FINANCIAL MANGEMENT 2 –
IMM GRADUATE SCHOOL
K MELVILLE
,Table of Contents
UNIT 1: THE ROLE OF FINANCIAL MANAGEMENT .................................................................................. 4
Glossary of Terms .................................................................................................................................... 4
Introduction ............................................................................................................................................... 4
Define Financial Management ................................................................................................................. 5
The Financial Manager ............................................................................................................................. 7
The Role of Financial Managers .............................................................................................................................. 7
The Goals of Financial Management ...................................................................................................... 7
The Corporate forms of business in South Africa................................................................................. 8
Sole Proprietorship .................................................................................................................................................. 8
Partnership .............................................................................................................................................................. 9
Company (Private or Public) .................................................................................................................................... 9
Closed Corporations (CC) ....................................................................................................................................... 9
The Agency Problem/ Issue and Agency Costs .................................................................................... 9
Financial Markets and Financial Institutions ....................................................................................... 10
Two Types of Financial Markets ............................................................................................................................ 10
Business Ethics and Corporate Governance....................................................................................... 10
Ethics ..................................................................................................................................................................... 11
Corporate Governance .......................................................................................................................................... 11
Appraising Investment Risk .................................................................................................................. 11
Uncertainty and Risk .............................................................................................................................. 12
Risk VS Return ........................................................................................................................................ 12
Approaches to Risk in Investment Appraisal ...................................................................................... 12
Types of Risk in Investment Projects ..................................................................................................................... 12
UNIT 2: THE FUNDAMENTALS OF TIME VALUE OF MONEY ................................................................. 14
Glossary of Terms .................................................................................................................................. 14
Introduction ............................................................................................................................................. 14
Interest Rates .......................................................................................................................................... 14
Simple Interest ....................................................................................................................................................... 15
Future Value and Compounding of Lump Sums ................................................................................. 15
Future Value and Present Value ............................................................................................................................ 15
Compounding Interest more frequently than annually ....................................................................... 17
Nominal and Effective Interest Rates ................................................................................................... 18
Present Value and Discounting ............................................................................................................. 18
Determining Interest rates ..................................................................................................................... 19
Determining the Number of Periods ..................................................................................................... 19
Valuing Annuities ................................................................................................................................... 20
Perpetuities ............................................................................................................................................. 22
UNIT 3: ANALYSIS OF FINANCIAL STATEMENTS .................................................................................. 23
Glossary of Terms .................................................................................................................................. 23
Introduction ............................................................................................................................................. 23
The Objective of Financial Reporting ................................................................................................... 23
Users of Financial Reporting ................................................................................................................. 24
Information provided by Financial Statements.................................................................................... 24
1
, Qualitative Characteristics of useful financial information ................................................................ 25
Standardisation of Financial Statements ............................................................................................. 25
Statement of Financial Position and Statement of Profit and Loss ................................................... 25
Ratio Analysis – Introduction ................................................................................................................ 26
Types of Ratios ....................................................................................................................................... 27
Profitability Ratios .................................................................................................................................................. 28
Profit Margins ......................................................................................................................................................... 29
Turnover Ratios ..................................................................................................................................................... 30
Liquidity Ratios ...................................................................................................................................................... 33
Solvency Ratios ..................................................................................................................................................... 35
Investment Ratios .................................................................................................................................................. 36
Types of Ratio Comparisons ................................................................................................................. 37
Limitations to using Ratio Analysis ...................................................................................................... 38
Financial Gearing.................................................................................................................................... 38
Additional Notes ..................................................................................................................................... 39
Statement of Financial Position Items ................................................................................................................... 39
Statement of Profit/Loss ........................................................................................................................................ 40
Summary of Ratios ................................................................................................................................................ 40
UNIT 4: SHORT-TERM FINANCIAL DECISIONS ....................................................................................... 42
Glossary of Terms .................................................................................................................................. 42
Introduction ............................................................................................................................................. 42
What is Working Capital? ...................................................................................................................... 42
Net Working Capital................................................................................................................................ 42
The Importance of Managing Working Capital .................................................................................... 43
The Cash Conversion Cycle .................................................................................................................. 43
Managing Cash ....................................................................................................................................... 44
Managing Inventory ................................................................................................................................ 45
Managing Accounts Receivable (debtors) ........................................................................................... 45
Managing Accounts Payable (Creditors).............................................................................................. 46
Cash Budget Example ............................................................................................................................ 46
UNIT 5: LONG-TERM FINANCIAL DECISIONS ......................................................................................... 49
Glossary of Terms .................................................................................................................................. 49
Introduction ............................................................................................................................................. 49
Equity VS Debt ........................................................................................................................................ 50
Equity as a Source of Financing ........................................................................................................... 50
Debt as a Source of Financing .............................................................................................................. 51
Medium-term Finance............................................................................................................................. 52
Pooling of Funds – The Capital Structure ............................................................................................ 53
Cost of Capital ........................................................................................................................................ 53
Non-redeemable preference shares ...................................................................................................................... 54
Redeemable preference shares ............................................................................................................................ 54
The Cost of Debt .................................................................................................................................................... 54
Summary of calculating Cost of Capital ................................................................................................................. 55
.................................................................................................................................................................. 55
Cost of Ordinary Shareholder’s Equity ................................................................................................ 56
2
, Dividends................................................................................................................................................. 56
Weighted Average Cost of Capital (WACC) ......................................................................................... 57
Gearing .................................................................................................................................................... 58
Using WACC in Investment Decisions ................................................................................................. 59
WACC Example ....................................................................................................................................... 59
UNIT 6: LONG-TERM INVESTMENT DECISIONS ..................................................................................... 61
Glossary of Terms .................................................................................................................................. 61
Introduction ............................................................................................................................................. 61
Estimating Relevant Cash Flows .......................................................................................................... 62
Sunk Cost VS Opportunity Costs.......................................................................................................... 62
Investment Evaluation............................................................................................................................ 62
Types of Investments ............................................................................................................................................. 63
The Payback Period Method ................................................................................................................................. 64
The Discounted Payback Period ........................................................................................................................... 65
The Net Present Value Method ............................................................................................................................. 68
The Internal Rate of Return Method ...................................................................................................................... 70
Comparing the Net Present Value & Internal Rate of Return Methods.............................................. 71
So which approach is better? NPV ....................................................................................................... 72
NPV & PBP Example............................................................................................................................... 72
Activities ...................................................................................................................................................... 74
Activity 1 Week 1&2:............................................................................................................................... 74
Activity 2 Week 1&2:............................................................................................................................... 74
Activity 3 Week 1&2:............................................................................................................................... 75
Activity 1 Week 3: ................................................................................................................................... 75
Activity 2 Week 3: ................................................................................................................................... 75
Activity 1 Week 4&5:............................................................................................................................... 76
Activity 2 Week 4&5:............................................................................................................................... 76
Activity 3 Week 4&5:............................................................................................................................... 77
Week 7,8&9:............................................................................................................................................. 77
Activity 1 Week 10&11:........................................................................................................................... 78
Activity 2 Week 10&11:........................................................................................................................... 78
Activity 3 Week 10&11:........................................................................................................................... 78
Activity 1 Week 13&14:........................................................................................................................... 78
Activity 2 Week 13&14:........................................................................................................................... 79
3
IMM GRADUATE SCHOOL
K MELVILLE
,Table of Contents
UNIT 1: THE ROLE OF FINANCIAL MANAGEMENT .................................................................................. 4
Glossary of Terms .................................................................................................................................... 4
Introduction ............................................................................................................................................... 4
Define Financial Management ................................................................................................................. 5
The Financial Manager ............................................................................................................................. 7
The Role of Financial Managers .............................................................................................................................. 7
The Goals of Financial Management ...................................................................................................... 7
The Corporate forms of business in South Africa................................................................................. 8
Sole Proprietorship .................................................................................................................................................. 8
Partnership .............................................................................................................................................................. 9
Company (Private or Public) .................................................................................................................................... 9
Closed Corporations (CC) ....................................................................................................................................... 9
The Agency Problem/ Issue and Agency Costs .................................................................................... 9
Financial Markets and Financial Institutions ....................................................................................... 10
Two Types of Financial Markets ............................................................................................................................ 10
Business Ethics and Corporate Governance....................................................................................... 10
Ethics ..................................................................................................................................................................... 11
Corporate Governance .......................................................................................................................................... 11
Appraising Investment Risk .................................................................................................................. 11
Uncertainty and Risk .............................................................................................................................. 12
Risk VS Return ........................................................................................................................................ 12
Approaches to Risk in Investment Appraisal ...................................................................................... 12
Types of Risk in Investment Projects ..................................................................................................................... 12
UNIT 2: THE FUNDAMENTALS OF TIME VALUE OF MONEY ................................................................. 14
Glossary of Terms .................................................................................................................................. 14
Introduction ............................................................................................................................................. 14
Interest Rates .......................................................................................................................................... 14
Simple Interest ....................................................................................................................................................... 15
Future Value and Compounding of Lump Sums ................................................................................. 15
Future Value and Present Value ............................................................................................................................ 15
Compounding Interest more frequently than annually ....................................................................... 17
Nominal and Effective Interest Rates ................................................................................................... 18
Present Value and Discounting ............................................................................................................. 18
Determining Interest rates ..................................................................................................................... 19
Determining the Number of Periods ..................................................................................................... 19
Valuing Annuities ................................................................................................................................... 20
Perpetuities ............................................................................................................................................. 22
UNIT 3: ANALYSIS OF FINANCIAL STATEMENTS .................................................................................. 23
Glossary of Terms .................................................................................................................................. 23
Introduction ............................................................................................................................................. 23
The Objective of Financial Reporting ................................................................................................... 23
Users of Financial Reporting ................................................................................................................. 24
Information provided by Financial Statements.................................................................................... 24
1
, Qualitative Characteristics of useful financial information ................................................................ 25
Standardisation of Financial Statements ............................................................................................. 25
Statement of Financial Position and Statement of Profit and Loss ................................................... 25
Ratio Analysis – Introduction ................................................................................................................ 26
Types of Ratios ....................................................................................................................................... 27
Profitability Ratios .................................................................................................................................................. 28
Profit Margins ......................................................................................................................................................... 29
Turnover Ratios ..................................................................................................................................................... 30
Liquidity Ratios ...................................................................................................................................................... 33
Solvency Ratios ..................................................................................................................................................... 35
Investment Ratios .................................................................................................................................................. 36
Types of Ratio Comparisons ................................................................................................................. 37
Limitations to using Ratio Analysis ...................................................................................................... 38
Financial Gearing.................................................................................................................................... 38
Additional Notes ..................................................................................................................................... 39
Statement of Financial Position Items ................................................................................................................... 39
Statement of Profit/Loss ........................................................................................................................................ 40
Summary of Ratios ................................................................................................................................................ 40
UNIT 4: SHORT-TERM FINANCIAL DECISIONS ....................................................................................... 42
Glossary of Terms .................................................................................................................................. 42
Introduction ............................................................................................................................................. 42
What is Working Capital? ...................................................................................................................... 42
Net Working Capital................................................................................................................................ 42
The Importance of Managing Working Capital .................................................................................... 43
The Cash Conversion Cycle .................................................................................................................. 43
Managing Cash ....................................................................................................................................... 44
Managing Inventory ................................................................................................................................ 45
Managing Accounts Receivable (debtors) ........................................................................................... 45
Managing Accounts Payable (Creditors).............................................................................................. 46
Cash Budget Example ............................................................................................................................ 46
UNIT 5: LONG-TERM FINANCIAL DECISIONS ......................................................................................... 49
Glossary of Terms .................................................................................................................................. 49
Introduction ............................................................................................................................................. 49
Equity VS Debt ........................................................................................................................................ 50
Equity as a Source of Financing ........................................................................................................... 50
Debt as a Source of Financing .............................................................................................................. 51
Medium-term Finance............................................................................................................................. 52
Pooling of Funds – The Capital Structure ............................................................................................ 53
Cost of Capital ........................................................................................................................................ 53
Non-redeemable preference shares ...................................................................................................................... 54
Redeemable preference shares ............................................................................................................................ 54
The Cost of Debt .................................................................................................................................................... 54
Summary of calculating Cost of Capital ................................................................................................................. 55
.................................................................................................................................................................. 55
Cost of Ordinary Shareholder’s Equity ................................................................................................ 56
2
, Dividends................................................................................................................................................. 56
Weighted Average Cost of Capital (WACC) ......................................................................................... 57
Gearing .................................................................................................................................................... 58
Using WACC in Investment Decisions ................................................................................................. 59
WACC Example ....................................................................................................................................... 59
UNIT 6: LONG-TERM INVESTMENT DECISIONS ..................................................................................... 61
Glossary of Terms .................................................................................................................................. 61
Introduction ............................................................................................................................................. 61
Estimating Relevant Cash Flows .......................................................................................................... 62
Sunk Cost VS Opportunity Costs.......................................................................................................... 62
Investment Evaluation............................................................................................................................ 62
Types of Investments ............................................................................................................................................. 63
The Payback Period Method ................................................................................................................................. 64
The Discounted Payback Period ........................................................................................................................... 65
The Net Present Value Method ............................................................................................................................. 68
The Internal Rate of Return Method ...................................................................................................................... 70
Comparing the Net Present Value & Internal Rate of Return Methods.............................................. 71
So which approach is better? NPV ....................................................................................................... 72
NPV & PBP Example............................................................................................................................... 72
Activities ...................................................................................................................................................... 74
Activity 1 Week 1&2:............................................................................................................................... 74
Activity 2 Week 1&2:............................................................................................................................... 74
Activity 3 Week 1&2:............................................................................................................................... 75
Activity 1 Week 3: ................................................................................................................................... 75
Activity 2 Week 3: ................................................................................................................................... 75
Activity 1 Week 4&5:............................................................................................................................... 76
Activity 2 Week 4&5:............................................................................................................................... 76
Activity 3 Week 4&5:............................................................................................................................... 77
Week 7,8&9:............................................................................................................................................. 77
Activity 1 Week 10&11:........................................................................................................................... 78
Activity 2 Week 10&11:........................................................................................................................... 78
Activity 3 Week 10&11:........................................................................................................................... 78
Activity 1 Week 13&14:........................................................................................................................... 78
Activity 2 Week 13&14:........................................................................................................................... 79
3
