9/20/2019

Finance Function
Shakilah Nagujja

Functions of a Finance Manager

• Estimating required finances and purposes for which they are needed
• Identifying the cheapest sources of finance
• Planning a fair return to the shareholders
• Planning and controlling the utilization and financing to ensure most
efficiency of operations and also ensure that the firm remains solvent.
• Generating and building internal surplus to finance growth and expansion

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Scope of the Finance Function

• Acquisition of funds
This involves determining the financing mix/capital structure of the firm. Funds have
to be raised from the cheapest and most effective sources in order to maintain an
optimal capital structure.

• 2. Utilization of funds
Funds raised have to be invested or utilized in the most efficient manner. Management
therefore has to make a decision on how much to invest in both current assets and
fixed assets.

Fixed Assets
• The decision on how much to invest in fixed assets requires management to
carry out capital budgeting.
• Capital Budgeting is the evaluation of the long term investment proposals
that a company has on hand.
•
• Capital Rationing is the selection of the best investment proposal after
evaluation given the financial constraints

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Determining Capital Requirements Mix

and Sources
• This generally involves estimation of fixed capital requirements, determining
working capital requirements and the capital structure to be adopted by the
company.
• It also involves examining the various sources of finance.

Determining Capital Requirements Mix

and Sources
Capital requirements mix involves both fixed and working capital
• Determining Fixed Capital
Fixed capital is the investment in fixed assets like plant and machinery, land, building,
furniture and patents. Fixed assets are used to meet the long term obligations of a
company. The amount of fixed capital acquired usually depends on the nature and

• Determining working capital

Working capital is the capital invested in current assets like inventory, debtors and bills
receivable. Working capital meets the short-term obligations of a company.

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Factors that determine Working Capital

• Labour intensity
• Proportion of the cost of raw materials to total cost
• Length of the production process
• Rapidity of turnover
• Terms of credit granted to customers
• Terms of credit given by suppliers
• Seasonal variations
• Market conditions (competition)
• Reliability of suppliers
• Nature of the business
• Source of funds-debentures used encourages payment of interest hence increase in working capital

Capital Structure
• This refers to the composition of a firm’s long term sources of finance.
• It also refers to the mix of both owners’ and borrowed capital adopted by a
firm.

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Factors that Determine the Capital Structure

• Trading on equity: This is the ability of the firm to employ debt in its capital structure to magnify the
earnings of its equity shareholders. A firm is said to trade on equity if the cost of debt is less than the
benefits realized from employing debt. The general return on investment is higher than the fixed rate of
interest and fixed preferred dividend. Equity shareholders, therefore get additional profit.
• Control of the company: When companies want to retain the prepared shareholders and where promoters
want to retain control of the company, they will raise a larger part of the capital by issues of debentures and
preferred shares because these don’t want to lose any of their voting rights.
• Nature of the Business: Less debt should be employed for high risk businesses and the opposite is true.
• Legal requirements: Sometimes, the law dictates as to what classes of shares and debentures are to be
issued. Companies have to comply with this. In addition, the controllers of Capital Issues Act usually
requires companies to have a debt-equity ratio of 2:1
• Growth rate: Rapidly growing firms need to rely more on debt in order to sustain their growth.

Factors that Determine the Capital Structure

• Profitability: Firms that are highly profitable usually use little debt in their capital structure.
• Interest on debt is a tax deductible expense whereas dividend payment is not. Therefore,
the higher the tax rate, the greater the incentive to employ debt capital.
• Attitude of Management: Conservative managers fear to take risk and therefore tend to
rely on use of more equity capital than debt in the company’s capital structure.
• Attitude of lenders – willingness of the lenders to provide borrowed capital.
• Timing in the Market: Prices of shares Vs the interest charged on borrowed capital

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Sources of Capital
• Owned capital
i) Share capital
ii) Retained earnings
b) Borrowed capital
i) Debenture issue
ii) Loans
III) Capital markets products.

Sources of Capital
Long term sources • 3) Preference shares
• Equity shares
• Debentures Short term sources
• Retained earnings • Trade credit
• Loans from financial institutions • Overdraft (Bank credit)
• Preference shares • Short term loans
• Bonds • Purchase/discount of bills
Medium term sources • Letters of credit
• 1) Term loans • Factoring
• 2) Debentures

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Equity shares/ Issue of Shares

A share is a participation in the provision of capital for a company. In case of public companies, issue, of shares is done by inviting members of the public
through the prospectus to buy shares.
Types of Shares
• Ordinary/equity shares
• Preference shares
Ordinary shares
These shares have got the following features:-
• Equity capital cannot be paid back during the life time of the company.
• The rate of dividend got by the shareholders depends on profits earned
• The dividend on ordinary shares is paid after paying the dividend on preference shares
• Ordinary shareholders have full voting rights therefore the control of the company lies with them.
• In case of liquidation, ordinary shareholders are the residual claimants of the assets of the company.
• Ordinary shareholders are risk takers hence the capital they provide is sometimes referred to as venture capital

Equity shares/ Issue of Shares

Preferred/ Preference shares
• These shares which carry a preferential right regarding both payment of dividends and return of
capital
Features of Preferred shares
• Preference shareholders receive a fixed rate of dividend
• Preference shareholders carry preferential voting rights
• The dividend on preference shares is paid before that of equity shareholders
• Preference shares may be participating or non participating, redeemable or irredeemable, cumulative or
non-cumulative and convertible or non-convertible.

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• Participating preference shareholders are those that are also included in sharing of dividends with
ordinary share holders after getting their own fixed dividends while Non participating share holders are
not included in the sharing of dividends with ordinary share holders after getting their fixed dividends.
• Redeemable preference shares are those whose share capital is paid during the life time of a company
while irredeemable, their share capital can’t be paid during the life time of a company.
• Cumulative vs. Non-cumulative: Cumulative shares are those where if the company is not making
profits in any given period, dividend payment for that particular period is transferred to the period when the
company makes profits where as the opposite is true for non – cumulative shares
• Convertible Vs. non – convertible: Convertible preference shares are those that can be converted into
equity shares of the issuing company after a predetermined period of time where as non – convertible
preference shares can’t be converted into equity shares of a liable or issuing company.

• Read about the advantages and disadvantages of ordinary shares

• Read about the advantages and disadvantages of preference shares

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Debenture
• A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount
with interest and although the money raised by the debentures becomes a part of the company's capital structure, it does not
become share capital.
• A debenture is an acknowledgement, under seal, of a debt or a loan.
Features of Debentures
• Debentures create a fixed charge on the assets of the company
• They carry a fixed rate of interest which has to be paid regardless of whether the company has made profits or not.
• They are normally redeemed after a specified period
• When a company is forced into liquidation, debenture holders are paid before preference and ordinary shareholders.
• Interest on debenture is paid before payment of dividend to shareholders.
• Debentures are generally freely transferable by debenture holders.

Types of Debentures
• Convertible debentures – These are securities that can be converted into equity
shares of the issuing company after a predetermined period of time. Convertibility
is a feature that corporations may add to these securities to make them attractive to
the buyers and they tend to have lower interest rates than non -Convertible
securities due to this advantage.
•
• Non - Convertible debentures – Can’t be converted into equity shares of a liable
or issuing company. Due to lack of this feature, they usually carry high interest rates
than convertible ones

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• Read about the advantages and disadvantages of debentures as a source of

capital

Bonds
A bond is a formal contract to repay borrowed money with interest at fixed intervals
It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed
the maturity date.
Key terms in bonds
• Nominal/ Principal / face value/ issue price – Price at which investors buy the bonds and amount which has to be paid at the end.
• Maturity Date- The date at which the issuer has to repay the nominal amount.
• Coupon – the interest rate that the issuer pays to bond holders.
Types of bonds
• Fixed rate bonds – Have a coupon that remains constant through out the life of a bond.; A fixed rate bond is a long term debt paper that carries a predetermined
interest rate.
• Floating rates bonds – Have a variable coupon that is recalculated periodically, typically every one or three months. are bonds that have a variable coupon, equal to a
money market reference rate,
• Zero – coupon bonds – Pay regular interest. They are issued at a substantial discount so that the interest is effectively rolled up to maturity.
• This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value.

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Retained Earnings
• These are undistributed portions of profits of the company. A company
ploughs back profits which are converted into reserves and used for the
financial requirements of the company.
• Ploughing back of profits or internal financing is especially useful in times of
depression.
• Read about its advantages and disadvantages

Medium Term Financing

Term loans
• There are medium term loans which are usually issued for a period of about 3-7
years. They are usually issued by commercial banks and development banks like the
Uganda Development Bank (UDB) in Uganda. The interest on these loans is
slightly higher than that on long term loans but at the time lower than that charged
on short-term (commercial) loans.

• In Uganda, the procedure for getting such loans is very lengthy and this may lead to
loss of profitable opportunities by companies that wish to acquire such loans

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Short Term Financing

• Trade Credit
• This is credit given by manufacturers, wholesalers and retailers at the incidence of sale. The usual duration
of such credit is usually 30-90 days no interest is expressly charged.
Factors to consider while determining trade credit
• Earnings record over a period of time. A firm with high earnings is looked at favourably by suppliers.
• Liquidity position of the firm.
This is usually measured by studying the acid test and current ratios of the firm.
• Record of payment
This helps in determining the credit worthiness of the firm.

Short term Financing

Bank Overdraft
• The customer is allowed by the bank to overdraw against his current account and pay interest on it. The borrower can
draw as often as he requires provided the outstanding do not exceed the overdraft limit. He also enjoys the facility of
paying back and when he requires. Interest is charged only on the running balance, not on the limit sanctioned.
Short term/Commercial loans
• These are advances of fixed amounts which are credited to the current account of the borrower. Interest is charged on the
entire loan amount, irrespective of how much he draws. Loans are payable on demand or in periodical installments using
post dated cheques or demand promissory notes. Penalty interest is charged if payments are made on time.
Letters of Credit (Indirect form of bank credit)
• Is an arrangement whereby a bank helps its customer to obtain credit from his suppliers. When a bank opens a letter of
credit in favour of its customers for some specific purposes, the bank undertakes the responsibility to honor the obligation
of its customers should the customers fail to do so.

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Assignment
Read about Capital Markets i.e.
• Definition Capital Markets
• Capital Markets Authority
• Uganda Securities Exchange
• Products on the USE / Uganda’s Capital Markets
• Companies listed on the USE
• Requirements for listing on the USE

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