activities of
procurement, production, sales and collection and the degree of synchronization among them.
Each current asset is swiftly transformed into other asset forms: cash is used for acquiring raw
materials; raw materials are transformed into finished goods ( these transformation may involve
several stages of work in process); finished goods generally sold on credit basis are converted to
accounts receivable; and finally accounts receivable, on realization, generate cash. Fig 5.1 shows
the cycle of transformation of current assets.
Finished Goods
Accounts
Receivable Work in Progress
Wages, Salaries,
Overheads
Raw Materials
Cash Suppliers
Order Cash
Received
Stock
arrives
Accounts Payable
Operating Cycle
Cash Cycle
From the financial statement of the firm, one can estimate the inventory period, the accounts
receivable period and the accounts payable period.
Acc. Receivable Period (days) = Accounts Receivable ($)/ (Annual Sales ($)/ 365 days)
Acc. Payable Period (days) = Acc. Payable ($) / (Annual Cost of Goods ($)/ 365 days)
Inventory Period (days) = Inventory ($)/ (Annual Cost of Goods sold ($)/365 days)
For the example below, estimate the operating and cash cycle of the firm given the following
data taken from the financial statement.
➢ Annual Sale: Birr 500 million
➢ Total cost of goods sold: Birr 360 million
➢ Inventories: Birr 60 million
➢ Accounts Receivables: Birr 80 million
➢ Accounts Payable: Birr 50 million
Solution:
Accounts Receivable = (80/ 500) X 365 = 58 days
Accounts payable = (50/ 420) X 365 = 43 days
Inventory Period = (60/ 420) X 365 = 52 days.
Operating Cycle = 52 + 58 = 110 days
Cash Cycle = 110- 43 = 67 days.
5.4.3. Factors Affecting Working Capital Requirements
The working capital needs of a firm are influenced by numerous factors. The important ones are:
I. Sales Volume: A firm maintains current assets because they are needed to support the
operational activities that culminate in sales. Over time, a firm will keep a fairly steady
rate of current assets to annual sales. A firm realizing a steady level of sales operates with
a fairly constant level of cash, receivables, and inventory, if properly managed. Firms
experiencing growth in sales require additional working capital. If sales are declining, a
reduction in working capital can be expected.
II. Nature of Business: The working capital requirement of a firm is closely related to the
nature of its business. A service firm with a short operating cycle and which sells
predominantly on cash basis has modest working capital requirement. On the other hand,
a firm which has a long operating cycle and which sells largely on credit has a very
substantial working capital requirement.
III. Production Policy: A firm marked by pronounced seasonal fluctuation in its sales may
pursue a production policy which may reduce the sharp variations in working capital
requirements. Foe example, a manufacturer of ceiling fans may maintain a steady
production throughout the year rather than intensify the production activity during the
peak business season. Such a production policy may dampen the fluctuations in working
capital.
IV. Market Conditions: The degree of competition prevailing in the market place has an
important bearing on working capital needs. When competition is keen, a larger inventory
of finished goods is required to promptly serve customers who may not be inclined to
wait because other manufacturers are ready to meet their needs. Further, generous credit
terms may have to be offered to attract customers in a highly competitive market. Thus
working capital needs tend to be high because of greater investment in finished goods
inventory and accounts receivable.
V. Conditions of Supply: The inventory of raw materials, spares and stores depend on the
conditions of supply. If the supply is prompt and adequate, the firm can manage with
small inventory. If, however the supply is unpredictable and scant with the firm, to ensure
continuity of production, the firm would have to acquire stocks as and when they are
available and carry large inventory on average.
5.4.4. Cash Requirement for Working Capital
As a finance manager, one will be interested in figuring out how much cash to be arranged to
meet the working capital need of the firm. To do this, two step procedures shall be followed:
Step 1: Estimation of the cash cost of various current assets require by the firm:
This follows to estimate the following:
• Cash cost of debtors (receivables) by removing the profit element (ROCE),
• Raw materials in stock
• Finished goods in stock
• Cash balance
Step 2: Deduct the current liabilities from the cash cost of current assets:
A portion of the cash cost of current assets is supported by trade credit and accruals of wages and
expenses, which may be referred to as spontaneous current liabilities. The balance left after such
deduction has to be arranged from other sources.
i) Transaction needs: A firm needs cash to carry out the day-to-day functions of the
business. Just as the firm’s level of operations affects working capital requirements, it
affects the need for cash. If the volume of sales increases, cash will be received from
customers and will be expended for materials and wages in large amounts. Adequate
cash to cover these and other transactions allow the firm to pay its bills on time.
ii) Contingency needs: If the firm could perfectly forecast its needs for cash, it would
not have to be concerned with unexpected occurrences or emergencies that require
cash. Because this is not possible, the firm must be prepared for contingencies.
iii) Opportunity needs: These involve the chance to profit from having cash available.
For example, a supplier may have several cancellations of orders and may wish to
move a large unwanted inventory of raw materials from his warehouse. If the supplier
offers a large discount for cash purchasing of the materials, the firm will have the
opportunity to realize a substantial savings on its purchase and, hence, profits from
the sale of the finished goods.
5.5.2. Forecasting Cash Flow
Once the financial manager has identified the firm’s policies on cash flow management, he must
face the problem of predicting the amounts and timing of future inflows and outlays of cash. This
is a difficult process for most firms because cash flows are affected by many factors. The failure
to prepare for the proper level of cash poses three risks to the company:
i) Default: The failure to pay interest or principal payments on a firm’s borrowings or
failure to perform as per contract is a default, a situation that may result in legal actions by the
firm’s creditors.
ii) Overdue Bills: The failure to pay short-term obligations, such as payables, is less serious
than default but may result in a lowering of the firm’s credit rating in the business community.
This may be accompanied by higher interest rates when the firm applies for loans or may cause
creditors to refuse to ship supplies on credit.
iii) Lost Savings on Purchases: Inadequate cash may cause the firm to lose opportunities to
make special cash purchases or to take generous trade discounts on purchases of goods.
In attempting to minimize these risks, the firm pursues the twin goals of cash forecasting,
namely:
• Liquidity: By predicting cash surpluses or cash shortages, the firm achieves liquidity-
sufficient money in the bank to pay debts as they come due.
• Profitability: Accurate cash forecasting achieves profits by allowing the firm to take
profitable discounts on purchases, invest surplus funds, or reduce the costs of maintaining
idle cash balances.
Example: On Cash flow forecast & Working Capital
Given the following information for a construction project:
• A contract budget has been prepared and the monthly evaluation forecasts are as
indicated hereunder:
Months 1 2 3 4 5 6
Cumulative Forecast (Birr) 8,000 10,000 12,000 14,000 10,000 6,000
Months 1 2 3 4 5 6
Cumulative self-cost (Birr) 6,640 14,940 24,900 36,520 44,820 49,800
Months 1 2 3 4 5 6
Cumulative Expenditure (Birr) 9,640 17,940 27,900 39,520 47,820 52,800
3) Cumulative Income
Monthly Income Forecast: It can be determined from cumulative contract value forecast subject
to deductions as retention money, advance payment and any previous payments.
Income month ( i+1) = Cumm. Contract Value month ( i) – retention – previous payments
Income month (2) = 8,000 – 0.03( 8,000) -0 = Birr 7,760
Income month (3) = 18,000 – 0.03 ( 18,000) – 7,760 = Birr 9,700
Income month (4) = 30,000 – 0.03( 30,000) – (7,760+9,700) = Birr 11,640
Income month (5) = 44,000 – 0.03( 44,000) – ( 7,760 +9,700+11,640) = Birr 13,580
Income month (6) = 54,000 – 0.03 (54,000) – (7,760+9,700+11,640+13,580) = Birr 9,700
Income month (7) = 60,000- 0.015(60,000) – (7,760+9,700+11,640+13,580+9,700) = Birr 6,720
Income month (12) = 0.0015 (60,000) = Birr 900
Cumulative Income:
Months 1 2 3 4 5 6 7 12
Monthly Income (Birr) 0 7760 9700 11640 13580 9700 6720 900
Cumm. Income (Birr 0 7760 17460 29100 42680 52380 59100 60000
Gross cash required (monthly) = Cumm. Income before receiving monthly payment - Cumm.
Expenditure
Months 1 2 3 4 5 6
7 12
Net Cash Req’d (Birr) -9,640 -10,180 -10,440 -10,420 -5,140 -420 6,300
7,200
Gross cash Req’d (Birr) -9,640 -17,940 -20,140 -22,060 -18,720 -10,120 -420
6,300
Value (Birr)
60000
Expenditure
Value Forecast
Income/ Revenue
30000
Cash (Birr)
+ 30000
Self-Financing Date
Surplus
1 2 3 4 5 6 7 Time, Months
Short
Fall
Gross Cash Requ’t
Net Cash Requ’t
Fig 5.3b Gross and Net Cash Requirements.
-30000 Max. Capital Required
Converted to cash
Cash in Cash on
Advance Delivery
i) Cash Terms: When goods are sold on cash terms, the payment is received either before
the goods are shipped (cash in advance) or when the goods are delivered (cash on delivery). Cash
in advance is generally insisted upon when goods are made to order. In such a case, the seller
would like to finance production and eliminate marketing risks. Cash on delivery is often
demanded by the seller if it is in a strong bargaining position and/or the customer is perceived to
be risky.
As with all assets and operations, the willingness to allow credit sales involve certain costs.
These include:
I. Financing the Receivables: Carrying accounts receivables ties up a portion of the firm’s
financial resources seeking for addition in working capital. These resources must be
financed from other sources such as past profits retained in the business, contributed
capital from owners and debt from creditors.
II. Administrative and Collection Expenses: To keep records on credit sales and payment
and the efforts made to aware and push debtors to settle their payments incurs additional
cost to the firm. In addition, most firms conduct investigations of potential credit
customers to determine their creditworthiness. These and other expenses, such as
telephone charges and postage constitute the administrative and collection costs of
maintaining receivables.
III. Bad Debt Loss: After making serious efforts to collect on overdue accounts, the firm
may be forced to give up. If a customer declares bankruptcy, no payment may be
forthcoming. If the customer leaves the city or state, it may be too costly to trace him and
demand payment. In these cases, the firm is forced to accept a bad debt loss on the
account.
5.6.3 Policies for Managing Receivables
The firm should establish its receivable policies after carefully considering both the benefits and
costs of different policies:
I. Profit: The firm should investigate different possibilities and forecast the effect of each
on its future profits. The cost of funds tied up in receivables, collection costs, bad debt
losses and money lost with discounts for early payment should be compared with
additional sales as a consequence of the proposed policy. Degree of relaxing the credit
policy as determined by residual income may be estimated as follows:
R = S ( p ) − S (r ) − I (k )
R : Residual Income
S ( p ) : Profit from change in sale
S (r ) : Bad debt loss
I (k ) : Opportunity cost of additional funds locked in receivables.
p, r ,& k : Multiplying factors for profit, bad debt loss and opportunity cost
respectively.
II. Growth in sales: Sometimes firms are willing to accept short term setbacks with
respect to profits if a new policy enables the firm to increase its sales significantly.
Because growth is so important aside from profits, it should be viewed as a separate
factor in determining receivable policies.
5.6.4 Credit Policy Variables
The important dimensions of a firm’s credit policy are credit standards, credit period, cash
discount and collection effort. These variables are related and have a bearing on the level of
sales, bad debt loss, discounts taken by customers, and collection expenses.
A. Credit Standards: A pivotal question in the credit policy of a firm is: What standard
should be applied in accepting or rejecting an account for credit granting? A firm has a
wide range of choice in this respect. At one end of the spectrum, it may decide not to
extend credit to any customer, however strong his credit rating may be. At the other
end, it may decide to grant credit to all customers irrespective of their credit rating.
Between these two extreme positions lie several possibilities, often the more practical
ones. In general, liberal credit standards tend to push sales up by attracting more
customers. This is, however, accompanied by a higher incidence of bad debt loss, a larger
investment in receivables, and a higher cost of collection. Stiff credit standards have the
opposite effects. They tend to depress sales, reduce the incidence of bad debt loss,
decrease the investment in receivables and lower the collection cost.
B. Credit Period: The credit period refers to the length of time customers are allowed to pay
for their purchases. When a firm does not extend any credit, the credit period would
obviously be zero. Lengthening the credit period pushes sales up by inducing existing
customers to purchase more and attracting additional customers. This is, however,
accompanied by a larger investment in debtors and a higher incidence of bad debt loss.
Shortening of the credit period should have an opposite effect. It tends to lower sales,
decrease investment in debtors, and reduce the incidence of bad debt loss.
C. Cash Discount: Firms generally offer cash discounts to induce customers to make
prompt payments. The percentage discount and the period during which it is available are
reflected in the credit terms. For example, credit terms of 2/10, net30 mean that a
discount of 2 percent is offered if the payment is made by the tenth day; otherwise the
full payment is due by the thirteenth day. Liberalizing the cash discount policy may mean
that the discount percentage is increased and/or the discount period is lengthened. Such
an action tends to enhance sales, reduce the average collection period and increase the
cost of discount.
D. Collection Effort: The collection program of the firm, aimed at timely collection of
receivables may consist of the following:
▪ Monitoring the state of receivables,
▪ Dispatch of letters to customers whose due date is approaching,
▪ Electronic and telephonic advice to customers around the due date,
▪ Threat of legal action to overdue accounts,
▪ Legal action against overdue accounts.
A rigorous collection program tends to decrease sales, shorten the average collection period,
reduce bad debt percentage and increase the collection expense. A lax collection program, on the
other hand, would push sales up, lengthen the average collection period, increase the bad debt
percentage and perhaps reduce the collection expense.
5.7. Inventory Management
Inventory may be defined as the goods held for eventual resale by the firm. Decisions relating to
inventories are taken primarily by executives in production, purchasing and marketing
departments. Usually, raw material policies are shaped by purchasing and production executives,
work in process inventory is influenced by the decisions of production executives, and finished
goods inventory policy is evolved by production and marketing executives. Yet, as an inventory
management has important financial implications. The financial manager has the responsibility
to ensure that inventories are properly monitored and controlled. He has to emphasize the
financial point of view and initiate programs with the participation and involvement of others for
effective management of inventories.
Generally three types of inventories may be identified.
▪ Raw materials: These are goods that have not yet been committed to
production.
▪ Goods in process: This category includes those materials that have been
committed to production process but have not been completed. Goods in process
include such items as components and sub components that are not yet ready to be
sold.
▪ Finished goods: These are completed products awaiting sale. In construction
process, they are the final output of the production process. For retail firms and
wholesalers, they are usually referred to as the merchandise inventory.
5.6.5. Benefits of Holding Inventories
Inventories are used to provide cushions so that the purchasing, production, and sales functions
can proceed at their own optimum paces.
In achieving the separation of these functions, the firm realizes a number of specific benefits.
I. Avoiding Losses of Sales: If the firm does not have goods available for sale, it will lose
sales. Customers requiring immediate delivery will purchase their goods from the firm’s
competitors, and others will decide that they do not need the goods after all, if they must
wait for delivery. The ability of the firm to give quick service and to provide prompt
delivery is closely tied to the proper management of inventory.
II. Gaining Quantity Discounts: If a firm is willing to maintain large inventories in selected
product lines, it may be able to make bulk purchases of goods at large discounts.
Suppliers frequently offer a great reduced price if the firm orders double or triple its
normal requirement. By paying less for its goods, the firm can increase profits, as long as
the costs of maintaining the inventories are less than the amount of discount.
III. Reducing Order Costs: Every time a firm places an order, it incurs certain costs. Forms
must be types, checked, approved and mailed. When goods arrive, they must be accepted,
inspected and counted. The variable costs associated with individual orders can be
reduced if the firm places a few large rather than numerous small orders.
IV. Achieving Efficient Production Runs: Once an assembly line or work team is prepared
and composed to receive certain raw materials and perform selected production
operation, a setup cost has been incurred which must be absorbed in the subsequent
production run. If the firm has to change setups frequently, it would experience high unit
costs of production.
In the figure, we can see the rising slope to carrying costs as the level of inventory is increased.
One can also see the declining order costs with higher inventory levels. The lowest total cost
considers both in carrying costs and ordering costs.
There are two basic questions relating to inventory management.
• The size of the order- Q optimal
• The level to order – Q level.
i) Order Quantity- Economic Order Quantity( EOQ)
The Economic Order Quantity refers to the order size that will result in the lowest total of order
and carrying costs for an item of inventory. If a firm places unnecessary orders, it will incur
unneeded order costs. If it places too few orders, it must maintain large stocks of goods and will
have excessive carrying costs. By calculating an economic order quantity, the firm identifies the
number of units to order that results in the lowest total of these two costs.
Variables in the EOQ model:
U: The forecast usage/demand for goods or raw materials for a year is known,
Q: Quantity Ordered,
F: Cost per Order,
C: Percent Carrying Cost
P: Price per Unit,
TC: Total Costs of ordering and carrying.
TC =
U
(F ) + Q (P )(C )
Q 2
The first term on the right hand side is the ordering cost, obtained as the product of the number
of orders (U/Q) and the cost per order (F), and the second term on the right hand side is the
carrying cost, obtained as the product of the average value of inventory holding (QP/2) and the
percentage carrying cost (C).
The total cost of ordering and carrying is minimized when the derivative of the above equation is
equated to zero:
dTC UF PC
=− 2 + =0
dQ Q 2
2UF
Q2 =
PC
2 FU
Q=
PC
Example: Given the following for a company:
U= Annual sale= 20,000 Units
F= fixed cost per order = Birr 2,000
P= Purchase price per unit= Birr 12
C= Carrying cost = 25% of inventory value
2 x 2,000x 20,000
Q= = 5,164units
12x0.25
ii) Order Level/Order Pont
The standard EOQ model assumes that materials can be procured instantaneously and hence
implies that the firm may place an order for replenishment when the inventory level drops to
zero. In the real world, however, procurement of materials takes time and hence the order level
must be such that the inventory at the time of ordering suffices to meet the needs of production
during the procurement period.
If the usage rate of materials and lead time for procurement are known with certainty then the
ordering level would simply be:
Lead time in days for procurement X Average daily usage.
SUMMARY
The main points of this chapter may be summarized as follows:
Working capital
◼ Working capital is the difference between current assets and current liabilities.
◼ That is, working capital = inventories + trade receivables + cash − trade payables − bank
overdrafts.
◼ An investment in working capital cannot be avoided in practice – typically large amounts
are involved.
Inventories
There are costs of holding inventories, which include:
➢ lost interest
➢ storage cost
➢ insurance cost
➢ Obsolescence.
◼ There are also costs of not holding sufficient inventories, which include:
➢ Loss of sales and customer goodwill
➢ Production dislocation
➢ Loss of flexibility – cannot take advantage of opportunities
➢ Reorder costs – low inventories imply more frequent ordering.
◼ Practical points on inventory management include:
➢ Identify optimum order size – models can help with this set inventories reorder levels
➢ Use forecasts
➢ Keep reliable inventories records
➢ Use accounting ratios (for example, inventories turnover period ratio)
➢ Establish systems for the security of inventories and authorization
➢ Consider just-in-time (JIT) inventories management.
Trade receivables
● When assessing which customers should receive credit, the fi ve Cs of credit can be
used:
– capital
– capacity
– collateral
– conditions
– character.
● The costs of allowing credit include:
– lost interest
– lost purchasing power
– costs of assessing customer creditworthiness
– administration cost
– bad debts
– cash discounts (for prompt payment).
● The cost of denying credit includes:
– loss of customer goodwill.
● Practical points on receivables management:
– establish a policy
– assess and monitor customer creditworthiness
– establish effective administration of receivables
– establish a policy on bad debts
– consider cash discounts
– use financial ratios (for example, average settlement period for trade receivables
ratio)
– use ageing summaries.
Cash
● The costs of holding cash include:
– lost interest
– lost purchasing power.
● The costs of holding insufficient cash include:
– loss of supplier goodwill if unable to meet commitments on time
– loss of opportunities
– inability to claim cash discounts
– costs of borrowing (should an obligation need to be met at short notice).
● Practical points on cash management:
– establish a policy
– plan cash flows
– make judicious use of bank overdraft finance – it can be cheap and flexible
– use short-term cash surpluses profitably
– bank frequently
– operating cash cycle (for a wholesaler) = length of time from buying inventories
to receiving cash from receivables less payables payment period (in days)
– transmit cash promptly.
REFERENCE
The end