The price level changes are a common phenomenon and will introduce entirely new distortions into ROI and RI measures. The principal distortions occur because revenues and cash costs are measured at current prices, while the investment cost and depreciation charge are measured at historical prices used to acquire the assets. Depreciation based on historical cost underestimates what the depreciation charge would be based on the current cost. This results in overstating the firm’s income. At the same time, the firm’s investment is understated, because most of firm’s assets were acquired in precious years at lower price levels than those currently prevailing. The combination of overstated net income and understated investment causes the ROI or RI measures to be much higher than if inflation had not occurred. The increased ROI or RI is not a signal of higher profitability and it is mainly due to a Continue reading
Financial Management Concepts
Relationship Between Agency Theory and the Existing Accountancy Practices
The agency theory is a mixture of the relationships between principals and agents, it occurs when the principal and the agents create a delegation. The agency theory argues that in modern corporations, where share ownership is widely held, managerial actions depart from those required to maximize the shareholder’s return. In Agency theory terms, the owners are principals and the managers are agents and there is an Agency loss which is the extent to which returns to the residual claimants, the owners, fall below what they would be if the principals, and the owners, exercised direct control of the corporation. The long-term strategies for agency theory include the principle of the company, business, franchise, etc. providing incentives such as increasing commission, continuing to provide advertising, training, and motivation to increase outlet operations. Regarding the exogenous factor, outlet managers have an incentive to shirk and misrepresent their abilities because the firm is Continue reading
The Advantages and Disadvantages of Budgeting
A budget can be described as a financial plan for a business that has been prepared well in advance to demonstrate and dictate the future course of work of a business. A budget may be set in money terms or it can be expressed in terms of units. Budgets can also be put across in the form of income budgets for money received i.e. sales budget, or expenditure budgets for money spent, i.e. a purchases budget. However, a major emphasis has always been on the cash budget which combines both income and expenditure in estimating the business working capital, cash in hand and bank balance during a course of work or a time period. The budgets are usually prepared for the following financial years (budget period), and are usually broken down into shorter time periods in order to emphasize on the figures and their attainment/fulfillment. The periods are usually monthly Continue reading
Financing of Current Assets
Current assets of enterprises may be financed either by short-term sources or long-term sources or by combination of both. The main sources constituting long-term financing are shares, debentures, and debts form banks and financial institutions. The long term source of finance provides support for a small part of current assets requirements which is called the working capital margin. Working capital margin is used here to express the difference between current assets and current liabilities. Short-term financing of current assets includes sources of short-term credit, which a firm is mostly required to arrange in advance. Short-term bank loans, commercial papers etc. are a few of its components. Current liabilities like accruals and provisions, trade credit, short-term bank finance, short-term deposits and the like warranting the current assets are also referred to a short-term term sources of finance.Spontaneous financing can also finance current assets, which includes creditors, bills payable, and outstanding receipts. Continue reading
Opportunity Cost of Capital
The opportunity cost of capital is defined as the return on capital which might be obtained by its employment when the central objective of planning policy is to use capital so its return to employment in any one investment is at least as high as its return from employment in any alternative investment. Similar to the cost of capital to equity shareholders, we have to allow for any risk differential. In other words, the opportunity cost of capital is the marginal productivity of additional investment in the best alternative uses. It is, therefore, not surprising that the marginal productivity of capital in the private sector is frequently suggested as an appropriate value for the opportunity cost of capital to be used in public investment projects. It seems reasonable to say that if the marginal investment can earn x percent in the private sector, no public investment project should be allowed Continue reading
Cash Budget – Definition, Objectives, Features, and Advantages
Meaning and Definition of Cash Budget A cash budget is a budget or plan of expected cash receipts and disbursements during the period. These cash inflows and outflows include revenues collected, expenses paid, and loans receipts and payments. In other words, a cash budget is an estimated projection of the company’s cash position in the future. Management usually develops the cash budget after the sales, purchases, and capital expenditures budgets are already made. These budgets need to be made before the cash budget in order to accurately estimate how cash will be affected during the period. For example, management needs to know a sales estimate before it can predict how much cash will be collected during the period. Management uses the cash budget to manage the cash flows of a company. In other words, management must make sure the company has enough cash to pay its bills when they come Continue reading