LSECN307

Financial Management Decisions

Prepared by:

Ø  Ahmed Al Musabi

Ø  Ali Al Qahtani

SECTION: CL2

15-12-2011 

Submitted to:

Ø  Gregory Vrhovnik

Introduction

The financial management department is one of the most important departments in a company because it links almost all the activities in the company to manage its duties such paying salaries, paying to suppliers, collect receivables as well as day-to-day expenses. Besides these duties which fall under the everyday activities, the financial department is responsible for considering the long term investments such as plant, machineries and equipment and at the same time how to secure the fund to provide them. There are many goals that the financial manger should achieve in order to maximize the shareholders’ wealth such as growth and profitability, maximize the market share, avoid financial insolvency, and survival.

This report highlights the Capital Structure, Leverage, Working Capital, and Current Assets to which the finance manager makes decisions upon to maximize the shareholders’ wealth.

Capital Structure

“Capital structure is the manner in which a firm’s assets are financed; that is, the right-hand side of the balance sheet. Capital structure is normally expressed as the percentage of each type of capital used by the firm; debt, preferred stock, and common equity”.(  Jean – Francois Huchet, Joel ruet,2006).

The debt can be obtained through loans from banks or through issuing bonds, the preferred stocks can obtained through issuing them, and the company can issue new shares to raise fund. The three types are sources of financing a company’s assets to finance its business. However, each type of these sources has its own characteristic; hence the role of finance manager becomes very important to balance these sources to reduce both risk and cost;

(Brigham and Ehrhart, 2008) summarized these aspects;

Debt increases the cost of the share: having the fact that the debtors have superior claim on the company’s assets over stockholders’, and the debt is bearing interest which should be paid to the debtors the stock return on the stock will decrease and reduce its price.

The higher the debt the higher of bankruptcy likelihood: when the company is in excessive borrowing position it will be exposed to financial insolvency and even bankruptcy in recession times. The International Financial Crisis in 2008 led many companies in the world to bankruptcy because excessive borrowing.

As the company’s capital structure decision should work to the benefit of the company in terms of cost of capital and bankruptcy risk, the finance manager should balance the capital structure through the proper Weighted Average Cost of capital (WACC); WAAC=W_d(1-T)R_d+W_eR_e

Where:

 W_d: Weight of Debt

(1-T): Tax rate

Rd: rate of debt

We: Weight of Equity

Re: rate of equity

Leverage

The leverage, the financial leverage, or debt ratio refers to the same meaning which indicates the extent to which a company depends on borrowing or debt to finance its assets. (www.referenceforbusiness.com).

The leverage ratio is the percentage of the debt (total liabilities which include commercial liabilities, bonds, and banking borrowings) to the total equity which includes (capital, preferred stocks, retained earnings, and other reserves), or simply Debt/Equity.

For example, suppose that XYZ Company has short-term liabilities of AED 450,000, long-term liabilities of AED 250,000, and Total Equity of AED 500,000. This means that the leverage ratio is 1.4 (450+250=700/500). To what extent the leverage ratio is acceptable and what are the financial manager decisions in this regard?

The leverage decisions should take into account the efficiency using the funds to generate the maximum income with minimum cost and use the debt in the most profitable business lines in both short and long-term. The finance manger should take into account that the debt bears interest which in turn decreases the net income. In addition, the lenders might hesitate to lend when they see that the leverage is too high and it become difficult to the company to raise more fund for profitable projects whereas the existing projects generate less profit.

The finance manager should take into account the specific internal factors as well as the external factors that might affect the financial position of the company; some internal factors like change in the company strategy, change of owners, losing key people which might reduce the productivity and the market share of the company and decrease the income. Accordingly, at high leverage level the company might face liquidity problems and might not be able to meet its financial obligations which will lead to insolvency or even bankruptcy. Some external factors such as recession, natural disasters, political unset might also put the company in critical positions when it is highly leverage. So the finance manager should balance the company’s financial leverage so he/she can adapt both internal and external factors.

Working Capital

“The phrase working capital refers to a firm’s short-term assets, such as inventories, and its short-term liabilities, such as money owed to suppliers”. (Ross, Westerfield, Jordan, Roberts, 2006).

Many questions arise when working capital phrase mentioned such as how much money should be kept on hand, how much quantity of inventory should be stored, how much time the inventory be kept, should the company sell cash or on credit and what is the credit term, and to whom should it sell, will the company purchase against cash or on credit, and from where the company manage/secure its short-term financing. All such questions the finance manager should answer to make sure that the short-term financing moves smoothly and efficiently to the interest of the shareholders’ wealth. 

“Net Working Capital is measured through simple equation; current assets minus current liabilities; it measures a business’s ability to its short-term obligations with its current assets”.

(Harrison, Horngren, 2007).

Generally, the higher the working capital the better the company can easily settle its short-term obligations. However, it is sometime inefficient to hold cash for just mentioned that the company can pay its short-term obligations smoothly because the current assets should be deployed to generate income.

The two common decision-making tools in working are current ratio and acid test ratio (quick ratio). The first is current assets divided by current liabilities which measure the ability of the firm to settle its current obligations from all the current assets. In general, it should be higher than 2 (higher is better) to indicate on time paying the obligations. The second is (cash + short-term investments + net current receivables) divided by (current liabilities) which measure the high liquidity assets to settle the current liabilities. In general, it should also be higher than 1 (the higher the better).

Another term is important and linked to the shareholders’ benefit; the cash cycle which is measured by computing the time from converting the time period of the paid cash to suppliers until converted to finished goods, then to payables, then to cash. Again the shorter the better as the company can utilize the cash again and again to increase the sales and income which ultimately contribute to maximize the shareholders’ wealth.

Current Assets

The current assets is entirely related to the working capital, it consists of cash, short-term investments ( marketable securities and time deposits), accounts receivables, inventories, and prepaid expenses, supplies, and others. The current assets in a business is considered the active assistance to the fixed asset which works together to generate the revenues and income.

The decisions related to these items are important being the finance manager has daily decisions to run them and to some extent consume the major of his/her time. The efficient management and best allocations of these items benefit the shareholders. For example, the finance manager can manage the cash on hand and with banks to maximize the gained interest generated from the time deposits and at the same time he/she can reallocate the cash to settle the short-term loans bit early to minimize the paid interest. He/she can negotiate to get discount against paying cash. The inventory can be provided exactly as required instead of purchasing more than required which lead to inventory cost. The finance manger should take care of accounts receivables through following credit control and active collections for quality of assets purposes. The finance manager should avoid the prepaid expenses as far as possible to keep the cash that can be used in other useful needs and so on.

Care should be taken in managing the current assets as they should be financed from current liabilities and at the same time the fixed assets should be finance from the long-term liabilities and equity. The reason is that to make sure the current assets keep streaming and not to reach to the point that the current assets cannot pay the current liabilities.

Conclusion

 Capital Structure, Leverage, Working Capital, and Current Assets are highly related; any decision made to one term will affect the other one by way or another. So the finance

manager’s is a challenging job to harmonize all the financial tasks. However, to succeed the role of the financial department, all departments should work in the same wave length as all are working to maximize the shareholders’ wealth in both short and long term.

References

Jean-François Huchet; Joel Ruet; EU-India Small Projects Facility Programme.

(New Delhi : European Union), 2006

Eugene F. Brigham, Michael C. Ehrhardt (2008), capital Structure Decisions: The Basics, Financial management, 12e, UAS, South-Western.

http://www.referenceforbusiness.com/small/Eq-Inc/Financial-Ratios.html

Ross, Westerfield, Jordan, Roberts (2006), Introduction to corporate finance, Fundumentals of corportate Finance, 6^th Edition, USA, McGrow-Hill.

Walter T. Harrison Jr., Charles T. Horngern (2005), Financial Statements Analysis, Financial management, 6^th Edition, USA, Pearson