Financial Management Discussion - Essay Example

Financial Management Discussion Working capital (i.e. current assets) is that portion of an entity’s investments that circulates from one form ofcurrent asset to another in the routine business activities. Like in a trading business cash gets converted into inventories, inventories to receivables, and then receivables back to cash. Current liabilities (accounts payables, accruals, notes payables etc.) are sources of financing for short period of one year or less than that; and net working capital is difference between current assets and current liabilities. Working capital management is bringing of the tradeoff between profitability and risk by managing the levels of current assets and liabilities. Profitability is the difference between revenue and costs generated by both current and fixed assets during normal business activities. From working capital point of view risk is the probability of the inability of the entity to pay its current liabilities when those become due. Simply the more the working capital the lesser is such risk. Working capital management is to decide this level of working capital so that the criteria of risk and profitability are balanced off. Business operations are directly affected by working capital management. More the current assets in ratio with fixed assets the lesser is the risk of short term insolvency, but the current assets are less productive than fixed assets and thus affect business operations producing less profitability. Contrary to the when current liabilities are more used ( as compared to ling term liabilities) to finance total assets the profitability increases as current liabilities as source of finance are considered less costlier than long term sources of finance. According management of working capital directly affects the business activities of the company. 2. Working capital mismanagement is aptly indicated by the adverse current ratio and this is what happened in the organization. Shortage of cash and near to cash current assets forced the entity to delay the timely liquidation of accounts payable forcing them to increase the liabilities by levying interest on delayed payments as per terms of credit. Suppliers forced renegotiations of agreements revising rates and terms of credit. Shortage of inventory forced delay in conversion to finished goods and that affected the flow of fresh sales orders and renewal of existing sales orders. These abnormalities affected the cash conversion cycle and average age of inventory. With the result operating cycle period started getting longer; and thereby cost of production/ sales increased bringing the profitability margins lower and lower. Finance charges and interest kept rising for not meeting due dates of notes payable. These abnormalities gripped normal business operations and the organization was knocking the doors of short term insolvency. The management decided to undertake emergent measures for bringing back normal working capital position. 3. Working capital crisis involves liquidity crunch to meet short term obligations. One way to improve liquidity is to shorten the cash conversion cycle. The factors affecting cash conversion cycle are average collection period, average age of inventory, and average payment period. The company should renegotiate sales orders lowering margins and bringing in cash discounting schemes to persuade customers for immediate or early payments. This will shorten the average collection period. Aging of receivables should be analyzed and revised. These measures will speed up collections. Customers should be persuaded to remit payments through on line banking to reduce the float time. Supplies should be taken only in economic ordering quantities to reduce cost of production. Efforts to reduce cost of goods sold should be made by seeking further discounts from suppliers at renewal of purchase orders. This will improve average age of inventory. Simultaneously payment float time should be extended carefully by systematically controlling the disbursement and without offending suppliers. These measures will shorten the cash conversion cycle and the cash and near cash assets will start rising reverting the liquidity position to normalcy. 4. In simple language risk is the chance of occurrence of financial loss. Inherent Risks are built in risks that always exist in a business. The project with which I am involved is a trading business. The inherent risks that are specific to a trading business are business risks and financial risks. Inherent business risk is that the entity will not be able to achieve its operating expenses, and the financial risk is that the entity will not be able to meet short term obligations and fixed- cost financial obligations. From the point of view of a shareholder the inherent risks are Interest rate risk, liquidity risk, and market risk. Inherent interest rate risk is that investment in such a project may lose its value on increasing of interest rates. Liquidity risk is that as an investor I may not be able to liquidate my investment at a reasonable price. Market risk of being associated with such a project is that value of such investment may decline because of independent factors like economic, political, and social events. 5. Timing difference in financial terminology is called time value of money, and this concept recognizes the fact that money in hand at present is more valuable than the money that will be received in future. This is because the money in hand can be invested and earn positive returns. One dollar when invested for particular period would grow to a dollar and interest for the period. Further in inflationary period a dollar at present value has greater purchasing power than a dollar say after one year. Also there is a general preference of current consumption as compared to future consumptions. That is why timing difference of value in money make an impact on decision making. Size of firms matters a lot in decision making. Smaller firm face more problems with regard taxation, financing, competition and other when compared to larger firms. Economies of scales are available to larger organizations. But larger firm are sometime affected by political influences as well. Also larger firms are more vulnerable to business risks. It is believed that there is a decreasing relationship between size of the firm and problems and obstacles faced by them. Large firms suffer more than medium sized firm, and medium sized firm suffer more than smaller firms. It is seen that over that recently there were more mergers and acquisitions amongst medium sized firm than larger firms. According while taking any decision with regard to say investments or other business dealings the size of the firm matters. 6. Incremental cost may also be called the marginal cost which is the cost of one extra unit of production in normal environments. But that is true only for increase in production up to a level where fixed costs do not fluctuate with increase in level of production. Therefore up to that level of increase incremental cost is therefore all direct costs plus variable overheads. As direct costs are variable costs, it can be said that incremental costs comprises all variable costs of additional production up to a level. Marginal costs treats fixed costs as period costs and those are bound to incur whatever may be the level of production. But fixed costs are fixed only in particular range. It can therefore be said that beyond a certain level of production incremental costs will involve rise in fixed costs besides incremental variable costs. There are semi variable costs that change not necessarily in proportion to change in volume of production. These costs have a fixed portion as well as a variable portion as in case of telephone bill that contains fixed portion of rental and variable portion of costs of number of calls made. Accordingly the incremental costs will also be inclusive of fixed costs besides variable portion of semi variable cost when production goes beyond a level production where fixed costs also changes with rise in production. A growth of 10% is normal growth as at that level the entity will not be required to increase infrastructural facilities. Fixed costs will remain the same for such growth. At this level therefore incremental cost will include only the rise in variable portion of the total costs, i.e. rise in direct costs and variable overheads. On the other hand 100% growth is considered a growth beyond a range where the entity might require extra infrastructural facilities and thus this level of growth incremental costs involve increase in fixed costs as well. Accordingly at the level of 100% growth the behavior of incremental costs include rise in variable as well as rise in fixed portion of the total costs. 7. EVA (Economic value added) is a method to find true economic profits which are operating profits after taxes as reduced by the opportunity costs. Opportunity costs mean costs of alternative use of resources that has not been undertaken. The traditional discounting cash flow methods bring forth the NPV or IRR of the project in order to evaluate the project on the basis of value additions of the project; whereas EVA method defines the pattern of such value creation over the entire period of project as is clear from cost allocation method adopted under each method explained hereafter. EVA valuation of capital budgeting is almost similar to convention methods of free cash flows (FCF) methods. The basic difference lies in the treatment of costs of capital investments. Under traditional FCF methods cash flows are calculated by subtracting the entire costs of investments in the periods in which those costs are incurred. Whereas under the EVA method these costs of investments are spread over the economic useful life of the project in order to find out net cash flows. This difference of allocation of costs makes the EVA method more superior than the conventional methods of evaluating capital investments. 8. Shareholders are the owners of corporations and in corporate setup the management is separate from this ownership. Though apparently mangers are employees of the corporation but effectively they are working for its owners, the shareholders. The objective of any business is to increase profitability and thereby the wealth of its owners. That is why the focus of corporation is to enhance shareholders wealth and their value. Elected government of a nation is the custodian of the interests of nation’s citizens. It is the fundamental responsibility of the government to take care of social and ethical considerations of the country as a whole. Corporations are not responsible for this, though corporations also have upheld the social and moral values of the society. The idea is that there may be socially responsible investment but only when they are maximizing the wealth of their shareholders. It may be noted that shareholders’ wealth can be measured monetarily as well as by the level of social status enjoyed by them being members of a particular corporation. It is seen that not for profits corporations are registered regularly but their objectivity always remain as enhancing the shareholders’ value, and that need not be measured in money terms but as the level of social status attained by them by being members of such prestigious not for profit corporations. In such cases corporations are increasing the level of social status of shareholders’ values. Accordingly there cannot be a conflict with ethical considerations when shareholders values are boosted. 9. The considerations of takeover other than the low fair value of assets acquired are enumerated here under: Elimination of competition between acquirer and acquiree is quite an attraction for takeover. Tax consideration is another motivation for takeover. A company may be paying taxes at higher rate. On its taking over an unsuccessful company its overall tax payments will be hugely lowered. Potential benefits of market powers from oligopoly or monopoly are great incentives for takeover. Availability of free cash flows with target company to write off exiting debts of acquirer is also a consideration. Acquirer’s ability to enhance profitability by effective exploitation of assets after displacing ineffective management of target company is another reason for takeover. 10. An article titled ‘Takeover and Business Growth’ published under the feature ‘Mind Your Business’ at biz/ed1, an online business news site provided information that around $145 billion was involved in bids of takeover of other companied during January 2004. Varieties of reasons were cited behind those actual and potential deals. For example in takeover bid of Lead United the reason described in the article is precarious financial position of the club. But in take over bid of Walt Disney by Comcast the board and shareholders of Walt Disney were considering short term potential gains as well as long term implications if they were to hold on shares. Analysts styled these takeover bids as hostile, predatory, weak and vulnerable. It was clear from the article that those takeover bids were not business like and were only for the sake of bidding only. If I were responsible for such takeover bids, I would have ensured that actual takeover not only serve to improve dwindling business of the acquiree, but also for a specific objectivity of the acquirer like improvement of capital structure with low debt financing or provide resources to increase the combined business after take over, or for the purpose of creating a dominance over the common market. Superfluous bidding rarely succeeds, as Comcast bidding never made a dent in the deal. 11. Technically the value of a firm is total present discounted value of its future profits. Therefore present profits may not impact the firm value as much as the existence of infrastructural assets and other facilities that will create future profits. Shareholders value is the value of the firm (that is discounted value of future profits) as reduced by future claims (future debts). In other words present value of free cash flows (FCF) is the shareholders value. As shareholders value itself is dependent on value of the firm, it may not have a direct impact on the value of the firm. The uppermost ethical consideration of maximization of profits is production of goods and providing the services, as businesses earn profits as result of theses activities. This is clear from the fact that no government issues licenses to earn profits only but to produce goods or provide services for the citizens and earn profits as repercussion of those purposes. Secondly the social and ethical responsibility of the business is to earn profits. It may be noted earning profits is not the purpose of business but a responsibility, and thus a consideration to earn profits. Therefore a business purpose that serves ethical responsibility can also be termed as earning profits for an ethical consideration. Businesses do change purposes to serve the ethical responsibilities. This is happening for tobacco industry in the last two decades. People consider tobacco production is unethical though its objective is to earn profits through production of goods. My organization, an accounting firm, serves the ethical purpose by evaluating the financial statements of corporations. The ethical consideration here is to serve the virtue of integrity by examining the financial statements where shareholders investments are accounted for. Accordingly responsibility of the accounting firm business is ethical consideration of integrity and as a recourse ensuring maximization of profits and shareholders value. 12. In a recent bankruptcy the company organized a scheme of restructuring with the help of principle creditors of the corporation, whereby the company reached an agreement with debtors with regard to a transaction that involved contributions by the company to a settlement trust in exchange of protection against injunction on company’s operations sought by creditors in court cases. The creditors withdrew court cases and petition under chapter 11 was filed for approval of the reorganization scheme of the company. The scheme was ultimately approved that resulted into creation of a trust for the benefits of claimants The company filed petition under chapter for approval of a restructuring scheme in order avoid injunction on the normal operations sought by creditor in court cases for recovery of dues that amassed quite a few millions of dollars. The company should have managed its working capital in a professional manner by slowly delaying the average payment period, making instant recoveries from receivables by reducing average collection period and thereby reducing the cash conversion cycle, before the creditors’ dues went out of proportion. 13. Venture capitalists are investor who take high risks and that is why they expect high awards for taking such risks. They examine business plans in detail before investing funds as the venture capitalist has to manage risk/ reward ratio by investing in ventures that comply with their requirements. Investment bankers indulge in number of activities. They help companies in issuing securities in primary markets, underwrite the issues, and also manage the foreign exchange business for their clients. Investment bankers, however, do not accept deposits and indulge in other activities of retail banking like commercial banks. The also provide professional guidance to investors and manage investment portfolios for their clientage. 14. Funds raising through private placements do not require formalities of preparations of offering statements and appointment of trustees in case bonds are issued. Private placement can be completed more easily and quickly than public issues. Companies have the liberty of raising funds in smaller increments as compared to public issue where the company is bound to raise full requirements because of high costs of the issue. The most important feature is that executives of the company can be easily compensated through private placements. Because of these advantages of private place a rule has emerged that company should go public only when funds cannot be raised through private placements. 15. The article considered is “Riding with the currency: when the dollar losses value in world market, there are pitfalls to watch out for Here is how to benefit whether weak or strong”2 by Harlan Brandon who was in shoe business that was affected by changes in value of dollars. According to him the costs of goods become costlier when dollar is weak. He pointed out two reasons for fall of dollar. One was lowering short term interest rates and the other increasing trade – deficit to GDP ratio. When costs of input go up profitability of European business will go down. The article also says that travelling for Americans becomes costlier on falling dollar. Week dollar makes product expensive in Europe. Investors will not like to invest in US securities and assets. When dollar become strong more units of foreign currency can be bought with one dollar, and result is that costs of goods become cheaper. Business profitability will rise because of lower input costs. More tourists from America will step out. The looser is US exporter, and also less people will tour US. More investors from Europe will invest in US assets. 16. Multinationals in small countries of Europe like Holland and Switzerland are currently seeking global investor base as is evident from following features incorporated in their business and fund raising approach: Netherlands and Swiss multinationals consider developing countries as major source of investors for them. Foreign capital also supplies resources like greater revenue yielding markets that are so essential for developing the investors cum consumer base. These multinationals have ability to integrate and allocate productive resources on international basis, and this induces a sense of security among global investors. The feature of creating wholly owned subsidiaries at different international avenues provides investors a feeling that their investments will also promote growth in their own nations as well. 17. The requirements of doing business internationally have changed with transformation of e- business. Internet technologies have extended global reach to find customers at minimum additional costs. It is easy to enter international collaboration agreements with websites interactions. Corporate efficiencies are achieved with easier access to corporate information. Under such circumstances the basic requirements of doing globalized business are as under: Internet accessibility is imperative to increase the customer base world over. Web site functioning should appears custom made for each and every user, and for achieving this major languages used in markets to be captured are required to be incorporated in the system. User id and password creation facilities should be provided in the home page of web site itself so that customer gets the feeling of security and exclusivity. E- Commerce based globalized business rise and fall sharply as has recently happened due to current credit crunch around the world. Precautionary measures are required to be developed so that people do not loose their jobs abruptly, as all of a sudden international business would look like a localized venture. References: Read More