BFN 303

FINANCIAL MANAGEMENT

MODULE 1
UNIT 1: NATURE, SCOPE AND PURPOSE OF FINANCIAL MANAGEMENT
3.1: FINANCIAL MANAGEMENT
Financial Management is that part of management which is concerned mainly with raising funds in the
most economic and suitable manner; using these funds as profitably (for a given risk level) as possible;
planning future operations, and controlling current performance and future developments through
financial accounting, budgeting, statistical analysis and other means (Ogunniyi, 2010; p. 1).

In other words, financial management is the process of planning and controlling of the financial
resources of a firm. It includes the acquisition, allocation and management of firms’ financial resources.
It is concerned with how best to manage an organization’s resources in order to make sure that the
resources are maximized fully.

The finance functions in all their facets are concerned with decisions about investment, financing and
appropriation of profit.
The quality of decision taken in these aspects – investment, financing and profit distribution has a lot of
implications for the success of a business.

Types of questions that financial management seeks to answer are as follows:

i. What percentage of funds needed by a business should be obtained from outsiders and
what percentage from the owners?
ii. The bank keeps offering us new types of business loans, but we like the traditional old
arrangement, should we change?
iii. Is it worthwhile for the company to replace its existing manufacturing machines with a new
computer integrated system?
iv. The earning per share (EPS) figure for the company is falling despite the fact the
manufacturing facilities have been modernized, should one be considered?
v. A potential customer has enquired whether we will sell goods to him now, and allows him 6
months to pay. Is it profitable to do so?
vi. What percentage of the annual profit should be paid out to shareholders as dividends?

3.2. OBJECTIVES OF FINANCIAL MANAGEMENT

The major objective of management is to maximize the shareholders’ wealth.
The shareholders’ wealth is the present value of future cash flows or present value of future dividends
payable to the shareholders infinitely.

The Shareholders wealth maximization is gradually becoming the single and narrow objective of firms
pursued by financial managers making it the most fashionable objective of the firm.

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This is being achieved through a combination of goals such as:
i. Increase in the market share of the firm
ii. Increase in reported profits.
iii. Continuous survival of the business
iv. Provision of valued services to customers
v. Ensuring public acceptability of the firm and its products/services coupled with both social
acceptability and legal acceptability.

3.3. FUNCTIONS OF THE FINANCIAL MANAGER/ROLES OF FINANCIAL MANAGEMENT

i. Financial Decision: This is the effective management of the capital structure of the business.
The financial manager must ensure maximum mixture of debt and equity in financing the
firm, so as to ensure maximum returns to the shareholders The maximum mix of finance of
debt and equity must be established to maximize the returns of shareholders
ii. Investment Decision: This involves the identification of viable projects. The financial
manager should select the most profitable investment portfolio that will reduce to the
barest minimum the risk of the organization not maximizing stockholders’ wealth.
iii. Dividend Decision: This involves the determination of the appropriate amount to be paid as
dividend and the profit that would be ploughed back to finance expansion in the company.
The financial manager must select the best dividend policy per time, the timing dividend,
the forms of dividend to be paid, the methods of payment, the amount to be paid etc. The
fund(s) to use is an important factor to be considered by the financial Manager. As dividend
can be paid either in cash (cash dividend), or by share allocation (stock dividend). The
amount to be retained by the firm for future finances must also be considered. Since
retained earnings is the cheapest source of fund to the firm, and a bird in hand is worth
more than ten in the bush. Thus, cash dividend will mean more to some section/segment of
investors than the retained earnings which still remains an integral part of the shareholder’s
wealth.
iv. Acquisition Decision: The financial manager must be interested in the organizations internal
and external growth. The growth of corporate organization can be varied, either by way of
merger or acquisition, by backward integration or forward integration etc.
v. Working Capital Management (Treasury Management): It is the totality of management of
cash, debtor prepayments, stocks creditors, short term loans accruals, etc. to ensure the
profitability of the firm’s operation. It is the management of current asset and liabilities of
firm, which is fast becoming important in the face of high cost of capital. In modern financial
world, efficient management of the working capital will ensure maximum utilization of
scarce financial resource and ipso facto maximization of the shareholder’s wealth.
vi. Financial Control and Reporting: Financial control and reporting is an important function of
the financial manager. He must be able to present a lucid yet concise financial report that
provides management with required information necessary to take financial decision.
CONCLUSION Financial management is the process of planning and controlling of the financial resources
of a firm. It includes the acquisition, allocation and management of firms’ financial resources. It is
concerned with how best to manage an organization’s resources in order to make sure that the
resources are maximized fully.
The major objective of management is to maximize the shareholders’ wealth. The shareholders’ wealth
is the present value of future cash flows or present value of future dividends payable to the
shareholders infinitely.

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UNIT 2: SOURCES OF FINANCE
3.1 SHORT TERM SOURCES OF FINANCE
Short term sources of finance are financing sources up to one-year duration (i.e. they are repayable
within one year). It is suitable for funding shortages in working capital.

They should not, if it can be avoided, be used to finance a long-term investment. A company that funds
long term project with short term funds may be forced to renegotiate a long-term loan under
unfavourable condition or to sell the asset, which is needed for the continuation of the business.

where short term sources are recalled by the holders, a company might find itself in a position of
technical or legal bankruptcy.

The main methods of obtaining short-term funds are:

i. Borrowing from friends and relations
ii. Borrowing from co-operatives
iii. Trade credits (Suppliers) involves buying of goods on credit. In other words, it is the
purchase or sales of goods or equipment whose payment would be effective at a future
date. It is a facility granted to a company by a supplier since the system allows the company
to pay at a later date. The cost of cash discount is depicted as follows:
Cost of Cash Discount (Implied cost) = % Discount X 365
100% - %Discount MP-MD
Where:
MP = Maximum payment period
MD = Maximum discount period

Definition of terms used in short sources of finance:

a. Accruals - These are deferred payment on items like salaries and wages, rent, tax. Accruals are
amount owing on services rendered to firms for which payments have not been made. The
amount owed is a source of finance. Example, wages and tax payable.
b. Bank borrowing -This usually takes two forms namely: Bank overdraft (E.g. Drawings against
unclear effect facility) and Bank loan facility. Bank overdraft means that the bank allows the
company to withdraw more than the amount the company has in its account with bank. The
bank charges interest on the amount overdrawn outstanding at any time. Bank rate is
negotiable with Central Bank of Nigeria requirements and the cost to the company is calculated
as follows:
Cost of the overdraft = Interest payment X 365
Total sum utilized Period of Loans
c. Factors to consider before granting bank borrowing:
i. The purpose for which the advance is required
ii. The Amount of the advance
iii. The Repayment term of the advance
iv. The Term of payment (i.e. how could the advance be paid?)
v. The Collateral security of the advance
vi. Does the Character or record of the customer justify the advance?
vii. What is the Capital structure of the borrowing company?
viii. How Credible/Credit-worthy are the owners of the business?
d. Documents to be requested before granting bank borrowing:

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 i. Application requesting for the loans.
ii. Memorandum of Association
iii. Articles of Association
iv. Names, Address & Particulars of the Directors
v. List of directors' shareholdings.
vi. Boards Resolution vii. Certificate of Incorporation
vii. Collateral Security including personal guarantee of the Managing Director.
viii. Audited Account of the company
ix. Management Accounts & Reports of the company.
x. Cash flow projection of the company.
xi. Acceptance of the offer letter (by affixing company seal & two directors or a director &
secretary must sign on behalf of the company).
e. Speeding up payment from Trade debtors (Customers) - This depends on the availability of
sound credit control and reminder system.
f. Debt Factoring - A factor is an agent that manages trade debts. Factoring involves turning over
the responsibility for collecting a firm's debt to specialist institution. A factor agent usually offers
three main services namely:
i. Taking over the management of client’s sales ledger.
ii. Insuring their clients against the risk of bad debts.
iii. Providing finance by means of advances against the security of trade debtors,
g. Bill of Exchange - This is a form of short term finance used in trade financing. A bill of exchange
is one method of settlement in a trade between a seller and a buyer. A bill of exchange takes
two forms:
1) Trade Bills - These are bills of exchange in which the buyer acknowledges it by writing
accepted across it and signing it.
2) Bank bills - These are bills or exchange drawn on a bank, which will accept them. This is
known as acceptance credit.
h. Invoice Discounting - This is similar to factoring except that only the financing service is used
meaning that the copies of company's invoices sent to customers are discounted with a financial
institution and the trading company still collects the debt as agents for the financial institution
and remits the cash on receipt to the account open for that purpose.
1) Commercial paper - This is a short term and an unsecured money market instrument used
to invest company's surplus. Large companies with good credit rating can raise short-term
funds by issuing commercial notes, which are then purchased by investors in the money
market. The financial institution does not guarantee the notes but assists in finding investors
to buy them.
3.2 MEDIUM TERM SOURCES OF FINANCE
These are financing sources between 1 to 5 years’ duration. Some of the medium term sources of
finance include:
i. Medium Term loans: These are usually issued for a definite period when compared with
overdraft. This is a negotiated loan between a financial institution and a company between 1-5
years, usually at a fixed rate of interest. Medium Term Loans in form of bank lending can be
secured or unsecured. Unsecured lending is not common and is only available to credit worthy
companies. Secured lending requires heavy collateral securities and proper evaluation of credit
worthiness of all customers are also considered.
ii. Hire purchase agreement: This is in form of a credit sales agreement by which the owner of the
assets or supplier grant the purchaser the right to take possession of the assets but ownership will

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 not pass until all the hire purchase payment has been paid. The purchaser will pay the hire purchase
payment over an agreed period. No form of collateral is required. It is normally reflected in the
balance sheet of the borrower. It reduces the gearing ratio and increases ability to raise further
finance. It also attracts capital allowance.
iv. Lease: A lease is a contractual agreement between the owner of an asset (lessor) and
the user of the asset (lessee) granting the user or lessee the exclusive right to use the
asset for an agreed period in return for the payment of rent. The main advantage of
lending to a lessee is the use of an asset without having to buy. This conserves an
organization's funds.
There are two major types of lease:
a. Finance leases (or full payment leases/ capital leases): The finance lease is non-
cancellable. The lessee is responsible for the upkeep, insurance and maintenance of
the leased asset. Finance lease is an example of off-balance sheet financing. It is off
balance sheet because sources of financing fixed asset are not shown as liabilities on
the balance sheet.
b. Operating leases: With operating lease, the owner (lessor) is responsible for the
upkeep, insurance, servicing and maintenance of the leased asset
v. Sales and leaseback: This is an arrangement by which a firm sells its assets to a financial
institution for cash and the financial institution immediately leases it back to the firm.
vi. Venture capital: This is a major source of capital for SMEs and collapsed businesses. The
provider of finance might decide to participate in the company instead of allowing the
client to run the business himself. The participation might be in the form of equity or
debenture stock. Small companies normally require this type of finance because of their
inadequate collateral securities and poor management skills and talents. It is otherwise
known as business angel.
vii. Project finance: This requires evaluation of the company and its project. The project
itself serves as a collateral security for the fund. It is a risky source of finance if the
project fails. However, the financial institution should request for additional collateral
security.
3.3. LONG TERM SOURCES
These are financing sources of 5 years and more duration. Long term sources of finance include:
1. Loan Stock/Debentures: This is long-term debt finance raised by a company for which interest is
paid usually at a fixed rate. The company must pay the interest whether it makes profit or not.
Loan stock also has a nominal value of ₦100. Debentures are a form of loan stock that is legally
defined as the written acknowledgement of a debt incurred by a company usually given under
company seal and containing provisions as to the payment of interest and eventual repayment
of principal.
2. Preference Shares: The holders of preference shares are entitled to a fixed percentage dividend
before ordinary shareholders can be paid any dividend. Preference shares are a form of hybrid
security between ordinary shares and debentures. These are often issued as an alternative to
debt when the company pays no tax. Preference shares can be redeemable or irredeemable.
3. Ordinary Shares: Ordinary shareholders are the owners of the firm. They exercise control over
the firm through their voting rights. A firm contemplating on raising funds through ordinary
shares will incur floatation cost/issue cost.

Ways of Raising Ordinary Shares

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1. Public Subscription (Stock Exchange Introduction): This is an invitation to the public at large so
as to invite them to subscribe for share in the company. The public issue must comply with
CAMA 1990. This is also known as Initial Public Offering (IPO).
Techniques of Conversion of Ordinary Shares:
a. Conversion Price (CP): It is the nominal value of convertible security that can be converted into
one ordinary share. It represents the effective price of ordinary shares paid for on conversion.
CP can be derived as follows:
Conversion Price = Market Value/Nominal value of Convertible security
Number of ordinary shares issued on conversion
b. Conversion Rate (CR): It is the number of convertible security that could be exchanged for new
ordinary shares or security. It is expressed as follows:
Conversion Rate= Number of ordinary shares issued on conversion
Market value/nominal value of converted security
c. Conversion Value (CV): It is the market value of ordinary shares into which unit of stock or
convertible security will be converted. This is expressed as follows:
Conversion Value = Conversion Rate X Market Value per share
d. Cost of option to convert: At the point of conversion, the holder of such security has two
options i.e. to convert and not to convert. The cost of option is derived as follows:
Cost of option = Actual price of convertible security Conversion price
Conversion Rate
e. Conversion Premium/Discount: This is the difference between the conversion price and market
price.
It should be noted that:
i. Where conversion price is greater than (>) market price of share, it is equal to discount.
ii. Conversion premium/discount could be presented in form of yield. Example below
Conversion Yield is known as: Premium/Discount X 100
Conversion Price 1
2. Bonus/Script/Capitalization issue: This is issued to existing shareholders by whom further
shares are credited as fully paid-up out of the company’s reserves in proportion to existing
holdings. This is known as capitalization of reserves.
3. Offer for sale: This is where a company issues its shares for public subscription through an
issuing house in which the sales proceeds go to the existing shareholders not the company.
Simply put, offer for sale is the sale of existing shares by existing shareholders but not a fresh
issue of shares. This method was used by Daar Communication Plc. and all the proceeds were
paid directly into Daar Holding Plc. for the existing shareholders of the company.
4. Offer for Sale by Tender: This is when a company’s share is being issued out by a company to
the public asking the price that all intending shareholders can subscribe. This is referred to as
striking price and the stock exchange will ensure that all shares are taken up at the striking price.
5. Retained Earnings: This is a part of a company’s profit not paid out as ordinary dividend. It is
also a source of financing. It is a cheap source of raising finance as compared to share issue
because no issue cost is involved. Raising funds through retained earnings avoid dilution of
control since there is no share issue to outside Retained earnings are an important source of
financing for companies that do not have access to the capital markets.

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 The table below is a summary of the sources of finance. This can be found on page 24 on the
course material.

5.0 CONCLUSION The business organization must ensure that their business is finance using the
cheapest and the most convenient sources for the highest effectiveness. It is therefore of value to
consider the various sources of finance to the business organization.

UNIT 3: COST OF CAPITAL

1.0 INTRODUCTION Cost of capital is an integral part of investment decision as it is used to measure
the worth of investment proposal provided by the business concern.
It is used as a discount rate in determining the present value of future cash flows associated with capital
projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager must take careful decision
with regard to the cost of capital; because it is closely associated with the value of the firm and the
earning capacity of the firm.

3.1 COST OF CAPITAL Cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attract funds. Cost of capital is the required rate of
return on its investments which belongs to equity, debt and retained earnings.
If a firm fail to earn return at the expected rate, the market value of the shares will fall and it will result
in the reduction of overall wealth of the shareholders.
In other words, cost of capital is the minimum required rate of return on investment. It is the present
value of future stream of Net Cash flow on investment. It is also the minimum value per share in the
capital market.

3.2 THE USEFULNESS OF COST OF CAPITAL.

a. It is an important tool in capital budgeting decision.
b. It is a useful measurement of the firm's financial performance
c. It is a tool of financial decision making.
d. It can be used in selecting source of finance; as cost of capital the market is known the Financial
Manager can select a cheap source of fund.
e. It is also important in dividend policy formulation and working capital management.

3.3 TYPES OF COST

1. Future Cost: Are expected cost associated with investment. They are those costs used in
appraising investment opportunities when matched with future benefits or expected returns on
the investment, it will produce the net return on such investment. Future cost of fund is also
used as discounting factor.
2. Historical Cost: These are past financial expenditures used in securing a future benefit. It is the
sacrificing of present consumption (in investment) for future consumption benefit.
3. Explicit Cost: The explicit cost of capital is that cost of capital that equates the present value of
future incremental cash inflow with present value of future incremental cash outflow. That is,
the cost of debt, equity etc.

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 4. Opportunity Cost of Capital/Explicit Cost of Capital: It is the cost of alternative project forgone
for the purpose of investing in the selected projects. Explicit cost of capital becomes relevant
only when there are several possible investment opportunities to be selected from.

3.4 VALUATION OF SECURITIES

Debt (Irredeemable debenture) The cost of Debt is the internal rate of return on Debt; that is the cost
at which the present value of incremental cash inflow equals the present market value (or purchase
cost) of the asset.
N0 = 1(1 + r)-1 + (1 + r)-2 + I (1 + r)-3 +EIn(1 + r)-n
I = 1 or 1 = I
Where N0 = Net cash inflow in year zero
In=Cash inflow in year 1 to year n

N = Number of years
R = Interest rate
Illustration I
Kemi-Alabi purchased a 15% irredeemable debenture for N100 ex-interest. Compute the cost of debt.
Solution
Cost of Debt = 15 x100 = N15
100
Cost of Redeemable Deb (Debenture) The cost of redeemable debt is calculated using the internal rate
of return method. This represents the discount rate that equates the current market value (ex-interest)
of the debenture with the present value of associated future cash inflows. These are the interest
payable annually plus the redemption value in the year of redemption:

Illustration 2
Yr 0 Current market value = N80 (outflow)
Yr 1 - 10 Interest net of tax = N12 (1- 0.4) = N 7.20
Yr.10 Redemption value= N100 at par inflow
Time

3.5 COST OF PREFERENCE SHARE

Irredeemable preference share/redeemable preference share
Preference share is assumed to be debt in nature because a preference shareholder is entitled to fix
Dividend like the Debenture holder that earn fix interest rate. Thus in computing the cost of preference
shareholder same method used in Debenture cost calculation is used.

SUMMARY The method of calculating the various cost of financial assets was discussed which include
ordinary share debenture and other bond. The various techniques of those appraisals and their market
value was also discussed in this unit.

MODULE 2
UNIT 1
3.1 DEFINITION OF CAPITAL BUDGETING
Capital budgeting decision can be defined as the firm’s decision to invest its current funds in most
efficient long term projects. It is the commitment of organization’s current funds in a long term project

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with the aim of profit making. It is a common practice in modern businesses for funds to be committed
on the acquisition of land, building, machinery and other capital project with a view to earning in the
future an income, which is greater than the funds committed.

Capital budgeting is the process whereby decisions are taken on how capital funds shall deployed. It
includes the appraisal of proposed investment projects by reference to their expected returns and to the
cost of capital

3.2 NEED AND IMPORTANCE OF CAPITAL BUDGETING

i. Huge investments: Capital budgeting requires huge investments of funds, but the available funds are
limited, therefore the firm before investing projects, plan are control its capital expenditure.
ii. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore, financial
risks involved in the investment decision are more. If higher risks are involved, it needs careful planning
of capital budgeting.
iii. Irreversible: The capital investment decisions are irreversible, are not changed back. Once
the decision is taken for purchasing a permanent asset, it is very difficult to dispose off those
assets without involving huge losses.
iv. Long-term effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term and will bring significant changes in the profit of the company by
avoiding over or more investment or under investment. Over investments leads to be
unable to utilize assets or over utilization of fixed assets.
Therefore, before making the investment, it is required carefully planning and analysis of the project
thoroughly.

3.3 KINDS OF CAPITAL BUDGETING DECISIONS

The overall objective of capital budgeting is to maximize the profitability. If a firm concentrates return
on investment, this objective can be achieved either by increasing the revenues or reducing the costs.
The increasing revenues can be achieved by expansion or the size of operations by adding a new product
line. Reducing costs mean representing obsolete return on assets.

3.4 PROCEDURES INVOLVED IN CAPITAL BUDGETING DECISIONS

The procedures involved in capital budgeting decisions are as follows:
1. Identification of possible projects
2. Evaluation of projects
3. Authorization of projects
4. Development
5. Monitoring and control of projects
6. Post audit
3.5 CHARACTERISTICS OF CAPITAL BUDGETING
Capital expenditures differ from day-to-day ‘revenue’ expenditure because:
1. They involve large outlay.
2. The benefits will accrue over a long period of time, usually well over one year and often much
longer, so that the benefits cannot all be set against costs in the current year’s profit and loss
account.
3. They are very risky.
4. They involve irreversible decision.

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3.6 METHODS OF CAPITAL BUDGETING EVALUATION
By matching the available resources and projects it can be invested. The funds available are always living
funds. There are many considerations taken for investment decision process such as environment and
economic conditions.
The methods of evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Accounting Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method In this unit, we shall discuss only the traditional methods.
These are explained in seriatim.

THE PAYBACK PERIOD METHOD:

The principle behind the Pay back method has more regard for liquidity than profitability. It is a measure
of liquidity over cost (or initial outlay).

Advantages of Pay Back Period

1. It is easy to understand and estimate.
2. It is liquidity based; rather than profitability, thus seems more acceptable where liquidity stands
as the main factor to be considered.
3. It is less forecast biased sensitive, unlike other investment criterion used.
4. It is suitable for use in an unstable economic environment.

Disadvantages of Pay Back Period

1. It disregards the time value of money.
2. It disregards all cash inflows which occur after the payback period.
3. It is not an objective criterion for decision-making
4. If it is not properly applied (Invoked). It may lead to wrong decision-making
5. It is highly subjective in nature.

Illustration 1 Two projects A and B with the following relevant information

Project A: Outlay = 200,000
Inflows year 1 = 60,000 Year2 = 80,000, Year 3 = 80,000 Year 4 =100,000.

Project B: Outlay = 200,000

Inflows Year 1 = 80,000 Year 2 = 80,000 Year 3 = 40,000 Year 4 = 60,000 Year 5 = 60,000

Required: Compute the payback period.

SOLUTION
Project A Cash flow Cumulative
Y0 (200,000) (200,000)
Y1 60,000 140,000
Y2 80,000 60,000
Y3 80,000

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3.7 ACCOUNTING RATE OF RETURN
The Accounting Rate of Return (ARR) is otherwise known as the Average Return on Investment. It is used
in measuring the rate of return to investment.

The formula used is as follows:

ARR = Average profit
Average investment
Where:
Average profit (AP) = Total Profit Generated
No of years
Average investment = Initial cash outlay
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3.7.1 ADVANTAGES OF ACCOUNTING RATE OF RETURN
1. It is simple to calculate
2. It uses readily available accounting data.
3. It considers the profits over the entire life of the project.
4. It could be used to compare performance of many companies.

3.7.2 DISADVANTAGES OF ACCOUNTING RATE OF RETURN

1. It ignores risk and management’s attitude to risk.
2. It takes no cognizance of the time value of money.
3. It can be calculated in several ways.
4. It uses accounting profit rather than cash as the measure of benefit.

CONCLUSION
In making decision, as to the kinds of project to be embarked upon, the payback period, the accounting
rate of return among others can be used to determine the viability and profitability of investment
project and be able to identify those the firm can engage in and those they will not accept based on
their profitability or otherwise.

UNIT 2: CAPITAL BUDGETING UNDER UNCERTAINTY 2

3.1 THE MODERN/DISCOUNTED CASH FLOW METHOD OF INVESTMENT APPRAISAL
The modern/discounted cash flow method of investment appraisal, unlike the traditional method, does
not give cognizance to the time value of money. This method is superior to the ARR and PBP techniques
earlier discussed.
The methods include:
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method
These methods are discussed below, and the following points should be noted:
1. Time Value of Money The net present value and the Internal Rate of Return (IRR) incorporate
time value of money. The time value of money concept states that the value of N1 today will not
be the same in a year's time, due to depreciation in the real value of naira. In order words, what
a naira can buy today in a year’s time an amount above a naira would be required to purchase
that same article. Thus a naira invested today should yield an amount over and above the naira
invested. Devaluation of money allows for this. However, in a relatively stable economy, the

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 interest rate could be taking to account for devaluation in naira. The interest rate per naira is
the compensation for the loss of value by the naira amount. Hence the interest rate is used for
discounting.
2. Money and Real Interest Rate: The scientific method assumes therefore that the interest rate
used is the real interest rate and not the money interest rate. The real interest rate is the after
tax interest rate while the money interest rate is the before tax interest rate. The scientific
method makes use of the real interest rate asking for granted that inflation rate will be equal
the tax rate. Since normally the value of good should only be inflated by the tax paid thereon.
For example, the money interest rate is 20% and the tax rate is 30% the real interest rate will be
(1-0.30) (20%) = (0.70) (20%) = 14%.

3.1.1 NET PRESENT VALUE METHOD

The net present value method is the total present value of a project which should be greater than the
initial capital outlay of the project before such project could be accepted.
The decision rule is that:
a). When total present value > capital outlay: Accept the project with positive NPV.
b). When total present value < capital outlay: Reject the project with negative NPV.

3.1.2 INTERNAL RATE RETURN

The internal rate of return (IRR) is the interest rate which produces a cumulative present value that is
equal to the initial outlay.

LINEAR INTERPOLATION Using the principle of similar triangle, a formula could be obtained for the
internal rate of return. This method entails deriving two Net Present Values (NPVs) from two interest
rates applied. One of the two NPVs must be negative and the other positive. These Net present values
and the associated interest rates can now be used to secure the internal rate of return. It is otherwise
known as Linear Interpolation Method: This is the short cut method of getting the correct internal rate
of return. When you tried at discount rate A, and the NPV is positive, try another rate B that gives you a
negative NPV. When you get a negative NPV, then stop and interpolate using the formulae below:

PROBLEM WITH NPV There are several problems inhibiting the usage of NPV as a method of project
evaluation.
1. Multiple Internal Rates of Return: This is a situation whereby a negative inflow occurs during
the project's life. While the Net present value of the project is still positive in this case multiple
internal rates of return will exist thus making our result ambiguous.
2. The Re-Investment Rate Problem of the IRR and NPV The internal rate of return assumes that
cash inflows are re invested at the internal rate of return margin. On the other hand the Net
present value (NPV) principle assumes that inflows of cash are reinvested at the NPV rate. This
can yield a different final result.

Advantages of NPV
1. It considers the time value of money unlike the payback period.
2. It considers the cash inflows both during and after the period i.e. over the project's entire life.

Disadvantages of NPV
1. It is cumbersome and difficult to compute.
2. It is not suitable for project with different cash inflows

12
Net Terminal Value (NTV) The net terminal value is a compounded value of the net present value of the
life of an asset or project obtained by compounding all the cash flows to the end year of the life span of
the project.

3.1.3 PROFITABILITY INDEX OR THE BENEFIT COST RATIO

This is the ratio of present value of project life to the initial capital outlay.

Illustration 6 ABC Ltd is planning to replace two of his machine with a new model because of the
maintenance cost of N 5,000. One of the two old machines is considered to be expensive. The old
machines are being depreciated over a period of 10 years on a straight line basis. The estimated scrap
value after 10 years is N900.00 for each machine while the current market value is estimated at N1,
500.00 each. The annual operating costs for each of the old machine are as follows:

N N
Materials 162,000
Labour - 3 operators at 1,800 Hrs 3,900
Variable expenses 2,274

Fixed expenses:
Depreciation 11,938
Fixed Factory overhead 7,800
Maintenance 4,500
24,238
The company's cost of capital is 10% and projects are evaluated on basis of rate of returns. In addition to
satisfying the profitability test, projects are also required to satisfy a financial viability test by meeting 5
year pay-back condition.

You are required to:

a. Advise management on the profitability of the proposal by applying a discounted cash flow
technique to calculate the internal rate of return.
b. Subject proposal to a financial viability test, and
c. Comment very briefly on two other factors that could influence the decision of management in
respect of this proposal.
d. (Assume that residual value is received on the last day of the machine’s working life and ignore
taxation).
Present value of N1 for 8 years
ANSWER
Two other factors that can influence the decision of management in respect of this proposal are:
(i) Taxation: The timing of taxation should especially take capital allowance into consideration.
In this type of investment appraisal as this will affect the cash flows from the project.
(ii) Inflation: In an inflationary situation, the existing techniques for investment appraisal (NPV,
IRR) are inadequate unless certain.
Adjustments are made, because real purchasing power is constantly being eroded. Unless this erosion is
taken into account company will find that ‘profitable' investment could actually turn out to be seriously
unprofitable.

13
CONCLUSION The students can use the internal rate of return, the net present value and the probability
index to make decision about the profitability of investment project and be able to identify those the
firm can engage in and those they will not accept based on their profitability or otherwise.

UNIT 3: WORKING CAPITAL MANAGEMENT

3.1 Working Capital
The working capital is the required fund necessary for the day to day running of the business. It is the
life blood of an organization. It includes Cash, Inventory, Accounts receivable, Prepayment, (which
constitute application of fund) accounts payable, accruals, etc. (which constitute sources of term fund).

The working capital constitutes the short term investment decision of the organization. It is the short
term sources and application of fund the cost of these short term sources of fund are very important to
an organization.

It is the current assets circulating or floating capital. It changes form in the production and trading
process. E.g. Cash is used to purchase raw materials (Inventory). These are being used up in the
production process to yield finished goods (stock).

The stocks are sold for cash or on credit (yielding) account receivables; sometimes inventories (raw
material) are obtained on credit (Account payable).

3.1.1 Working Capital Concepts

A. The Gross concept: It is the totality of the current assets of the business which include accounts
receivable, cash, short dated securities (short term investment), bill receivable and Stock (or inventory).
The gross concept advocates that a firm should possess working capital just adequate and sufficient to
meet the firm's operating cycle. It ensures that excess investment in cash is avoided, since excess
investment in cash results in excess liquidity resulting to high cost of income.

Thus, it is called optimal level of Investment in current assets; excess investment in current asset is
avoided.
Secondly, this emphasizes available source of fund- such that such fun are called up as at when needed.
Excess investment in current asset is thus avoided.

B. The Net Concept: This emphasizes continuous liquidity of the firm. The concept advocates a finance of
Working Capital by a permanent source of funds e.g. shares, debentures, long term debts, preference
shares, retained earning etc. The Net concept advocates the efficient mix of long term and short term
sources of funding working capital.
There exists no rule as to the exact Working Capital level a firm should hold and there exists no rule as to
how current asset should be financed.

3.2 Factors Affecting Working Capital

i. The fluctuations necessitated by seasonal sales, change in taste and fashion.
ii. The operating cycle affect the working capital, a long term operating cycle would result into capital tie
down and hence increased cost of working capital.

14
iii. The nature of the business also determines the level and extent of working capital the business will
have.
iv. The variability in stock purchase due to the firm speculators purchase is another factor
affecting working capital.
v. The growth stage of the firm is another factor. A new growing firm will require a high level
of Working Capital and the Working Capital cycle will be short and rapid.
vi. The credit policy of' a firm can impact either negatively or positively upon its working
capital. A liberal credit term will result in capital tie-up but a high level sales, and hence high
level, while a tight credit policy may reduce sales but improve liquidity. Profitability may be
low with high credit policy. Thus, the firm must strike a balance between liquidity and
profitability.
vii. Another factor affecting the working capital of a firm is the extent to which short term funds
(cash) are used to finance long term investment.
viii. An efficient operating cost will contribute to the working capital efficiency of a firm.

3.3 Operating Cycle

It is the total period of converting raw materials into cash and returning the cash into raw materials. This
actually involves converting the raw materials to work in progress and the work in progress to finished
good and the finished goods into sales and finally the sales to cash.

Figure 1 conversion cycle: Page 66

The operating cycle is the total period it will take to convert raw materials into cash as above.
To maintain an uninterrupted operating cycle, cash must be maintained.
Liquidity is the most important factor for operating cycle.

3.3.1 Operating Cycle Length

To determine the length of operating cycle the total period of cash component of the operating cycle
must be determined.
1. Inventory Raw materials conversion period = Raw materials x 360
Raw materials consumption
Raw materials conversion RMI x 360 (0r 365)
RMC
2. Work In Progress Work in progress conversion period (WIPCP) =
= Work in Progress Inventory
Cost of Production

= W I P I X 360 ( or 365)
Cost of production

3. Finished Goods
Finished good conversion period (FGI) X 360 (or 365)
Cost of goods sold

4. Book Debts Conversion Period (BDCP)

(Debt repayment period)

15
 = Book debt inventory or Debtor x 360(or 365)
Credit sales Credit sales

5. Payable Different Period

(Credit Repayment Period)

Creditors
Credit purchase x 360(or 365)
Illustration 1. See Pages 66 to 69

3.4 Financing Working Capital

In financing working capital the risk return trading must be considered That is, the cost of fund and
return from usage of that fund must be given a considerate attention, to ensure profitability and
liquidity. Financing method must equally be flexible to accommodate constant change involved in
working capital management.

Thus there are three major methods of financing working capital namely:
1. Long Term Financing: This involves using fund from long term securities.
2. Short Term Financing: This involves using fund from short term securities.
3. Spontaneous Financing: This involve utilization of short term un negotiated financing source e.g.
credit from creditors.

CONCLUSION Working capital is the life blood of an organization, it consists the liquidity flow as
different from the profitability of the organization. A profitable but illiquid business could be forced to
close down.

UNIT 4: CASH MANAGEMENT

3.1 Cash Management
Cash is the most liquid assets of the company; it is used as a medium of exchange in business activities.
No business can survive without it. Sales represent inflow of cash, while purchase brings about outflow
of cash. It is used to meet daily components of organization obligations.
Cash management involves three major stages namely: Cash planning, Cash flow management and
maintaining optimal cash level.

Cash planning entails analyzing the organizational cash needed and estimating inflow and outflow of
cash. The purpose is to avoid carrying excess cash or running into cash shortages.

Managing the cash flow involves evolving method of maximizing cash outflow. Keeping optimal cash
level, no surplus cash or shortage of cash exist.

3.1.1 Cash Planning

This is a process of estimating current and future cash needs for the organization and making
appropriate effort to attain these. The singular purpose of cash planning is to avoid excess liquid and low
shortage of cash.

3.1.2

16
3.1.3 Cash Budgeting and Financing
Cash budgeting entails estimating relative inflow and outflow throughout the life of the asset. The cash
budget could be long term or share term capital. A cash budget that goes beyond a year will be termed
long term budget.

Illustration 1 Aderidoh Nigeria Limited produced the following information covering November,
December, January, February, and March 2015. The information is stated below:
See pages 73-75

3.1.4 Cash Management Techniques

1. Accelerated Cash Collections: This is a method of ensuring reduction in time lag or gap
between the time customers enjoys a service or buys a product and the time the customer
receives the bill and settles it, and the time cash becomes available for maintaining the
operating cycle.
A cash collection method could either be centralized or decentralized system or the lock- box
system. The lock-box system entails establishing various collections centres taking into account
customer location and the volume of remittances.
2. Optimal Cash Level: This is determined through the use of Economic Order Quantity. It is used to
determine the optimal cash level.
Formula: EOQ = 2DO
C
D = Cash need or cash demand
O = Cost of cash investment
C = Cost of carrying cash
Illustration 2 Realtutu Plc operates a centralized collection system. It takes 6 days to receive mail
remittance and another 3 days for processing mail. Realtutu Plc daily collection amount to N600,000.
Realtutu Plc currently is thinking about the introduction of Lock - Box System. By this same time mailing
is expected to fall by two days while the processing time is also expected to drop by two days. Interest
of' 22% is expected to be paid by PEPZIM BANK PLC.
SOLUTION see pages 76-79

3.2 Motives for Holding Cash

Organization should hold cash for three purposes as follows:
I. Transactionary Motives The business organization holds cash for the purpose of
conducting its day to day activities such as for the purchase of raw materials, payment of
wages and salaries, maintenance of machine etc.
II. Precautionary Motives The business organization holds cash to meet unexpected
contingencies. This acts as a `buffer' to meet unexpected needs for cash.
III. Speculative Motives Corporate organization may hold cash for the purpose of
investing in business opportunities that may surface suddenly.

UNIT 5: INVENTORY MANAGEMENT

III.1 Inventory Management
Inventory is stock. It includes raw materials, work in progress and finished goods ready for sales.

17
It is the most illiquid component of the working capital. Thus a company willing to estimate its liquid
must deduct the inventory or stock portion of the current asset before it against the current liability to
obtain the quick asset ratio or the acid out Ratio.

The formula for calculating working capital and Acid test ratios are:
Working Capital Ratio = Current Asset
Current liability

Acid test ratio = Current Asset – Stock

Current Liabilities

The firm must decide what quantity of stock is needed, at what point should order be made and at what
price and what is the cost of stock out; can we reduce stock costs? These questions will help the
financial manager to work out a proper stock management policy.

It is imperative to know that the firm can pile up stock in order to eliminate cost in production runs,
sometimes they do keep large stock to reduce the time lag between when an inventory is needed and
when t is fully bought.

III.1.1 Optimum Level of Stock

The economic order quantity (E.O.Q provides the firm with the most profitable form of obtaining the
Optimum level of raw material.

E.O.Q = 2DO
C
Where D = Annual demand
O = Ordering cost
C = Carry cost

Ordering Cost: This is cost associated with placing new order such as invoices cost, book-keeping of
inventory, cost of stationary, transportation cost and inspection handling cost.

Carrying Cost: Is the cost incurred to hold the stock. To protect the stock, such cost includes, storage
cost, insurance, depreciation, cost of obsolescence and deterioration cost.

III.1.2 Minimum Stock Level (Margin of safety or buffer stock):

It is the level to which stock should not fall before new order is place it is the stock's margin of safety. It
constitutes the firms buffer stock.

Minimum Stock Level: Re-order level - (Normal consumption X Average reorder period).

Maximum Stock Level: This is the highest level stock must not rise above. It is the level above which
stock should not rise.
Maximum Stock Level = Reorder Level - (Min consumption x minimum reorder period) + Reorder
quantity.

ROL - (Min consumption x min reorder period) + ROQ.

18
Illustration 1 See pages 83- 84
SUMMARY Inventory management – an important component of working capital management – also
known as stock includes raw materials, work in progress and finished goods ready for sales. It is the
most non-liquid component of the working capital.

UNIT 6: ACCOUNT RECEIVABLES AND PAYABLES

3.1 Management of Creditors (Account Payable):
This is a source of fund to the firm. It constitutes the cheapest source of fund to the firm, however, the
firm must design a proper method of settling the creditors. This will enhance continuous and repeated
purchase.
Creditors include the accounts payable where the credit is on overdraft, then the cost of the overdraft
must be considered and compared with cost of alternative financing.

III.2 Management of Debtors (Account Receivable):

The Debtor includes accounts receivable. It is very important to the firm due to the fact that such debtor
could impact negatively on the liquidity of the firm. Liquidity of the firm accounts for the viability of such
firm’s security. The debtor is a tied down capital, this capital tied down would impact negatively on the
firm's ability to finance other current assets.

Thus the firm must establish a flexible credit policy. Sometimes the credit Policy of a firm might be rigid
depending on the nature of the business, the Current Asset Stock and the preference for liquidity over
profitability.

III.3 Factors Influencing Credit Control Policy

1. Policy of the competitors: The Credit Control Policy of the competitors is of utmost important in
deciding a company Credit policy; since Credit Policy have direct impact on sales such that the higher the
credit granted the higher the sales; Thus a competitor offering a hot credit facility {say 90 days} will be
considered to have more sales than a company with less credit facility (say 30 days).

3. Nature of Product: A company with a unique product, without substitute will not need to
consider any credit policy. A monopoly will not consider any credit facility nor have any credit
policy.
4. Trade-Off between Profits on Sales and Cost of Having Debtors Plus Bad Debts: Increased
profits anticipated from increased sales coming in a result of credit facility should be compared
with cost of bad debt and maintenance cost of a wage credit control department before
deciding on a particular credit policy.
5. Customers Risk Category: The customers risk category should be considered in grating credit
facility. Customer with poor record of credit repayment will have less chance of obtaining credit
facility compare compared with a customer with good record of credit repayment.
6. Cost of Debt Factoring and Invoice Discounting: The cost involved in debt factoring and invoice
discounting should be given congruence in granting credit facilities. Where the cost of factoring
is too high, it becomes difficult therefore, to grant credit facilities.
7. Cost of Working Capital: The financial cost of working capital should be considered. The
increased working capital required should be considered in term of cost involved and risk
thereon.

19
 III.4 Factors to be considered in Granting Credit to a Specific Customer
a. Trade Reference: One or more companies which the customer has dealt with in business before
will be asked to give a reference on the Customer.
b. Bank reference or bank's opinion: A bank may also be asked to comment on the financial
standing of its customers.
c. Published information: e.g. annual accounts of the particular customer can be analyzed to
determine its liquidity and profitability position.
d. Salesmen’s Opinion: The opinion of the salesmen should be considered when granting credit
facility to a customer since they are more close to the customer than others.
e. Customers Past Credit Record: An emanation of how will the customer has paid in the past
might give some insight as to how well he will perform in the future.

CONCLUSION The management of creditors and debtors is very crucial in any business organization. And
considerable factors should be looked into when granting credit to customers.

MODULE 3
UNIT 1: ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL
INTRODUCTION A financial statement is an official document of the firm, which explores the entire
financial information of the firm. The main aim of the financial statement is to provide information and
understand the financial aspects of the firm. Hence, preparation of the financial statement is important
as much as the financial decisions.

3.1 MEANING AND DEFINITION OF FINANCIAL STATEMENT

According to Hamptors John, the financial statement is an organized collection of data according to
logical and consistent accounting procedures.
Its purpose is to convey an understanding of financial aspects of a business firm.
It may show a position at a moment of time as in the case of a balance-sheet or may reveal a service of
activities over a given period of time, as in the case of an income statement.

Financial statements are the summary of the accounting process, which, provides useful information to
both internal and external parties.

John N. Nyer also defines it “Financial statements provide a summary of the accounting of a business
enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a certain data and the
income statement showing the results of operations during a certain period”.

The Balance Sheet and Income Statement formats are designed as general models and are not complete
for every business operation. Computation of income for financial accounting purposes is done
according to the rules of Generally Accepted Accounting Principles (known as GAAP).

Financial statements generally consist of two important statements:

a. the income statement or profit and loss account.
b. the position statement.

20
A part from that, the business concern also prepares some of the other parts of statements, which are
very useful to the internal purpose such as: (
i) Statement of changes in owner’s equity.
ii) Statement of changes in financial position.

3.1.1 Income Statement

Income statement is also called as profit and loss account, which reflects the operational position of the
firm during a particular period. Normally it consists of one accounting year.
It determines the entire operational performance of the concern like total revenue generated and
expenses incurred for earning that revenue. Income statement helps to ascertain the gross profit and
net profit of the concern.

Gross profit is determined by preparation of trading or manufacturing a/c and net profit is determined
by preparation of profit and loss account. The following terms are commonly found on an income
statement:

i. Heading The first facts to appear on any statement are the legal name of the business, the type of
statement, and the period of time reported, e.g., month, quarter, or year.
ii. Column Headings If you include both current month and year-to-date columns on the Income
Statement you can review trends from accounting period to accounting period and compare previous
similar periods. Also, it is often helpful to show the dollar amounts as percentages of net sales. This
helps you analyze performance and compare your company to similar businesses. Remember, you can
choose any period of time to analyze.
iii. Revenue All income flowing into a business for services rendered or goods sold comes under this
category. In addition to actual cash transactions, the revenue figure reflects amounts due from
customers on accounts receivable as well as equivalent cash values for merchandise or other tangible
items used as payment.
v. Less Sales Returns and Allowances The value of returned merchandise and allowances
made for defective goods must be subtracted from gross sales to determine net sales.
vi. Cost of Goods Sold Cost of goods sold equals the amount of goods available for sale minus
the inventory remaining at the end of the accounting period. (Total goods available =
beginning inventory + cost of purchasing or manufacturing new merchandise during the
accounting period). Cost of goods sold includes all costs directly related to the production of
the product invoiced during the accounting period. businesses generally have no cost of
goods sold.
vii. Gross Profit Service Also called gross margin, this figure is the difference between the cost
of goods sold and net sales (Net Sales - Cost of Goods Sold = Gross Profit). It is the business’s
profit before operating expenses and taxes.
viii. Operating Expenses The expenses of conducting business operations generally fall into two
broad categories: selling and general administrative. Manufacturers normally include some
operating expenses, such as machinery and labor depreciation, as part of cost of sales (Item
5).
ix. Total (Net) Operating Income Total operating expenses are subtracted from gross profit to
show what the business earned before financial revenue and expenses, taxes, and
extraordinary items.
x. Other Revenue and Expenses Income and expenses that are not generated by the usual
operations of a business and that are not considered extraordinary (see Item 11) are

21
 recorded here. Typically included in this category are financial revenue, such as interest
from investments, and financial expenses, such as interest on borrowed capital. (Loan
principal is not considered an expense. It is a liability and is listed as such on the Balance
Sheet).
xi. Pretax Income To derive this figure, also called pretax profit, total financial revenue (minus
total financial expenses) is added to total operating income. Taxes are subtracted from
pretax income if the business is a ‘C’ corporation. Proprietorships, limited liability
companies, and ‘S’ corporations do not pay business taxes on income; the income is
reported on the owners’ personal returns. (For tax planning purposes, accountants estimate
the annual taxes due, then project the monthly portion.)
xii. Extraordinary Gain [Loss] Net of Income Tax [Benefit] Within the framework of an
individual business type and location, any occurrence that is highly unusual in nature, could
not be foreseen, is not expected to recur, and that generates income or causes a loss is
considered an extraordinary item.
The extraordinary gain or loss is shown after calculating tax liability (or tax benefit, as would
be the case with an extraordinary loss) on the Income Statement. Examples: A court award
to a business not previously involved in lawsuits would be an extraordinary gain; a major
casualty would be an extraordinary loss.
xiii. Net Income Also called net profit, this figure represents the sum of all expenses (including
taxes, if applicable). Net income or profit is commonly referred to as the bottom line.
xiv. Earnings per Share Total outstanding common stock (the number of shares currently owned
by stockholders) is divided into net income to derive this figure. It is not applicable to
proprietorships and limited liability companies, but must be shown on the Income
Statements of all publicly held corporations.

3.1.2 Position Statement

Position statement is also called as balance sheet, which reflects the financial position of the firm at the
end of the financial year.
Position statement helps to ascertain and understand the total assets, liabilities and capital of the firm.
One can understand the strength and weakness of the concern with the help of the position statement.

The following terms are commonly found on a balance sheet:

i. Heading The legal name of the business, the type of statement, and the day, month, and
year must be shown at the top of the report.
ii. Assets Anything of value that is owned or legally due the business is included under this
heading. Total assets include all net realizable and net book (also called net carrying) values.
Net realizable and net book values are amounts derived by subtracting from the acquisition
price of assets any estimated allowances for doubtful accounts, depreciation, and
amortization, such as amortization of a premium during the term of an insurance policy.
Appreciated values are not usually considered on Balance Sheets, except, for example, when
you are recording stock portfolio values.
iii. Current Assets Cash and resources that can be converted into cash within 12 months of the
date of the financial position (or during one established cycle of operations) are considered
current. Besides cash (money on hand and demand deposits in the bank, such as regular
savings accounts and checking accounts), these resources include the items listed below.
They are ranked in a generally accepted order of decreasing liquidity--that is, the ease with

22
which the items could be converted to cash. The items that appears on the financial position
of an organization include:
A. Accounts Receivable: The amounts due from customers in payment for merchandise or
services.
B. Inventory: Includes raw materials on hand, work in process, and all finished goods either
manufactured or purchased for resale. Inventory value is based on unit cost and is
calculated by any of several methods (see Inventory Valuation below).
C. Temporary Investments: Interest- yielding or dividend yielding holdings expected to be
converted into cash within a year. Also called marketable securities or short-term
investments, they include certificates of deposit, stocks and bonds, and time deposit
savings accounts. According to accounting principles, they must be listed on the
Financial position at either their original cost or their market value, whichever is less.
D. Prepaid Expenses: Goods, benefits, or services a business pays for in advance of use.
Examples are insurance protection, floor space and office supplies.
E. Long-Term Investments Also called long-term assets, these resources are holdings that
the business intends to keep for a year or longer and that typically yield interest or
dividends. Included are stocks, bonds and savings accounts earmarked for special
purposes.
F. Fixed Assets: Fixed assets, frequently called plant and equipment, are the resources a
business owns or acquires for use in operations and does not intend to resell.
Regardless of current market value, land is listed at its original purchase price, with no
allowance for appreciation or depreciation. Other fixed assets are listed at cost, minus
depreciation. Fixed assets may be leased rather than owned. Depending on the leasing
arrangement, both the value and liability of the leased property may need to be listed
on the Balance Sheet.
G. Other Assets: Resources not listed with any of the above assets are grouped here.
Examples include tangibles, such as outdated equipment which can be sold to the scrap
yard, and intangibles, such as goodwill, trademarks and patents.
H. Liabilities This term covers all monetary obligations of a business and all claims creditors
have on its assets.
I. Current Liabilities All debts and obligations payable within 12 months or within one
cycle of operations are detailed here. Typically, they include the following, which
generally are listed in the order due:
1. Accounts Payable: Amounts owed to suppliers for goods and service purchased in
connection with business operations.
2. Short-Term Debt: The balances of principal due to pay off short-term debt for
borrowed funds.
3. Current Portion of Long-Term Debt: Current amount due of total balance on notes
whose terms exceed 12 months.
4. Interest Payable: Any accrued amounts due for use of both short-and long-term
borrowed capital and credit extended to the business.
5. Taxes Payable: Amounts estimated by an accountant to have been incurred during
the accounting period. For accounting purposes, this total may differ from the actual
tax total required by the Internal Revenue Codes, since taxes payable are based on
accounting income and not taxable income.
6. Accrued Payroll: Salaries and wages currently owed but not yet paid

23
 j. Long Term Liabilities Long-term liabilities are notes, payments, or mortgage payments due over
a period exceeding 12 months or one cycle of operations. They are listed by outstanding balance
(minus the Current Portion due).
k. Equity Also called net worth, equity is the claim of the owner(s) on the assets of the business. In
a proprietorship or limited liability company, equity is each owner’s original investment, plus
any earnings after withdrawals.

In a corporation, the owners are the shareholders--those who have invested capital (cash or
other assets) in exchange for shares of stock. The corporation’s equity is the sum of
contributions plus earnings retained after paying dividends. It is detailed as follows:
i. Capital Stock: The total amount invested in the business in exchange for shares of stock
at value up to the par value. Par is the per-share price assigned to the original issue of
stock, regardless of subsequent selling prices.
ii. Capital Paid-In in Excess of Par: The amount in excess of par value that a business
receives from shares of stock sold at a value above par.
iii. Treasury Stock: When a company buys back its own stock or when a closely held
business buys out other owners. The value of the stock is recorded here and ordinarily
does not receive dividends.
iv. Retained Earnings: The total accumulated net income minus the total accumulated
dividends declared since the corporation’s founding. These earnings are part of the total
equity for any business. However, the figure is usually listed separately from owner
investments only on corporate Balance Sheets which are done for the benefit of
shareholders
L. Total Liabilities and Equity The sum of these two amounts must always equal Total Assets.

3.1.3 Reconciliation of Equity

This statement reconciles the equity shown on the current Balance Sheet. For corporations this
statement is referred to as the Statement of Retained Earnings or Statement of Shareholder Equity.

For limited liability companies it is referred to as the Statement of Members Equity, and for
Proprietorships as the Statement of Owner’s Equity. It records equity at the beginning of the accounting
period and details additions to, or subtractions from, this amount made during the period.

Additions and subtractions typically are net income or loss and owner contributions and/or deductions.

3.1.4 Statement of Cash Flows

The fourth main document of financial reporting is the Statement of Cash Flows. Many small business
owners and managers find that the cash flow statement is perhaps the most useful of all the financial
statements for planning purposes. Cash is the life blood of a small business – if the business runs out of
cash chances are good that the business is out of business. This is because most small businesses do not
have the ability to borrow money as easily as larger business can.

The statement can be prepared frequently (monthly, quarterly) and is a valuable tool that summarizes
the relationship between the Balance Sheet and the Income Statement and traces the

24
3.1.5 Statement of Changes in Owner’s
Equity It is also called as statement of retained earnings. This statement provides information about the
changes or position of owner’s equity in the company. How the retained earnings are employed in the
business concern. Nowadays, preparation of this statement is not popular and nobody is going to
prepare the separate statement of changes in owner’s equity.

3.1.6 Statement of Changes in Financial Position

Income statement and position statement shows only about the position of the finance; hence it can’t
measure the actual position of the financial statement. Statement of changes in financial position helps
to understand the changes in financial position from one period to another period.

Statement of changes in financial position involves two important areas such as fund flow statement
which involves the changes in working capital position and cash flow statement which involves the
changes in cash position.

3.1.7 Notes to Financial Statements

If an important factor does not fit into the regular categories of a financial statement, it should be
included as a note. Also, anything that might affect the financial position of a business must be
documented. Three major types of notes include:
1. Methodology Discussion of the accounting principles used by the company. For example,
accrual basis of accounting vs. cash basis of accounting.
2. Contingent Liabilities Circumstances that have occurred as of the statement date and which
represent potential financial obligations must be recorded by type and estimated amount.
Example: A business owner cosigns a bank note. If the primary borrower should default, the
business owner who cosigned would become liable.
3. Required Disclosures It is necessary that all significant information about the company be
described in a disclosure statement. Example: If the business has changed accounting
procedures since the last accounting period, the change must be described.

3.1.8 Financial Ratios

Financial ratios are a valuable and easy way to interpret the numbers found in statements. Ratio
analysis provides the ability to understand the relationship between figures on spreadsheets. It can
help you to answer critical questions such as whether the business is carrying excess debt or
inventory, whether customers are paying according to terms, and whether the operating expenses
are too high.

When computing financial relationships, a good indication of the company's financial strengths and
weaknesses becomes clear. Examining these ratios over time provides some insight as to how
effectively the business is being operated.

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