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Training the Next Generation of Managers to Manage Financing and Investing Activities

Training the Next Generation of Managers to Manage Financing and Investing Activities

WHAT IS FINANCIAL MANAGEMENT?

A business exists to provide goods and services to the society. The foremost concern of business is its survival. In order for the business to survive, it must be able to generate sufficient cash inflows to cover its cash outflows.

Second, the purpose of business is generating profits or cash flows. To put it simply, a business is to get money and use it to make more money. “Financing” is about getting money, and “investing” is using the money to generate more money.

 

STARTING A NEW BUSINESS – WHERE IS THE MONEY

Let’s say you have an idea – importing and selling tropical fruits. You want to turn it into a viable business, and you are confident that this will be a good business, so you incorporate a company.

When a business entity is formed, the first task is to raise long-term finance. You want to raise $100,000. You invite your good friends, James and Violet, to invest in this new business venture. They agree, and you manage to raise the first $60,000 – $20,000 each from James, Violet, and yourself. James and Violet are called equity investors.

This type of financing – money raised from the investors – is called equity financing.

Next, you approach OCBC Bank, and the bank agrees to provide a $40,000 10-year term loan at 6% interest per annum. This type of financing – borrowing money from lenders – is called debt financing.

When a firm borrows money from a bank, the bank demands the firm to pay interest regularly. When the firm invites investors to invest their money, they become shareholders of the firm and expect the firm to reward them in the form of dividends. The interest and dividend demanded by these fund providers (banks and investors) imply that this money is not free.

These interest and dividends are the obligations a firm must pay; otherwise, serious consequences will result. For example, lenders may force the firm to sell assets to pay back the overdue interest and outstanding loans, whereas the investors will demand drastic changes in the management and corporate structure. The worst-case scenario is that the firm may have to be wound up (declared bankrupt), and cease business.

 

MONEY IS NOT FREE

These burdens – paying interests and dividends – are usually expressed in percentage terms. For example, if a bank charges 6% annual interest on a loan borrowed by a firm, every year the firm has to pay $6,000 for every $100,000 borrowed. Similarly, investors also demand a return on their money invested in the firm, called the required rate of return on equity.

Let us say that the investors demand a 10% rate of return. You may ask: how does this 10% return being derived? The answer is opportunity cost. In order to put their money into your business, investors may have to give up their alternative investment elsewhere, currently earning a 10% return. Since this money could earn a 10% return now, the investors also expect your firm to make at least a 10% return, otherwise, there is no incentive for them to do so, i.e. switching investments.

If your business is viewed as having risk higher than that of the investors’ existing investment, then they will demand a return higher than the 10% rate. You must remember an important principle in investment: “high risk, high return; low risk, low return”.

As long as the company continues to use the money from the lenders and investors, it is obliged to pay interests and dividends.

 

IT IS TIME TO INVEST

So, your firm manages to get money from both lenders and investors, and business operations commence. The firm uses the money to buy assets – machinery, office equipment. It starts to produce goods to sell, and pay for operating expenses – marketing and promotion, salaries, rentals, telephone and utility bills, printing, stationery, transportation, etc.

How do you know the firm is making money? Every year, the firm needs to calculate the sales amount generated in the business, and then deduct all the expenses incurred, and the net balance will be its operating profit (or loss).

Is the firm able to pay interests? That depends on the operating profit generated. Operating profit must be sufficient to pay interest expenses, otherwise, the lenders will take action against the firm.

Is the firm able to pay dividends? That depends on the net profit after tax figure. You see, the dividend amount is the last to be paid, and therefore, there is no guarantee that the amount is fixed. In good years, a firm could pay very high dividends, but in bad years, no dividend could be paid out. Why the dividend is uncertain?

 

IT IS ABOUT RISK MANAGEMENT

No business in the world can guarantee the investors that they will make money. In business, although the plan projects that the firm will make money in the future, such a plan could be adversely affected by factors beyond its control – war, recession, change in government policies, competition environment, etc.

Since a firm pays fixed interest before paying dividends, and that dividend is uncertain because of the risk faced by the firm, we can say that an equity investor faces a higher risk than that of the lender.

The minimum return demanded by investors in any investment must be at least equal to the anticipated rate of return. Otherwise, the rewards are not sufficient to compensate the investors to combat the erosion in purchasing power of their money.

When the risk of investment increases, investors will demand a higher return.  For example, a savings deposit offers low-interest-rate, because such a deposit is considered a low-risk investment. On the other hand, buying ordinary shares is considered a high-risk investment, as there is a greater risk in the future dividend payment.

 

SO, FINANCING AND INVESTING DECISIONS ARE LINKED

In a nutshell, financial management strives to achieve the balance between three important decisions – financing, investing, and distribution. “Financing” is about raising money, “investing” is about putting money to make more money, and “distribution” is about paying interest, taxes, and dividends.

In today’s fast-changing business development, it is very important for the management staff in any organization (private sectors, not for profit organizations, social services providers, etc) to acquire the following financial management skills:

  • Identify challenges faced in raising finance
  • Manage, mitigate and reduce risk in long term investments
  • how to evaluate long term investment proposals
  • Factors to be considered when making financing and investing decisions

 

To know how to improve financial management, we have created an intensive 1-day workshop on Financial Management for Non-Finance Managers to enable participants to understand the essential long term financing and investing related terms and learn how to manage relevant activities effectively.

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