Exhaustive Foundations in Financial Management (FFM) Study Notes

Foundations in Financial Management (FFM)

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Working Capital Management: Nature and Ratios

• Definition of Working Capital: Working capital refers to net current assets available for day-to-day operating activities.

  • Components: It typically includes inventories, receivables, and cash (and cash equivalents), less payables.

  • Formula: $\text{Working capital} = \text{receivables} + \text{cash} + \text{inventory} - \text{payables}$

• The Working Capital Cycle: This is an ongoing operating cycle where:

  • Goods are purchased (usually on credit).

  • Goods are stored in inventory.

  • Goods are sold (often on credit).

  • Suppliers are paid.

  • Money is eventually received from customers.

• The Profitability vs. Liquidity Trade-off:

  • Profitability: Profit is earned by non-current assets (e.g., machinery). Working capital does not directly earn profit. Minimizing it theoretically maximizes profit-earning investment.

  • Liquidity: Companies must maintain working capital to allow credit sales (remaining competitive), carry inventory (fulfilling demand), and keep cash balances (paying bills).

  • Management Goal: The financial manager must find the optimal level to balance these competing interests.

• Financing Working Capital:

  • Long-term Finance: Raised from equity (shares) or long-term borrowing.

  • Short-term Finance: Involves overdrafts or delaying payables. It is often cheaper but riskier as it is repayable on demand.

  • The Matching Principle:

    • Permanent Working Capital: The minimum level of working capital that remains fixed in the long term. This should be financed via long-term sources.

    • Temporary Working Capital: Day-to-day fluctuations (e.g., seasonal peak inventory). This should be financed via short-term sources.

• Working Capital Ratios:

  • Liquidity Ratios:

    • $\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$

    • $\text{Quick ratio (Acid Test)} = \frac{\text{Current assets} - \text{inventory}}{\text{Current liabilities}}$

  • Efficiency Ratios:

    • $\text{Inventory turnover} = \frac{\text{Cost of goods sold p.a.}}{\text{Average inventory}}$

    • $\text{Receivables turnover} = \frac{\text{Credit sales p.a.}}{\text{Average receivables}}$

    • $\text{Payables turnover} = \frac{\text{Credit purchases p.a.}}{\text{Average payables}}$

  • Time-Based Measures:

    • $\text{Number of days of inventory} = \frac{\text{Average inventory}}{\text{Cost of sales per day}}$

    • $\text{Receivables days} = \frac{\text{Average receivables}}{\text{Sales per day}}$

    • $\text{Payables days} = \frac{\text{Average payables}}{\text{Purchases per day}}$

The Operating Cycle and Capitalization

• The Operating Cycle (Cash Operating Cycle): The time elapsed between paying for materials and receiving cash from sales.

  • Calculation: $\text{Receivables days} + \text{Inventory days} - \text{Payables days}$

  • Sector Variation: Supermarkets have short cycles (fast sales, instant cash, slow payments to suppliers). Engineering firms have long cycles (high inventory, long credit terms).

• Over-capitalisation: Occurs when working capital levels are excessively high.

  • Risks: High inventory can deteriorate or become obsolete; idle cash is wasteful and could be better used for efficiency-improving equipment.

• Over-trading (Under-capitalisation): Occurs when working capital is too low to support the volume of trade.

  • Implication: Expanding a business requires more working capital. If a company doubles in size and funds non-current assets but neglects inventory/receivables financing, it may face severe liquidity crises involving ballooning overdrafts (e.g., moving from $\$50$ cash to a $\$100$ overdraft despite high profitability).

Inventory Management: EOQ and JIT

• Costs in Inventory Systems:

  • Purchase Cost: Usually constant unless quantity discounts apply.

  • Re-order Cost: Fixed costs per order (admin, delivery), regardless of quantity.

  • Inventory-Holding Cost: Warehousing, insurance, and interest on capital tied up.

• Economic Order Quantity (EOQ): The fixed order quantity that minimizes the sum of annual ordering and holding costs.

  • Formula: $EOQ = \sqrt{\frac{2 \times C_o \times D}{C_H}}$

  • Variables: $C_o = \text{fixed costs per order}$; $D = \text{annual demand}$; $C_H = \text{stockholding cost per unit per annum}$.

• Quantity Discounts:

  • Evaluation Step 1: Calculate EOQ ignoring discounts.

  • Evaluation Step 2: Calculate total annual costs (holding + ordering + purchasing) at the EOQ level.

  • Evaluation Step 3: Recalculate total annual costs at the specific minimum quantity required for the discount.

  • Decision: Select the option with the lowest total annual cost.

• Just-in-Time (JIT): A philosophy of minimizing inventories across finished goods, work-in-progress (WIP), and raw materials.

  • Requirements: Short production cycles, accurate demand forecasting, high-quality production, flexible workforce, and reliable, high-quality suppliers with tight contracts.

  • Risks: Significant risk of production disruption if suppliers fail or quality issues arise, as there is no "buffer" stock.

Accounts Payable and Receivable Management

• Trade Credit Strategy: Taking credit from suppliers provides "free" short-term finance but risks loss of goodwill, supply refusal, or loss of settlement discounts.

• Cost of Refusing a Discount:

  • Concept: If a supplier offers a 2% discount for payment in 10 days instead of 30, the business "invests" 98% of the invoice for 20 days to save 2%.

  • Mathematical Formula for Effective Annual Rate (R): $1 + R = (1 + r)^{\frac{365}{p}}$

  • Variables: $r = \text{rate for the period (discount/amount paid)}$; $p = \text{number of days paid earlier}$.

  • Comparison: If the effective annual cost of the discount (e.g., 24.69%) is higher than the overdraft interest rate (e.g., 13%), the company should borrow to pay early and take the discount.

• Payment Methods: Cash, cheque, standing orders (constant periodic transfer), direct debit (payee-authorized variable transfer), and Electronic Funds Transfer (EFT/internet banking).

Cash Budgeting: Preparation and Statistical Techniques

• Accruals vs. Cash Accounting:

  • Accruals: Matches income and expenditure by time regardless of cash flow.

  • Cash Flow: Vital for survival; profitable businesses can fail if they run out of cash due to heavy capital expenditure, high dividends, or unexpected taxes.

• Differences between Profit and Cash Flow:

  • Receivables/Payables timing.

  • Depreciation (Profit charge only, no cash flow).

  • Non-current asset purchases (Cash outflow only, no immediate profit charge).

  • Share issues and loan repayments (Cash flows only).

• Cash Budget Format:

  • Total Receipts (Cash sales + credit receipts + other income).

  • Total Payments (Cash purchases + credit payments + revenue expenses + capital expenditure + tax + dividends).

  • Net Cash Flow (Receipts - Payments).

  • Balance b/f and Balance c/f.

• Growth Rate Calculation:

  • If a value grows from $P$ to $S$ over $n$ increments, the growth rate $g$ is: $P \times (1 + g)^n = S$

• Least Squares Linear Regression:

  • Equation: $y = a + bx$ ($y = \text{dependent variable (cost)}$, $x = \text{independent variable (output)}$).

  • Formulae:

    • $b = \frac{n \sum xy - \sum x \sum y}{n \sum x^2 - (\sum x)^2}$

    • $a = \frac{\sum y}{n} - b \frac{\sum x}{n}$

• Correlation Coefficient ($r$): Measures the strength of the linear relationship.

  • $+1$ = Perfect positive correlation.

  • $-1$ = Perfect negative correlation.

  • $0$ = No association.

  • Coefficient of Determination ($r^2$): The percentage of variation in $y$ explained by variation in $x$ (e.g., $r = 0.9 \implies r^2 = 0.81 \text{ or } 81\%$

Time Series Analysis and Forecasting

• Elements of Time Series:

  • Trend: The underlying long-term pattern.

  • Cyclical Variations: Long-term wave-like booms and slumps.

  • Seasonal Variations: Regular short-term rise and fall (< 1 \text{ year}).

  • Random Variations: Unpredictable residuals.

• Moving Averages: Used to isolate the trend. Centering is required for even-numbered periods ($n=4$ quarters).

• Additive Model: $\text{Actual} = \text{Trend} + \text{Seasonal Variation}$

• Multiplicative Model: $\text{Actual} = \text{Trend} \times \text{Seasonal Index}$. Used when variations increase proportionally with the trend.

Managing Cash Balances: Treasury and Markets

• The Treasury Function: Manages liquidity, surplus investment, fund raising, credit policy, and financial risk (IRR and Foreign Exchange).

• Centralised vs. Decentralised Treasury:

  • Centralised Advantages: Expert staff, pooling surplus to get better rates, easier matching of foreign currency flows.

  • Centralised Disadvantages: Less local knowledge, possible delays, reduced autonomy for subsidiaries.

• Motives for Holding Cash:

  • Transaction motive: Daily operations.

  • Precautionary motive: Unexpected emergencies.

  • Speculative motive: Taking advantage of opportunities.

• Financial Intermediaries: Banks/Institutions that bridge the gap between lenders and borrowers.

  • Aggregation: Pooling small deposits into large loans.

  • Maturity transformation: Turning short-term deposits into long-term loans.

  • Risk transformation: Minimizing risk for individual depositors via scale and government guarantees.

• Money Market Instruments:

  • Bank Deposits: Term or notice accounts.

  • Certificates of Deposit (CDs): Negotiable receipts for fixed-term deposits.

  • Treasury Bills: Government-issued short-term debt.

  • Repo (Repurchase Agreement): Secured short-term loan where securities are sold and repurchased at a higher "repo rate."

  • LIBOR: London Inter-bank Offered Rate.

• Cash Management Models (Baumol):

  • Determines when to move cash between deposit and current accounts based on the cost of transactions vs. the opportunity cost of holding idle cash.

  • Upper Limit: Maximum cash level.

  • Return Point: Target cash level after adjustment.

Long Term Finance: Shares and Debt

• Equity (Ordinary Shares):

  • Entitled to dividends (variable, non-guaranteed).

  • Voting rights in general meetings.

  • High risk (last in liquidation) but high potential capital gains.

• Preference Shares:

  • Fixed dividend priority over ordinary shares.

  • Cumulative: Unpaid dividends accumulate for future years.

  • Redeemable: Treated as debt; Irredeemable: Treated as equity.

• Debt Finance:

  • Loan Notes/Debentures: Large scale borrowing in units (e.g., $\$100$).

  • Secured: Backed by assets (priority in liquidation).

  • Convertible: Option to convert into equity shares later.

  • Warrants: Gift-voucher-like entitlement to buy shares at fixed prices.

• Stock Markets:

  • Primary Market: Raising new capital via initial listing.

  • Secondary Market: Trading existing shares (liquidity).

  • Methods of Listing: Public offer (Fixed price or Tender), Placing (institutions only), Introduction (listing existing shares).

  • Rights Issue: Offering new shares to existing owners pro-rata below market price to avoid dilution.

• Gearing (Leverage):

  • $\text{Gearing Ratio} = \frac{\text{Debt}}{\text{Equity}} \text{ or } \frac{\text{Debt}}{(\text{Debt} + \text{Equity})}$

  • Impact: Debt is cheaper and tax-deductible, but high gearing makes equity returns (EPS) more volatile and increases risk of failure.

• SME Finance:

  • Funding Gap: The difficulty small/medium firms face in raising capital between family/friends and public listings.

  • Venture Capital: Private equity firms or "Business Angels" seeking high returns ($\approx 30\% \text{ p.a.}$).

  • Other Sources: Hire Purchase (HP), Leasing, Sale and Leaseback, Debt Factoring (admin + collection), and Invoice Discounting (cash advance only).

Money in the Economy and Investment Concepts

• Money Supply: Includes M0 (narrow - cash/operational balances) and M4 (broad - securities/deposits).

• Government Policy:

  • Fiscal Policy: Management of government spending, borrowing, and taxation.

  • Monetary Policy: Management of money supply and interest rates (Quantitative Easing increases supply).

• Inflation Relationship:

  • $1 + \text{Nominal Rate} = (1 + \text{Inflation Rate}) \times (1 + \text{Real Rate})$

• Interest Calculations:

  • Simple Interest: Applied only to the principal.

  • Compound Interest: Applied to principal and accumulated interest.

  • Future Value Formula: $S = P(1 + r)^n$

• Discounting (Present Value):

  • $\text{PV} = \frac{S}{(1 + r)^n} \text{ or } S \times \text{Discount Factor}$

  • Annuity: Constant annual flow for defined years. $\text{PV} = \text{Annual Flow} \times \text{Annuity Factor}$.

  • Perpetuity: Constant annual flow forever. $\text{PV} = \frac{\text{Annual Flow}}{r}$.

Capital Budgeting and Investment Appraisal

• Relevant Cash Flows: Future, incremental, and cash-based. Exclude sunk costs, depreciation, and interest (interest is in the discount rate).

• Appraisal Methods:

  • Accounting Rate of Return (ARR): $\frac{\text{Average Annual Profit}}{\text{Average Investment}}$. Simple but ignores timing and cash flow.

  • Payback Period: Time taken to recoup initial outlay. Focuses on liquidity and risk but ignores total project profitability.

  • Net Present Value (NPV): Total PV of all inflows minus PV of all outflows. Accept if positive. Theoretically strongest method.

  • Internal Rate of Return (IRR): The discount rate where $NPV = 0$.

    • Acceptance: If IRR > \text{Target Rate}.

    • Linear Interpolation Formula: $IRR = A + \left( \frac{NPV_A}{NPV_A - NPV_B} \right) \times (B - A)$

    • Problems: Does not measure absolute value; yields multiple rates for non-normal cash flows (e.g., $-, +, -$).

Legal and Regulatory Frameworks

• Elements of a Contract: Agreement (Offer + Acceptance), Consideration (value exchanged), Intention (legal relations), and Capacity.

  • Termination of Offer: Acceptance, Rejection/Counter-offer, Revocation, Lapse, Death, or failure of condition.

• Misrepresentation: False statement of fact/law inducing a contract. Types: Innocent, Negligent, Fraudulent.

• Remedies for Breach: Damages, Specific Performance (court-ordered compliance), Injunction (ordering non-breach), Quantum Meruit (pay for work done).

• Sale of Goods Rules:

  • Ownership (title) typically passes at contract (Rule 1) or when specific tasks are done (Rules 2-5).

  • Retention of Title (Rompa Clause): Ownership remains with supplier until full payment is received; protects against buyer insolvency.

• Data Protection (GDPR/UK Data Protection Act 2018):

  • Principles: Lawful processing, specified purpose, adequacy, accuracy, limited storage, security.

  • Subject Rights: Fact access, rectification, erasure (the "right to be forgotten"), and portability.

• Credit Management Practicalities:

  • Sources: Financial statements, trade/bank references, credit agencies (e.g., search court judgments), and Companies House.

  • Factoring: "With Recourse" (seller keeps bad debt risk) vs. "Without Recourse" (factor bears bad debt risk).

  • Aged Receivables Analysis: Categorizing debts by age (e.g., <30, 30-60, 60-90, >90 days) to identify problematic accounts.