Question 1
A float is a sum of money that is supposed to be transferred from the account of one party to another after a transaction but it is reflected in both accounts before the process of transferring is over. A float occurs when there is a delay in deducting the required amount of money from the paying party’s account causing a short-term double counting of the amount. It is the objective of every management to reduce these delays on collections.
There are four components of a float that affects both collections and payouts. A payment that is made using a check will require that the check is prepared and sent through a mail where some time will be needed for the mail to be received. This is what is referred to as mail float. After the mail is received, some processing has to be done before the deposits are placed in the required account. This results into processing float that takes longer than the others and is well reflected when payments are done by check. The mail float and processing float are similar as they are viewed from the same perspective by both the receiving and paying party. The other two components are different; there is the availability float from the receiving party and the clearing float from the paying party. The availability float describes the time between the check deposit and the time which the money is available in the firm’s account. After the deposit is done, the check has to be taken through the clearing system where some time is required hence resulting to clearing float.
Question 2
A collection policy is a culture created in a firm which is usually used during the process of collecting overdue. The policy should ensure that the debts do not take too long before they are collected because this will increase the probability of default and complexity in collection. All debts are supposed to be paid within ninety days apart from the exceptional ones from the government. Before 120 days are over, action should be taken on the debtor. After the dead line of payment has passed, three letters should be sent at intervals of thirty days to request for payment. Phone calls should also be made in support of the letters. If there are no responses, the following steps should be followed; first issue a pre-collect notice, then pass the debt to a collection agency and finally take the case to the court personally.
Pre-collection notice is sent to the client by an agent and a fair charge is paid on each account. The agent gives the client options for convincing purposes and at this point the client is allowed to pay directly to the creditor. Collection agencies on the other hand, receive the debt account from the firm. The firm sells the account to the debt collection agencies. Legal procedures are followed and the agency is allowed to take a portion of the debt if it succeeds in collection. If this fails, the firm should take the matter to court as it is advisable to use legal procedures in every undertaking when collecting debts.
Question 3
The process of organizing information to meet the set goals is referred to as financial planning process. Information on financial resources of an organization must be obtained for purpose of organizing the future objectives of the organization. The following steps are followed during this process; assessing the economic factors that can influence financial planning, establishing a comprehensive master plan, finding out alternative financing scheme, determining annual financial requirement, computing the estimated expenses and evaluating the effect to customers.
Strategic plan is a tool used by the management in ensuring that all the organization’s resources are directed towards the same objective. It involves adjusting and evaluating the organization’s focus in relation to changes in environmental factors. A strategic plan describes what the organization entails, its purpose and the reason for this purpose with a future focus. Strategic planning establishes the most suitable tactics of dealing with different circumstances of the environment while basing its intentions on achieving the set goals and objectives.
The major role of financial managers in strategic planning is setting a goal and resolving on what resources will be required for this goal to be achieved. The role is strategic because the process of achieving this goal is taking place in a changing environment. Financial managers are always affected by changes in the following external environment; technology, taxation and financial innovation. The financial managers should come up with steps to be followed in the process of working to achieve the organization’s strategic goal. It is only the financial managers who can establish this plan, decide on the required resources and the allocation procedure of the available resources.
Question 4
In sustainable growth model, sustainable means the maximum level of growth that a firm can achieve given its returns, resources utilization, the best dividend payout and debt ratios. Sustainable growth model has three assumptions on the firm’s wants which include sustaining a desired capital structure with no new equity issue, uphold a desirable ratio on dividend payout and maximize sales as much as the market allows. At the beginning, the equity ratio is constant and the sources of new equity to the firm are the retained earnings, revenue from the sales and debt that can be acquired using the retained earnings. Sustainable growth rate is always consistent when there is no additional equity issue from the firms. If a firm issues extra equity there will be no financial restriction or constrain to its growth.
A conflict is reflected between a firm’s competing objectives in a sustainable growth model. For example, it is the objective of the sales management to maximize growth in sales while the objective of the financial management is to uphold a certain rating on credits. Sustainable growth model is beneficial when more finances are acquired through borrowing. This borrowing may expose the firm to a risky position of high debts and low equity. This borrowed fund may also lower the creditworthiness of the firm. The firm could opt to increase sales by diversifying its production. Producing variety of goods and services will result to higher inventory. In this case, higher inventory will definitely cause underutilization of resources in the firm.
Exercise
Question 1
Short term goals are used as bridge to achieving long term goals. This is because the strategy implemented in a short term goal enables the firm to get closer to its long term objectives. Short term goals also act as an inspiration to achieve higher goals through more efforts hence getting to the final long term goal. Short term goals also help in directing all the efforts towards achieving long term goals by enabling the planning process to go through the changing activities and events in the environment. Short term goals also help to create an optimistic view of a long term objective by splitting it into lesser portions.
Money market mutual funds enable firms to meet short term goals by allowing investors to form pools of money with them that can be used to acquire short term investments that qualify according to the standards set by Securities and Exchange Commission for credit worth and liquidity. The U.S. Treasury issue short term securities called treasury bills. The treasury bills are used to fund public debts in the United States. Regular bills are issued to facilitate an efficient movement of revenue from tax payers. The federal Government Issues federal agency notes as a short or long term obligation which does not require any collateral. Federal or central chartered banks issue certificates of deposit which earn returns for a specified period of time. Corporations issue commercial paper as a short term financial instrument with an unsecured promissory note. It requires lower costs than bank loans and highly preferable because they do not demand for expensive collateral or registration with Security and Exchange Commission.
Question 2
Cash conversion cycle is an efficient model of measuring the liquidity of small businesses. It measures the time from when the business purchases inputs from the suppliers and the time it receives cash from the sale of output. It emphasizes on the length of time for which cash is tied up in the process. Small business owners are obligated to practice an effective supervision on the cash conversion cycle. Cash conversion cycle provides a clear reflection of the pressure exerted by the working capital on the cash flow. Maintaining the cash conversion cycle at its lowest levels is the objective of every business management. It is important to hold the cash conversion cycle at constant levels during times of fast growth in sales. The level of cash conversion cycle should only be affected by changes in policies related to the inventory, supplier or credit.
In this case, the owner of the hot dog cart operates a small business making cash conversion cycle an important tool for management. The conversion period will be determined by the following factors; the time taken by customers to pay for the goods and services, time taken by the owner to make the goods and services ready for sale, time taken before the goods are bought and the time allowed for the owner to pay the suppliers. The owner of the hot dog cart purchases the inventory on credit. The owner receives ready-made goods and therefore needs no time to prepare them for sale. The goods are sold the same day for cash before the supplier demands for payment hence a negative cash conversion cycle.
Question 3
Pro forma statements are important tools to the financial management when planning for the future financial needs. Financial managers are able to predict and estimate the amount of funds that will be needed and when they will be needed using estimated future income statement and balance sheet. The sum of the owners’ equity and the total liability must be equal to the total asset. If there is an imbalance the management must take the necessary action to avoid reaching critical points which are complex to correct. To ensure that the balance sheet is balanced shortfalls should be rectified by financing it using external sources of funds. This extra financing is called the plug figure. The plug figure shows the amount of the external finance that was acquired to achieve a balanced balance sheet. In this case, where external financing is acquired the plug figure is said to be positive. In some cases, the plug figure might be negative and the excess funds can be invested in profitable securities, used to settle notes payable or increase dividends pay out.
Having short term liabilities or cash as a plug does make sense. If a firm happens to have excess funds, there is a high probability that it will invest these funds in a viable investment. On the other hand, if it has a shortfall, the financial management will correct this through acquiring a short term debt. Fixed assets cannot be used as a plug figure because it requires a longer decision making to increase or reduce. Alteration of fixed assets requires intense and longer analysis hence cannot be used as a plug figure.
Question 4
Some current assets are affected by sales when preparing a pro forma balance sheet. These current assets include accounts receivable, accounts payable and inventory. Forecasting must be done first on these current assets before the pro forma balance sheet is prepared. For example, there may be a constant credit sale of 10% in a firm. Dividends and long term accounts should be derived from sales but instead the management might use assumptions not related to sales to determine the accounts. A firm can also expect that the sales will increase by 20% the following year. To determine next year’s sale, the current year’s sales will be multiplied by 110%. The figure will be determined on the assumption that there will be no increase in the cost of production. These assumptions that are used when calculating figures used in the pro forma statement may result in a different yield from other alternative sources. In other long run circumstances, plant and equipment accounts may be related to sales and this relationship may fail to be well reflected when calculating pro forma statement figures. Regression analysis, calculating sales percentage and ratios are used to describe the relationship between current accounts and sales. In such a case, a different projection for the firm’s financial needs may be reflected by pro forma statement and the equation for external funds required. The equation for the external funds requirement is used as an easy and short way of determining a firm’s financial needs and may not consider other important complexities in a firm.
References
Ehrhardt, M. C., & Brigham, E. F. (2008). Corporate Finance: A Focused Approach. New York: Cengage Learning.
Vernimmen, P., & Quiry, P. (2009). Corporate Finance: Theory and Practice. Chicago: John Wiley and Sons.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice. New York: SAGE.
Graham, J., Smart, S. B., & Megginson, W. L. (2009). Corporate Finance: Linking Theory to What Companies Do. New York: Cengage Learning.
