Summary FIN2603 Exam Study Notes.

FIN2603 Exam Study Notes. Finance For Non-Financial Managers. The financial goal of a firm. • Role of financial management is assessed form viewpoint of an investor in a firm. • Investors need to diversify their investments. • Diversification - means not placing all ones money in a single investment, but spending it over various investments. • The investor has a choice between various asset classes, the main ones: - Real estate (rent generating assets) - Shares (dividend generating assets) - Fixed-interest securities ( interest generating assets) - Cash • Investors want to achieve the highest possible return for the lowest possible risk. • Investors not only run risk of losing money but also the the opportunity cost when making an investment. • Investors and managements long-term financial goal should be to increase the value of firm, thereby increasing the wealth of owners. • Short-term financial goals should be: - Profitability: the firm’s ability to generate revenues that will exceed total costs by using the firm’s assets for productive purposes; may be achieved by marketing products/services to maintain a sufficient profit margin with the support of promotions at competitive prices directed to appropriate target markets through appropriate distribution channels. - Liquidity: is firms ability to satisfy its short-term obligations as they become due. - Solvency: the extent to which a firm’s assets exceed its liabilities; differs from liquidity in that liquidity pertains to the settlement of short-term liabilities, while solvency pertains to the excess of total assets over total liabilities. • The goal of the firm is to maximise shareholders’ wealth and not maximise profit. Profit maximisation is not consistent with wealth maximisation, because of - the timing of earnings per share. - earnings that do not represent cash flows available to shareholders. - a failure to consider risk. 4. Financial management and accounting. • Many people regard financial management and accounting in the business environment as the same thing; however, there is a difference. Handling of funds and decision making are the two reasons why financial management and accounting are considered different fields. • Handling of funds - The primary functions of an accountant are to develop and provide data for measuring the performance of the firm, to assess its financial position and to see to the payment of taxes. - The financial manager’s role differs in the way in which he/she views the funds of the firm. • Decision making - The accountant devotes the majority of his/her attention to the collection and presentation of historical financial data, whereas the financial manager evaluates the accountant’s financial statements, processes and additional data, and makes decisions based on sub- sequent analyses. 5. The functions of a financial manager. • Financial managers functions may be evaluated in terms of the firms financial goals. • He/she has the following primary functions: - making investment decisions. - making financing decisions. - ensuring profitability. - ensuring positive cash flow. - ensuring solvency. • Financing involves 2 major decisions: - Raising enough equity and loan financing to acquire and maintain non-current and current assets. - Determining which individual short/long term sources of financing should be used in order to achieve lowest possible cost of capital. 6. Financial management and the non-financial manager. • The management of the firms assets is not exclusively in the hands of a financial manager. • The other functional departments, especially procurement and marketing departments play a significant role in determining inventory levels. • Inventory represents an investment of a portion of the firms available funds and should be managed sensibly. • All functional department in the business devote their energy to the achievement of the firms gaols. 7. The fundamental principles of financial manager. • Financial management is based on the following principles: - the cost-benefit principle - the risk-return principle - the time value of money The cost-benefit principle - Sound financial decision making requires that an analysis of the total cost and the total benefits be conducted. - Decision making based on the cost of resources only will not always lead to most economic utilisation of resources. - The benefits should be greater than the cost of any decision. - Cost-Benefit principle may be used by the following steps: ‣ Obtain clarity about objective to be attained. ‣ Identify alternative ways objective can be attained. ‣ Calculate the cost and benefits of each alternative. ‣ Determine effectiveness of the benefits of each alternative. ‣ Decide on a criterion or standard to be used against which the acceptability of an alternative may be weighed. ‣ Take a decision about most appropriate course of action. The risk-return principle -Risk is an integral component of any decision. -Risk is the probability that the actual result of a decision may deviate from the planned end result, with an associated financial loss or waste of funds. -Risk is different from uncertainty. - Uncertainty: there is no probability or measure of the chances that an event will take place. -Risk is measurable by profitabilities. - The risk-return principle there is a trade off between risk and return. - The greater the risk, the greater the required rate of return. - The return should exceed the risk involved in any business decision. -Risk should me minimised and managed. The time value of money - A concept used to evaluate any financial decision involving differences in the timing of cash inflows and outflows. - A matter of interest that may be earned if money is available today and invested, or of opportunity cost if an amount will only be received at some future date – an amount of money today is worth more than it will be at some point in the future. - The return that could be earned is strongly influenced by the supply and demand for capital in the financial markets. 8. Financial management and the operating environment of the firm. • The firm operates in a constantly changing yet competitive environment. • Economy goes through economic cycles. • An economy expands for a number of years and then followed by periods of contraction. • It is important fo the sustainability of the firm to be aware of the economy and manage the firm accordingly. • Periods of growth in the economy - firms increase their marketing efforts, invest more in equipment, appoint more staff members and budget for expansion. • Periods of economic decline - firms need to control its expenses and reduce them to a bare minimum in order to survive until the next economic upswing, which leads to budget cuts. The economic environment - A business can benefit from an expanding economy, but requires careful analysis of leading and lagging economic indicators. - Examples of leading indicators are: ‣ The indices of the stock exchange. ‣ Manufacturing statistics provided by Stats SA. ‣ Increase in stock levels. ‣ Statistics about retail sales. ‣ Statistics about building plans approved. ‣ Statistics about the housing market. ‣ Statistics about new company registrations and business start-ups. - Examples of lagging indicators are: ‣ The economic growth rate, as measured by the growth in the GDP of the country. ‣ The inflation rate, as measured by the production price index (PPI). ‣ Interest rates. ‣ Employment and unemployment statistics. ‣ The exchange rate of the local currency against the currencies of major trading partners. ‣ The financial performance (profitability) of corporate firms. ‣ The balance of trade. 9. The agency problem. • An agency problem results when managers, as agents for owners, place personal goals ahead of corporate goals. • There is a great likelihood that manager may place personal goals ahead of corporate goals. Two factors – market forces and agency costs – serve to prevent or minimise agency problems. • Market forces – major shareholders, particularly institutional investors exert pressure on management to perform, by communicating their concerns to the firm’s board. • Agency problem: the cost incurred by the owners of a business when using an agent (management); associated with problems such as the disparity between management and shareholder’s objectives. Understanding financial statements. 1. Introduction. • Every company/firm should periodically provide a report of its financial activities to its stakeholders. • Reports known as financial statements. • Financial statements contain rules and guidelines set by the accounting professions rule-setting body in South Africa (Accounting Practices Board APB). • Statement of financial performance: (also known as the statement of profit and loss and other comprehensive income.)measures the financial performance during a certain period; that is, whether a profit or a loss was recorded; also referred to as the earnings statement of operations, and profit and loss statement. (previously known as income statement) • Statement of financial position: indicates the firm’s financial position at a specific point in time, that is, what the assets of the firm are worth (at book value) and how they were financed by means of equity and debt financing. • Statement of shareholders changes in equity: summarises the movement in the equity accounts during the year, namely share capital, share premium, retained earnings, revolution surplus, unrealised gains on investment etc. • Statement of cash flow: indicates what cash flows were generated from operating activities, from financing activities and from investment activities. • Financial statements are used by owners and managers of the firm to assess their progress towards their objectives. 2. Users of financial statements • Financial statements are used by various stakeholders for many reasons: - Shareholders need them to assess the worth of the business. - Management requires them to help plan and control the activities of the firm in order to achieve objectives of firm. - Lenders (creditors) to the business to see how likely they are of repayment. - Labour Unions need them as a basis for wage negotiations. - Investment analysts, require them for making investment decisions. - The state requires them for checking whether the amount of taxes paid is correct, and also for statistical purposes. - Credit bureaux need them to issue credit ratings. 3. Key generally accepted accounting principles. • The financial statements must be generated according to generally accepted accounting principles (GAAP) to be reliable, understandable and relatively consistent between reporting periods. Accounting entity - For financial statements to be meaningful, the entity that information belongs to must be clearly defined. - Only transactions concerning the specific accounting entity must be recorded. Money measurement - Money measurement is a universal accounting denominator used to express the assets, liabilities and owners equity so to describe the financial position of the firm accurately. Conservatism - Refers to the use of the most conservative approach of profit determination, whenever other procedures exist for the treatment of a transaction or event in accounting process. The consistency concept - There must be consistency of accounting treatment of like items within each accounting period and from one period to another. Chapter 2 - Any change in methods/procedures must be reported. Materiality - Requires the transactions and events which are not material in relation to the nature and scope of an unites activities need to be taken into account if the costing difficulty of recording them are not justified by the resulting benefit. Historic cost - Refers to when the assets are initially bought into the accounting process at the cost the entity incurred in acquiring them. The double-entry system - For every debit entry there must be a credit entry of the same amount (and vice versa) The going-concern concept - The going-concern concept gives the users of the financial statements the assurance of the continuity of the firm. - The business entity will continue in operational existence for the foreseeable future. The accounting period - Income and expensive insured in generating income must be brought into account during the same accounting period. - Revenue and costs are accrued, matched with each other insofar as their relationship can be established or justifiably assumed, and dealt with in the statement of financial performance for the period to which they relate. (referred to matching principle) The realisation principle - Refers to two conditions that must be met in recognising income, it must have been earned and realised - Income is earned when the party giving value has completed its obligations towards the party receiving value. - To be realised income must be measurable and the ability to recover it must be reasonably certain. The accrual principle - States that in calculating the profit for a specific period, only income earned during that period may be brought into account, and that only value consumed during that period can be brought into account as expenses in the determination of profit. - Value that has been received but not yet earned constitutes an obligation = liability - Value which has been earned but not yet received = asset - Expenditure on services/goods not yet consumed = asset - Value which has been consumed but not yet paid for = liability - To provide up to date financial information about a business its necessary for an accountant to record all daily transactions, he/she must ‣ classify ‣ record ‣ summarise financial information 4. The classification of financial information. • The vast amount of financial information generated in a firm requires a system of accounts. • The accountant may use either a computerised system (for example, AccPac, Pastel, Baan or SAP) or a manual system. • Regardless of the system used, it must provide for five types of accounts, namely: - assets account - liabilities account - owners’ equity account - revenue account - expense account • Assets, liability and owners equity accounts are used to determine the liquidity and solvency of the firm by means of the statement of financial position and cash flow statements. • Income and expenses accounts are used to determine profitability of the firm by means of the statement of financial performance. • Ledgers are used to record each transactions of the business, various ledgers are used such as general ledger, debtors ledger and creditors ledgers. • Business transactions can be recorded or classified by making use of an accounting equation: Assets (A) = Liabilities (L) + Owners equity (OE) 5. Recording changes in the financial position.