Financial Management

TABLE OF CONTENT

1. INTRODUCTION ...................................................................................................................................... 1
1.1 Capital Requirement of a Corporation ....................................................................................... 1
1.2 Fields of Finance ..................................................................................................................... 3
1.3 Goals of Financial Management ............................................................................................... 4
1.4 Functions of Financial Management .......................................................................................... 5
1.5 Organization of Finance Function ............................................................................................. 7
2. FINANCING DECISIONS ......................................................................................................................... 9
2.1 Short-term financing ................................................................................................................ 9
2.2 Intermediate-Term Financing ................................................................................................. 12
2.3 Long-Term Financing ............................................................................................................ 13
3. FIRM’S FINANCIAL OPERATION ......................................................................................................... 16
3.1 Financial Statement ............................................................................................................... 16
3.2 Financial Analysis ................................................................................................................. 19
4. INVESTMENT POLICY .......................................................................................................................... 22
4.1 The Time Value of Money ...................................................................................................... 22
4.2 Investment Appraisal ............................................................................................................. 24
4.3 Capital Budgeting on Contract Investment: .............................................................................. 28
4.4 A System of Control Levels .................................................................................................... 31
5 WORKING CAPITAL MANAGEMENT.................................................................................................. 35
5.1 Working Capital Policy ........................................................................................................... 35
5.2 Cash & Liquid Management ................................................................................................... 41
5.3 Credit Management ............................................................................................................... 47
5.4 Inventory Management .......................................................................................................... 51

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1. INTRODUCTION

1.1 Capital Requirement of a Corporation

Suppose one is planning to start his own business. No matter what the nature the proposed business is and
how it is organized, he has to address the following questions.
• What capital investment should be made? That is what kind of material and equipment should be
purchased, the type of land to be leased or building to be rented, etc.
• How and where the money to pay for the proposed capital investment will be raised? That is, what will
be the equity and debt mix in the financing plan?
• How the day-to-day financial activities are handled like collecting the receivables and paying the
suppliers?
In the modern society, Financial Management goes beyond answering those fundamental questions. It
assumes the responsibility of dealing with the problems and decisions associated with managing the firm’s
assets that has made it an exciting and challenging area in managing large organizations. Financial decision
making is primarily concerned with developing the skills needed to make correct decisions in a fast moving and
technologically complex corporate environment. Some of these issues include:
• Which new proposals for employing capital should be accepted by the firm?
• What steps can be taken to increase the value of the firm’s common stock?
• How much working capital will be needed to support and expand the company’s operation?
• Where should the firm go to raise the short and long-term capital demand and how much will it cost?
• Should a firm declare a cash dividend on its common stock and if so, how much a dividend should be
declared?
Finance is a specialized functional field of business administration. The term finance can be defined as the
management of the flows of money through an organization, whether it to be a corporation or non-corporate
business or government agency. Finance concerns itself with the actual flow of money as well as any claims
against money.
The flow of funds within a corporation is basically a continuous process, particularly if the corporation has been
in business for a period of time. Fig 1-1 illustrates a typical cash flow diagram with the focal point being the
reservoir of cash. One could see the following as inflow and outflow of cash.
• Cash is raised through equity, debt or through investment by other corporations,
• Cash inflow includes net credit sales, net cash sales and sales of assets,
• Cash is disbursed through purchase of materials, fixed assets, expenses as wages and salaries to
workmen,
• Cash is repaid to stockholders in form of dividends, creditors in the form of loan repayment and also to
other corporations stocks or bonds.
If total cash inflow exceeds all costs (including depreciations) for a given period, then there is a profit for that
particular period, if not there is a loss.

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Stockholders’ Other Corporations, Creditors (Debt)

Equity Businesses and Agencies

Outside Investment Loan Payment Loan

Dividends

Cash
Investment

Collections

Purchase of Sale of Payment of Accounts

Assets Assets Expense Receivables
Payment for
Material

Personal Expenses
Fixed Wages, Benefits
Raw Materials Net Credit Net Cash
Assets & Operating Exp. Sales Sales

Sales
Depreciation Expense
Labor Expense

Work in Process Product Inventories

Fig 1-1 Fund flows of a corporation.

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1.2 Fields of Finance

The academic discipline of financial management may be viewed as being made up of four specialized fields.
In each field, the financial manager is dealing with the management of money and claims against money.
Distinctions arise because different organizations pursue different objectives and do not face the same basic
set of problems.
Four areas of finance:

Fields of finance Fund owned by Fund collected through Use of fund

Public Finance Federal, State and Revenue from taxes and To accomplish Social and
Local Government levies, Loan , Grant etc Economic objectives. Perform
non-profit oriented
corporations.
Finance Securities Individuals, Institutional Purchase and sale of Means of raising finance for
investors stocks and bonds. institutional investors. Means
of achieving profit for
individuals.
International Finance Individuals, businesses Through International Means of collecting foreign
and governments transactions currency.
involved in international
transactions
Institutional Finance Banks, Insurance Individual savers Finance function of the
companies, and economy through capital
pension funds and formation.
credit unions.

Financial Management:
• Studies financial problems in individual firms,
• Seeks sources of low-cost funds
• Seeks profitable business activities.

Debt versus Equity financial securities, a means for raising finance for a corporation.
i) Debt Security. It arises when a firm borrows money from creditors. The firm incurs liability to repay the
amount of money borrowed in some future maturity date.
ii) Equity Security. It represents ownership claim in the firm. People who purchase equity securities are
entitled to rights and conditions that are different from those of firm’s creditors.

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The three forms of financial securities:

a) Bond (Loan): a security representing a long-term promise to pay a certain sum of money at a certain
time or over the course of the loan, with a fixed rate of interest payable to the holder of the bond.
Two forms of bond: Secured bond and unsecured bond.
• Secured bond: Denote borrowings of the firm against which specific collateral have been
provided. Eg. Mortgage bond : secured by a piece of property or building
• Unsecured bond: Borrowings of the firm against which no specific security has been provided.
Eg. Advance payment, inter-corporate borrowings, unsecured loan from banks based on the
good reputation with the firm.

b) Common Stocks (equity): a security representing the residual ownership of a corporation.

• Guarantees only the right to participate in sharing the earnings of the firm if the firm is
profitable,
• Common stockholders have the additional right to vote at stockholders’ meeting on issues
affecting fundamental policies of the corporation,
• They have the right to elect the board members and directors,
• They have the right to inspect the firm’s books and documents.
• Common stockholders are entitled to receive dividends if and only when they are declared by
board members.
• Common stockholders have the right to transfer their ownership by selling their stock with out
the consent of the corporation.

1.3 Goals of Financial Management

The starting for developing a goal-oriented financial structure is the defining of workable goals for the
firm as a whole. Properly defined and understood goals are the key to successfully move a firm to a
future desired position.
Two primary objectives are commonly encountered: Maximization of profits and maximization of wealth.

Profit Maximization:
Fequently stated goal of a firm is to maximize profits. A simple and straight forward statement of
purpose. It is easily understood as a rational goal for business and focuses the firm’s efforts toward
making money.
Profit maximization has several weaknesses.
i) It is vague: Profit in the short run may be quite different from profits in the long run. If a firm
continues to operate a piece of machinery without proper maintenance, it may lower this year’s
operating expenditure and increase profits. But the firm will pay the short run saving in future
years, when the machine is no longer capable of operating due to prior neglect.

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ii) It leaves consideration of timing and duration undefined. There is no guide for comparing profit
now with profit in future or for comparing profit streams of different durations.
iii) It overlooks future aspects.
• Some businesses have placed a high value on the growth of sales and are willing to accept
lower profits to gain stability of the market sales,
• Other businesses recognize diversifying their activities into different products that
strengthen the firm but short-term decline in profits.
• Others firms use a portion of their profits to achieve social goals or to make contributions to
society.

Maximization of Wealth

The second frequently encountered goal of a firm to maximize value of a firm in the long run. The
maximization of wealth is linked with long term profits of the firm. A firm who is maximizing wealth must
do the following.
• Avoid high levels of risk: Projects that promise exceptionally high profits with relatively high
degrees of risk should be avoided.
• Pay consistent dividend: By paying consistent dividends, the firm helps attract investors
seeking cash income, which maintains the market value of the stocks and keep up its present
value.
• Seek growth in sales. As a firm increases its sales and develops new markets for products, it
protects itself against economic recessions, changes in consumer preferences or other
reductions in demand for the firm’s products. However profit may decrease from the additional
cost required for promotion and secure attraction of various customers.
• Maintain market price of stock. A company’s manager can take a number of positive steps to
maintain the market price of the stock at reasonable level by
- taking time to explain company’s actions
- encourage individuals to invest in the firm
- seek sound investments, the firm will appear to be a wise investment choice over the
long-term.
1.4 Functions of Financial Management

Goals of Financial Management Functions of finance

Maximize Profits: Maximize Wealth: achieved
A weak Statement of A good statement of • Liquidity functions
Goal goal • Profitability functions
It is vague, Implies avoiding risk through • Managing funds
Overlooks quality Seeking growth • Managing assets
Ignores timing Paying dividends

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In the context of achieving their goals, financial managers perform tasks in several areas which are referred as
functional areas of finance. This includes:
i) Functions leading to liquidity
This means that the firm has adequate cash on hand to meet its obligations at all times. Stated
Another way, the firm can pay all its bills when due and have sufficient cash to take unanticipated
discounts for large cash purchases.
In seeking sufficient liquidity to carry out the firm’s activities, the financial manger performs the following:
• Forecasting cash flows. Successful day-to day operations require the firm to pay its bills
promptly. This is a matter of matching cash inflows against cash outflows.
• Raising funds. The firm receives finance from a variety of resources. The financial manager
must identify the amount of funds available from each source and the periods when they will be
needed. Then the manager must take steps to ensure that the funds will actually be available
and committed to the firm.
• Managing the flow of internal funds. In a large firm, the financial manager should control and
manage the flow of cash within the different bank accounts for various operating divisions. A
manager can achieve a high degree of liquidity and reduce costs associated with short-term
borrowing by continuously checking the cash level in each bank account and monitor the timely
transfer of cash.

ii) Functions leading to profitability

In seeking profits for the firm, the financial manager shall provide specific input into the decision-
making process based on financial training and actions. Some of his specific functions are the
following:
• Cost Control. Firms require detailed cost accounting systems to monitor expenditures in the
operational areas of the firm. Because of supervising the accounting and reporting functions,
the financial manager is in a position to monitor and measure the amounts of money spent or
committed by the company.
• Pricing. Important decisions by the firm involve pricing established for products, product lines
and services. Determination of the appropriate price should be a joint decision of marketing
and finance. E.g. Reasonable and fair preparation of engineering cost estimates for projects
using the cost break down of activities is important for a firm to achieve profitability. The
financial manager can supply important information about costs, changes in cost, risk and
profit margin in pricing decisions.
• Forecasting Profits. The financial manager is usually responsible for gathering and analyzing
the relevant cost and sales data and forecast profit levels. Before funds are committed to new
projects, the expected profits must be determined and evaluated. Will the profits justify the
initial expenditures?

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• Measuring risk-return of a proposal. Every time when a firm invests, it must make risk-return
decisions. Is the level of return offered by the project adequate for the level of risk therein?

iii) Managing Assets.

Assets are the resources by which the firm is able to conduct business. The term asset includes
buildings, machinery, vehicles, inventory, money and other resources owned by the firm. A firm’s asset
must be carefully managed and a number of decisions must be made concerning their use. The
decision making role crosses liquidity and profitability lines. Converting idle equipment to cash
improves liquidity, reducing costs improves profitability.

1.5 Organization of Finance Function

Although there is no complete agreement, many firms designate three major financial positions in their
corporate structure.
i) Chief Finance Officer: the top financial officer with responsibilities over all financial activities. The
Chief finance officer is accountable for all the firm’s financial activities, including control of funds,
decision making, management and planning. The officer works closely with other members of the
top management team in formulating policies and strategies. He supervises the staff including the
treasurer and controller, who work together closely to monitor the financial impact of operations of
other departments.
ii) Treasurer: The treasurer’s principal responsibilities include:
• Managing the firm’s cash flow
• Forecasting financial needs
• Maintaining relations with financial institutions
• Capital budgeting

iii) Controller: The functions related to management and controls of assets come under the scope of
the controller:
• Financial accounting
• Internal auditing
• Taxation
• Management accounting and control
• Payroll functions

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Chief Finance
Officer

Treasurer Controller

Cash Credit Financial Management

Manager Manager Accounting Accounting
Manager Manager

Capital Fund Tax Data

Budgeting Raising Manager Processing
Manager Manager Manager

Portfolio Internal
Manager Auditor

Figure 1-3 Organization of finance function

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2. FINANCING DECISIONS
Management acceptance of proposal is based not only on the feasibility of the proposals itself in terms of
technical criteria, but on the status of the corporation relative to profitability and risk. Projects require the
acquisition and utilization of manpower, raw material, and fixed assents, such as real state, facilities and
capital equipment. The availability of these resources is dependent on the current cash position of the
corporation and the ability to acquire additional sources of funding for project support. Thus part of the
investment and financing decisions, management should:
• Review the corporation’s profitability and cash position
• Forecast future cash needs,
• Determine possible methods of attaining additional funds through short-term and/or long-term
financing.
In this chapter, we will examine short and long-term financing sources and the corresponding decisions to
raise financial need of firms.
2.1 Short-term financing
Short-term financing usually includes loans that mature within a year or less. Such loans are frequently used to
raise temporary funds to cover seasonal or cyclic business peak or special finding needs involving a short time
frame. Short-term loans are generally self-liquidating, in that the assets acquired with the borrowed money
should be easily convertible to cash with a high degree of certainty.

Long-term financing
Total requirements Decision level
for funds
Fund
(Birr)

Time (Years)

Fig 2-1: Fund requirement.

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Goals of short-term financing:

• Funds are needed o finance inventories during a production/construction period; excessive finds are
on hand once inventories are sold or payments are collected after delivery of services. Short financing
allows the firm to match its funds against its needs over an annual, seasonal or other cyclical period.
• To achieve low-cost financing. The interest-free sources provide low-cost financing for the firm by
reducing its borrowing need from interest-bearing sources.

Short-term financing sources:

i) Unsecured Interest-Free Sources:
Two major sources of short-term financing arise spontaneously from the daily activities of the firm
and have no interest charges associated with them. These are accounts payable and accruals.
• Accounts Payable. Accounts payable are created when the firm purchases raw materials,
supplies or goods for resale on credit terms without signing a formal note for the liability.
These on ‘open account’ or ‘credit invoice’ are for most firms the largest single source of
short-term financing. Payables represent unsecured form of financing since no specific assets
are pledged as collateral for the liability.
• Accruals are short-term liabilities that arise when services are received but payment has not
yet been made. Examples:

Sub-contract works for excavation, masonry works etc.

Salaries/wages payable

Taxes payable
Employees work for 2 weeks or months before receiving a paycheck. These form unsecured
short-term financing for the firm.
• Advance Payment: It is a common practice to pay an advance payment for delivery
engineering services upon signing of contract agreement. Contract stipulations require that an
advance payment amounting to 10-30 % of the contract price to be paid to firm delivering the
services. This is deemed to alleviate the firm’s high financial requirement in connection with
site mobilization at the commencement of the contract works.
• Advance for purchase of materials/ Material on site. Pursuant to the terms of any international
contracts, the contractor is paid after accomplishing and reaching a certain minimal amount of
construction activities/works which are certified through measurement by the Engineer.
Furthermore to alleviate the cash demand of the contractor, he will be paid for the raw
material on site including any transportation cost rendered for consignment to the site.
Sometimes, in order to minimize the time delay arising from cash shortage and assist in
expediting the work progress, Client’s are involved in the purchase of materials or transfer the

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cash to suppliers for the purchase of materials and the corresponding price will be deducted
from the successive payment to be due to the contractor.
ii) Unsecured Interest-Bearing Sources:
A stable and profitable firm can borrow funds from short-term sources at competitive rates of
interest.
• Self-Liquidating Bank Loans. The bank provides finance for an activity that will generate cash
to payoff the loan. Short-term bank loans are generally tied in to the prime rate plus a
premium to reflect the degree of financial risk against the borrower. Three kinds of unsecured
short-term bank loans are commonly used:

Single payment note: lending a business customer with as lump sum repayable with
interest in a single payment and at a specified maturity, usually 30 to 90 days.

Unsecured Overdraft Facility/ Line of Credit: An agreement between Bank and Firm
where by the bank agrees to make available upon demand up to a stipulated
amount of unsecured short-term funds, if the bank has the funs available. It is
normally established as one year and the interest rate is expressed as prime plus
some fixed percentage.

Revolving Credit Agreement: Extended Lines of Credit to avoid the need to
reexamine the credit worthiness of a customer each time a small loan is required.
• Non-bank short-term sources

Commercial Paper/ Bond (Treasury bond): These consist of promissory notes with
maturities of few days say 270 days. Commercial paper is purchased by other firms
that are seeking marketable securities to provide a return on temporarily idle funds.
Individuals, commercial banks, insurance companies, pension funds and other
institutions also purchase the commercial notes.

Private Loans: A short-term unsecured loan may be obtainable from a wealthy
shareholder, a major supplier, or any other party interested in assisting the firm
through a short-term difficulty. This kind of arrangement generally occurs when a
temporary liquidity problem endangers the firm’s operation and their stock in the
company is in jeopardy.

iii) Secured Short-term Sources

A secured loan occurs when the borrower pledges a specific asset, called collateral, to back a
loan. The collateral may be in the form of:
• Warehouse receipt loan: it is a form of short-term financing that is secured by a pledge of
inventory controlled by the lender. The lender which may be a commercial bank or finance
company, selects the inventory that is acceptable as collateral for the loan.

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• Receivables: Receivables are normally quite liquid, they are attractive as collateral to finance
companies. Two techniques of secured short-term financing are commonly employed with
accounts receivable as collateral.
- Pledging of accounts receivable: An assignment is a transfer of claim or right in an
asset from one party to another. By pledging or assigning an account receivable, a
firm gives up the rights to the cash collected on that account.
- Factoring receivables: is the outright sale of the accounts receivable to a factor that
generally accepts all credit risks associated with collection of the accounts.
• Physical assets: Short-term financing by holding physical assets of a company which are
easily convertible to cash.

2.2 Intermediate-Term Financing

It is defined as borrowings with maturities greater than 1 year and less than 5 to 7 years. Many analysts and
accountants ignore the distinction between intermediate and long-term debt. They consider only two kinds of
debt: short-term for maturities of 1 year or less; long-term for maturities in excess of 1 year. When
intermediate-term debt is identified as a separate category, three types are common:
i) Revolving Credit Agreement: This is a guaranteed line of credit whereby the bank agrees to lend
money on demand in a future period, frequently 2 to 3 tears.
ii) Term Loan. This is a loan from bank, finance company, insurance company and other financial
institutions for a period of 1-7 years accompanied with fixed or floating interest rates.
iii) Lease: This is an agreement that allows the use of assets without ownership of the assets. The
owner agrees to allow a user to use the fixed assets in return for a rental payment over a
stipulated period of time.
Intermediate-Term Financing Institutions:
Commercial Bank Loans: These are primary intermediate-term lenders to business firms. Commercial Bank
Loans offer both advantages and disadvantages to firms.
Advantages: Establishing a working relationship with a bank that can result in advice and financial expertise
from the bank’s officer.
Disadvantages: The need to reveal confidential information and the restrictions that may be imposed as part of
the loan agreement.
Insurance Companies: A number of life insurance companies make term-loans to business firms but
concentrate on low risk loans to large and very strong companies only.
Advantage: Insurance company term loans are the longer terms and higher amounts of money as compared to
commercial bank financing.
Disadvantage: slightly higher interest rates are charged and the fact that only the most creditworthy business
can borrow from insurance companies.

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Pension Funds: A minor source of intermediate-term financing is the employee pension funds that make
secured loans to businesses. These loans are frequently secured by mortgages on property and have terms a
nd conditions similar to loans made by life insurance companies.
Equipment Manufacturers: Manufacturers of industrial equipment make loans to assist in the purchase of fixed
assets. The loans may require the firm to make a down payment of 10-30 percent, and the assets must be
pledged and mortgaged to secure the loan.

2.3 Long-Term Financing

Long-term financing usually refers to the borrowing of money for a long period of time in order to invest in fixed
assets relatively permanent in nature with long life. Equity and debt represent the two broad sources of finance
for a business firm. Equity capital refers to ownership money acquired through the sale of common stocks,
preferred stock and retained earnings. Debt refers to borrowed money acquired from term loans and sale of
bonds.
Key difference between equity and debt are:
• Debt investors are entitled to a contractual set of cash flows (interest and principal) whereas
equity investors have a claim of residual cash flows of the firm after it has satisfied all other
claims and liabilities.
• Interest paid to debt investors represents a tax-deductible expense whereas dividend paid to
equity investors has to come out of profit after tax.
• Debt has a fixed maturity whereas equity ordinarily has infinite life.
• Equity investors enjoy the prerogative to control the affairs of the firm whereas debt investors
play a passive role- of course they often impose certain restrictions on the way the firm is run
to protect their interests.
Equity Capital
i) Common Stock: Represents ownership capital as equity shareholders collectively own the
company. They enjoy the rewards and bear the risks of ownership. However, their liability, unlike
the liability of sole proprietors and general partners, is limited to their capital contributions.
Rights and Position of Equity Shareholders:
• Right to income: The equal investors have a residual claim to the income of the firm. The
income left after satisfying the claims of all other investors belong to the equity shareholders.
This income is simply equal to profit after tax minus preferred dividend.
• Right to Control: Equity shareholders as owners of the firm elect the board of directors and
have the right to vote on every resolution placed before the company.
• Pre-emptive Right: It enables existing equity shareholders to maintain their proportional
ownership by purchasing the additional equity shares issued by the firm.
• Right in Liquidation: In the event of liquidation, claims of all others – bondholders, secured and
unsecured lenders, preferred stock – are prior to the claim of equity shareholders.
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Advantages to the firm:

• There is no compulsion to pay dividends, if the firm has insufficiency of cash,
• Equity capital has no maturity date and hence the firm has no obligation to redeem.
• It enhances the creditworthiness of the company. The larger the equity base, the greater the ability of
the firm to raise debt finance on favorable terms.
Disadvantages to the firm:
• Sale of equity shares to outsiders dilutes the control of existing owners,
• The cost of equity capital is high. The rate of return required by equity shareholders is generally higher
than the rate of return required by other investors,
• Equity dividends are paid out of profit after tax, whereas interest payments are tax deductible
expenses.

ii) Preferred Stock: represents hybrid form of financing. It resembles equity in the following ways,

• Dividend is payable only out of distributable profits

• Preference dividend is not an obligatory payment,
• Preference dividend is not a tax-deductible payment
• It is an expensive source of financing.
Preferred Stock is similar to debt in several ways:
• Preference shareholders do not enjoy the right to vote,
• The claim of preference shareholders is prior to the claim of equity shareholders,

iii) Retained Earnings:

Depreciation charges and retained earnings represent the internal sources of finance available to a
firm. If we assume that depreciation charges are used for replacing worn-out plant and equipment,
retained earnings represent the only internal source of financing expansion and growth. Companies
retain 30-80% of profit after tax for financing growth. It is referred as internal equity since it retained
through a sacrifice made by equity shareholders.
Advantages to the firm:
• Retained earnings are readily available. Low-cost to the firm,
• No dilution of control when a firm relies on retained earnings,
• The stock market generally views the equity issue with skepticism. Retained earnings,
however, do not carry any negative connotation.
Disadvantage to the firm:
• The amount that can be raised by way of retained earnings may be limited, because
companies pursue a stable dividend policy,

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• The opportunity cost of retained earnings is quite high. The cost foregone by equity
shareholders is quite high, by not paying dividend.

Long-Term Debt
i) Term Loans: Represents a source of debt finance which is generally payable in 5 to 10 years. They
are employed to finance acquisition of fixed assets and working capital margin.
Advantages of debt financing:
• Debt financing doesn’t result in dilution of control,
• Debt lenders do not partake in the value created by the company except payments of interest
and principal.
• If there is a abrupt decline in the value of the firm, shareholders have the option of defaulting
their debt obligations and turning over the firm to debt lenders.
• Issue costs of debt are significantly lower than those on equity and preferred stock.
Disadvantages of debt financing:
• Debt financing entails fixed interest and principal repayment obligation. Failure to meet these
commitments may cause to bankruptcy.
• If the rate of inflation turns out to be unexpectedly low, the real cost of debt will be greater
than expected.

ii) Bonds/ Debenture/. Corporations, in search for outside funds to support operation and growth, may
initiate a bond issue with the promise of paying the investor (Bond holding firm) a designated interest
on his money at certain scheduled intervals of time. The obligation of a company toward its debenture
holders is similar to that of a borrower who promises to pay interest and principal at specified times.
Bonds often provide more flexibility than term loans as they offer greater variety of choices with
respect to maturity, interest rate, security, repayment and special features.

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3. FIRM’S FINANCIAL OPERATION

3.1 Financial Statement
A financial Statement is a collection of monetary data and information organized according to logical and
consistent accounting procedures. The main purpose is to convey an understanding of some financial aspects
of a business firm. It provides understanding of what happens to the firm’s money as the firm pursues its
business activities.
Uses of Financial Statement
•To present a historical record of the firm’s financial development when complied over a number of
years.
• Used to forecast a course of action for the firm. Financial statement is often prepared for a future
period. It expresses the financial manager’s estimate of the firm’s future performance.
• A means employed by firms to present their financial situations to stockholders, creditors and the
general public.
Major Forms of Financial Statements:
• The Balance Sheet
• The Income Statement ( Profit and loss statement)
• A Flow of Funds Statement
3.1.1 The Balance Sheet
• It shows the financial position of the firm at a moment of reporting,
• It declares the assets, liabilities and equity for the firm at the last day of the accounting period,
• It matches resources (assets) with sources (liabilities and equity).
i) ASSETS: There exist two categories of assets namely: Fixed and Current Assets.
a) Fixed Assets: The assets used by the firm to generate revenues. These assets can not be converted
into cash in the accounting period. This includes:
• Plant & Equipment Cost. This includes building, machinery and other equipments and are
adjusted by the depreciation record.
• Real Estate (if any): This account lists the property owned by the firm. (Land)
b) Current Assets: Contains all assets to be converted into cash within the current accounting period or
within the next year through the ordinary operations of the business.
• Cash and Cash equivalents ( highly liquid investments),
• Marketable Securities: stocks or bonds of other firms that the firm has purchased.
• Receivables: Cash to be gained after the making of sales on credit. ( Work in progress)
• Inventories: goods held by the firm for eventual resale. This includes raw material and goods
tied up in the production process.
ii) LIABILITIES: These are debts of the firm. They represent sources of assets since the firm either

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borrows the money or make use of certain assets that have not yet been paid for. There exist two
forms of liabilities: current liabilities and long-term liabilities.
a) Current Liabilities: debts of the firm that must be paid during the current accounting period. This
includes:
• Accounts payable: when a firm makes purchase on credit,
• Short-term notes payable: promissory notes that mature in one year,
• Other payables: accruals (wages payable), tax liabilities.
b) Long-Term Liabilities: liabilities that will not be paid off during the next year. This includes the long-
Term secured and unsecured financing which covers mortgage and notes where a building or other
Fixed assets are pledged as specific collateral for debts.
iii) EQUITY: Ownership rights in the company and includes:
• Preferred Stock,
• Common Stock,
• Contributed capital in excess,
• Retained earnings.

( Pls refer to samples of balance sheets prepared by some of the local contractors)

3.1.2 The Income Statement

The income statement is a report of a firm’s activities during a given accounting period. Firms often publish
income statements showing the results of each quarter and the full accounting year. It shows the revenues and
expenses of the firm, the effect of interest and taxes and the net income for the period. It may be called as the
profit-and-loss statement or the statement of earnings. The balance sheet offers a view of the firm at a moment
in time, whereas the income statement summarizes the profitability of operations over a period of time. It is an
accounting device designated to show stockholders and creditors whether the firm is making money. It can
also be used as a tool to identify the factors that affect the degree of profitability.
It includes cost accounting of:
• Net sales or construction income or work execution in monetary terms.
• Construction costs/ production costs/ that include the direct costs,
• General and administration costs / overhead costs/
• Interest: the fixed charges paid by the firm on the money that it borrows.
( Pls refer to samples of Income Statements prepared by some of the local contractors)

3.1.3 Flow-Of-Funds Statement

This statement shows the movement of funds into the firm’s current asset accounts from external sources such
as stockholders, creditors and customers. It also shows the movement of funds to meet the firm’s obligation, or
pay dividends. The movements are shown for a specific period, normally the same time period as the firm’s
income statement.

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 Financial Management

Sales of Fixed Sales of stock Debts Funds from

Assets Operations

Working-Capital Pool
(All current accounts)

Marketable
Securities Cash Accounts Receivables

Inventory

Purchase fixed assets Pay Dividends Retire debt Tax, Interest

Fig. 3.1: Sources and uses of funds and the working capital pool.

The difference between sources and uses is shown as an increase or decrease in net working capital. The
pool is a measure of net working capital. If the firm has more funds coming in than going out, net working
capital increases.

Sample on Flow-Of-Funds
1988 1987
Source of funds
Net Income from operations Birr 148,262 Birr 127,065
Noncash expenses 107,296 92,297
Total funds from operations 255,558 219,362

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 Financial Management

Proceeds from long-term borrowing 92,621 41,831

Sales of property 6,101 1,499
Sales of common stock 2,112 1,804

Total sources of Funds Birr 356,392 Birr 264,497

Application of funds
Expenditures for property and equipment Birr 234,511 Birr 174,408
Miscellaneous investments 4,728 3,215
Payments of cash dividends 50,924 48,107
Funds held for plant construction 975 45,378

Total application of funds Birr 291,138 Birr 271,108

Increase (decrease) in net working capital Birr 65,254 Birr (6,611)

3.2 Financial Analysis

If properly analyzed and interpreted, financial statements can provide valuable insights into a form’s
performance. Analysis of financial statements is of interest to:
• Lenders (short-term as well as long-term)
• Investors,
• Security analysts,
• Managers, public and others.
Financial statements analysis is helpful in assessing:
• Corporate excellence,
• Judging creditworthiness,
• Forecasting bond ratings,
• Predicting bankruptcy and assessing market risks.
Financial ratio can be extracted from financial statements for analyzing financial performance. These can be
classified as follows.

Ratio Formula Remarks

Liquidity
• Current ratio Current assets ability of a firm to meet its obligation
Current Liabilities in short-run. Current assets get
converted into cash in the operating
cycle of the firm and provide the funds
needed to pay current liabilities. As a
general rule a 1.5 to 2.0 ratio is
considered acceptable.

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Ratio Formula Remarks

• Acid-test ratio Quick assets (Current assets –Inventories) A more stringent measure of liquidity
Current liabilities than the current ratio. Inventories are
Least liquid of current assets. It
requires a two-step process in order
to be converted into cash. The acid
test is so named because it shows
the ability of a firm to pay its
obligation without relying on the
sale and collection of its inventories.
A 1/1 quick ratio has traditionally
been deemed adequate for most
firms.

Profitability
• Gross profit margin Gross Profit This ratio shows the margin left after meeting
Income production costs. It measures the efficiency
of production and pricing.
• Return on capital employed Net profit A measure of how efficiently the capital is
Current assets employed. A key indicator of profitability of a
Firm. Firms that are efficiently using their
Assets have a relatively high return. Less
efficient firms have a lower return.
• Return on equity Net profit Profit indicator to shareholders. The ratio
Total equity indicates the degree to which the firm is able
To convert equity to generate net profit that
eventually can be claimed by shareholders.

Turnover
• Debtors’ Turnover Net credit sales indicates efficiency of credit management.
Accounts receivables (debtors) the higher the ratio, the more efficient the
Credit management by the firm.

• Total asset Turnover net sales (income) measures how efficiently assets are
Total assets employed.

Leverage
• Debt-equity ratio Debt helps in assessing the risk arising from the
Equity use of debt capital. The lower the debt-
Equity ratio, the higher the degree of
Protection enjoyed by creditors.

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• Interest coverage ratio Profit before tax and interest shows the relationships between
Interest charge debt servicing commitments and
The sources for meeting these
burdens.

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4. INVESTMENT POLICY
Investment (capital budgeting) may be defined as the decision making process by which firms or promoters
evaluate the purchase of fixed assets, including buildings, machinery and equipment. Investment policy
describes the firm’s formal planning process for the acquisition and investment of capital and results in capital
budget for expenditure of money to purchase fixed assets.
Significance of investment
• Substantial expenditure,
• Long Time Periods,
• Implied sales forecasts.
• Investment appraisal
• Planning horizon/ decision regarding return on investments.
4.1 The Time Value of Money
Money has time value. If one is given the choice to receive 100 birr today or 100 birr next year. The individual
will definitely choose 100 birr today. This is because money has value.
• Individuals in general prefer current consumption to future,
• To account for opportunity cost and inflation of money through time. Opportunity cost is a cost
foregone by not using resources at their best possible option.
Financial investments involve cash flows occurring at different points in the time series. These cash flows have
to be brought to the same point of time for purposes of comparison and aggregation.
4.1.1 Present and Future Value of a Single Amount
Compound Interest: refers to the case where interest payment is reinvested to earn further interest in future
periods. The relationship is given by:

FVn = PV (1+r)n
Where, FV: Future Value
PV: Present Value
n: number of years over which the cash flows occurs
r: Interest rate or discount rate.

Simple interest: no interest is earned on the interest. Interest is accounted only for the principal.

FV = PV (1+ nr)

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Compound Interest
FV

Simple Interest

PV

Periods

Eg. If the firm is due to receive Birr 550,000 in 2 years at a time when money is worth 10 percent compounded
annually. What is the present value?

PV = FV / (1+r)n ‘ r’ here designates a discount rate.

PV= Birr 454,545

4.1.2 Present Value of an Uneven Series

In financial analysis, one often comes across uneven cash flow streams. The present value of cash flow
stream –uneven or even- may be calculated as follows:

n
A1 A2 An AT
PVn = +
(1 + r ) (1 + r )2
+ ... + = ∑
(1 + r ) t =1 (1 + r )t
n

At = cash flow occurring at the end of year t

4.1.3 Present Value of Annuity

An annuity is a stream of constant cash flow occurring at regular intervals of time.

 1  1 
PVn = A 1 − 
n 
 r  (1 + r ) 

If a firm is due to receive Birr 400,000 annually for three years with annual discount rate of 10 percent. What is
the present value?
PV = 400,000 (1/0.1) (1-1/ (1.1)3 = Birr 994,741

4.1.4 Future Value of an Annuity

 (1 + r )n − 1 
FVn = A 

 r 

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4.2 Investment AppraisaL=INVESTMENT VALUATION=EVALUATION=ESTIMATING OF HOW MUCH

MONEY IS STH WORTHY.

The decision making processes of determining the economic analysis and financial viability of capital
investments under conditions of certainty. Financial viability analysis values investment proposals toward
meeting the profitability and/or wealth maximization targets of firms or individuals. However economic analysis
in addition, values social and economical costs and benefits of an investment proposal pursuant with local or
national development plan. Often firms and governments have more investment opportunities than financial
resources. Investment analysts should look to the available evaluation methods to distinguish among the
competing proposals and develop a ranking procedure that will determine the method of allocation of capital
funds.
A wide range of methodology has been suggested to judge the worthwhileness of investment projects. The
important investment evaluations from simple to more complex methods are the following.
• Payback Period,
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Cost-Benefit Analysis
• Cost-effective analysis
• Multi-Criteria analysis
• Linear Programming ( e.g. Simplex Methods)
• Dynamic Programming (e.g. Combinatorial Problems).
Under this section, we deal only the top four evaluation techniques.
4.2.1 The Payback Period
The payback period is the length of time required to recover the initial cash outlay on the project. According to
the payback criterion, the shorter payback period, the more desirable the project would be. Firms using this
criterion generally specify the maximum acceptable payback period. If this is ‘n’ years, projects with a payback
period of ‘n’ years or less are deemed worthwhile and projects with a payback period exceeding ‘n’ years are
considered unworthy.
Example of Payback Period:
Year Cash Flow Discounting Present Value Cumulative net
(Birr) Factor (10%) cash
0 -10,000 1.000 -10,000 -10,000
1 3,000 0.909 2,727 - 7,273
2 3,000 0.826 2,478 -4,795
3 4,000 0.751 3,004 -1,791
4 4,000 0.683 2,732 941

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5 5,000 0.621 3,105

6 2,000 0.565 3,130
Looking to the above simple example, the payback period is between 3 and 4 years.
The payback period seems to provide the following advantages:
• Quite simple and readily understood,
• It is a rough and ready method for dealing with risks. It favors projects that generate substantial cash
inflows in earlier years. If risk tends to increase in the future, the payback period may be helpful in
screening risky projects.
• Since it emphasizes earlier cash flows, it may be a sensible method of evaluation for firms pressed
with problems of liquidity.
Major shortcoming:
• It ignores cash flows beyond the payback period. This leads to discrimination against projects which
generate substantial cash inflows in later years. Hence the payback period is a measure of the
project’s capital recovery not profitability.
4.2.2 The Net Present Value (NPV)
The net present value of a project is the sum of the present values of all the cash flows both positive and
negative that are expected to occur over the life of the project.

n n
NPV = ∑ Bt (1 + r ) − ∑ Ct (1 + r )
−t −t

t =1 t =1
Where, Bt = the benefit or return at the end of year t
Ct = the cash outlay or investment at the end of year t
r = the required return
With the NPV method, the cash flows are discounted using the required return as discount rate. If the net
present value is positive, the proposals’ forecast return exceeds the required return and the proposal is
acceptable. If the net present value is negative, the forecast return is less than the required return and hence
the proposal is not acceptable.
The Required Return – Acceptance Criterion
The most important single factor in evaluating proposals is the level of risk inherent in the project and the
required return. If a project offers high risk that the return will not be achieved, the required return on the
project will also be high. The trading off of risk and return is the process that the firm should use in determining
acceptability of its proposals.
Expected Return

Business Risk

Risk less

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Degree of Risk
 Financial Management

To illustrate the net present value assessment of projects, consider the following cash flow streams.

Year Benefit (Birr) Cost (Birr)

0 -- 1,000,000
1 200,000 --
2 200,000 --
3 300,000 --
4 300,000 --
5 350,000 --

200,000 200,000 300,000 300,000 350,000 1,000,000

NPV = + + + + −
(1.1)1 (1.1)2 (1.1)3 (1.1)4 (1.1)5 (1.1)0

NPV = Birr 5,273. The net present value is shown positive with firm’s required return accounted 10% to
compensate for time and risk.
Application:
For investments of large size with longer project life whose future conditions are certain or future potential risks
associated with the project market and finance are predictable. It is useful for comparing mutually exclusive
projects of equivalent size when potentially higher return or profitability is a concern.
4.2.3 The Internal Rate of Return (IRR)
The internal rate of return method calculates the actual rate of return provided by a specific stream of net cash
benefits compared to a specific net cash outlay. It uses a trial-and-error approach to find the discount factor
that equates the original investment to the net cash benefits. In other words, it is the internal discount rate
which equates NPV with zero.

n n

∑ Bt (1 + r ) =∑ Ct (1 + r )
t =1
−t

t =1
−t

The idea is to find ‘r’ that equates benefits with cost outlay. Investment projects that yield higher internal rate of
return as compared with the required rate return by the firm will be accepted and those that fail to meet this
acceptance criterion would be rejected.

NPV

IRR

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Discount Rates
 Financial Management

Example for IRR:

Consider the following cash flow stream:

Year Benefit (Birr) Cost (Birr)

0 -- 100,000
1 30,000 --
2 30,000 --
3 40,000 --
4 45,000 --

The IRR is the value of ‘r’ that satisfies the following equation.

30,000 30,000 40,000 45,000

100,000 = + + +
(1 + r )1 (1 + r )2 (1 + r )3 (1 + r )4
The calculation ‘r’ involves a process of trial and error. Let’s begin with r=15%:
The right hand side provides net present value of Birr 100,802. Since this is higher than the cost, we require
higher discount rate to arrive at the value of 100,000. Try with 16% of discount rate. The value drops to Birr
98,641. We can conclude that the IRR is between 15 and 16%.
Application
Very similar application with NVP except that it is not effective for ranking of competing proposals. Managers
and financial analysts prefer to think of return of projects in terms of IRR to required return. Because this can
easily be related with the expected inflation, current borrowing interest rates, the opportunity cost and so on.
Further more in the absence of required return rate, it is still possible to determine the IRR and analyze the
acceptance range of the project.

4.2.4 The Cost Benefit Ratio

This evaluation method related the benefits with its investment cost:

∑ B (1 + r )
t
−1

CBR = t =1
n

∑ C (1 + r )
t =1
t
−1

When CBR is greater than 1.0, the project accepted and if it is less than 1.0, the project is rejected. This
criterion measures the benefit out of the project per unit of the cost outlay. It is can discriminate better between

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large and small investments. The cost benefit ratio may rank projects correctly in the order of decreasing
efficient use of capital.

4.3 Capital Budgeting on Contract Investment:

Cash flow budgeting, monitoring and control are a natural progression in the functioning of a construction
company. Cash, while being a resource in its own right, is also the means by which other resources are
acquired. The provision of cash in the desired amounts, and at the right time, is one of the most important
aspects of managing a construction company.
The majority of cash flows experienced by a construction company occur as a result of the contractual and
credit arrangements existing on a series of contracts in any trading period. Every contract carried out by a
construction company requires an initial investment which will not be recovered until sometime in the future.
The sources of finance needed to carry out contracts can be divided into two distinct classifications:
• Internal Sources: generated from the company’s operations with in the contract, which are most of the
time ‘locked up’ in a contract from the following two factors:

stage payments as a requirement of the contract itself,

During disagreements that might be a case for many contract.
• External Sources: costing a market interest rate measured by risks perceived by the lenders. This cost
is prepared from the head office.
The important aspect of a construction company, in the establishment of corporate budget planning and
monitoring, is to consider the profitability at the end of the day and evaluate and monitor with the one
anticipated at the time the tender was prepared. The two distinct concepts that affect a company’s profitability:
• The company’s desired return on capital employed (ROCE) and its ability to maintain market share,
• The mark-up on contract costs required to achieve the desired ROCE and its effect on tender success
rates.
4.3.1 Establishing ROCE & Mark-up in the corporate budget planning:
ROCE is a successful measurement of profitability of a company. It represents the return anticipated by the
company in relation with the total capital employed to perform the business. Budget preparation or
performance measurement starts by establishing ROCE. ROCE is determined at the corporate level. The
ROCE will be established to account the following costs:
• The average weighted cost of capital ( Interest of capital employed)
• Profit margin (dividends, capital reserves...)
• Corporate obligations such as taxations and deprecation costs.
• Contingencies to cover uncertainties ( Risks)
Example:
Balance Sheet Summary of a Company:
Fixed Asset: Birr 230,000
Current Assets: Birr 550,000

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Current Liabilities: Birr 450,000

Net Current Assets: Birr 100,000
Total Capital Employed: Birr 330,000
Financed By:
Share Capital: Birr 32,080
Reserves: Birr 132,920
Loans: Birr 153,234
Preference shares: Birr 11,766
Funds Employed: Birr 330,000

The ROCE target can be evaluated as follows:

• The average weighted cost of capital ( Interest of capital employed)………………….8%
• Profit margin (dividends, capital reserves...) …………………………………………….5%
• Corporate obligations such as taxations and deprecation costs………………………..5%
• Contingencies to cover uncertainties ( Risks)…………………………………………….2%
Required ROCE………………………………………………..20%

ROCE = Birr 66,000 ( 20% of Birr 330,000)

Since company cash flow represents a series of aggregated cash flows generated by contracts, The ROCE
shall be collected from the cash flows of the individual contracts through the inclusion of a Mark-up.
Mark-up (Head Office) = Administrative Expenses + ROCE

Administrative expenses (Head Office Expenditure) can be identified within a company’s accounts by items
such as rent, telephone charges, electric bills, office equipment hire charges, payment to staff directors etc.
Often it is established in relation with the total turnover planned in the trading year. If the company mentioned
above is planning for a total turnover of Birr 2,200,000 in the planning year, one can assume a 10% fee as
administrative expenses.
Administrative expense: Birr 220,000

Mark-up = 220,000+ 66,000 =Birr 286,000

This contribution has to be earned from the respective contract investment.

Turnover = ∑ Production Cost of Contract + Mark-up,

Where, Production Cost = Direct cost + Site Overhead Cost

∑ Production Cost of Contract = 2,200,000- 286, 000 = Birr 1,914,000.

This refers to a cost incurred at the site to produce the end deliverables.
Mark-up at individual projects = Birr 286,000/ Birr 1,914,000 = 15%

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 Financial Management

Managements or quantity surveyors need to add 15% to the estimated costs (Direct cost + site overhead
costs) in order to turn an estimate into a tender, in order that general overheads, risks and profit are covered.

4.3.2 The corporate Budget

The corporate budget is the starting point for setting up a monitoring and reporting system. It also becomes the
reference point at the end of a financial year, against which the measurement of financial performance and the
achievement of planned objectives are made. The production of this budget will be a rolling exercise, looking
back at past performance and taking advice from staff. However, the important element of a corporate budget
is that, the company has to prepare cash flow at the corporate level (head office cash flow) to maintain and
secure its commitment to a set of objectives for a given period.
The gross and net cash demand in the planning period has to be collected from the individual contracts. The
administrative expenses should also be identified such that the planner can establish the entire cash flow
expenses, define financing sources at a low cost to the corporate and the right timing for funding the
respective contracts.

Cash Inflow

Time in Months

Max. Capital Required

Cash Outflow

Corporate Budget (Cash Outlay) = Administrative Cost + ∑ Capital Required by Individual Contracts

This has to be balanced with:

Capital Budget (Cash Inflow) = Net Working Capital + Finance Sources (Debt, Sales of stocks, Sales of Fixed
Assets)

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4.4 A System of Control Levels

The estimate should be seen as the starting point for a company’s cost control considerations. If all the tender
sums of contracts are added together, it will represent the company’s turnover for a given tendering period. It
must be stressed that a tender sum and amounts agreed at the final account stage will generally be different
for many reasons. It is important to identify the difference between anticipated turnover and actual turnover.
The cost calculated within the estimate represent ‘cost targets’ against which ‘actual costs’ must be measured,
the outcome of such comparisons represent profit or loss on individual contracts and goes to make up
company’s profit/loss. It is important to establish a strong system of controlling levels, especially if liquidity is to
be managed effectively.

Responsibility Responsibilities Statements used Logical Links

Level

Board/ General Company turnover profitability, Corporate Budget

Management Overhead control systems (Master Budget)
Pay accounts,
Secure work
Manage Contracts

Contracts Management Contract costs (production costs) Contract Budget

Set performance objectives Statement,
Operational Budget,
Control Statement

Site Management Activity costs Activity cost statement,

Operational cost

Control Responsibility Components:

Managing Director Level:

• Major contracts- Production costs
• Administrative expenses
• Return on Contracts Employed (ROCE)
Contracts Management Level:
• Contract 1
• Contract 2 - Production Costs

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• Contract 3
• Contract 4

Site Management Level:

• Labor cost
• Material cost Direct Costs
• Plant cost
Monitoring and Control at Contracts Management Level
It is at this level that the monitoring of actual cash flow on a contract and its comparison with estimated cash
flow takes place. The contract managers have to produce a contract budget statement, operational budget and
control statement with the help of quantity surveyors.

a) Contract 1 Contract Budget Statement /sample Date March 2005

Operations Labor Cost Materials Equipment Sub- Cost Total Value Margin
(Birr) (Birr) Contractor. (Birr) (Tender)
Site overheads

Earth work

Concrete Work

Exterior Walls

Roofing Work

* ** ***
Totals

Information on the first five columns can be driven from the cost break down prepared during estimates.
The last two columns are taken from the tender values.
* Production Cost (Direct Cost + Site Overhead Cost)
** Tender Sum (The price at which the contractor is awarded the contract)
*** Contracts Mark-up by the corporate (Aggregated contract mark-up will cover the administrative expenses
and ROCE of the company)
b) The operational Budget:
Once the contract budget is established, the contract manager should produce the operational budget on
monthly basis using the contract work program. It is worth noting that the statements produced at this level
have two primary functions:
• To provide managers with cost data on a monthly basis,

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• To enable managers at each level to take decisions or implement corrective actions when necessary.

Contract 1 Operational Budget Statement /sample Date March 2005

Operations Budget April, 2005 May 2005 June 2005

Total Cost Value Margin Cost Value Margin Cost Value Margin
Cost (Birr)
Site overheads
Earth Work
Concrete Work
Exterior Walls
Roofing Work

Monthly Totals

Cumm. Totals

The monthly total enables the monthly cost target to be monitored

The Cumulative total enables the total period cost to be viewed.

c) Control Statement:
It is of vital importance that the value of the work carried out is accurately monitored and adequately recorded
and presented for agreement and subsequent payment by the client.
Contract1: Contract Manager’s Control Statement

Item May 2005 Previous Month (April)

Actual Estimated Variance Actual Estimated Variance
Materials Delivered
Materials on site
Materials Fixed
Labour Cost
Plant Cost
Sub-Contractors
Overhead Costs

Contract Cost (Total)

The project manager has to identify the reasons behind why the contract might be under or over-valued:
• Additional order of the client, work change

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• Omission of the original work,

• Design errors , omissions or mistakes of the quantity surveyor
• Contractor’s default by not maintaining quality of work,
• Unforeseen Circumstances, etc.
Once a variation has occurred it is important that it is first identified. Agreement that it has caused a
change in the nature of the work must be sought and from this a valuation must be made to ensure that
payment is issued to adequately maintain cash flow in a contract.

Monitoring and Control at Site Level

The final control aspects to consider are control and reporting at site level. At site level, the site engineer is
interested in the cost efficiency of each individual activity. The concern is for comparison of resource costs,
labor, materials and plant included in the estimates for cost units, with those actually incurred and recorded on
labor allocation sheets, material invoices and plant returns.

Site Manager’s Control Statement

Activity Quantity Unit Rate Value Labor Plant Material

Est. Cost Act. Cost Est. Cost Act. Cost Est. Cost Act. Cost

Earth Work

Concrete Work

Exterior Walls

Roofing Work

Finishing Work

Total

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5 WORKING CAPITAL MANAGEMENT

5.1 Working Capital Policy
One of the most important areas in the day-to-day management of the firm deals with the
management of Working Capital, which is defined as all the short term assets used in daily
operations. As discussed in the previous chapters, the key difference between long-term financial
management and short term financial management (also referred as working capital management) is
in terms of the timing of cash. While long term financial decisions like buying capital equipment,
building structures or issuing debentures involve cash flows over an extended period of time, short
term financial decisions typically involve cash flows within a year or within the operating cycle of
the firm.
There are two concepts of working capital: gross working capital and net working capital. Gross
working capital is the total of all current assets. Net working capital is the difference between
current assets and current liabilities. The constituents of current assets and current liabilities are
shown hereunder.
Current Assets: Liquidating assets in the accountable period
• Inventories that comprise
 Raw materials and components
 Work in progress
 Finished goods
• Trade debtors ( Accounts receivable)
• Cash and marketable securities
Current Liabilities: Cash or services delivered in advance but repayment not yet effected.
• Sundry creditors ( Accounts payable)
• Trade advances
• Short term borrowings
• Accruals, deferred tax etc,
Working capital management is the functional area of finance that covers all the current accounts of
the firm. It is concerned with the adequacy of current assets as well as the level of risk posed by
current liabilities. Arranging short term financing, negotiating favorable credit terms, controlling the
movement of cash, administering accounts receivable and monitoring the investment in inventories
consume a great deal of time of financial managers. It is a discipline that seeks proper policies for

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managing current assets and liabilities and practical techniques for maximizing the benefits from
managing working capital.

5.1.1 Characteristics of Current Assets

In the management of working capital, two characteristics of current assets must be borne in mind:
• Short life span,
• Swift transformation into other asset forms.
Current assets have a short life span. Cash balances may be held idle for a week or two, accounts
receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to 100 days.
The life span of current assets depend upon the time required in the activities of procurement,
production, sales and collection and the degree of synchronization among them.
Each current asset is swiftly transformed into other asset forms: cash is used for acquiring raw
materials; raw materials are transformed into finished goods ( these transformation may involve
several stages of work in process); finished goods generally sold on credit basis are converted to
accounts receivable; and finally accounts receivable, on realization, generate cash. Fig 5.1 shows
the cycle of transformation of current assets.

Finished Goods

Accounts
Receivable Work in Progress

Wages, Salaries,
Overheads

Raw Materials

Cash Suppliers

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Fig 5.1 Current Asset Cycle

5.1.2 Operating Cycle and Cash Cycle

Investments in working capital are influenced by four key events in the production and sales cycle
of the firm:
• Purchase of raw materials,
• Payment for raw materials,
• Sale of finished goods
• Collection of cash sales.
Fig 5.2 depicts these events on the cash flow line. The firm begins with the purchase of raw
materials which are paid for after a delay which represents the accounts payable period. The firm
converts the raw materials into finished goods and then sells the same. The time lag between the
purchase of raw materials and the sale of finished goods is the inventory period. Customers pay the
bills some time after the sales. The period that elapse between the date of sales and the date of
collection of receivables is the accounts payable period. The time that elapse between the purchase
of raw materials and the collection of cash for sales is referred to as the operating cycle, whereas the
time length between the payment for raw material purchases and the collection of cash for sales is
referred to as the cash cycle. The operating cycle is the sum of the inventory period and the
accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts
payable period.

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Order Cash
Received
Stock
arrives

Inventory Period Accounts Receivable

Accounts Payable

Credit Cash paid for

Invoice Materials

Operating Cycle

Cash Cycle

Fig 5.2 Operating and Cash Cycle

From the financial statement of the firm, one can estimate the inventory period, the accounts
receivable period and the accounts payable period.

Acc. Receivable Period (days) = Accounts Receivable ($)/ (Annual Sales ($)/ 365 days)
Acc. Payable Period (days) = Acc. Payable ($) / (Annual Cost of Goods ($)/ 365 days)
Inventory Period (days) = Inventory ($)/ (Annual Cost of Goods sold ($)/365 days)

For the example below, estimate the operating and cash cycle of the firm given the following data
taken from the financial statement.
• Annual Sale: Birr 500 million
• Total cost of goods sold: Birr 360 million
• Inventories: Birr 60 million
• Accounts Receivables: Birr 80 million
• Accounts Payable: Birr 50 million

Solution:
Accounts Receivable = (80/ 500) X 365 = 58 days
Accounts payable = (50/ 420) X 365 = 43 days
Inventory Period = (60/ 420) X 365 = 52 days.
Operating Cycle = 52 + 58 = 110 days

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Cash Cycle = 110- 43 = 67 days.

5.1.3 Factors Affecting Working Capital Requirements

The working capital needs of a firm are influenced by numerous factors. The important ones are:
i) Sales Volume: A firm maintains current assets because they are needed to support the
operational activities that culminate in sales. Over time, a firm will keep a fairly steady rate of
current assets to annual sales. A firm realizing a steady level of sales operates with a fairly constant
level of cash, receivables, and inventory, if properly managed. Firms experiencing growth in sales
require additional working capital. If sales are declining, a reduction in working capital can be
expected.
ii) Nature of Business: The working capital requirement of a firm is closely related to the
nature of its business. A service firm with a short operating cycle and which sells predominantly on
cash basis has modest working capital requirement. On the other hand, a firm which has a long
operating cycle and which sells largely on credit has a very substantial working capital requirement.
iii) Production Policy: A firm marked by pronounced seasonal fluctuation in its sales may
pursue a production policy which may reduce the sharp variations in working capital requirements.
Foe example, a manufacturer of ceiling fans may maintain a steady production throughout the year
rather than intensify the production activity during the peak business season. Such a production
policy may dampen the fluctuations in working capital.
iv) Market Conditions: The degree of competition prevailing in the market place has an
important bearing on working capital needs. When competition is keen, a larger inventory of
finished goods is required to promptly serve customers who may not be inclined to wait because
other manufacturers are ready to meet their needs. Further, generous credit terms may have to be
offered to attract customers in a highly competitive market. Thus working capital needs tend to be
high because of greater investment in finished goods inventory and accounts receivable.
v) Conditions of Supply: The inventory of raw materials, spares and stores depend on the
conditions of supply. If the supply is prompt and adequate, the firm can manage with small
inventory. If, however the supply is unpredictable and scant with the firm, to ensure continuity of
production, the firm would have to acquire stocks as and when they are available and carry large
inventory on average.

5.1.4 Cash Requirement for Working Capital

As a finance manager, one will be interested in figuring out how much cash to be arranged to meet
the working capital need of the firm. To do this, two step procedures shall be followed:

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Step 1: Estimation of the cash cost of various current assets require by the firm:
This follows to estimate the following:
• Cash cost of debtors (receivables) by removing the profit element (ROCE),
• Raw materials in stock
• Finished goods in stock
• Cash balance
Step 2: Deduct the current liabilities from the cash cost of current assets:
A portion of the cash cost of current assets is supported by trade credit and accruals of wages and
expenses, which may be referred to as spontaneous current liabilities. The balance left after such
deduction has to be arranged from other sources.
Example: Given the following annual figures of a firm:
• Annual sales ( Two months credit is given) : Birr 240 million
• ROCE: 20%
• Material cost (Suppliers give three months credit): Birr 72 million
• Wages ( wages are paid with one month arrears): Birr 48 million
• Manufacturing Expense (Plant expense) paid in one month arrears: Birr 48 million
• Administrative expenses (Paid as incurred) : Birr 32 million
• The firm keeps two months’ stock of raw materials and one month’s stock of finished goods.
• The firm wants to maintain a cash balance of Birr 5 million.
• Neglect work in progress
Estimate the working capital requirement of the project.
Solution:
Given cost of sale = Birr 200 million
ROCE = Birr 40 million
Step1: Current Assets:
• Receivables = (200/12) x 2 = Birr 33.33 million
• Raw material in stock = (72/12) x 2 = Birr 12 million
• Finished goods = (168/12) x 1 =Birr 14 million
• Cash Balance = Birr 5 million
Total Current Assets = Birr 64.33 million

Step 2: Current Liabilities

• Sundry creditors = (72/12) x 3 = Birr 18 million
• Wages = ( 48/12) x 1 = Birr 4 million
• Plant expense = (48/12) x 1 = Birr 4 million

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Total current liabilities = Birr 26 million

Working Capital requirement = Birr 64.33 million – Birr 26 million = Birr 38.33 million
Birr 38.33 million should be arranged from other financial sources.

5.2 Cash & Liquid Management

In a financial sense, the term cash refers to all money items and sources that are immediately available to help
pay a firm’s bill. Cash, the most liquid asset, is of vital importance to the daily operations of business firms. On
the balance sheet, cash assets include deposits in financial institutions and cash equivalents in money market
funds or marketable securities. All highly liquid short-term securities are treated as cash.
Three securities are widely used as short-term investments and alternative forms of cash. Each security offers
different characteristics that make it suitable for different firms.
i) Treasury Bills: A treasury bill is an unconditional promise by Government’s Treasury Agent to pay to
the holder of the bill a specified amount at maturity. Treasury bills are issued for short periods of time, normally
3, 6 or 12 months. Two characteristics of treasury bills should be noted:
• Non interest bearing: Treasury bills are sold at a discount on a bid basis, mainly to security dealers
and large commercial banks, who resell them to individuals and firms.
• Most secure and liquid marketable security: Treasury bills are most secured and liquid kind of
marketable security because government guarantees their redemption.
ii) Commercial Paper: Commercial paper represents short term unsecured promissory notes issued by
firms that are generally considered to be financially strong. Commercial paper usually has a maturity period of
90 days or 180 days. They are purchased by individuals or other firms with excess cash that have a desire to
earn a higher yield than available from treasury bills. In turn for the higher yield, the firm accepts slightly
greater risk and less liquidity.

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iii) Certificates of Deposit: A certificate of deposit represents a negotiable receipt of funds deposited in a
bank for a fixed period. The bank agrees to pay the bearer the amount of the deposit plus a stipulated amount
of interest at maturity. Certificate of deposits are a popular form of short term investment for companies since
they are fairly liquid, generally risk free and offer a higher rate of interest than treasury bills.
5.2.1 How large a cash balance is needed?
The size of a firm’s cash balance depends basically upon the three major reasons for liquidity. This includes:
i) Transaction needs: A firm needs cash to carry out the day-to-day functions of the business. Just
as the firm’s level of operations affects working capital requirements, it affects the need for cash. If
the volume of sales increases, cash will be received from customers and will be expended for
materials and wages in large amounts. Adequate cash to cover these and other transactions allow
the firm to pay its bills on time.
ii) Contingency needs: If the firm could perfectly forecast its needs for cash, it would not have to be
concerned with unexpected occurrences or emergencies that require cash. Because this is not
possible, the firm must be prepared for contingencies.
iii) Opportunity needs: These involve the chance to profit from having cash available. For example, a
supplier may have several cancellations of orders and may wish to move a large unwanted
inventory of raw materials from his warehouse. If the supplier offers a large discount for cash
purchasing of the materials, the firm will have the opportunity to realize a substantial savings on its
purchase and, hence, profits from the sale of the finished goods.
5.2.2 Forecasting Cash Flow
Once the financial manager has identified the firm’s policies on cash flow management, he must face the
problem of predicting the amounts and timing of future inflows and outlays of cash. This is a difficult process
for most firms because cash flows are affected by many factors. The failure to prepare for the proper level of
cash poses three risks to the company:
i) Default: The failure to pay interest or principal payments on a firm’s borrowings or failure to perform as
per contract is a default, a situation that may result in legal actions by the firm’s creditors.
ii) Overdue Bills: The failure to pay short-term obligations, such as payables, is less serious than default
but may result in a lowering of the firm’s credit rating in the business community. This may be accompanied by
higher interest rates when the firm applies for loans or may cause creditors to refuse to ship supplies on credit.
iii) Lost Savings on Purchases: Inadequate cash may cause the firm to lose opportunities to make special
cash purchases or to take generous trade discounts on purchases of goods.
In attempting to minimize these risks, the firm pursues the twin goals of cash forecasting, namely:
• Liquidity: By predicting cash surpluses or cash shortages, the firm achieves liquidity- sufficient money
in the bank to pay debts as they come due.

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• Profitability: Accurate cash forecasting achieves profits by allowing the firm to take profitable discounts
on purchases, invest surplus funds, or reduce the costs of maintaining idle cash balances.

Example: On Cash flow forecast & Working Capital

Given the following information for a construction project:
• A contract budget has been prepared and the monthly evaluation forecasts are as indicated
hereunder:
Month 1 2 3 4 5 6

Monthly Value (Birr) 8,000 10,000 12,000 14,000 10,000 6,000

• Profit included in the estimate is 12 %

• Payments are to be made monthly within 28 days
• Retention money for every monthly payment – 3 % where 1.5% will be released during the completion
period and the remaining at the expiry of defects liability period.
• Defects liability period – 6 months
• No advance payment
• 5 % of the total project cost is used as mobilization cost.

i) Prepare the gross and net cash requirements for the project.
ii) Assuming even contract budget throughout the contract period, estimate the working capital.
• Material on site to be considered in the payment as delivered to the site: 50% of production cost
• Wages and plants : every month amounting to 40% of production cost
• Overhead cost 10%
Solution:
i) Cash flow forecast:

1) Cumulative contract value forecast from the monthly value forecast.

Months 1 2 3 4 5 6
Cumulative
Forecast (Birr) 8,000 18,000 30,000 44,000 54,000 60,000

2) Cumulative self-cost of contract & expenditure:

Cumulative self-cost = Cumulative contract value – profit release- mobilization cost

Months 1 2 3 4 5 6
Cumulative self-cost

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(Birr) 6,640 14,940 24,900 36,520 44,820 49,800

Cumm. Expenditure = Cumulative self-cost + mobilization

Months 1 2 3 4 5 6
Cumm.Expenditure
(Birr) 9,640 17,940 27,900 39,520 47,820 52,800
3) Cumulative Income
Monthly Income Forecast: It can be determined from cumulative contract value forecast subject to deductions
as retention money, advance payment and any previous payments.
Income month( i+1) = Cumm. Contract Value month( i) – retention – previous payments
Income month (2) = 8,000 – 0.03( 8,000) -0 = Birr 7,760
Income month (3) = 18,000 – 0.03 ( 18,000) – 7,760 = Birr 9,700
Income month (4) = 30,000 – 0.03( 30,000) – (7,760+9,700) = Birr 11,640
Income month (5) = 44,000 – 0.03( 44,000) – ( 7,760 +9,700+11,640) = Birr 13,580
Income month (6) = 54,000 – 0.03 (54,000) – (7,760+9,700+11,640+13,580) = Birr 9,700
Income month (7) = 60,000- 0.015(60,000) – (7,760+9,700+11,640+13,580+9,700) = Birr 6,720
Income month (12) = 0.0015 (60,000) = Birr 900

Cumulative Income:
Months 1 2 3 4 5 6 7 12
Monthly Income (Birr) 0 7,760 9,700 11,640 13,580 9,700 6,720 900
Cumm. Income (Birr) 0 7,760 17,460 29,100 42,680 52,380 59,100 60,000

4) Gross and Net Cash Requirements

et cash required (monthly) = Cumm. Income after receipt of each monthly payment - Cumm. Expenditure
Gross cash required (monthly) = Cumm. Income prior to receiving monthly payment - Cumm. Expenditure
Months 1 2 3 4 5 6 7 12
Net Cash Req’d (Birr) -9,640 -10,180 -10,440 -10,420 -5,140 -420 6,300 7,200
Gross cash Req’d (Birr) -9,640 -17,940 -20,140 -22,060 -18,720 -10,120 -420 6,300

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Value (Birr)

60000
Expenditure

Value Forecast
Income/ Revenue

30000

0
1 2 3 4 5 6 7 Time, months

Fig 5.3a Cash Flow Forecast

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Cash (Birr)

+ 30000

Self-Financing Date

Surplus

1 2 3 4 5 6 7 Time, Months

Short
Fall
Gross Cash Requ’t
Net Cash Requ’t

-30000 Max. Capital Required

Fig 5.3b Gross and Net Cash Requirements.

ii) Working Capital Requirement:

Given cost of sale = Birr 52,800
ROCE = Birr 7,200
Step 1: Current Assets
• Receivables: (52,800/6) x 1 = Birr 8,800
• Raw material on stock= ((0.5 x 52,800)/6) x 1 = Birr 4,400
Total current assets = Birr 13,200

Step 2: Current Liabilities

• Wages and plant cost = (( 0.4 x 52,800)/ 6) x 1 = Birr 3,520
• Raw material (( 0.5 x 52,800)/6) x 1 = Birr 4,400
Total Current liabilities = Birr 7,920
Working capital Requirement = Birr 5,280 monthly.

iii) Working Capital assuming 20% advance payment.

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5.3 Credit Management

While business firms would like to sell on cash, the pressure of competition and the force of custom persuade
them to sell on credit terms. Firms grant credit to facilitate sales. It is valuable to customers as it augments
their resources. It is particularly appealing to those customers who cannot borrow from other sources or find it
very expensive or inconvenient to do so. The credit period extended by business firms usually ranges from 15
to 60 days. When goods are sold on credit, finished goods get converted into accounts receivable (trade
debtors) in the books of the seller. In the books of the buyer, the obligation arising from credit purchase is
represented as accounts payable (trade creditors).
A firm’s investment in accounts receivable depends on how much it sells on credit and how long it takes to
collect receivables. For example, if a firm sells Birr 1 million worth of goods on credit a day and its average
collection period is 40 days, its accounts receivable will be Birr 40 million.
5.3.1 Terms of Payment
Terms of payment vary widely in practice. At one end, if the seller has financial sinews it may extend liberal
credit to the buyer till it converts goods bought into cash. At the other end, the buyer may pay cash in advance
to the seller and finance the entire trade cycle. Most commonly, however, some in between arrangements is
chosen wherein the trade cycle is financed partly by the seller, partly by the buyer, and partly by some financial
intermediary. The major terms of payment are discussed below:

Order Delivery Sale

Cash Terms Credit Terms

Converted to cash
Cash in Cash on
Advance Delivery

Fig 5.4 Terms of Payment

i) Cash Terms: When goods are sold on cash terms, the payment is received either before the goods
are shipped (cash in advance) or when the goods are delivered (cash on delivery). Cash in advance is
generally insisted upon when goods are made to order. In such a case, the seller would like to finance
production and eliminate marketing risks. Cash on delivery is often demanded by the seller if it is in a strong
bargaining position and/or the customer is perceived to be risky.

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ii) Credit Terms:

• Open Account: Credit sales are generally on open account. This means that the seller first ships the
goods and then sends the invoice. The credit terms (credit period, cash discount for prompt payment,
the period discount, and so on) are stated in the invoice which is acknowledged by the buyer.
• Bill of exchange: A more secure arrangement that represents an unconditional order by the seller
asking the buyer to pay on demand or at a certain future date, the amount specified on it. It is typically
accompanied by shipping documents that are delivered to the buyer when he pays or accepts it. The
bill of exchange performs three useful functions:
 It serves as a written evidence of a definite obligation
 It helps in reducing the cost of financing to some extent,
 It represents a negotiable instrument.
• Consignment: When goods are sent on consignment, they are merely shipped but not sold to the
consignee. The consignee acts as the agent of the seller. The title of the goods is retained by the
seller till they are sold by the consignee to the third party.
• Letter of Credit (L/C): Commonly used in international trade. A letter of credit is issued by a bank on
behalf of its customer to the seller. As per this document, the bank agrees to honor drafts drawn on it
for the supplies made to the customer if the seller fulfills the conditions laid down in the L/C. The L/C
serves several useful functions:
 Virtually eliminates credit risk,
 Reduces uncertainty as the seller knows the conditions that should be fulfilled to receive
payment,
 Offers safety to the buyer who wants to ensure that payment is made only in conformity with
the conditions of the L/C.
5.3.2 Costs of Maintaining Receivables:
As with all assets and operations, the willingness to allow credit sales involve certain costs. These include:
i) Financing the Receivables: Carrying accounts receivables ties up a portion of the firm’s financial
resources seeking for addition in working capital. These resources must be financed from other sources such
as past profits retained in the business, contributed capital from owners and debt from creditors.
ii) Administrative and Collection Expenses: To keep records on credit sales and payment and the efforts
made to aware and push debtors to settle their payments incurs additional cost to the firm. In addition, most
firms conduct investigations of potential credit customers to determine their creditworthiness. These and other
expenses, such as telephone charges and postage constitute the administrative and collection costs of
maintaining receivables.
iii) Bad Debt Loss: After making serious efforts to collect on overdue accounts, the firm may be forced to
give up. If a customer declares bankruptcy, no payment may be forthcoming. If the customer leaves the city or

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state, it may be too costly to trace him and demand payment. In these cases, the firm is forced to accept a bad
debt loss on the account.
5.3.3 Policies for Managing Receivables
The firm should establish its receivable policies after carefully considering both the benefits and costs of
different policies:
i) Profit: The firm should investigate different possibilities and forecast the effect of each on its future
profits. The cost of funds tied up in receivables, collection costs, bad debt losses and money lost with
discounts for early payment should be compared with additional sales as a consequence of the proposed
policy.
Degree of relaxing the credit policy as determined by residual income may be estimated as follows:
∆R = ∆S ( p ) − ∆S (r ) − ∆I (k )

∆R : Residual Income
∆S ( p ) : Profit from change in sale
∆S (r ) : Bad debt loss
∆I (k ) : Opportunity cost of additional funds locked in receivables.
p, r ,&k : Multiplying factors for profit, bad debt loss and opportunity cost respectively.

ii) Growth in sales: Sometimes firms are willing to accept short term setbacks with respect to profits if a
new policy enables the firm to increase its sales significantly. Because growth is so important aside from
profits, it should be viewed as a separate factor in determining receivable policies.
5.3.4 Credit Policy Variables
The important dimensions of a firm’s credit policy are credit standards, credit period, cash discount and
collection effort. These variables are related and have a bearing on the level of sales, bad debt loss, discounts
taken by customers, and collection expenses.
i) Credit Standards: A pivotal question in the credit policy of a firm is: What standard should be applied
in accepting or rejecting an account for credit granting? A firm has a wide range of choice in this respect. At
one end of the spectrum, it may decide not to extend credit to any customer, however strong his credit rating
may be. At the other end, it may decide to grant credit to all customers irrespective of their credit rating.
Between these two extreme positions lie several possibilities, often the more practical ones.
In general, liberal credit standards tend to push sales up by attracting more customers. This is, however,
accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of
collection. Stiff credit standards have the opposite effects. They tend to depress sales, reduce the incidence of
bad debt loss, decrease the investment in receivables and lower the collection cost.

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ii Credit Period: The credit period refers to the length of time customers are allowed to pay for their
purchases. When a firm does not extend any credit, the credit period would obviously be zero. Lengthening the
credit period pushes sales up by inducing existing customers to purchase more and attracting additional
customers. This is, however, accompanied by a larger investment in debtors and a higher incidence of bad
debt loss. Shortening of the credit period should have an opposite effect. It tends to lower sales, decrease
investment in debtors, and reduce the incidence of bad debt loss.
iii) Cash Discount: Firms generally offer cash discounts to induce customers to make prompt payments.
The percentage discount and the period during which it is available are reflected in the credit terms. For
example, credit terms of 2/10, net30 mean that a discount of 2 percent is offered if the payment is made by the
tenth day; otherwise the full payment is due by the thirteenth day.
Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the discount
period is lengthened. Such an action tends to enhance sales, reduce the average collection period and
increase the cost of discount.
iv) Collection Effort: The collection program of the firm, aimed at timely collection of receivables may
consist of the following:
 Monitoring the state of receivables,
 Dispatch of letters to customers whose due date is approaching,
 Electronic and telephonic advice to customers around the due date,
 Threat of legal action to overdue accounts,
 Legal action against overdue accounts.
A rigorous collection program tends to decrease sales, shorten the average collection period, reduce bad debt
percentage and increase the collection expense. A lax collection program, on the other hand, would push
sales up, lengthen the average collection period, increase the bad debt percentage and perhaps reduce the
collection expense.

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5.4 Inventory Management

Inventory may be defined as the goods held for eventual resale by the firm. Decisions relating to inventories
are taken primarily by executives in production, purchasing and marketing departments. Usually, raw material
policies are shaped by purchasing and production executives, work in process inventory is influenced by the
decisions of production executives, and finished goods inventory policy is evolved by production and marketing
executives. Yet, as an inventory management has important financial implications. The financial manager has
the responsibility to ensure that inventories are properly monitored and controlled. He has to emphasize the
financial point of view and initiate programs with the participation and involvement of others for effective
management of inventories.
Generally three types of inventories may be identified.
 Raw materials: These are goods that have not yet been committed to production.
 Goods in process: This category includes those materials that have been committed to
production process but have not been completed. Goods in process include such items as
components and sub components that are not yet ready to be sold.
 Finished goods: These are completed products awaiting sale. In construction process, they
are the final output of the production process. For retail firms and wholesalers, they are
usually referred to as the merchandise inventory.
5.4.1 Benefits of Holding Inventories
Inventories are used to provide cushions so that the purchasing, production, and sales functions can proceed
at their own optimum paces.

In achieving the separation of these functions, the firm realizes a number of specific benefits.
i) Avoiding Losses of Sales: If the firm does not have goods available for sale, it will lose sales.
Customers requiring immediate delivery will purchase their goods from the firm’s competitors, and
others will decide that they do not need the goods after all, if they must wait for delivery. The
ability of the firm to give quick service and to provide prompt delivery is closely tied to the proper
management of inventory.
ii) Gaining Quantity Discounts: If a firm is willing to maintain large inventories in selected product
lines, it may be able to make bulk purchases of goods at large discounts. Suppliers frequently
offer a great reduced price if the firm orders double or triple its normal requirement. By paying less
for its goods, the firm can increase profits, as long as the costs of maintaining the inventories are
less than the amount of discount.
iii) Reducing Order Costs: Every time a firm places an order, it incurs certain costs. Forms must be
types, checked, approved and mailed. When goods arrive, they must be accepted, inspected and

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counted. The variable costs associated with individual orders can be reduced if the firm places a
few large rather than numerous small orders.
iv) Achieving Efficient Production Runs: Once an assembly line or work team is prepared and
composed to receive certain raw materials and perform selected production operation, a setup
cost has been incurred which must be absorbed in the subsequent production run. If the firm has
to change setups frequently, it would experience high unit costs of production.

5.4.2 Costs of Holding Inventories

When a firm holds goods for future sale, it exposes itself to a number of risks and costs. The effective
management of inventory involves a tradeoff between having too little and also too much inventory. The
benefits of holding inventory have already been discussed, basically helps to reduce risks, hold down costs
and increase revenues. To examine inventory from cost side, one shall identify the following categories of
costs:
• Ordering Costs: relating to purchased items would include expenses on the following: requisitioning,
preparation of purchase order, expediting, transport and receiving and placing in storage.
• Carrying Costs: includes expense on the following: interest on capital locked up in inventory, storage,
insurance, obsolescence, and taxes.
• Shortage Costs: arise when inventories are short of requirement for meeting the needs of production
or the demand of customers.
5.4.3 Inventory Management - Minimizing Costs

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The goal of effective inventory management is to minimize the total costs that are associated with ordering and
holding inventories. One need to estimate the different expenses with varying inventory levels and chooses the
level with the lowest total cost.

In the figure, we can see the rising slope to carrying costs as the level of inventory is increased. One can also
see the declining order costs with higher inventory levels. The lowest total cost considers both in carrying costs
and ordering costs.
There are two basic questions relating to inventory management.
• The size of the order- Q optimal
• The level to order – Q level.
i) Order Quantity- Economic Order Quantity( EOQ)
The Economic Order Quantity refers to the order size that will result in the lowest total of order and carrying
costs for an item of inventory. If a firm places unnecessary orders, it will incur unneeded order costs. If it
places too few orders, it must maintain large stocks of goods and will have excessive carrying costs. By
calculating an economic order quantity, the firm identifies the number of units to order that results in the lowest
total of these two costs.
Variables in the EOQ model:
U: The forecast usage/demand for goods or raw materials for a year is known,

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 Financial Management

Q: Quantity Ordered,
F: Cost per Order,
C: Percent Carrying Cost
P: Price per Unit,
TC: Total Costs of ordering and carrying.

TC =
U
(F ) + Q (P )(C )
Q 2
The first term on the right hand side is the ordering cost, obtained as the product of the number of orders (U/Q)
and the cost per order (F), and the second term on the right hand side is the carrying cost, obtained as the
product of the average value of inventory holding (QP/2) and the percentage carrying cost (C).
The total cost of ordering and carrying is minimized when the derivative of the above equation is equated to
zero:
dTC UF PC
=− 2 + =0
dQ Q 2
2UF
Q2 =
PC
2 FU
Q=
PC
Example: Given the following for a company:
U= Annual sale= 20,000 Units
F= fixed cost per order = Birr 2,000
P= Purchase price per unit= Birr 12
C= Carrying cost = 25% of inventory value

2 x 2,000 x 20,000
Q= = 5,164units
12 x0.25
ii) Order Level/Order Pont

The standard EOQ model assumes that materials can be procured instantaneously and hence implies that the
firm may place an order for replenishment when the inventory level drops to zero. In the real world, however,
procurement of materials takes time and hence the order level must be such that the inventory at the time of
ordering suffices to meet the needs of production during the procurement period.
If the usage rate of materials and lead time for procurement are known with certainty then the ordering level
would simply be:
Lead time in days for procurement X Average daily usage.

AAU; Department of Construction Technology & Management Asfaw Eshetu 54