Financial Functions
Introduction
The spin offs around capital have significant effects on the success of any business entity (Al-Mwalla, 2012). The key party concerned with the financial strategy and essential decisions for managing the business is the financial manager. Financial managers make financial decisions that ensure smooth running of the business. For a business to be in operation, it should have sufficient capital in terms of finance and assets. This implies that the spin offs around business finance can affect the success of the business. In light of this, the making of financial decisions in any business is inevitable. This because the contributive factors to business failure are manageable through making strategies and financial decisions. In addition, financial decisions of any business entity can rotate around the capital markets, working capital, cost of capital and capital (Chisholm, 2009). Effective management of these areas clearly depicts finance functions in a business. These finance functions are interdependent and if well managed will result in business expansion. Businesses need to identify and manage the capital required to carry out the daily business operations. For example, some key business operations might include purchasing goods and services from suppliers and outsourcing finance for expansion. These business operations involve the interplay of capital; hence might increase or reduce capital. With regard to this, this paper discusses the aforementioned finance functions by describing the concept behind them and the current thinking.
Capital Markets
Capital markets are markets for trading securities. They are not different from the usual markets; the distinction is only in the products traded and their organizations. Business organizations use capital markets as an avenue for raising funds for business expansion or investments. Business organizations achieve this by issuing securities. The government, just like any other private sector business, issues its securities to raise finance in capital markets to construct roads, bridges and build electricity dams. This reveals the significant role played by capital market in the economy of any country (Miller, Vandome, & McBrewster, 2010). The abovementioned term, securities refer to legal financial documents or instruments showing the ownership or position of the company or creditor relationship with the government or a company.
Shares represent a part-ownership in a business concern (Chisholm, 2009). This implies that shareholders have a say in the running of the business organization and are entitled to a share of the profits. The part of profit given to shareholders is known as dividend, which is determined by the company’s management and profitability and government-issued bonds to the private companies. Other terms related to capital markets are stocks and bonds. These are long-term fixed securities issued by the companies and government.
The trading of shares involves buying and selling. Shares are bought from either primary or secondary market. Purchasing shares from the primary market majorly refers to the purchase of shares in an Initial Public Offering (IPO) (Miller, Vandome, & McBrewster, 2010). During Initial Public Offering, the company sells its shares to the members of the public for the first time. Companies issuing shares during IPO normally use selling agents or banks. Secondary market uses the stock exchange to sell and buy shares. A stock exchange refers to organized markets dealing in shares, stocks and bonds. Companies and individuals in stock exchange buy shares through legal stockbrokers.
Significance of Capital markets
Capital markets play a critical role in stimulating economic development and growth. Through mobilization of domestic saving, capital markets enable the transfer of financial resources from dormant to more income generating activities (Chisholm, 2009). Capital markets also enable the selling of State Owned Enterprises (SOEs). The shares in SOEs are sold to the public through the stock exchange; hence transferring part of ownership to the members of the public. This form of privatizing SOEs through the stock exchange increases the asset base by providing an avenue to citizens to a share in the assets of the public.
Capital markets also create employment expansion and generate income. Companies achieve this through increased investment. In addition, savings and consumption increases since a larger portion of the public earn income (Chisholm, 2009). This results in a cycle of increased production and investment that stimulates economic development and wealth creation.
Current Thinking
There have been various transformations in the present status of capital markets. The first change witnessed is the disappearing of construction loans. With the effects of the 2008 financial crisis, the disappearance construction lenders in capital markets crippled many developers. The general lack of demand among prospective tenants and failed construction led to the absence of construction loan lenders (Chisholm, 2009). The few construction loan lenders that exist in the capital market require guarantees from sponsors with liquid net worth.
Banks have also shortened the amortization periods for loans with fixed rates by 5 to 10 years. These banks reviewed amortization schedules on loans and reduced the amortization period from 30 years to 25 year and from 25 to 20 or 15 years in some assets (Chisholm, 2009). The shorter the amortization period, the expensive the annual debt service payments become. This results in subsequent effects on cash flows and debt service coverage ratios.
Working Capital
Working capital refers to a financial metric that indicates the operating liquidity exposed to an enterprise, organizations or any entity (Al-Mwalla, 2012). Business enterprises and organizations need to have working capital that it is neither excess nor inadequate (Al-Mwalla, 2012). Excess working capital will result in idle funds that do not earn profits. On the other hand, insufficient working capital will result in inadequate funds for sustaining the business. The management of working capital requires the understanding of the association between risk and return, and working capital. The primary aim of managing working capital is to control the current assets, and current liabilities of the business to ensure the maintenance of working capital level. This level should be at a point where it is neither excess nor insufficient.
Some financial scholars have defined the management of working capital as management decisions and choices, which influence the value and efficacy of the working capital (Al-Mwalla, 2012). According to these scholars, working capital management is about the most effective decision of sources of working capital. In addition, the management of working capital needs to measure the level of current assets along with their use. The management must effectively concentrate on regulating current assets and liabilities and the association between them. In the current times of ever-increasing capital cost and inadequate finance, the benefit of working capital requires significant emphasis. There is also a wider perception that the profitability of a business organization likely depends on working capital management. Inefficient management practices of working capital reduce the profits of the business and ultimately lead to financial crisis. Efficient management practices of working capital positively affect profitability by increasing savings and guarantees financial returns at the optimum of level of capital employed (Al-Mwalla, 2012).
Working capital is also referred to as circulating capital. With regard to this, the operating cycle represents the most essential need for working capital. In the operating cycle, capital flows commence with the conversion of cash to raw materials. The raw materials are in turn converted to works-in-progress and processed goods. The processed goods are then sold, turning into accounts receivable. Collection of receivables reverts the cycle to cash. As a result, the business effectively follows the circulation of capital in the cycle with low limits of working capital.
Significance of Working Capital
Efficient management of working capital comes with various advantages. In this context, efficient management ensures that the business runs on adequate capital that is not excess. Businesses having adequate working capital have the advantage of increasing the in debt capacity and goodwill (Chisholm, 2009). Working capital that is sufficient indicates the company’s financial security. Financially sound companies are able to meet creditors demand on time and properly. As a result, it increases the goodwill of the company. Additionally, adequate working capital places confidence among creditors and investors. This implies that business entities that have sufficient working capital can source necessary finance from the market, borrow short-term loans from banks and buy inventories of raw materials.
Sufficient working capital increases efficiency in production. Business entities with adequate working capital are able to perform effortlessly research and development activities; hence increases its production efficiency (Chisholm, 2009). Firms with adequate working capital can also exploit favorable business opportunities as a way of utilizing excess resource. Having adequate working capital enables companies to make bulk purchases and seasonal storage of supplies, including raw materials. As a result, this reduces production costs leading to large profits.
Companies with adequate working capital enjoy cash discounts since they are capable of making a cash payment for raw materials and other supplies. Cash discounts offered to the business also reduce production costs and increase the profit margins. In addition, adequate working capital maintains the company’s solvency and efficiency of fixed assets. The maintenance of fixed assets depends on the availability of funds. Another benefit of having adequate working capital is that it enables companies to provide attractive dividends to shareholders. Consequently, it increases the sense of confidence and security among shareholders.
Current Thinking
It is apparent that the 2008 financial crisis and market dynamics placed working capital in highly prioritized areas for corporates (Al-Mwalla, 2012). Currently, financial managers have a new perspective about risks. Additionally, various kinds of risk areas have become of interest include the counterparty risk. The counterparty risk has resulted in many unanswered questions such as; what businesses at the bank will survive? How will bailouts in other nations affect the banks in those nations with which corporates do business? Will the bank be forced into a merger?
Another current issue relating to working capital management is the adoption of treasury management system (TMS). The TMS is software that integrates the operations of financial units with corporate outcome. Other functionalities of the software include cash management, forecasting, debt management and making of investment decisions among others.
Cost of Capital
Cost of capital refers to the overall cost of the resources used to finance a company’s assets. The cost of capital evaluates new projects of a business organization (Al-Mwalla, 2012). It is the minimum return investors expect to finance business operations; hence, sets a target that the new project has to achieve. The calculation of the cost of debt involves taking the rate on a risk free bond then adding to default premium. The duration of rate on free risk bond needs to match with term structure of the corporate debt. The default premium rises as the amount of increases. The cost of debt is calculated as an after tax cost to make it similar to the equity cost. This is because, in most cases, debt overheads are deductible expenses. The cost of equity is computed by adding risk free rate of return to premium expected for a risk (Chisholm, 2009). In the corporate world, calculating the cost of capital is extremely beneficial in increasing the company value and in making investment business decisions. Business organization should determine where to get necessary funds for financing projects. Additionally, the business must identify the cost of each source of funds.
Financial Crisis and Capital Cost
Company’s cost of capital indicates the investor’s attitudes toward risks, particularly, the expected return for risks (Al-Mwalla, 2012). When investors get disinclined to risks, firms are most likely to face difficulties in raising capital. With such difficulties, they might defer or cancel some investments or even decline mergers and acquisitions. As a result, many executives have gotten concerned with the price of risks and the how the cost of capital will affect their strategic decisions.
Current Thinking
According to the Federal Reserve report in 2010, US companies held almost 2 trillion dollars in cash and short-term liquid assets (Al-Mwalla, 2012). This amount of cash represented the largest portion of cash held by companies as a share of corporate assets in over 50 years. The likely reason for this is that firms remain worried about sustainability and strength of economic recovery. The other reason is that consumer spending and job growth continues to be an uninspiring. This has made investors hesitate to invest in the growing workforce. The slow growth of the economy and elevated levels of business risks around the globe have reduced business opportunities (Chisholm, 2009). This implies that these firms cannot invest in long-term productive assets that generate returns for their shareholders.
Capital Budgeting
Capital budgeting refers to the planning process deployed to determine long-term investments of a company (Al-Mwalla, 2012). Some of long-term investments include purchase of new machinery, new products, and research development projects that are worth pursuing. Various techniques such as accounting rate of return, payback period, net present value, profitability index and equivalent annuity are used in the determination of long-term investments. These techniques use the incremental cash flows from every prospective investment. The net potential value (NPV) uses the discounted cash flow (DCF) valuation to determine long-term investment. The DCF valuation involves approximating the size and timing of incremental cash flows from the project. The internal rate of return (IRR) refers to the discount rate that gives a zero NPV (Chisholm, 2009). This technique is usually used to measure the efficiency of an investment. The equivalent annuity method computes the NPV as an annualized cash flow by dividing it by the current value of the annuity factor. It is frequently used to assess the costs of projects having similar cash flows.
Capital Budgeting Process
Capital budgeting is a five-stepped process. The first step is investment screening and selection. This stage involves the identification and evaluation of projects or investment that conform to the strategies of the business (Chisholm, 2009). The main aim of this stage is to determine if the project will affect the company’s future cash flow. The second stage is the preparation of capital budget proposal, which lists the cost of the recommended project or investment. The third stage is the approval and authorization if the capital budget. This stage should authorize expenditures on the project to take place. The fourth stage is project tracking and it where operations on the project begin (Miller, Vandome, & McBrewster, 2010). The project manager oversees and reports occasionally on revenues and costs incurred (Miller, Vandome, & McBrewster, 2010). The last stage is post completion audit. At this stage, the company’s management shows how cash flows forecasted relate to cash flows realized (Miller, Vandome, & McBrewster, 2010).
Current Thinking
Present studies on capital budgeting point out that large companies use capital budgets techniques more frequently when choosing their investments and projects. Many firms also tend to consider factors such as financial leverage, dividend payout policies and growth opportunities in capital budgeting.
Conclusion
Financial decisions of any business entity can rotate around the capital markets, working capital, cost of capital and capital. . Business organizations use capital markets as an avenue for raising funds for business expansion or investments. Business organizations achieve this by issuing securities. Business enterprises and organizations need to have working capital that it is neither excess nor inadequate. Cost of capital refers to the overall cost of the resources used to finance a company’s assets, both debt and equity.
References
Al-Mwalla, M. (2012). The impact of working capital management policies on firm’s profitability and value: the case of Jordan. International Research Journal of Finance and Economics , 147-154.
Chisholm, A. (2009). An Introduction to International Capital Markets: Products, Strategies, Participants. Chichester : John Wiley & Sons.
Miller, F., Vandome, A., & McBrewster, J. (2010). Capital Cost. New York: Alphascript Publishing.
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