Corporate Finance: educational manual 9786010444980

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AL-FARABI KAZAKH NATIONAL UNIVERSITY

M.Zh. Daribayeva

CORPORATE FINANCE Educational manual

Almaty «Qazaq University» 2020

UDC 658(075) LBC 65.290.93я73 D 20 Recommended for publication by the decision of the Academic Council of the High School of Economics and Business and Editorial and Publishing Council of al-Farabi KazNU (Protocol No.5 dated 27.06.2019) Reviewers: PhD, Acting Associate Professor R.D. Doszhan PhD, Acting Associate Professor Sh.A. Boluspayev c.e.s., Professor S. Yessengaziyeva

D 20

Daribayeva M.Zh. Corporate Finance: educational manual / M.Zh. Daribayeva. – Almaty: Qazaq University, 2020. – 285 p. ISBN 978-601-04-4498-0 The content of the educational manual «Corporate Finance» includes the issues of formation of own financial resources, fundraising from external sources, distribution and use of borrowed resources. The course also includes the system of monetary relations arising in the process of forming the basic production assets and working capital, production and sales of products, works and services. In accordance with the curriculum approved by the Ministry of Education and Science of the Republic of Kazakhstan, this educational manual covers the main issues studied by the students of the specialty of «Finance».

UDC 658(075) LBC 65.290.93я73 ISBN 978-601-04-4498-0

© Daribayeva M.Zh., 2020 © Al-Farabi KazNU, 2020

CONTENT

ABBREVIATIONS .......................................................................................6 INTRODUCTION .........................................................................................7 1. FINANCE OF CORPORATIONS: CONTENT AND ORGANIZATION OF ACTIVITY ...............................9 1.1. Essence and functions of corporate finance ............................................9 1.2. Principles of organization of corporate finance .....................................14 1.3. Financial mechanism of corporations ....................................................19 Tasks ..............................................................................................................23 Test questions ................................................................................................24 2. FUNDAMENTALS OF FINANCIAL ANALYTICS OF CORPORATION ..................................................................................29 2.1. Purpose and objectives of the financial analysis of a corporation ........29 2.2. Financial analysis and management decisions .......................................35 2.3. Methods of financial analysis ................................................................40 Tasks ..............................................................................................................45 Test questions ................................................................................................46 3. FIXED CAPITAL OF CORPORATIONS ............................................51 3.1. Essence of fixed capital: composition and structure .............................51 3.2. Indicators of the movement of fixed assets ............................................57 3.3. Depreciation and amortization of fixed assets .......................................62 3.4. Indicators of the efficiency of fixed assets use .......................................67 Tasks ..............................................................................................................71 Test questions ................................................................................................72 4. CONTENT AND STRUCTURE OF THE WORKING CAPITAL OF CORPORATION ..................................................................................76 4.1. Content and structure of working capital ...............................................76

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Corporate Finance 4.2. Sources of financing working capital .....................................................81 4.3. Efficiency of working capital use...........................................................86 Tasks ..............................................................................................................91 Test questions ................................................................................................91 5. CLASSIFICATION OF CORPORATE COSTS .................................96 5.1. General Characteristics of Corporate Costs ...........................................96 5.2. Cost Planning Methods ........................................................................107 5.3. The effect of operating leverage...........................................................110 Tasks ............................................................................................................113 Test questions ..............................................................................................114 6. EARNINGS OF THE CORPORATION AND THEIR CLASSIFICATION ...........................................................118 6.1. General characteristics of corporate earnings ......................................118 6.2. Profit and profitability ..........................................................................128 Tasks ............................................................................................................131 Test questions ..............................................................................................132 7. EQUITY CAPITAL OF CORPORATIONS: COMPOSITION AND STRUCTURE ..................................................................................136 7.1. Equity capital of corporations: structure ..............................................136 7.2. Management of own (equity) capital ...................................................143 Tasks ............................................................................................................152 Test questions ..............................................................................................153 8. DEBT SOURCES OF FINANCING THE CORPORATION ...........157 8.1. The role of borrowed sources of financing in the activities of the corporation ........................................................................................157 8.2. Sources and methods of financing loans ..............................................163 8.3. The Effect of Financial Leverage .........................................................169 Tasks ............................................................................................................174 Test questions ..............................................................................................175 9. COST AND STRUCTURE OF CORPORATE CAPITAL ...............179 9.1. The economic nature of capital ............................................................179 9.2. Methodology of capital formation .......................................................184 9.3. Methods for calculating the capital structure .......................................190 Tasks ............................................................................................................195 Test questions ..............................................................................................196 10. FINANCIAL PLANNING AND FORECASTING OF CORPORATIONS ..............................................................................201

Content 10.1. The concept of financial planning: objectives and principles ............201 10.2. Types of financial planning ................................................................206 10.3. Current and operational financial planning ........................................213 Tasks ............................................................................................................219 Test questions ..............................................................................................220 11. EVALUATION OF FINANCIAL CONDITION OF THE CORPORATION: CONCEPT OF FINANCIAL STABILITY ..............................................................................................224 11.1. The concept of the financial condition of the company .....................224 11.2. Analysis of solvency and liquidity of the enterprise ..........................232 11.3. Indicators of financial stability of the enterprise, the method of their calculation.......................................................................................243 Tasks ............................................................................................................248 Test questions ..............................................................................................249 12. DETERMINATION OF FINANCIAL INSOLVENCY OF CORPORATION ................................................................................252 12.1. Financial relations of the enterprise in terms of economic insolvency and bankruptcy..........................................................................252 12.2. Diagnostic system of financial crisis of an enterprise ........................257 12.3. Financial management of the processes of stabilization, reorganization and liquidation of an enterprise ...........................................267 Tasks ............................................................................................................275 Test questions ..............................................................................................275 TASKS FOR INDEPENDENT SOLUTION ..........................................279 REFERENCES ..........................................................................................283

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ABBREVIATIONS

ACH CF CD COGS CPA CFO DSO FASB FA GRFA IAS IRR IRS JSC MW NPV PP&E RIAs ROE ROA ROI RP SIT VAT WC WCC WCM WIP

– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Automated Clearing House flow coefficient of disposal costs of goods sold Certified Public Accountant Chief Financial Officer Days Sales Outstanding cash Financial Accounting Standards Board Fixed asset generally accounting growth rate of fixed assets International Accounting Standards Internal Rate Internal Revenue Service Joint Stock Company marginal of minimum wage value plant Registered Investment Advisers Return on Equity Return on assets Return on investment Reported period systematic investment plan Value Added Tax Working capital cost capital working capital cycle Working Capital Management work in progress

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INTRODUCTION

Corporate finance is a set of economic relations arising in the process of formation, distribution and use of funds generated in the process of production and sale of goods and services. Corporate finance is a part of the financial system that creates part of the national wealth and gross national product. It formulates the main source of state budget revenues – tax payments of legal entities. Corporate finance is the basis for the development of technology, scientific and technical progress, therefore forms the basis for the development of the industrial, economic and financial relations of the society. The vast majority of jobs serving as the main source of income for another part of the financial system, household finances, are created with the help of corporate finance. The peculiarity of corporate finance is the availability of production assets, functioning of which determines the significance of financial relations. The content of Corporate Finance educational manual covers the formation of internal financial resources, attraction of external sources of funding, their distribution and use. The course also includes a system of monetary relations arising in the process of forming the basic production assets and working capital, production and sale of goods and services. Economic monetary relations associated with the creation, distribution and use of funds and savings in the sphere of material production is the subject of Corporate Finance course. The financial activity of an enterprise is formed under the influence of two multidirectional factors: intra-company relations and rela7

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Corporate Finance

tions with the external business environment. Therefore, a necessary tool for managing a system of financial relations at the level of a corporation in a market environment is a clear understanding of the interrelation of all factors affecting the overall level of financial condition. It is necessary to properly use the financial levers and incentives in order to achieve the highest economic efficiency. Moreover, it is important to take into account the nature and prospects of relations with partners (not only with corporations associated with the purchase and sale of goods, supplies of inventory, but also with shareholders, creditors, stock markets, tax and insurance agencies). The development of ownership forms led to the emergence of new types of enterprises: private, cooperative, joint-stock, mixed, joint with economic entities of foreign countries. The finances of each branch of the economy have significant differences arising from the technical and economical features of these business entities. The purpose of studying corporate finance is to study the essence of corporate finance, its principles and management. In order to achieve this goal it is necessary to solve the following tasks: – to study the theory of corporate finance; – to study the nature and principles of corporate finance management; – to study the features of corporate finance management; – to reveal the analysis of the corporate finance management system. The results of studying Corporate Finance for students: 1. To become a master of the theory and practice of financial relations of corporations in a market economy, to know the features of corporate finance organization in various forms of ownership and management. 2. To be able to assess the financial position of the corporation, make financial plans and forecasts. 3. To acquire the skills to make the right financial decisions in an unstable economy in various areas of corporate operations. In accordance with the curriculum approved by the Ministry of Education and Science of the Republic of Kazakhstan, this educational manual covers the main course of issues studied by the students of Finance specialty.

1. FINANCE OF CORPORATIONS: CONTENT AND ORGANIZATION OF ACTIVITY

1.1. Essence and functions of corporate finance 1.2. Principles of organization of corporate finance 1.3. Financial mechanism of corporations

1.1. Essence and functions of corporate finance The main concepts of corporate finance. Corporate finance essentials can be divided into two main categories: investment analysis or capital budgeting, and working capital management. What are these concepts? Investment analysis or capital budgeting. Investment analysis or capital budgeting has at its core the aim of adding value to the longterm corporate finance projects. These are projects, which relate to the investments that are funded through capital structure. In other words, corporate finance first studies how the company deploys its long-term capital, i.e. where it is spending or investing its money. So, how do corporations get their hands on capital and then how do they invest it? First, let us examine the different capital structures of the company and the basis of corporate finance. Capital structure. Corporate finance is interested in increasing the shareholder value and in order to do so, it generally has to invest in order to expand and to grow. In order to be able to invest, the organization must find ways to finance this growth and investment. There are generally two different ways of financing corporate activity: 9

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Corporate Finance

‒ Self-generating the capital (i.e. selling products and services) ‒ Issuing new debt and equity. Furthermore, the capital structure usually consists of a combination of the following sources of capital: ‒ Debt capital – which is often borrowed funding, either as debt capital or credit. ‒ Equity capital – which refers to the money companies raise by selling shares to investors. ‒ Preferred stock – which is a hybrid version, including both an equity and a debt instrument. The organization’s role is to find a balance between these different options for sourcing capital and creating a sustainable capital structure. Generally, this means using different capital sources to ensure there is no an over-reliance on a single source or capital model. You can find out more about capital structure from the introductory video below: Investment and project valuation. After a business has dealt with the capital structure, the focus of corporate finance moves to capital investment and budgeting. The process of capital investments, i.e. the process of deciding where the money should go in order to attract long-term value, is determined by capital budgeting. For this, the organization must consider investment and project valuation. The valuation process essentially determines how to maximize the benefits, i.e. profits, and to minimize risks and costs. The most common calculation related to investment and project valuation is the discounted cash flow (DCF) valuation. This determines the cash flow expected from the investment and therefore, shows whether it is worth it. To calculate DCF, the organization needs to implement concepts such as time value of money to determine the present value of future cash flows. The sum of the different present values will provide the net present value (NPV), which shows whether the investment is worth the costs. Other key ways to measure the investment value as part of corporate finance include: ‒ Discounted payback period. ‒ Equivalent annuity. ‒ Rate of return.

1. Finance of corporaƟons: content and organizaƟon of acƟvity

Furthermore, project valuation requires an understanding of flexibility. This refers to accounting for uncertainty in terms of the project in question. This could be a consideration about the right growth rate for building the additional factory and the rate of growth at which this would not happen. Therefore, this part of corporate finance is often considered the most serious in terms of business implications. If you make capital investments wrong, you might end up with a non-functioning business. Essentially, bad capital budgeting and investing will lead to either over-investments or under-investments, which in turn can damage the financial competitiveness of the organization. Correct arrangement of this part of corporate finance is a must-do for organizations. Furthermore, the concept of capital financing, i.e. finding the balance of sourcing capital either in the form of debt or equity, is crucial. Working capital management. The second major concept of corporate finance is working capital management. This is a day-to-day process of running the business and therefore it is more focused on the short-term growth of the business. So, whereas the capital budgeting looks at the long-term investment and growth, capital management refers to managing the relationship of short-term assets and liabilities. The idea is that through proper working capital management, the business has the right kind of capital to fund the long-term investments and keep long-term finances of the organization in great check. What is working capital? The term working capital refers to the funds that are required for the day-to-day business operations before the organization receives payments on products and services it has delivered to customers. It is essentially the money the organization needs to have at hand to produce goods and services, keep employees and offices running, before anyone pays the company for these said services and goods. The amount is calculated by analyzing the difference between current assets (the resources in cash) and current liabilities (cash requirements).

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Corporate Finance

The difference here in terms of the above calculations of cash flow is the focus on present. The capital considered is always current instead of a predicted sum, for example. The criteria applied in working capital are as follows: ‒ Cash management is the determination of the balance you need to have to meet day-to-day expenses while reducing the cost of holding on to large amounts of cash. ‒ Inventory management is the determination of the right level of the inventory, which guarantees an uninterrupted provision with goods and services, while reducing the cost of investment in the raw materials for the production of such goods and services. The aim of the above functions is to manage the current assets of the organization (cash, inventory and debtors), as wells as the shortterm financing (cash flow, returns) and ensure the short– and longterm growth of the organization. That is acceptable and leads to the ultimate objective of corporate finance: enhancing shareholder value. Working capital management is often referred to in this context as short-term liquidity, as the process is to ensure that the organization has enough liquidity to finance the on-going operations. If the company cannot meet the current liability obligations, the long-term growth will suffer. Functions of Corporate Finance: These significant functions of corporate financing are used to reduce the financial risks to which their corporate sector is actually exposed. In addition, these ideas are used to boost the profits of this corporations. Such significant functions of corporate finance could be used to analyze, solve certain financial problems for nearly every company. That important concepts of corporate finance are used to make investment decisions both for long and short term. All choices which are pertaining to the capital investment are long-term decisions, while working capital handling is termed short-term move. Here are some of the key functions of corporate finance mentioned below: Separation of Management and Ownership: One of the basic functions of corporate finance is actually the separation of management and ownership. In this case the company is not really restricted

1. Finance of corporaƟons: content and organizaƟon of acƟvity

by just the capital typically provided by the owner / founder only. The general public requires the ways for investing their extra money. They are not content with placing all their funds in risk free accounts with the bank. They would like to take a calculated risk with some of their money. It is for this reason money areas emerge and they serve their dual purpose of offering corporations the supply with funding, whereas in addition they offer a range of choices concerning investment and returns on investments. Collaboration between the Capital Markets and Company: Functions of corporate finance look just like a collaboration in the frames of each company as well as with capital markets. The function of financial manager along with other expert professionals within the corporate finance domain are two– folded. Firstly, they have to make sure that the company has adequate funds, that they are using the best sources of funding that allow minimal costs. Next, they have to make sure that that company is actually placing each fund appropriately and creating best returns on investments for its corporation. These two functions are the primary ones of corporate financing in every company. Finance Decisions: Let us consider that the company now has the access to the capital market to fulfill their funding specifications. But, the company confronts numerous options concerning funding. The company should firstly decide whether it wants to increase the debt capital or perhaps the equity capital. Even here there are various choices when selecting either equity or debt capital for a company. They may choose corporate loans, public fixed deposits, bank loan, and debentures to raise capital from the market. Financial innovation and then securitization have provided a variety of instruments the company can easily use to increase the capital. The functions of corporate finance manager are so promising that the company has both possible capital and appropriate capital structure. These have an appropriate combination concerning equity and debts along with other financial tools. Investment Choice: When the company has raised the required capital from various sources, their financial manager deals with the

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Corporate Finance

following big move. The decision is to deploy the funds in a manner that yields the best returns for shareholders. The company needs to be aware of its cost of capital. When the company sees the cost of the capital, it can deploy its funds in a way that each return exceeds the cost of the capital which the company maintains in order to pay. Looking for these investments plus deploying each funds effectively is the basis for the investment decision. It is also recognized that cost management is a fundamental function of corporate finance. Money cost management possesses theoretical presumption that the company has the access to unlimited financing as long they have feasible projects. The difference of this choice is capital rationing. Acquisition of Resources: Acquisition of resources suggests fund generation in cheapest possible ways. Fund resources generation is actually available through two groups – liability (it consists of warranties out of bank loans, goods, as well as payable accounts) and equity (this includes money from retained profits, investment returns or stocks selling). Allocation of Resources: Allocation of resources concerns income / profit maximization. Investment is categorized in 2 groups – fixed assets (land, buildings, machinery etc.) and current assets (receivable accounts, cash, stock, etc.) Broad functions of corporate finance tend to be: budgeting of capital, financial management, raising of capital or financing, risk management, corporate governance, etc. 1.2. Principles of corporate finance organization The objective of maximizing the value of the corporation while minimizing the risk is the soul of corporate financial theory. Corporate Finance Principles: Let us understand the three most fundamental principles in corporate finance which are the following ones – the investment, financing, and dividend principles. Investment Principle: This principle revolves around the simple concept that businesses have resources that need to be allocated in the most efficient way. The first and important decision that is to be made

1. Finance of corporaƟons: content and organizaƟon of acƟvity

in corporate finance is to do this wisely, i.e. decisions that not only provide revenue opportunities but also save money for future. This also encompasses the working capital decisions such as the credit days to be provided to the customers etc. Corporate finance also measures the return on a planned investments by comparing it to the minimum tolerable hurdle rate and deciding if the project/investment is feasible to be undertaken. Financing Principle: Most often businesses are funded with either debt or equity or both. In the investment decision that we earlier discussed once we have finalized the mix of equity and debt and its effects for the minimum acceptable hurdle rate, the next step would be to determine if the mix is the right one in the financing principle section. The job here for the corporate financier is to make sure that the business has the right amount of capital and the right mix of debt, equity and other financial instruments. In order to determine the optimal mix we need to study conditions where the optimal financing mix minimizes the acceptable hurdle rate. We also need to analyze the effects on firm value due to the change in capital structure. After we have defined the optimal financing mix, next we need to consider whether it would be a long term or a short term financing. We then include other considerations such as taxes and the success of strong decisions on the structure of financing. Dividend Principle: Businesses reach a stage in their life cycle where they grow and mature and the cash flow they generate exceeds the expected hurdle rate. At this stage the company needs to determine the ways of rewarding the owners. So the basic discussion here is that if the excess cash should be left in the business or given away to investors/owners. A company that is publicly held has the option of either pay off dividends or buy back stocks. Corporate finance is a very vast area of finance. There are so many fundamentals and concepts which require that you should have a knack of. Let us understand a few of them: 1. Capital budgeting. Capital budgeting is the process of planning expenditures on the assets (fixed assets) whose cash flows are

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Corporate Finance

expected to extend beyond one year. Managers study the projects and decide which ones to include in the capital budget. ‒ The term «capital» refers to long-term assets. ‒ The «budget» is a plan which details projected cash inflows and outflows during future period. The most common approaches that are used in project selection are discussed below: Net Present Value (NPV): This method discounts all cash flows (including both inflows and outflows) at the cost of the project capital and then sums those cash flows. The project is accepted if the NPV stands positive. NPV = Σ [CFt / (1 + k) t],

(1.1)

where CFt is the expected cash flow at the period t, k is the projects where CFt is the expected cash flow at period t, k is the cost of the project capital and n is its life. Internal Rate of Return (IRR): It is the discount rate that forces a project’s NPV to equal to zero. NPV = Σ [CFt / (1 + IRR)t].

(1.2)

Note this formula is simply the NPV formula solved for the particular discount rate that forces the NPV to equal zero. The IRR is the expected rate of return on a project. The NPV and IRR approaches will usually lead to the same accept or reject decisions. Payback period: It is the expected number of years required to recover the original investment. Payback happens when the cumulative net cash flow equals to 0. The shorter the payback period, the better it is. A company should establish a benchmark payback period and reject the proposal if payback is greater than the benchmark. 2. Time value of money. «A dollar today is worth more than a dollar tomorrow». If you have a 1000 tenge today, you can earn interest on it and have more than a 1000 tenge next year. For example, 100

1. Finance of corporaƟons: content and organizaƟon of acƟvity

tenge of today’s money invested for one year and earning 8% interest will be worth 108 tenge after one year. Annuity. Annuity is a bunch of structured payments or equal payments made regularly, e.g., every month or every year. Perpetuity. A perpetuity is a special kind of annuity – it has an infinite number of cash flows, all of the same dollar amount. Thus, it is an annuity that never ends! 3. Cost of capital. Capital is an essential factor of production, and it has a cost. The suppliers of capital require a return on their money. A company must evidently ensure that stockholders or those that have lent money to the company, e.g. banks, receive the return that they seek. It is significant for the company to calculate the cost of capital, as this is the rate of return that must be used when evaluating capital projects. The return from the project must be higher than the cost of the project in order for it to be acceptable. One of the methods to calculate the cost of capital is Weighted Average Cost of Capital (WACC).The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock and common stock or equity. It is also referred to as the marginal cost of capital (MCC) which is the cost of obtaining another dollar of new capital. 4. Working capital management. Working capital management involves the relationship between the company’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the company is able to continue its operations and that it has adequate ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital encompasses managing inventories, accounts receivable and payable, and cash. 5. Measures of leverage. Leverage, in the sense we use it here, refers to the amount of fixed costs the company has. These fixed costs might be fixed operating expenses, such as building or equipment leases, or fixed financing costs, such as interest payments on debt. Greater leverage leads to greater variability of the company’s after-tax operating earnings and net income.

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Corporate Finance

There are certain principles on which the organization of the company’s finances should be based. These principles ensure the adoption of effective strategic and tactical financial decisions, and on the basis of them the financial policy of the enterprise is developed. The following basic principles are distinguished: the principle of economic independence, profitability and self-financing, financial responsibility, material interest and the principle of financial resources. The principle of economic autonomy is that the company must independently determine the costs, sources of financing and the direction of investment of funds, the correspondence of expenses to sales volumes in order to obtain profit. The principle of profitability and self-financing is the full cost recovery, investment in the development of production at the expense of own sources, and in case of shortage – of bank and commercial loans. Thanks to profitability and self-financing it increases the economic responsibility of the enterprise and ensures independence. The category of profit in terms of self-financing is decisive. It is a source of selffinancing, including the financing of investments of the enterprise. The principle of liability is the presence of a certain system of responsibility for the result of financial and economic activity. Enterprises that violate financial laws pay fines, penalties, and charges. This principle is also implemented in respect of managers of the company through the system of fines, and towards individual employees in cases of violation of labor discipline by means of fines, deprivation of bonuses and dismissal from work. The principle of material interest is the need to make a profit, which is the main purpose of business. The material interest of the enterprise is manifested in obtaining sufficient profit, rational distribution of net profit and the establishment of the optimal tax burden. The principle of security of financial resources is based on the need to form financial reserves that provide business activities in the face of risks associated with the uncertainty of the external market environment. Financial reserves in enterprises that are formed from net income, if necessary, should be easily converted into cash and, accordingly, should be kept in liquid form with the aim of generating income.

1. Finance of corporaƟons: content and organizaƟon of acƟvity

According to the foreign and domestic experience of the organization of corporate finance, the following principles of corporate finance are highlighted: – planning; – financial ratio of terms; – the interdependence of financial indicators; – flexibility (maneuvering); – minimization of financial costs; – rationality; – financial sustainability. For the full implementation of these principles of the organization of corporation finance, certain forms and methods are applied which correspond to the level of development of the enterprise. 1.3. Financial mechanism of corporations The central element of the state’s financial system is the financial mechanism of a corporation, since it is a financial management system of an enterprise, which is expressed in organizing, planning and promoting the use of financial resources – the main goal of an effective impact on the final result of production. The elements of the structure of the financial mechanism are (there are only five): 1. Financial methods. 2. Financial leverage and tools. 3. Legal support. 4. Regulatory support of the financial mechanism. 5. Information support of the financial mechanism. A financial mechanism refers to the way in which a business, organization, or program receives the funding necessary for it to remain operational. Private companies, for example, typically receive such funding through a variety of means, including revenue generated from the sale of services and products as well as from loans or the sale of stock. Other organizations typically receive funding through various

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Corporate Finance

means, such as donations provided by individuals and companies as well as fund-raising events. The financial mechanism for government typically comes from taxes or other means of acquiring resources from the citizens, which is then used as funding for various agencies and programs. There are many different contexts in which the term «financial mechanism» can be used, though they all typically refer to the same basic concept. This is something of a catchall term for the source of funding that an organization or business receives. By using this term, a company can more easily establish practices and regulations for the utilization of funding on the operational level, without having to refer to the process of receiving money at every usage. The exact financial mechanism for an organization can be quite complex, and the use of a simple term makes it easier to describe and consider in overall. Revenue is one of the most common forms of financial mechanism for a business. This is typically generated through the sale of various products or services that the company manufacturers or otherwise provides for customers. Large companies, especially corporations, may use the creation and sale of stocks as a form of financial mechanism, to allow for a greater influx of resources based on the perceived value of the company. Businesses can also take out loans from banks and other institutions that ultimately have to be paid back, but which provide that company with initial capital for the development. Organizations, such as charities and other non-profit groups, can use different mechanisms to generate the resources necessary for ongoing operations. Donations from businesses and private individuals are quite common. An additional financial mechanism can come in the form of fund-raising through events and campaigns, and some groups may receive funding from governmental bodies. The method of influence of financial relations on the business process we call the financial methods. Financial methods include: – Financial Accounting. – Financial planning and forecasting. – Financial control.

1. Finance of corporaƟons: content and organizaƟon of acƟvity

– Financial regulation (taxation, crediting, insurance, financial and material incentives). – Financial analysis. Financial leverage and tools are a method of adopting a financial method. Financial leverage includes income, income, depreciation, special purpose economic funds, financial sanctions, rent, interest rates on loans, deposits, bonds, share contributions, contributions to authorized capital, portfolio investments, dividends, discounts, quotation of the exchange rate of tenge etc. Legal support of the functioning of the financial mechanism includes legislative acts, decrees, orders, circular letters and other legal documents of the governing bodies. Regulatory support for the functioning of the financial mechanism consists of instructions, standards, norms, tariff rates, guidelines and explanations, etc. Information support of the functioning of the financial mechanism consists of various types and types of economic, commercial, financial and other information. Financial information includes awareness of the financial stability and solvency of its partners and competitors, prices, rates, dividends, interest on the commodity, stock and foreign exchange markets, etc.; report on the situation on the exchange, overthe-counter markets, on the financial and commercial activities of any noteworthy economic entities; other various information. The financial mechanism and financial management are closely related to each other, since the financial mechanism is implemented in corporations through financial management. Financial management is the activity of an enterprise aimed at financial management, which involves the use of various techniques, methods and means to achieve the goals of the enterprise, as well as to increase profitability and minimize risks. The financial policy of a corporation determines the forms and methods of implementing the functions of financial management. The elements of this policy are: 1) accounting policy; 2) credit policy; 3) cash management policy; 4) cost management policy; dividend policy.

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Corporate Finance

The five major systems of financial management are: 1. Comprehensive budget management system. 2. Internal control management system. 3. Cost management system. 4. Financial information management system. 5. Financial management system. The objectives of financial management are: 1. Maximizing output value. 2. Maximizing profit. 3. Maximizing shareholder wealth. 4. Maximizing corporate value. 5. Maximizing stakes of related parties. The concept of financial management system is as follows: financial management system refers to the system that divides the relationship between rights and responsibilities in financial management of enterprises, and is a concrete manifestation of financial relations. In general, it includes two levels: the financial management system between the enterprise investor and the operator and the financial management system within the enterprise. The financial management system of the enterprise group is a system that clarifies the financial authority, responsibility and interests of the financial level of the group. The core issue is how to configure the financial management authority, which is mainly based on the distribution of financial power between the parent company and the subsidiary company. It belongs to the «superstructure» of the corporate financial management work, and plays a role in promoting, distributing and guiding the financial activities of the «economic base» of the enterprise group. The types of financial management systems are the following ones: the financial management system can be divided into centralized financial management system, decentralized financial management system and mixed-standard financial management system according to the degree of centralized management. The centralized financial management system. The so-called centralized management system refers to the financial management

1. Finance of corporaƟons: content and organizaƟon of acƟvity

system in which the major financial decision-making powers are concentrated in the parent company, and the parent company adopts strict control and unified management methods for the subsidiaries. Tasks: 1. Explain the financial relations of the company in terms of the implementation of financial and economic activities. 2. What are the characteristic features of financial relations between the state and business? 3. Explain the content of the finance distribution function. 4. Expand the essence of the control function of finance in the process of reproduction. 5. What are the principles of organization of finance companies that are directly related to the distribution of profits Activity 1. Based on the information provided on the website of the Private Asset Management Company, Halyk Bank, Freedom Finance, determine whether the company can be attributed to a corporation or not. To answer this question, fill in the table below: Yes/No 1 Is Private Asset Management Company (Halyk Bank, Freedom Finance) an open joint stock company? 2 Does the company have a typical corporate governance structure? 3 Does Private Asset Management Company (Halyk Bank, Freedom Finance) have an opportunity to interact with the capital market? 4 Does the company disclose materials on its website? Activity 2. Match the expression

1 2 3 4 5

Attract / Invest Strategic Structure Company Investment

a b c d e

Investor Capital Financial assets Decision Stock type

Interpretation

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Corporate Finance Test questions: chapter 1 1. The basic concepts associated with the borrowed capital of the company: a) bond issue b) financial leverage c) credit risk d) dividends e) company profit f) company reserves g) stock issue h) production leverage 2. Discount cash flow method: a) estimate of the future value of the cash flow from the position of the current point in time b) method of determining the present value of future cash flows c) income assessment method that determines the amount of discounted cash flow d) income from providing capital or investment e) income from capital in debt in various forms f) industrial and financial investments g) a valuation method that takes into account changes in the value of money in h) past 3. Types of fixed assets: a) residual b) liquidation c) initial (recovery) d) implemented e) intermediate f) cost-effective g) corporate h) investment 4. Stages of capital turnover: a) production b) procurement (purchase of raw materials) c) preparatory d) primary e) cash f) long-term g) semi-finished h) secondary

1. Finance of corporaƟons: content and organizaƟon of acƟvity 5. Factors taken into account in the planning of current expenditures: a) price factors b) fluctuations in the range and range of products c) change in the volume of production and sales of products d) production e) basic f) minor g) material h) specification of production 6. The composition of external sources attracted for the formation of own company equities includes: a) raising additional share capital b) gratuitous assistance from legal entities and the state c) founders’ contributions to the share capital d) short-term loans e) funds from revaluation of fixed assets f) Bonds issued g) long-term loans h) company reserve funds 7. The value of the indicator of the coefficient of financial tension can be: a) 40% in balance sheet b) 30% in balance sheet c) 50% of the balance sheet d) 90% in balance sheet e) 100% in balance sheet f) 70% in balance sheet g) 80% in balance sheet h) 60% in balance sheet 8. The formation and use of corporation capital is based on the following principles: a) consideration of the development prospects of the corporation b) assurance of the rational use of capital c) assurance of an optimal capital structure d) fulfillment of corporate obligations e) reality principle f) principle of publicity g) the principle of completeness h) the value of fixed assets

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Corporate Finance 9. The analysis of the financial state of the corporation is necessary for: a) identification of the factors affecting the financial state b) assessment of quantitative and qualitative changes in financial c) determination of trends in financial state d) determination of the share capital e) determination of the amount of dividends paid f) identification of long-term assets g) determination of equity h) determination of taxable income 10. The 3 groups of external factors of crisis financial development are: a) market factors b) other external factors c) socio-economic factors of the general development of the country and indirect factors d) non-core business e) ineffective strategy f) financial factors g) general economic factors 11. Forecast of cash flows contains the operations: a) calculation of total short-term financing needs b) cash flow planning and net cash flow calculation c) forecasting cash receipts for the period d) current (operational) activity e) calculation of long-term financing needs f) calculation of future costs g) forecasting revenue from sales of products h) investment attraction 12. The steps of the financial planning process include: a) preparation of the main forecast financial documents b) practical implementation of plans and monitoring of their implementation c) analysis of financial performance for the previous period d) increased production e) accounts payable analysis f) determination of the reserves of the enterprise g) increase in receivables h) increase in tax burden 13. In accordance with the portfolio of financial investments we distinguish the following types of consumers: a) conservative type

1. Finance of corporaƟons: content and organizaƟon of acƟvity b) aggressive type c) moderate type d) creative type e) differentiated type f) loyal type g) short term h) diversification type 14. Main terms of interest accrual: a) annually b) quarterly and semi-annually c) monthly d) incomplete month e) twice a month f) continuously g) in the afternoon h) daily 15. Depreciation is: a) in material terms, the restoration of the value of fixed assets b) in monetary terms, the depreciation of fixed assets in the process of their productive functioning c) the process of transferring the value of worn fixed assets to the product produced with their help d) in monetary terms, revolving funds e) increase in productivity f) transferring value for revolving funds g) in monetary terms, the renewal of labor in the process of productive functioning 16. The policy of attracting a bank loan includes the following main steps: a) determination of the purposes of using the attracted bank loan b) credit and collateral valuation c) assessment of the ratio between equity and credit, as well as the loan amount d) consumer research e) study of depreciation policy f) supplier research g) accounts payable analysis h) salary increase 17. Methods of analysis of financial and economic activities: a) trend analysis b) horizontal analysis

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Corporate Finance c) factor analysis d) qualitative analysis e) lateral analysis f) quantitative analysis g) circular analysis h) endless analysis 18. Crisis management involves the diagnosis of financial state based on the analysis of groups of financial indicators: a) analysis of financial stability and profitability b) solvency and liquidity analysis c) structural analysis of assets and liabilities d) comparative balance analysis e) express diagnostics f) balance sheet analysis g) horizontal balance analysis h) economic and mathematical analysis 19. The main objectives of the financial planning of the enterprise are: a) provision of the necessary financial resources of industrial, investment and financial activities b) identification of ways of effective capital investment, assessment of its rational use c) control over the financial state, payment and creditworthiness of the enterprise d) labor reduction e) reduced demand for products f) increase in tax burden g) increased payroll h) solvency decline 20. Financial resources are the source of the formation of the following trust funds: a) consumption b) accumulation c) backup d) absorption e) banking f) retirement g) distribution h) education

2. FUNDAMENTALS OF FINANCIAL ANALYTICS OF CORPORATION

2.1. Purpose and objectives of the financial analysis of the corporation 2.2. Financial analysis and management decisions 2.3. Methods of financial analysis

2.1. Purpose and objectives of the financial analysis of the corporation One of the main elements of corporate finance management is financial analysis. Effective enterprise finance management is necessary to achieve corporate stability financially. With the help of diagnostics of the internal and external economic environment, financial management is reflected in the development of strategy and tactics. Leading managers and analysts are interested not only in the current financial situation of the company, but also in the forecast for the near future. Accounting and reporting data, the study of which helps to reproduce all key aspects of production and commercial activities and operations in a generalized form, serve as the initial basis for financial analysis. Financial analysis can assist small businesses in their planning. Evaluation of the company’s balance sheet, income statement and cash flow statement – interpreting trends and identifying strengths and weaknesses – might yield enough information to enable the management to make projections of revenues and profits for three to five years. With the knowledge of trends in the general economy and in the company’s industry, they can form a reasonable estimate of how well 29

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the company might function in the coming years. Such analyses can be helpful to businesses that need to plan equipment purchases and other initiatives. The main methods of financial analysis that are used in practice include: – analysis of the financial statements; – horizontal analysis; – vertical analysis; – trend analysis; – comparative (spatial) analysis; – factor analysis; – the method of financial ratios. The development of measures for the effective management of assets, equity and borrowed capital of the enterprise is carried out in the framework of the diagnosis of the internal environment. The analysis of the external environment includes the following parameters: – the study of the dynamics of prices for goods and services; – the study of tax rates; – the study of interest rates on bank loans and deposits; – the rate of issued securities; – the activities of competitors in the commodity and financial markets. The ultimate goal of the analysis is to identify possible alternative solutions and to evaluate them before the implementation. Only the enterprise management of the highest level, able to make decisions on the formation and use of capital and income, as well as influence cash flow, has the authority to conduct financial analysis. Local management decisions include determination of the price of the finished product, the volume of purchases of material resources or the supply of finished products, the replacement of equipment and technology. Their effectiveness is evaluated in terms of the final financial result. Financial analysis helps to make decisions on: – financing of the enterprise in the short term;

2. Fundamentals of financial analyƟcs of corporaƟon

– financing of the enterprise in the long term; – paying dividends to shareholders; – mobilizing of the reserves of economic growth. Financial analysis is an integral part of the overall economic analysis. It consists of financial analysis and production management analysis, which are closely interrelated. The classification of the analysis into financial and managerial is explained by the practice of division of accounting into financial and management accounting. Objectives of Financial Analysis. 1. Review of the performance of the company over the past periods: to predict the future prospects of the company, past performance is analyzed. Past performance is analyzed by reviewing the trend of the past sales, profitability, cash flows, return on investment, debt-equity structure and operating expenses, etc. 2. Assessment of the current position and operational efficiency: examination of the current profitability & operational efficiency of the enterprise so that the financial health of the company can be determined. For long-term decision making, assets and liabilities of the company are reviewed. Analysis helps in finding out the earning capacity and operating performance of the company. 3. Prediction of the growth and profitability prospects: the top management is concerned with future prospects of the company. Financial analysis helps them in reviewing the investment alternatives for judging the earning potential of the enterprise. With the help of financial statement analysis, assessment and prediction of the bankruptcy and probability of business failure can be done. 4. Loan Decision by Financial Institutions and Banks: financial analysis helps the financial institutions, loan agencies and banks to decide whether a loan can be given to the company or not. It helps them in determining the credit risk, deciding the terms and conditions of the loan, if sanctioned, interest rate, maturity date, etc. Financial analysis is an aspect of the overall business finance function that involves examination of the historical data to gain information about the current and future financial health of the company. Financial analysis can be applied in a wide variety of situations

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to give business managers the information they need to make critical decisions. The ability to understand financial data is essential for any business manager.

Figure 1. Documents used in financial analysis Note: compiled by the author

Balance Sheet. The balance sheet outlines the financial and physical resources that are available for business activities in the future. It is important to note, however, that the balance sheet only lists these resources, and makes no judgment about how well they will be used by the management. For this reason, the balance sheet is more useful in analyzing the company’s current financial position than its expected performance. The main elements of the balance sheet are assets and liabilities. Assets generally include both current assets (cash or equivalents that will be converted to cash within a year, such as accounts receivable, inventory, and prepaid expenses) and noncurrent assets (assets that are held for more than one year and are used in running the business, including fixed assets such as property, plant, and equipment; long-

2. Fundamentals of financial analyƟcs of corporaƟon

term investments; and intangible assets such as patents, copyrights, and goodwill). Both the total amount of assets and the makeup of asset accounts are of interest to financial analysts. The balance sheet also includes two categories of liabilities – current liabilities (debts that will come due within a year, such as accounts payable, short-term loans, and taxes) and long-term debts (debts that are due in more than one year from the date of the statement). Liabilities are important to financial analysts because businesses have the same obligation to pay their bills regularly as individuals, while business income tends to be less certain. Long-term liabilities are less important to analysts, since they lack the urgency of short-term debts, though their presence does indicate that a company is strong enough to be allowed to borrow money. Income Statement. In contrast to a balance sheet, an income statement provides information about the company’s performance over a certain period of time. Although it does not reveal much about the company’s current financial state, it does provide indications of its future viability. The main elements of the income statement are revenues earned, expenses incurred, and net profit or loss. Revenues are generated mainly by sales, though financial analysts may also note the inclusion of royalties, interest, and extraordinary items. Likewise, operating expenses usually consist primarily of the cost of goods sold, but can also include some unusual items. Net income is the «bottom line» of the income statement. This figure is the main indicator of the company›s accomplishments over the statement period. Cash Flow Statement. The cash flow statement is similar to the income statement in which the company’s performance over a specified period of time is recorded. The difference between the two is that the income statement also takes into account some non-cash accounting items such as depreciation. The cash flow statement strips away all of this and shows exactly how much actual money the company has generated. Cash flow statement shows how companies have performed in managing inflows and outflows of cash. It provides a sharper picture of a company’s ability to pay bills, creditors, and reflects finance growth better than any other one financial statement.

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Figure 2. Elements of financial health. Note: compiled by the author

The company’s overall financial health can be assessed by examining three major factors: its liquidity, leverage, and profitability. All three of these factors are internal measures that are largely within the control of the company’s management. It is important to note, however, that they may also be affected by other conditions-such as overall trends in the economy-that are beyond the management’s control. Liquidity. Liquidity refers to the company’s ability to pay its current bills and expenses. In other words, liquidity relates to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. All small businesses require a certain degree of liquidity in order to pay their bills on time, though start-up and very young companies are often not very liquid. In mature companies, low levels of liquidity can indicate poor management or a need for additional capital. Of course, any company’s liquidity may change due to seasonal variations, the timing of sales, and the state of the economy. Companies tend to run into problems with liquidity because cash outflows are not flexible, while income is often uncertain. Creditors expect their money when promised, and employees expect regular paychecks. However, the cash received by a business does not often follow a set schedule. Sales volumes fluctuate as do collections from customers. Due to this difference between cash generation and cash

2. Fundamentals of financial analyƟcs of corporaƟon

payments, businesses should maintain a certain ratio of current assets to current liabilities in order to ensure adequate liquidity. Leverage. Leverage refers to the proportion of the company’s capital that has been contributed by investors as compared to creditors. In other words, leverage is the extent to which the company depends upon borrowing to finance its operations. The company that has a high proportion of debt in relation to its equity would be considered highly leveraged. Leverage is an important aspect of financial analysis because it is reviewed closely by both bankers and investors. A high leverage ratio may increase the company’s exposure to risk and business downturns, but along with this higher risk the potential for higher returns also becomes possible. Profitability. Profitability refers to the management’s performance in using the resources of a business. Many measures of profitability involve calculation of the financial return that the company earns on the money that has been invested. Most entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If profitability measures demonstrate that this is not occurring – particularly once a small business has moved beyond the start-up phase – then the entrepreneur should consider selling the business and reinvesting the money elsewhere. However, it is important to note that many factors can influence profitability measures, including changes in price, volume, or expenses, as well the purchase of assets or borrowing of money. 2.2. Financial analysis and management decisions Financial analysis (also referred to as financial statement analysis or accounting analysis or analysis of finance) refers to an assessment of the viability, stability, and profitability of a business, sub-business or project. Financial analysis may determine whether a business will: ‒ Continue or discontinue its main operations or part of its business.

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‒ Make or purchase certain materials in the manufacture of its product. ‒ Acquire or rent/lease certain machineries and equipment in the production of its goods. ‒ Issue stocks or negotiate for a bank loan to increase its working capital. ‒ Make decisions regarding investing or lending capital. ‒ Make other decisions that allow the management to make an informed choice from various alternatives in the conduct of the business. Financial analysis consists of external financial analysis and internal financial analysis. External financial analysis is based on public financial reporting data, and internal financial analysis is based on accounting and reporting data. Management analysis includes internal financial analysis according to accounting and reporting data and internal production analysis according to management accounting data. Financial analysis is based on the data from public financial statements that considered external analysis. Special features of external financial analysis are: – a large number of subjects of the analysis – the users of information about the activities of the enterprise; – personal goals and interests of each subject of the analysis; – openness, maximum results of the information about the work of the enterprise, analysis for users. Partners of the company carry out external financial analysis in the following areas: – analysis of the balance sheet liquidity, solvency, and financial stability; – analysis of the own asset utilization efficiency, and the borrowed capital; – absolute study of profit indicators; – analysis of relative rates of return; – overall assessment of the financial state of the company. Goals. Financial analysts often assess the following elements of the company:

2. Fundamentals of financial analyƟcs of corporaƟon

1. Profitability – its ability to earn income and sustain growth in both the short- and long-term. A company’s degree of profitability is usually based on the income statement, which reports on the company’s results of operations. 2. Solvency – its ability to pay its obligations to the creditors and other third parties in the long-term. 3. Liquidity – its ability to maintain positive cash flow, while satisfying immediate obligations. Both points 2 and 3 are based on the company›s balance sheet, which indicates the financial condition of a business as of a given point in time. 4. Stability – the company›s ability to remain in business in the long run, without having to suffer significant losses in the conduct of its business. Assessing a company›s stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators. Methods. Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):  Past Performance is across historical time periods for the same company (the last 5 years for example),  Future Performance is the use of historical figures and certain mathematical and statistical techniques, including present and future values, for preparing the forecast. This extrapolation method is the main source of errors in financial analysis as past statistical data can be poor predictors of future prospects.  Comparative Performance is the comparison between similar companies. These ratios are calculated by dividing (a group of) account balance(s), taken from the balance sheet and/or the income statement, by another variable, for example: Net income / equity = return on equity (ROE)

(2.1)

Net income / total assets = return on assets (ROA)

(2.2)

Stock price / earnings per share = P/E ratio

(2.3)

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Corporate Finance

Comparison of financial ratios is merely one way of conducting financial analysis. Financial ratios face several theoretical challenges: ‒ They say little about the company›s prospects in an absolute sense. Their insights concerning relative performance require a reference point in other time periods or similar companies. ‒ One ratio holds little meaning. As indicators, the ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the company ‘s performance. ‒ Seasonal factors may prevent year-end values from being representative. A ratio’s values may be distorted as the account balances change from the beginning to the end of the accounting period. Use average values for such accounts whenever possible. ‒ Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values. ‒ Fundamental analysis. Financial analysts can also use percentage analysis which involves reducing a series of figures as a percentage of some base amount. For example, a group of items can be expressed as a percentage of net income. When proportionate changes in the same figure over a given time period are expressed as a percentage it is known as horizontal analysis. Vertical or common-size analysis reduces all items on a statement to a «common size» as a percentage of some base value which assists in comparability with other companies of different sizes. As a result, all Income Statement items are divided by Sales, and all Balance Sheet items are divided by Total Assets. Another method is a comparative analysis. This provides a better way to determine trends. Comparative analysis presents the same information for two or more time periods and is presented side-by-side to allow for easy analysis. Financial accounting allows a business to keep track of all its financial transactions. It is the process in which the company records and reports all the financial data that go in and out of its business operations. The accounting data is recorded in a series of financial state-

2. Fundamentals of financial analyƟcs of corporaƟon

ments including the balance sheet, income statement and cash flow statement. There are a series of accounting principles the companies adhere to in their financial accounting. The majority of publicly traded companies in the United States follow the generally accepted accounting principles (GAAP), a common set of standards the accountants follow when they complete their financial statements. Companies outside the U.S. generally follow other international standards that vary by region and country. There are three main areas where financial accounting helps decision-making:  It provides investors with a baseline of analysis for – and comparison between – the financial health of securities-issuing corporations.  It helps creditors assess the solvency, liquidity, and creditworthiness of businesses.  Along with its cousin, managerial accounting, it helps businesses make decisions on the ways of allocating scarce resources. Investing Decisions. Fundamental analysis depends heavily on a company’s balance sheet, its statement of cash flows and its income statement. All of the financial statements for publicly traded companies are created and reported according to the financial accounting standards set forth by the Financial Accounting Standard Board (FASB). Investors use the information from financial statements to make decisions about the valuation and creditworthiness of a company. Without the information provided by financial accounting, investors would have less understanding about the history and current financial health of stock and bond issuers. The requirements set forth by the FASB create consistency in the timing and style of financial accounts, which means the investors are less likely to be subject to accounting information that has been filtered based on the company›s current condition. Lending Decisions. Financial accounting is also a key for lenders. Since the financial statements outline all the assets as well as the short – and long-term debt, lenders get a better sense of the company’s creditworthiness.

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A number of common accounting ratios the creditors rely on, such as the debt-to-equity (D/E) ratio and times interest earned ratio, are derived from the company›s financial statements. Even for privately-owned businesses that do not necessarily follow the requirements of the FASB, no lending institution assumes the liability of a large business loan without critical information provided by financial accounting techniques. Ultimately, a lender wants to know just how much risk is involved by lending money to a company, which can be determined by reviewing the company›s financial accounting. Once this is determined, the lender will also be able to outline exactly how much to lend and at what interest rates. Corporate Governance. Reliable accounting serves a practical function not only for investors and lenders but also for the companies themselves. The most obvious benefit for businesses to complete their financial accounting is to meet the legal and regulatory obligations outlined for (public) companies. Companies must be honest about their financial activities and the data must be accurate and published regularly. In addition to regulatory and compliance requirements financial accounting also helps managers create budgets, understand public perception, track efficiency, analyze product performance and develop short- and long-term strategies. The Bottom Line. Financial accounting is a way for businesses to keep track of their operations, but also to provide a snapshot of their financial health. By providing data through a variety of statements including the balance sheet and income statement, a company can give investors and lenders more power in their decision making. 2.3. Methods of financial analysis In practice, various methods of financial analysis are applied. All of them involve the use of accounting data and financial statements for the current and past periods.

2. Fundamentals of financial analyƟcs of corporaƟon

Financial Analysis is defined as the process of identifying financial strength or weakness of a business by establishing relationship between the elements of balance sheet and income statement. The information pertaining to the financial statements is of a great importance through which the interpretation and analysis are made. It is through the process of financial analysis that the key performance indicators, such as, liquidity solvency, profitability as well as the efficiency of operations of a business entity may be ascertained, while short term and long term prospects of a business may be evaluated. Thus, identifying the weakness, the intent is to arrive at recommendations as well as forecasts for the future of a business entity. Financial analysis focuses on the financial statements, as they are a disclosure of a financial performance of a business entity. «A Financial Statement is an organized collection of the data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspects of a business. It may show assets position at a moment of time as in the case of balance sheet, or may reveal a series of activities over a given period, as in the case of an income statement». Since there is a recurring need to evaluate the past performance, the present financial position, the position of liquidity and to assist in forecasting the future prospects of the organization, various financial statements are to be examined in order to forecast the earnings and to ascertain the progress of the company. The financial statements are the income statement, balance sheet, statement of earnings, statement of changes in financial position and the cash flow statement. The income statement, having been termed as profit and loss account is the most useful financial statement to enlighten what has happened to the business between the specified time intervals while showing the revenues, expenses, gains and losses. A balance sheet is a statement which shows the financial position of a business at certain point of time. The distinction between income statement and the balance sheet is that the former is for a certain period and the latter indicates the financial position on a particular date. However, on the basis of financial statements, the objective of finan-

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cial analysis is to draw information to facilitate decision making, to evaluate the strength and the weakness of a business, to determine the earning capacity, to provide insights on liquidity, solvency and profitability and to decide the future prospects of a business entity. There are various types of Financial analysis: External analysis: the external analysis is made on the basis of published financial statements by those who do not have access to the accounting information, e.g., by stock holders, banks, creditors, and the general public. Internal Analysis: this type of the analysis is made by finance and accounting department. The objective of such analysis is to provide the information to the top management, while assisting in the decision making process. Short-term Analysis: it is concerned with the working capital analysis. It involves the analysis of both current assets and current liabilities, so that the cash position (liquidity) may be determined. Horizontal Analysis: comparative financial statements are an example of horizontal analysis, as these involve the analysis of the financial statements for a number of years. Horizontal analysis is also regarded as Dynamic Analysis. Vertical Analysis: it is performed when financial ratios are to be calculated for one year only. It is also called a static analysis. An assortment of techniques is employed in analyzing financial statements. These techniques are: comparative financial statements, statement of changes in working capital, common size balance sheets and income statements, trend analysis and ratio analysis. Comparative Financial Statements: it is an important method of analysis which is used to make comparison between two financial statements. Being a technique of horizontal analysis applicable to financial statements, income statement and balance sheet, it provides meaningful information when compared to the similar data of prior periods. The comparative statement of income statements enables to review the operational performance and to draw conclusions, whereas the balance sheets, presenting a change in the financial position during the period, show the effects of operations on the assets and liabilities.

2. Fundamentals of financial analyƟcs of corporaƟon

Thus, the absolute change from one period to another may be determined. Statement of Changes in Working Capital: The objective of this analysis is to extract the information relating to working capital. The amount of net working capital is determined by deducting the total of current liabilities from the total of current assets. The statement of changes in working capital provides the information in relation to working capital between two financial periods. Common Size Statements: the figures of financial statements are converted to percentages. It is performed by taking the total balance sheet as 100%. The balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability to total liabilities. Thus, it shows the relation of each component to the whole. Trend Analysis: it is an important tool of horizontal analysis. Under this analysis, the ratios of different items of the financial statements for various periods are calculated and the comparison is made accordingly. The analysis over the prior years indicates the trend or direction. The trend analysis is a useful tool to understand whether the financial health of a business entity is improving in the course of time or it is deteriorating. Ratio Analysis: The most popular way to analyze the financial statements is computing ratios. It is an important and widely used tool of analysis of financial statements. While developing a meaningful relationship between the individual items or group of items of balance sheets and income statements, it highlights the key performance indicators, such as liquidity, solvency and profitability of a business entity. The tool of ratio analysis performs in a way that it makes the process of comprehension of financial statements simpler, at the same time, it reveals a lot about the changes in the financial condition of the business entity. It must be noted that Financial analysis is a continuous process applicable to every business to evaluate its past performance and current financial position. It is useful in various situations to provide managers with the information that is needed for critical decisions. The process of financial analysis provides the information about the

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ability of a business entity to earn income while sustaining both short term and long term growth. Analysis of financial statements helps the company leaders determine the opportunities and problems the company faces financially. At its core, the financial statement is a pulse of the financial health of the company, determining if it is capable of paying expenditures, is overburdened with debt or flux with of capital to expand. There are two primary methods of financial statement analysis: horizontal and vertical. Other methods are the extensions of these ones. Horizontal Financial Data Analysis. Horizontal financial data analysis covers the financial information as it changes from one reporting period to another reporting period. Comparison of the line items of the financial statement, such as cost of goods sold or net income from one quarter to another one helps the business leader determine the progress. The analysis may span over several defined reporting periods, such as months, quarters or years. The critical thing a business leader looks for in horizontal financial analysis is whether a specific line item has changed significantly. For example, if the cost of goods sold rose by 20 percent but the revenues did not reflect the increase in sales, something costs the company more money. Likewise, if the gross profit rises but the net profit drops, the business leader must determine if cost-cutting measured are required. Vertical Financial Data Analysis. Vertical financial data analysis takes a look at the financial statement independent of time. This means the statement is reviewed as it is without comparing it to other months or quarters. The goal of vertical analysis is to find the correlations of various line items to each other in the financial statement. Business leaders are looking for overall efficiency in the flow of revenues and expenses. All information is reviewed as a ratio, comparing one line in the vertical with another line. Trends and Ratios in Financial Analysis. As the horizontal analysis examines the same line items over time, it is specifically designed to recognize trends in the company’s financial status. The ratios determined in the vertical analysis help clearly show upward and downward trends in gross and net profits. A business leader looks for

2. Fundamentals of financial analyƟcs of corporaƟon

specific indices for the company to meet. For example, a manufacturer might want to see a 10 percent increase in the cost of goods sold, representing more products on the market annually. He would then want to see the correlating net profit increase by 20 percent to show that the production growth resulted in the net revenue growth. Understanding how various line items of the financial statement work with each other and change over time gives business leaders the information to make strategic plans. If overhead, such as rents and administrative labor, start to suppress the ability of the company to improve net profits, it might be the time to strategize cost-cutting measures. Executives would need to determine what roles are necessary to fulfill the company vision and where they can reduce costs. They might actually choose to relocate the office to a less expensive location. Forecasting With Financial Analysis The use of financial analysis methods provides a great look at what has happened and what is currently happening with the company. However, it cannot predict the future. While it identified trends, it cannot foresee market factors that change all variables affecting total revenues, cost of goods sold or net profits. Business leaders should use this as a tool but prepare themselves to make adjustments as new information arises affecting costs and revenues. Tasks: 1. Identify the role of timely reporting as a basis for developing management financial decisions. 2. Express your opinion on corporate financial disclosure standards. 3. What do you think is the most important in conducting a financial analysis? 4. Conduct independent express diagnostics of the corporate reporting of the company on the basis of the data on the website www.kase.kz 5. Suppose you are the owner of a large corporation. Determine the main priorities in keeping the financial statements of your company. Activity 1. Imagine a company that organizes its business as follows: firstly, the company buys raw materials from suppliers, secondly, it manufactures finished products from it, then sells them on the market. Imagine that in the first period, the company bought raw materials for $ 1,000, then sent them to the warehouse, as the next step it manufactured finished products and, in anticipation of the sale, also placed them in the warehouse, waiting for shipment. Tell us how in these three cases your own working capital will change.

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Corporate Finance Activity 2. Select on the website www.kase.kz a joint-stock company and analyze the financial statements for the last 3 years. Explain your opinion on the following points: if the company does not have debts, is this phenomenon a positive or negative sign for its further development? Test questions: chapter 2 1. An option to sell, or a put option, allows the option buyer to: a) sell the security b) sell currency c) sell shares d) buy assets e) buy currency f) buy stock g) buy and sell currency at the same time h) buy and sell assets at the same time 2. Depreciation is not charged on: a) library funds and construction in progress b) urban improvement facilities, land plots c) public roads d) basic production assets e) vehicles f) cars g) buildings, structures h) equipment 3. The types of evaluation of finished products include: a) production cost b) total cost c) enterprise contract price and commercial price d) non-production costs e) conditional cost f) wholesale price g) non-commercial cost 4. The increase in the profitability of a corporation may be due to: a) improved financial management b) cost reduction c) increased production d) increase in tax burden e) lower tax rates f) increase in depreciation

2. Fundamentals of financial analyƟcs of corporaƟon g) lower production volumes h) reduced value of fixed assets 5. Classification of capital by organizational and legal forms of activity: a) share b) individual c) shareholder d) domestic e) state f) consumed g) functioning h) borrowed 6. Bonds provide: a) the right to return the nominal value after the expiration of its circulation b) the right to receive a guaranteed income c) the right to pay interest before calculating dividends on shares. d) the right to convert them into government securities e) the right to purchase and sell other securities of the company f) the right to an appropriate share in the company’s share capital and g) the balance of the company’s assets in case of its liquidation (h) the right to govern i) the right to vote 7. The main forms of financial reporting: a) profit and loss account b) balance sheet c) cash flow statement d) declaration e) working capital report f) patent g) financial analysis h) equity report 8. Methods of legal procedures characterizing the process of absorption of some companies by the other ones: a) takeover by acquiring company assets b) takeover by acquiring a controlling interest. c) merger or consolidation d) denationalization e) privatization f) unification

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Corporate Finance g) capitalization of funds h) investment 9. Planning methods: a) settlement – analytical b) optimization of planned decisions and economics – mathematical simulation c) regulatory and balance sheet d) economic – calculated e) multifactorial f) chain performances g) linear h) unbalanced 10. The financial policy of the corporation includes: a) implementation of practical actions in accordance with the objectives aimed at achieving the growth of the market value of the company b) development of an optimal financial management concept c) identification of the main directions of formation and use of financial resources in the current period d) achievement of financial transparency in financial management e) use of capital in material form f) accounting and analysis of capital formation g) attraction of shareholders h) raising capital 11. The essence of the concept of the time value of money is: a) money today is more expensive than money tomorrow b) the money invested is depreciated over time c) cash is equal in absolute value, but received and spent in different periods of time is unequal d) today’s money is less valuable than future money e) future money always has more value f) funds of equal magnitude, received and spent in different periods of time, are equivalent g) cash is equal in absolute value, but received and spent in different periods of time is equivalent h) tenge tomorrow is more expensive than tenge today 12. Depreciation methods: a) production method b) equal cost write-off c) accelerated write-off

2. Fundamentals of financial analyƟcs of corporaƟon d) residual value e) uneven write-off of value f) recovery g) initial h) at residual value 13. Working capital with an average risk of investment: a) prepaid expenses b) short-term receivables c) work in progress d) cash e) goods are not in demand f) inventory g) accounts payable h) stale reserves 14. Selling expenses: a) advertising costs b) the cost of packaging and storing the products in finished goods warehouses c) costs associated with the sale of finished products d) depreciation deductions e) overhead costs f) direct costs g) payment for electricity h) administrative and management expenses 15. Profit of the enterprise: a) the difference between income and expenses b) the final financial result of operations c) the economic effect resulting from the activities of the enterprise d) the ratio of fixed costs to gross margin 16. Types of preferred shares: a) floating rate dividend b) convertible c) cumulative d) short term e) coupon f) discount g) transferable h) medium term

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Corporate Finance 17. Types of bonds: a) registered and bearer b) interest and interest free c) secured and unsecured d) declared and posted e) equity and debt f) simple and privileged g) basic and derivatives h) cumulative and non-cumulative 18. Basic principles of capital formation: a) taking into account the prospects for the development of the corporation and increase in the return on equity b) the rational use and growth of the market value of the capital c) minimization of capital formation costs d) lack of borrowed capital sources e) the principle of planning f) excess of the cost of capital over the return on investment g) principle of diversification h) principle of publicity 19. Groups of financial ratios in financial analysis: a) solvency and financial stability ratios b) profitability and liquidity ratios c) business ratios and market value d) risk factors e) independence factors f) break-even ratios g) credit ratios h) balance factors 20. Principles of crisis financial management of the enterprise: a) differentiation of crisis indicators by the degree of their risks b) for financial development of the enterprise c) financial risk management, hedging insurance d) early diagnosis of crisis events that disrupt financial balance e) recruitment of qualified personnel f) dismissal of workers with the purpose of saving on wages g) evasion of excessive payment of taxes that violate financial balance h) employee insurance i) cost reduction

3. FIXED CAPITAL OF CORPORATIONS

3.1. Essence of fixed capital: composition and structure 3.2. Indicators of the movement of fixed assets 3.3. Depreciation and amortization of fixed assets 3.4. Indicators of the efficiency of fixed assets use

3.1. Essence of fixed capital: composition and structure Capital is a part of financial resources advanced and invested in production for profit. The object of investment distinguish between fixed and circulating capital. Equity capital is that part of capital used by an enterprise that is invested in all types of non-current assets. Fixed capital includes: 1. Tangible assets (buildings, structures, transmission devices, machinery and equipment, vehicles, tools, industrial equipment, household equipment). 2. Intangible assets (patents, licenses, rights, trademarks, business reputation). 3. Financial assets (long-term financial assets). Fixed capital includes the assets and capital investments, such as property, plant, and equipment (PP&E), that are required to start up and conduct business, even at a minimal stage. These assets are considered fixed in that they are not consumed or destroyed during the actual production of goods or services but have a reusable value. Fixed-capital investments are typically depreciated in the company’s accounting statements over a long period of time – up to 20 years or more. Fixed capital 51

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can be contrasted to variable capital, the cost and level of which change over time and with the scale of a company’s output. For instance, machinery used in production would be considered fixed capital, while human labor would be a component of variable capital. The concept of fixed capital was first introduced in the 18th century by the political economist David Ricardo. According to Ricardo, fixed capital refers to any kind of real or physical asset that was consumed in the production of a product. This contradicts to Ricardo’s idea of circulating capital, that includes raw materials, operating expenses and labor. In Marxian economics, fixed capital is closely related to the concept of constant capital. Fast Facts. Fixed capital includes the assets and capital investments, such as property, plants, and equipment. The amount of fixed capital required to set up a business is quite variable, especially from industry to industry. Fixed capital is subject to the accounting practice of depreciation. Explanation of Fixed Capital. Serving as the mechanism upon which production activities take place, fixed capital includes tangible items, such as equipment and facilities, which are required for business operations. Fixed capital does not include materials used in the actual composition of the goods being produced. Investments in fixed capital include the addition of new tools and equipment, as well as real estate required to create and house the goods produced. A fixed asset may be resold and reused at any time before its useful life is over, which often happens with vehicles and airplanes. Fixed Capital Requirements. The amount of fixed capital required to set up a business is quite variable, especially from industry to industry. Some lines of business require high fixed-capital investment. Common examples include industrial manufacturers, telecommunications providers and oil exploration companies. Service-based industries, such as accounting firms, may have more limited fixed capital. This can include office buildings, computers and networking devices, and other standard office equipment. Procurement Procedures. While production businesses often have easier access to the inventory necessary to create the goods to be

3. Fixed capital of corporaƟons

produced, the procurement of fixed capital can be lengthy. It may take a business a significant amount of time to generate the funds necessary for larger purchases, such as new production facilities, or external financing may be required. This can increase the risk of financial losses associated with low production if the company faces an equipment failure and does not have redundancy built into the fixed capital assets. Actual Depreciation Rates. Fixed capital investments typically do not depreciate in the even way that is shown on income statements. Some devalue quite quickly, while others have nearly infinite usable lives. For example, a new vehicle loses a significant portion of value when it is officially transferred from the dealership to the new owner. In contrast, company-owned buildings may depreciate at a much lower rate. The depreciation method allows investors to see a rough estimate of how much value the fixed-capital investments are contributing to the current performance of the company. Liquidity of Fixed Capital Assets. While fixed capital often maintains a level of value, these assets are not considered very liquid in nature. This can be due to the limited market for certain items, such as manufacturing equipment, or the high price involved, as with real estate. Additionally, the time commitment required to sell fixed capital assets is often lengthy. The economic content of fixed assets is revealed through the following features: ‒ The term of use is not less than 1 year. ‒ The ability to bring economic benefits in the future. ‒ It is immobile, low-liquid part of assets. ‒ The use of fixed capital is carried out for profit. The concepts of «fixed capital» and «non-current assets» are not identical. The composition of non-current assets, along with fixed capital (fixed assets), includes intangible assets, equipment for installation, profitable investments in tangible assets, long-term financial investments, deferred tax assets and other non-current assets. The structure of the fixed capital includes: fixed assets and unfinished construction (work in process).

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Fixed assets are a part of the property of an organization used as a means of labor in the production of goods, the performance of work or the provision of services, or for managing an organization for a period longer than 12 months or a normal operating cycle if it exceeds 12 months. Fixed assets are classified according to a number of characteristics: 1. Depending on the use in the production process (by appointment): ‒ productive; ‒ non-productive. 2. By the role in production: ‒ active (machinery, equipment, vehicles); ‒ passive (buildings, structures, transmission devices). 3. By types: ‒ buildings; ‒ structures; ‒ workers and power machines and equipment; ‒ transfer devices; ‒ computer engineering; ‒ vehicles; ‒ tools; ‒ production and household equipment; ‒ working, productive and breeding cattle; ‒ perennial plantations; ‒ other fixed assets. 4. According to the accessories: ‒ own; ‒ rented; ‒ in economic management or operational management. 5. By the degree of use: ‒ in service; ‒ in stock; ‒ on conservation; ‒ under restoration;

3. Fixed capital of corporaƟons

‒ under short term lease; ‒ transferred on leasing. 6. By industry basis: ‒ industrial production; ‒ building; ‒ agricultural production, etc. The construction in progress includes the expenses for construction and installation works, the acquisition of buildings, equipment, vehicles, and other material objects of long-term use that are not documented by acts of acceptance and transfer of fixed assets. The composition of fixed capital is the totality of its constituent elements. The structure of fixed capital is the proportion of each element in its total volume. It serves as an indicator of the technical level of development of production in the sectors of the national economy. Management of the structure is of a practical importance for each enterprise, as it allows optimizing the flow of investment resources directed to the renewal and technical improvement of its production potential. Share capital is classified according to the following features: 1. By functional purpose: – active; – passive. 2. By the nature of service of certain types of activities: – productive; – non-productive. 3. By the nature of ownership: – own; – leased. 4. According to the forms of collateral for the loan and the features of insurance: – driven; – real. 5. According to the forms of valuation: – initial; – restorative;

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– residual; – liquidation value of individual elements of fixed capital. For accounting, fixed assets are accepted at cost. The initial cost of fixed assets is the value at the time of their production and commissioning in the prices of a given year. It is determined taking into account the channel of the receipt of fixed assets (Table 1). Table 1 The initial cost, taking into account the channels of receipt of fixed assets № 1 2 3

Income channel Purchase for a fee Construction Capital contribution 4 Free transfer 5 Exchange (barter)

Determination of initial cost Actual costs, excluding VAT and other recoverable taxes Actual costs, excluding VAT and other recoverable taxes Monetary valuation agreed between the founders (participants) of the organization Market value on the date of taking into account The value of the exchanged property, according to which in comparable circumstances the organization usually determines the value of similar goods The table was drawn by author using www.managementstudyguide.com

The initial cost of fixed assets is not subject to change, except for the cases of completion, additional equipment, reconstruction, partial liquidation and revaluation of the relevant objects. The replacement cost shows the value of the asset at the time of the revaluation. The replacement cost is the cost of similar objects of fixed assets in the current conditions of reproduction (at the current level of market prices and the level of scientific and technological progress). It is important for determining the costs that will be required to replace the funds. Revaluation of fixed assets is carried out using two methods: index and expert. The expert method, or the method of direct recalculation of the book value to the restoration, corresponding to the market price level, is the use of the documented data received from the organizationsmanufacturers, from the bodies of pricing, state statistics, trade inspectorates, published in the media and special literature, as well as in the form of special opinions of experts and licensed appraisal firms.

3. Fixed capital of corporaƟons

The value of land and environmental facilities is not subject to revaluation. The residual value represents the initial (replacement) value of fixed assets less depreciation. Liquidation value is established by the liquidation commission in case of liquidation of fixed assets or on other grounds provided by law. The purpose of this classification is to identify and meet the needs for certain types of fixed assets to support the operational and investment process, as well as to optimize their composition and structure, supporting the conditions for the effective operation of the organization. 3.2. Indicators of the movement of fixed assets The following factors are used for the analysis of the movement of FA: – Indicators of the movement of fixed assets. – Updates. – Income. – Disposals. – Increment. – Update intensity. – Elimination. – Replacements. The rate of renewal of fixed assets One of the main coefficients, which is calculated on the objects of fixed assets, is the update coefficient. It determines the share of fixed assets in operation during the reporting period in the total value of fixed assets at the end of this reporting period. In the form of a formula, the coefficient of renewal (Cr) can be represented as follows: Cr = FARP / FAE,

(3.1)

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where FARP is the cost of fixed assets put into operation during the reporting period; FAE is the value of the organization’s assets at the end of the reporting period. Sometimes, the coefficient of the receipt of assets (CR) is calculated separately. A similar formula is used for it, but the indicator relies on the fixed assets received by the organization during the reporting period, regardless of whether they were commissioned in this reporting period or not: CR = FAR / FAE,

(3.2)

where FAR is the cost of fixed assets received by the organization during the reporting period. The coefficient of disposal of fixed assets In contrast to the update coefficient, the coefficient of disposal of fixed assets is calculated. To calculate it, the value of fixed assets disposed of during the reporting period should be divided by the value of fixed assets at the beginning of the reporting period (usually a year). Thus, the formula for the coefficient of disposal (CD) can be represented as follows: CD = FAL / FAB,

(3.3)

where FAL is the cost of fixed assets that left the organization during the reporting period; FAB is the value of the organization’s assets at the beginning of the reporting period. Using the information on the fixed assets entered and disposed of during the reporting period, the intensity ratio of the renewal of fixed assets (IR) can be calculated, which, if less than 1, indicates the increase in production: IR = FAL / FARP,

(3.4)

3. Fixed capital of corporaƟons

As well as the growth rate of fixed assets (GRFA): GRFA = FAG / FAE,

(3.5)

where FAG is the amount of growth of fixed assets for the reporting period, which is calculated as the difference between the entered and disposed assets for the reporting period The organization, taking into account its specific needs, characteristics of the activities and tasks of the analysis, can also calculate other indicators. At the same time, these indicators can be calculated both for all objects of fixed assets and for their individual groups and types. The calculated indicators of the movement of fixed assets should be compared with each other, including their changes in dynamics, as well as with the industry average data or information of competitors. The analysis of the calculated coefficients of the movement of fixed assets contributes to the adoption of informed decisions in the field of management of fixed assets and, consequently, improves the efficiency of their use. A company’s balance sheet statement consists of its assets, liabilities, and shareholders’ equity. Assets are divided into current assets and noncurrent assets, the difference for which lies in their useful lives. Current assets are typically liquid assets which can be converted into cash in less than a year. Noncurrent assets refer to the assets and property owned by a business which are not easily converted to cash. The different categories of noncurrent assets include fixed assets, intangible assets, long-term investments, and deferred charges. A fixed asset is bought for production or supply of goods or services, for rental to third parties, or for use in the organization. The term ‘fixed’ translates to the fact that these assets will not be used up or sold within the accounting year. A fixed asset typically has a physical form and is reported on the balance sheet as property, plant, and equipment (PP&E). When a company acquires or disposes of a fixed asset, this is recorded on the cash flow statement under the cash flow from investing activities. The purchase of fixed assets represents a cash outflow to the

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company, while the sale is a cash inflow. If the value of the asset falls below its net book value, the asset is subject to an impairment write-down. This means that its recorded value on the balance sheet is adjusted downward to reflect that it is overvalued compared to the market value. When a fixed asset has reached the end of its useful life, it is usually disposed of by selling it for a salvage value, which is the estimated value of the asset if it was broken down and sold in parts. In some cases, the asset may become obsolete and may no longer have a market for it, and will, therefore, be disposed of without receiving any payment in return. Either way, the fixed asset is written off the balance sheet as it is no longer in use by the company. Some accountants categorize intangible long-term assets, such as trademarks and patents, as fixed assets, and more specifically refer to them as fixed intangible assets. Refresh rate. The rate of renewal of fixed assets is the cost of fixed industrial and production assets that have been re-entered into the enterprise for a given period divided by the cost of fixed assets that the enterprise has available at the end of this reporting period. It represents the ratio of the value of the new funds introduced during the year to their total value at the end of the year. The rate of renewal of FA = Cost of new fixed assets / Cost of fixed assets at the end of the year.

(3.6)

Admission rate: Coefficient of income = the value of received fixed assets / value of fixed assets at the end of the year. (3.7) Be careful when calculating the update and receipt rates. The update coefficient takes into account the cost of the fixed assets introduced, and the coefficient of receipt is the cost of the incoming fixed assets. Some textbooks take into account only the update rate. In these textbooks, the update rate = cost of fixed assets received during the year from various sources / cost of fixed assets at the end of the year.

3. Fixed capital of corporaƟons

Retirement rate. The retirement rate of fixed assets is the value of the main industrial and production assets alienated from the enterprise in a given reporting period divided by the value of the fixed industrial assets that the enterprise has available at the beginning of this reporting period. Calculated as the ratio of the value of funds retired over the year to the value of funds at the beginning of the year. Growth rate. The growth rate of fixed assets is the sum of the growth of the main industrial and production assets divided by the value of the main industrial and production assets at the beginning of the period. The numerator of this formula is defined as the difference between the value of fixed assets received and alienated during the reporting period. Refresh rate: Update intensity factor = D / R.

(3.7)

D is the value of the outgoing fixed assets during the year in all directions of disposal R is the cost of fixed assets received during the year from various sources Coefficient of liquidation. Calculated as the ratio of liquidated fixed assets for the year to the value of fixed assets at the beginning of the year. Coefficient of liquidation = Fixed Assets / Fixed Assets at the beginning of the year.

(3.8)

Replacement rate: Replacement ratio = cost of liquidated fixed assets / cost of new fixed assets received.

(3.9)

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Analysis of the values of indicators. To understand the state of the company’s operating system, the indicators of the movement of fixed assets are not only to be calculated, but also to be analyzed correctly. In order to properly analyze the results, you can use the following table: Table 2 Indicators of the operating system of the company Coefficient Updates

Value It characterizes the part of the new FA of the organization. A positive phenomenon is its growth in dynamics. Income A positive phenomenon is the growth of this indicator over time. Disposals It reflects how much FA has become less compared to the value at the beginning of the settlement period. Positive value is its decrease in dynamics. Increment It reflects how much the value of the FA has increased compared to the value at the beginning of the reporting period. A positive development is its growth over time. Update intensity Any value of this coefficient less than 1 is a positive phenomenon. The smaller it is, the more intensive the updating process is. Liquidations It reflects how much the value of an asset has decreased due to its liquidation. Replacements It reflects the speed with which the liquidated FAs are replaced with new ones. The smaller the result, the faster the replacement. If the value of the coefficient in the dynamics grows, then the FA of the company is in an unfavorable state. The table was drawn by author using www.managementstudyguide.com

3.3. Depreciation and amortization of fixed assets Depreciation and amortization both are meant to reduce the value of the asset year by year, but they are not one and the same thing. The difference between the two must be appreciated. Writing off tangible assets for a certain period is termed as depreciation, whereas the process of writing off intangible fixed assets is amortization.

3. Fixed capital of corporaƟons

The term fixed assets refers to the assets, whose benefit lasts for more than one accounting period. Fixed assets can be tangible fixed assets or intangible fixed assets. The value of fixed asset tends to decrease over time. As per matching concept, the portion of the asset employed for creating revenue, needs to be recovered during the financial year, so as to match the expenses for the period. And for this purpose, depreciation and amortization is applied to the fixed assets. Table 3 Depreciation and amortization on fixed assets Basis for comparison Meaning

Governing Accounting Standard Applies to

Purpose Methods

Depreciation

Amortization

Depreciation is a technique used measure the decrease in the value of the asset due to age, wear and tear or any other technical reason. IAS – 6 for Depreciation

Amortization is a method of allocating the depreciable amount over the life of the intangible fixed asset. IAS – 26 for Intangible Assets

Non-current Tangible Asset like machinery, vehicle, computers etc.

Non-current Intangible Asset like copyright, patent, goodwill etc. To prorate the cost of the asset over To capitalize the cost of the its life years. asset over its life period. Straight Line, Reducing Straight Line, Reducing Balance, Balance, Annuity, Increasing Annuity, Sum-of-years’ digits depreciation, etc. Balance, Bullet etc. Non-Cash Non-Cash

Type of Expense The table was drawn by author using www.managementstudyguide.com

Definition of Depreciation. A technique used to determine the loss in the value of the long-term fixed tangible asset due to its usage, wear and tear, age or change in market conditions is known as depreciation. Long term fixed tangible assets mean the assets which are owned by the company for more than three years, and they can be seen and touched. The depreciation is charged as the capital expenditure against the revenue generated from the asset during the year.

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For the purpose of calculating the depreciation, the cost of the asset is taken into consideration, from which the salvage value is deducted, and then the amount obtained is divided by the estimated number of life years as per Straight Line Method of Depreciation. Now, the amount obtained is charged every year as an expense in the Profit and Loss Account and is simultaneously deducted from the value of the asset in the Balance Sheet. Salvage Value means the value obtained when the asset is resold at the end of its lifetime. There are two very popular methods of depreciation, i.e. StraightLine Method and Written Down Value Method (Reducing Balance Method). An organization may opt any method of depreciation, but it should be applied consistently in every financial year. If an organization wants to change the method of depreciation, then the retrospective effect is to be noted. Any surplus or deficit arising on account of such change in the method of depreciation shall be debited or credited to the profit & loss account as the case may be. Straight-Line Depreciation. Straight-line depreciation is considered the most common depreciation method. To compute the amount of annual depreciation expense using the straight-line method requires two numbers: the initial cost of the asset and its estimated useful life. Straight-Line Depreciation Formula: Initial Cost / Useful Life = Depreciation per Year.

(3.10)

Accelerated Depreciation. To encourage investment spending, governments often pass legislation to allow what is called «accelerated depreciation», which allows businesses to more quickly expense depreciation than they are allowed to under straight-line depreciation. With accelerated depreciation, you are typically allowed to deduct a higher percentage of your depreciation in the first few years. Accelerated depreciation is meant to encourage investment. Sometimes, governments even let small businesses deduct all of their capital expenses up to a small threshold in the first year, particu-

3. Fixed capital of corporaƟons

larly when they are trying to ramp up the economy in a small way – since small businesses are the job growth engines of the economy – or because some politicians are trying really hard to win political support from small businesses. Definition of Amortization. Amortization is a method of measuring the loss in the value of long-term fixed intangible assets due to the passage of time to know about their decreased worth. Long term fixed intangible assets are the assets which are owned by the entity for more than three years, but they do not exist in its material form like computer software, license, franchises, etc. Similarly, like depreciation, the amount of amortization is also shown on the assets side of the Balance Sheet as a reduction in the intangible asset. Various methods of amortization are known, such as Straight Line, Reducing Balance, Bullet, etc. The cost of the asset is reduced by the residual value, then it is divided by the number of its expected life, the amount obtained will be the amount of amortization, this is a Straight line method. There are cases when the amortization is charged in a lump sum, i.e. in the year in which the intangible asset is acquired, which is incorrect, as the benefit from that asset will be received over a long time so it should be apportioned for the life of the asset, this method is known as Bullet Method. Sometimes the pattern for charging amortization is also given in which the amount is charged every year on a proportionate basis. Amortization is not charged as an expense on the assets which are internally generated or on the assets which have infinite life periods. Calculating Amortization. The formula for calculating the amortization on an intangible asset is similar to the one used for calculating straight-line depreciation: you divide the initial cost of the intangible asset by the estimated useful life of the intangible asset. For example, if it costs $10,000 to acquire a patent and it has an estimated useful life of 10 years, then the amortized amount per year equals $1,000. The amount of amortization accumulated since the asset was acquired appears on the balance sheet as a deduction under the amortized asset.

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Formula: Initial Cost / Useful Life = Amortization per Year.

(3.11)

For most small businesses, amortization will play a smaller role over time than depreciation will, so I wouldn’t spend a lot of time thinking about it. Basically, it is very similar to depreciation. For a new small business owner, one of the most common ways you run into amortization is if your accountant advises you that the expenses incurred in the beginning of your business are the type of start-up costs that need to be amortized over time, instead of operating expenses that can be expensed immediately. Key Differences Between Depreciation and Amortization. The major differences between depreciation and amortization are as under: 1. A technique used to calculate the reduced value of the tangible assets is known as Depreciation. Amortization is a measure to calculate the reduced worth of the intangible assets. 2. Depreciation applies to tangible assets, i.e. the assets which exist in physical form like plant and machinery, vehicle, computer, furniture, etc. Conversely, Amortization applies to intangible assets i.e. the assets which exist in their non-physical form like royalty, copyright, computer software, import quotas, etc. 3. The primary objective of depreciation is to allocate the cost of assets over its expected useful life. Unlike amortization, which focuses on capitalizing the amount of the cost of an asset over its useful life. 4. Methods for calculating depreciation are Straight Line, Reducing Balance, Annuity, etc. On the other hand, the method for calculating amortization are Straight Line, Reducing Balance, Annuity, Bullet, etc. Depreciation and Amortization are typically identical terms, the only difference is that depreciation applies to tangibles while amortization applies to intangibles. Both are non-monetary capital expenditures and hence are shown in the assets side of the Balance Sheet as a reduction in the value of the asset concerned. However, these two terms are governed by different accounting standards.

3. Fixed capital of corporaƟons

3.4. Indicators of efficiency of use of fixed assets The use of fixed assets is represented by indicators of capital productivity, capital and labor ratio. Capital productivity. The efficiency of use of fixed assets characterizes the rate of capital productivity, calculated as the ratio of the volume of output for the year (at the enterprise level) to the average annual total value of fixed assets. At the level of industries, output or gross value added is used as an indicator of production, and at the level of the economy as a whole, the value of gross domestic product is used. Capital productivity is the volume of output divided by the average amount of industrial production fixed assets at cost. The rational use of basic production assets is necessary to increase the production of the social product and national income. Increasing the level of use of fixed assets allows you to increase the size of production without additional capital investments and in a shorter time. It accelerates the pace of production, reduces the cost of reproduction of new funds and reduces production costs. The economic effect of increasing the level of use of fixed assets is the growth of social labor productivity. Capital productivity shows how much production (or profits) the organization receives from each ruble of its existing fixed assets. Determine the method of absolute differences impact on the volume of production of two factors associated with fixed assets: – quantitative (extensive) factor – the amount of fixed assets; – qualitative (intensive) factor – capital productivity. Capital intensity. Capital intensity is the reciprocal of capital productivity. It describes how much the basic production assets account for 1 ruble of output. The capital intensity is the average amount of industrial production of fixed assets at initial cost divided by the volume of output. Reducing fundamentals means labor saving. The value of capital productivity shows how much production is received from each ruble invested in fixed assets and serves to determine the economic efficiency of using existing fixed assets.

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The value of fundamentals shows how much money you need to spend on fixed assets to get the required volume of production. Thus, capital intensity shows how much fixed assets fall on each ruble of output. If the use of fixed assets improves, capital productivity should increase, and capital intensity should decrease. When calculating the capital productivity, from the composition of fixed assets working machines and equipment (the active part of fixed assets) are allocated. Comparison of growth rates and percentages of the fulfillment of the plan for capital productivity per 100 tenge of the cost of basic industrial production assets and 100 tenge of the cost of working machines and equipment shows the effect of changes in the structure of fixed assets on the efficiency of their use. The second indicator in these conditions should be ahead of the first one (if the proportion of the active part of fixed assets increases). Stock ratio. The capital stock has a huge impact on the value of capital productivity and capital intensity. The capital-labor ratio is used to characterize the degree of labor equipment of workers. The capital-labor ratio and capital productivity are interconnected through the indicator of labor productivity (labor productivity = output / average number of employees). Thus, capital productivity = labor productivity / capital-labor ratio. To improve the efficiency of production, it is important that the outpacing growth of production is ensured compared to the growth of fixed production assets. Analysis of the state and use of fixed assets. The volume of output depends on many factors, which can be divided into three main groups: – factors associated with the availability, use of means of labor, i.e. the main industrial production funds (funds); – factors associated with the security of objects of labor (material resources) and their use; – factors associated with the availability, movement and use of labor resources.

3. Fixed capital of corporaƟons

The analysis should study and measure the effect of these factors on the volume of output. At the same time, the influence of each group of factors (resources) is determined with other things being equal, that is, it is assumed that the factors belonging to other groups acted as provided. Consider the first group of factors (resources) that affect the volume of output. Other things being equal, the volume of production will be the greater, the greater is the amount of fixed assets and the better is their use. Analysis should be started with the study of the structure of fixed assets, i.e. the ratio of different groups of fixed assets in the total amount of their value. It is necessary that in the structure of fixed assets the proportion of their active part increases, i.e. the proportion of working machines and equipment that directly affect the objects of labor, i.e. the materials. In this case, the return on the use of fixed assets increases. Then you should check how the fixed assets are updated, and calculate these indicators: – The rate of renewal of fixed assets. – The coefficient of disposal of fixed assets. – Growth rate of fixed assets. These coefficients should be calculated over several periods and the dynamics of the renewal, retirement and growth of fixed assets should be traced. Then it is necessary to study the age composition of the equipment, which is very important to characterize the technical condition of fixed assets. To this end, the equipment is grouped by operating life. This grouping shows the proportion of new equipment, the return on the use of which is the highest, the proportion of equipment with average service lives, as well as the percentage of obsolete tools. The condition of fixed assets is also expressed by the coefficients of their wear and shelf life. Comparison of these indicators over several years shows the trends of their changes (it should be borne in mind that the update and disposal rates are calculated for a given period, and the wear and expiration rates are calculated at the beginning and end of the period).

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Technological level of equipment. It is necessary to study the technological level of the equipment. For this equipment is divided into the following groups: – manual equipment; – partially mechanized simple equipment; – fully mechanized simple equipment; – partially automated equipment; – fully automated equipment; – automated and programmable equipment; – flexible, automated and programmable equipment. Indicators of maintenance of machinery and equipment. Consider further the indicators characterizing the maintenance of machinery and equipment. These are indicators of staff specialization. The level of mechanization of labor is the number of workers serving the mechanized equipment divided by the total number of production workers. The level of automation of labor is the number of workers serving the automated equipment divided by the total number of production workers. Analysis of the use of fixed assets. After analyzing the state of fixed assets, proceed to the analysis of their use. The most common indicators of the use of fixed assets are capital productivity, capitaloutput ratio and capital-labor ratio. Equipment utilization rates. After studying the general indicators of the use of fixed assets, it is necessary to consider the use of equipment as the most active part of fixed assets, on which output mainly depends. Extensive use of equipment can also be characterized by the coefficient of extensive use of equipment. The coefficient of extensive use of equipment is the actual amount of machine-hours worked by the equipment divided by the base (planned) amount of machine-hours worked by the equipment. Of actual use of equipment, hours / Time of operation of equipment at a rate, hours. Having considered the extensive use of equipment, we proceed to study its intensive use, i.e. not use but performance. It is analyzed by

3. Fixed capital of corporaƟons

comparing the actual rates of removal of products for one machinehour with the planned, with indicators of previous periods, as well as with indicators of other enterprises of the related profile in groups of the same type of equipment. The use of equipment in terms of productivity can be characterized by the coefficient of intensive use of equipment. The coefficient of intensive use of equipment is the actual average output of products for one spent machine-hour divided by the base (planned) average output of products for one used machine-hour. Integral use of equipment, i.e. simultaneous use in terms of time and productivity, is expressed by the ratio of the integral use of equipment, which is defined as the product of the coefficients of extensive and intensive use of equipment. In conclusion, the analysis should summarize the reserves of the increase in the output associated with fixed assets. Such reserves may be: – commissioning of non-installed equipment; – increase in the shift work of equipment; – elimination of the causes of the above-planned all-shift and interchangeable equipment downtime; – reduction of the planned loss of equipment operation time; – implementation of organizational and technical measures aimed at reducing the time spent on the production of equipment per unit of production. Tasks: 1. What are the basic requirements for fixed capital. Think about how you would manage a fixed capital of own capital. Give an example. 2. What methods would you use when conducting a revaluation of fixed assets? What method would you add yourself, for managing fixed assets? 3. How do you understand the term: capital productivity? Explain the value of fixed capital. 4. With what can you increase the capital intensity of the company? Explain your point of view. 5. What gives the company the calculation of depreciation of fixed assets? Explain how it can affect the attraction of additional investments?

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Corporate Finance Activity 1. The company’s net profit is equal to 10 million tenge, amortization is 5.1 million tenge, the value of current assets at the beginning of the period was 500 million tenge, at the end – 600 million tenge, the increase in short-term interestfree liabilities of the company amounted to 300 million tenge. What can be said about the company’s cash flow from operating activities? Activity 2. Calculate the company’s cash flow if its net income is equal to 1,890,000 tenge, depreciation is 37800 tenge, the increase in current assets is 113400 tenge, increase in short-term interest-free liabilities of the company is 75,600 tenge, while the amount of interest payable on existing debts is 18,900 tenge. Activity 3. The company’s net profit is equal to 567,000 tenge, depreciation is equal to 37,800 tenge. Information about the change in the assets of the company and its liabilities is as follows: accounts payable to employees for the period equal to 75,600 tenge. Payables to suppliers for the period make 3780 tenge. Tax arrears for the period are of 18,900 tenge. Accounts receivable for the period is 309960 tenge. The increase in reserves amounts to 272160 tenge. Determine the cash flow for the operating activities of the company. Test questions: chapter 3 1. Fixed assets are classified depending on participation in the production process: a) Production b) Buildings c) Vehicles d) Those on conservation 2. Share capital is classified by the nature of ownership: a) Residual b) Driven c) Own d) Liquidation value of individual elements of fixed capital 3. The economic content of fixed assets is revealed through the following features: a) Term of use is not less than 1 year b) The ability to bring economic benefits in the future c) Immobile, low-liquid part of assets d) All answers are correct 4. Fixed assets are classified by role in production: a) Rented

3. Fixed capital of corporaƟons b) In service c) Buildings d) Passive (buildings, structures, transmission devices) 5. Share capital is classified according to the forms of collateral for the loan and the features of insurance: a) Real b) Restorative c) Leased d) Liquidation value of individual elements of fixed capital 6. Admission rate formula: a) Cost of new fixed assets / Cost of fixed assets at the end of the year b) The value of received fixed assets / Value of fixed assets at the end of the year c) Cost of fixed assets received during the year from various sources / Cost of fixed assets at the end of the year d) All answers are incorrect 7. The rate of FA renewal formula: a) Cost of new fixed assets / Cost of fixed assets at the end of the year b) The value of received fixed assets / Value of fixed assets at the end of the year c) Cost of fixed assets received during the year from various sources / Cost of fixed assets at the end of the year d) All answers are incorrect 8. The coefficient of disposal (CD) can be represented as follows: a) FARP / FAE b) FAR / FAE c) FAL / FAB d) All answers are incorrect 9. Update intensity factor formula: a) Cost of new fixed assets / Cost of fixed assets at the end of the year b) The value of the outgoing fixed assets during the year in all directions of disposal / The cost of fixed assets received during the year from various sources c) Cost of fixed assets received during the year from various sources / Cost of fixed assets at the end of the year d) All answers are incorrect 10. What does the term disposals mean? a) It reflects how much FA has become less compared to the value observed at the beginning of the settlement period. Positive is its decrease in dynamics

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Corporate Finance b) Any value of this coefficient less than 1 is a positive phenomenon. The smaller it is, the more intensive the updating process is c) It reflects the speed with which the liquidated FAs are replaced with new ones. The smaller the result, the faster the replacement. If the value of the coefficient in the dynamics grows, then the FA of the company is in an unfavorable state d) It reflects how much the value of the asset has decreased due to its liquidation 11. What is the meaning of the term depreciation? a) It means to capitalize the cost of the asset over its life years b) It is a technique used to measure the decrease in the value of the asset due to the age, wear and tear or for any other technical reason c) Non-current Intangible Asset, such as like copyright, patent, goodwill, etc. d) It is a method of allocating the depreciable amount over the life of the intangible fixed asset 12. Straight-Line Depreciation Formula: a) Useful Life / Initial Cost b) Initial Cost / Depreciation per Year c) Initial Cost / Book Value d) Initial Cost / Useful Life 13. The major differences between depreciation and amortization are as under: a) A technique used to calculate the reduced value of the tangible assets is known as Depreciation. Amortization is a measure to calculate the reduced worth of the intangible assets b) Depreciation applies to tangible assets i.e. the assets which exist in physical form, such as plants and machinery, vehicles, computers, furniture, etc. Conversely, Amortization applies to intangible assets i.e. the assets which exist in their non-physical form, e.g. royalty, copyright, computer software, import quotas, etc. c) The primary objective of depreciation is to allocate the cost of assets over its expected useful life unlike amortization, which focuses on capitalizing the amount of the cost of an asset over its useful life d) All answers are correct 14. To encourage investment spending, governments often pass legislation to allow what is called «______________», which allows businesses to more quickly expense depreciation than they are allowed to under straight-line depreciation. a) Straight-Line depreciation b) Accelerated depreciation c) Amortization d) All answers are incorrect

3. Fixed capital of corporaƟons 15. Governing Accounting Standard of Amortization: a) IAS – 26 b) IAS – 6 c) IAS – 16 d) All answers are incorrect 16. The method of absolute differences impact on the volume of production of factors associated with fixed assets: a) Productivity b) Quantitative (extensive) – the amount of fixed assets c) Availability d) All answers are correct 17. The volume of output depends on many factors, which can be divided into the following main groups: a) Factors associated with the availability, use of means of labor, i.e. the main industrial production funds (funds) b) Factors associated with the security of objects of labor (material resources) and their use c) Factors associated with the availability, movement and use of labor resources d) All answers are correct 18. Labor productivity formula: a) Output / Average number of employees b) Labor productivity / Capital-labor ratio c) Average number of employees / Labor productivity d) All answers are incorrect 19. Capital productivity formula: a) Output / Average number of employees b) Labor productivity / Capital-labor ratio c) Average number of employees / Labor productivity d) All answers are incorrect 20. Fixed assets are calculated using these indicators: a) The rate of renewal of fixed assets b) The coefficient of disposal of fixed assets c) Growth rate of fixed assets d) All answers are correct

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4. CONTENT AND STRUCTURE OF THE WORKING CAPITAL OF CORPORATION

4.1. Content and structure of working capital 4.2. Sources of financing working capital 4.3. Efficiency of working capital use

4.1. Content and structure of working capital The efficient management of working capital is essential for the profitability and overall financial health of any company. Working capital is the cash that companies use to operate and conduct their businesses. The aspects of working capital that investors and analysts assess to evaluate a company are the key elements for a company’s cash flow – money coming in, money going out and management of inventory. This helps ensure that a company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations. These are three main components associated with working capital management: 1. Accounts Receivable Accounts receivable are revenues due, i.e. what is owed to the company by its customers. Timely and efficient collection of accounts receivable is essential to the company’s smooth financial operation. Accounts receivable are listed as assets on the company’s balance sheet, but they are not actually assets until they are collected. A common metric analysts use to assess the company’s handling of accounts receivable is days sales outstanding, which reveals the average number of days the company spends to collect sales revenues. 76

4. Content and structure of the working capital of corporaƟon

2. Accounts Payable Accounts payable, the money that the company is obligated to pay out over the short term, is also a key component of working capital management. Companies seek to strike a balance between maintaining maximum cash flow by delaying payments as long as is reasonably possible and the need to maintain positive credit ratings while sustaining good relationships with suppliers and creditors. Ideally, the company’s average time to collect receivables is significantly shorter than its average time to settle payables. 3. Inventory Inventory is a company’s primary asset that it converts into sales revenues. The rate at which the company sells and replenishes its inventory is an important measure of its success. Investors consider the inventory turnover rate to be an indication of the strength of sales and a measure of efficiency of the company in its purchasing and manufacturing process. Inventory that is too low puts the company in danger of losing out on sales, but excessively high inventory levels represent wasteful, inefficient use of working capital. Classification of Working Capital: Working capital can be categorized on the basis of the concept (gross working capital and net working capital) and on the basis of time (permanent/ fixed WC and temporary/variable WC). The two major components of Working Capital are Current Assets and Current Liabilities. One of the major aspects of an effective working capital management is a regular analysis of the company’s currents assets and liabilities. This helps to take into account unforeseen events such as changes in the market conditions and competitor activities. Furthermore, steps taken to increase sales income and collect accounts receivable also improves the company’s working capital. Working Capital in adequate amount: For every business entity adequate amount of working capital is required to run the operations. It needs to be seen that there is neither excess nor shortage of working capital. Both the excess and shortage of working capital are bad for any business. However, out of the two,

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inadequacy or shortage of working capital is more dangerous from the point of view of the company operations. Inadequate working capital reveals its disadvantages where the company is not capable to pay off its short term liabilities in time, faces difficulties in exploring favorable market situations, its day to day liquidity worsens and ROA and ROI fall sharply. On the other hand, one should keep in mind that excess of working capital also leads to wrong results, such as idle funds, poor ROI, unnecessary purchases and accumulation of inventories over the required level due to low rate of return on investments. All this leads to a fall in the market value of shares and credit worthiness of the company. Working capital cycle: The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer the business is tying-up the funds in its working capital without earning any return. This is also one of the essential parameters to be recorded in working capital management. Working Capital Management: Working Capital Management (WCM) refers to all the strategies adopted by the company to manage the relationship between its short term assets and short term liabilities with the objective to ensure that it continues with its operations and meet its debt obligations when they fall due. In other words, it refers to all aspects of administration of current assets and current liabilities. Efficient management of working capital is a fundamental part of the overall corporate strategy. The WC policies of different companies have an impact on the profitability, liquidity and structural health of the organization. Although investing in good long-term capital projects receives more emphasis than the dayto-day work associated with managing working capital, companies that do not handle this financial aspect (working capital) well will not attract the capital necessary to fund those highly promising ventures; in other words, you must get through the short run to get to the long run. Components associated with WCM: Often the interrelationships among the working capital components create real challenges for the financial managers. Materials and

4. Content and structure of the working capital of corporaƟon

stocks are purchased from suppliers, the sale of these materials and stocks generates accounts receivable and collected in cash from customers to pay to those suppliers. Working capital has to be managed because the company is not always able to control how quickly the customers will buy, and once they have made purchases when exactly they will pay. That is why the control of the «cash-to-cash» cycle is paramount. The different components of working capital management of any organization are: ‒ Cash and Cash equivalents. ‒ Inventory. ‒ Debtors / accounts receivables. ‒ Creditors / accounts payable. A. Cash and Cash equivalents: One of the most important working capital components to be managed by all organizations is cash and cash equivalents. Cash management helps in determining the optimal size of the company’s liquid asset balance. It indicates the appropriate types and amounts of shortterm investments along with efficient ways of controlling collection and payout of cash. Good cash management implies the co-relation between maintaining adequate liquidity with minimum cash in bank. All companies strongly emphasize cash management as it is the key to maintain the company’s credit rating, minimize interest cost and avoid insolvency. B. Management of inventories: Inventories include raw material, WIP (work in progress) and finished goods. Where excessive stocks can place a heavy burden on the cash resources of a business, insufficient stocks can result in reduced sales, delays for customers etc. Inventory management involves the control of assets that are produced to be sold in the normal course of business. For better stock/inventory control: ‒ Regularly review the effectiveness of existing purchase and inventory systems. ‒ Keep a track of stocks for all major items of inventory.

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‒ Slow moving stock needs to be disposed as it becomes difficult to sell if kept for long. ‒ Outsourcing should also be a part of the strategy where part of the production can be done through another manufacturer. ‒ A close check needs to be kept on the security procedures as well. C. Management of receivables: Receivables contribute to a significant portion of the current assets. For investments into receivables, there are certain costs (opportunity cost and time value) that any company has to bear, along with the risk of bad debts associated with it. It is, therefore necessary to have a proper control and management of receivables which helps in taking sound investment decisions in debtors. Thereby, for effective receivables management one needs to have control of the credits and make sure that clear credit practices are a part of the company’s policy, which is adopted by all other companies associated with the organization. One has to be vigilant enough when accepting new accounts, especially larger ones. Thereby, the principle lies in establishing appropriate credit limits for every customer and sticking to them. For effective management of accounts receivable: ‒ Process and maintain records efficiently by regularly coordinating and communicating with credit managers and treasuries. ‒ Prepare performance measurement reports. ‒ Control accuracy and security of accounts receivable records. ‒ Captive finance subsidiary can be used to centralize accounts receivable functions and provide financing for company’s sales. D. Management of accounts payable: Creditors are a vital part of effective cash management and have to be managed carefully to enhance the cash position of the business. One has to keep in mind that purchasing initiates cash outflows and an undefined purchasing function can create liquidity problems for the company. The trade credit terms are to be defined by the companies as they vary across industries and also among companies. Factors to consider: ‒ Trade credit and the cost of alternative forms of short-term financing are to be defined.

4. Content and structure of the working capital of corporaƟon

‒ The disbursement float which is the amount paid but not credited to the payers account needs to be controlled. ‒ Inventory management system should be in place. ‒ Appropriate methods need to be adopted for customer-to-business payment through e-commerce. ‒ Company has to centralize the financial function with regards to the number, size and location of vendors. Time and money concept in Working Capital: Every component of working capital (namely inventory, receivables and payables) has two dimensions – TIME and MONEY– in managing working capital. By making the money move faster around the cycle, one can reduce the amount of money tied up. This helps the business generate more cash or it will need to borrow less money to fund its working capital. Consequently, it would either reduce the cost of interest or have free funds to support additional sales growth or investments of the company. Similarly, if one can negotiate on better terms with suppliers, i.e. get an increased credit limit or longer credit, it will effectively create additional cash to help fund future sales. Hence to conclude, Working capital in laymen terms can be compared to the blood vessels in any human body which makes the body function properly and thus make maximum utilization of the human or company assets. 4.2. Sources of financing working capital Working capital is the difference between the company’s assets and company’s liabilities. It is a figure derived from the company’s balance sheet to determine its operational efficiency, as well as its short-term financial health. Operating costs are required to keep the lights on and run the business. These include the costs of goods sold (COGS), as well as all administrative, sales and marketing costs, including payroll and taxes. If a company doesn’t have the working capital to meet the operating costs for the next 12 months, it is considered financially vulnerable.

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Working Capital Definition Working capital is a figure that determines the value left in the company, after liabilities are subtracted from assets. Assets include cash, investments, real estate, machinery and any other tangible assets. Liabilities include bank loans, mortgages, accounts payable and other accrued expenses. To determine the company’s financial health, a business leader or analyst needs to consider whether a company has enough assets to pay current liabilities, as well as to determine how easily those assets can be converted to cash. You cannot pay this week’s liability payments with real estate holdings; they are not liquid. Therefore, an analyst wants to see both cash and cash equivalents in the assets column to truly feel comfortable about the financial health of the company. Some companies allow customers to pay over time for large purchases. An appliance store could allow consumers to buy a refrigerator and pay for it, with no interest, for six months. These accounts receivable are considered an asset, but are not considered a cash equivalent beyond a certain time frame of payments, because the business can’t change the terms of sale with the consumer and demand the rest of the money up front. For example, terms that allow someone to pay over a period of several years might not consider that the asset will remain liquid beyond 12 months of payments. A financially healthy business has enough cash and consistent revenue to take care of all liability obligations, without incurring more debt. A business with higher margins of profit can retain those earnings. In the public stock investment sector, a business that retains too much in earnings is viewed negatively, because it should use these for its growth. A small business may decide to retain earnings for several years, as a long-term strategy to save for new capital expenses, such as new machinery, without taking on new debt. Working Capital Ratio. Working capital is also described as a ratio. The ratio is derived by dividing current assets by current liabilities. Good working capital ratios are considered the ratios that range between 1.2 and 2.0. A number of indices in this range suggests approaching negative working capital with significant liquidity issues. Once the ratio is equal to one or below this value, the company is in

4. Content and structure of the working capital of corporaƟon

negative working capital. A ratio above this range suggests that the company is not effectively using excess assets to grow revenues. Components of Working Capital. Working capital looks at different components of the balance sheet assets and liabilities. Determine which type of working capital is liquid. Under the assets, there are several items that are cash or cash equivalents; thus, they are the real sources of working capital: ‒ Cash. ‒ Marketable Securities. ‒ Accounts Receivable. ‒ Inventory. Cash is anything you can tender at the value immediately. For example, the company checking account has a cash balance. There may also be a company savings account or money market account held at the bank or credit union. The business owner can walk into the bank and withdraw from these accounts. Marketable securities are financial instruments the business can sell or redeem within 12 months. These could be bank certificates of deposit, bonds, or stocks. Since certificates of deposit are held in a bank, there are penalties associated with withdrawing the funds prior to the certificate of deposit maturing. This is why they are not considered cash. Bonds and stocks can also be sold at any time but they are subject to daily market fluctuations, though bonds can be held until their maturity, to receive their full face value. Accounts receivable are the accounts your consumers still owe you. If you extend credit in any way to your customers, you are waiting to get paid for something you have already sold. Accounts receivable also include money about to hit for credit card payments from merchant accounts. This can take a few days to settle; thus, the money is not received on your account immediately, so it is a receivable. Inventory includes what you have on the shelves to sell and what is stored in the storage areas and warehouses. You already own it and if you can sell it sooner, you can generate cash from it to pay liabilities. Those are the cash equivalent assets. On the liabilities side of the balance sheet, there are items that must be paid – the liabilities.

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‒ Accounts Payable. ‒ Accrued Expenses. ‒ Notes Payable. ‒ Current Portion of Long-term Debt. Accounts Payable are those costs you owe to vendors. The supplier or wholesaler who sells you goods and materials might extend 30 to 90 days of credit before payment is due for the inventory shipment. This is an account payable. Accrued Expenses are expenses noted in the books even though they are not yet paid for. These include wages, interest and taxes. Even though they will be paid in the future, the company is already committed to the expenses that are more than likely going to be collected. Notes Payable are the loans you owe. It is similar to some accrued expenses, but notes payable is the principal amount owed for a short-term loan or promissory note taken on behalf of the company. Short-term notes are considered due within 12 months. Accounts payable is not a promissory note but is instead an agreement on terms with a vendor or supplier. Current Portion of Long-Term Debt is the amount due within a year on larger long-term loans. These could be a vehicle, real estate or equipment loans. The aggregate amount due within 12 months of the entire principal balance is the current portion of long-term debt considered for working capital. Long-Term vs. Short-Term Sources Long-term and short-term sources of finance are viewed differently by the experts. Analysts consider the company with a large amount of short-term debt to be more vulnerable financially. The reason is that short-term debt, such as promissory notes or lines of credit, are usually used as a means of working capital financing. This implies that the company had an imbalance of revenues and cash flow to handle its needs, and that it sought for a short-term solution. Long-term debt is usually viewed as a capital expense. This is an investment in the company for a long-term benefit. A new means to expand the sales territory often yields higher revenues. As too much of

4. Content and structure of the working capital of corporaƟon

any debt is not good for a company without the assets or cash flow to pay for it, long-term debt generally suggests better financial management than short-term debt. Leveraging Assets for Working Capital Business leaders might need to look at long-term assets and find ways to create healthier working capital figures. There are ways to leverage assets such as real estate equity and accounts receivable to obtain a liquid asset sooner. There are companies and investors who buy assets such as accounts receivable or accounts already in collection. They give a business cash based on a percentage of the asset. For example, a company might buy the current accounts receivable for 80 cents on the dollar, giving itself margin for profit while giving the company the required liquid working capital. Businesses could also obtain an equity line of credit that they do not need to access based on the equity in real property. This allows the business to access capital to pay for operating costs, if it runs into revenue issues, without having to liquidate a property for pennies on the dollar to meet that demand. Keep in mind that these strategies are not ideal for companies, in most situations. Leveraging equity in real estate has similar issues. You are assuming a new debt, with obligations to pay. While you have met your immediate capital needs, you increase your short-term liabilities in doing so. Business Strategies Around Working Capital. While working capital as a metric looks strictly at the total assets and liabilities, smart business leaders know that assets that can be converted to liquid capital and cash are more important to the financial health of the company. There is an understanding that if most of the assets are tied up in a long-term asset such as real estate, then the working capital needs should be increased and the ratios should be adjusted to reflect what a company can access quickly. Keep a consistent tab on your sources of working capital. Business leaders should also consider how they allow customers to pay for products or services. When a company extends credit

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in accounts receivable for a longer period than that the suppliers are extending in accounts payable, then more working capital is required. For example, if your suppliers require payment within 30 days but the company allows consumers to pay in 60 days, the working capital must be able to pay and restock accordingly. Having approved credit lines with no balance gives companies the ability to access small amounts of working capital quickly, without negatively affecting assets or acquiring significant amounts of new debt. Business leaders should assess how their assets are helping the company. If an asset is not truly helping a company, business leaders need to take actions to change that. A warehouse owned by the company that is declining in value, could be sold before the asset declines too significantly. The company could then lease a property or buy a new one in a place where it will appreciate. Understanding how to use all assets is an imperative to long-term business success. 4.3. Efficiency of the working capital use Working capital management has an important role to play in the success of any business enterprise. Over 75% of companies that are running at loss or struggling financially would be profitable and liquid if these were more disposed to the knowledge and practice of efficient working capital management. The working capital management system helps in ensuring that tied down capital that could otherwise be put to productive use is released. Many finance professionals and business experts often ignore the importance of this management. They usually do not go the extra mile in striving for optimum utilization of resources tied to working capital just because they only look at the work involved in carrying out proper working capital management exercise. Working capital management is an effective management technique tool that has the potential of guaranteeing long-term success. Indices such as: «cash management», «accounts receivable manage-

4. Content and structure of the working capital of corporaƟon

men», «accounts payable management», «marketable securities management», and «accruals management», are crucial responsibilities of financial managers that require constant supervision from the CFO (Chief Financial Officer). Ten meanings / benefits and uses of working capital management. 1. Expansion of investment portfolio Funds released through sound working capital management practices act as a cheap source of finance that can be used for expansion of existing projects or for investment in new spheres of investment. 2. Increased profitability Increasing profitability is one of the main objectives of those engaged in working capital management. One of the ways of increasing profitability through adequate working capital management is saving of financial cost that would have otherwise been incurred but for managing short-term assets and liabilities. 3. Assurance of the availability of sufficient resources Through stock management which is a component of working capital management, a business is able to ensure that resources are sufficient at all times. Optimal stock level, for instance, is determined using some models outside the scope of this article. 4. Solidification of the going concern status of the company In business, it is very common to find that a profitable company goes out of business if it fails to meet the short-term financial needs of the business. Businesses need to meet their short term and medium term obligations in order to be in business and still remain competitive. 5. Improvement of the overall efficiency of the company The overall operational excellence of the company would be greatly improved by an effective working capital management system. Where this system is in place, finances are managed in such a way that it poses no hindrance or obstacle to any aspect of the entity. 6. Help to the company in avoiding overtrading Overtrading is one of the fastest ways to business failure. One main characteristic of overtrading is mismatching of assets and financ-

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es. The business goes beyond the set financial goals and objectives, and in the long run, it meets with ruin. Some trends signaling overtrading will include uncontrolled, out of proportion business expansion. 7. Maintenance of good relations with suppliers and other creditors Where a business engages in the proper management of its working capital and other financial indices, trade creditors and other nontrade creditors are poised to continue doing business with it. Their knowledge of the existence of this system goes a long way to boost their confidence in the business and their dealings. 8. Avoidance of underutilization of resources: While we condemn overtrading and tag it as a negative impact on the functionality of the business, we must also reiterate that undertrading can cost a business a fortune in an unearned profit. Through proper management of working capital, a company can ensure that there are no idle resources. 9. Provision of better insight into the true financial state of the company: Through working capitals ratios, analysts and financial experts can gain a better understanding of a business. The working capital management affords the business the opportunity of taking a closer look at all of its financial indices. 10. Allocation of resources: Management of working capital is essential in the allocation of resources. It assists the business management in correct allocation of the right resources to appropriate quarters. Applying the ratios revealed upon the utilization of the management system, as well as all other necessary analysis, areas with surplus resources and the shortage of resources are identified and corrected swiftly with appropriate even distribution of resources. Managing working capital is synonymous with efficiently managing other resources in the business. Other financial indices, such as the ratios of turnover, the ration of the collection, the ration of key performance are also considered. All of these can only be effectively achieved by a standard, efficient and state of the art management of working capital.

4. Content and structure of the working capital of corporaƟon

Companies that make working capital efficiency part of their organization’s culture have the opportunity to generate more of their working capital internally, thereby lowering costs, improving their performance and boosting their competitive position. When outside capital is required, good cash flow and working capital management will make it easier to find and less expensive irrespective of the economic cycle. But even the best companies can do better. The key is not to treat the pursuit of working capital efficiency as a limited project that ends at implementation, but to realize that implementation is just the beginning of an ongoing process. Establish goals and develop an action plan. The first step is to establish the «best in class» performance goals around the central issues – e.g., the length of your cash conversion cycle – and develop metrics that measure actual performance against the desired outcome. Continually monitor performance against your goals and analyze gaps to determine their root causes. Then, develop and execute detailed action plans to address and remedy performance shortfalls and uncover additional metrics or measures that should be tracked. Your action plan might include establishment of a «closed loop» procedure to link cash management processes across departments. This move can improve control and decision-making and increase operational flexibility. Consider reinforcing the importance of working capital efficiency throughout the organization. For example, you might tie management and employee bonuses to working capital metrics, sending the message that they are just as important as revenue and profitability goals. In order for this strategy to be effective, you will need to make the tracking of performance measures transparent throughout the organization. Assess and improve collection processes. Treasurers today have access to timely information that can enable them to reduce such items as Days Sales Outstanding (DSO).

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Analytics are also available through lockbox programs that can help to drive down unauthorized discounts and deductions by tracking and managing exceptions faster and more accurately. These tactics can help you lessen the difference between gross and net sales. You should also consider remote deposit and remote capture, technologies that enable businesses to scan paper checks and transmit the images and/or ACH data to a bank for posting and clearing. Benefits can include accelerated clearing and improved availability. Evaluate payment strategies. Make sure you are using the best method of payment to maximize efficiency, float or revenue sharing for the best return. Purchasing card programs can boost cash flow and increase working capital. These programs can be integrated into your existing accounts payable process and extend payment cycles. Re-think short-term investments. Interest rates have been static for longer than at any point in history. There are new reforms and regulations that did not exist before. And the economy is exceptionally volatile, both domestically and globally. Revise your policies and make sure you are positioned to accommodate your short – term cash and investment needs in today’s environment. If you do not have an investment policy, now is a good time to create one. Invest strategically. It is not always necessary to sacrifice project-oriented tactics. Investment in projects that help minimize the cost of capital can reap benefits now and in the future. These might include improvements in payment processes. Leverage external resources. Look to external resources for fresh approaches to continual improvement. Benchmark your results against those of companies that are recognized as best in class for optimizing working capital. Scorecards from industry publications put a microscope on the details of financial performance and can help you identify the most effective companies.

4. Content and structure of the working capital of corporaƟon

Find out how those enterprises manage and measure cash flow performance. You might even consider reaching out to peers at leading companies to gather more insight, or participate in industry research panels. Tasks: 1. Select one company on www.kase.kz. Explain your understanding of the classification of working capital based on the company’s balance sheet. 2. Explain the concept of time and money in working capital based on the balance sheet of the selected company. 3. Describe all components of the company’s working capital management. 4. Analyze the key differences between long-term and short-term sources of company financing. 5. Explain your understanding of the use of assets for working capital. 6. Explain the business strategy in the formation of working capital. 7. Describe ten important gains from working capital management. Activity 1. Which project is better to choose for the companies: project A will bring in the first year 37,800 tenge, 56,700 in the second and 113400 in the third year, or project B which brings in the first year 1,51200 tenge, and 37,800 tenge in the second and third years. The rate of return is 10%. Activity 2. You are offered to buy a warehouse for 151,20000, which you can rent for five years at the price of 3780000 tenge, and then sell at the price of 15876000 tenge. In addition, in the second year, according to the repair plans approved by the mayor’s office, you need to repair the warehouse, spending $ 18,900,000. Is it worth starting the project, if the yield in the economy is at the level of 20%? Test questions: chapter 4 1. Main components associated with working capital management: a) Accounts Receivable b) Accounts Payable c) Inventory d) All answers are correct 2. For better stock/inventory control it is required to: a) Regularly review the effectiveness of existing purchase and inventory systems b) Process and maintain records efficiently by regularly coordinating and communicating with credit managers and treasury in-charges c) Prepare performance measurement reports d) Control accuracy and security of accounts receivable records

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Corporate Finance 3. The different components of working capital management of any organization are: a) Cash and Cash equivalents b) Inventory c) Debtors / Creditors d) All answers are correct 4. Effectively managing accounts receivable: a) Slow moving stock needs to be disposed as it becomes difficult to sell if kept for a long time b) Outsourcing should also be a part of the strategy where part of the production can be done through another manufacturer c) Process and maintain records efficiently by regularly coordinating and communicating with credit managers’ and treasury in-charges d) All answers are incorrect 5. Factors to consider: a) Trade credit and the cost of alternative forms of short-term financing are to be defined b) The disbursement float which is the amount paid but not credited to the payers account needs to be controlled c) Inventory management system should be in place d) All answers are correct 6. What is Accounts Receivable? a) Amounts obligated to be paid out over the short term, this is also a key component of working capital management b) What is owed to a company by its customers for sales made c) This is a company’s primary asset that it converts into sales revenues d) All answers are incorrect 7. What is Inventory? a) Amounts obligated to pay out over the short term, this is also a key component of working capital management b) What is owed to a company by its customers for sales made c) This is a company’s primary asset that it converts into sales revenues d) All answers are incorrect 8. The real sources of working capital are: a) Cash b) Marketable Securities c) Accounts Receivable / Inventory d) All answers are correct

4. Content and structure of the working capital of corporaƟon 9. Marketable securities are financial instruments the business can sell or redeem within ___ months: a) 6 months b) 12 months c) 9 months d) 24 months 10. Good working capital ratios are the ratios that range between 1.2 and 2.0: a) 5.6 and 6.0 b) 2.7 and 3.5 c) 1.2 and 2.0 d) 10.7 and 12.5 11. An approved credit line with no balance gives companies the ability to access small amounts of working capital quickly, without negatively affecting assets or acquiring significant amounts of new _____: a) Debt b) Inventory c) Cash d) All answers are incorrect 12. Accounts Payable are the costs you owe to vendors. The supplier or wholesaler who sells you inventory might extend ___ to ___ days of credit before payment is due for the inventory shipment: a) 15 to 30 days b) 90 to 120 days c) 20 to 40 days d) 30 to 90 days 13. Working capital looks at different components of the balance sheet’s assets and _______: a) Accounts Payable b) Liabilities c) Accounts Receivable d) All answers are incorrect 14. Expansion of investment portfolio: a) Funds released through sound working capital management practices act as a cheap source of finance that can be used for expansion of existing projects or for investment in new spheres of investment b) Increasing profitability is one of the main objectives of engaging in working capital management

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Corporate Finance c) Through stock management which is a component of working capital management, a business is able to ensure that resources are sufficient at all times d) All answers are incorrect 15. Ensure the availability of suffcient resources: a) Funds released through sound working capital management practices act as a cheap source of finance that can be used for expansion of existing projects or for investment in new spheres of investment b) Increasing profitability is one of the main objectives of engaging in working capital management c) Through stock management which is a component of working capital management, a business is able to ensure that resources are sufficient at all times d) All answers are incorrect 16. Helps the company avoid overtrading: a) Where a business engages in the proper management of its working capital and other financial indices, trade creditors and other non-trade creditors are poised to continue doing business with it b) One main characteristic of overtrading is mismatching assets and finances. The business goes beyond set financial goals and objectives, and in the long run, it meets with ruin c) While we condemn overtrading and tag it as a negative impact on the functionality of the business, we must also reiterate that undertrading can cost a business a fortune in an unearned profit d) All answers are incorrect 17. Avoid underutilization of resources: a) Where a business engages in the proper management of its working capital and other financial indices, trade creditors and other non-trade creditors are poised to continue doing business with it b) One main characteristic of overtrading is mismatching assets and finances. The business goes beyond set financial goals and objectives, and in the long run, it meets with ruin c) While we condemn overtrading and tag it as a negative impact on the functionality of the business, we must also reiterate that undertrading can cost a business a fortune in an unearned profit d) All answers are incorrect 18. Provides better insight into the true financial state of a company: a) Through working capitals ratios, analysts and financial experts can gain a better understanding of a business. The working capital management affords the business the opportunity of taking a closer look at all of its financial indices

4. Content and structure of the working capital of corporaƟon b) One main characteristic of overtrading is mismatching assets and finances. The business goes beyond the set financial goals and objectives, and in the long run, it meets with ruin c) While we condemn overtrading and tag it as a negative impact on the functionality of the business, we must also reiterate that undertrading can cost a business a fortune in an unearned profit d) All answers are incorrect 19. Allocation of resources: a) Through working capitals ratios, analysts and financial experts can gain a better understanding of a business. The working capital management affords the business the opportunity of taking a closer look at all of its financial indices b) Management of working capital is essential in the allocation of resources. It assists the business management in correct allocating of the right resources to appropriate quarters c) While we condemn overtrading and tag it as a negative impact on the functionality of the business, we must also reiterate that undertrading can cost a business a fortune in an unearned profit d) All answers are incorrect 20. Maintain good relation with suppliers and other creditors a) Through working capitals ratios, analysts and financial experts can gain a better understanding of a business. The working capital management affords the business the opportunity of taking a closer look at all of its financial indices b) Where a business engages in the proper management of its working capital and other financial indices, trade creditors and other non-trade creditors are poised to continue doing business with it c) While we condemn overtrading and tag it as a negative impact on the functionality of the business, we must also reiterate that undertrading can cost a business a fortune in an unearned profit d) All answers are incorrect

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5. CLASSIFICATION OF CORPORATE COSTS

5.1. General Characteristics of Corporate Costs 5.2. Cost Planning Methods 5.3. The effect of operating leverage

5.1. General Characteristics of Corporate Costs Costs of the Corporation mean a decrease in economic benefits as a result of the disposal of assets (cash, other property) and (or) liabilities, resulting in a decrease in the capital of the organization. Cost classification is the process of grouping costs according to their common characteristics. It is the placement of like items together according to their common characteristics. A suitable classification of costs is of vital importance in order to identify the cost with cost centers or cost units. Costs may be classified according to their nature, i.e., material costs, labor costs and expenses and according to a number of other characteristics. The same cost figures are classified according to different ways of costing depending upon the purpose to be achieved and requirements of a particular concern. The important ways of classification are as follows: 1. By Nature or Elements, or Analytical Classification: According to this classification, the costs are divided into three categories i.e., Materials, Labor and Expenses. There can be further sub-classification of each element; for example, material is sub-classified as raw material components, spare parts, consumable stores, 96

5. ClassificaƟon of corporate costs

packing material etc. This classification is important as it helps to find out the total cost, how such total cost is constituted and valuation of work-in-progress. 2. By Functions (i.e., Functional Classification): According to this classification costs are divided in the light of different aspects of basic managerial activities involved in the operation of a business undertaking. It leads to grouping of costs according to the broad divisions or functions of business undertaking i.e., production, administration, selling and distribution. According to this classification the costs are divided as follows: a. Manufacturing and Production Cost: This is the total of costs involved in manufacture, construction and fabrication of units of production. b. Commercial Cost: This is the total of costs incurred in the operation of a business undertaking other than the cost of manufacturing and production. Commercial cost may further be sub-divided into (a) administrative cost and (b) selling and distribution cost. 3. By the degree of Traceability to the Product (Direct and Indirect): According to this classification, total cost is divided into direct costs and indirect costs. Direct costs are those which are incurred for and may be conveniently identified with a particular cost center or cost unit. Materials used and labor employed in manufacturing an article or in a particular process of production are common examples of direct costs. Indirect costs are those costs which are incurred for the benefit of a number of cost centers or cost units and cannot be conveniently identified with a particular cost center or cost unit. Examples of indirect costs include the rent of buildings, management salaries, machinery depreciation etc. The nature of the business and the cost unit chosen will determine which costs are direct and which are indirect. For example, the hire of a mobile crane for the use by a contractor at the site would be regarded as a direct cost, but if the crane is

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used as a part of the services of the factory, the hire charges would be regarded as indirect cost because it will probably benefit more than one cost center. The importance of the distinction of costs into direct and indirect lies in the fact that direct costs of a product or activity can be accurately determined while indirect costs have to be apportioned on certain assumptions as regards their incidence. 4. By Changes in Activity or Volume: According to this classification, costs are classified according to their behavior in relation to changes in the level of activity or volume of production. On this basis, costs are classified into three groups, namely, fixed, variable and semi-variable. (i) Fixed Costs: Fixed Costs are commonly described as those which remain fixed in total amount with the increase or decrease in the volume of output or productive activity for a given period of time. Fixed cost per unit decreases as production increases and increases as production declines. Examples of fixed costs are rent, insurance of the factory building, factory manager’s salary etc. These fixed costs are constant in total amount but fluctuate per unit as production changes. These costs are known as period costs because these are dependent on time rather than on output. Such costs remain constant per unit of time such as factory rent of Rs 10,000 per month remaining the same for every month irrespective of output of every month. Fixed costs can be classified into the following categories: (a) Committed Costs: These costs are the result of inevitable consequences of commitments previously made or are incurred to maintain certain facilities and cannot be quickly eliminated. The management has little or no discretion in such type of costs, e.g. rent, insurance, depreciation on building or equipment purchased. (b) Policy and Managed Costs: Policy costs are incurred for implementing some management policies, such as executive development, housing etc., and are often

5. ClassificaƟon of corporate costs

discretionary. Managed costs are incurred to ensure the operating existence of the company e.g., staff services. (c) Discretionary Costs: These costs are not related to the operation but can be controlled by the management. These costs arise from some policy decisions, new researches, etc., and can be eliminated or reduced to a desirable level at the discretion of the management. (d) Step Costs: Such costs are constant for a given level of output and then increase by a fixed amount at a higher level of output. (ii) Variable Costs are those which vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. Thus, variable costs fluctuate in total amount but tend to remain constant per unit as production activity changes. The examples are direct material costs, direct labor costs, power, repairs etc. Such costs are known as product costs because they depend on the quantum of output rather than on time. For example, expenditure incurred by, say, the Tool Room, is controllable by the foreman in-charge of that section but the share of the tool-room expenditure which is apportioned to a machine shop is not to be controlled by the machine shop foreman. (iii) Semi-variable Costs are those which are partly fixed and partly variable. For example, telephone expenses include a fixed portion of annual charge plus variable according to calls; thus total telephone expenses are semi-variable. Other examples of such costs are depreciation, repairs and maintenance of building and plant etc. 5. By Controllability: Under this, costs are classified according to whether or not they are influenced by the action of a given member of the enterprise. On this basis costs are classified into two categories: (i) Controllable Costs: Controllable Costs are those which can be influenced by the actions of a specified member of the enterprise, that is to say, costs which are at least partly within the control of management. An organization

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is divided into a number of responsibility centers and controllable costs incurred in a particular cost center can be influenced by the action of the manager responsible for the center. Generally speaking, all direct costs including direct materials, direct labor and some of the overhead expenses are controllable by the lower level of management. (ii) Uncontrollable Costs: Uncontrollable Costs are those which cannot be influenced by the action of a specified member of the enterprise, that is to say, which are not within the control of management. Most of the fixed costs are uncontrollable. For example, rent of the building is not controllable and so is a managerial salary. Overhead cost, which is incurred by one service section and is apportioned to another which receives the service, is also not controllable by the latter, The distinction between controllable and uncontrollable costs is sometimes left to individual judgment and is not sharply maintained. In fact, no cost is controllable, it is only in relation to a particular level of management or an individual manager that we may say whether a cost is controllable or uncontrollable. A particular item of cost which may be controllable from the point of view of one level of management may be uncontrollable from another point of view. Moreover, there may be an item of cost which is controllable from the long-term point of view and uncontrollable from the short-term point of view. This is partly so in the case of fixed costs. 6. By Normality: Under this, costs are classified according to whether these are costs which are normally incurred at a given level of output in the conditions in which that level of activity is normally attained. On this basis, it is classified into two categories: (а) Normal Cost: It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is a part of cost of production. (b) Abnormal Cost: It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally at-

5. ClassificaƟon of corporate costs

tained. It is not a part of cost of production and is charged to Costing Profit and Loss Account. 7. By Relationship with Accounting Period (Capital and Revenue): The cost which is incurred in purchasing an asset either to earn income or increasing the earning capacity of the business is called capital cost, for example, the cost of a rolling machine in case of steel plant. Such cost is incurred at one point of time but the benefits obtained from it are spread over a number of accounting years. If any expenditure is done in order to maintain the earning capacity of the concern such as the cost of maintaining an asset or running a business it is revenue expenditure, e.g., cost of materials used in production, labor charges paid to convert the material into production, salaries, depreciation, repairs and maintenance charges, selling and distribution charges etc. The distinction between capital and revenue items is important in costing as all items of revenue expenditure are taken into consideration while calculating cost whereas capital items are completely ignored. 8. By Time: Costs can be classified as: (i) Historical costs and (ii) Predetermined costs. (i) Historical Costs: The costs which are ascertained after being incurred are called historical costs. Such costs arise only when a particular thing has already been produced. Such costs are only of historical value and not at all helpful for cost control purposes. Basic characteristics of such costs are: 1. They are based on recorded facts. 2. They can be verified because they are always supported by the evidence of their occurrence. 3. They are mostly objective because they relate to the events which have already taken place. (ii) Predetermined Costs: Such costs are estimated costs i.e., computed in advance of production taking into consideration the previous period costs and the factors

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affecting such costs. Predetermined cost specified on scientific basis becomes standard cost. Such costs when compared with actual costs will reveal the reasons for variance and will help the management fix the responsibility and take remedial actions to avoid its recurrence in future. Historical costs and predetermined costs are not mutually exclusive but they work together in the accounting system of an organization. In competitive age, it is better to lay down standards, so that after comparison with the actual, the management may be able to take stock of the situation to find out as to how far the standards fixed by it have been achieved and take suitable action in the light of such information. Therefore, even in a system when historical costs are used, predetermined costs have a very important role to play because a figure of historical cost by itself has no meaning unless it is related to some other standard figure to give meaningful information to the management. 9. According to Planning and Control: Planning and control are two important functions of management. Cost accounting furnishes the management with the information which is helpful in the due discharge of these two functions. According to this, costs can be classified as budgeted costs and standard costs. Budgeted Costs: Budgeted costs represent an estimate of the expenditure for different phases of business operations, such as manufacturing, administration, sales, research and development etc., coordinated in the conceived framework for a period of time in future which subsequently becomes a written expression of managerial targets to be achieved. Various budgets are prepared for various phases, such as raw material cost budget, labor cost budget, cost of production budget, manufacturing overhead budget, office and administration overhead budget etc. Continuous comparison of actual performance (i.e., actual cost) with that of the budgeted cost is made so as to report the management on the deviations from the budgeted cost for corrective actions taking. Standard Costs. Budgeted costs are translated into actual operation through the instrument of standard costs. Budgeted costs and standard costs are similar to each other to the extent that both of them represent estimates for cost for a period of time in future.

5. ClassificaƟon of corporate costs

In spite of this, they differ in the following aspects: (i) Standard costs are scientifically predetermined costs of every aspect of business activity whereas budgeted costs are mere estimates made on the basis of past actual financial accounting data adjusted to future trends. Thus, budgeted costs are projection of financial accounts whereas standard costs are projection of cost accounts. (ii) The primary emphasis of budgeted costs is on the planning function of management whereas the main thrust of standard costs is on the control because standard costs lay emphasis on what should be the costs. (iii) Budgeted costs are extensive whereas standard costs are intensive in their application. Budgeted costs represent a macro approach of business operations because they are estimated in respect of the operations of a department. Contrary to this, standard costs are concerned with each and every aspect of business operation carried in a department. Thus, budgeted costs deal with aggregates whereas standard costs deal with individual parts which make the aggregate. For example, budgeted costs are calculated for different functions of the business i.e., production, sales, purchases etc., whereas standard costs are compiled for various elements of costs i.e., materials, labor and overhead. 10. By Association with the Product: Under this classification, costs can be product costs and period costs. Product Costs: Product costs are associated with the purchase and sale of goods. In the production scenario, such costs are associated with the acquisition and conversion of materials and all other manufacturing inputs into finished product for sale. Hence under-absorption cost, total manufacturing costs constitute inventorial or product cost. Products Costs are those costs which are traceable to the product and are included in inventory valuation. Product costs are inventorial costs and they become the basis for product pricing and cost plus contracts. They comprise direct materials, direct labor and manufacturing overheads in case of manufacturing concerns. These are used for valu-

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ation of inventory and are shown in the Balance Sheet till they are sold because such costs provide income or benefit only after sale. The product cost of goods sold is transferred to the cost of goods sold account. Period Costs: These are the costs which are not assigned to products but are incurred on the time basis, e.g. rent, salaries etc. These may relate to administration and selling costs essential to keep the business running. Though these are not associated with production and are necessary to generate revenue but cannot be assigned to a product. These are charged against revenue of the period in which these are incurred and treated as expense. The net income of a concern is influenced by both product and period costs. Product costs are included in the cost of production and do not affect income till goods are sold. Period costs are not at all related to production and as such are not inventoried but are charged to the period in which these are incurred. 11. By Managerial Decisions: On this basis, costs may be classified into the following cost: (i) Marginal Cost: Marginal cost is the total of variable costs i.e., prime cost plus variable overheads. It is based on the distinction between fixed and variable costs. Fixed costs are ignored and only variable costs are taken into consideration for determining the cost of products and value of work-in-progress and finished goods. (ii) Out of Pocket Costs: This is that portion of the costs which involves payment to outsiders i.e., gives rise to cash expenditure as opposed to such costs as depreciation, which do not involve any cash expenditure. Such costs are relevant for price fixation during recession or when the decision on making or buying is to be made. (iii) Differential Cost: The change in costs due to change in the level of activity or pattern or method of production is known as differential cost. If the change increases the cost, it will be called incremental cost. If there

5. ClassificaƟon of corporate costs

is decrease in cost resulting from decrease in output, the difference is known as decremental cost. (iv) Sunk Cost: A sunk cost is an irrecoverable cost and is caused by complete abandonment of a plant. It is the written down value of the abandoned plant less its salvage value. Such costs are historical costs which are incurred in the past and are not relevant for decision-making and are not affected by the increase or decrease in volume. Thus, expenditure which has taken place and is irrecoverable in a situation is treated as sunk cost. For taking managerial decisions with future implications, a sunk cost is an irrelevant cost. If a decision has to be made for replacing the existing plant, the book value of the plant less salvage value (if any) will be a sunk cost and will be irrelevant cost for taking decision of the replacement of the existing plant. (v) Imputed or Notional Costs: Imputed costs and notional costs have the same meaning. The American equivalent term of the British term «notional cost’ is «imputed cost’. These costs are notional in nature and do not involve any cash outlay. Examples of such costs are: notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid. When alternative capital investment projects are being evaluated, it is necessary to consider the imputed interest on capital before a decision is arrived as to which is the most profitable project. Actual payment of interest on capital is not made but the basic concept is that, had the funds been invested somewhere else, they would have earned interest. Therefore, imputed costs or notional costs can also be described as opportunity costs. Imputed or notional cost is a hypothetical cost to represent the benefit enjoyed by a firm in respect of which actual expense is not incurred. (vi) Opportunity Cost: It is the maximum possible alternative earning that might have been earned if the productive capacity or services had been put to some alternative use. In simple words, it is the advantage, in measurable terms, which has been foregone due to not using the facility in the manner originally planned.

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For example, if an owned building is proposed to be used for a project, the likely rent of the building is the opportunity cost which should be taken into consideration while evaluating the profitability of the project. (vii) Replacement Cost: It is the cost at which there could be purchase of an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price. (viii) Avoidable and Unavoidable Costs: Avoidable costs are those which can be eliminated if a particular product or department with which they are directly related is discontinued. For example, salary of the clerks employed in a particular department can be eliminated, if the department is discontinued. Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager or factory rent cannot be eliminated even if a product is eliminated. (ix) Explicit Costs: Explicit Costs are also known as out of pocket costs and refer to costs involving immediate payment of cash to outsiders and are entered in the books of account. Salaries, wages, interest on capital, etc. are some examples of explicit costs. They can be easily measured. These costs are very much relevant in the consideration of price fixation during trade recession or when a make-or-buy decision is to be made. (x) Implicit Costs: Implicit Costs do not involve immediate payment of cash and are known as Economic Costs. Example of such cost is depreciation. Main points of difference between Explicit Costs and Implicit Costs are: (i) Implicit costs do not involve immediate payment of cash whereas explicit costs involve immediate outgo of cash. (ii) Implicit costs are not recorded in the books of accounts while explicit costs are entered in the books of accounts.

5. ClassificaƟon of corporate costs

5.2. Cost Planning Methods In the practice of cost planning and cost of production, several methods are used: estimate, normative, calculation and constructive, economic and mathematical. The traditional method that it is widely used in the current planning is estimated. In special tables of the plan are estimates of costs in accordance with their articles on the cultures (groups), species (groups), etc. Costs are calculated on the basis of technological maps or planning regulations costs per hectare, head of livestock, production unit. The main disadvantage of this method is the large complexity of the planned calculations. There is no such drawback in the normative method, according to which the cost and cost of production planning is based on scientifically verified standards developed in relation to specific conditions of production. The improvement of the economic mechanism of management in agricultural enterprises, the effective functioning of the anti-cost mechanism require the creation of an appropriate regulatory framework. It should include a set of reasonable labor, material and financial norms and standards, different in the level of detail, the order and methods of their development and use in the process of planning, economic and other calculations. In the long-term planning, along with the above, a calculation and constructive method is used. It is based on the actual cost and determination of the size of the reduction (increase) costs due to the influence of certain technical and economic factors. The following groups of factors are distinguished: 1) improvement of the technical level of production through the introduction of new technology, mechanization and automation of production processes, the use of new varieties of plants, breeds of livestock, more efficient fertilizers, pesticides and the like; 2) improvement of production and labor organization (improvement of production management, specialization and concentration, increase of load and output standards, reduction of working time losses, elimination of non-productive expenses, reduction of losses from marriage);

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3) changes in the volume and structure of production (relative reduction of conditionally constant costs with an increase in production volumes primarily due to increased productivity and productivity of livestock, changes in the structure of production); 4) the influence of national economic and industrial factors (changes in prices of material means and changes in wages; changes in the placement of consumers of agricultural products and suppliers of material and technical means). The variable and fixed costs are analyzed simultaneously and especially minutely. Variable costs are directly proportional to the volume of production. Savings from the reduction of variable material costs (Em) is calculated by the formula: Em = (NB · C – NP · C) Op,

(5.1)

where NB and NP is the ratio of the costs of feed, seed, fertilizer, petroleum products, etc. per unit of production (works) respectively in the base and planned periods; C – the unit price of the products or materials: Op – the planned volume of production, works. Cost savings on wages (Esw), due to the decrease in labor intensity, is determined by the formula: Esw = (Pb · ZB – PP · ZP) Op,

(5.2)

where Pb and PP stand for the complexity of the unit of production (work) in the base and planning periods, ZB and ZP – payment of man-hours in the base and planning periods. The saving of fixed costs is a consequence of the increase in production volumes, since fixed costs are inversely proportional to these volumes. Saving (overspending) on fixed costs (EP) is determined by the planned increase (decrease) in production and the proportion of these costs in the cost price: EP = [(Op-Ob) a]: 100,

(5.3)

5. ClassificaƟon of corporate costs

where Op and Ob are production volumes, respectively, in the planned and base periods; a is the percentage of fixed costs in the cost of the base period. The results of calculations on the impact of all factors on the cost of production are reduced to a general form, where they determine the planned cost. Special attention should be paid to the factors associated with the growth of cost, but at the same time, the increase in production efficiency. For example, improvement of the product quality is often accompanied by a certain increase in costs. However, they are usually overlapped by additional revenue from the sale of high quality products. For effective planning and analytical work and improving the quality of management decisions, it is necessary to organize separate management accounting, which will inform about the level of fixed and variable costs and will be conducted in the following groups: – variable costs that vary in proportion to the volume of production. These are the costs of seeds, productive feed, fertilizers, wages of the main production personnel, fuel and lubricants, electricity, transportation costs, etc.; – fixed costs that are not associated with changes in production volumes. These include depreciation, support of feed, means of protection of plants and animals, rent, interest on loan, cost of administration etc.; – mixed costs, consisting of fixed and variable components. For example, the cost of maintenance of equipment, postal, telegraph, office expenses and so on. When planning costs, as well as in general in the process of planning the economic and social development of the enterprise, a significant role is played by the expert method, where a limited factual information is the object of expert rather than statistical analysis. For example, the level of application of technological materials per 1 hectare or unit of production should be justified by expert calculations, which are based on indicators of natural fertility, nutrient reserves in the soil, the coefficients of the use of the active ingredient of mineral fertilizers, the spread of weeds, entomological forecasts, etc., that

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should provide for the use of the most common and standard types of technological materials, that is, take into account the real state of the market of means of production. The disadvantage of traditional methods of cost planning (estimate, normative, calculation and constructive) is a great complexity of calculations for each plan option, especially in long-term planning. In addition, they do not take into account the complex impact of each factor on the cost. Therefore, in the practice of planning the cost of crop and livestock production, economic and mathematical methods based on the use of production functions are increasingly applied. The functional dependence of the cost (s) of the independent quantitiesfactors can be expressed by a linear equation: y = f (X1, x2,..., HP),

(5.4)

where X1, x2, ... HP are the factors of production. The main factors that form the value of the cost of production are: crop-crop productivity, labor intensity of production, productivity and level of payment, concentration and specialization of production, capital equipment, etc.; livestock – productivity of livestock, labor intensity of production, labor productivity and level of payment, the cost of feed and their balance of digestible protein, concentration and specialization of production. The use of the above production function in the current and future planning of production costs, as well as in the calculation of the expected cost is similar to the planning of livestock productivity and crop yields. 5.3. The effect of operating leverage Operating leverage, in simple terms, is the relationship between fixed and variable costs. Fixed costs are the costs that are incurred regardless of the number of units sold. Variable costs change with the level of sales. A company with high operating leverage has a high

5. ClassificaƟon of corporate costs

percentage of fixed costs to total costs, which means more units have to be sold to cover costs. A company with low operating leverage has a high percentage of variable costs to total costs, which means fewer units have to be sold to cover costs. In general, a higher operating leverage leads to lower profits. The Formula for Operating Leverage: Degree of operating leverage = Contribution margin / Profit. (5.5) Which can be restated as: Degree of operating leverage = Q(CM) / / Q(CM-Fixed operating costs),

(5.6)

where Q = unit quantity CM = contribution margin (price – variable costs per unit). Calculation of Operating Leverage. For example, Company A sells 500,000 products for a unit price of 6 tenge each. The company’s fixed costs are 800,000 tenge. It costs 0.05 tenge in variable costs per unit to make each product. Let us calculate company A’s degree of operating leverage as follows: 500,000 x (6 – 0.05) / [500,000 x (6 – 0.05) – 800,000] = 2,975,000 / / 2,175,000 = 1.37 or 137%. Therefore, a 10% revenue increase should result in a 13.7% increase in operating income (10% x 1.37 = 13.7%). What Does Operating Leverage Tell You? The operating leverage formula is used to calculate a company’s break-even point and helps set appropriate selling prices to cover all costs and generate a profit. The formula can reveal how well a company is using its fixed-cost items, such as its warehouse and machinery and equipment, to generate profits. The more profit a company

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can squeeze out of the same amount of fixed assets, the higher is its operating leverage. One conclusion the companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to selling price, contribution margin or the number of units they sell. High and Low Operating Leverage It is the key to compare operating leverage among companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly defined. Most of the company’s costs are fixed costs that reoccur each month, e.g. building rent, regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered and profits are earned. Other company costs are variable costs that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials that are transformed into products. Some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs. For example, a software business has greater fixed costs in developers’ salaries and lower variable costs with software sales. Therefore, the business has high operating leverage. In contrast, a computer consulting firm charges its clients hourly, and doesn’t need expensive office space because its consultants work in clients’ offices. This results in variable consultant wages and low fixed operating costs. Therefore, the business has low operating leverage. The more operating leverage a company has, the more it has to sell before it can make a profit. In other words, a company with a high operating leverage must generate a high number of sales to cover high fixed costs, and as these sales increase, so does the profitability of the company. Conversely, a company with a lower operating leverage will not see a dramatic improvement in profitability with higher volume, because variable costs, or costs that are based on the number of units sold, increase with volume.

5. ClassificaƟon of corporate costs

Break-even Point. Operating leverage defines a company’s break-even point, which drives pricing. The break-even point is the point at which costs are equal to sales; the company «breaks even» when the cost to produce a product equals the price customers pay for it. To make a profit, the price must be higher than the break-even point. A company with a high operating leverage, or a higher ratio of fixed costs to variable costs, always has a higher break-even point than a company with a low operating leverage. The company with a high operating leverage, all other things being equal, must raise prices to make a profit. Benefits of High Fixed Costs. It may seem as though a high operating leverage is detrimental to profits, but a high fixed cost structure has some benefits. The principal advantage is that the companies with a high operating leverage have more to gain from each additional sale because they do not have to increase costs to generate more sales. As a result, profit margins increase at a faster pace than sales. For example, most software and pharmaceutical companies invest a large amount in upfront development and marketing. It doesn›t matter if Microsoft or Pfizer sell one unit or 100 units, as their fixed costs will not change much. Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product. Low-operating-leverage companies may have high costs that vary directly with their sales, but have lower fixed costs to cover each month. The operating leverage formula can show how a company›s costs and profit relate to each other, and show that reducing fixed costs can increase profits without changing sales quantity, contribution margin or selling price. Tasks: 1. Select one company on www.kase.kz. Describe the general characteristics of the corporate expenses of the selected company. Independently classify the company’s corporate expenses. Explain the direct and indirect costs of the corporation. 2. Make a classification of corporate expenses for management decisions.

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Corporate Finance 3. Name and describe the main methods of planning the costs of the company. 4. Explain the estimated and regulatory cost planning methods. Explain the calculation and constructive cost planning methods. 5. What is an operating lever? Explain the impact of operating leverage on corporate income and expenses. Activity 1. The following source of information is available. The company’s activity is characterized by the following main indicators: – sales revenue – 1800 000 tenge; – the sum of variable costs in the cost structure – 1400 000 tenge; – the amount of fixed costs in the cost structure – 135,000 tenge. The company plans to increase sales revenue to 1950 000 tenge without going beyond the relevant range. Based on the data provided, it is required: 1. Calculate the amount of profit corresponding to the new level of revenue from sales using the operating lever. 2. Assess the estimated level of the enterprise’s capital-output ratio and the degree of its entrepreneurial risk. Activity 2. The volume of wholesale sales of electric heaters is predicted by the plant in the amount of 75 million tenge. Depreciation, general and other similar expenses in the volume of sales make 15 million tenge. The cost of production, depending on the volume of production of electric heaters, along with commercial expenses, is 45 million tenge. Value added tax paid by customers is 10 million tenge. Define: 1. The strength of the operating leverage. 2. How much can the profit increase with a possible increase in sales by 5% in the planned year? Test questions: chapter 5 1. Variable costs include cost items such as... a) general expenses b) rent c) fuel and energy for technological purposes d) depreciation 2. Costs, having a dependence on the volume of production, are called: a) overhead b) factory-wide c) permanent d) variables

5. ClassificaƟon of corporate costs 3. By the method of reference to the cost of production costs are divided into: a) technological and industrial b) direct and indirect c) constants and variables d) economic elements and calculation items 4. Costs, formed in connection with the organization, maintenance and management of production, are called… a) craft b) invoices c) direct d) simultaneous 5. The main costs include such costs as: a) shop expenses b) general expenses c) the cost of fuel and energy for technological purposes d) the cost of sales 6. The purpose of cost classification by items of calculation is… a) determining the cost of raw materials b) the basis for the preparation of estimates of production costs c) calculating the unit cost of a particular product d) the pricing of the product 7. Fixed costs of the enterprise are: a) the cost of resources on the prices in force at the time of their acquisition b) the minimum cost of production of the products c) the costs incurred by the company even if the products are not made d) commercial costs 8. The cost of production is: a) reduction of economic benefits as a result of disposal of assets b) decrease in the capital of the organization, due to the occurrence of obligations c) expressed in monetary terms for the production and sale of products d) cost estimation used in the production of natural resources, materials, fuel, labor and other resources 9. Indirect costs are analogous to: a) direct costs

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Corporate Finance b) overhead costs c) variable costs d) fixed costs 10. The material costs include: a) purchased semi-finished products b) the cost of certification of products c) notary services d) wages of storekeepers 11. What types of costs are divided by nature and elements: a) Materials, Labor and Expenses b) Direct, indirect c) Fixed, variable d) Controllable, uncontrollable 12. What does not apply to the types of financial costs by managerial decisions? a) Marginal costs b) Out of pocket costs c) Sunk costs d) Indirect costs 13. What does not apply to cost planning methods? a) Estimate b) Normative c) Calculation d) Correlational 14. The most widely used method of financial cost planning? a) Estimate b) Constructive c) Calculation d) Normative 15. What method of cost planning is used for long terms? a) Normative b) Calculation c) Constructive d) Calculation and constructive

5. ClassificaƟon of corporate costs 16. What factor is not taken into account in the methods of calculation and constructive methods? a) improvement of production and labor organization; b) changes in the volume and structure of production; c) the influence of national economic and industrial factors; d) factor of globalization 17. What cost planning methods are currently used around the world? a) Normative and calculation b) Economic and mathematical c) Constructive and estimate d) Estimate and normative 18. What is operating leverage? a) It is the relationship between fixed and variable costs; b) It is the degree to which a company uses fixed-income securities such as debt and preferred equity; c) It is the degree to which a company uses fixed-income securities such as debt and preferred equity; is the relationship between fixed and variable costs; d) There is no correct answer 19. The formula of operating leverage: a) Operating leverage = contribution margin/profit b) Operating leverage = profit/contribution margin c) Operating leverage = contribution margin-profit d) Operating leverage = contribution margin/k 20. Operational leverage reflects: a) the level of business risk inherent in the firm; b) the degree of financial risk inherent in the firm; c) the degree of financial risk on the financial market; d) the level of business risk on the financial market.

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6. EARNINGS OF THE CORPORATION AND THEIR CLASSIFICATION

6.1. General characteristics of corporate earnings 6.2. Profit and profitability

6.1. General characteristics of corporate earnings In the context of market relations, any enterprise can receive income from the following activities: main (operating), non-core (financial and investment) and emergency activities. Operating activities are the principal income-generating activities of a legal entity and other activities not related to investment and financial ones. This is the activity for which the company was created. Investment activity is the activity on acquisition and sale of long-term assets, issue and receipt of repayable loans. Financial activity is the activity of a legal entity, the result of which is a change in the amount and composition of equity and borrowed funds. Various aspects of production, sales, procurement, financial and investment activities of the enterprise receive a complete monetary assessment in the system of indicators of financial results. In summary, the most important indicators of financial results of the company are presented in the form of annual and quarterly financial statements – «statement of income and expenses». Indicators of financial results characterize the absolute efficiency of the enterprise. The most important among them are the indicators of profitability, which in a market economy form the basis of economic 118

6. Earnings of the corporaƟon and their classificaƟon

development of the enterprise. The growth of income creates a financial basis for self-financing, expanded reproduction, solution of the problems of social and material requirements of labor teams. At the expense of income, part of the enterprise›s obligations to the budget, banks and other enterprises and organizations is also fulfilled. Thus, profitability indicators become the most important for the assessment of production and financial activities of enterprises. They characterize the degree of business activity and financial well-being. The level of return of advanced funds and the profitability of investments in the assets of the enterprise are determined by the profitability. The main objectives of the analysis of the financial results of the company are: • assessment of the dynamics of indicators of profitability, the validity of education and the distribution of their actual quantities; • identification of the effect of various factors on income and correction of these; • assessment of possible reserves for further growth of profitability based on optimization of production volumes and costs. The theoretical basis for the economic analysis of the financial results of an enterprise is the single model of the economic mechanism of the enterprise under market relations adopted for all enterprises, regardless of their form of ownership, based on income generation. It reflects the unity of the objectives of activity, the unity of indicators of financial performance, the unity of the processes of formation and distribution of income, the unity of the taxation system, which is inherent in all enterprises operating in the market conditions as independent producers. The business model in a market economy contains a series of steps or calculations. Consider them in more detail. The report on income and expenses contains the following indicators: 1) income from the sale of finished products (goods, works, services) is shown net of value added tax, excise taxes, other taxes and obligatory payments, as well as the value of the returned goods, sales discounts and price discounts provided to the buyer.

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This item reflects income from operating activities. Income from operations can be obtained from the sale of inventories, services, as well as in the form of remuneration, dividends, fees and annuities, depending on the core business; 2) the cost of sold finished products (goods, works, services) includes actual costs directly related to the production of products (works, services), which are grouped in accordance with their economic content by the following elements: material costs, labor costs, deductions for insurance, depreciation of fixed assets, other expenses; 3) gross income is the financial result from the sale of finished products (goods, works, services) and is defined as the difference between the income from sales of finished products (goods, works, services) and the cost of sold finished products (goods, works, services) as a result of main activity; 4) expenses of the period: – general and administrative expenses; – the cost of implementing; – expenses on payment of remuneration. Period expenses are the expenses that are not included in the production cost of finished products (goods, works, services); 5) income (loss) from operating activities is a net financial result and is defined as the difference between gross income and expenses of the period; 6) income (loss) from non-core activities. This article shows the net financial result (income, loss) from non-core activities. Income arising from non-core activities is the transfer of non-current assets, revaluation of securities traded on the exchange, etc.; 7) income (loss) from ordinary activities before taxation. This indicator reflects the net financial result (income, loss) from ordinary activities before taxation, which is determined by calculation in terms of points 5 and 6; 8) income tax is determined in accordance with the accounting standard 11 «Income tax Accounting»; 9) income (loss) from ordinary activities after tax is determined by calculation in the form of a difference according to the indicators of points 7 and 8;

6. Earnings of the corporaƟon and their classificaƟon

10) income (loss) from emergency situations. This indicator reflects the net result of emergencies minus income tax. Emergencies are the events or operations other than the normal activities of the organization. It is assumed that such events and operations will not be repeated frequently or regularly; 11) net income (loss) reflects the net result (net income, loss) received by a legal entity for the reporting period. Generalized characteristics of economic activity of enterprises in a market economy give the value of net profit (income) and indicators of financial position. It is important not only to get the greatest possible profit, but also to use correctly that part of it which remains at the disposal of the enterprise, i.e. to provide an optimum ratio of rates of scientific and technical, production and social expanded reproduction. The considered model of formation and distribution of financial results of activity of the enterprise in the conditions of market economy reflects the main features of the system of the accepted normative distributive relations between the interests of the state and separate enterprises (businessmen). For an enterprise income corporate tax as a system of gratuitous withdrawal of a certain share of income in the state budget is a necessary element in the functioning of the capital of the enterprise. The value of this element can be minimized by improving the system of internal planning and control of costs and investments, due to the complex rationalization of economic activity and reasonable choice of accounting policy. Income from the sales of products, works and services is the main source of corporate financing. Finished products are the products of the main and auxiliary shops, intended for sale. Finished products must be manufactured, completed, comply with the standards or specifications, accepted by the technical control services, provided with a passport, certificate or other document certifying its quality and completeness, delivered to the warehouse, and when delivered on site to the customer – supplied with the issued acts of acceptance or other documents. The finished products include works and services of an industrial nature, performed by the third parties, as well as the cost of semi-fin-

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ished products of own production intended for sale. Implementation of the plan for the production and sale of products (works, services) is the main indicator characterizing the activities of the subject. The subject sells its products, works and services in order to fulfill economic contracts concluded with consumers. Part of the products he can sell through its sales network for the sale of products. The most important duty of the subject is fulfillment of the contractual obligations as per quantity, nomenclature, delivery time, product quality and other conditions. Timely payment of products delivered to customers (each manufacturer is also a buyer) is an essential condition for the stable operation of each subject and the economy of the Republic as a whole. In synthetic accounting, finished products are estimated at the actual cost; in analytical accounting – at solid prices that can be the planned cost or contractual prices. The difference between the actual and planned cost of production or between the contract prices and the actual cost is taken into account separately. The following types are used in accounting evaluation of the finished product: ‒ production cost (planned, actual), which includes all production costs for the plunder of finished products; ‒ full cost (planned, actual), consisting of production cost with the addition of commercial costs (costs associated with the sale, advertising, etc., not reimbursed by buyers); ‒ contractual prices of the enterprise; ‒ retail prices – the prices for the goods primarily for personal consumption, arriving at a broad market and sold through retail network and public catering enterprises. Income from the sale of finished products and goods purchased and the provision of services is determined by the cost of their implementation, provided for in the contract (agreement) between its parties. The amount of income arising from transactions is measured by the value received or to be received, taking into account the amounts of discounts on prices or sales, as well as markdowns (additional assessments) agreed in the contract. Income and expenses caused by the same transactions or events in the activities of the entity are recognized simultaneously.

6. Earnings of the corporaƟon and their classificaƟon

If the receipt of funds is delayed or payment occurs before the due date, the value of compensation may be less or more than the nominal amount of funds received or receivable. The difference between the cost of sale and the nominal amount of payment is recognized as income expressed as the percentage. The cost of sale is the amount that the buyer pays for the asset or the cost of its exchange between ready-to-deal independent parties. The cost of implementation also assumes that the parties to the contract take into account the principles of accounting, such as: accrual, truthful and impartial representation, prudence, etc. Income from the sale of goods is recognized subject to the following conditions: the amount of income is estimated with a greater degree of reliability, i.e., both parties involved in the transaction know about what amount the seller requests, and what amount should be paid by the buyer. There is a possibility that the economic benefit associated with the transaction will be obtained by the entity. This means that the seller is confident that the buyer will pay the agreed amount for the goods sold. – Income from works and services is recognized if the requirements for determining income from the sale of goods and the following conditions are met: – the stage of completion of the transaction by the reporting date is determined with a greater degree of reliability; – the costs incurred in carrying out the transaction and the costs required to complete the transaction are assessed with greater certainty. When the result of the transaction on rendering of services cannot be assessed with a greater degree of certainty, the income is recognized only to the extent of incurred costs that will be recoverable. Formation of income from core activities. Income from operating activities is organized in the accounts subsection 70 «Income from operations». This group includes the following types of income (synthetic passive accounts): 1. Income received from the sale of products, work performed and services rendered to the PA side. 2. Income received from the sale of purchased goods. This is applied by trade, supply, intermediary and foreign trade organizations.

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This account may be used by industrial, agricultural and other enterprises, the statutes of which provide for the implementation of trade, brokering and export-import operations. 3. Income from the sale of construction and assembly, projectprospecting, exploration, research etc. work. This account is used by construction and installation, exploration, design and survey and research enterprises and organizations to reflect the income received from the delivery of works to customers. The account may be applied by industrial and other enterprises, the statutes of which provide for the performance of one or more types of the above works. 4. Income from services for the carriage of goods and passengers. The account is used by enterprises of railway, automobile, air, sea, river and other types of transport (metro, tram, trolleybus) to record the income received from the provision of appropriate services for the transportation of goods and passengers. Account can be used by enterprises and other sectors of the economy, performing work on the transportation of goods and passengers. 5. Income received from the rental of property. 6. Income from the services of communication organizations. 7. Income from the activities of insurance companies. 8. Other income from operating activities. On this account the income received as a result of the main activity, not recorded in the above accounts is reflected. Such income includes the income received from the sale of products, works and services by other activities of the enterprise. Income from non-core activities. To account for income from non-core activities is a subsection «income from non-core activities», which includes the following types of income: 1. Income from the sale of intangible assets. 2. Income from the sale of fixed assets. 3. Income from the sale of securities. 4. Dividends on shares and interest income. 5. Foreign exchange gain. 6. Subsidies of executive authorities. 7. Other income from non-core activities:

6. Earnings of the corporaƟon and their classificaƟon

– surplus property, plant and equipment identified in the inventory of property, plant and equipment and construction work in progress; – surplus materials, finished products and goods purchased, identified in the inventory; – surplus funds identified in the inventory; – amounts of accounts payable with expired limitation periods (3 years) written off in accordance with the established procedure; – fixed assets, intangible assets, materials, goods, securities, cash received free of charge from other legal entities and individuals; – amounts withheld from the personnel›s remuneration for compensation of damage caused to the enterprise (downtime, fines due to the fault of employees and other non-productive expenses); – the amount of accrued fines, penalties, and other compensations to legal entities and individuals. Income (loss) from emergencies and discontinued operations. To account for income or losses from natural disasters and discontinued operations, subsection 86 «Income (loss) from emergencies and discontinued operations» is intended. The composition of these moves and losses includes: – «Income (loss) from natural disasters». – «Uncompensated losses from natural disasters». – «Income (loss) from discontinued operations». – «Other income (loss) from emergencies». Losses from natural disasters are losses that arise if the policyholder has concluded a contract for insurance of property, business risk, etc., but has not fulfilled all the requirements of the insurance contract. These can be: – deliberate actions of the policyholder aimed at the occurrence of an insured event or contribution to its occurrence; – intentional crimes or administrative offences recognized in accordance with the procedure established by law, which are in causal connection with the insured event; – military actions and related actions of a military nature, recognized as such in accordance with the procedure established by legislative acts, if the contract does not provide for military risk insurance.

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As a result of natural disasters, the enterprise may in some cases receive income. For example, if the insurer reimburses the full residual value of the lost property, and the company from its disassembly (liquidation) receives some liquidation value. Uncompensated losses from natural disasters occur if the potential policyholder has not concluded a contract for property insurance, business risk, etc., as a result, the insured will not receive insurance compensation from the insurer in the event of an insured event. Discontinued (interrupted) operations result from the sale of an operated asset or the termination of operations that constitute a separate, significant line of economic, production or trading activity of the enterprise. The activities of the enterprise, assets, liabilities, net income or loss associated with such transactions can be identified and recorded in the accounting records. For each discontinued (interrupted) transaction, the financial statements and the explanatory note disclose: – the nature of the interrupted operation; – the industry and geographic segments in which the transaction is included for financial reporting purposes; – the date of actual interruption of the transaction for accounting purposes; – method of interruption (sale or termination, etc.), profit or loss and accounting policies applied to measure this profit or loss; – income and net income or loss from ordinary activities for the reporting period, with corresponding amounts for each previous period presented. From time to time, the company may interrupt or terminate an individual significant areas of activity, different from other types of economic activity. The results of the interrupted transaction should be included in the profit or loss from the ordinary course of business. If the interruption is caused by a natural phenomenon or state intervention, the total income or loss from the interruption may meet the definition of an extraordinary article. Emergencies are the events or operations other than the normal activities of a legal entity. It is assumed that such events and operations will not be repeated frequently or regularly.

6. Earnings of the corporaƟon and their classificaƟon

Extraordinary events or transactions that have a sufficiently high degree of abnormality and are not explicitly or accidentally related to the ordinary activities of the enterprise, given the environment in which it operates. Rarity of occurrence of events or transactions must be such that their occurrence cannot reasonably be expected in the foreseeable future, given the environment in which the enterprise operates. Usually, an emergency situation arises as a result of a natural disaster, state intervention, etc., e.g., an earthquake or expropriation by the state of the assets belonging to the enterprise, and other income or loss as a result of an emergency that are presented separately in the income statement. The nature and amounts of each emergency should be disclosed in an explanatory note to the annual report. It should be understood that emergencies are not defined as repetitive and are not part of the normal activities of the enterprise, but are unexpected and unpredictable. Business is always exposed to accidents and surprises; variability is a fact of a business life. It is possible to receive less profit (to incur a loss) from changes in the prices in the market of goods, as well as from an emergency situation. Net profit (income) is profit after tax, it is a source of further development of the organization (enterprise) and a source of income of the owner of the enterprise (entrepreneur). Distribution and use of net income of the organization (enterprise) is regulated by the state by indirect methods. Net income is at the full disposal of the owner of the enterprise and at the same time is the subject of financial management in terms of state regulation of investment activities, the use of available funds in the financial market, property taxation, income of individuals, etc. Net income remaining at the disposal of the enterprise is distributed by the decision of the owners (shareholders, participants). At the presentation of managers at the beginning of the year, the owners approve the estimate of profit distribution for the projected year, quarter. It should be borne in mind that some taxes and fees under the current legislation are paid from the net income remaining at the disposal of the enterprise (for example, the tax on excess profits, etc.).

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Net income remaining at the disposal of the enterprise is divided into two parts: distributed throughout the year for the purposes provided for in the Charter, and Unallocated part. The latter shows the size of the projected balance of retained earnings at the end of the year (quarter). According to the decision of the owners, it is possible to predict the distribution of all profits remaining at the disposal of the enterprise. During the year, profits may be directed to special-purpose funds, for special purpose financing (maintenance of pre-school institutions and social infrastructure), covering losses on housing and communal services, replenishment of the authorized fund, repayment of interest on short-term loans above the level provided for by the current legislation, payment of interest on long-term lease of fixed assets, payment of dividends on shares and ordinary shares, etc. Part of profits may remain undistributed. The directions of use of profit during the year are provided in the Charter of a particular enterprise, and the amount of deductions from profit for each of them is determined annually by the owners of the enterprise. During the year, the actual profit is used in accordance with the approved estimate. In addition to the planned costs at the expense of profits remaining at the disposal of the enterprise, some payments are paid to extra-budgetary funds, some are referred to entertainment expenses, advertising costs, training and retraining of personnel in excess of established norms and standards, penalties for violation of tax legislation, etc.. At the end of the year, a statement of income and expenses of the company and the use of profit in the reporting year is prepared, the amount of retained earnings is determined. 6.2. Profit and profitability Profitability indicators are relative characteristics of financial results and efficiency of the enterprise. They measure the profitability of the enterprise from different positions and are grouped according to the interests of participants in the economic process, market exchange.

6. Earnings of the corporaƟon and their classificaƟon

Profitability indicators are important characteristics of the factor environment of profit (and income) of enterprises. For this reason, they are mandatory elements of comparative analysis and assessment of the financial condition of the enterprise. In the analysis of production profitability indicators are used as an instrument of investment policy and pricing. The main profitability indicators can be grouped as follows: 1) the profitability of the products; 2) return on equity (assets); 3) indicators based on cash flows. The first group of indicators is formed on the basis of the calculation of the levels of profitability on indicators of profit (income), reflected in the reporting of the enterprise. For example: R = Return on operations / sales R = Income from ordinary activities / net sales R = Income from ordinary activities before taxation / net sales R = Income from ordinary activities after taxation / net sales R = Net income / sales. These indicators characterize the profitability of the products of the base and reporting periods. The second group of profitability indicators is formed on the basis of calculation of profitability levels depending on changes in the size and character of the advanced means: all assets of the enterprise; investment capital (own means + long-term obligations); joint-stock (own) capital. For example: R = Net income / total assets R = Net income / investment capital R = Net income / share capital R = Net income / own capital. The discrepancy between the levels of profitability of these indicators characterizes the degree of use of financial instruments by the enterprise to increase the profitability of long-term loans and other borrowed funds. These indicators are very practical. They are in the interest of the participants. For example, the administration of the enterprise is

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interested in the return (yield) of all assets (total capital); potential investors and creditors – in the return on invested capital; owners and founders – in the return on shares, etc. Each of these indicators is easily modeled by factor dependencies. Consider the following obvious dependency: R = Net income / total assets = = (R = Net income / sales) – (Sales / net income). This formula reveals the relationship between the profitability of all assets (or production assets), return on sales and return on equity (turnover of production assets). The economic connection is that the formula directly indicates the ways to increase profitability: at low profitability of sales, it is necessary to strive to accelerate the turnover of production assets. Let us consider a one factor model of profitability (DuPont Formula): Net income / equity = = (net income / sales) – (sales / all assets) – (all assets / equity). As you can see, the return on equity (share) capital depends on changes in the level of profitability of products, the speed of asset turnover and the ratio of own and borrowed capital. The study of such dependencies has a great evidential force for assessment of the financial condition of the enterprise, assessment of the degree of its performance. It follows from this relationship that, ceteris paribus, the return on equity increases with an increase in the share of borrowed funds in total capital. The third group of profitability indicators is formed on the basis of calculations of the level of profitability similar to the indicators of the first and second groups, but instead of net income (profit), net cash inflow is taken into account. For example: R = Net cash inflow / sales R = Net cash inflow / all assets R = Net cash inflow / own capital.

6. Earnings of the corporaƟon and their classificaƟon

These indicators show the extent to which an enterprise is able to provide lenders, borrowers and shareholders with cash in connection with its existing productive capacity. The concept of profitability, calculated on the basis of cash inflows, is widely used in the countries with developed market economies. It is a higher priority, because cash flow operations are an essential feature of the intensive type of production, a sign of «health» of the economy and the financial condition of the enterprise. The transition to this concept requires a restructuring of enterprise reporting. This work is only at an early stage. The variety of profitability indicators determines the alternative of finding ways to improve it. Each of the initial indicators is decomposed into a factor system with a different degree of detail, which sets the boundaries of identification and evaluation of production reserves. When analyzing the ways to improve profitability, it is important to separate the influence of external and internal factors. Such indicators as the price of the product and resource, the amount of resources consumed and the volume of production, profit from sales and profitability of sales are in close functional relation. Large enterprises pay main attention to the problems of controlling changes in industrial productivity and try to reduce the role of an external factor, or financial productivity. The fact is that one among the conditions of prosperity of the enterprise is the expansion of the market for products by reducing the price for the goods offered. Since this process is not accompanied by a decrease in prices for consumed resources, the role of the price deflator in forming the profitability of the enterprise decreases. It naturally switches the efforts of the management to the control of the changes of industrial performance, i.e. internal factors: the reduction of material consumption and labor intensity of production, improvement of the efficiency of fixed assets, machinery and equipment, etc. Tasks: 1. Select one company on www.kase.kz. Describe the general characteristics of the corporate income of the selected company. Make a description of the corporate earnings of the company. 2. Determine the total profit of the company. Describe the model of the financial mechanism of the selected company.

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Corporate Finance 3. Explain how revenues from sales of products, works and services are formed and distributed. 4. Explain the value of the company’s profitability. Describe the system for determining profitability indicators: the basic formulas, methods for determining profitability and ways to improve the company’s profitability. 5. What does a corporate net income show? How does the decrease in a company’s net income affect its value? Activity 1. Conduct financial diagnostics of the company. It is necessary to diagnose the profitability of the enterprise and the reasons that led to a change in profitability according to the table: Indicators Proceeds from sales of products, thousand. Variable costs, thousand Fixed costs, thousand Equity capital, thousand Long-term loans, thousand Short-term loans, thousand Average estimated interest rate, % Tax rate, %

Values 20000 12000 4000 15000 1500 1500 12 20

Activity 2. Calculate the value of the price of capital of the company under the following conditions: the total amount of share capital is 240 million tenge, retained earnings – 9 million tenge, long-term liabilities – 270 million tenge. At the same time, the profitability of the company’s shares is 20%, the price of retained earnings is 35%, and the average calculated rate on long-term liabilities is 30%. Test questions: chapter 6 1. The profit of the Corporation is: a) the financial result of the Corporation, in which income exceeds the expenses b) the financial result of the Corporation’s activities, in which expenses exceed income c) the financial result of the Corporation, in which income is equal to expenses 2. The main purpose of corporations is... a) gaining profit b) satisfaction of social tasks of the state c) provision of charity and sponsorship

6. Earnings of the corporaƟon and their classificaƟon 3. Operating profit (EBIT) is: a) the difference between gross profit and operating costs b) operating profit less adjusted taxes. c) profit before income tax and interest on borrowed funds d) all answers are correct 4. What is included in the price structure? a) cost (production costs) b) indirect taxes c) profit d) profitability 5. At the level of operating leverage equal to 4.2 determine how much interest will change profit before interest and taxes deduction when the volume of sales in physical units is 8 % a) 15.41 % b) 33,6 % c) 1,9 % d) 24,7 % 6. Calculate the threshold of profitability, if fixed costs are 8 million tenge, margin income per 1 unit of production is 20 tenge. a) 400 thousand units. b) 9.7 million units. c) 100 thousand units. d) 1.6 million units. 7. Profit is a) the production and handling costs b) this is the difference between income and expenses c) profitability and efficiency of the enterprise d) additional factor 8. The main objectives of the analysis of the financial results of the company are (choose the wrong answer): a) assessment of the dynamics of indicators of profitability, the validity of education and the distribution of their actual quantities; b) identifying and changing the effect of various factors on income; c) assessment of possible reserves for further growth of profitability based on optimization of production volumes and costs. d) preparation of financial statements

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Corporate Finance 9. Which of the reporting forms contains detailed information about the income of the organization? a) statement of income and expenses, b) statement of financial position, c) statement of cash flows, d) statement of changes in equity 10. Finished products are reflected: a) Only at discount price b) At standard or actual cost c) Only for the actual cost d) Only at standard cost 11. What is not used in the evaluation of finished products? a) production cost; b) commercial cost; c) contractual prices of the enterprise; d) retail prices 12. The prices for the goods primarily for personal consumption, arriving at a broad market and sold through retail network and public catering enterprises. a) Retail prices b) Wholesale prices c) Free prices d) Prices of commodity auctions 13. Income is recognized in accounting under the following conditions (choose the wrong answer): a) there is a possibility that the economic benefit associated with the transaction will be obtained by the entity b) the stage of completion of the transaction by the reporting date is determined with a greater degree of reliability c) the costs incurred in carrying out the transaction and the costs required to complete the transaction are assessed with greater certainty. d) when all accompanying documents are completed 14. The account is used by construction and installation, exploration, design and survey and research enterprises and organizations to reflect the income received from the delivery of works to customers. a) Income from the sale of construction and assembly, design, exploration, research etc. work. b) Income received from the sale of purchased goods.

6. Earnings of the corporaƟon and their classificaƟon c) Income from services for the carriage of goods and passengers. d) Income received from the sale of products, work performed and services rendered. 15. The account for income from non-core activities does not include the following type of income: a) Income from the sale of intangible assets. b) Income from the sale of fixed assets. c) Income from the sale of securities. d) Income received from the sale of products, work performed and services rendered. 16. What type of income is included in the income from emergencies? a) Dividends on shares and interest income. b) Foreign exchange gain. c) Subsidies of Executive authorities. d) Uncompensated losses from natural disasters 17. These operations result from the sale of an operated asset or the termination of operations that constitute a separate, significant line of economic, production or trading activity of the enterprise. a) Financial operations b) Discontinued (interrupted) operations c) Trading operations d) Investment operations 18. Product profitability can be defined as the ratio of: a) a revenue from sales to material costs b) absolute value of profit to the cost of production c) profit to material costs d) profits to the wage fund 19. What does not apply to the types of income? a) Accounting b) Limit c) Average d) Gross 20. The types of profitability do not include a) product profitability b) return on assets c) overall profitability d) cost effectiveness

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7. EQUITY CAPITAL OF CORPORATIONS: COMPOSITION AND STRUCTURE

7.1. Equity capital of corporations: structure 7.2. Management of own (equity) capital

7.1. Equity capital of corporations: structure A corporation’s share capital or capital stock (in US English) is the portion of a corporation’s equity that has been obtained by the issue of shares by the corporation to a shareholder, usually for cash. «Share capital» may also denote the number and types of shares that compose a corporation›s share structure. In a strict accounting sense, share capital is the nominal value of issued shares (that is, the sum of their par values, as indicated on share certificates). If the allocation price of shares is greater than their par value, as in a rights issue, the shares can be sold at a premium (otherwise called share premium, additional paid-in capital or paid-in capital in excess of par). Commonly, the share capital is the total of the aforementioned nominal share capital and the premium share capital. Conversely, when shares are issued below par and issued at a discount or part-paid. Sometimes, shares allocated in exchange for non-cash consideration, most commonly when corporation A acquires corporation B for shares (new shares issued by corporation A). Here the share capital is increased to the par value of the new shares, and the merger reserve is increased to the balance of the price of corporation B. 136

7. Equity capital of corporaƟons: composiƟon and structure

In practice, the concept of «par value» has very little meaning, since shares usually represent a residual claim; they do not endow their owners with a claim toward any fixed sum of money. In some jurisdictions, share par values are abolished or made optional, so a corporation can issue shares having no par value. In that case, from an accounting perspective, all of the corporation’s share capital is a premium one. Besides its meaning in accounting, described above, «share capital» may also describe the number and types of shares that compose a corporation›s share structure. A corporation might have an «outstanding share capital» of 500,000 shares (the «structure» of usage); it has received for them a total of 2 million dollars, which is the «share capital» in the balance sheet (the accounting usage). The legal aspects of share capital are mostly dealt with in a jurisdiction corporate law system. An example of such an issue is that when a company allocates new shares, it must do so without inequitably diluting its existing shareholders. The concept and purpose of the share capital. The property basis of the corporation is the so-called authorized capital, the amount of which is fixed in the charter and which is formed from the funds received by the corporation from its members. The authorized capital of a corporation holds a special position among its own funds, performing the following functions: 1. Start function. The statutory fund reflects the availability of the material base for the participants in a corporation’s own (independent) business activity, enshrined in the company’s charter. This is the starting, or initial, amount of capital, giving impetus to the future activities of the company. Over time, in case of successful work, the profit obtained by the joint-stock company may be several times higher than the value of the authorized capital, however, and then it will remain the most stable item of liability. 2. Warranty function. Essentially, share capital is a part of a corporation’s property, intended for repayment to creditors, it is that minimum of funds, the availability of which is always guaranteed by a corporation. In a corporation balance sheet, equity treated as a liability

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item. Distribution as a dividend is subject only to the balance sheet (net) profit, which is the difference between the asset and the company’s debt obligations plus equity capital. If the company’s activity led to losses, because of which the size of the property became less than the authorized capital, then the profit received in the next year should, be used to replenish the company’s property to the amount specified in the charter. Shareholders may not require the capital contributed by a corporation, except for the situations involving reorganization and liquidation of the corporation. Even in this extreme situation, creditors have a primacy for payments receipt, and only after satisfying their claims allowances are paid to shareholders. 3. The function of determining the share of participation of each shareholder in the company. The ratio of the amounts of nominal prices of shares owned by shareholders to the amount of the share capital determines the share of participation of each shareholder in the corporation. Indicator of the position of the shareholder is, above all, the number attributable to his share of the share capital. Despite the fact that the presence of authorized capital is recognized as one of the main conditions for the creation of a corporation, it is necessary to note that the category of «authorized capital» is very relative. First, because the valuation of property contributed to the authorized capital carried out under an agreement between the founders and the shareholders. Secondly, before the registration of the joint stock company, it still does not have property, although the amount of the share capital is indicated in the statute. Thirdly, after the registration of the charter of a corporation, the authorized capital is put into circulation and may either increase or decrease. Fourthly, it is necessary to distinguish the so-called paid-up capital, i.e. the amount actually received for the shares at any given moment, and the unpaid capital, i.e. the amount of shares issued after the subscription. Thus, it is often quite difficult to determine the actual volume of the share capital. Thus, the authorized capital largely loses its original purpose – to serve as a guarantee of payment of the claims of creditors.

7. Equity capital of corporaƟons: composiƟon and structure

Therefore, in some countries (for example, in the USA), the requirement to necessarily support a certain size of the statutory premium is abandoned. Nevertheless, the idea of its preservation still prevails in the world, including Russia. This idea has led to three specific rules of corporate law: 1) a ban (although not hard) on the purchase by the joint stock company of its own shares; 2) limitation of the payment of dividends from funds constituting the share capital; 3) a technically clear distinction between authorized capital and current expenses. Share capital structure. The authorized fund created at the expense of contributions (shares) of the founders – for partnerships and limited liability companies – through the exchange of cash, and property contributions for the shares of the founders and shareholders invited by them to participate in the company – for joint-stock companies. The founders and shareholders of the company may make their contributions in the form of: – cash (in rubles and foreign currency); – various types of property (buildings, structures, equipment, etc.); – rights to use land, water and other natural resources, buildings, structures, equipment; – other property rights, including the use of inventions, knowhow, copyright in a work of art, for example, a script, a manuscript, a book, etc. (It is important that the property right treated as a contribution is alienable, that is, it can be transferred, sold on the market in order to satisfy the claims of creditors). In order to avoid fictions, the entire amount of the authorized share capital must be distributed between the founders of the jointstock company by the date of its registration: the available at this moment shares intended for placement by open subscription are not allowed to be sold. According to the Law on Joint-Stock Companies, the authorized capital must be paid by 50% within the first 30 days after

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issuing a temporary certificate of registration of a joint-stock company and fully in the first year of the joint-stock company functioning (unless otherwise provided by the Federal Law on State Registration of Legal Entities); otherwise, the company is deemed to have failed, or the authorized capital must be reduced to its actual size. Additional shares of the company must be paid within the period stipulated by the decision on their placement, but no later than one year from the date of issue. If the form of payment for the company’s shares at its establishment is determined by the agreement on its creation or the charter, then the form of payment for additional shares or other securities is decided by their placement. In the case of cash payment for additional shares, at least 25% of their nominal value must be paid immediately. In non-cash form, shares and other securities are paid in full at the time of their purchase (unless otherwise provided by the agreement on the creation of the company or the decision to place additional shares). By virtue of its stability, the statutory fund covers, as a rule, the least liquid assets – such as land, real estate, equipment. In case of creation of a new joint-stock company, the funds received from the sale of shares (authorized capital) primarily are used to acquire fixed assets: buildings, structures, machinery and equipment, computers, etc. – assets that are not intended for sale. They used in unchanged natural form for a long period, during which their value is transferred in parts to manufactured products. Current assets of a joint stock company, including cash and assets that can quickly become such in the production process, usually have adequate coverage – this is short-term debt in the form of a bill of exchange or a bank loan. In addition, the company can make a profit by the results of its business. It goes either to pay dividends, or to develop production, or to both at the same time in a certain proportion. The distribution of profits is an independent financial flow, as a rule, does not affect the authorized capital of the company. Increase in the authorized capital. This issue is regulated by law only in the basic parameters, but it finds detailed elaboration in relation to the specifics of a particular joint-stock company in a special

7. Equity capital of corporaƟons: composiƟon and structure

corporate regulatory act, usually the Provision on the Procedure for increasing (decreasing) the authorized capital. Every subscription to shares is accompanied by the adoption of many corporate acts. We will name only some of them having a typical character: Notice of Public Subscription, Obligation to Sell Shares, Certificate of Contributions, On Restrictions on Subscription, etc. The reduction in the share capital is made to achieve the following goals: a) get rid of surplus by paying dividends; b) write off losses. As for the first, we are talking about cases when, for one reason or another, the size of the authorized capital exceeded the optimal one. It is impossible to distribute the part of capital that has become redundant to shareholders, since the return of deposits is not allowed, but by reducing the authorized capital, you can release this part and manage it either by paying dividends or transferring to the reserve. The second goal is pursued when the company’s activity has become unprofitable, with the result that there is a clear discrepancy between the actual assets and the size of the share capital. Such a discrepancy may lead to the compulsory liquidation of a company, because if the size of a company’s property becomes less than the size of the authorized capital stipulated in the Law, there is a basis for its compulsory liquidation. Factors Determining Capital Structure 1. Trading on Equity – The word «equity» denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the idea that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of company’s earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

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2. Degree of control. In a company, the directors are the so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares. 3. Flexibility of financial plan. In an enterprise, the capital structure should be such that there are both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires, while equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans. 4. Choice of investors. The company’s policy generally is directed to having different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors. Bold and adventurous investors generally go for equity shares and loans, while debentures are generally raised at the expense of conscious investors. 5. Capital market condition. In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans. While in the period of boons and inflation, the company’s capital should consist of share capital, generally, equity shares. 6. Period of financing. When the company wants to raise finance for a short period, it goes for loans from banks and other institutions; while for a long period it goes for issue of shares and debentures. 7. Cost of financing. In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of the company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.

7. Equity capital of corporaƟons: composiƟon and structure

8. Stability of sales. An established business which has a growing market and high sales turnover, is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If the company is having unstable sales, then the it is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases. 9. Sizes of a company. Small size business firm capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. 7.2. Management of own (equity) capital The management of own capital consists in the formation of target sources of financing at the expense of profits, contributions of founders and participants and other incomes, as well as their use. The financial manager determines the composition and structure of funds created in the enterprise, as well as establishes target areas for their spending. A number of funds are formed by enterprises in accordance with the requirements of laws, other funds depend on the decision of the founders and the accounting policy of the enterprise. Authorized capital. It is the main and, as a rule, the only source of financing at the time of the creation of a joint-stock commercial organization; it characterizes the share of owners in the assets of the enterprise. In the balance of the authorized capital is reflected in the amount determined by the constituent documents. The increase (decrease) in the authorized capital is allowed by the decision of the owners of the organization following the annual meeting with the obligatory change of constituent documents. For business societies, the law provides for the necessity of a forced change in the value of the share

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capital (downward) in the event its value exceeds the value of the company’s net assets. The authorized capital of the organization determines the minimum amount of its property, which guarantees the interests of its creditors. For some business forms, its value is limited to the bottom; in particular, the minimum authorized capital of an open company must be at least a thousand times the minimum wage (MW) on the date of its registration, and that of a closed company at least one hundred times the amount of the minimum wage. The authorized capital of a joint stock company may consist of two types of shares – ordinary and preferred, and the nominal value of the placed preferred shares shall not exceed 25%. Shares of the company distributed at its establishment must be fully paid up within a period defined by the company’s charter, and at least 50% of the distributed shares must be paid within three months from the moment of state registration of the company, and the rest – within a year from registration. A share is a security indicating the participation of its owner in the company’s own capital. Purchase of shares is accompanied for the investor by the acquisition of a number of property and other rights: – the right to vote, i.e., the right to participate in the management of a company through, as a rule, voting at a shareholders’ meeting when electing its executive bodies, adopting strategic directions of the company’s activities, deciding issues relating to the property interests of shareholders, in particular issues related to liquidation sales of part of the property, issue of securities, etc.; We note that the share does not provide the right to vote until it is fully paid, except for shares acquired by the founders when creating the company; – the right to participate in the distribution of profits, and, consequently, to receive the proportional part of the profit in the form of dividends; – the right to an appropriate share in the company’s share capital and a balance of assets in case of its liquidation; – the right to limited liability, according to which shareholders are responsible for the company’s external liabilities only to the extent of the market value of their shares;

7. Equity capital of corporaƟons: composiƟon and structure

– the right to sell or transfer the share by its owner to another person; – the right to receive information on the company’s activities, mainly the one that is presented in the published annual report. Ordinary shares are the main component of the share capital of the company. From the perspective of potential investors, the following features characterize them: 1) these shares can generate a relatively higher income, but more risky than other options for investing funds; 2) there is no guaranteed income; 3) there is no guarantee that the owner does not incur a loss when selling shares; 4) in case of liquidation of the company, the right to receive part of the property is exercised last. The ordinary share gives the right to receive floating income, i.e., income depending on the company’s performance, as well as the right to participate in management. Distribution of net profit among holders of ordinary shares is carried out after the payment of dividends on preferred shares and the replenishment of reserves provided for by the constituent documents and the decision of the shareholders’ meeting. In other words, the payment of dividends on ordinary shares is not guaranteed by anything and depends solely on the results of current activities and the decision of the shareholders’ meeting. The owner of a preferred share, as a rule, has a priority, as compared with the owner of an ordinary share, the right to receive dividends in the form of a guaranteed fixed interest, as well as a share in the balance of assets during the liquidation of a company. Dividends on such shares in most cases should be paid regardless of the performance of the company and prior to their distribution among the holders of ordinary shares. This results in a relatively lower riskiness of preferred shares; at the same time, this is reflected in the amount of dividends, the level of which on average is usually lower compared to the level of dividends paid on ordinary shares. In addition, a preferred share does not entitle to participate in the management of the company, unless otherwise provided by the statutory documents. We

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emphasize that the meaning of the term «privileged», expressed in privileges in dividends and privileges in the liquidation of a company, is revealed only in relations between the owners of two fundamentally different types of shares. As for other individuals and legal entities related to this company, it is not a matter of privilege for the shareholders, of course. In an ever-changing capital market environment, long-term maintenance of interest rates unchanged, as is the case with preferred shares, is very problematic. That is why preferred shares most often have a limited lifetime – they are either converted into ordinary shares or redeemed (in the latter case, the prospectus provides for the creation of a redemption fund). In this regard, these financial instruments are often interpreted as hybrid securities, since they simultaneously possess the properties of ordinary shares (entitle them to receive a share in current profits and assets) and bonds (constancy and, as a rule, the obligation to pay fixed dividends). Additional paid-in capital is essentially an addition to the share capital and includes the amount before valuation of fixed assets, capital construction objects and other tangible assets of an organization with a useful life of more than 12 months. It is carried out in the prescribed manner, as well as an amount received in excess of the nominal value of shares placed. In terms of the revaluation of non-current assets, additional capital can be formed rather artificially. Directions for the use of this source of funds regulated by accounting guidelines include: – repayment of the decline in the value of non-current assets as a result of their revaluation; – increase in the authorized capital; – distribution between members of the organization. Reserve capital. The sources reflected in this subsection may be created in the organization either on a compulsory basis or if this is provided for in the constituent documents. Retained earnings. The profit received by the company at the end of the year is distributed by the decision of the competent authority (for example, the general meeting of shareholders in a joint-stock

7. Equity capital of corporaƟons: composiƟon and structure

company or a meeting of participants in a limited liability company) to pay dividends, form contingency and other funds, cover losses of previous years, etc. It is essentially represents the reinvestment of profits in the assets of the enterprise; it is reflected in the balance sheet as a source of own funds and remains unchanged until the next meeting of shareholders. If the annual share of reinvested profits is consistently high over time, i.e. shareholders are satisfied with the return on equity generated by the enterprise, then over the years this source can be very significant in the structure of sources of own funds. Ways of financing an enterprise at its own expense. It is easy to see from the above characteristics of the elements of equity capital, their role in financing the company is quite diverse. The source of financing investment activities, as well as ensuring and expanding current activities, of course, is the profit of the enterprise. For the implementation of strategically important projects, a one-time increase in the share capital through the additional issue of shares can be a source of financing. In world practice, various methods of issuing shares are known: – sale directly to investors by subscription; – sale through investment institutions that buy the entire issue and then distribute shares at a fixed price among individuals and legal entities; – tender sale (several investment institutions buy the entire issue at a fixed price from the borrower and then arrange an auction, the results of which form the optimal share price); – placement of shares by a broker with a small number of its clients. The issue of shares is a costly and time-consuming process, in addition, it is regulated by law (in particular, the Federal Law «On Joint-Stock Companies»). As the experience of economically developed countries shows, additional emission due to the so-called signal effect is often accompanied by a decrease in the market price of equities, therefore, this method of mobilizing financial resources is rarely used – in cases where there are clearly marked prospects for using borrowed funds.

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Tasks and functions of managing the company’s own capital Managing your own capital involves managing the process of its formation, maintenance and effective use, that is, management of already formed assets. This implies both the management of own capital as a whole, and the management of its structural elements. The management of equity should be preceded by the study of the effectiveness of its management in the previous period. The analysis is required to determine the reserves for the formation of own funds. The problem of the formation of equity capital cannot be limited only to the direct choice and use of a particular method or instrument of financing and should be considered in the context of managing the structure of the total capital. With an increase in the «age» of a company, its capital structure becomes more complex, and actions to manage this structure become more popular because they affect such key performance indicators of the company as financial stability and profitability, business value and investment attractiveness in the market . In the process of managing the formation of their own financial resources, they are classified according to the sources of this formation. A certain role in the composition of domestic sources is also played by depreciation, especially in the enterprises with a high value of their own fixed assets and intangible assets used; however, they do not increase the amount of the company›s own capital, but are only a means of reinvesting it. Other internal sources do not play a significant role in shaping the company›s own financial resources. As part of external sources of formation of their own financial resources, the main place belongs to the attraction of additional share capital by the enterprise (through additional contributions to the authorized capital) or equity capital (through additional issue and sale of shares). For individual enterprises, one of the external sources of formation of their own financial resources may be the gratuitous financial assistance provided to them (as a rule, such assistance is provided only to certain state-owned enterprises of different levels). Other external sources include tangible and intangible assets that are included in its balance sheet free of charge to an enterprise.

7. Equity capital of corporaƟons: composiƟon and structure

The basis of management of own capital of the enterprise is the management of the formation of its own financial resources. In order to ensure effective management of this process, an enterprise usually develops a special financial policy aimed at attracting its own financial resources from various sources in accordance with the needs of its development in the forthcoming period. The main objectives of managing their own capital are: – determining the appropriate amount of equity capital; – an increase, if required, in the amount of equity capital at the expense of retained earnings or an additional issue of shares; – determination of the rational structure of newly issued shares; – definition and implementation of dividend policy. The development of a policy for the formation of the company›s own financial resources is carried out in the following main stages. 1. Analysis of the formation of own financial resources of the enterprise in the previous period. The purpose of this analysis is to identify the potential of formation of own financial resources and its compliance with the pace of development of the enterprise. At the first stage of the analysis, we study the total amount of formation of our own financial resources, the correspondence of the growth rates of equity capital to the growth rates of assets and the volume of products sold by the company, the dynamics of the share of own resources in the total volume of financial resources formation in the pre-planning period. At the second stage of the analysis, sources of formation of own financial resources are considered. First of all, the ratio of external and internal sources of formation of own financial resources is studied, as well as the cost of attracting equity capital from various sources. At the third stage of the analysis, the sufficiency of its own financial resources, formed at the enterprise in the pre-planning period, is assessed. 2. Determination of the total need for own financial resources. The calculated total demand covers the required amount of own financial resources generated from both internal and external sources. 3. Estimation of the cost of attracting equity from various sources. Such an assessment is carried out in the context of the main elements

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of equity capital generated from internal and external sources. The results of this assessment are the basis for the development of management decisions regarding the choice of alternative sources of formation of their own financial resources, ensuring the growth of the company›s own capital. 4. Ensuring the maximum amount of attracting own financial resources from domestic sources. 5. Ensuring the necessary volume of attracting own financial resources from external sources. The volume of attraction of own financial resources from external sources is intended to ensure that their part, which could not be formed at the expense of internal sources of financing. If the sum of own financial resources attracted at the expense of internal sources fully satisfies the general need for them in the planned period, then it is not necessary to attract these resources at the expense of external sources. 6. Optimization of the ratio of internal and external sources of formation of their own financial resources. The process of this optimization is based on the following criteria: – ensuring the minimum total cost of attracting their own financial resources; – ensuring the preservation of the management of the company by its original founders. The management of the company›s own capital also includes the determination of the optimal ratio between own and borrowed financial resources. Financial leverage («financial leverage») is a financial mechanism for managing return on equity by optimizing the ratio of used own and borrowed funds. The effect of financial leverage is an increment to the profitability of own funds, obtained through the use of credit, despite the payment of the latter. The effect of financial leverage arises from the discrepancy between economic profitability and the «price» of borrowed funds. The economic return on assets is the ratio of the magnitude of the effect of production (i.e., profit before interest on loans and income tax) to

7. Equity capital of corporaƟons: composiƟon and structure

the total value of the total capital of the enterprise (i.e., all assets or liabilities). In other words, the company must initially develop such an economic profitability, so that the funds will be enough, at least, to pay interest on the loan. To calculate the effect of financial leverage, you can apply the following formula: EGF = (Rk – Rzk) x ZS / SK,

(6.1)

where Rk is the profitability of the aggregate capital (the ratio of the sum of net profit and the price paid for borrowed funds and the amount of capital); RZK – profitability of borrowed capital (the ratio of the price paid for borrowed funds to the amount of borrowed funds); ZK – borrowed capital (average value for the period); SK – equity (average value for the period). Thus, the effect of financial leverage determines the economic feasibility of attracting borrowed funds. The high positive value of the EGF indicator shows that the company prefers to use its own funds, does not use investment opportunities sufficiently and does not pursue the goal of maximizing profits. In this situation, shareholders, having received modest dividends, can start selling shares, reducing the market value of the company. At the end of the first part of the work we will focus on the functions of managing the company›s own capital. The main functions of managing their own capital include: Protective function. Equity allows you to maintain the solvency of the company by creating a reserve of assets that allow the company to operate, despite the threat of loss. In this case, however, it is assumed that most of the losses are covered not by capital, but by the current income of the enterprise. Capital plays the role of a kind of protective «cushion» and allows the company to continue operations in the event of major unforeseen losses or expenses. To finance such costs, various reserve funds are included in equity.

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Operational function. It is of the secondary importance compared to the protective one. It includes the allocation of own funds for the purchase of land, buildings, equipment, as well as the creation of a financial reserve in case of unexpected losses. This source of financial resources is indispensable in the initial stages of the enterprise, when the founders make a number of priority expenses. At the subsequent stages of the development of an enterprise, the role of equity is no less important; some of these funds are invested in long-term assets and in the creation of various reserves. Although the main source of covering the costs of the expansion of operations is accumulated profit, enterprises often resort to new issues of shares or long-term loans when carrying out structural measures – establishment of branches and mergers. Regulatory function. It is associated with the special interest of society in the successful functioning of enterprises. These functions of equity show that equity is the basis of the commercial activity of any enterprise. It ensures its independence and guarantees its financial stability, being a source of smoothing the negative effects of various risks borne by the company. Improving the efficiency of managing own capital is stimulated, on the one hand, by striving to improve the financial performance of the company and increase the welfare of its owners, and on the other hand, by the company›s dependence on the external economic environment, which assesses its activities from the outside and forms a system of economic relationships with it. Tasks: 1. Explain the difference between the cost of capital and the value of the enterprise. Express your opinion concerning these differences. 2. Name and justify the most common factors that are used for the company analysis. 3. How is financial modeling expressed and how is it useful in Equity Research? 4. Based on data from the site www.kase.kz select one company. Analyze discounted cash flows in Equity Research. 5. Free cash flow to the company is an excess of cash that is generated after taking into account the requirements for working capital, as well as the costs associated with the maintenance and renewal of fixed assets. What does free cash flow mean for a company?

7. Equity capital of corporaƟons: composiƟon and structure Activity 1. Two large open companies have agreed to merge. No operational synergies are expected. Since their profitability indicators are not too closely correlated positively, the variation in profitability of the merged corporation will decrease. One group of consultants argued that risk reduction is a sufficient basis for a merger. Another group believes that this type of risk reduction does not apply to this situation, since shareholders themselves could buy shares of both companies and thus receive the benefits of risk reduction without any negotiation and merger costs. Whose statement is correct? Test questions: chapter 7 1. The minimum size of the authorized capital of the company is ….. times the monthly calculation index established by the law of the Republic of Kazakhstan on the republican budget for the relevant financial year. a) 10 000 b) 50 000 c) 55 000 2. What is the definition of capital stock? a) it is the portion of a corporation’s equity that has been obtained by the issue of shares in the corporation to a borrower, usually for cash b) it is the portion of a corporation’s equity that has been obtained by the issue of shares in the corporation to a shareholder, usually for cash c) it is a corporation’s debt that has been obtained by the issue of shares in the corporation to a shareholder, usually for cash 3. It is the total of the aforementioned nominal share capital. a) whole capital b) total capital c) share capital 4. The concept of «…….» has very little meaning, since shares usually represent a residual claim; they do not endow their owners with a claim toward any fixed sum of money. a) par value b) bit value c) pari value 5. Essentially, share capital is a part of a corporation’s property, intended for repayment with creditors, as that is minimum of funds, the availability of which is always guaranteed by a corporation. In a corporation balance sheet, equity is always treated as a liability item. This is the function named …. a) Start function

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Corporate Finance b) Warranty function c) The function of determining the share of participation of each shareholder in the company 6. The founders and shareholders of the company may make their contributions in the form of 1 – rights to use land, water and other natural resources, buildings, structures, equipment; 2 – other property rights, including the use of inventions, and …3… a) debt (in rubles and foreign currency); – various types of property (buildings, structures, equipment, etc.) b) loans (in rubles and foreign currency); – various types of property (buildings, structures, equipment, etc.) c) cash (in rubles and foreign currency); – various types of property (buildings, structures, equipment, etc.) 7. The reduction of the share capital is made to achieve the following goals: a) get rid of surplus by paying dividends and … a) white off losses b) write off losses c) wrong off losses 8. This factor is named ….. The word «equity» denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares a) Trading on Equity b) Degree of control c) Stability of sales 9. Who is determining the composition and structure of funds created in the enterprise, as well as establishes target areas for their spending? a) CEO b) shareholders c) financial manager 10. It is the main and, as a rule, the only source of financing at the time of the creation of a joint-stock commercial organization; he characterizes the share of owners in the assets of the enterprise. a) authorized capital b) effective capital c) basic capital

7. Equity capital of corporaƟons: composiƟon and structure 11. The right to vote is… a) the right to participate in the management of a company through, as a rule, voting at a shareholders’ meeting when electing its executive bodies, adopting strategic directions of the company’s activities, deciding on relating to the property interests of shareholders, in particular issues related to liquidation sales of part of the property, issue of securities, etc. b) the right to participate in the distribution of profits, and, consequently, to receive the proportional part of the profit in the form of dividends c) the right to an appropriate share in the company’s share capital and a balance of assets in case of its liquidation 12. 1)… can generate a relatively higher income, but are more risky than other options for investing funds; 2) there is no guaranteed income; 3) there is no guarantee that the owner does not incur a loss when selling shares 4) in case of liquidation of the company, the right to receive part of the property is exercised last: a) Ordinary shares b) Original shares c) Non-Ordinary shares 13. One of the main objectives of managing own capital is: a) determination of the equity capital b) determination of the appropriate amount of equity capital c) determination of the appropriate amount of borrowed capital 14. In the company the directors are the so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. a) Degree of control b) Degree of motive c) Degree of debt 15. The authorized capital of a joint stock company may consist of two types of shares – ordinary and preferred, and the nominal value of the placed preferred shares shall not exceed …%. a) 30 b) 25 c) 45 16. It is of secondary importance compared to the protective one. It includes the allocation of own funds for the purchase of land, buildings, equipment, as well as the creation of a financial reserve in case of unexpected losses.

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Corporate Finance a) Operational function b) Regulatory function c) Protective function 17. It is associated with the special interest of society in the successful functioning of enterprises. These functions of equity show that equity is the basis of the commercial activity of any enterprise. a) Regulatory function b) Protective function c) Operational function 18. Shares of a company distributed at its establishment must be fully paid up within a period defined by the company’s charter, and at least …. % of the distributed shares must be paid within three months from the moment of state registration of the company, and the rest – within a year from registration. a) 30 b) 50 c) 25 19. At the second stage of the analysis, sources of formation of own financial resources are… a) multiplied b) counted c) considered 20. It is a financial mechanism for managing return on equity by optimizing the ratio of used own and borrowed funds. a) Corporate leverage b) Operational leverage c) Financial leverage

8. DEBT SOURCES OF FINANCING THE CORPORATION

8.1. The role of borrowed sources of financing in the activities of the corporation 8.2. Sources and methods of financing loans 8.3. The Effect of Financial Leverage

8.1. The role of borrowed sources of financing in the activities of the corporation To meet their needs for financial resources, corporations can attract various types of loans. Effective use of loans allows you to expand the scope of activities, increase the return on equity, and ultimately – the cost of corporate business. Sources and forms of debt financing are quite diverse. Further we give a brief description of the nature and features of the most popular forms of loans used in domestic and international practice. Loan financing is based on the following fundamental principles that define its essence: – refundability; – payment; – urgency. The principle of repayment reflects the need for the borrower to fully repay the amount received (principal amount) in a timely manner. In actual practice, the fulfillment of this requirement by the borrower depends on the stability of the financial results of its activities (revenue from sales, profit, etc.), as well as on the quality of loan security. 157

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The principle of payment indicates the obligation of the borrower to pay interest for the right to use the resources provided by the lender for a certain time. Interest rates on loans include the market value of money, depending on the timing and volume, as well as risk premiums, liquidity, etc., required by lenders. The principle of urgency describes the period of time for which the borrowed funds are provided and after which they must be returned to the lender. In general, debt financing, regardless of the form of attraction, has the following advantages: – fixed cost and time, providing certainty when planning cash flows; – the size of the fee for the use does not depend on the income of the company, which allows you to save an excess of income in case of the growth at the disposal of the owners; – the ability to increase the return on equity through the use of financial leverage; – the fee for the use is deducted from the tax base, which reduces the cost of the source being attracted and the capital of the company as a whole; – it is not intended to intervene and obtain management rights, etc. General disadvantages of debt financing include: – the obligation of the promised payments and repayment of the principal amount of the debt, regardless of the results of operations; – increased financial risk; – the presence of restrictive conditions that may affect the business policy of the company (for example, restrictions on the payment of dividends, the attraction of other loans, mergers and acquisitions, registration of a pledge of assets, etc.); – possible security requirements; – restrictions on terms of use and volumes of attraction. In addition, each specific form of debt financing may have its own advantages and disadvantages arising from its specificity. The main forms of debt financing are: bank loan (bank loan), issue of bonds (bond), rent or leasing (leasing).

8. Debt sources of financing the corporaƟon

Bank loan. A credit (from Latin Credo – «I believe») is a classic and most well-known form of debt financing of enterprises. The subject of crediting is a legal entity or an individual applying for receiving monetary resources on loan terms and meeting the requirements imposed by lenders (as a rule, commercial banks) to borrowers. The availability of loans for legal entities depends on various factors: the macroeconomic situation, the organizational and legal form of business, industry, type of activity, financial condition, creditworthiness, etc. The object of lending are the purposes for which the borrower needs funds. When obtaining a loan, enterprises usually have the following objectives – working capital financing (current activities); – financing of investment projects (capital investments); – refinancing of previously borrowed loans; – financing of mergers and acquisitions, etc. Loans for replenishment of current assets are short-term (up to 1 year). As a rule, obtaining them takes little time (up to two weeks). In most cases, when they are provided, banks do not require collateral in the form of fixed assets. Such collateral is the company’s future earnings or purchased inventory (subject to their liquidity). However, it is difficult for banks to control the safety of stocks in the quantity necessary to secure a loan, and enterprises for various reasons may need to reduce them and put them into circulation. Therefore, such a loan is easier to obtain for corporations with a good business reputation and a stable financial condition. Financing capital investments is a more complicated procedure, since for these purposes significant amounts of funds are usually required, and the crediting period exceeds 1 year. The provision of collateral to the bank for such loans is a mandatory requirement regardless of the scale of corporate activity, reputation, financial indicators, etc. As a separate area, you can highlight the use of bank loans to finance investment projects launched from scratch. Refinancing of previously borrowed funds is obtaining a new loan on more favorable terms and repaying with it the debt raised on less

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favorable terms. Refinancing operations, on the one hand, have an objective basis in the form of lowering interest rates on loans, and on the other hand, they are constrained by their short terms that reduce the flexibility and efficiency of this operation. Financing mergers and acquisitions with borrowing. These operations are characterized by significant risk. Banks issuing loans for these purposes seek to compensate for their risks through increased security requirements and higher interest rates. It is necessary to distinguish between credit and line of credit. When a credit is granted, the client’s loan account reflects the entire amount available for him, the interest is calculated in accordance with the terms of the loan agreement, regardless of the actual use of the funds allocated by the borrower. The corresponding loan agreement is with the borrower. The loan is provided either by a one-time deposit of funds to a settlement or foreign currency account, or by crediting these to specified accounts according to the agreed schedule, indicating specific dates or periods of transfer defined in the terms of the contract. In the case of a credit line on the loan, account reflects the actual debt (actually used by the borrower of funds), on which the interest is calculated. In this case, the borrower has a limit of credit resources, within which he can use them. Credit line is renewable and non-renewable. A non-renewable credit line is opened for making various payments related to one or several contracts or a batch of goods, regular financial and business operations, as well as to cover periodically arising temporary gaps in the payment turnover of enterprises. The framework credit line is opened for the borrower to pay for individual deliveries of goods within the framework of contracts executed during a certain period, as well as for financing the implementation stages of the costs associated with the fulfilment of targeted programs. For each delivery (or stage of the target program) a separate loan agreement is concluded as part of the general agreement on opening a framework credit line. Security is issued for each loan agreement. Financial practice has developed various forms of loans. The most common is the so-called term, or ordinary, loan provided by the bank to the client for targeted use for a fixed period at a certain percentage.

8. Debt sources of financing the corporaƟon

Overdraft is a form of lending that provides an opportunity for a client to receive a short-term loan, usually without collateral, in excess of the balance in the current account within the limit set for him, the amount of which depends on the credit history, the stability of average monthly turnover in the bank and other factors. The overdraft interest rate is usually higher than the usual secured loan. The on credit loan is provided to the borrower without specifying the term of its use (as part of short-term lending) with the obligation of the latter to repay it at the first request of the lender. When repaying this loan, a grace period is usually granted (according to current practice, up to three days). A revolving (automatically revolving) loan is granted for a certain period, during which both phased «sampling» of the allocated funds and a phased partial or full repayment of obligations are allowed. The funds contributed to the settlement of obligations may be re-borrowed by the enterprise during the period of validity of the loan agreement within the limits of the established credit limit. Payment of the remaining outstanding amount of principal and interest thereon is made upon the expiration of the loan agreement. The advantage of this type of loan is the minimum restrictions imposed by the bank, although the interest rate on it is usually higher. An investment loan is a long-term loan (or line of credit) for the implementation of a project or program at an operating enterprise. Therefore, along with the standard requirements for the borrower›s creditworthiness and security, when issuing such a loan, the bank carefully examines the business plan of the project (program) for which the funds are requested. Mortgage loans can be obtained from banks that specialize in issuing long-term loans secured by fixed assets or the property complex of enterprises as a whole. An enterprise that pledges its property is obliged to insure it in full in favor of the bank. At the same time, the property pledged in the bank continues to be used by the enterprise. A syndicated loan is a loan organized by a pool of lenders for one borrower in order to finance large-scale business programs or implement large investment projects. It is characterized by the following main features:

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– joint responsibility – the pool of creditors acts in relation to the borrower as one party, all creditors bear joint responsibility to the borrower; – equality of creditors – none of the banks has advantages in debt collection, and all funds received to repay a loan or from the sale of collateral are divided between them in proportion to the amount provided; – unity of documentation – all agreements are multilateral; – unity of information for all participants in the transaction. Stages of obtaining a loan. The variety of forms and conditions for obtaining loans determines the need to develop specific policies for managing this process in enterprises. The process of obtaining a loan can be divided into several stages. The first stage is the determination by the borrower of the need for credit resources and loan parameters (type of loan, volume, term, acceptable interest rate, etc.), as well as the economic justification for their use. Special attention should be paid to the economic justification of the need for borrowed funds. According to the majority of experts and specialists of commercial banks, the problem of inability of borrowers to submit a high-quality business plan or feasibility study remains relevant for enterprises. On the one hand, this is due to erroneous ideas about the degree of importance of these documents when making decisions by the bank, on the other hand, to the low professional level of the specialists responsible for their preparation. A frequent consequence of poor quality justification is an increase in the cost of a loan (interest rate) or even a bank’s refusal to provide borrowed funds. At this stage, you should also pre-select the subject of collateral, based on your own ideas about its value. The second stage is choosing a bank and holding preliminary consultations with a potential lender. At this stage, the company must make a choice in favor of a bank and determine the most significant terms of the loan agreement. When choosing a bank, one should take into account the mandatory economic standards of its activities established by the Central Bank. In addition to liquidity and reliability,

8. Debt sources of financing the corporaƟon

the analysis of standards allows determining the maximum amount of funds that can be provided by this bank for a loan. The standard limiting the size of loans provided, in standard cases, is 25% of the bank›s own capital. If the borrower is a shareholder of the bank, then the maximum is limited to 20%. The almost indispensable condition for the provision of credit by domestic banks is the availability of a guarantee of timely and full fulfillment of obligations by the borrower. The main requirement for the collateral is that its market value should be sufficient to compensate the principal for the loan (loan amount), all interest in accordance with the contract for 1 year, as well as the possible costs associated with the realization of the collateral (penalties, fines, court fees and other costs of foreclosure on collateral). The second requirement for the pledge is to prepare the legal documentation so that the time required for its implementation in the event of a non-repayment of the loan does not exceed 150 days. It is obvious that property or rights transferred as collateral must be liquid in relation to not only market demand, but also current legislation. As a result, the total amount of collateral in practice exceeds the amount of the loan received. Insufficient amount of collateral is the most typical and main problem faced by enterprises in the process of attracting a loan. 8.2. Sources and methods of financing loans Finding sources of financing investments has always been one of the most important problems in investment activities. In modern conditions for Kazakhstan, this problem remains, perhaps, the most acute and urgent. With all the variety of sources of financing, self-financing, equity financing, budget financing, credit financing, leasing and combined (mixed) financing can be attributed to the main methods of financing investment activities. The method of financing is understood as a mechanism for attracting investment resources in order to finance the

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investment process. The forms of financing are understood as external manifestations of the essence of the method of financing. Financing projects involves the use of one method or several methods at the same time. Basic financing methods are: • state; • extra budgetary; • self-financing; • bank lending; • rental properties; • leasing; • investment tax credit. Financing of projects, as a rule, involves the following stages: 1) preliminary search for resources; 2) development of financial strategy; 3) development of operational financial plans; 4) conclusion of contracts with potential investors. Only the presence of a well-organized project financing system can ensure high efficiency. Untimely and insufficiently financed investment projects lead to losses in their efficiency and discredit the organization’s management and staff. The main methods of financing are a combination of methods aimed at improving the efficiency of business facilities. They are based on such principles as the time value of monetary resources, analysis of cash flows of entrepreneurial and financial risks, the search for effective markets for investment resources. Important economic categories of the investment process are private property, market pricing, the labor and capital markets, and state regulatory and legal regulation of investments. The system of financing of the investment process consists of the organic unity of sources, methods and forms of financing investment activities. In modern conditions, the basic sources of financing investments are: – net profit of the enterprise; – depreciation deductions; – intra-economic reserves and other funds of the enterprise;

8. Debt sources of financing the corporaƟon

– cash accumulated by the credit and banking system; – credits and loans of international organizations and foreign investors; – funds from the issuance of securities; – internal targeted financing (receipt of funds for specific purposes from the parent organization); – funds of budgets of various levels, etc. Sources of financing investment projects in real assets, depending on the relationship to property, are divided into internal and external. The organization’s own financial resources are profits, depreciation, authorized capital, etc., for example, funds paid by insurance agencies in the form of losses from natural disasters, accidents, and in the form of revenues from fines, penalties, and other charges. Financial resources are attracted as a result of the issue of shares, the receipt of share and other contributions of members of the labor collective, individuals and legal entities, as well as through bond loans, bank and budget loans. Own and attracted sources of investment form the equity capital of the enterprise. The amounts raised by these sources from the outside, as a rule, are not refundable. Investors participate in the income from the sale of investments on the rights of shared ownership. Borrowed sources of investment form the borrowed capital of the enterprise. The main advantages of using own sources include: in terms of profit – lack of time and money spent on their mobilization, no risk of no return, using as a source improves the investment attractiveness of the enterprise; in terms of depreciation – the presence at the disposal of the company in any financial condition, the possibility of depreciation by various methods. The disadvantages in terms of profit include the limited sources of this method, due to non-payments, barter, taxation, etc., in terms of depreciation – the dependence of the value of the depreciation fund on inflation, the possibility of inappropriate use due to the lack of an effective control mechanism. The rest of these own sources of formation of investment resources, as a rule are not considered in the process of developing an

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investment strategy, since their formation is the subject of tactical or operational planning. Full internal self-financing is the most reliable and provides for the financing of an investment project solely from its own (internal) sources. This method of financing characterized in foreign practice by the term «financing without leverage». The most important own sources of financing investments are net income and depreciation. Profit acts as the main form of the net income of the enterprise, expressing the value of the surplus product and being a generalizing indicator of the performance of enterprises. The formation of a self-financing system is carried out mainly at the expense of profits and depreciation deductions. Own accumulations of the organization are supplemented by credit sources and the issue of securities. In the countries with developed market economies, the level of self-financing in firms is considered high if the share of their own financial resources is at least 60% of the total amount of financing investment activities. The increase in state financing of private companies by reducing the share of own funds is seen as a fall in the company›s image and the beginning of a bankruptcy move. In this regard, firms are seeking to use public funds temporarily. In the United States, Canada, and the EEC countries, stimulating investment by financial and monetary policy makes it possible to accelerate the cycle of funds invested in fixed and circulating capital and increase the competitiveness of the economy as a whole. After paying taxes and other obligatory charges, the company remains in net profit, which is accumulated in the form of reserve capital, retained earnings and an accumulation fund. As a rule, part of the profit allocated for investment purposes is accrued in the accumulation fund or other funds of similar purpose. The accumulation fund acts as a source of funds of an economic entity, used to create new property, purchase fixed assets, working capital, etc. A reserve fund is created to cover the company›s losses, redeem bonds and repurchase its own shares. The unallocated part of the profit can also be directed for capitalization, since by its economic content, profit is a form of

8. Debt sources of financing the corporaƟon

reserve of own funds used for development. The amount of net profit directed to industrial development depends on several factors: sales volume, price, unit cost, income tax rate, distribution policy for consumption and enterprise development, which is based on the chosen overall economic development strategy. The next most important source of investment financing is depreciation, which is formed in enterprises as a result of the transfer of the value of fixed production assets to the value of finished products. Cash released in the process of gradually recovering the value of fixed assets is accumulated in the form of depreciation in the depreciation fund. The value of the depreciation fund depends on the volume of fixed assets of the enterprise, their initial or replacement value, the type and age structure, as well as the objectives and accrual methods used. In economic practice, in accordance with the current legislation, depreciation of fixed assets is performed in one of the following ways: linear method; diminishing residue method; method of writing off the cost of the sum of the numbers of years of useful life; method of writing off the cost in proportion to the volume of production (works). The borrowed funds include loans, national and foreign investments. Borrowed funds of industrial enterprises are the funds received for a specific period and subject to return with payment of fees for their use. They can be divided into long-term and short-term ones. Long-term borrowed funds include long-term loans from banks and other institutional investors; long-term government investment loans; funds from the issuance of long-term bonds and other debt obligations (term of over one year); leasing, etc. Foreign countries, international financial and investment institutions, individual organizations, institutional investors, banks, credit institutions take part in foreign investment. Short-term borrowed funds include a commercial (commodity) loan; funds from the issue of short-term bonds and other debt obligations (for less than a year); short-term loans from banks and other institutional investors. One of the important sources of financing projects and programs implemented at the level of the national economy, regions and cities is

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the funds of the state budget, which are directed mainly to the financing of federal targeted integrated programs and extra-budgetary funds. State financing of projects and programs at the level of the national economy and organizations can be carried out on a returnable, non-refundable or mixed basis. Such funding is meant to ensure the restructuring of the Russian economy. To do this, the main directions of economic development of individual industries are determined, which require state support in the implementation of investment projects and programs. Specific investment projects for state support are selected in three stages. The selection of projects at the first stage is carried out on a competitive basis, proceeding from the federal state necessity. At the end of the competition, a decision is made to include the projects in the list of construction projects and facilities for federal state needs. At the second stage, contract bidding of customers for the construction of selected objects is held, government contracts are concluded, volume of capital investments and the timing of the necessary works are specified. The third stage is the choice of a financing system. Direct state financing on a returnable basis provides for the allocation of funds from the federal budget within the limits of loans issued by the Central Bank. Financing of investment projects on an irrevocable basis at the expense of the federal budget can be carried out in the absence of other sources of financing. Opening of financing to state customers is carried out by the Ministry of Finance by transferring funds on the basis of existing agreements. Mixed financing is carried out on a returnable and irrevocable basis – at the expense of the federal budget and at the expense of the organization’s own funds. Capital investments are made by investors in the bank account by the agreement of the parties. Financing of the investment activities of the organization can be carried out through targeted integrated programs. Such programs are a set of research, development, production, socio-economic, organizational, and other measures coordinated in terms of resources, performers, and deadlines and are aimed at solving problems in the economic, environmental, social, and defense development of the country.

8. Debt sources of financing the corporaƟon

8.3. The Effect of Financial Leverage Imagine that there are two identical firms with the equal amount of equities. The first one uses only its own funds and makes a profit. The second one attracts a loan, exposing its own funds as collateral. In this case, the firm is obliged to pay interest on the loan, but also receives additional income from the use of borrowed funds. That is, own funds bring additional income due to the fact that they are a loan security. Financial leverage of the enterprise (analogue: leverage, credit leverage, financial leverage, leverage) shows how the use of borrowed capital of the enterprise affects the amount of net profit. Financial leverage is one of the key concepts of financial and investment analysis of the enterprise. In physics, the use of a lever allows lifting more weight applying less effort. A similar principle acts in the economy for financial leverage, which allows increasing the amount of profit by applying a smaller effort. The purpose of using financial leverage is to increase the company’s profits by changing the capital structure: the shares of own and borrowed funds. It should be noted that an increase in the share of borrowed capital (short-term and long-term liabilities) of the enterprise leads to a decrease in its financial independence. But at the same time, with the increase in the financial risk of an enterprise, the possibility of obtaining greater profits also increases. The effect of financial leverage is due to the fact that the attraction of additional funds allows increasing the efficiency of production and business activities of the enterprise. After all, attracted capital can be directed to the creation of new assets that will increase both cash flow and the net profit of the enterprise. Additional cash flow leads to an increase in the value of the enterprise for investors and shareholders, which is one of the strategic objectives for the owners of the company. The Effect of financial leverage. The effect of financial leverage is the product of the differential (with a tax offset) and the lever arm. The figure below shows the key elements of the formation of the effect of financial leverage.

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If you paint three indicators included in the formula, then it will look like this: DFL – the effect of financial leverage; T – the interest rate of income tax; ROA – the profitability of the assets of the enterprise; r – interest rate on attracted (borrowed) capital; D – borrowed capital of the enterprise; E – equities of the enterprise. So, let us analyze in more detail the concept and each of the elements of the effect of financial leverage. Tax corrector. The tax proofreader shows how the change in the income tax rate influences on the effect of financial leverage. The profit tax is paid by all legal entities of the Russian Federation (LLCs, JSCs, etc.), and its rate may vary depending on the type of activity of the organization. For example, for small enterprises employed in the housing and utilities sector, the total income tax rate will be 15.5%, while the income tax rate without amendments is 20%. The minimum tax rate on profits cannot be lower than 13.5%. Differential financial leverage. Differential financial leverage (Dif) is the difference between return on assets and interest rates. In order for the effect of financial leverage to be positive it is necessary that the return on equity be higher than the interest on loans and loans. With a negative financial leverage, the company begins to incur losses, because it cannot ensure the production efficiency higher than the payment for borrowed capital. Table 4 Differential Value Differential Value Comments Dif 0 The company increases the size of its profits through the use of borrowed funds Dif = 0 Profitability is equal to the interest rate on the loan, the effect of financial leverage is zero The table was drawn by the author using www.managementstudyguide.com

8. Debt sources of financing the corporaƟon

Financial lever coefficient. The ratio of financial leverage (analogue: leverage of financial leverage) shows what share in the total capital structure of an enterprise falls on borrowed funds (loans, loans and other liabilities), and determines the strength of the impact of borrowed capital on the effect of financial leverage. The effect of financial lever (European concept). The first considered component of the effect of financial leverage: this is a tax offset: 1 – Tax rate. The second component – Differential – is the difference between the economic profitability that the funds bring and the average calculated interest rate paid on borrowed funds. Due to the taxation of the differential, only a part remains: D = (1 – the tax rate) – (econ. profitability is % of the loan). The third component – the shoulder of the financial arm – is the ratio between borrowed (CS) and its own funds (SS). FIU = Borrowed funds / Own funds.

(8.1)

Thus, the first method of calculating the level of the effect of financial leverage is reduced to the above calculation formula, but having a more simplified form: EGF = D – PFR = (1 – Tax rate) – (econ. profitability is % of the loan – Borrowed funds / Own funds. (8.2) This method allows you to determine the safe amount of borrowed funds, acceptable credit conditions. However, there is a contradiction between the differential and the shoulder of financial leverage. With increasing leverage, the ratio of borrowed and own funds, the lender will increase the interest rate, which will lead to a decrease in the differential. That is, sooner or later

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the time will come when borrowing will lead not to a growth, but to a drop in profitability. If the new borrowing brings the company an increase in the level of effect of financial leverage, then such borrowing is beneficial. The lender’s risk depends on the differential: the greater the differential, the less the risk; the smaller the differential, the greater the risk. It is necessary to change the level of financial leverage, that is, the ratio of borrowed and own funds depending on the differential, that is, the difference between the cost of borrowed capital and the profit it brings. Differential should not be negative. A negative differential means that interest on borrowed funds is greater than the income they bring, which is unacceptable. It is believed that the effect of financial leverage (that is, an increase in profitability through the use of borrowed funds) should be 30-50% of the level of economic profitability of assets. Effect of the financial lever (the USA concept). The effect of financial leverage can also be calculated as a change in net profit per ordinary share (in percent), due to the change in the economic profitability of investments (also in percent). The strength of the impact of financial leverage is calculated as follows: EGF = Δ Net profit per share / Δ Economic profitability = = 1 – % of the loan / book profit. (8.3) With the help of this formula, they answer the question of how many percent the net profit per ordinary share will change if the economic profitability of a company changes by 1%. This approach allows to evaluate the financial leverage from a fundamentally different side. If, according to the European concept, we calculated the required level of borrowing, which is necessary primarily for managers of the enterprise itself, the calculation of the American concept of financial leverage helps, first of all, to potential shareholders of the company. This indicator shows how attractive are

8. Debt sources of financing the corporaƟon

the shares of the enterprise, and predicts the future growth of their value. The investor will prefer stocks, which, with an equal growth in the company›s profitability, will bring in more income in the form of dividends and growth in the market value, which will certainly affect the current value of the shares. Normal value of factor. The optimal ratio, is an equal ratio of liabilities and equities (net assets), i.e. financial leverage ratio equals to 1. The value of up to 2 may also be acceptable (for large public companies this ratio may be even greater). With large values of the coefficient, the organization loses its financial independence, and its financial position becomes extremely unstable. It is more difficult for such organizations to attract additional loans. The most common coefficient in developed economies is 1.5 (i.e., 60% of borrowed capital and 40% of own capital). A too low value of the financial leverage ratio indicates a missed opportunity to use financial leverage – to increase the return on equity by engaging borrowed funds in the activity. Like other similar coefficients characterizing the capital structure (autonomy ratio, financial dependence ratio), the normal value of the financial leverage ratio depends on the industry, enterprise scale and even the way of organizing production (capital-intensive or labor-intensive production). Therefore, it should be evaluated in dynamics and compared with the indicator of similar enterprises. Example of calculating the effect of a financial leverage for GazProm (by balance). One of the formulas for calculating the effect of financial leverage is the excess return on equity (ROA, Return on Assets) over return on equity (ROE, Return on Equity). Return on equity (ROA) shows the profitability of an enterprise using both equities and borrowed capital, while ROE reflects only its own efficiency. The calculation formula will be as follows: Where: DFL – the effect of financial leverage; ROA – return on equity (assets) of an enterprise; ROE – return on equity.

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We calculate the effect of financial leverage for the enterprise of PJSC Gazprom on the balance sheet. To do this, we calculate the profitability ratios, the formulas of which are presented below: The calculation of the return on assets (ROA) balance. The calculation of the return on equity (ROE) on the balance sheet. The statement of financial performance is presented below: The balance of PJSC Gazprom was taken from the official site of the enterprise. Calculation of effect of financial lever for PJSC «GazProm». Calculate each of the profitability ratios and estimate the effect of financial leverage for the enterprise of PJSC Gazprom for 2016. ROA = 411 424 597/13 852 945 759 = 2.9% ROE = 411 424 597 / 10 414 000 247 = 3.9% The effect of financial leverage (DFL) = ROE – ROA = 3.9 – 2.9 = 1% The effect shows that the use of borrowed capital by PJSC Gazprom is optimal and amounts to 1%, i.e. the ratio of liabilities (borrowed capital) and equities (net assets) are equal. Conclusion. The effect of financial leverage shows the effectiveness of the use of borrowed capital by an enterprise in order to increase its efficiency and profitability. Increased profitability allows you to reinvest funds in the development of production, technology, human resources and innovation potential. All this allows the increase in the competitiveness of the enterprise. The illiterate management of borrowed capital can lead to a rapid increase in insolvency and the risk of bankruptcy. Tasks: 1. What are the main objectives of attracting and using long-term borrowed sources of funding. 2. What are the main types of long-term borrowed sources of financing. 3. Select one company on www.kase.kz. Describe the general characteristics of borrowed sources of financing of the selected company. Independently classify borrowed sources of the company’s financing. 4. Explain the issuing activity of the company you have chosen. Evaluate the financial instruments of your chosen company: stocks, bonds. 5. Explain the significance of the effect of financial leverage.

8. Debt sources of financing the corporaƟon Activity 1. Imagine that company D acquires company K. The present value of D is equal to 350,000 dollars, and PVK = 900,000 dollars. The financial director of the firm D has calculated that the acquisition of K creates savings on the scale of production and PV after the post-tax savings amounts, is estimated at the level of 600 000 dollars. The purchase price of company K is 900,000 dollars: a) find the economic benefits of the merger; b) determine the cost of the purchase of company K; c) what benefits will the shareholders of company D and company K receive? Activity 2. Suppose that the theory of MM is fair for dividend policy. If the state forbids paying dividends, what effect will it produce? a) on stock prices; b) on the amount of capital investment? Test questions: chapter 8 1. The principle of payment indicates a) the ability to pay interest for the right to use the resources provided by the lender for a future period b) the obligation of the lender to pay interest for the right to use the resources provided by the lender for a certain time c) the obligation of the borrower to pay interest for the right to use the resources provided by the lender for a certain time 2. In general, debt financing, regardless of the form of attraction, has this advantage: a) fixed cost and time, providing certainty when planning to get loans b) fixed cost and time, providing certainty when planning cash flows c) non-fixed cost and time, providing certainty when planning cash flows 3. It is a classic and most well-known form of debt financing of enterprises. a) bank loan b) rent or leasing (leasing) c) issue of bonds (bond) 4. General disadvantages of debt financing include: a) the size of the fee for the use does not depend on the income of the company, that allows you to save an excess of income in case of its growth at the disposal of the owners b) the ability to increase the return on equity through the use of financial leverage c) increased financial risk

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Corporate Finance 5. …is a legal entity or an individual applying for receiving monetary resources on loan terms and meeting the requirements imposed by lenders (as a rule, commercial banks) to borrowers. a) The subject of crediting b) The object of crediting c) The purpose of crediting 6. This is the purpose for which the borrower needs funds a) The purpose of crediting b) The subject of crediting c) The object of lending 7. Loans for replenishment of current assets are … a) long-term b) short-term c) middle-term 8. It is a loan which is granted for a certain period, during which both a phased «sampling» of the allocated funds and a phased partial or full repayment of obligations are allowed. a) Revolving (automatically revolving) loan b) Ordinary loan c) Overdraft 9. State; extra budgetary; self-financing – are the … a) basic financing methods b) basic financing principles c) basic financing functions 10. Financing of projects, as a rule, involves the following stages. In addition, which is not one of them? a) Preliminary search for resources b) Development of financial strategy c) Development of cash system 11. The main methods of financing are a) combination of methods of financing in order to improve the efficiency of business facilities b) combination of rules and methods of financing in order to improve the efficiency of business facilities c) combination of codes and methods of financing in order to improve the efficiency of business facilities

8. Debt sources of financing the corporaƟon 12. Refinancing previously borrowed funds is a) obtaining a new loan on more favorable terms and repaying with it the debt raised on less favorable terms b) obtaining a new share on more favorable terms and repaying with it the debt raised on less favorable terms c) obtaining a new bond on more favorable terms and repaying with it the debt raised on less favorable terms 13. It is a loan organized by a pool of lenders for one borrower in order to finance large-scale business programs or implement large investment projects. a) A syndicated loan b) A specific loan c) A synoptic loan 14….at the first stage is carried out on a competitive basis, proceeding from the federal state necessity. a) The provision of projects b) The recruitment of projects c) The selection of projects 15. Which of the following statements appropriately describes the effect of financial leverage on a company’s net income and return on equity? a) An increase in financial leverage always results in an increase in a company’s net income and return on equity b) An increase in financial leverage always results in a decrease in a company’s net income and return on equity c) An increase in financial leverage may result in either an increase or decrease in a company’s net income and return on equity 16. The components of the financial leverage effect are: a) cost of capital b) differential c) amount of interest for a loan 17. Is it worth for a firm to take a loan with a financial leverage equal to 1? a) It is worth, as the company can attract borrowed funds with this indicator b) It is not recommendable, because the company is on the verge of bankruptcy c) the company can still gain loans, but the slightest hitch in the production process or an increase in interest rates may adversely affect the financial condition of the enterprise

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Corporate Finance 18. EGF a) = Δ Net profit per share / Δ Economic profitability = 1 – % of the loan / book profit b) = Δ Net debt per share / Δ Economic profitability = 1 – % of the loan / book profit c) = Δ Net loan per share / Δ Economic profitability = 1 – % of the loan / book profit 19. A negative differential means … a) that the interest on borrowed funds is greater than the income they bring, which is unacceptable b) that the interest on borrowed funds is lower than the income they bring, which is unacceptable c) that the interest on borrowed funds is greater than the loan they bring, which is unacceptable 20. The lender›s risk depends on the differential: the greater the differential, the less the risk; the smaller the differential, a) the greater the risk b) the lower the risk c) the risk is equal

9. COST AND STRUCTURE OF CORPORATE CAPITAL

9.1. The economic nature of capital 9.2. Methodology of capital formation 9.3. Methods for calculating the capital structure

9.1. The economic nature of capital Meaning of Capital: Capital has been defined as that part of a person’s wealth, other than land, which yields an income or which aids in the production of further wealth. Obviously, if wealth is left unused or is hoarded, it cannot be considered capital. Capital serves as an instrument of production. Anything which is used in production is capital. Is Money Capital? In the ordinary language, capital is used in the sense of money. But when we talk of capital as a factor of production, it is quite wrong to confuse capital with money. There is no doubt that money is a form of wealth and it yields income, when it is lent out. But it cannot be called capital. Capital is a factor of production, but money as such does not serve as a factor of production. It is another thing that with money we can buy machinery and raw materials which then serve as factors of production. Are Securities and Shares Capital? There is no doubt that securities, bonds, stocks, shares, etc., possessed by a man yield income to him. But they cannot be called capital, because they represent only titles of ownership rather than factors of 179

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production. Capital has also been defined as «produced means of production». This definition distinguishes capital from land and labor, because both land and labor are not produced factors. Land and labor are often considered as primary or original factors of production. But capital is not a primary or original factor, it is a «produced’ factor of production. Capital has been produced by man working with nature. Hence, capital may also be defined as man-made instrument of production. Capital, thus, consists of those physical goods which are produced for use in future production. Machines, tools and instruments, factories, canals, dams, transport equipment, stocks of raw materials, etc., are some of the examples of capital. All of them are produced by man to help in the production of further goods. Characteristics of Capital: The following are the main characteristics of capital: (i) Capital is man-made. It is, therefore, possible to increase its supply when the situation requires. (ii) It involves the element of time, as it renders its service over a period of time. That is why payment for capital is calculated in terms of per cent per annum. (iii) The use of capital makes roundabout methods of production possible. Its application increases efficiency and the productive power of all the factors with which it is combined and used. Fixed Capital and Working Capital: Capital may be divided into fixed capital and working capital. Fixed capitals are the durable-use producer goods which are used in production again and again till they wear out. Machinery, tools, railways, tractors, factories, etc., are all fixed capital. Fixed capital does not mean fixed in location. Capital in the form of a plant, tractors and factories is called «fixed» because if money is spent upon these durable-use goods it becomes «fixed» for a long period in contrast with the money spent for purchasing raw materials that is released as soon as the goods made with them are sold out. Working capital, on the other hand, includes the single-use producer goods like raw materials, goods in process, and fuel. They are

9. Cost and structure of corporate capital

used up in a single act of consumption. Moreover, money spent on them is fully recovered when goods made with them are sold on the market. Wealth and Capital: From the definition of capital, it is clear that capital consists of valuable economic goods which are scarce. Such goods are called wealth in Economics. All capital, therefore, is wealth. But all wealth is not capital. Only that part of wealth, which is used productively, is called capital. The car which is used for personal enjoyment is wealth but not capital. Wealth and capital are, therefore, not synonymous. Capital and Income: Capital and income should be distinguished from each other. The factory that a man owns is his capital, but the profit that he gets out of it every year is his income. Capital is a fund (or stock) and income is a flow. Income flows in at regular intervals. It is calculated per week, per month or even per year. Is land Capital? Land is nature’s free gift to man; it is limited in area, and is of infinite variety. On the other hand, capital is man-made, and can be increased at will. Land lacks mobility, whereas capital is fairly mobile. Land has no supply price, i.e., its supply does not depend on the price for its use (i.e., rent). If, therefore, rent falls, its supply cannot be withdrawn. But the supply of capital varies with its price. For all these reasons, land can be distinguished from capital and is not regarded as capital. Functions of Capital: Capital is valued for the very useful functions it performs in the production of wealth. In fact, production would almost come to a stand-still without adequate and suitable supply of capital. The following are its main functions: Supply of Raw Materials: Capital supplies raw materials. Every businessman must have on hand a sufficient supply of raw-materials of a good quality. A cotton mill must have cotton ready; a paper mill must keep straw or bamboo cuttings; a sugar mill must buy large quantities of sugarcane, and so

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on. This is undoubtedly very essential, otherwise how is production to go on? Supply of Appliances and Machinery: Another equally necessary function that capital performs is the supply of tools, implements and appliances. It is clear that these things are essential for production. Without their aid large-scale production is impossible. Tools are needed even in the most primitive stages of economic development. But they are all the more necessary today when production has become capitalistic. Modern industry is highly mechanized. Even agriculture employs all sorts of machines like tractors, threshers, harvester-combines, etc., All these are obtained with capital. Provision of Subsistence: Capital provides subsistence to the laborers while they are engaged in production. They must have food, clothes and lodging. Production today is a long-drawn-out affair, and has to pass through many stages. It may be after years that the goods reach the market and bring income to the manufacturer. Means must be found in the meantime to bridge this gap, and this is the function which capital performs. It provides means of subsistence for the workers when they are engaged in the work of production. Provision of Means of Transport: Goods have not only to be produced, they have also to be transported to the markets and put into customers’ hands. For this purpose, means of transport, like railways and motor-trucks, are essential. A part of the capital must be devoted to the supply of this need. Provision of Employment: In modern times, capital is performing another very important function, viz., providing employment. This function is of special importance to under-developed or developing economies. Among the determinants of employment in a country, probably the most important is saving and its investment in the form of capital. Application of capital to agriculture, trade, transport and industry creates work on the farms, in the factories, in commercial houses and on roads, railways, ships, etc. It is the lack of capital which is respon-

9. Cost and structure of corporate capital

sible for unemployment, or under-employment in backward countries. A sure way to tackle the problem is to create more and more capital. Importance of Capital: Capital plays a vital role in the modern productive system: (i) Essential for Production: Production without capital is hard for us even to imagine. Nature cannot furnish goods and materials to man unless he has the tools and machinery for mining, farming, foresting, etc. If man had to work with his bare hands on barren soil, productivity would be very low indeed. Even in the primitive stages, man used some tools and implements to assist him in the work of production. Primitive man made use of elementary tools like bow and arrow for hunting and fishing-net for catching fish. But elaborate and sophisticated tools and machines are required for modern production. (ii) Increases Productivity: With the growth of technology and specialization, capital has become still more important. More goods can be produced with the aid of capital. In fact, greater productivity of the modern economy like that of the U.S.A. is mainly due to the extensive use of capital, i.e., machinery, tools or implements in the productive process. Capital adds greatly to the productivity of worker and hence to the economy as a whole. (iii) Importance in Economic Development: Due to its strategic role in raising productivity, capital occupies a central position in the process of economic development. In fact, capital accumulation is the very core of economic development. It may be free enterprise economy like American economy or a socialist economy like that of Soviet Russia or a planned and mixed economy of India, nevertheless, economic development cannot take place without capital formation. Much economic development is not possible without making and using machinery, construction of irrigation works, the production of agricultural tools and implements, building of dams, bridges and factories, roads, railways, airports, ships and harbors which are all capital. Broadening and deepening of capital are mainly responsible for economic development.

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(iv) Creating Employment Opportunities: Another important economic role of capital is the creation of employment opportunities in the country. Capital creates employment in two stages. First, when the capital is produced. Some workers have to be employed to make capital goods like machinery, factories, dams and irrigation works. Secondly, more men have to be employed when capital has to be used for producing further goods. In other words, many workers have to be engaged to produce goods with the help of machines, factories, etc. Thus, we see that employment will increase as capital formation is stepped up in the economy. Now if the population grows faster than the increase in the stock of capital, the entire addition to the labor force cannot be absorbed in productive employment, because not enough instruments of production are there to employ them. This results in unemployment. The rate of capital formation must be kept sufficiently high so that employment opportunities are enlarged to absorb the additions to working force of the country as a result of population growth. In India, the stock of capital has not been growing at a fast enough rates so as to keep pace with the growth of population. That is why there is a huge unemployment and under-employment in both urban and rural areas. The fundamental solution to this problem of unemployment and under-employment is to step up the rate of capital formation so as to enlarge employment opportunities. 9.2. Methodology of capital formation Meaning of Capital Formation: Capital formation means increasing the stock of real capital in a country. In other words, capital formation involves making of more capital goods such as machines, tools, factories, transport equipment, materials, electricity, etc., which are all used for future production of

9. Cost and structure of corporate capital

goods. For making additions to the stock of capital, saving and investment are essential. Process of Capital Formation: In order to accumulate capital goods some current consumption has to be sacrificed. The greater the extent to which the people are willing to abstain from present consumption, the greater the extent that society will devote resources to new capital formation. If society consumes all that it produces and saves nothing, future productive capacity of the economy will fall as the present capital equipment wears out. In other words, if whole of the current productive activity is used to produce consumer goods and no new capital goods are made, production of consumer goods in the future will greatly decline. Cutting down some of the present consumption and waiting for more consumption in the future require far-sightedness on the part of the people. There is an old Chinese proverb, «He who cannot see beyond the dawn will have much good wine to drink at noon, much green wine to cure his headache at dark, and only rain water to drink for the rest of his days». Three Stages in Capital Formation: Although saving is essential for capital formation, but in a monetized economy, saving may not directly and automatically result in the production of capital goods. Savings must be invested in order to have capital goods. In a modern economy, where saving and investment are done mainly by two different classes of people, there must be certain means or mechanism whereby the savings of the people are obtained and mobilized in order to give them to the businessmen or entrepreneurs to invest in capital. Therefore, in a modern free enterprise economy, the process of capital formation consists of the following three stages: (a) Creation of Savings: An increase in the volume of real savings so that resources, that would have been devoted to the production of consumption goods, should be released for purposes of capital formation. (b) Mobilization of Savings: A finance and credit mechanism, so that the available resources are obtained by private investors or government for capital formation.

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(c) Investment of Savings: The act of investment itself so that resources are actually used for the production of capital goods. We will now explain these three stages: Creation of Savings: Savings are done by individuals or households. They save by not spending all their incomes on consumer goods. When individuals or households save, they release resources from the production of consumer goods. Workers, natural resources, materials, etc., thus released are made available for the production of capital goods. The level of savings in a country depends upon the power to save and the will to save. The power to save or saving capacity of an economy mainly depends upon the average level of income and the distribution of national income. The higher the level of income, the greater will be the amount of savings. The countries having higher levels of income are able to save more. That is why the rate of savings in the U.S.A. and Western European countries is much higher than that in the under-developed and poor countries like India. Further, the greater the inequalities of income, the greater will be the amount of savings in the economy. Apart from the power to save, the total amount of savings depends upon the will to save. Various personal, family, and national considerations induce the people to save. People save in order to provide against old age and unforeseen emergencies. Some people desire to save a large sum to start new business or to expand the existing business. Moreover, people want to make provision for education, marriage and to give a good start in business for their children. Further, it may be noted that savings may be either voluntary or forced. Voluntary savings are those savings which people do of their own free will. As explained above, voluntary savings depend upon the power to save and the will to save on the part of the people. On the other hand, taxation by the Government represents forced savings. Moreover, savings may be done not only by households but also by business enterprises and government. Business enterprises save when they do not distribute the whole of their profits, but retain a part

9. Cost and structure of corporate capital

of them in the form of undistributed profits. They then use these undistributed profits for investment in real capital. The third source of savings is government. The government savings constitute the money collected as taxes and the profits of public undertakings. The greater the amount of taxes collected and profits made, the greater will be the government savings. The savings made so can be used by the government for building up new capital goods like factories, machines, roads, etc., or it can lend them to private enterprise to invest in capital goods. Mobilization of Savings: The next step in the process of capital formation is that the savings of the households must be mobilized and transferred to businessmen or entrepreneurs who require them for investment. In the capital market, funds are supplied by the individual investors (who may buy securities or shares issued by companies), banks, investment trusts, insurance companies, finance corporations, governments, etc. If the rate of capital formation is to be stepped up, the development of capital market is very necessary. A well-developed capital market will ensure that the savings of the society will be mobilized and transferred to the entrepreneurs or businessmen who require them. Investment of Savings in Real Capital: For savings to result in capital formation, they must be invested. In order that the investment of savings should take place, there must be a good number of honest and dynamic entrepreneurs in the country who are able to take risks and bear uncertainty of production. Given that a country has got a good number of venturesome entrepreneurs, investment will be made by them only if there is sufficient inducement to invest. Inducement to invest depends on the marginal efficiency of capital (i.e., the prospective rate of profit) on the one hand and the rate of interest, on the other. But of the two determinants of inducement to invest – the marginal efficiency of capital and the rate of interest – it is the former which is of greater importance. Marginal efficiency of capital depends upon the cost or supply prices of capital as well as the expectations of profits.

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Fluctuations in investment are mainly due to changes in expectations regarding profits. But it is the size of the market which provides scope for profitable investment. Thus, the primary factor which determines the level of investment or capital formation, in any economy, is the size of the market for goods. Foreign Capital: Capital formation in a country can also take place with the help of foreign capital, i.e., foreign savings. Foreign capital can take the form of: (a) Direct private investment by foreigners, (b) Loans or grants by foreign governments, (c) Loans by international agencies like the World Bank. There are very few countries which have successfully marched on the road to economic development without making use of foreign capital in one form or the other. India is receiving a good amount of foreign capital from abroad for investment and capital formation under the Five-Year Plans. Deficit Financing: Deficit financing, i.e., newly-created money is another source of capital formation in a developing economy. Owing to very low standard of living of the people, the extent to which voluntary savings can be mobilized is very much limited. Also, taxation beyond the limit becomes oppressive and, therefore, politically inexpedient. Deficit financing is, therefore, the method on which the government can fall back to obtain funds. However, the danger inherent in this source of development financing is that it may lead to inflationary pressures in the economy. But a certain measure of deficit financing can be taken without creating such pressures. There is specially a good case for using deficit financing to utilize the existing under-employed labor in the schemes which yield quick returns. In this way, the inflationary potential of deficit financing can be neutralized by an increase in the supply of output in the short-run. Disguised Unemployment: Another source of capital formation is to mobilize the saving potential that exists in the form of disguised unemployment. Surplus ag-

9. Cost and structure of corporate capital

ricultural workers can be transferred from the agricultural sector to the non-agricultural sector without diminishing agricultural output. The objective is to mobilize these unproductive workers and employ them on various capital creating projects, such as roads, canals, building of schools, health centers and bunds for floods, where much more capital to work with is not required. In this way, the hitherto unemployed, labor can be utilized productively and turned into capital, as it were. Capital Formation in the Public Sector: In these days, the role of government has greatly increased. In an under-developed country like India, government is very much concerned with the development of the economy. Government is building dams, steel plants, roads, machine-making factories and other forms of real capital in the country. Thus, capital formation is organized not only in the private sector by individual entrepreneurs but also in the public sector by the government. There are various ways in which a government can get resources for investment purposes or for capital formation. The government can increase the level of direct and indirect taxation and then can finance its various projects. Another way of obtaining the necessary resources is borrowing by the Government from the public. The government can also finance its development plans by deficit financing. Deficit financing means the creation of new money. By issuing more notes and exchanging them with the productive resources the government can build real capital. But the method of deficit financing, as a source of finance development, is dangerous because it often leads to inflationary pressures in the economy. A certain measure of deficit financing, however, can be taken without creating such pressures. Another source of capital formation in the public sector is the profits of public undertakings which can be used by the government for further investment. As stated above, government can also get loans from foreign countries and international agencies like the World Bank. India is getting a substantial amount of foreign assistance for investment purposes under the Five-Year Plans.

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9.3. Methods for calculating the capital structure Capital Structure refers to the amount of debt and/or equities employed by a firm to fund its operations and finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used to fund the business operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to raise debt or equity and managers will balance the two and try to find the optimal capital structure. Optimal capital structure The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in practice, and firms often have a strategic or philosophical view of what the structure should be. In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue whichever it requires. The new capital that’s issued may be used to invest in new assets or may be used to repurchase debt/equity that is currently outstanding as a form of recapitalization. Cost of capital A firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt, known as the weighted average cost of capital (WACC). The formula is as follows: WACC = (E/V x Re) + ((D/V x Rd) x (1 – T)), where E = market value of the firm’s equity (market cap); D = market value of the firm’s debt; V = total value of capital (equity plus debt); E/V = percentage of capital that is equity;

(9.1)

9. Cost and structure of corporate capital

D/V = percentage of capital that is debt; Re = cost of equity (required rate of return); Rd = cost of debt (yield to maturity on existing debt); T = tax rate. Capital structure by industry Capital structures can vary significantly by industry. Cyclical industries like mining are often not suitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to repay the debt. Other industries like banking and insurance use huge amounts of leverage and their business models require large amounts of debt. Private companies may have a harder time using debt over equity, particularly small businesses which are required to have personal guarantees from their owners. How to recapitalize a business A firm that decides it should optimize its capital structure by changing the mix of debt and equity has a few options to effect this change. Methods of recapitalization include: 1. Issue debt and repurchase equity. 2. Issue debt and pay a large dividend to equity investors. 3. Issue equity and repay debt. Each of these three methods can be an effective way of recapitalizing the business. In the first approach, the firm borrows money by issuing debt and then uses all that capital to repurchase shares from its equity investors. This has the effect of increasing the amount of debt and decreasing the amount of equity on the balance sheet. In the second approach, the firm will borrow money (i.e. issue debt) and use that money to pay a one-time special dividend, which has the effect of reducing the value of equity by the value of the divided. This is another method of increasing debt and reducing equity. In the third approach, the firm moves in the opposite direction and issues equity by selling new shares, then takes the money and uses it

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to repay debt. Since equity is costlier than debt, this approach is not desirable and often only applied when a firm is overleveraged and desperately needs to reduce its debt. The significance of cost of capital is as follows: (a) Capital Budgeting Decision: Refers to the decision, which helps in calculating profitability of various investment proposals. (b) Capital Requirement: Refers to the extent to which fund is required by an organization at different stages, such as incorporation stage, growth stage, and maturity stage. When an organization is in its incorporation stage or growth stage, it raises more of equity capital as compared to debt capital. The evaluation of cost of capital increases the profitability and solvency of an organization as it helps in analyzing cost efficient financing mix. (c) Optimum Capital Structure: Refers to an appropriate capital structure in which total cost of capital would be the least. Optimal capital structure suggests the limit of debt capital raised to reduce the cost of capital and enhance the value of an organization. (d) Resource Mobilization: It enables an organization to mobilize its fund from non-profitable to profitable areas. Resource mobilization helps in reducing risk factor as an organization can shut down its unproductive projects and move the resources to productive projects to earn profit. (e) Determination of duration of Project: Refers to evaluating whether the project, for which the capital is raised, is long term or short term. If the project is long term in nature then the organization decides to raise equity capital. However, if the project is short term in nature then the organization determines to raise debt capital. Cost of capital can be measured by using various methods, as shown in Figure-3:

9. Cost and structure of corporate capital

Figure 3. Methods of Measuring Cost of Capital Note: compiled by the author

The explanation of methods of measuring cost of capital (as shown in Figure-2) is as follows. Cost of Debt Capital: Generally, cost of debt capital refers to the total cost or the rate of interest paid by an organization in raising debt capital. However, in a real situation, total interest paid for raising debt capital is not considered as cost of debt because the total interest is treated as an expense and deducted from tax. This reduces the tax liability of the organization. Therefore, to calculate the cost of debt, the organization needs to make some adjustments. Let us understand the calculation of cost of debt with the help of an example. Suppose an organization has raised debt capital of Rs. 10000 and paid 10% interest on it. The organization is paying corporation tax at the rate of 50%. In this case, the total 10% of interest rate would not be deducted from tax and the deduction would be 50% of 10%. Therefore, the cost of debt would be only 5%. While calculating the cost of debt capital, discount allowed, underwriting commission, and cost of advertisement are also considered. These expenses are added to the amount of the interest paid, which is considered as the total cost of debt capital. For example, when an organization increases its proportion of debt capital more than the optimum level, then it increases its risk factor. Therefore, the investors feel insecure and their expectations of EPS start increasing, and this is the hidden cost related to debt capital.

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Formulae to calculate the cost of debt are as follows: 1. When the debt is issued at par KD = [(1-T)-R]-100,

(9.2)

where KD = Cost of debt; T = Tax rate; R = Rate of interest on debt capital; KD = Cost of debt capital. 2. Debt issued at premium or discount when debt is irredeemable KD = [1/NP-(1-T)– 100],

(9.3)

where NP = Net proceeds of debt. 3. Cost of redeemable debt: KD = [{I (1 – T) – H (P – NP/N) – (1 – T)}/ (P – H NP/2)] – 100, (9.4) where N = Numbers of years of maturity; P = Redeemable value of debt. For example, an organization issued 10% debentures of the face value of Rs. 100 redeemable at par after 20 years. Assuming 50% tax rate and 5% floatation cost, calculate the cost of debt in the following conditions: 1. When debentures are issued at par. 2. When debentures are issued at 10% discount. 3. When debentures are issued at 10% premium. Solution: The solution is given as follows: Cost of redeemable debt = = [{I (1 – T) + (P – NP/N) (1 – T)}/ (P + NP/2)] – 100 1. When debentures are issued at par KD = [{10(1 – 0.50) + (100 – 95/20) (1 – 0.50)}/ / (100 + 95/2)] – 100 = 5.25%.

9. Cost and structure of corporate capital

2. When debentures are issued at 10% discount KD = [{10(1 – 0.50) + (100 – 85/20) (1 – 0.50)}/ / (100 + 85/2)] – 100 = 5.81%. 3. When debenture is issued at 10% premium KD = [{10(1 – 0.50) + (100 – 110/20) (1 – 0.50)}/ / (100 + 110/2)] – 100 = 4.52%. Common method of Calculation: Percentage of Equity =

Market Value of Equity Market Value of Equity + Market Value of Debt

(9.5)

Percentage of Debt =

Market Value of Debt Market Value of Equity + Market Value of Debt

(9.6)

If market values are not available, the percentages are calculated based on book values. Capital structure is also expressed by debt to total assets ratio. Percentage of equity and percentage of debt can also be calculated if we know the financial leverage ratio or debt to equity ratio of the business. In the same way we can find capital structure as percentage of equity and percentage of debt from the debt to equity ratio. Tasks: 1. Explain the economic nature of capital. Identify key capital characteristics. 2. Name the countries that have successfully passed the way to economic development without using foreign capital in one form or another. Give a comparative table. 3. Give an explanation of the methods of measuring the cost of capital. Describe the three stages of capital formation. 4. The share price usually increases in case of an unexpected increase in dividends and falls otherwise. Explain why.

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Corporate Finance 5. Companies are more reluctant to lower dividends than to increase them. Explain why. Activity 1. Company A wants to acquire firm B for $ 50 million. And the merger is expected to provide additional cash flow to the amount of 6.5 million dollars per year for 10 years. The marginal price of capital for these investments is 13%. Analyze the investment budget from company A’s point of view to determine whether to make a purchase? Activity 2. Dividend policy is often characterized as «sticky». What is the basis of this characteristic? What do you think can explain this nature of dividends? Explain. Test questions: chapter 9 1. A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called? a) dividend yield b) cost of equity c) capital gains yield d) cost of capital e) income return 2. Textile Mills borrows money at the rate of 13.5 percent. This interest rate is referred to as the: a) compound rate b) current yield c) cost of debt d) capital gains yield e) cost of capital 3. The average of a firm’s cost of equity and after-tax cost of debt that is weighted based on the firm’s capital structure is called the: a) reward to risk ratio b) weighted capital gains rate c) structured cost of capital d) subjective cost of capital e) weighted average cost of capital 4. When a manager calculates the cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is applying the _____ approach. a) subjective risk b) pure play c) divisional cost of capital

9. Cost and structure of corporate capital d) capital adjustment e) security market line 5. A firm’s cost of capital: a) will decrease as the risk level of the firm increases. b) for a specific project is primarily dependent upon the source of the funds used for the project. c) is independent of the firm’s capital structure. d) should be applied as the discount rate for any project considered by the firm. e) depends upon how the funds raised are going to be spent. 6. The weighted average cost of capital for a wholesaler: a) is equivalent to the after-tax cost of the firm’s liabilities. b) should be used as the required return when analyzing a potential acquisition of a retail outlet. c) is the return investors require on the total assets of the firm. d) remains constant when the debt-equity ratio changes. e) is unaffected by changes in corporate tax rates. 7. Which one of the following is the primary determinant of a firm’s cost of capital? a) debt-equity ratio b) applicable tax rate c) cost of equity d) cost of debt e) use of the funds 8. Scholastic Toys is considering development and distribution of a new board game for children. The project is similar in risk to the firm’s current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm’s rapid growth. How should the firm determine its cost of equity? a) by adding the market risk premium to the after-tax cost of debt b) by multiplying the market risk premium by (1 – 0.40) c) by using the dividend growth model d) by using the capital asset pricing model e) by averaging the costs based on the dividend growth model and the capital asset pricing model 9. All else being equal, which one of the following will increase a firm›s cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2. a) a reduction in the dividend amount

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Corporate Finance b) an increase in the dividend amount c) a reduction in the market rate of return d) a reduction in the firm’s beta e) a reduction in the risk-free rate 10. The firm’s overall cost of equity is: a) generally less that the firm’s WACC given a leveraged firm. b) unaffected by changes in the market risk premium. c) highly dependent upon the growth rate and risk level of the firm. d) generally less than the firm’s after-tax cost of debt. e) inversely related to changes in the firm’s tax rate. 11. The cost of equity for a firm: a) tends to remain static for firms with increasing levels of risk. b) increases as the unsystematic risk of the firm increases. c) ignores the firm’s risks when that cost is based on the dividend growth model. d) equals the risk-free rate plus the market risk premium. e) equals the firm’s pretax weighted average cost of capital. 12. The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. firms that have a 100 percent retention ratio II. firms that pay a constant dividend III. firms that pay an increasing dividend IV. firms that pay a decreasing dividend a) I and II only b) I and III only c) II and III only d) I, II, and III only e) II, III, and IV only 13. The dividend growth model: a) is only as reliable as the estimated rate of growth. b) can only be used if historical dividend information is available. c) considers the risk that future dividends may vary from their estimated values. d) is applied only when a firm is currently paying dividends. e) uses beta to measure the systematic risk of a firm. 14. Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure. a) This model considers a firm’s rate of growth. b) The model applies only to non-dividend paying firms.

9. Cost and structure of corporate capital c) The model is dependent upon a reliable estimate of the market risk premium. d) The model generally produces the same cost of equity as the dividend growth model. e) This approach generally produces the cost of equity that equals the firm’s overall cost of capital. 15. Which of the following statements are correct? I. The SML approach is dependent upon a reliable measure of a firm’s unsystematic risk. II. The SML approach can be applied to firms that retain all of their earnings. III. The SML approach assumes a firm’s future risks are similar to its past risks. IV. The SML approach assumes the reward-to-risk ratio is constant. a) I and III only b) II and IV only c) III and IV only d) I, II, and III only e) II, III, and IV only 16. The pre-tax cost of debt: a) is based on the current yield to maturity of the firm’s outstanding bonds. b) is equal to the coupon rate on the latest bonds issued by a firm. c) is equivalent to the average current yield on all of a firm’s outstanding bonds. d) is based on the original yield to maturity on the latest bonds issued by a firm. e) has to be estimated as it cannot be directly observed in the market. 17. The after-tax cost of debt generally increases when: I. a firm’s bond rating increases. II. the market rate of interest increases. III. tax rates decrease. IV. bond prices rise. a) I and III only b) II and III only c) I, II, and III only d) II, III, and IV only e) I, II, III, and IV 18. The cost of preferred stock is computed the same as the: a) pre-tax cost of debt. b) return on an annuity. c) after-tax cost of debt. d) return on a perpetuity. e) cost of an irregular growth common stock.

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Corporate Finance 19. The cost of preferred stock: a) is equal to the dividend yield. b) is equal to the yield to maturity. c) is highly dependent on the dividend growth rate. d) is independent of the stock›s price. e) decreases when tax rates increase. 20. The capital structure weights used in computing the weighted average cost of capital: a) are based on the book values of total debt and total equity. b) are based on the market value of the firm›s debt and equity securities. c) are computed using the book value of the long-term debt and the book value of equity. d) remain constant over time unless the firm issues new securities. e) are restricted to the firm›s debt and common stock.

10. FINANCIAL PLANNING AND FORECASTING OF CORPORATIONS

10.1. The concept of financial planning: objectives and principles 10.2. Types of financial planning 10.3. Current and operational financial planning

10.1. The concept of financial planning: objectives and principles Financial planning is the process of articulating and defining personal and financial goals and formulating a comprehensive, integrated strategy to achieve them without the assumption of undue risk. Before initiating a new business, the organization puts an immense focus on the topic of Financial Planning. Financial planning is the plan needed for estimating the fund requirements of a business and determining the sources for the same. It essentially includes generating a financial blueprint for company’s future activities. It is typically done for 3-5 years-broad in scope and generally includes long-term investment, growth and financing decisions. How to Do Financial Planning? 1. Determine The Total Capital Requirements For a Business Financial planning is usually done by the business financial manager. The financial manager first looks at the business environment they operate in, this will tell him/her how sales performance of the business will look like in coming months or years. If the sales are to take an upward trajectory he needs to plan for that. The business will 201

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need to increase its production to meet increasing sales, so the funds for this need to be sourced and allocated. 2. Work Out How to Raise and Allocate the Money Required After getting to know how much money is required by the business the next step is getting the funds. The business can either use its own reserves, revenue for the growth or source for funding externally. External sources could include the sale of company shares, bank loans, debentures etc. Once the funds are available suitable policies for proper utilization and administration of the money must be followed. 3. Financial Planning Doesn’t Stop After Raising Funds For The Business A financial manager also has to look at various investment opportunities and determine if they make business sense to go into, create a financial plan, both short and long-term. In the short term you come up with budgets which detail how money will be spent over a period of one year or less, long-term is focused on a capital expenditure plan. Objectives of Financial Planning.  Ensuring availability of funds: financial planning majorly excels in the area of generating funds as well as making them available whenever they are required. This also includes estimation of the funds required for different purposes, which are, long-term assets and working capital requirements.  Estimating the time and source of funds: time is a game-changing factor in any business venture. Delivering the funds at the right time and at the right place is very much crucial. It is as vital as the generation of the amount itself. While time is an important factor, the sources of these funds are necessary as well.  Generating capital structure: the capital structure is the composition of the capital of a company, that is, the kind and proportion of capital required in the business. This includes planning of debt-equity ratio both short-term and long-term.  Avoiding unnecessary funds: it is an important objective of the company to make sure that the firm does not raise unnecessary resources. In the situation of shortage of funds the firm cannot meet its

10. Financial planning and forecasƟng of corporaƟons

payment obligations, whereas with a surplus of funds, the firm does not earn returns but adds to costs. Process of Financial Planning.  Preparation of sales conjecture.  Decision on the number of funds – fixed and working capital.  Conclusion on the expected benefits and profile ts to decide the number of funds that can be provided through internal sources.  This causes us to evaluate the requirement from external sources.  Determination of the conceivable sources and setting up the money spending plans consolidating these variables. Importance of Financial Planning. • For Optimum Fund Raising As I have already mentioned as a business you don’t want to have less funds as this will hamper your operations negatively. So, to avoid under or over capitalization it is necessary to do financial planning, it will tell you how much capital you need. • Determining Capital Structure Organizations raise short, medium, and long-term funds from various sources. When preparing a financial plan, you will determine how to raise the money for various stages. Generally long-term funds are contributed by shareholders, debenture holders, for the mediumterm funds business applies to financial institutions while for shortterm – to commercial banks. • Help in Financing the Right Projects Since financial planning looks at the company spending you can choose the best investments which guarantee the best return on investment. You will be able to choose this given that as you come up with the financial plan you will be comparing various investments proposed. • Investor Confidence If somebody is to invest in your business they definitely want to know that you understand what you are doing. Assurance that your business does financial planning will make it easier for you to attract investors. If they ask for the data you can give them that and not guess things when they ask the tough question.

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 Help in Surviving Turbulent Times Remember I told you the first step to financial planning is studying your business environment. As you had already anticipated and determined your financial requirements, the business will be able to manage shocks better than if it didn’t have a financial plan. One thing financial planning does is ensuring you have cash reserves which you can use in bad times.  Linking Present and Future Financial planning outlines what is required now so as to achieve growth in the future, i.e. these are the sales figures we need to be able to achieve this level of growth in 2 years.  Help in Operational Activities Succeeding or failing in the production or distribution process largely depends on financing decisions. If proper financial plans are not made, for example, you have not prepared good plans to pay for trucks maintenance and serving of machinery, the smooth working in corresponding department will be disrupted and this only means one thing – losses for your business. Financial Planning is the procedure of confining company’s targets, policies, techniques, projects and budget plans with respect to the financial activities of a longer duration. This guarantees viable and satisfactory financial investment policies. The importance is as follows:  It guarantees sufficient funds.  Planning helps in guaranteeing a harmony between outgoing and incoming of assets with the goal that stability is kept up.  It guarantees providers of funds that they can effortlessly put resources into organizations which carry out financial planning.  Financial Planning supports development and expansion programs which support in the long-run sustenance of the organization.  It diminishes vulnerabilities with respect to changing business sector patterns which can be confronted effortlessly through enough funds.  Financial Planning helps in diminishing the vulnerabilities which can be a deterrent to the development of the organization. This aids in guaranteeing security and benefits of the organization.

10. Financial planning and forecasƟng of corporaƟons

The Financial Planning activity involves the following principles:  Assessment of the business environment  Confirmation of the business vision and objectives  Identification of the types of resources required to achieve these objectives  Quantification of the amount of resources (labor, equipment, materials)  Calculation of the total cost of each type of resource  Summarizing the costs to create a budget  Identification of any risks and issues with the budget set. Financial plans do not have a specific template, though most licensed professionals apply knowledge and considerations of the client’s future life goals, future wealth transfer plans and future expense levels. Extrapolated asset values determine whether the client has sufficient funds to meet future needs. A good financial plan can alert an investor to changes that must be made to ensure a smooth transition through financial phases, e.g., decreasing spending or changing asset allocation. Financial plans should also be flexible, with occasional updates when financial changes occur. Elements of a Financial Plan.  Financial goals: a financial plan is based on an individual’s or a family’s clearly defined financial goals, including funding a college education for the children, buying a larger home, starting a business, retiring on time or leaving a legacy. Financial goals should be quantified and set to milestones for tracking.  Personal net worth statement: a snapshot of assets and liabilities serves as a benchmark for measuring progress towards financial goals.  Cash flow analysis: an income and spending plan determines how much can be set aside for debt repayment, savings and investing each month.  Retirement strategy: the plan should include a strategy for achieving retirement independent of other financial priorities. The plan should include a strategy for accumulating the required retirement capital and its planned lifetime distribution.  Comprehensive risk management plan: identify all risk exposures and provide the necessary coverage to protect the family and

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its assets against financial loss. The risk management plan includes a full review of life and disability insurance, personal liability coverage, property and casualty coverage, and catastrophic coverage.  Long-term investment plan: include a customized asset allocation strategy based on specific investment objectives and a risk profile. This investment plan sets guidelines for selecting, buying and selling investments and establishing benchmarks for performance review.  Tax reduction strategy: identify ways to minimize taxes on personal income to the extent permissible by the tax code. The strategy should include identification of tax-favored investment tools that can reduce taxation of investment income.  Estate plan: create arrangements for the preservation and distribution of assets with attention to minimizing settlement costs and taxes. 10.2. Types of financial planning Financial planning means to prepare the financial plan. A financial plan is also called capital plan. A financial plan is an estimate of the total capital requirements of the company. It selects the most economical sources of finance. It also tells us how to use this finance profitably. Financial plan gives a total picture of the future financial activities of the company. Financial Planning is the mathematical sum of the following parameters: Financial Resources (FR) + Financial Techniques (FT) = = Financial Planning. (10.1) A financial plan contains the answers to the following questions: 1. How much finance (short-term, medium-term and long-term) will be required by the company? 2. From where this finance will be acquired (gathered)? In other words, what are the sources of finance? That is, owned capital (pro-

10. Financial planning and forecasƟng of corporaƟons

moter contribution, share capital) and borrowed capital (debentures, loans, overdrafts, etc.). 3. How the company will use this acquired finance? That is, application or utilization of funds. Financial plan is generally prepared during promotion stage. It is prepared by the promoters (entrepreneurs) with the help of experienced (practicing) professionals. The promoters must be very careful while preparing the financial plan. This is because a bad financial plan will lead to over-capitalization or under-capitalization. It is very difficult to correct a bad financial plan. Hence immense care must be taken while preparing a financial plan. Types of Financial Plans After the company starts, the finance manager does the financial planning. The types of financial plans are depicted and briefly explained below.

Figure 4. Types of Financial Plans Note: compiled by the author

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There are three types of financial plans, viz., 1. Short-term financial plan is prepared for maximum one year. This plan takes into consideration the working capital needs of the company. 2. Medium-term financial plan is prepared for a period of one to five years. This plan takes into consideration replacement and maintenance of assets, research and development, etc. 3. Long-term financial plan is prepared for a period of more than five years. It takes into consideration the long-term financial objectives of the company, its capital structure, expansion activities, etc. In business, a financial plan can refer to the three primary financial statements (balance sheet, income statement, and cash flow statement) created in the framework of a business plan. Financial forecast or financial plan can also refer to an annual projection of income and expenses for a company, division or department. A financial plan can also be an estimation of cash needs and a decision on how to raise the cash, e.g. – through borrowing or issuing additional shares in a company. A financial plan may contain prospective financial statements, which are similar, but differ from a budget. Financial plans are the entire financial accounting overview of a company. Complete financial plans contain all periods and transaction types. It is a combination of financial statements which independently only reflect a past, present, or future state of the company. Financial plans are the collection of the historical, present, and future financial statements; for example, a (historical and present) costly expense from an operational issue is normally presented prior to the issuance of the prospective financial statements which propose a solution to said operational issue. The confusion surrounding the term financial plans might stem from the fact that there are many types of financial statement reports. Individually, financial statements show either the past, present, or future financial results. More specifically, financial statements also only reflect the specific categories which are relevant. For instance, investing activities are not adequately displayed in a balance sheet. A

10. Financial planning and forecasƟng of corporaƟons

financial plan is a combination of the individual financial statements and reflect all categories of transactions (operations & expenses & investment) over time. Some period-specific financial statement examples include pro forma statements (historical period) and prospective statements (current and future period). Compilations are a type of service which involves «presenting, in the form of financial statements, information that is the representation of management». There are two types of «prospective financial statements»: financial forecasts and financial projections and both relate to the current/future time period. Prospective financial statements are a time period-type of financial statement which may reflect the current/future financial status of a company using three main reports/financial statements: cash flow statement, income statement, and balance sheet. «Prospective financial statements are of two types – forecasts and projections. Forecasts are based on management›s expected financial position, results of operations, and cash flows. «Pro forma statements take previously recorded results, the historical financial data, and present a «what-if»: «what-if» a transaction had happened sooner. While the common usage of the term «financial plan» often refers to a formal and defined series of steps or goals, there is some technical confusion about what the term «financial plan» actually means in the industry. The accounting and finance industries have distinct responsibilities and roles. When the products of their work are combined, a complete picture is produced – i.e. a financial plan. A financial analyst studies the data and facts (regulations/standards), which are processed, recorded, and presented by accountants. Normally, finance personnel study the data results – what has happened or what might happen – and propose a solution to an inefficiency. Investors and financial institutions must see both the issue and the solution to make an informed decision. Accountants and financial planners are both involved with presenting issues and resolving inefficiencies, so both the results and explanation are provided in a financial plan.

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The Different Types of Financial Planning Services. Insurance Agent Insurance agents sell life, disability, long term care, property and casualty, and other types of insurance products. They customize related plans and programs to cover a variety of risks that best suit clients’ needs. They weigh the advantages and disadvantages of these policies and promote the associated sales – oftentimes compensated via commissions based on those policies’ premiums. Accountant Accountants primarily examine and prepare financial records, ensuring the accuracy and timely preparation and submission of tax returns to the Internal Revenue Service (IRS). They review the financial operations of businesses and fiscal matters of individuals, and assist in creating plans to improve efficiencies. Many accountants get Certified Public Accountant (CPA) licenses from their respective state board of accountancy – a distinction denoting extensive education, experience and competency within the profession. Estate Attorney Estate Attorneys, as their titles indicate, specialize in estate planning issues, such as, for instance, estate taxes and the effective distribution of assets to heirs. They provide advice to clients on strategies of the best preparation for the possibilities of mental illness or incapacitation, and eventually, death. Advice on wills, trusts, estate tax minimization, business succession, and strategies to ensure that clients’ assets and savings are secure following their deaths are the typical elements of such services. Estate attorneys can provide further legal advice regarding these areas, and also prepare related legal documents. Stockbroker Stockbrokers, as aforementioned, may sometimes refer to themselves as «financial planners» or «investment advisors», but in fact they

10. Financial planning and forecasƟng of corporaƟons

are more accurately described as salespeople employed by brokerage firms («broker-dealers»), who sell stocks, mutual funds, and other securities on a commission basis. Thus, the more products sold or transactions made, the more they benefit – and while professionals in this area are heavily regulated and are most often quite scrupulous, there is an inherent conflict of interests and an incentive structure here that could result in sales that may not necessarily be aligned with clients’ financial objectives. Investment Advisor Investment advisors are typically focused on the management of clients’ investment portfolios and planning issues directly related to the securities and accounts being managed for the client. Such advisors typically collect a fee for ongoing management of the securities portfolio based on an annual percentage of assets under management. Their firms are regulated by either the states or the SEC (depending on whether they are federal or state registered) as Registered Investment Advisers (RIAs). While such investing arrangements tend to provide a much better alignment of the goals of the investor with the incentives of the advisor than a traditional stock broker’s compensation, but in case the associated fees are too high, they may provide a significant drag on returns in the long term (if not kept in check). In addition, compensation solely by this means is likely to lead to an over-focus on investing and a neglect of other financial planning issues. Financial Planner or Wealth Manager Financial Planners and Wealth Managers who are compensated based on either a fixed fee, retainer fee, or hourly rate fee have perhaps the most optimal incentive structure to provide the broad, comprehensive, concept-based solutions needed for fully coordinated multidisciplinary financial planning and wealth management. Such professionals are free to think from the multiple perspectives of Investment Planning, Estate Planning, Business Succession Planning, and Fringe Benefits Planning, and may focus their energies on crafting and developing purely concept-based (as opposed to product-based) strat-

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egies to help clients achieve their short– and long-term goals. Like the companies of investment advisors, their firms are also regulated as Registered Investment Advisers (RIAs), and as such they are both required to act as fiduciaries with clients’ best interests in mind, and may be monetarily incentivized to do so (depending on their exact fee structure). Types of Individual Financial Planning Models and Strategies. There are key important types of financial planning strategies and models which one has to start thinking of. There are various different types of financial plans which one has to draft to achieve the goals of the life. Let us understand in detail below: 1. Cash Flow Planning. It is one of the important types of financial planning. An individual or a company forecast their short term and long term expenses against the projected cash flow. But there are cases when emergency expenses or unexpected expenses occur. One should plan its cash flow appropriately. Incorrect cash flow planning can lead to bankruptcy. 2. Investment Planning. You should make his investment plan to achieve your goals in his life. Your investment plan is always based on your savings. Once you know your amount of savings, you can take the help of financial adviser for various investment opportunities, for example fixed income, investment in stocks, gold, forex market, bonds, mutual funds, etc. He can either invest lump sum amount or you can start systematic investment plan (SIT) for a long term to fulfill the long term financial goals. 3. Insurance Planning. Insurance coverage for a long term is a very crucial type of financial planning. Under unforeseen situations, if you haven’t plan your insurance well in advance, it can spoil your other financial plans as well. Insurance planning is dependent upon individual lifestyle. You should analyze first before you buy any insurance. 4. Retirement Planning. It is the event which occurs in everyone’s life. It is one of the important types of financial planning. Mostly you will hear that people set their financial goals for their retirement in-

10. Financial planning and forecasƟng of corporaƟons

come due to rising inflation and rising standard of living. You will have to start your saving and investment early in your life for your retirement so that you do not have to compromise on standard of living during retirement. 5. Tax Planning. Proper tax planning can help you to maximize your finance saving. There are various benefits and exemptions provided by countries for the tax payers. You should take the education and draft a plan on it. At the end of the year, you can take the benefits of exemptions and minimize your taxes. Everyone should keep one’s knowledge up-to-date on his/her tax planning as a part of your financial planning strategy. 6. Real Estate Planning. Asset creation is again one of the important types of financial planning. Wealth creation or retirement planning can be achieved with real estate planning. Real estate is considered as a low risk and high return investment option. So everyone should think of drafting such plan as a part of financial planning. In case of unforeseen situations in life, real estate planning turn out to be one of the best plans for your family safety. 10.3. Current and operational financial planning In the face of uncertainty, high dependence on external factors, frequent changes in legislation, inflation expectations, many domestic enterprises face the problems of forecasting and planning for the future. Therefore, they focus on current (short-term) planning. The system of current planning of the financial activity of an enterprise is based on the developed financial strategy and financial policy on certain aspects of the financial activities of an economic entity. This type of financial planning consists in developing specific types of current financial plans that enable enterprises to determine all sources of financing for their development for the upcoming period, form their income and expenses structure, ensure its solvency, and determine the structure of assets and capital of the enterprise at the end of the planned period. . The current financial planning is considered as

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an integral part of the long-term plan and represents the concretization of its indicators. Current financial planning includes the development of: – financial plan of the main activity; – financial plan of non-core activities; – current financial plan; – calculation of indicators of the current financial plan (taxes; profits; depreciation charges; stable liabilities; increase in the standard of own current assets); – credit, currency plan, tax plan (budget); – cash flow plan, which is based on the determination of the reserve of liquid funds; – operational financial plans. All planning documents are based on the same source data and must correspond to each other. Documents of current financial planning are compiled for a period equal to one year. This is explained by the fact that, for a year, seasonal fluctuations of the market situation are largely aligned. Moreover, such a period of time complies with the legislative requirements for the reporting period. For the accuracy of the result, the planned period is divided into smaller units: a half and quarter of the year. The main purpose of keeping these documents is to assess the financial situation of the company at the end of the planned period. Current financial plans are developed on the basis of data that characterize: – financial strategy of the enterprise; – results of financial analysis for the previous period; – the planned volume of production and sales of products, as well as other economic indicators of the operating activities of enterprises; – a system of norms and standards developed for the enterprise at the cost of individual resources; – the current tax system; – the current system of depreciation rates; – average rates of loan and deposit interest in the financial market. Consider the content of the main current plans drawn up in the enterprise. The leading financial plan in modern conditions is the cur-

10. Financial planning and forecasƟng of corporaƟons

rent balance of income and expenses. It is compiled for a year with quarterly breakdown. In order to control the flow of actual revenue to the account and the expenditure of cash financial resources of the enterprise, it is necessary to carry out operational planning, which complements the current one. This is due to the fact that the financing of planned activities should be carried out at the expense of funds developed by the company, which requires effective control over the formation and use of financial resources. The system of operational planning of financial activities consists in the development of a complex of short-term planned tasks for the financial support of the main areas of economic activity of an enterprise. Operational plan is necessary to ensure the financial success of the enterprise. Therefore, when compiling it, it is necessary to use objective information on the trends of economic development in the field of enterprise activity, inflation, and the organization of the production process. Operational financial planning includes the preparation and execution of a payment calendar, cash plan and credit plan. In drawing up the payment calendar, the financial department works closely with the accounting department, since it provides for the collection of information on transactions in the company’s accounts, on paying taxes, on the status of receivables and payables, on settlements with suppliers and contractors, and others. The payment calendar is the most effective and reliable tool for the operational management of the enterprise cash flow. In the process of drawing up the payment calendar, the following tasks are solved: – organization of the account of the temporary docking of cash receipts and forthcoming expenses of enterprises; – formation of an information base on the movement of cash inflows and outflows; – daily accounting of changes in the information database; – analysis of payments (by the amount and sources of occurrence) and organization of specific measures to settle them;

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– calculation of the need for a short-term loan in cases of temporary mismatching of cash receipts and liabilities and prompt acquisition of borrowed funds; – calculation (by the sum and terms) of temporarily free funds of the enterprise; – analysis of the position of the financial market from the point of view of the most reliable and profitable placement of temporarily free funds of the company. The payment calendar is prepared for a month, 15 days, a decade, and five days. At the same time, the period is determined on the basis of the frequency of the company’s basic payments. In order for the payment calendar to be real, its developers should monitor the progress of production and sales of products, the state of stocks, and receivables in order to prevent the financial plan from failing. There is no officially established form of the payment calendar. In the payment calendar, the inflows and outflows of cash (both in cash and non-cash form) must be balanced. Properly compiled payment calendar allows you to identify financial errors, lack of funds, reveal the reason for this situation, outline relevant measures, and, thus, avoid financial difficulties. Payment calendar is compiled on the basis of a real information about the company’s cash flows. Information base of the payment calendar is formed by: – plan for sales of products; – capital investment plan; – estimated production costs; – extracts from the company’s accounts and appendices to them; – contracts; – internal orders; – payroll schedule; – invoices; – set payment deadlines for financial obligations. The process of drawing up a payment calendar may be divided into 6 stages:

10. Financial planning and forecasƟng of corporaƟons

1. Choice of planning period. As a rule, it is a quarter (month). In enterprises where cash flows often change over time, shorter periods are possible (ten days). 2. Planning of the volume of products sold (works, services) is carried out according to a special methodology, taking into account the volume of production in the period under review and changes in the balance of finished products. 3. The calculation of the amount of possible cash receipts (income). Cash receipts and changes in receivables can be calculated using the balance equation RGS + SR = RGS + CR,

(10.2)

where RGS = receivables for goods and services, SR = sales revenue for the period CR = cash receipts in this period. If there are other sources of cash inflows (revenue from other sales, non-operating income), their forecast estimate is performed using the direct account method. The amount received is supplemented to the amount of cash receipts. 4. Estimation of cash expenses expected in the planned period. 5. Determination of cash balance. It represents the difference between the amounts of income and expenses over the planning period. 6. Summarizing shows whether the enterprise will have a shortage of funds or a surplus. The expected balance at the end of the period is compared with the minimum amount of funds in the current account, which it is advisable to have as an insurance reserve, as well as for profitable investments forecasted in advance (the size of the minimum amount is determined by the managers of the enterprises). The excess of the planned expenditures over the expected receipts (together with the carry-over balance in the accounts) means that there is insufficient capacity to cover them and may, is a sign of deteriorating financial condition. In these cases, the following measures should be taken:

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– a part of non-prime expenses should be transferred to the next calendar period; – shipment and sales of products should be accelerated, if possible; – efforts to find additional sources of cash flow should be made. In the latter case, the total demand for short-term financing is calculated, that is, the amount of a short-term bank loan is determined for each period, which is necessary to ensure the projected cash flow. An enterprise may not be limited to drawing up a general payment calendar covering all activities. Its differentiation by activity is allowed: the main (current), investment, financial and responsibility centers. Such differentiation improves the quality of cash management of the enterprise and provides a closer link between the payment calendar and cash flow plan. In many enterprises, along with the payment calendar, a tax calendar is drawn up, which indicates when and what taxes the company should pay according to the legislation, thus avoiding delays and sanctions. In addition to the payment calendar, an enterprise can draw up a cash plan – a cash turnover plan that reflects the receipt and payment of cash through the cash register. Timely availability of cash characterizes the state of financial relations between the enterprise and its employees, that is, one of the parties to the solvency of the enterprise. The cash plan is necessary for the company to control the receipt and expenditure of cash. A commercial bank servicing a company also needs its cash plan in order to draw up a consolidated cash plan for servicing its customers on time. The baseline data for the cash plan are as follows: – estimated payroll payments; – information on the sale of material resources or products to employees; – information on other receipts and payments in cash; – information on the amount of taxes, as well as the calendar of payment of wages and payments equivalent to it.

10. Financial planning and forecasƟng of corporaƟons

In accordance with the «Procedure for conducting cash operations», all organizations and institutions, regardless of their form of ownership, are obliged to keep their funds in banks. Enterprises may have cash in their cash registers within the limits established by banks in agreement with the management of the enterprise. Companies and organizations are required to hand over cash in excess of the established limit to banks in the manner and time agreed with the bank. The cash plan is developed for the quarter and in due time is submitted to a commercial bank, with which the company has entered into an agreement on cash management services. A commercial bank analyzes the accuracy of cash plan indicators and, if necessary (with the agreement of the company), makes an adjustment to the calculation. Further advancement to the market will be accompanied by an increase in the volume of non-cash payments and, ultimately, the predominance of these calculations in all areas of settlement operations, as is the case in world practice. An important part of the operational financial work is the preparation of a credit plan. If an enterprise has a certain need for short-term financing, it must justify the amount of the requested loan, determine the amount taking into account the interest that must be returned to a commercial bank, calculate the effectiveness of the credit measure, and conclude a loan service agreement with the bank. The final stage of financial planning is the preparation of a summary analytical note. In the analytical note, conclusions are drawn on the planned security of the enterprise with financial resources and the structure of the sources of their formation. Tasks: 1. Select one company on www.kase.kz. Describe the company’s financial planning process. 2. Determine the general capital requirements for this company. What are the main goals of financial planning? 3. Think and explain your opinion: Why are enterprises focused on current (short-term) planning? 4. Why the payment calendar is the most effective and reliable tool for the operational management of cash flows of the enterprise?

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Corporate Finance 5. Explain the process of operational financial planning and how it differs from current planning. Activity 1. What assumptions underlie the argument of Modigliani and Miller about the absence of the influence of dividends on the value of the firm? Can real companies exist in the world of MM? Activity 2. It is often said that dividends on stocks create problems for shareholders. Is this true for all investors? Explain with examples. Test questions: chapter 10 1. Government places controls on the personal financial environment by the application of a) taxation and fiscal policy b) taxation and regulation c) taxation and competition d) regulation and competition e) regulation and fiscal policy 2. The three key groups in the economic environment are a) government, regulation, and business b) government, consultants, and business c) consumers, economists, and business d) consumers, business, and managers e) government, consumers, and business 3. While you are still working, you should be managing your finances for retirement planning. Which of the following is not a goal of your retirement planning? a) maintaining your standard of living b) effectively passing wealth on to heirs c) a vacation at home or abroad d) travel 4. Estate planning involves a) consideration how your wealth can be most effectively passed on to heirs b) payment of all back taxes c) dissolution of all privately held corporations d) valuation and auctioning of your valuables e) planning retirement 5. Investments are distinguished from savings on the basis of a) length of time they are held

10. Financial planning and forecasƟng of corporaƟons b) initial dollar outlay c) depreciation d) voting rights e) level of risk and expected return 6. Tax planning is most commonly carried out to a) reduce debt balances b) change income patterns to avoid taxes c) minimize taxes d) pay extra taxes e) learn the tax code 7. Employee’s benefits may include a) health insurance b) disability insurance c) life insurance d) only a and b above e) all of the above 8. Employee’s benefits may include a) retirement plans b) health insurance c) employee’s discounts d) tuition reimbursements e) all of the above 9. Sam and Lele are in their late 20s with 3 young children. Their most important financial planning concerns would probably include all of the following except for a) asset acquisition planning b) liability and insurance planning c) retirement and estate planning d) savings and investment planning e) employee’s benefit planning 10. Martha is 80 and has a very high net worth. Her most important financial concern is probably her a) career b) employee’s benefits c) estate d) insurance e) savings

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Corporate Finance 11. The most important financial planning for young people concerns a) career b) insurance c) investment d) taxes e) retirement 12. The main reason to do personal financial planning is to a) minimize overall costs b) minimize overall utility c) assign monetary value to consumption d) maximize overall utility e) stabilize overall utility 13. Utility refers to a) the satisfaction you receive from purchasing something b) how much money you receive during the year c) the total of your spending for the year d) the value of your investments at any given time e) none of these 14. Family financial goals should be a) very general in nature b) realistically attainable c) individually determined d) set once for a lifetime e) reserved for retirement planning 15. An example of a liquid asset is: a) stock b) cash c) automobile d) mutual funds e) retirement fund 16. A ____ is an example of a real asset. a) stock b) bond c) mutual fund d) savings account e) stamp collection

10. Financial planning and forecasƟng of corporaƟons 17. The amount of money we set aside for future consumption will be determined by a) our level of current wealth b) how much we currently earn and spend c) our education level d) the current needs of our family e) the cost of life`s necessities 18. Generally, as income rises, the average propensity to consume a) stabilizes b) drops to zero c) increases d) becomes erratic e) decreases 19. Which of the following goals is stated in a way that is most useful for developing a financial plan? a) Make a $12,000 down payment for an automobile in 4 years b) Retire with a comfortable lifestyle in 25 years c) Buy a $125,000 house in 6 years d) Purchase a $40,000 boat e) Join the country club when retired in 20 years 20. When setting financial goals, one should typically start by setting a) short-term goals b) intermediate-term goals c) long-term goals d) a and b e) b and c

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11. EVALUATION OF FINANCIAL CONDITION OF THE CORPORATION: CONCEPT OF FINANCIAL STABILITY

11.1. The concept of the financial condition of the company 11.2. Analysis of solvency and liquidity of the enterprise 11.3. Indicators of financial stability of the enterprise, the method of their calculation

11.1. The concept of the financial condition of the company The concept of financial condition may be applied in the generic sense or specifically with respect to businesses. Generically, a financial condition is a status check on the state of any entity’s income, expenses, assets and liabilities at a specific point in time. It can be established for a household, a person, a project or any other item or entity that has financial obligations. In a business context, financial condition is an analysis of a company’s equity position and profitability at a specific point in time, using financial statements, calculations and ratios. Businesses keep track of revenue, expenses, assets and liabilities to comply with government regulations, to have substantiation when they pay taxes and to keep shareholders and potential investors informed of the status of operations. This information is kept in an accounting system. The information is pulled out of the system for analysis by generating financial reports. These reports include income statements, balance sheets, cash flow statements and statements of owners’ equity and are standardized by the accounting standards 224

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

boards in each jurisdiction that, in turn, comply with international standards. Standardized financial statements create a level playing field, so investors can compare the performance of various companies using common instruments. These statements present a company›s condition, or the status of its revenue, expenses, assets and liabilities, at a particular point in time. They show financial tallies, such as total revenue and total expenses generated, and present financial conclusions, such as whether a company’s cash flow covered operating expenses over a time period. A company’s financial condition is also determined by financial analysts by reviewing financial ratios. These ratios take information from financial statements and use the information in calculations designed to highlight certain financial relationships. For example, information from financial statements is often used to generate a price/earnings ratio. This ratio compares the price of a company’s stock to the earnings per share. This type of analysis of a company’s financial condition is intended to reveal profitability. Typically, a review of an organization’s condition is a prelude to a quality determination. For example, a company might be in good or bad financial condition, depending upon the state of its financial affairs. This type of determination is made frequently by loan officers, investors, financial analysts and government agencies. The determination can be somewhat subjective, because there is no specific formula for establishing financial condition. Although there are common methods, a reviewer can take other information into account or view ambiguous financial results in a different way. Financial condition of the enterprise may be stable, unstable and crisis. The company’s ability to successfully operate and develop, maintain balance its assets and liabilities in a changing internal and external environment, constantly maintain its solvency and investment appeal within the boundaries of the acceptable level of risk testifies to its strong financial position, and vice versa. If solvency is the outward manifestation of the financial condition of the company, the financial stability is its inner side, reflecting the balance of cash and cash flows, income and expenses, assets and sources of their formation. To en-

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sure the financial stability, the company should have a flexible capital structure and be able to organize its movement so as to provide a constant excess of income over expenditure in order to maintain the solvency and to create conditions for normal functioning. Stable financial position is the result of skillful management of the whole complex of factors that determine the financial results of the company. The main objectives of the analysis of the financial condition of the company The main objectives of the analysis of the financial condition of the company are: – Timely and objective diagnosis of the financial condition of the company, the establishment of «pain points» and the study of the causes of their formation. – Search to improve the financial condition of the company, its solvency and financial stability. – Development of specific measures aimed at more efficient use of financial resources and strengthening of the financial condition of the company. – Forecasting of possible financial results and financial condition, the development of models with a variety of options for the use of resources. Analysis of Financial Condition includes the following blocks: – Assessment of property and capital structure. – Evaluation of the effectiveness and usage of capital. – Assessment of financial stability and solvency. Analysis of financial condition is based primarily on relative terms. Effectiveness analysis depends on the organization and perfection of information base. The main sources of financial analysis of the enterprise The main sources of information for the analysis of the financial condition of the company are: – Balance sheet. – Statement of income and expenditure. – Statement of cash flows. – Statement of changes in shareholders’ equity.

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

– Primary data and analytical accounting, which decrypts and detail the individual balance sheet items. Problems and difficulties that occur in the company’s financial condition usually have some common features. They can be grouped into the following sets: 1. Problems connected with the lack of funds, bad financial solvency. This means that the company is facing problems with paying its short-term obligations or has a high risk of facing such problems in the near future. Indicators of the low debt-paying ability are bad liquidity indicators (significantly different from normative values), overdue accounts payable and enormous debt owed to budget, employees, and credit organizations. 2. Unsatisfactory return on stockholders’ equity (low revenues level for company’s owners, low profitability). This means that the level of revenues generated by the company is not adequate to the capital invested by owners. This would possibly lead to the negative estimation of the company’s management. 3. Low financial sustainability. This means there is a high chance for the company to have problems with paying off its debt in future. In other words, this means dependence of the company on creditors and loss of self-sufficiency. Not being financially sustainable enough for the company means the risk of not being able to meet its obligations, while the financial condition of the firm would be highly dependent on external sources of financing. Signs of the low financial sustainability are the decrease in the autonomy indicator to the level lower than normative, negative equity, the decrease of the net working capital to the value lower than optimal, etc. Generally, all described problems can be caused by two basic factors:  Lack of possibilities to keep the financial condition on the satisfactory level (or low profits);  Unreasonable management of the operating results (unreasonable finance management). The above troubles with solvency, profitability, financial sustainability have common causes: either the enterprise performance in-

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dicators are not good enough to keep the financial condition at the satisfactory level, or the firm’s finance management quality is at the unsatisfactory level. An insight into the process of the company’s financial condition optimization. Basic for the process of the company’s financial condition optimization is finding, which of the factors has caused the problem. Depending on that managerial decisions can be made, aimed at the financial condition improvement. At the same time, simple finding the problematic area is not enough. The detailed analysis of the company’s actions and industry changes are needed. The potential ability of the enterprise to keep the financial condition at the satisfactory level is determined by the volume of revenues generated. Main components that affect the revenue are prices and sales volume, cost of goods sold and income from other activities. The analysis of profit and loss from the company’s activities is being applied with the use of the income statement and profitability indicators. To estimate the level of fixed and variable expenses and the relationships between prices for the used resources and the sold product the marginal analysis is applied. The increase in the cost of the goods sold can be caused not only by suppliers but also by the company itself. High expenses for electricity, heat, water and other resources can be a consequence of the absence of the control of the resource consumption. In some cases the necessity of decreasing the expenses needs decisive actions, such as decreasing the fixed assets amount. The company cannot keep the whole amount of the generated revenue in its possession. Part of it is being used to cover different fees, accounts payable, non-production activities, etc. Limitation of these expenses can also become a way of profit optimization, and thus the financial condition improvement. Three key parts of the company’s operating results of management are current assets management, investment policy management and the source of finance management. Considering everything mentioned, there are two main ways of optimization of the company’s financial condition: optimization of the

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

operating results (the firm should generate greater profit) and reasonable management of the working results. However, the optimization of the financial condition by increasing the reasonability and efficiency of the working results usage is an effective, yet exhaustible way. It should be remembered that the basis for the stable financial condition in a long run is the generated revenue. To understand and evaluate a company, investors have to look at its financial position. Fortunately, it is not as difficult as it sounds to perform a financial analysis of a company by examining its financial statements. If you borrow money from a bank, you have to list the value of all of your significant assets, as well as of all of your significant liabilities. Your bank uses this information to assess the strength of your financial position; it looks at the quality of the assets, such as your car and your house, and places a conservative valuation upon them. The bank also ensures that all liabilities, such as mortgage and credit card debt, are appropriately disclosed and fully valued. The total value of all assets less the total value of all liabilities gives your net worth or equity. Evaluation of the financial position of a listed company is quite similar, except for the necessity for the investors to take another step and consider that financial position in relation to market value. Let’s take a look. Start with the Balance Sheet Like your own financial position, a company’s financial situation is defined by its assets and liabilities. A company’s financial position also includes shareholder equity. All of this information is presented to shareholders in the balance sheet. Let’s suppose that we are examining the financial statements of the fictitious publicly listed retailer The Outlet to evaluate its financial position. To do this, we review the company’s annual report, which can often be downloaded from a company’s website. The standard format for the balance sheet is assets, followed by liabilities, then shareholder equity.

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An Introduction to the Balance Sheet Current Assets and Liabilities Assets and liabilities are broken into current and non-current items. Current assets or current liabilities are those with an expected life of fewer than 12 months. For example, suppose that the inventories that The Outlet reported as of December 31, 2018, are expected to be sold within the following year, at which point the level of inventory will fall, and the amount of cash will rise. Like in most other retailers, The Outlet›s inventory represents a significant proportion of its current assets, and so should be carefully examined. Since inventory requires a real investment of precious capital, companies will try to minimize the value of a stock for a given level of sales, or maximize the level of sales for a given level of inventory. So, if The Outlet sees a 20% fall in inventory value together with a 23% jump in sales over the prior year, this is a sign they are managing their inventory relatively well. This reduction makes a positive contribution to the company›s operating cash flows. Current liabilities are the obligations the company has to pay within the coming year, and include existing (or accrued) obligations to suppliers, employees, the tax office and providers of short-term finance. Companies try to manage cash flow to ensure that funds are available to meet these short-term liabilities as they come due. The Current Ratio The current ratio – which is a total of current assets divided by total current liabilities – is commonly used by analysts to assess the ability of a company to meet its short-term obligations. An acceptable current ratio varies across industries, but should not be so low that it suggests impending insolvency, or so high that it indicates an unnecessary build-up in cash, receivables or inventory. Like any form of ratio analysis, the evaluation of a company’s current ratio should take place in relation to the past.

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

Non-Current Assets and Liabilities Non-current assets or liabilities are those with lives expected to extend beyond the next year. For a company like The Outlet, its biggest non-current asset is likely to be the property, plant and equipment the company needs to run its business. Long-term liabilities might be related to obligations under property, plant and equipment leasing contracts, along with other borrowings. Financial Position: Book Value If we subtract total liabilities from assets, we are left with shareholder equity. Essentially, this is the book value, or accounting value, of the shareholders’ stake in the company. It is principally made up of the capital contributed by shareholders over time and profits earned and retained by the company, including that portion of any profit not paid to shareholders as a dividend. Market-to-Book Multiple By comparing the company’s market value to its book value, investors can in part determine whether a stock is under– or over-priced. The market-to-book multiple, while it does have shortcomings, remains a crucial tool for value investors. Extensive academic evidence shows that companies with low market-to-book stocks perform better than those with high multiples. This makes sense since a low marketto-book multiple shows that the company has a strong financial position in relation to its price tag. Determination of what can be defined as a high or low market-tobook ratio also depends on comparisons. To get a sense of whether The Outlet’s book-to-market multiple is high or low, you need to compare it to the multiples of other publicly listed retailers. The Bottom Line A company’s financial position tells investors about its general well-being. A financial analysis of a company’s financial statements – along with the footnotes in the annual report – is essential for any serious investor wanting to understand and value a company’s properly.

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11.2. Analysis of solvency and liquidity of the enterprise The financial condition of the enterprise has adopted to assess short-term (liquidity and solvency) and long term (financial sticks) perspective. I. Liquidity. Liquidity of current assets means their ability to convert into cash, and the degree of liquidity is determined by the length of the period during which such conversion can happen. The shorter this period is the more liquid is each given element of assets. Liquidity measures is the capacity of an enterprise to execute any payments and debt settlements with creditors on a due date and in a certain amount. Liquidity is the key issue in the financial performance of an enterprise. The objective of the enterprise performance is to ensure a constant, sufficient amount of the means of payment. Liquidity can be discussed from two points of view: from the point of view of dissolution of an enterprise, i.e., it should be specified what means of payment would be there at the disposal of an enterprise that could be allocated to meet the liabilities if an enterprise should undergo the process of dissolution due to insolvency or insufficient profitability. In order to find the answer to this question the following information is required: – the revenues that an enterprise could acquire in the case of potential dissolution from the disposal of its property; – the amount of preferential claims; the amount of a secured loan. Such information cannot be found in the financial statements. This means that in the process of the annual report analysis liquidity in this aspect is not discussed. Liquidity is discussed in this way when the crediting arrangements are being established. – From the point of view of the enterprise as a going concern; – the probability that an enterprise could become insolvent and could be forced into liquidation should be assessed. However, as the information found in the financial statements is based on the going concern principle, while analyzing the balance sheet liquidity may be discussed only from this perspective. Information regarding liquidity is crucial as insolvency causes the threat of

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

winding up the operations of an enterprise. Businessmen and analysts are interested in the future liquidity figures and in not those of the past. The anticipated liquidity figures cannot be found out merely according to the data of accounting reports, but the data from the finance planning must be extensively used. A profitable enterprise is usually also solvent as it has the access to sufficient credit resources. There are several disadvantages of the liquidity measures: – they are static – the presented ratios are calculated based on the balance sheet data which describe the property status as of a certain date, therefore, to assess the changes in the ratio it is recommended to view them in dynamics or compare with the ratio level of other similar enterprises; – they provide little information for the forecasting of future revenues and expenses, however, this is exactly the main current solvency task; – incomplete accounting for enterprise liabilities (if there is a choice to present a loan in the balance sheet with or without the interest). – classification of assets depends on changes in the economic conditions. It is not fixed, but varying (unstable deliveries and high inflation). – peculiarities of the areas of enterprise activities and the working capital. This ratio can be increased in two ways: – by increasing the amount of individual items of current assets; – by reducing the amount of short-term liabilities. Usually it is believed that the higher the liquidity ratio, the higher the liquidity of an enterprise. However, it is not always so, as the calculation method of this ratio has a few drawbacks: – Let us assume upon calculation of the ratio that all current assets are liquid. This assumption may be unrealistic, especially in respect of inventories; – The ratios may be increased as a result of unfavourable processes. – Liquidity ratios may on some occasions be transferred into the opposite – the liquidation ratio. Only in the case of liquidation an en-

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terprise sells a large amount of stock in order to repay its short-term liabilities. – This ratio reflects a static situation – the status as of a certain date. Turnover of assets is not taken into consideration in the calculation. Due to these reasons when making analysis of the enterprise liquidity a variety of factors need to be considered by drawing conclusions from the liquidity ratios calculated. For example, the specifics of the enterprise operations must be taken into account. In production or construction enterprises there will be a considerable excess of the percentage of stock over cash assets than in the enterprises operating in trade. The application of the debtors’ collection policy also needs to be taken into account. If there is a short debt collection period, the balance sheet will reflect a small amount of debt, while a long period of collection may be reflected in the balance sheet as a considerable amount of debtor’s debts. It has to be noted also what is the structure of stock and accounts receivable in an enterprise. Neither the nonliquid stock, nor bad debtors for which an adjustment has not been made do reflect the true financial position of an enterprise. Also the relationship between short-term and long-term assets from the total enterprise property, the relationship between unrealizable and readily realizable assets from total assets, the relationship between current assets and short-term liabilities (the dynamics of the cover ratios), the dynamics and the reasons for changes in own working capital, the rate of own working capital in the structure of current assets have to be taken into consideration too. According to the degree of liquidity current assets may be subclassified into three groups, each of them differing in composition of current assets accepted as a cover for the repayment of short-term liabilities: – highly liquid assets which are readily realizable (cash assets). These are liquid assets that are at the disposal of an enterprise (customers’ debts, liquid securities listed on the stock exchange); – less liquid assets at the disposal of an enterprise (stock of materials for goods: goods, work in progress, stock of raw materials);

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

– non-liquid assets (doubtful debtors’ debts, semi-finished goods, prepaid expenses). Enterprise cash in till and on the bank account are believed to be the most liquid assets among current assets. Liquidity ratios associated with these assets are called the overall liquidity ratio (current ratio) and it is expressed as the ratio between current assets and current liabilities. The following liquidity indicators: 1. Total liquidity ratio (overall coverage ratio) is calculated as: Total liquidity = Current assets / Current liabilities.

(11.1)

Current liabilities are debts with the repayment term not exceeding one year. Current liabilities are made up of such items of balance sheet liabilities as bank loans, bills of exchange payable, trade accounts payable, customers’ advances, taxation payable, salaries payable etc. Current or short-term assets are the assets that are used, consumed or sold within a single reporting period. These include cash assets, short-term financial investments, accounts receivable and stock of raw materials for production of goods. The absolute or overall liquidity ratio (current ratio) describes the capacity of an enterprise to repay its short-term debts. The higher this ratio is the higher the paying capacity (solvency) of an enterprise estimated. Changes in this ratio must be looked at in a dynamic perspective. In accordance with the generally accepted international standards it is believed that this ratio must be within the limits of 1 and 2 (sometimes 3). The lower limit is preset as 1, because the amount of current assets in any enterprise must be at least as high as to be able to meet its current liabilities, otherwise the enterprise may face difficulties in settlement of its short-term debts. The excess of current assets over current debts above two or three times also is not desirable as this may be a proof or an irrational capital structure – the enterprise has invested too much in the current asset items or has insufficiently used its short-term loans. The overall liquidity ratio (current ratio) can be raised in two ways: either by increasing the value of some current asset items or reducing the value of its short-term debts.

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Quick ratio= Current assets – (Stock + Prepaid expenses) / / Current liabilities. (11.2) There can be other formulas found in the sources of reference according to which the quick ratio is calculated, although the mathematical outcome remains the same: Quick ratio = Cash + Short-term securities + accounts receivable / / Current liabilities. (11.3) This ratio shows the asset capital involved in the enterprise operations which is estimated as the difference between the amounts of current assets and current liabilities (any increase in the capital shows the improvement of the company financial status, or just on the contrary – worsening of the situation). This ratio also describes the share of current liabilities that can be repaid not only in cash, but also from expected earnings from any works performed, goods dispatched and services provided. The reference level of the ratio is 1, because then an enterprise is in a real position of meeting its current liabilities, it can fully settle its debts with the creditors without stopping its operations. Too high quick ratio is not a sign of good business performance either as this would mean that there is too much cash accumulated in the till and on the bank accounts. Too low level of the ratio could be related to the fact that there is either too much stock in the enterprise or that there are difficulties in selling this stock. 3. Absolute liquidity. In the majority of cases the most secure assessment of liquidity is by the amount of cash assets at the disposal of an enterprise. This value is called the absolute liquidity ratio and estimated as the relationship between cash and current liabilities: Absolute liquidity ratio = Cash in till and at bank / / Current liabilities.

(11.4)

If there are any short-term securities at the disposal of an enterprise, these should also be added to the amount of cash assets, because

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

they are either already expressed in terms of cash or are easily convertible into cash. In this case the absolute liquidity ratio is calculated by the following equation: Absolute liquidity ratio = Cash + Short-term securities / / Current liabilities. (11.5) The higher the amount of current assets is the larger the probability or repayment of the short-term debts from the existing assets. It is clear though that their amount will depend on the area of operations of an enterprise. It is generally accepted that, if the relation between current assets and current liabilities is lower than 2:1, an enterprise is not in a position of meeting its liabilities in due time and amount. An excess of current assets over current liabilities several times indicates a considerable amount of spare resources either created from its own assets or by insufficient use of its short-term credits (bank loans and trade credits). Form the point of view of efficiency of performance in accumulation of stock the allocation of assets for financing of debtors is considered to be an unprofessional use of assets. In analyzing the liquidity of an enterprise large attention needs to be paid to identification of Net current assets or the Current capital (Working capital). Net current assets = Current assets – Current liabilities.

(11.6)

Net current assets are required for the maintenance of financial stability of an enterprise, because the excess of current assets over current liabilities evidences that an enterprise is not only in a position of meeting its short-term debts, but it also has the financial resources available for expansion of business in the future. Net current assets that are at the disposal of an enterprise can convince creditors in favor of lending the resources to the enterprise. Net current assets provide a significant financial freedom for an enterprise in a situation of an increased rate of turnover of current assets, impairment or loss of the value of assets. Optimal amount of the working capital depends on several factors:

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– the area of operations of an enterprise; – the size of an enterprise – the scope of production or sales; – the terms of the enterprise crediting; – the speed of stock turnover; – the debtors collection period. II. Solvency measures Solvency is one of the most significant criteria in assessment of the financial position of an enterprise. It describes the situation when an enterprise has sufficient cash assets to settle at a short notice their open transactions with creditors, while the potential creditors after the assessment of these measures want to find out to what extent the enterprise is dependent on the capital borrowed or to what extent can it rely on its own capital. These measures are especially important for assessment of the capacity to borrow of an enterprise. If the amount of liabilities is excessive an enterprise could be in danger of insolvency. The main features of solvency are as follows: – Sufficient amount of cash on the current bank account and in till; – Due repayment of creditors debts. It has to be noted that the recommendable amounts should not be taken literally. There are situations when the share of equity from the total may be less than a half, however, the enterprise will still maintain high financial stability. This, first of all, is true in respect of the enterprises with the operations related to a high asset turnover, permanent demand for the goods for sale, well managed contacts with customers and sellers, low level of fixed costs (for example, trade and brokerage entities). This group of measures describes the asset structure. They are designed to: – establish and describe the relationship of liabilities against the equity or the total amount of assets; – assess the ability of an enterprise to increase its amount of debt; – assist in the assessment of the ability of a firm to meet its debts on due date. The measures of this group reflect the ability of an enterprise to repay its long-term and short-term liabilities. These measures are especially important for existing and also for potential creditors as

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

they show to what extent the revenue of an enterprise cover the interest and other fixed payments, as well as whether in the case of enterprise liquidation there are sufficient assets to repay its debts. Shareholders are interested in this measure, because the accrued interest is considered to be an expense that increases the liabilities of an enterprise. If the amount of loans and, therefore, also the amount of interest payable is excessive, the enterprise may face the bankruptcy procedure. Financial position of an enterprise is often dependent on how optimal the relation is between the shareholders’ equity and the capital borrowed. Development of an appropriate financing strategy helps enterprises to increase the efficiency of their operations. Consequently, measures of the capital structure are applied in financial analysis. These measures describe the level of protecting the interests of creditors and investors, allow identifying the relations with the shareholders’ equity or the total amount of assets, evaluation of the ability of an enterprise to increase the amount of liabilities and the ability of an enterprise to pay for its debts when they fall due. The capital structure or solvency ratios are especially significant to creditors as these allow them to assess the borrowing capacity of the enterprise. The percentage of shareholders’ equity from total capital structure is described by the ownership ratio or financial independence ratio and it can be expressed as the ratio between the interests of the owners and those of the creditors. The ratio is calculated as follows: Ownership ratio = Equity capital/Total assets.

(11.7)

Capital is the assets required for the business operations of an enterprise that are reflected in the liabilities of the balance sheet. The ownership ratio describes the financial stability. It is considered in the practice of the western companies that this ratio should be sufficiently high, that it is a feature of a strong structure of the financial assets of an enterprise. Creditors prefer such a structure upon taking their decisions on granting a loan to the enterprise. If the percentage of the loan assets is not high, there is a leverage provided against losses during the periods of diminished operating activity as well as for the

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receipt of a loan. It is assumed that the ratio should be approximately at the level of 60% both from the point of view of creditors and investors. If the ratio is sufficiently high, issuance of a loan to an enterprise may be considered. Low level of this ratio indicates that there should be a high amount of interest payable on the loans, and the enterprise may lose possibilities of receiving further loans; this means that the amount of liabilities should be decreased or else it is necessary to receive an additional long-term loan in order to repay the short-term debts for which the repayment date is approaching. One of the most often used measures in this group is the percentage of the capital borrowed in the balance sheet (the debt ratio); this is defined as the relationship between total debts and total assets. Percentage of debt in the balance sheet (Debt ratio) = = Total liabilities / Total assets. (11.8) The percentage of debts in the balance sheet describes the financial dependence of an enterprise on external loans. The higher it is, the more the enterprise is in debt, and the more risky is the situation that may lead to bankruptcy. At the normal level this ratio should not exceed 40%. Creditors usually want to see lower debt ratios, because it is more certain that they would receive the amounts lent without any obstructions. Higher debt ratio means that high interest rate is paid on the loans, and the terms of crediting will be strict or an enterprise may even lose the chance to receive a loan. Risk plays the main role in the assessment of the level of liabilities. Most often there are two types of risk that the enterprises may face: – business risk associated with normal level of activities in the operating conditions; – financial risk arising from the method by which the enterprise assets are financed. The underlying principle is as follows: if the business risk is high, the financial risk should not be undertaken.

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

The level of liabilities depends also on the state legislation on issuing of loans, the interest rate, as well as the peculiarities of an enterprise, the area of business conditions, etc. The financial independence of an enterprise is also described by a measure called the independence ratio which is also called the financial leverage (gearing) which is calculated by dividing the liabilities of an enterprise by its equity: Financial leverage = (gearing) Liabilities / Equity capital. (11.9) Ratio shows, what amount of borrowed capital payable per one unit of equity capital is. Dynamic increase in this ratio may evidence the ability of the enterprise to expand its operations on the account of raising the debt capital. At the same time it may be an indicator of a growing financial dependence on borrowed capital. Experts believe that if the level of this ratio has reached 1, the financial stability of an enterprise is under the threat, however, there is no one single solution regarding the critical limit of this ratio. This ratio depends on the type of business activities and the rate of turnover of current assets. If the turnover of current assets is high, the critical limit of this ratio may considerably exceed 1 without seriously affecting the financial autonomy of an enterprise. Creditors usually select the lower level of this measure. High level of dependence from external debt may considerably impair the conditions of an enterprise in circumstances when the rate of sales of goods is decreasing, because the expenses for payment of interest on loans are believed to be relatively fixed, i.e., the expenses which in other similar conditions would not decrease proportionally with the reduction in the sales volume of goods. Evaluation of this measure depends on the following positions: – the level of the ratio in other industries; – the possibilities for an enterprise to receive further loans; – stability of business performance. There is an approach in some books on economics that are devoted to various concerns about the balance sheet analysis, according

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to which the relationship between the share of equity capital and the break-even point of sales is determined. The concept of this approach lies in the assumption that nobody except the owners of an enterprise should be obliged to provide any capital required for performance of business activities during the period when the amount of sales does not cover all of the expenses according to the prime cost of the products as it has been established. Therefore, the higher the break-even amount, the larger equity capital must be made available. This directly proportional correlation is expressed in the following equation: Theoretical amount of equity capital / Break-even amount of sales = = Total liabilities / Amount of sales for the period. (11.10) Theoretical amount of equity capital = Break-even amount of sales – – Total liabilities / Amount of sales for the period. (11.11) Consequently, if the size of equity capital reflected in the balance sheet is lower than the theoretical amount, it can be concluded that the share of representation of equity capital in the relationship between income and expenses is low, but the structure of capital is risky for creditors. We expect that the estimate of the safe share of equity capital in the composition of liabilities according to the method shown will be useful for assessment of the financial stability for both the enterprise and its business partners. The ability of an enterprise to pay the interest out of its profit without touching the equity capital is represented by the measure called the interest cover: Interest cover = Profit before interest and tax / / Amount of interest payable.

(11.12)

This ratio should be well above 1; then it would mean that an enterprise is capable of paying for all interest out of its profit as well as that there are still spare resources left. If the ratio is 1, it means that an enterprise can only pay interest out of its profit, but then it would

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

not have any profit left and there would be no need to pay the income tax. There would be no net profit and the owners would not receive any dividends. If it is below 1, an enterprise has been operating at a loss, subsequently there is no profit, from which any interest payable should be covered and additional assets for payment of interest should be sought. 11.3. Indicators of financial stability of the enterprise, the method of their calculation The financial stability of an enterprise is an estimate risks associated with the financing of its work, thanks to attracted sources of funds. Any enterprise has two sources of financing activities: own and attracted. Own source of financing activities is a loan that is provided to the enterprise by its owner for the period during which its activities will be carried out. Accordingly, own source of financing is the amount that the enterprise does not give to the creditor. In addition, the financial stability of the enterprise is defined as a measure of providing the enterprise with the necessary financial resources to carry out economic activities and timely performance of its obligation. The attracted source of funds, on the contrary, is characterized by precisely defined terms of existence – up to the period when accounts payable must be repaid, i.e., existing credits are repaid by the credit from the counterparty of the enterprise, considering (counterparties) in general, this means whether the counterparty will deal with the lender of your company. Hence, the financial stability of the enterprise (when there is such a source of financing activities as creditor debts) is associated with the constant risks that the creditor will stop lending to the enterprise and it will remain without sources of financing. The analysis of profitability of the enterprise gives the picture of the financial stability of an enterprise, or rather its indicators, assesses these risks. An analysis of the profitability of an enterprise, taking into account this report, is related to a certain difficulty stemming

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from the issue how exactly the balance sheet is constructed on the grounds of property rights. The property that belongs to the company is taken into account separately from the property of another legal entity that is located in this company. Given this requirement, the asset balance can affect only property that belongs to the company on the property rights. The property that the organization owns is shown on the off-balance account. In a situation where the asset of the balance sheet shows only the proprietary property owned by the enterprise as a property, the liability of the creditor’s debt shows the amount of the external financing of only the transaction for which the enterprise can receive the given property or money. Finances of the enterprise are things that are owned by the company. The funds in the bank account of the organization are liabilities of the bank, its receivables to the company. In addition, if the subject of the activity of an enterprise is a property that does not belong to it as a property, it means that the counterparty of the company in this transaction finances its activity, invests in the corresponding asset. In fact, for example, to make a rental transaction, it is required that the landlords buy or manufacture certain property, that is, they invest money in it. It should also be noted that the lease contract (from economic point of view) is a loan that landlords provide to tenants, and rental fees are a percentage of these loans. Accordingly, for example, when a commission agreement is concluded, the committee finances the activities of the company. But, since the rule of constructing assets of the balance sheet on the grounds of property rights operates, the amounts of financing become invisible if account information of the accounting report is taken into consideration. Absolute financial stability (in practice – very rare) – situation in which working capital ensure that inventory and costs are well balanced. The coefficient of financial stability is an indicator which characterizes the ratio of own and borrowed funds of the company (how much borrowed money were raised by the company per one ruble invested in assets of its own funds). This coefficient is calculated:

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

KFS = equity / Borrowed funds.

(11.13)

It is considered normal when the ratio is greater than 1. The excess of own funds over debt indicates that the company has a stable financial position and is relatively dependent on external sources. There are four types of financial stability: absolute stability (if the company stocks are less than the sum of planned sources for their formation); normal resistance (in which the solvency of the company is guaranteed); unstable condition (which interferes with the balance of payments, but still may be possible to restore the balance of payment instruments and obligations); crisis. Net assets An important indicator in determining the stability of the enterprise is the sum of net assets. Net assets make the real value of equity. It shows that the owners of the company will remain after payment of all obligations in the event of liquidation. Net assets = Total assets – Taxes on acquired assets – Debt founders of contributions to the share capital – Cost of treasury shares from shareholders – Target funding and income – Long-term financial liabilities – Short-term financial obligations. It should be borne in mind that the net asset value is rather conventional, as it is calculated on the basis not of the liquidation balance and balance sheet in which assets are considered not at market, but at discount prices. Nevertheless, their value must be greater than the share capital. If the net assets are less than the value of share capital, a corporation necessarily reduce its share capital to the value of its net assets. And if the net assets are less than the minimum amount of the authorized capital, in accordance with the legislative acts it must decide to self-destruct. With the unfavorable ratio of net assets and the authorized capital the effort should be made to increase the net income and profitability, debt repayment by the founders of contributions to the charter capital.

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The relative financial stability indicators The financial condition of the company, its stability depends largely on the optimal structure of capital sources, i.e., the ratio of the debt to equity, on the optimal structure of the company›s assets, and primarily on the ratio of fixed and current assets, as well as the balance of assets and liabilities of the company. Therefore, you must first analyze the structure of venture capital sources and assess the degree of financial stability and financial risk. For this purpose, calculate: – The coefficient of autonomy (independence) – that is, the proportion of equity in the balance sheet. – The dependency ratio – i.e. the share of debt capital in the balance sheet. – Current debt ratio – i.e. the ratio of short-term financial liabilities to the balance sheet. – Financial stability ratio (long-term financial independence) – that is, the ratio of equity and long-term debt to the balance sheet. – Debt service coverage ratio equity (solvency ratio) – that is, the ratio of equity to debt. – Financial leverage ratio (ratio of financial risk) – i.e. the ratio of debt to equity. The higher the level of the coefficients (autonomy, financial stability, covering debt equity), and the lower the level of the coefficients (dependence, current debt, financial leverage), the higher is the stability of the financial condition of the company. Financial leverage is also called «leverage of financial leverage». For banks and other creditors it is preferred when the share of equity in a higher customer eliminates the financial risk. Companies are interested in debt financing for two reasons: – Interest on borrowed capital maintenance are treated as expenses and are not included in taxable income. – Interest expense is usually lower than the income generated from the use of borrowed funds in the company›s turnover, resulting in increased return on equity.

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability

In a market economy, a large and increasing proportion of equity does not mean the advancement of enterprise capabilities to respond quickly to changing business climate. On the contrary, the use of borrowed funds indicates flexibility of the enterprise, its ability to find and return the loans, that is, its credibility in the business world. Financial leverage The ratio of debt and equity funds is almost non-existent. The level of financial leverage depends on the industry characteristics of the enterprise. In those industries where slow-moving capital and a high proportion of long-lived assets is observed, financial leverage should not be high. In other industries, where the capital is turned over quickly and equity ratio is low, it may be much higher. Financial leverage is not only an indicator of financial stability, but also has a great influence on the increase or decrease in the value of income and equity of the enterprise. Financial leverage, i.e. the ratio of debt to equity capital is precisely the lever with which increases the positive or negative effect of financial leverage. The level of financial leverage shows how many times the growth rate of net income exceeds the rate of growth of the balance of income. This excess is ensured due to the effect of financial leverage, one of whose components is its shoulder, that is, the ratio of debt to equity. Increasing or decreasing the shoulder of financial leverage depending on the prevailing conditions, it is possible to influence the income and return on equity. Production leverage Financial stability of the enterprise is determined by the level of production and leverage. Production is also called leverage operating leverage. Its level indicates the degree of sensitivity to changes in income production. It is determined by the ratio of the rate of growth of income before interest and taxes to the growth rate of sales. With its high-value, even a slight decline or increase in production leads to a significant change in income. A higher level of leverage of industrial enterprises typically has a higher level of technical equipment production. The increase in the level of technical equipment is an increase in

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the proportion of fixed costs and the level of production of leverage. With the growth of the latter the risk of shortfall in revenue required to recover fixed costs increases. The greatest value of the coefficient of leverage has the production company with a higher ratio of fixed to variable costs. To determine the stock of financial stability it is necessary to deduct from the proceeds breakeven sales volume and divide the result by revenue. Break-even sales volume is determined by dividing the fixed costs in the cost of goods sold by the share of marginal income in revenue. It is necessary to constantly monitor the supply of financial stability, to find out how close or far the profitability threshold below which should not fall the company’s revenue is found. This is a very important indicator to assess the financial stability of the company. Ways to enhance the financial stability Ways to enhance the financial stability: – Acceleration of capital turnover. – A reasonable decrease in inventories and costs. – Completion of own working capital from internal and external sources. Tasks: 1. Explain the concept of the financial condition of the company. 2. Select one company on www.kase.kz. What are the main problems of analyzing the financial condition of the company? What are the main sources of financial analysis of a company? 3. Describe the coefficients of financial analysis according to the financial statements of your company. What relative indicators characterize the company’s financial stability? 4. What are the main ways to improve the financial sustainability of the enterprise. Explain your opinion. Activity 1. Based on the data of the income statement and the balance sheet of the company, assess the state of the receivables and payables, calculate the indicators of business activity and draw the appropriate conclusions. Activity 2. The value of the working capital of the corporation at the end of the reporting year was 25 million tenge, urgent liabilities amounted to 16.9 million tenge.

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability It is assumed that in the planned year the urgent obligations will not increase. What amount of income should be directed to the replenishment of working capital in order for the current liquidity ratio to reach the standard value in the planned period. Test questions: chapter 11 1. In a business context, financial condition is an analysis of a company’s equity position and profitability at a specific point in time, using __________________ a) financial statements, calculations and ratios b) balance sheets, cash flow statements c) income, expenses, assets and liabilities 2. Financial condition of the enterprise may be a) stable b) unstable c) crisis d) ABC 3. The main objectives of the analysis of the financial condition of the company: a) Search to improve the financial condition of the company, its solvency and financial stability; b) Development of specific measures aimed at more efficient use of financial resources and strengthening of the financial condition of the company c) Assessment of property and capital structure d) Evaluation of the effectiveness and usage of capital 4. The main sources of financial analysis of the enterprise are: a) lack of funds b) bad financial solvency c) statement of income and expenditure d) stockholders’ equity 5. Current assets or current liabilities are those with an expected life of fewer than a) 12 months b) 20 months c) 2 months d) 10 months 6. The financial condition of the enterprise is adopted to assess a) liquidity and solvency prospects b) long term prospects c) non-current assets prospects

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Corporate Finance 7. The following terms are liquidity indicators: a) Total liquidity b) Current assets c) Absolute liquidity 8. Calculating formulas of the quick ratio a) Quick ratio = Cash in till and in bank/ Current liabilities b) Quick ratio = Current assets – (Stock + Prepaid expenses) /Current liabilities c) Quick ratio = Cash + Short-term securities + accounts receivable / Current liabilities 9. Total liquidity ratio (overall coverage ratio) is calculated as: a) Total liquidity = Cash in till and in bank/ Current liabilities b) Total liquidity = Current assets / Current liabilities c) Total liquidity = Current assets – (Stock + Prepaid expenses) / Current liabilities 10. In accordance with the generally accepted international standards it is believed that this ratio must be within the limits of: a) 1 and 2 b) 0 and 1 c) 2 and 2.5 11. Calculate formulas of Absolute liquidity: a) Absolute liquidity ratio = Cash in till and at bank/ Current liabilities b) Absolute liquidity ratio = Cash + Short-term securities/Current liabilities c) Absolute liquidity ratio = Current assets – Current liabilities 12. Net current assets formulas a) Net current assets = Cash in till and at bank/ Current liabilities b) Net current assets = Cash + Short-term securities/Current liabilities c) Net current assets = Current assets – Current liabilities 13. Optimal amount of Working capital depends on several factors: a) the terms of the enterprise crediting b) net current assets c) debtors collection period 14. The main features of solvency are as follows a) Sufficient amount of cash on the current bank account and in till; due repayment of creditors debts b) Area of operations of an enterprise; size of an enterprise – the scope of production or sales c) Establish and describe the relationship of liabilities against the equity or the total amount of assets

11. EvaluaƟon of financial condiƟon of the corporaƟon: concept of financial stability 15.___ is one of the most significant criteria in assessment of the financial position of an enterprise: a) Assets b) Liquidity c) Solvency 16. Ownership ratio is calculated as: a) Ownership ratio = Equity capital+ Total assets b) Ownership ratio = Equity capital-Total assets c) Ownership ratio = Equity capital/ Total assets 17. Financial leverage is calculated as: a) Liabilities – Equity capital b) Liabilities/ Equity capital c) Liabilities + Equity capital 18. Liabilities/ Equity capital is calculated as: a) Profit before interest and tax + Amount of interest payable b) Profit before interest and tax/ Amount of interest payable c) Profit before interest and tax-Amount of interest payable 19. _______is an indicator which characterizes the ratio of own and borrowed funds of the company a) The coefficient of financial stability b) Financial leverage c) Net assets 20. It shows that the owners of the company will remain after payment of all obligations in the event of liquidation. a) The coefficient of financial stability b) Financial leverage c) Net assets

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12. DETERMINATION OF FINANCIAL INSOLVENCY OF CORPORATION

12.1. Financial relations of the enterprise in terms of economic insolvency and bankruptcy 12.2. Diagnostic system of financial crisis of an enterprise 12.3. Financial management of the processes of stabilization, reorganization and liquidation of an enterprise

12.1. Financial relations of the enterprise in terms of economic insolvency and bankruptcy Insolvency and bankruptcy are two dread words for any person or business. These are often baffling for a common man as he fails to differentiate between the two. The two terms are often used interchangeably but there are differences between the two. A business is said to be insolvent when the net assets are less than current net liabilities and bankruptcy follows insolvency. It is also insolvent when it is unable to pay its debts when they fall due. Bankruptcy is a legal term and a person or a business file for bankruptcy when they are unable to pay off their debts. Bankruptcy is a legal proceeding; when a person is in a financial mess and cannot repay his debts, he can file for bankruptcy in a court of law. In some countries such as the U.K., bankruptcy applies to a person or partnership and not to a business. A different legal term «liquidation’ is used instead. When a person is unable to meet his financial obligations and cannot repay his debts and his creditors start to threaten him, he may take 252

12. DeterminaƟon of financial insolvency of corporaƟon

recourse to bankruptcy. He files an application to a court to this effect and the court decides whether to liquidate his assets to settle the debts or to reorganize his loans to relieve the person so that he could be able to pay back his debts. Insolvency is similar to bankruptcy, and describes a condition when a person or a business is unable to pay debts when they fall due. It is not a legal term and just describes the condition of any business. When the cash flow in a business dries up and the liabilities cannot be met, the business is said to be insolvent though the assets may exceed the liabilities. Bankruptcy is however, not imminent, and there are ways to come out of insolvency. Normally businesses keep on going even when their balance sheet declares them to be insolvent and this is because of the cash inflows. Difference between Bankruptcy and Insolvency Bankruptcy is the last stage of insolvency. When it is clear that no other remedy is possible, an insolvent business may apply for bankruptcy. Insolvency is only a financial or accounting term, while bankruptcy is a legal term. In some countries bankruptcy applies to individuals, while insolvency applies to business. A business or a company do not file for bankruptcy, they rather face liquidation. If a business has become insolvent, it is not necessarily a bankrupt. Bankruptcy is a legal process to provide relief to a person whose business has become insolvent. At times businesses are insolvent as they have taken long term debts, but as long as they are paying their debts on time, though technically they are insolvent, they need not file for bankruptcy. There are many reasons for a person filing for bankruptcy such as poor cash inflow, unexpected recession, a natural disaster or poor business management. But one thing is clear that the person or business has clearly become insolvent and he cannot repay his debts on time. The creditors become restless and insist for their payments. When a business cannot face these threatening creditors, it can ask for government intervention and apply for bankruptcy to come out of insolvency. Key differences between Insolvency and Bankruptcy. The points presented to you, explain the difference between insolvency and bankruptcy in a detailed way:

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‒ Bankruptcy refers to a legal state in which an individual/company becomes bankrupt, whereas the Insolvency relates to a financial state where an individual/company becomes insolvent. ‒ Bankruptcy is caused due to the inability of paying off the outstanding debts while Insolvency arises due to the non-payment of financial obligations. ‒ Insolvency may not necessarily lead to bankruptcy while all bankrupt individuals/companies are insolvent. ‒ In Bankruptcy, the person/company goes to the court and voluntarily declares himself as an insolvent. ‒ Bankruptcy is initiated by the individual himself, wherein the person/company goes to the court and declares himself as an insolvent, therefore, the process is voluntary. On the other hand, insolvency is involuntary. ‒ Bankruptcy is the final stage of insolvency, resulting in winding up of an individual or entity’s assets. Conversely, Insolvency is for a particular time period only, until the business reaches a stage where it is ready to pay off outstanding debts. ‒ Bankruptcy severely affects the credit score of the individual or entity whereas Insolvency does not affect the credit score of the individual. Similarities: ‒ Both arise due to the non-payment of debts. ‒ Liabilities exceed assets. The development of market relations and the current economic situation increase the responsibility and independence of enterprises in the development and adoption of management decisions to ensure the effectiveness of activities. In these circumstances, in order to rationally organize financial activities, improve the efficiency of financial resources management, the company needs to conduct a financial analysis of these resources. Financial analysis is carried out in order to obtain an objective assessment of the solvency of the enterprise, its financial stability, business and investment activity, performance; identification of evidence showing the sufficiency or insufficiency of liquid property owned by the enterprise for the repayment of creditors’

12. DeterminaƟon of financial insolvency of corporaƟon

claims during the period of time that can be set by the court. When analyzing the financial condition of insolvent organizations, special indicators are used: ‒ Solvency in the narrow sense of the word estimates the corresponding coefficient. The formula of the indicator: Sc = total assets / ((the most urgent liabilities) + + (short – Term liabilities) + (Long-term liabilities)).

(12.1)

The grouping of liabilities is adopted for the purposes of financial analysis, the sum of these three elements corresponds to the full amount of actual debt to creditors, borrowers and suppliers of the company. This amount does not include deferred income and estimated liabilities, which, however, are recorded in the balance sheet as liabilities. The economic meaning of the Ratio indicator gives us the information on how much assets cover the amount of liabilities with their value, whether they will be enough to repay loans and to pay off the state and suppliers. Guideline value for index is >1. That is, assets should be enough to repay all liabilities. Current Ratio The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because shortterm liabilities are due within the next year. This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will be able to pay off current liabilities more easily when these become due without having to sell off long-term, revenue generating assets. The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric format rather than in decimal format. Here is the calculation:

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Current ratio = current assets / current liabilities.

(12.2)

Normative value for current liquidity ratio is >2. The optimal level of liquidity is influenced by the industry affiliation of the enterprise and its main activity. As a result, it is always necessary to compare not only with the General normative values, but also with the average industry indicators of the coefficient. Liquidity is the ability of an enterprise to meet its short-term debt obligations. Lack of liquidity may increase funding costs and result in the inability to make payments. There are several liquidity ratios. – The quick ratio is calculated as the ratio of highly liquid assets to current liabilities and must be greater than 1. Cal.term.liquidity = Liquid assets / Current liabilities.

(12.3)

This ratio shows whether the company in the event of a fall in sales volumes is able to cover its obligations to creditors. Liquidity of funds invested in receivables, is dependent on the speed of the payment document passing in the banks, the timeliness of registration of Bank documents, terms of commercial loans to individual buyers and their solvency. If the quick ratio is greater than 1, then the company has low financial risk, and thus the potential for attracting additional financial resources. – Absolute liquidity ratio as a ratio of cash and marketable securities to current liabilities. Cal. abs. liquidity = Absolutely liquid assets / Current liabilities. (12.4) The value of this ratio is sufficient, if it exceeds 0,2 – 0, 25. Of the two companies in a better financial situation is that one which has a large share of cash and marketable securities in current assets. When the value of the absolute liquidity ratio is less than 0.2, and the ratio is less than 0.5, the company is considered bankrupt and may be subject to liquidation with sale of property.

12. DeterminaƟon of financial insolvency of corporaƟon

– Interim liquidity ratio is the ratio of current assets to short-term liabilities. The coefficient shows the projected payment capacity of the enterprise subject to timely settlements with debtors. Normal value is not less than 0.5-0.8. Internal liquidity = (current asset is inventory and cost). – Total liquidity ratio (overall coverage ratio) is calculated as: COP. liquidity =Current assets / Current liabilities.

(12.5)

Normative is considered to be the value of this ratio greater than 2. When the value of the ratio is less than 2, the solvency of the company is insignificant, so there is a financial risk, both for the enterprise and for its partners. Low level of liquidity usually indicates a complication of marketing, or poor organization of logistics. With considerably high liquidity ratio (3,4) there is some doubt about the efficiency of use of circulating assets of the enterprise. – Coefficient of restoration of solvency: The description of this indicator is present in the Methodical position, which determines the assessment of the material situation of the company and the unsatisfactory state of its balance. In the document there is also an equation on which you can find the coefficient of solvency restoration. 12.2. Diagnostic system of financial crisis of an enterprise Diagnosis of financial crises is a system of targeted financial analysis aimed at identifying the parameters of the crisis development of the enterprise, generating a threat of bankruptcy in the coming period. Depending on the goals and methods of the enterprise bankruptcy diagnostics is divided into two main systems: 1) the system of express-diagnostics of bankruptcy; 2) the system of fundamental diagnostics of bankruptcy. Rapid diagnosis of financial crises (bankruptcy) characterizes the system of regular assessment of crisis parameters of financial develop-

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ment of the enterprise, carried out on the basis of its financial accounting data by standard analysis algorithms. The main purpose of rapid diagnostics of bankruptcy is early detection of signs of crisis development of the enterprise and preliminary assessment of scales of its crisis state. Rapid diagnostics of bankruptcy is carried out in the following main stages: 1. Determination of the objects of observation of the «crisis field» that implements the threat of bankruptcy. Experience shows that in modern economic conditions almost all aspects of financial activity of the enterprise can generate threat of its bankruptcy. Therefore, the system of observation of the «crisis field» should be based on the degree of generation of this threat by identifying the most significant objects on this criterion. From these positions, the system of observation of the «crisis field» of the enterprise can be represented by the following main objects: – net cash flow of the enterprise; – market value of the enterprise; – capital structure of the enterprise; – composition of financial liabilities of the enterprise on maturity; – composition of the company›s assets; – composition of current costs of the enterprise; – the level of concentration of financial transactions in high-risk areas. 2. Formation of a system of indicators to assess the threat of bankruptcy. The system of such indicators is formed for each object of observation of the «crisis field». In the process of formation, all indicators are divided into volume (expressed by an absolute sum) and structural (expressed by relative indicators). The given system of indicators for assessing the threat of bankruptcy of an enterprise can be expanded taking into account the peculiarities of its financial activities and diagnostic purposes. 3. Analysis of certain aspects of the crisis of financial development of the enterprise, carried out by standard methods. The basis of this analysis is the comparison of actual indicators with planned

12. DeterminaƟon of financial insolvency of corporaƟon

(normative) values and the identification of the size of deviations in the dynamics. The increase in the size of negative deviations in the dynamics characterizes the increase in the crisis phenomena of financial activity of the enterprise, generating the threat of its bankruptcy. In the process of the analysis of individual parties to the crisis of financial development of the enterprise, the following standard methods are used: horizontal (trend) financial analysis; vertical (structural) financial analysis; comparative financial analysis; analysis of financial ratios; analysis of financial risks; integral financial analysis. 4. Preliminary assessment of the scale of the financial crisis of the enterprise. This assessment is based on the analysis of certain aspects of the crisis development of the enterprise for a number of previous stages. The practice of financial management uses three fundamental characteristics in assessing the scale of the crisis financial condition of the enterprise: – mild financial crisis; – deep financial crisis; – financial disaster. The system of rapid diagnostics of bankruptcy provides early detection of signs of crisis development of the enterprise and allows you to take operational measures to neutralize them. Its preventive effect is most noticeable at the stage of a light financial crisis of the enterprise. At other scales of crisis financial condition of the enterprise it surely has to be supplemented with system of fundamental diagnostics. Fundamental diagnostics of financial crises (bankruptcy) characterizes the system of evaluation of parameters of crisis financial development of the enterprise, carried out on the basis of methods of factor analysis and forecasting. The main objectives of the fundamental diagnostics of bankruptcy are: – detailing of the crisis results of the evaluation parameters of the financial development of the enterprise obtained in the process of express-diagnostics of bankruptcy; – confirmation of the preliminary assessment of the scale of the financial crisis of the enterprise;

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– forecasting the development of certain factors generating the threat of bankruptcy of the enterprise and their negative consequences; – assessment and forecasting of the enterprise›s ability to neutralize the threat of bankruptcy at the expense of its internal financial potential. Fundamental diagnostics of bankruptcy is carried out in the following main stages: 1. Systematization of the main factors that determine the crisis financial development of the enterprise, factor analysis and forecasting are the basis of the fundamental diagnosis of bankruptcy, so the systematization of individual factors to be studied should be given a priority. In the process of study and evaluation, these factors are divided into two main groups: 1) not dependent on the activity of the enterprise (external or exogenous factors); 2) business-dependent (internal or endogenous factors). External factors of crisis financial development, in turn, are divided in the analysis into three subgroups: – socio-economic factors for the overall development of the country. As part of these factors only those that have a negative impact on the economic activity of the enterprise, i.e., form a threat of bankruptcy are considered; – market factors. When considering these factors, the negative trends in the development of commodity (both raw materials and products) and financial markets for this enterprise are investigated; – other external factors. The company›s discretion taking into account the specifics of its activities. Internal factors of crisis financial development are also divided in the analysis into three subgroups depending on the characteristics of the formation of cash flows of the enterprise: a) factors related to operating activities (inefficient marketing, inefficient current cost structure (high share of fixed costs), low level of use of fixed assets, high size of insurance and seasonal stocks, insufficiently diversified product range, inefficient production management);

12. DeterminaƟon of financial insolvency of corporaƟon

b) factors related to investment activities (inefficient stock portfolio, high duration of construction and installation works, significant over expenditure of investment resources, failure to achieve the planned volumes of profit on real projects, inefficient investment management); c) factors related to financial activities (inefficient financial strategy, inefficient asset structure (low liquidity), excessive share of borrowed capital, high share of short-term sources of borrowed capital, growth of accounts receivable, high cost of capital, excess of acceptable levels of financial risks, inefficient financial management). 2. Conduct of a comprehensive fundamental analysis using special methods to assess the impact of certain factors on the crisis financial development of the enterprise. 3. Forecast of the development of crisis financial condition of the enterprise under the negative influence of certain factors. This forecast is carried out on the basis of the development of special multivariate regression models, the use for this purpose of the methodological apparatus of SWOT analysis and other methods of analysis. The forecasting process takes into account the factors that have the most significant negative impact on financial development and generate the greatest threat of bankruptcy in the coming period. 4. Forecast of the enterprise’s ability to neutralize the threat of bankruptcy due to its internal financial potential. In the process of such forecasting it is determined by how quickly and to what extent the company is able to: – increase net cash flow; – reduce the overall amount of financial liabilities; – restructure its financial liabilities by transferring them from short-term to long-term; – reduce the level of current expenditures and the coefficient of operating leverage; – reduce the level of financial risks in its activities; – positively change the other financial indicators, despite the negative impact of certain factors,

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5. The final determination of the scale of the financial crisis of the enterprise. Identification of the scale of the financial crisis should include analytical and predictive results of fundamental diagnostics of bankruptcy and determine possible directions of restoration of the financial balance of the enterprise. The scale of the financial crisis of the enterprise and possible ways out of it: – in a moderate probability of bankruptcy (with a slight crisis), it is possible to normalize current financial activities; – in a high probability of bankruptcy (in a deep crisis), it is necessary to use internal mechanisms of financial stabilization; – in a very high probability of bankruptcy (in financial accident) it is necessary to recover the enterprise, that is to carry out reorganization, and in case of its unsuccessful performance – to liquidate the enterprise. Fundamental diagnostics of bankruptcy allows to get the most detailed picture of the crisis financial condition of the enterprise and to specify the forms and methods of its forthcoming financial recovery. Thus, the diagnosis is a system of targeted financial analysis aimed at identifying the parameters of the crisis development of the enterprise, generating a threat of bankruptcy in the coming period. The systems used to diagnose financial crises have their own application features, advantages and disadvantages, but have a common goal – to bring the enterprise out of the crisis and prevent bankruptcy [6]. Anti-crisis financial management is a system of principles and methods of development and implementation of a set of special management decisions aimed at preventing and overcoming financial crises of the enterprise, as well as minimizing their negative financial consequences. The main purpose of crisis financial management is to restore the financial balance of the enterprise and minimize the size of the decline in its market value caused by financial crises. In the process of realization of its main goal, the anti-crisis financial management of the enterprise is aimed at solving the following main tasks:

12. DeterminaƟon of financial insolvency of corporaƟon

1. Timely diagnosis of pre-crisis financial condition of the enterprise and the adoption of the necessary preventive measures to prevent the financial crisis. 2. Elimination of insolvency of the enterprise. 3. Restoration of financial stability of the enterprise. 4. Prevention of bankruptcy and liquidation of the enterprise. 5. Minimization of the negative consequences of the financial crisis of the enterprise. The system of anti-crisis financial management is based on certain principles: 1. The principle of constant readiness to respond. 2. The principle of preventive action. 3. The principle of urgency of response. 4. The principle of adequate response. 5. The principle of complexity of decisions. 6. The principle of alternative actions. 7. The principle of adaptive control. 8. The principle of priority use of internal resources. 9. The principle of optimality of external rehabilitation. 10. The principle of efficiency. Anti-crisis financial management of the enterprise is a process, the main content of which is preparation, adoption and implementation of management decisions to prevent financial crises, overcoming of that and minimizing its negative consequences. The process of anti-crisis financial management of the enterprise is based on the following main stages: 1. Implementation of continuous monitoring of the financial condition of the enterprise for the purpose of early detection of symptoms of the financial crisis. At the first stage, the system of general financial monitoring establishes a special group of monitoring objects that form a possible «crisis field», i.e. parameters of the financial condition of the enterprise, the violation of which indicates its crisis development. At the second stage, in the context of each of the parameters of the «crisis field», a system of observed indicators – «indicators of crisis development» – is formed.

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At the third stage, the frequency of observation of indicators – «indicators of crisis development» – is determined. At the fourth stage, the results of monitoring determine the size of deviations of the actual values of indicators – «indicators of crisis development» from the provided (planned, regulatory) ones. At the fifth stage, the analysis of deviations of indicators for each of the parameters of the «crisis field» is carried out. At the sixth stage, according to the results of monitoring, a preliminary diagnosis of the nature of the development of the financial activities of the enterprise and its financial condition is carried out. In the process of such a diagnosis «normal», «pre-crisis» or «crisis» financial condition of the enterprise is stated. 2. Development of a system of preventive measures to prevent the financial crisis in the diagnosis of pre-crisis financial condition of the enterprise. Anti-crisis financial management of the enterprise at this stage, characterized as «management by weak signals», is mainly preventive. At the first stage, the possibility of preventing a financial crisis in the conditions of the forthcoming dynamics of the factors of the external and internal financial environment of the enterprise is assessed. At the second stage, depending on the results of such an assessment, the directions of actions to prevent the financial crisis or to mitigate the conditions of its future course are differentiated. At the third stage, a system of preventive anti-crisis measures aimed at neutralizing the threat of the financial crisis is developed. At the fourth stage, the results of preventive anti-crisis measures determine their effectiveness and, if necessary, additional measures are taken. 3. Identification of the parameters of the financial crisis in the diagnosis of its occurrence. At the first stage, the scope of the financial activities of the enterprise is identified by the financial crisis, i.e. it is determined whether it is systemic or structural. If a financial crisis is identified as structural, its predominant structural form is determined. In the second stage, the degree of impact of the financial crisis on financial activities is identified, i.e. whether it is light, deep or catastrophic.

12. DeterminaƟon of financial insolvency of corporaƟon

At the third stage, taking into account the previous assessments, a possible period of the financial crisis of the enterprise is predicted. 4. Study of the factors that caused the financial crisis of the enterprise and generating the threat of its further deepening. This study is consistently carried out as follows: At the first stage, certain factors of the financial crisis are identified. In the process of such identification, their totality is divided into external and internal factors. At the second stage, the degree of influence of certain factors on the form and scale of the financial crisis of the enterprise in the context of individual parameters of the «crisis field» is studied. At the third stage, the development of factors of the financial crisis and their cumulative negative impact on the development of financial activities of the enterprise is predicted. 5. Assessment of potential financial capabilities of the enterprise to overcome the financial crisis. At the first stage, the volume of net cash flow of the enterprise generated in the crisis conditions of its functioning and the degree of its sufficiency to overcome the financial crisis are estimated. At the second stage, the state of insurance reserves of financial resources of the enterprise and their adequacy to the scale of the threats generated by the financial crisis is assessed. In the third stage possible areas of savings in financial resources of the enterprise in the period of occurrence of financial crisis (savings of current costs associated with the implementation of operational activities, savings investment resources due to the suspension of the implementation of separate real investment projects, etc.) are identified. At the fourth stage, possible alternative external sources of financial resources necessary for the operation of the enterprise in crisis conditions and ways of withdrawal of that from the financial crisis are determined. At the fifth stage, the qualitative state of the financial potential of the enterprise is assessed from the standpoint of possible overcoming the financial crisis – the level of qualification of financial managers, their ability to respond quickly to changes in the factors of the external

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financial environment, the effectiveness of the organizational structure of financial management, etc. 6. The choice of directions of financial stabilization mechanisms of the enterprise, adequate to the scale of its financial crisis. The choice of specific mechanisms of financial stabilization in the process of restructuring the main parameters of financial activity of the enterprise in the context of its crisis development should be aimed at the phased solution of the following tasks: – elimination of insolvency; – restoration of financial stability; – financial support of sustainable growth of the company in the long term. 7. Development and implementation of a comprehensive program to bring the company out of the financial crisis. A comprehensive plan of measures for the withdrawal of the enterprise from the financial crisis is developed in cases where it is envisaged to use mainly internal financial stabilization mechanisms within the scope of financial resources generated from internal sources. This plan contains the following main sections: – list of anti-crisis measures; – the amount of financial resources allocated for their implementation; – terms of implementation of certain anti-crisis measures; – persons responsible for the implementation of certain anti-crisis measures; – expected results of financial stabilization. The investment project of financial reorganization of the enterprise is developed in cases when the enterprise for an exit from financial crisis intends to involve external turnaround managers. Such a project is in the form of a business plan of rehabilitation and usually contains the following main sections: – general information about the sanitized enterprise; – assessment of the crisis state of the enterprise; – justification of the concept and form of reorganization of the enterprise;

12. DeterminaƟon of financial insolvency of corporaƟon

– system of proposed measures for financial recovery; – expected results of rehabilitation. After the development and approval of a comprehensive program to bring the company out of the financial crisis, the company begins its implementation. 8. Control over the implementation of the program of withdrawal of the enterprise from the financial crisis. 9. Development and implementation of measures to eliminate the negative consequences of the financial crisis. 12.3. Financial management of the processes of stabilization, reorganization and liquidation of an enterprise The main role in the system of crisis management of the enterprise is given to a wide use of internal mechanisms of financial stabilization. This is due to the fact that the successful use of these mechanisms can not only relieve the financial stress of the threat of bankruptcy, but also to a large extent to save the company from dependence on the use of borrowed capital, to accelerate the pace of its economic development. The main stages of the financial stabilization of the enterprise. – Elimination of insolvency – Restoration of financial stability (financial equilibrium) – Ensuring financial balance in the long term 1. Elimination of insolvency. No matter how much the scale of the crisis state of the enterprise is assessed by the results of bankruptcy diagnostics, the most urgent task in the system of measures of its financial stabilization is to restore the ability to make payments for its urgent financial obligations in order to prevent the occurrence of bankruptcy proceedings. 2. Restoration of financial stability (financial equilibrium). Although the insolvency of an enterprise can be remedied in a short period through a series of emergency financial transactions, the causes of insolvency may remain unchanged if the financial stability of the enterprise is not restored to a safe level.

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3. Ensuring financial balance in the long term. Full financial stabilization is achieved only when the company has provided a long-term financial balance in the course of its future economic development, i.e. has created the conditions for a stable decrease in the weighted average cost of capital used and a constant increase in its market value. This task requires accelerating the pace of economic development by making certain adjustments to certain parameters of the financial strategy of the enterprise. Adjusted for adverse factors, the financial strategy of the enterprise should ensure high rates of sustainable growth of its operating activities while neutralizing the threat of its bankruptcy in the coming period. Each stage of financial stabilization of the enterprise corresponds to its certain internal mechanisms, which in the practice of financial management are divided into operational, tactical and strategic. The tactical mechanism of financial stabilization, using separate protective measures, in the predominant form is an offensive tactic aimed at breaking the unfavorable trends of financial development and reaching the financial equilibrium of the enterprise. The strategic mechanism of financial stabilization is an exclusively offensive strategy of financial development, providing optimization of the necessary financial parameters, subordinated to the objectives of accelerating the entire economic growth of the enterprise. Let us consider in more detail the content of each of the internal mechanisms used at certain stages of financial stabilization of the enterprise. 1. The operational mechanism of financial stabilization is a system of measures aimed, on the one hand, at reducing the size of the current external and internal financial obligations of the enterprise in the short term, and on the other hand – at increasing the amount of monetary assets that ensure the urgent repayment of these obligations. The principle of «cut-off excess» underlying this mechanism determines the need to reduce both current needs (causing the corresponding financial liabilities) and certain types of liquid assets (for their immediate conversion into cash). The choice of the appropriate direction of the operational mechanism of financial stabilization is dictated by the nature of the real

12. DeterminaƟon of financial insolvency of corporaƟon

insolvency of the enterprise, the indicator of which is the coefficient of net current solvency. In contrast to the previously considered traditional coefficient of current solvency of the enterprise, it requires additional adjustment (determined by the crisis financial condition of the enterprise) of the composition of current assets and the composition of short-term financial liabilities. The following illiquid (in the short term) part of the current assets is excluded from the composition of the current assets: ‒ bad accounts receivable; ‒ illiquid stocks commodity-material values; ‒ expenses of future periods. The following internal part of short-term financial liabilities is excluded from the structure of short-term financial liabilities, which can be transferred to the period of completion of financial stabilization: ‒ calculation of accrued dividends and interest payable; ‒ settlements with subsidiaries (branches). Accelerated liquidity of current assets, ensuring the growth of positive cash flow in the short term, is achieved through the following key measures: ‒ liquidation of the portfolio of short-term financial investments; ‒ acceleration of cash collection of receivables; ‒ reduction of the period of provision of commodity (commercial) credit; ‒ increase in the size of the price discount at implementation of cash payment for the sold production; ‒ reduction of the size of insurance stocks of inventory; ‒ markdowns of hardly liquid types of inventories to the level of the demand price simultaneously ensuring their subsequent realization, etc. Accelerated partial disinvestment of non-current assets, ensuring the growth of positive cash flow in the short term, is achieved through the following main measures: – implementation of a highly liquid part of long-term financial instruments of the investment portfolio;

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– carrying out return lease operations, during which previously acquired property, plant and equipment are sold to the lessor with the simultaneous execution of their financial lease agreement; – accelerated sale of unused equipment at demand prices on the relevant market – lease of equipment previously planned to be acquired in the process of updating fixed assets, etc. The accelerated reduction in the amount of short-term financial liabilities, ensuring a decrease in the volume of negative cash flow in the short-term period, is achieved through the following main activities: ‒ prolongation of short-term financial loans; ‒ restructuring of the portfolio of short-term financial loans with the transfer of some of them to long-term; ‒ extension of the period of commodity (commercial) credit provided by suppliers; ‒ deferral of settlements on certain forms of internal accounts payable of the enterprise, etc. The objective of this stage of financial stabilization is considered to be achieved if the current insolvency of the enterprise is eliminated, i.e. the amount of cash flows exceeded the amount of urgent financial obligations in the short term. This means that the threat of bankruptcy of the enterprise in the current period of time is eliminated, although it is usually deferred. 2.The tactical mechanism of financial stabilization is a system of measures aimed at achieving the point of financial balance of the enterprise in the coming period. The principal model of financial balance of the enterprise has the following form: Net operating profits of the enterprise + The amount of depreciation + The amount of increase of joint-stock (share) capital when additional shares (increasing the size of shares in the authorized Fund) + Growth of their own financial resources through = Increase in the volume of investments financed by to the owners of the enterprise on the invested capital) + volume of the program of participation of employees in profit (payments at the expense of profit) + The volume of social, environmental and other external programs of the enterprise

12. DeterminaƟon of financial insolvency of corporaƟon

financed by profit + Increase in the amount of the reserve (insurance) fund of the enterprise. As it can be seen from the above formula, the right part of it consists of all sources of formation of own financial resources of the enterprise, and the left one, respectively – of all areas of use of these resources. Therefore, in a simplified form, the model of financial balance of the enterprise, to achieve which the enterprise seeks in a crisis situation, can be presented in the following form: The possible amount of generating its own financial resources of the enterprise = Necessary consumption of own financial resources of the enterprise. 3. Strategic financial stabilization program is a system of measures aimed at maintaining the financial balance of the enterprise in a long period. This mechanism is based on the use of the model of sustainable economic growth of the enterprise, provided by the main parameters of its financial strategy. The model of sustainable economic growth has different mathematical options depending on the basic indicators of the financial strategy of the enterprise. However, given that all these basic indicators are quantitatively and functionally interrelated, the results of the calculation of the main sought indicator – the possible rate of increase in the volume of sales (i.e. the volume of its operating activities) for this enterprise – remain unchanged. From the above model, decomposed into separate components of its elements, it can be seen that the possible rate of increase in the volume of sales that does not violate the financial balance of the enterprise, is the product of the use of four coefficients achieved at its equilibrium state at the previous stage of crisis management: 1) the return on sales; 2) the capitalization ratio of net profit; 3) the leverage ratio of assets (it characterizes the «financial leverage» with which the equity of the enterprise forms assets used in its economic activities); 4) the turnover ratio of assets. If the basic parameters of the financial strategy of the enterprise remain unchanged in the coming period, the calculated indicator will

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be the optimal value of the possible increase in the volume of sales. Any deviation from this optimal value will either require additional financial resources (disrupting the financial balance), or generate an additional amount of these resources, without ensuring their effective use in the operational process. If under the conditions of the commodity market, the enterprise cannot reach the planned rate of growth in the volume of sales or, conversely, can significantly exceed it, to ensure a new stage of financial equilibrium of the enterprise, appropriate adjustments should be made to the parameters of its financial strategy (i.e., the values of individual basic financial indicators are changed). Thus, the model of sustainable economic growth is a regulator of optimal rates of development of the volume of operating activities (increase in sales) or in its reverse version – the regulator of the main parameters of financial development of the enterprise (reflected in the system of the considered coefficients). It allows consolidating the financial balance achieved at the previous stage of crisis management of the enterprise in the long term of its economic development. The policy of anti-crisis financial management is a part of the overall financial strategy of the enterprise, which consists of the development of a system of methods of preliminary diagnosis of the threat of bankruptcy and the use of mechanisms of financial recovery of the enterprise, ensuring its exit from the crisis. The main objectives of the anti-crisis financial management are: – assessment of the crisis state; – elimination of insolvency; – the restoration of liquidity and financial stability; – stabilization of financial activity. Implementation of the anti-crisis financial management policy in the event of bankruptcy provides for the following stages: 1. Implementation of continuous monitoring of the financial condition of the enterprise for the purpose of early detection of signs of its crisis development. For these purposes, the system of general monitoring of the financial condition of the enterprise is a special group of objects of observation, forming a possible «crisis field», realizing the

12. DeterminaƟon of financial insolvency of corporaƟon

threat of its bankruptcy. In the observation process used both traditional and specific indicators – «the indicators of crisis development». 2. Determination of the scale of the crisis state of the enterprise. When significant deviations from the normal course of financial activity determined by the directions of its financial strategy and the system of planned and regulatory financial indicators are detected in the process of monitoring, the scale of the crisis state of the enterprise, i.e. its depth from the standpoint of the threat of bankruptcy, is revealed. This identification of the scale of the crisis state of the enterprise allows for an appropriate selective approach to the choice of the system of mechanisms of protection against possible bankruptcy. 3. Research of the main factors causing crisis development of the enterprise. Development of anti-crisis financial management policy determines the need for pre-grouping of such factors on the main defining features, the study of the degree of influence of individual factors on the form and scale of the crisis of financial development and forecast of the development of factors that have such a negative impact. 4. Formation of a system of goals for the exit of the enterprise from the crisis, adequate to its scale. The objectives of anti-crisis financial management are specified in accordance with the scale of the crisis state of the enterprise. It is necessary also to take into account the forecast of the development of the main factors determining the threat of bankruptcy of the enterprise. Taking into account these conditions, financial management at this stage can be aimed at the implementation of three fundamental goals, adequate to the scale of the crisis state of the enterprise: – elimination of insolvency of the enterprise: – restoration of financial stability of the enterprise (ensuring its financial balance in the short term); – change in the financial strategy to ensure sustainable economic growth of the enterprise (achieving its financial balance in the long term). 5. Selection and use of internal mechanisms of financial stabilization of the enterprise, corresponding to the scale of its financial crisis.

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Internal financial stabilization mechanisms are designed to ensure the implementation of urgent measures to restore solvency and financial balance of the enterprise at the expense of internal reserves. These mechanisms are based on the consistent use of certain models of management decisions chosen in accordance with the specifics of the economic activity of the enterprise and the scale of its crisis development. In the system of anti-crisis financial management of the company this policy is given priority. 6. Selection of effective forms and tools of rehabilitation of the enterprise. If the scale of the financial crisis of the enterprise does not allow to get out of it through the use of internal mechanisms and financial reserves, the enterprise is forced to resort to external assistance, which usually takes the form of its rehabilitation. Reorganization of the enterprise can be carried out as before and in the process of bankruptcy proceedings. In the first case, the company itself can initiate its rehabilitation and the choice of its forms. In the process of reorganization, it is necessary to justify the choice of the most effective forms and tools (including tools related to the reorganization of the enterprise) in order to achieve financial recovery as soon as possible and prevent the bankruptcy of the enterprise. 7. Ensuring control over the results of the developed measures to bring the company out of the financial crisis. Given the importance of the implementation of the developed measures for the subsequent life of the enterprise, such control is given priority. It is assigned, as a rule, directly to the heads of the enterprise. The main part of these activities is controlled in the system of operational controlling organized at the enterprise. The results of the control are periodically discussed in order to make the necessary adjustments aimed at improving the effectiveness of anti-crisis measures. Thus, the policy of anti-crisis financial management is part of the overall financial strategy of the enterprise, which consists in the development of a system of methods of preliminary diagnosis of the threat of bankruptcy and the use of mechanisms of financial recovery of the enterprise, ensuring its exit from the crisis [9].

12. DeterminaƟon of financial insolvency of corporaƟon Tasks: 1. What are the main differences and similarities between insolvency and bankruptcy? 2. Select one company on www.kase.kz. Describe the main systems for assessing the financial condition of the company: – quick diagnostics of bankruptcy of the company; – fundamental diagnostics of bankruptcy of the company. 3. Name and describe the external and internal factors of financial development of the crisis. 4. Explain the scale of the company’s financial crisis and possible ways out of it. 5. Identify the main stages of financial stabilization of the company. Activity 1. Determine the absolute liquidity ratio to establish the self-sufficiency of the company «AAA». For this, the following data are given: Cash – 500 000 tg. Investments – 780 000 tg. Buildings and facilities – 854 000 tg. Bank loan – 1 200 000 tg. Taxes, fees and other obligatory payments – 200 450 tg. Activity 2. In the Republic of Kazakhstan, enterprises often go bankrupt in order to gain control over property. On the other hand, there are a lot of enterprises in poor condition that are not declared bankrupt. Discuss: 1. Why such contradictory phenomena can occur? 2. What methods of establishing control over the company are used in practice? 3. What changes need to be made, so that enterprises really undergo a financial recovery, and would not replace only the owner? Test questions: chapter 12 1. Bankruptcy is… a) a legal proceeding; when a person is in a financial mess and cannot repay his debts, he can file for bankruptcy in a court of law. b) is similar to insolvency, and describes a condition when a person or a business is unable to pay debts when they fall due. c) not a legal term and just describes the condition of any business. 2. Insolvency is…. a) a legal proceeding; when a person is in a financial mess and cannot repay his debts, he can file for bankruptcy in a court of law. b) is similar to bankruptcy, and describes a condition when a person or a business is unable to pay debts when they fall due. c) not a legal term and just describes the condition of any business.

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Corporate Finance 3. Key Differences Between Insolvency and Bankruptcy: a) Arise due to the non-payment of debts b) Bankruptcy refers to a legal state in which an individual/company becomes bankrupt, whereas Insolvency relates to a financial state where an individual/company becomes insolvent c) Liabilities exceed assets 4. Key Similarities Between Insolvency and Bankruptcy: a) Arises due to the non-payment of debts. b) Bankruptcy refers to a legal state in which an individual/company becomes bankrupt, whereas Insolvency relates to a financial state where an individual/company becomes insolvent c) Liabilities exceed assets 5. The formula of the indicator of solvency a) Sc= Liquid assets / Current liabilities b) Sc =current assets/current liabilities c) Sc = total assets / ((the most urgent liabilities) + (short – Term liabilities) + (Long-term liabilities)) 6. The formula of Current Ratio a) Current ratio = current assets/current liabilities b) Current ratio = Liquid assets / Current liabilities c) Current ratio = total assets / ((the most urgent liabilities) + (short – Term liabilities) + (Long-term liabilities)) 7. The quick ratio is calculated as a) Cal.term.liquidity = current assets/current liabilities b) Cal.term.liquidity = Liquid assets / Current liabilities c) Cal.term.liquidity = total assets / ((the most urgent liabilities) + (short – Term liabilities) + (Long-term liabilities)) 8. When the value of the absolute liquidity ratio is less than 0.2, and the ratio is less than ….the company is considered bankrupt and may be subject to liquidation with sale of property. a) 0.5 b) 0.3 c) 1 9. Depending on the goals and methods of the enterprise bankruptcy diagnostics is divided into …main systems a) 3

12. DeterminaƟon of financial insolvency of corporaƟon b) 4 c) 2 10. The main objectives of the fundamental diagnostics of bankruptcy are… a) detailing of the crisis results of the evaluation parameters of the financial development of the enterprise obtained in the process of express-diagnostics of bankruptcy b) preliminary assessment of the scale of the financial crisis of the enterprise c) forecast of the development of certain factors generating the threat of bankruptcy of the enterprise and their negative consequences 11. External factors of crisis financial development, in turn, are divided in the analysis into three subgroups… a) Socio-economic factors for the overall development of the country b) Market factors c) Factors related to operating activities 12. Internal factors of crisis financial development are also divided in the analysis into subgroups depending on the characteristics of the formation of cash flows of the enterprise… a) Socio-economic factors for the overall development of the country b) Market factors c) Factors related to operating activities 13. Forecasting is determined by how quickly and to what extent the company is able to.. a) Increase net cash flow b) Socio-economic factors for the overall development of the country c) Market factors 14. The scale of the financial crisis of the enterprise and possible ways out of it… a) Very high probability of bankruptcy is b) The increase in net cash flow c) Factors related to operating activities 15. Anti-crisis financial management is….. a) preventive measures to avoid the financial crisis in the diagnosis of pre-crisis financial condition of the enterprise b) a system of principles and methods of development and implementation of a set of special management decisions aimed at preventing and overcoming financial crises of the enterprise, as well as minimizing their negative financial consequences

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Corporate Finance c) depending on the results of such an assessment, the directions of actions to prevent the financial crisis or to mitigate the conditions of its future course are differentiated 16. In the process of realization of its main goal, the anti-crisis financial management of the enterprise is aimed at solving the following main tasks: a) Elimination of insolvency of the enterprise b) Minimization of the negative consequences of the financial crisis of the enterprise c) The principle of adequate response 17. The system of anti-crisis financial management is based on certain principles: a) Elimination of insolvency of the enterprise b) Minimization of the negative consequences of the financial crisis of the enterprise c) The principle of adequate response 18. The main stages of the financial stabilization of the enterprise are.. a) Elimination of insolvency b) Restoration of financial stability c) Development and implementation 19. The following illiquid (in the short term) part of the current assets is excluded from the composition of the current assets….. a) bad accounts receivable b) calculation of accrued dividends and interest payable c) settlements with subsidiaries 20. The following internal part of short-term financial liabilities is excluded from the structure of short-term financial liabilities, which can be transferred to the period of completion of financial stabilization…. a) bad accounts receivable b) calculation of accrued dividends and interest payable c) settlements with subsidiaries

TASKS FOR INDEPENDENT SOLUTION

Task №1. Analyze early repayable corporate bonds with a nominal value of 2000 and a 15% coupon rate, where the second is paid once a year, with a maturity of 18 years and a condition of early redemption not earlier than in 3 years at the rate of 115% of the nominal value. The current bond rate is 119% of the nominal value. It is required to determine: a) the current yield of the bond; b) approximate yield to maturity; c) full yield to maturity; d) approximate yield to early repayment (recall); e) full yield to early repayment (recall). Task №2. You have the following data: a zero-coupon bond with a par value of 200 and a maturity of 1 year is sold for 194, and similar bonds, but with a maturity of 2 years, are sold at the rate of 184. It is required to determine: a) spot rates; b) yield to maturity of each bond. Task №3. You are considering a decision to acquire shares of a young airline. The size of dividends varied greatly from year to year. However, the company clearly maintains the share of dividend payments at the level of 35%. Financial statements show that last year the company’s net profit amounted to 1.9 billion dollars. Analysts say that the growth rate of the net profit in the first year will be 6%, in the second – 9%, and in the third year – 8%. After that, everyone expects the onset of stabilization and predict a growth in financial indicators of 3%. It is also expected that after entering the stable phase, airline managers will decide to reduce the share of net profit spent on investments to 30%. The required return on investment in shares of this company is 10%. The number of shares circulating on the market is 245 million units. Determine the true value of one share of the airline. Task №4. Determine the yield to maturity corporate bonds with a par value of 1000 and a 10% coupon rate, 10 years left to maturity and the current rate of which

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Corporate Finance leaves 108% of the nominal. Perform calculations based on two different payment schemes: annual and semi-annual payments. Task №5. Suppose you bought a corporate bond with a maturity of 10 years, with a par value of 1000 and a coupon rate of 8%, which is paid once a year. Immediately after you had performed this operation, the market rates increased to 10%, and this level is fixed. Determine your yield if you sold this bond 3 years later. Task №6. Suppose two bonds with the same 2 year maturity and risk bring coupon income of 100 and 90, respectively. Suppose also that the spot rate for investments with a maturity of 1 year is 6% and for a period of 2 years – 12%. a) determine the total yield to maturity of each bond; b) explain the results of your calculations. Task №7. In 2009, the company paid dividends of € 0.87 per share, and at the same time received profit of 2.18 euros per share. Over the past 5 years, earnings per share grew by 12% annually, but its rate will decrease evenly over the next 10 years to the level of 5%. The dividend payout ratio will remain unchanged. The required return on investment in the shares of this company is 8%. The current stock price is 35.20 euros. a) determine the true value of the company’s common stock; b) give a detailed commentary on the result, what investment strategy would you recommend to an individual investor who is not risk averse? Task №8. Firm Salem has debt commitments. If the firm were free from debt, the total value of its shares, based only on operating income, would have been 9,000 dollars. The market value of the debt is $ 5,000, the interest rate is 10%, the tax rate is 30%, personal tax on bond income is 10%, and on equity income – 15%. The ratio of «owner›s quota» (debt to equity) is equal to 3.0. In the event of bankruptcy, the costs should be 9000 dollars, and the probability of bankruptcy is 0.5. Find the value of the company Salem. Task №9. Calculate the planned costs, if you know that the remnants of unsold products at the beginning of the year were 2 896 000 tg, commercial products for the planned year were at the cost of 27,500,000 tg, the balance of unsold products at the end of the period was 650 000 tenge. Non-manufacturing costs amounted to 220 000 tg. Task №10. The balance of unallocated products at the beginning of the year for the production made 600 000 tg., non-manufacturing costs – 500 000 tg. In the course of financial and economic activities, by the end of the year the company had balances of unsold products totaling 450,000 tons. The unit cost of production was 95 tg. A total of 380,000 items were sold. Find planned costs.

Tasks for independent soluƟon Task №11. The enterprise costs for wages and social tax per unit of product are 26 000 tg., The average annual wage of 1 worker is 549 120 tg. Average annual output per worker is 15 600 280 tg. The planned release is 12 566 units of products. Determine the savings from cost reduction due to productivity growth. Task №12. The company manufactures products of the same name at the price of 2300 tenge per unit. Unit variable costs are 1800 tenge. The total amount of fixed costs is 5500 tenge. As a result of rising rent, total fixed costs will increase by 8%. Determine how the increase in fixed costs will affect the break-even point (profitability threshold). Task №13. In the first quarter, the specific variable cost of the product amounted to 950 tenge. The unit price is 1,250 tg, total fixed costs amounted to 2,000 tg. In the second quarter, as a result of rising commodity prices, variable costs increased by 10%. Determine how the change in commodity prices affected the profitability threshold. How to change the threshold of profitability, if the company increases the price by 5%? Task №14. The joint-stock company issued ordinary shares for 10 million tenge, preferred shares – for 1 million tenge with a 50% dividend and a bond loan of 2 million tenge with payment of 30% per annum. How to determine the net profit of 1200 tg. to pay income on: 1) common shares; 2) bonds; 3) preferred stock. Task №15. The company has invested 25 million tenge. and made a profit of 6 million tenge. Prices for the year increased by an average of 30%, and a decrease in the rate of inflation is not expected. It is necessary to decide what part of the profit can be withdrawn from circulation and sent to the consumption fund. Task №16. Calculate the economic feasibility of the project under the following conditions: the amount of investment is 30 million tenge, the project implementation period – 5 years, revenues by year (thous. tenge) – 7000, 8500, 9000, 9000, 8000. Current discount rate is 15%, the average annual inflation index is 10%. Determine the net present value (NPV): a) excluding inflation; b) adjusted for inflation. Task №17. Company «ССС» is analyzing the possibility of changing its own capital structure. Before the changes, the market price of the company’s shares was $ 200. per share. The company issued only 2,000 ordinary shares. Currently, the company partially finances its activities by placing risk-free one-year zero-coupon bonds, the total current market value of which is 20,000 dollars. Suppose an investor owns 200 shares. The company plans to buy 500 tradable shares worth $ 50,000 and

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Corporate Finance finance the ransom by issuing risk-free bonds on 50,000 dollars It assumes an ideal capital market and no transaction costs. a) show how an investor can offset the change in the level of a company›s debt in order to receive such cash flows, whatever they would be if the original capital structure was maintained; b) comment: «In the absence of transaction costs, the investor is indifferent to changes in the capital structure of the company». Task №18. The following source of information is available. The company’s activity is characterized by the following main indicators: – sales revenue – 2800 000 tenge; – the sum of variable costs in the cost structure – 1600 000 tenge; – the amount of fixed costs in the cost structure – 145 000 tenge. The company plans to increase sales revenue to 1350 000 tenge without going beyond the relevant range. Based on the data provided, it is required: 1. To calculate the amount of profit corresponding to the new level of revenue from sales using the operating lever. 2. To assess the estimated level of the enterprise’s capital-output ratio and the degree of its entrepreneurial risk. Task №19. The company’s net profit is equal to 997 000 tenge, depreciation is equal to 45 800 tenge. Information about the change in the assets of the company and its liabilities is as follows: Accounts payable to employees for the period make 82,600 tenge, payables to suppliers for the period make 5420 tenge, tax arrears for the period – 22,600 tenge, accounts receivable for the period – 401250 tenge. The increase in the reserves amounted to 341650 tenge. Determine the cash flow for the operating activities of the company. Task №20. Conduct financial diagnostics of the company. It is necessary to diagnose the profitability of the enterprise and the reasons that led to the change in profitability according to the table: Indicators Proceeds from sales of products, thousand. Variable costs, thousand Fixed costs, thousand Equity capital, thousand Long-term loans, thousand Short-term loans, thousand Average estimated interest rate,% Tax rate,%

Values 30000 17000 5000 17000 2200 1300 15 15

REFERENCES

1. Kaderova N.N. Corporate Finance. – Almaty: Economy, 2008. – 376 p. 2. Kramarenko T.V., Nesterenko M.V., Shchennikov A.V. – Corporate Finance. Flint, 2014. – P. 187. 3. Blank I.A. Fundamentals of financial management: scientific publication, volume 1, 2nd edition, revised and enlarged. – Kiev: Elga, Nika-Center, 2004. 4. Borisova O.V. Corporate Finance: Textbook and Workshop for Academic Bachelor / O.V. Borisova, N.I. Malykh, Yu.I. Gryshchenko. – Lyubertsy: Yurait, 2016. – P. 621. 5. Kovalev, V.V. Corporate Finance and Accounting: Concepts, Algorithms, Indicators: Study Guide / V.V. Kovalev, V.V. Kovalev. – M.: Prospect, 2013. – P. 880. 6. Leontiev, V.E. Corporate Finance: textbook / V.E. Leontyev, V.V. Bocharov, N.P. Radkovskaya. – Lyubertsy: Yurait, 2016. – P. 331. 7. Nikitina, N.V. Corporate Finance: textbook / N.V. Nikitina, V.V. Yanov. – M.: KnoRus, 2013. – P. 512. 8. Nikitushkina, I.V. Corporate Finance: a textbook for academic bachelor / I.V. Nikitushkina, S.G. Makarova, S.S. Studnikov. – Lyubertsy: Yurayt, 2015. – 521 p. 9. Solovyova, N.A. Corporate Finance (for bachelors) / N.A. Solovyova, M.V. Sentsova. – M.: KnoRus, 2013. – P. 512. 10. Teplova, T.V. Corporate Finance: A textbook for bachelors / T.V. Teplova. – M.: Yurayt, 2013. – P. 655. 11. Zhurikov, K.K. Corporate Finance: studies. / Kenes Kazhgereevich Zhurikov, Serik Aytakhynovich Alpysbayev. – Ed. 2nd, revised and enlarged. – Almaty: KazATK, 2006. – 405, (3) p. 12. Roberts, M.V. A Workshop on Corporate Finance / M.V. Roberts, Vladimir State University named after A.G. and N.G. Stoletovs. – Vladimir: VlSU Publishing House, 2013. – 56 p. – ISBN 978-5-9984-0330-9.

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Corporate Finance Normative and legal acts: 1. Civil Code of the Republic of Kazakhstan (General part) (with amendments and additions as of 01.01.2019) 2. The Enterprise Code of the Republic of Kazakhstan (with amendments and additions as of 01.01.2019) 3. Law of the Republic of Kazakhstan dated May 2, 1995 No. 2255 On business partnerships (as amended and additions as of 01.01.2019) 4. Law of the Republic of Kazakhstan dated May 13, 2003 No. 415-II On joint-stock companies (with amendments and additions as of 01.01.2019) 5. Law of the Republic of Kazakhstan «On Financial Leasing» dated July 5, 2000. №78-11254 (with amendments and additions as of 01.01.2019) 6. Law of the Republic of Kazakhstan «On Bill of Exchange in the Republic of Kazakhstan» dated April 28, 1997. №97-1 (with amendments and additions as of 01.01.2019) 7. Law of the Republic of Kazakhstan «On Registration of Pledge of Movable Property» dated June 30, 1998. No. 254 (with amendments and additions as of 01.01.2019) Internet resources: Official website of the Ministry of Finance: www.minfin.kz Official website of NBRK: www.nationalbank.kz Official website of the Kazakhstan Stock Exchange: www.kase.kz Customs Control Committee: www.customs.kz Financial Control Committee: http://goszakup.kz Agency of Statistics of the Republic of Kazakhstan: www.stat.gov.kz http://www.gazprom.com/ Useful links for self-study: 1. www.smallbusiness.chron.com 2. www.managementstudyguide.com 3. www.investopedia.com 5. www.scopus.com 6. www.elsevier.com

Еducational issue

Daribayeva Meruyert Zhumabayevna CORPORATE FINANCE Educational manual Editor V. Popova Typesetting G. Kaliyeva Cover design Y. Gorbunov Cover design photos were used from sites www.background-2672597_960_720.com

IB No.13416

Signed for publishing 03.03.2020. Format 60x84 1/16. Offset paper. Digital printing. Volume 17,81 printer’s sheet. 100 copies. Order No.2421. Publishing house Qazaq University Al-Farabi Kazakh National University KazNU, 71 Al-Farabi, 050040, Almaty Printed in the printing office of the Qazaq University Publishing House.

Новые книги издательского дома «ҚАЗАҚ УНИВЕРСИТЕТІ» Ли В.Д. Финaнсы: учеб­ное по­со­бие / В.Д. Ли, A.К. Мустaфинa, Л.A. Би­мен­диевa. – Алматы: Қазақ университеті, 2019. – 336 с. ISBN 978-601-04-4372-3 В учеб­ном по­со­бии рaсс­мот­ренa спе­ци­фикa и зaко­но­мер­нос­ ти оргa­низaции финaнсо­вой сис­те­мы стрaны, уде­ле­но внимa­ние осо­бен­нос­тям рaбо­ты эко­но­ми­ки и финaнсов об­ще­ст­вен­но­го сек­торa, рaск­ры­ты со­держa­ние и роль в эко­но­ми­ке го­судaрст­вен­но­го бюд­жетa, рaсс­мот­ренa ст­рук­ турa и клaсси­фикaция до­хо­дов и рaсхо­дов бюд­жетa. Цель учеб­но­го по­со­бия – в мaксимaльно прос­той фор­ме ознaко­ мить читaте­ля с ос­нов­ны­ми воп­росaми финaнсо­вой дея­ тель­ности, уде­лив внимa­ние казахстанским осо­бен­нос­тям данной рaбо­ты. Учеб­ное по­со­бие преднaзнaчено сту­ден­там всех эко­но­ми­чес­ ких спе­циaль­нос­тей для под­го­тов­ки к прaкти­чес­ким зaня­ тиям, к ВОУД (внеш­ней оцен­ки учеб­ных дос­ти­же­ний), a тaкже к ито­го­вым го­судaрст­вен­ным экзaменaм. Джулaевa A.М. Оргa­н изaция биз­н есa: учеб­н ое пособие / A.М. Джу­лaе­вa. – Алматы: Қазақ университеті, 2019. – 240 с. ISBN 978-601-04-4231-3 В ус­ло­виях ры­ноч­ной эко­но­ми­ки ус­той­чи­вое эко­но­ми­чес­кое рaз­ви­тие стрaны нaпря­мую зaви­сит от уров­ня рaзви­тия предп­ри­нимaтельской дея­тель­ности. Кaк от­мечaет­ся в Послa­нии Первого Пре­зи­дентa Рес­пуб­ли­ки Кaзaхстaн Н.A. Нaзaрбaевa, рaзви­тый предп­ри­нимaтельс­кий сек­тор – это ос­новa эко­но­ми­ки лю­бой стрaны. Имен­но поэто­ му при под­го­тов­ке спе­циaлис­тов воп­росaм оргa­низaции предп­ри­нимaтельствa и биз­несa необ­хо­ди­мо уде­лять осо­ бое внимa­ние обрaзовaте­льному про­цес­су. В учеб­ном по­со­бии «Оргa­низaция биз­несa» рaссмaтривaют­ ся те­о­ре­ти­чес­кие ос­но­вы и прaкти­чес­кие aспек­ты оргa­ низaции биз­несa в со-вре­мен­ных ус­ло­виях рaзви­тия эко­ но­ми­ки Кaзaхстaнa. Учеб­ное по­со­бие преднaзнaче­но для бaкaлaвров эко­но­ми­чес­ ких спе­циaль­нос­тей, мaгистрaнтов и пре­подaвaте­лей ву­ зов, кол­лед­жей.

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