CHAPTER 5 Financial Management

Learning outcomes
 explain what financial management is
 explain why financial management is important to any manager in any position;
 discuss how financial management relates to the other functional activities in any enterprise;
 explain and define financial management both as a concept and as an organisational function;
 discuss how the generic function of management is applied in financial management;
 explain the most important concepts (eg. different types of assets and liabilities, fixed and variable
capital needed, ROI and ROE) used in financial management;
 Provide everyday examples (preferably from your own experience) for each of the above-
mentioned aspects of financial management.
 define the two primary sources of finances or capital: own capital (share capital, equity, retained
earnings) and outside capital (foreign, borrowed, external, loan) capital
 describe the major characteristics of:
 permanent financing or capital and its sources
 long-term financing or capital and its sources
 medium-term financing or capital and its sources
 short-term financing or capital and its sources
 Learning outcomes
 explain which principles are involved in correctly choosing sources of finance/capital;
 discuss the typical problems experienced by managers in obtaining finance/capital.
 define debt and credit, as well as debtors and creditors, and demonstrate how these concepts are
related
 explain what is meant by the term “credit transaction”
 Describe at least four different forms of credit
 explain to an organisation the possible advantages and disadvantages of granting credit
purchasing facilities to customers
 Identify and discuss the issues that must be addressed in a credit policy document
 explain and give examples of the seven major elements indicating a customer's creditworthiness
 elaborate on the important factors relating to the effective implementation of credit decisions
 This man is Haruka Nishimatsu

Former Japan Airlines CEO ( World top 10 international airlines who cut his pay
to save company costs and improve revenue, and keep people employed.

One year he earned only $90 000 and he takes the bus to work and buys suits
at the discount store.
What is financial management?

 Definition (pg 122)

 Financial management involves the responsibility of
timeously acquiring the needed financial resources under
the best conditions possible, and ensuring the best or
optimal use of these resources over the short and long
term

 Finances refers to money or other resources that can be

converted into money such as assets, stocks, investments,
capital, savings, funds, etc.
 What Managers should Consider

Cash vs.
Credit?
Salary/
Allowance
What Managers should Consider (cont.)
Will the
What is a fair forecasted Profit
price to ask? be enough?

Own capital
vs. Borrowed
Capital?
Sales- Cash
vs. Credit
The financial function in any
enterprise/ organisation

 The financial function does not

work in isolation. All business
functions (e.g. marketing, human
resources etc.) are interrelated.
 The financial function must
COLLABORATE/WORK
TOGETHER with other business
functions to ensure that goals
are achieved and a successful
organisation is created.
 The managerial functions of
financial management
Financial Planning Financial
-Budgeting
Organising
-Sales forecast and production planning -Who does what?
-Planning bookkeeping and accounting systems. -Delegation
-Decide on pricing, credit policies and other -Signing Cheques, Payments etc.
financial procedures
-Drawing up quotations
Management
in Finances
Financial Leading
-Communicating and Motivating
Financial Control
-Keep departments informed: Annual -Actual performance in line with
Financial Budget targets
Ensure work is been done -Corrective measures
-Checking and Auditing
 Obtain External
Information
Negotiating with Preparing Financial
Suppliers of Capital Budgets

Salary Administration Recording all Financial

Transactions

Financial
Activities
Analysing Financial
Debt Collection Performance

Financial
Formulating Credit
Policy Reporting

Protecting/safeguarding
Cash Resources
 The Building Blocks

Assets

Capital
Assets
 Main objective of a private organisation:

 Maximise the rate of return on investment to the

owners(s) over the long term, taking into consideration
the interests of all applicable stakeholders.
 To achieve this, the business needs ASSETS
 The investment decision determines what assets are required to
do business successfully (i.e. manager/ entrepreneur must make
investment decisions on what assets are required by the
organisation)

 Get fixed, current and other assets.

 ASSETS

FIXED/NON- CURRENT ASSETS

CURRENT ASSETS Will be turned into
Owned and Required manufacturing/
by a Business for usage/ sales within a
longer than 12 months period of 12 months

OTHER ASSETS
Not directly involved in
normal operational
activities
 Assets

Fixed Assets Current Assets Other Assets

• Used in
• Longer than 12 manufacturing, sales, • Not part of the
months cash normal business
• Land and Buildings, • Within 12 months activities.
Equipment, Vehicles • Raw materials,
Inventory, Debtors, • Shares in other
Cash businesses,
Investments
In the following slides, see if you are able to identify
the assets correctly

FIXED/NON-
CURRENT CURRENT ASSETS
ASSETS

OTHER
ASSETS
Fixed/non-current assets. Why?
Current/liquid assets. Why?
Current assets. Why?
Current/liquid assets. Why?
Current/liquid assets. Why?
 Fixed asset = car
Other asset = shares
Other asset. Why??
 How are
Assets
financed???
Different types of capital
 2 Major types of capital
 Internal sources or financing – Own capital
 Alsoknown as owner’s capital, shareholder’s funds or
owner’s equity
 Obtained from owners or retained from the business

 External sources of financing – Outside capital

 Capital that is supplied
 Long-term
 Medium-term
 Short term
 Capital

Own Capital Outside Capital/Liabilities

(Equity, Share capital, Internal Sources) (Foreign, Borrowed, External Source)

• Total contribution made by all legal • Short, Medium or Long-term.

owners • Repaid sometime in the future
• Serves as a basis to attract outside
capital • Remunerated in the form of
• Is Permanent
interest paid/ goods sold.
• Seldom Withdrawn • Preferential claim over owners to
• Remunerated in the form of be remunerated when the
dividends and growth in value business is liquidated/terminated
• Is in full charge of the management e.g. SARS
of the business • Regularly withdrawn
• Last claim to be remunerated-
liquidation/termination
Specific types of outside capital

Permanent
Short-Term / variable

Medium- Long-Term
Term
Specific types of outside capital

 5 to 20 years
Formal written
document
Pay interest
Long-Term
Permanent Collateral
Shareholder loans -
owners contribution,
“Business Angels”

Short-Term Medium-
Term
Specific types of outside capital
 1 to 7 years
Formal written
document
Pay interest
Medium- Payments: interest +
finance charges
Long-Term Term Renting and Leasing
assets
Hire Purchase
Agreement

Permanent Short-Term
Specific types of outside capital

 Shorter than 1 year

Supplier Credit (30/90
days), bank overdraft
(24h)
Medium- Short-Term No interest charged,
Term except arrears/
overdrafts/ short terms
loans
Not strictly on credit-
Long-Term Permanent aim to encourage sales
Specific types of outside capital
 Permanent Capital
- amount of assets,
funds, money
required by
Permanent business AT ALL
Short-Term / variable TIMES (e.g. over a
yr)

Variable -
additional amount of
Medium- Long-Term assets/ money
Term required from time
to time (E.g. during
Easter / Christmas)
Factors to consider when choosing
sources of capital (finance)
Factors to consider when choosing
sources of capital (finance)
Matching life
expectancy of assets • Asset Lifespan =Length of time for
and credit time which source of credit is available
available

Availability and • Difficult to apply to Financial Principles

Accessibility issues • Mislead by Easiest Source

Costs associated with • Negotiate with Suppliers of Credit

a specific source
Factors to consider when choosing
sources of capital (finance)
Independence
• Desire for Independence
vs. Dependence • Outside Capital-Threatens Independence
and control

Freedom of
• Used for a specific pre-determined purpose
Application of • E.g. Mortgage Bond? Suppliers Credit?
capital (finance)

Effects of • Looks at the cost and use of borrowed capital

financial • ROI > interest rate on borrowed capital =
increase in own profitability (opposite is also true)
leverage
Factors to consider when choosing
sources of capital (finance)
Considerations • Specific source can have a direct
of liquidity and influence on liquidity and profitability
profitability • In short term you focus on liquidity

Tax • EVERY Decision has TAX implications

Considerations

Building Long-
term • Combine Wisdom and Strength
Relationships
Typical Problems in Obtaining Finance
Own Capital
Contribution- Too Small

• Own capital- at
least 50% Lack of Experience
in Financial
• Growth-using Management
outside Capital
• Difficult
approaching Lack of Financial
potential suppliers Expertise
of finance. • Understand that
other business
functions are
involved
• If you don’t have
the knowledge,
tend to ignore it
Typical Problems in Obtaining Finance

Creditworthiness

• Motivate and
Convince finance
provider
Lack of Planning

Too much emphasis

on collateral • Doesn't ensure
success.
• Application for
funding from major
banks - required
Creditors vs. Debtors

BUY NOW
PAY LATER

CREDITOR
DEBTOR
I OWE YOU
 Creditors vs. Debtors

Sum of money owed

by a business to the
suppliers of a
business

CREDITORS

DEBTORS
Sum of money,
owed to a business
by the consumer.
 The Credit Transaction
-Without full payment

Provide Receive

Goods &
Services

Payment
1. Obligation
1. Right
2. Not paid in
Creditor 2. Believe Debtor
full- will at a
later stage
Forms of Credit
Forms of Credit
 Open Account
 Creditis extended regularly to customer,
 FULL amount for the specific purchases must be paid
WITHIN the agreed-upon period.

 Revolving Credit
 Maximum limit/ceiling
 Available credit
= allowed limit-actual amount owed
Forms of Credit
 Instalment Credit
 Fairly expensive products
 Consumer makes regular payments until the debt is
paid in full
 Best known is hire-purchase

 Also include leasing or rental agreements

 Other forms of credit

 Anycredit transaction that may occur
 Overdraft/ Personal lending etc.
Cash or Credit???
1. A consumer received equipment from ABC merchants on 1
Feb and makes a full payment at the end of Feb.

2. A consumer purchases products via credit card from ABC

stores.

3. A consumer buys goods from ABC merchants and pays cash

for the full amount.

4. A consumer pays for equipment from ABC merchants with one

cheque dated for today and the other three dated for the
end of the following three months.
Granting Credit???
Granting Credit - Advantages
 Increasing
sales

Increasing Increasing
profit market share

Aiding
advertisements Facing
and competition
communications

Evaluating
exchange & Selling more
adjustment expensive
requests products

Retaining Cross-
Customer selling to
Base existing
consumers
Advantages
• Consumers prefer to make most
Increasing purchases on CREDIT
Sales • Do not have cash resources available
RIGHT NOW Risk/ Someone else pays

Increasing • Growth in sales=Growth in market share

Market Share

Facing • + / - The same policy, if not

Competition a unique product offering
Advantages

Selling More • Most consumers cannot buy expensive

Expensive products on a FULL cash basis -
Products/ Services alternative credit.

Cross-selling to •Special offers promoted on account statements

•Consumer feels he/she gets special treatment
Existing Customers •Opportunities are created

Retention of • Create a long-

Customer Base term relationship with consumers
 Advantages

Easier to Exchange • Companies can better determine whether

and Adjust exchange or return of goods are
Returned Goods legitimate.

Aiding
• The message to the target market can be
Advertisements and delivered in a personal form
Communications

Increasing Profit
• Consumer Price Sensitivity-
lower with regard to credit
Granting Credit - Disadvantages
 Higher
Administrative &
Operational
Costs

Possibility
Slower cash of late
inflow payment by
debtors

Increased Likelihood
need for of bad debts
capital
Disadvantages

Higher
• Extra cost = formulating credit policies, maintain
administrative and records, monitor credit purchases and payments etc.
operational costs

Possibility of late
• Not everyone pays on time- NEGATIVE
payments by impact on the business.
debtors

Likelihood of bad • Consumers don't pay their debt

(intentionally/ unintentionally)-
debts WRITTEN OFF
Disadvantages

Increased • Additional Financing= Debtors

need for who have not paid + admin
and operational costs
capital

Slowdown • Wait longer to receive

in Cash cash, but still spending on own
purchases and overheads.
Inflow
Importance of a realistic and sound credit policy

If you decide to offer credit, answer the following questions when

developing a credit policy:

 Will we sell on credit?

 What % of total sales should be credit sales?
 All goods and services offered on credit?
 Criteria and procedure for customer applications for credit?
 Who will authorize credit to a customer?
 What conditions?
 How will you handle accounts in arrears?

“This is the way we extend credit to customers in

OUR business”
 Credit

Creditworthiness
History
Indications of
Common Capital
Sense

Collateral
7 C’s Conditions

Character Capacity
Indications of creditworthiness
 Credit History
 Use credit bureaus to identify consumers, individuals or businesses that
have been black-listed. Such individuals and businesses could be
eliminated early in the assessment process.
 Capital
 Set credit limit on how much customer can buy.

 Conditions
 Negotiate and agree – interest rate, instalment, method of payment,
means of communication etc.

 Capacity
 Ability to make regular payments – proof of regular income/ annual
financial statements.
 Indications of creditworthiness
 Character
 Is the customer trustworthy, who does customer give priority to in tough
times and how punctual is the applicant?

 Collateral
 Guarantee to credit provider that applicant will comply with all
obligations of the credit agreement.
 Applicant allows creditor to register a first, second or even third bond over
fixed property.

 Common Sense
 Once all information has been collected, the manager makes an informed,
well-assessed and well-motivated decision.
 Implementing Credit Decisions
Confirming the Signing a formal Ensuring efficient and
outcome of an agreement effective
application administration

• Notification - • Credit terms should • Record each credit

outcome of their be thoroughly purchase and
explained, discussed payment
application & understood by the
consumer for the 1st • Timely and regular
• Starting point transaction. accounts sent out to
for good debtor
relations
• Any Deviations-
Inform Management
 Implementing Credit Decisions

Controlling
Sound
debtors’ Administration Follow-up
accounts

• Used for • Don't give • Handling

marketing consumers an accounts:
opportunity to
• FAD delay or dispute • Arrears
• Fanatical payment • Debt collection.
• Attention to
• Detail • Timely, Precise
and correct
statements
Things to Remember...
 Formal credit policy, system administration and
dedicated and disciplined follow-up

 Aim to achieve all possible advantages of credit

 Effective and Efficient Communication

 Remain friendly and professional when dealing with

customers in arrears
Other financial management Concepts
Financial Structure Profitability

• Composition of assets and • ROI/ROA (Return on Investment)

Actual profit from business.
capital
• Own or Outside • ROE (Return on equity) Gain on
own capital

• Equity= (Assets – Liabilities)

Other financial management Concepts
Liquidity Solvency
• The ability of the • Degree to which total
business to pay its assets of the business
short-term financial cover its total
commitments on time. liabilities
• Liabilities> Assets=
INSOLVENT
After studying this chapter, do you feel that you can explain the concepts
well? Are you able to answer to all the learning outcomes found at the
beginning of this learning unit?

If you feel like there are still part you need to re-visit, now is a good time!