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Chapter 3

FINANCIAL FUNCTION

 

by josavere

Four types of decisions can be taken in business: trade, personnel, production and finance. The financial area has the responsibility of the efficient administration of the funds of the company. The financial executive has to help in the study of the investments to take the more suitable decision of financing, and to make an efficient handling of the funds that are generated, looking for the increase of the company and the generation of value that allows to pay dividends and to increase the value of the share in the market.

As the result of the combination of investments and financing, a good operation generates value and as consequence the profits are going to increase. Part of profits is distributed in dividends, which maintain the attitude of the investors. Almost all the authors of finances agree in affirming that the financial basic objective consists of maximizing the value of the company, because it implies the handling of long term, not thus, maximizing the value of the profits, since these in certain cases, can be obtained sacrificing the permanence of the company.

A financial function is full, if the intrinsic value of a share and in stock-exchange increased. In some cases, the space between the internal situation and the one of the market is explained fundamentally by lack of sufficiently ample information for the investors.

If we leave the objective of maximizing the value of the company, we found procedures that facilitate this goal in damage of the apparent yield. Among other reasons, in some countries has taken to a tax direction of the accounting for the sake of reducing the payment of taxes.

Mechanisms as accelerated depreciation; the protection of portfolio, inventories and investments; the LIFO system cost; the appropriations for contingencies, etc., that really lead to decrease the profit and as obvious consequence tend to reduce the participation of the statement treasury and the distribution of profits, complemented with the retention of the profits, fit perfectly within the frame of maximizing of the value of the company through which the lawyers call hidden reserves.

If we approve the objective previously mentioned, we could affirm that the management is good because it increases the value of the company. However, we analyze that happens with the shareholder.

Like the thickness of the public (the small shareholders), it does not know east type of direction acts generally under the concept of yield, calculated according to press report, like the relation between the dividend and the value of market. Low dividends reduce yield, which decreases price of the share in the stock-exchange.

In the meantime, the great shareholders that have access to the information and they dominate the financial techniques. They know that with the handling of this practice, the real value of the stock divided by the number of shares is the real value of the share. They tend to rise and, when noticing the great abyss between the intrinsic value of the share and the value of market, they try to find a great business in the purchase of shares. As consequence, the property is concentrated decreasing of step the new shares like financing source. When concentrating the property and dominating the boards of directors, is easy to lower or still to suspend the dividend in damage of the small shareholders, in addition to so many abuses that are committed using the power.

It is important to insist on the objective to maximize the value of the share in the market; let us remember that the things are worth according to pay by them, is due to look for a good index of stock-exchange, indicator of the facility or not to negotiate the share.

 

1. HOW TO OBTAIN THE OBJECTIVE

Until now, countable science has developed elements of measurement of a
business: the earnings statement, the general balance sheet, the statement of changes in the financial situation, the statement of cash flow and the statement of changes in the equity.

But, as we can analyze in the development of other published documents, the accounting is not able to follow the rate of the business. It is very probable that a certain company practically has a made business but without formalizing and the accounting although partly corrects the deficiency in notes to the balance does not know it, in regard to the principle of accomplishment of the profit, etc.

By the great amount of emptiness that presents the accounting information, the different methods to estimate as depreciation, recognition of the profit is presented; it is necessary complement the financial information with notes to the balance, clarifying the accounting practices in the particular case. With a good attached explanation it is had judgment elements to determine a suitable criterion of estimate that allows to consider the value of the share. In another document we took care of this subject. It is healthy logic, the investor, of being able to do it,  calculate the net present value of the future dividends that hopes to receive, plus the considered value of distraction and will compare with the value of the share in the market  stock. If the net value (VPN) is superior at the cost of market, buys and if no, it rejects.

VPN > VM: buys
VPN < VM: rejects
VPN:
net present value
VM:
market value
DF: waited for future dividends
VR:
accomplishment value
K:
minimum required rate
t: period

However, if the objective of the financial function consists of maximizing the value of the share, we will try to illustrate the three types of basic decisions to obtain it.

2. INVESTMENT DECISIONS

Accounting classified the assets in three groups: currents, fixed and others. We are speaking about the left of the balance: the structure of de actives

We understand as current assets those that represent money or are susceptible to eliminate within a cycle of the business (production, marketing, and collection) in a short period of time. These are: box and banks, temporal investments, accounts to receive, and inventories.

The fixed assets are part of the assembly itself. They are not for being commercialized but for its operation by means of the combination with the working capital. Generally, it implies great investments of capital, valorized in some cases, like lands and depreciable in others like the buildings and the machinery; amortizable in other cases like patents, mines of operation.

What it is not easily classifiable as current or fixed is called, other assets. Let us remember that these are characterized by their capacity to generate cash, its claim on them, are perfect identity and being residual in case of bankruptcy.

Now we are looking for elements that allow defining the structure of the assets.
Known the objective trade for a certain period of time (hopefully minimum five years), and quantified in terms of units to produce (buy) and to sell, is basic to respond to the following question: ¿ What is the minimum installation absolutely indispensable to take care of it?

In this case the minimum, indicates that the plant must be structured looking for its maximum use, avoiding immobilizing assets or this of another form, treating of which there is not installed capacity different from the contemplated one in the development plan of the company. The growth must be programmed with a maximum care. It is clear that the answer to that question not always is easy, but never will be impossible. For each case will be necessary to use the corresponding indicators to respond, in the light of the technological advances, the land availability, the premises, public services, personnel, enabled and value of the pertinent investments.

If the cost of the capital is very high, we have sufficient power facilities, good transport service to the personnel, reasonable security and the sector offers abundant labor. It is recommendable to work two or three shifts analyzing the costs labor originated by the particular circumstances.

Once the questions are solved that can be done in the feasibility study, the financial calculation begins. For it, we must quantify with extreme prudence and of maximum well-taken care, the income waited in cash and the corresponding expenses to establish the net cash flow of each specific project.

For example:  a project could consist of working in the rented premises, with two machines A, three B, and one D, in days of three shifts, using the third part of the premises. Another alternative could be triple the machines and the physical space in a single shift.

As the most important element appears the cost of capital, based on the time of manufacture. Logically, the faster we have the merchandise available, faster we will be able to recover the costs and to obtain the profit, if the conditions of the market allow it.

Financial mathematics has developed five methods to evaluate projects, that means:

a. Rate average of return: it represents the relation between the averages of net profits and the investment.

Example:

Average profits in five years: $4.000

Investments: $10.000

Comparing the number obtained with the required rate, it is accepted or rejected. This method is very simple. It has the great disadvantage to ignore the dates of income and debits of the cash and therefore it does not consider the value of the money in the time, limitation very hard in inflationary economies. In addition, it does not consider the risk that implies the industrial activity.

b. Period of reimbursement: it indicates the time (generally in years or months), that is required to recover an initial investment.

Example:

Initial investment: $100.000

Average profit year: $20.000

Comparing with a period previously defined it is accepted or it rejected.
This method also is very simple. It does not consider the income that can be obtained after the recovery of the initial investment. In addition, it does not know the dates of the cash flow and consequently it ignores the value of the money in the time.

 

It can be very useful to calculate investments in hard currency or for projects of very fast recovery in inflationary, as the case of businesses of season or purely occasional business.

c. Internal rate of return: it consists to calculate the interest rate that equals the future income and outcome programmed of cash. This number is compared with the rate of cut of the company that the directors consider like the minimum acceptable yield.

A0:
initial investment
A1, A2, A3:
future cash flow
t:
rate that equals the cash flows
t vs. k, being k, the rate of cut of the company

The computers facilitate the solution of this financial problem.

This method has some disadvantages: it assumes that the funds generated by the project, are reinvested to the internal rate of return during the rest of his life, which not always occurs in the reality.

d. Net present value: it is very similar to the previous one. This one discounts the net cash flow using required rate of return. If the sum of the discounted cash flow is equal or greater than zero, the proposal is accepted, and if not, the proposal is rejected.

VPN > 0: Accept
VPN < 0:
Reject
VPN:
Net present value
k:
Rate of cut
A: Future income

e. Index of yield: it is equal to the value of the future net cash flows divided by the initial payment. If the index is superior to 100, the project is acceptable.

IY: index of yield
VPN: net present value
I:
initial investment
A: future income
k: rate of cut

Using the most recommendable method in each case, the waited for yield of the investment calculates and soon it is compared with the parameters fixed by the directors to effect to decide if the investment is recommendable or no.

With assets fixed, we entered to calculate the proportion of working capital required for a well-organized operation.

As an initial idea, in cash is required the necessary money for the transactions programmed plus a reserve considered for unforeseen expenses. The amount of accounts to receives equal to the cost of the merchandise to sell proportionality to the period. The inventory of raw material, is equal the consumption for one day by the time of replacement (days) plus the reserve. In product in process, the daily requirements by the period that takes the productive process and in finished product, the amount that gives a high probability of not losing sales. The sum of the investments in cash, accounts to receive and inventories represents the investment in working capital.

Of this form is completed the structure of the assets, the most important of all because it does the times of leader. If we don’t have a good investment, nobody would be arranged to put or, to lend its money.

In order to make the decision from investment, we must complete with the alternatives of financing for calculating if is favorable the difference between the awaited yields and the cost of financing.

 

3. FINANCING DECISIONS

There are related to the structure of the liabilities, that is, the right part of the balance sheet. We never due to study if investment expectation if does not have one based well, considering the risk in direct proportion to the awaited yield.

We presented as the initial recommendation devices to look for the maximum possible indebtedness in the long term (the limit places the prescribed restrictions of the different credits from promotion). The difference between the sum of the fixed assets and the minimum of current assets, except the financed part in the long term must finance with equity capital and the temporary requirements, with liabilities in the short term. (See graph).

As far as lines of credit the ceaseless search of the alternatives will be the function of the financial manager that appears because these continuously change, in agreement with the economic situation and the governmental decisions. It will have to maintain updated the calculation the cost of capital permanently (dynamic concept), as it bases to verify if the company generates value or if it destroys it, in order to correct the situation.

The equity capital can be obtained by stock and retention of profits, as long as the investment alternative is better for the company than for the individually considered partners.

 

4. DIVIDENDS

There is the third area of basic decisions in finances. The investors put the stock with the hope to obtain an economic benefit that is moderate in terms of the dividend plus the possible valuation of the share in the market, or the value that can be obtained by accomplishment of the contribution.

When one makes this type of decisions, the executive must be cautious when processing the cash flow as he base to calculate the dividend that can be decreed without affecting the liquidity of the company and to take care of a possible reduces the stock by a bad decision.

In the event of temporary difficulties of capital and with a good perspective of yield, it can be decided on the alternative of dividend in share as a mechanism to preserve its value, protecting the shareholders (about this subject we talk widely in another document).

In summary,  the basic objective of the finances is fulfilled by means of the combination of three types of decisions: investment, financing and dividends.

 

To decide it is fundamental that the management studies carefully the external environment (macroeconomic, competition, policies of foreign trade, tributary situation, etc.), and tries to adapt the company to the general conditions for the best benefit. The study of the economic measures is fundamental, measuring the repercussion on the company and its owners, on base of much operative efficiency, because a good financial handling without an efficient activity is not possible to generate value calculated according to the formulate :

EVACp: Corrected and projected EVA
Pr: Profits of the period
ID: Investments in investigation and development
Po: Investments in able to be capitalized publicity
Qu: Qualification
O: Other able to be capitalized investments properly supported
C of C: Cost of capital

One is an indicator very used by the international investors; we write about it later on.

 

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