12.1 Introduction
- All business organizations need to obtain finance to start, operate, grow and maintain their activities.
- Their survival or failure rests on how successful they have practiced effective and efficient management of their finances.
- Large enterprises operating in a competitive market have to mobilize and employ their funds more judiciously to get maximum return from funds used by them.
- Sound financial management must be exercised by all organizations including the private sector and public sector regardless of their popular and laudable social intentions.
- The taxpayers, general public, donor community and state officials are all demanding for transparency and accountability in the use of funds.
- Several tools and techniques have been developed to enable professionals in finance
- To present a clear and correct statement of affairs of Enterprises at any particular time that they are required
12.2 Meaning of Business Finance.
The term finance has been defined:-
§ As that administrative area or set of administrative functions in an organization may have the means of carrying out its operations efficiently and effectively.
§ Finance includes those business activities that are concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise.
12.3 Role of Finance.
- Finance is an important area of management of any organization.
- This is so because the effectiveness of any business enterprise will depend on sound management of funds. Its main role is:
§ Determination of the financial needs of the firm.
§ Raising of funds at minimum cost.
§ Making optimum allocation of funds to specific performance.
§ Development of controls to evaluate the financial performance.
§ Development of financial data for decision-making.
12.4 Objectives of Business Finance.
- Objectives of Business Finance should be understood in the light of the overall objectives or the organization.
- Finance objectives are as follows:
§ Pay dividends – These are payments by the enterprise to the owners.
§ Avoiding high-level risk – A company should avoid high-level risk deals or investments to avoid failure.
§ Maximization of profits – Finance function has to control costs to maximize profits.
§ Minimization or Risk – Business Finance Section has to seek such sources of operations and actions which would avoid unnecessary risks.
§ Maintenance Control – Control measures have to be taken to safeguard misuse of funds.
§ Liquidity – A good enterprise has to maintain its liquidity position at all times.
§ Flexibility – Effective Management of funds enable an enterprise to meet financial obligations in situations when cost of production is unpredictable due to external forces.
§ Profitability – This is where an organization has sufficient funds to carry on its operations to yield long-term profits.
Intext Question
What is the role of finance in an economy?
12.5 Functions of a Finance manager.
- The following are the functions of a finance manager:
a) Determination of the need for capital funds for the firm. He should forecast the cash inflows and outflows of the firm, and estimate the financial needs.
b) Coordinate with other top managers in the allocation of funds among various assets.
c) Raising of financial resources through supplier’s credit, lease financing loans from banks and other financial institutions, issue of ordinary and preferred shares etc.
d) Dividend decisions – decisions regarding payment of surplus by the company to its shareholders or owners of the company.
e) Financial planning and control – preparation of budgets, cash flow statement, profit and loss account and balance sheet.
f) Routine functions –
§ receipt and disbursement of cash,
§ maintenance of financial records,
§ preparation of financial statement,
§ negotiation with banks and other financial institutions on financial aspects of the firm.
Intext Question
What are the functions of a finance manager of a small firm?
12.7 Sources of Finance in Business
- Source of finance means the various ways in which an organization obtains its finance for its operations.
- The sources of finance may be in two broad categories:-
a) Sources of Finance for the public sector:
- Business organizations in the public sector are financed by:-
§ General taxation given in form of Treasury grants.
§ Borrowing from the Treasury.
§ Retained surplus from operations of corporations.
§ Locally raised income by the corporation from normal activities or grants.
§ Grants from Donor Agent.
§ Borrowing from local and international financial institutions.
b) Sources of Finance for the private sector:
- Business organizations in the private sector principally sole traders, partnerships, limited companies and co-operatives have the following sources of finance available to them.
§ Retained profits
§ Selling assets which are no longer required.
§ Trade Credit: This is credit offered by suppliers.
§ Investing Surplus Cash – firms receive interest on their investments.
§ Reducing Stocks – to release cash tied up in such stock.
§ Personal Savings or loans from friends and relatives.
§ Financial institutions can give loans or mortgages.
§ Finance houses can be used in leasing equipment.
§ Overdrafts from commercial banks – these are short-term loans.
§ Factoring – firms can sell debts owed to them by customers to organizations such as merchant banks to receive cash.
§ Issue of shares – public companies may sell shares to the general public while private companies may sell shares privately.
§ Issue of Debentures – a debenture is an acknowledgement of a debt given under seal of the company.
Intext Question
Which are the best sources of finance available to a private school?
12.8 Shares
12.8.1. Meaning of a Share
- A share is measured by a sum of money for the purposes of liability in the first place and of dividend in the second but also consisting of a series of mutual convenience entered into by all the shareholders internally.
- A share is evidenced by a share certificate which is issued by the company under its common seal.
- Shares of any member in a company are a moveable property, transferable in the manner provided by the Articles of Association of the Company.
12.8.2. Type of Shares
- Two main types of shares are authorized by the companies Act Cap 486 Laws of Kenya viz: Preference shares and Equity or ordinary shares.
- Preference shares (Quasi Equity) preference shares are those shares which enjoy preferential rights both with respect to dividends and with respect to pre payment of capital either during the lifetime of the company or on winding up.
12.8.3. Kinds of Preference Shares
a) Cumulative preference share, - dividend payable on these shares accumulates till it is fully paid off.
A share of this type has a right to claim the fixed dividend of current year out of future profits.
b) Non-Cumulative preference shares. They get dividends as and when they are declared only out of the profits of the current year.
c) Participating preference shares – They share in surplus profits on top of the fixed rate after the ordinary shares have got their first claim.
d) Non participating preference shares – They only get a fixed rate of dividends.
e) Convertible preference shares – Members of these shares have a right to convert them into equity shares within a certain period.
f) Non convertible preference shares – They do not have a right to conversion to equity shares.
g) Redeemable preference shares – A company may be authorized by its articles of association to issues of preference shares which are redeemable or repaid after a certain fixed period of time but before a specified maximum period of time.
h) Non- Redeemable (irredeemable) preference shares. They constitute permanent capital of the company.
They are never redeemed by the issuing company during its lifetime. They can only be paid if the company is facing liquidation.
12.8.4. Equity Shares of Ordinary Shares.
- Ordinary Shares means all shares which are not preference shares.
- They share in residual amount of distributable net profits after all types of preference shares have got their rights.
- Dividend on equity share is not fixed and will vary according to the magnitude of available profit for distribution in the form of dividends.
- Equity shares vote proportionate to the paid up amount on shares.
12.8.5. Differed Shares of Management or Founders Shares
- Their right to share profits is postponed or deferred until all classes of shares including equity have been paid.
- They used to have extra-ordinary voting rights and owners of such shares enjoy controlling voice in the management of a company.
- Their face value is usually, low but market value is usually high. In profitable undertaking, they get huge dividends.
12.9. Debentures
- A debenture is an acknowledgement of a debt given under the seal of the company and containing a contract for the repayment of the principal sum at a specified date and payment of interest at a fixed date and fixed rate.
- They are issued like shares through a prospector.
12.9.1 Kind of Debenture
a) Registered Debentures
§ They are those debentures that are payable to registered holders.
§ Such holders are one that their names appear both on debenture certificate and register of debentures of a company.
b) Bearer Debentures
§ These are debentures which a payable to bearer and regarded as negotiable instrument.
§ They can be transferred by mere delivery.
c) Secured or Mortgaged Debentures
§ These are secured debentures by a charge on the assets of a company.
§ The charge may be fixed or floating.
d) Simple Naked or Unsecured Debentures
§ These are debentures that do not have a charge on the assets of a company.
§ The holders of such debentures can only use the company like ordinary creditor to recover debt owed to them.
e) Redeemable Debentures
§ These are debentures that are issued on the condition that they shall be redeemed after a certain period of time.
f) Non (irredeemable) Debentures
§ These are debentures that are not repayable during the life-time of a company.
§ When the company goes into liquidation then they become redeemable. They are also called perpetual debentures.
g) Convertible Debentures
§ These are debentures that have an option of being converted into preference of ordinary shares at a stated rate of exchange after a certain period of time.
h) Non-Convertible Debentures
These are debentures that do not have an option of being converted into shares.
12.10 Factors Influencing the Method and Source of Finance
A number of factors exist to influence the method of raising finance for an organization. Some of these factors include:
a) Nature of the project:
- This may determine the source of finance. A long-term project would need more funds to be provided at a particular point in time.
- Such projects are better financed by long-term loan or issue of shares while short-term project may be financed by bank overdrafts.
b) Nature of Business:
- Some methods and sources are only suitable or available to certain forms of business.
c) Degree of Risk Involved:
- Business enterprises in high risk areas may not be attractive to commercial banks.
- Their cost of finance may also be high due to high interest rate charged.
Intext Question
What are debentures?
12.10. Financial Analysis
- Financial analysis is the process of the determination of the important operative and financial characteristics of a firm from the accounting data.
- It makes use of financial statement and financial ratio.
12.11.1. Financial Statements
- Balance sheet is concerned with presenting a statement of assets, capital and liabilities.
- Current assets include cash and money in the bank together with near cash assets such as stock in hand, debtors.
- Current liabilities are amounts owed by the firm which have to be paid in the near future.
- Share capital is the total value of the investment made by various shareholders.
12.11.2 Financial Ratios
- A financial ratio is simply one accounting figure expressed in the terms of other accounting figures.
a) The purposes of Ratios are:
- Used as an aid to interpret performance of an enterprise over a defined period of time.
- To help in evaluation of a firm’s historical and future trend analysis.
- To help in prediction of future performance, growth and financial position of an enterprise.
b) Classification of Ratios:
o Profitability ratios
o Liquidity ratios
o Activity ratios
o Market ratios
- Profitability Ratios
- Return on Total Assets: = Profits before interest and tax X 100
Total assets or capital employed
- Return on Fixed Assets: = Profits before interest and Tax X 100
Total of Fixed Assets
- Return of Shareholders Equity: = Profits after interest and tax X 100
Shareholders Funds
- Earnings per Share: =Earning after interest and tax less preference dividend
No. of ordinary shares issued and outstanding
- Price earnings Ratio:= Marketing price
Earnings per share
- Liquidity Ratios
- Current Ratio:= Current assets
Current liabilities
- Quick asset/liquid ratio:= Current assets – stocks
Current liabilities
- Acid test / cash ratio:= Cash + Bank
Current liabilities
- Solvency Ratios
- Debt equity ratio:= Long-term debt X 100
Equity capital
- Debt ratio:= Total liabilities X 100
Total assets
- Interest cover: = Earnings before interest and tax
Interest payable
- Efficiency (or Activity) Ratios
- Total Asset Turnover Ratio:= Sales
Total assets
- Net Asset Turnover:= Sales
Total assets – Current liabilities
- Fixed Asset Turnover := Sale
Fixed assets
- Debtors Turnover := Sale
Debtors
- Stock Turnover: = Cost of Sales
Stock
- Average Collection Period: = Debtors X 365
Credit sales
- Average Payment Period: = Creditors X 365
Credit purchases
- Market or Investment Ratios
- The following ratios are classified as falling under market or investment ratios.
- The ratios and how they are calculated is as given below:
Yield Ratios
Dividend Yield: - = Dividend paid X 100
Market price
Interest yield: = Interest paid X 100
Market value
Redemption Yield: = Dividend paid + No. of Years to Maturity X 100
Market value of the security
Earning Yield: = Earnings per Share X 100
Market value per share
Price earnings ratio: = = Market Price
Earning per share
Dividend cover: = Earning after interest and tax
Dividend paid
Limitations of Financial Ratios
- The figure used in arriving at ratios are derived from accounts based on historical cost and other accounting conventions with all their deficiencies, inconsistencies and arbitrariness.
- Published accounts reveal only a minimum of relevant information.
- Different ratios may give conflicting messages.
- Impact of inflation may produce misleading signals.
- Changes in accounting policies such as stock valuation, post balance sheet events and depreciation may make purpose or ratio analysis meaningless of misleading.
Intext Question
What are the purposes of financial ratios?
12.12 Financial Institutions
- A financial institution may be described as any institution which operates in the financial market and engaged in the transfer of financial securities.
12.12.1. Purposes of Financial Institutions
§ Intermediation – They act as intermediaries in the system allowing interaction between savers and borrowers.
§ Provision of securities – They provide financial securities.
§ Takes over the burden of risk bearing from those who have surplus to lend
§ Provide faster transfer of funds.
12.12.2. Classification of Financial Institutions:
a) Commercial Banks
- A commercial bank is any company carrying out banking business in Kenya.
- Banking business involves taking deposits of money from the public repayable on demand or after notice and employment these deposits in whole or in a part by lending.
- Commercial banks are regulated to the Banking Act and the Central Bank of Kenya.
b) Non Bank Financial Institution
§ Finance houses
§ Building societies
§ Insurance companies
§ Post office savings bank
§ Merchant banks
§ Savings and credit co-operative societies
§ Hire purchase companies
§ Development finance companies
§ Micro finance institutions
12.13 The Stock Exchange Market.
A Stock Exchange Market consists of primary market and secondary market.
a) Primary Market
- This is a market where new issue of shares or stock is traded.
- It is a market where securities which are being issued for the first time are offered.
b) Secondary Market
- It is a market for the transfer of already outstanding shares.
- Shares traded on the secondary market are referred to as second hand shares and they are merely changing hands between investors.
12.13.1 Quotation
- A company is said to be quoted when its name is listed on the stock exchange and the prices of its shares are regularly published or quoted by the stock exchange.
12.13.2 Benefit of Quotation
§ A company receives a certain amount of free advertising and publicity.
§ A company is aware of the market value of its shares.
§ It is easier to raise more capital by issue of securities since investors will respond more favorably.
§ Shareholders will find a ready market for the transfer of their shares.
§ Shares are negotiable and easily acceptable as security.
§ It protects investors through rules and discipline.
§ International dealing may be effected through stock exchange.
12.13.3 Functions of Stock Exchange
The stock exchange performs the following essential functions in an economy.
§ Determines and test values of securities.
§ Facilitates investment process by increasing the Liquidity of Investment Securities.
§ Help in channeling large part of savings in an economy.
§ Publishes useful information about companies.
§ Acts as a watchdog to the investors by keeping an eye on the quoted companies.
§ Stock exchange acts as a barometer indicating the performance of an economy.
§ Provides a medium of exchange or transfer of securities.
Activity 12.1
- Discuss the various sources of finance of a joint stock company.
- What is the meaning of share? Explain the various kinds of preference shares
- Explain the meaning of debenture.
- What factors determine the source and method of finance?
- Name four institutions through which a company can obtain long-term finance.
