BBM 206 Principles of Finance

BBM 206: PRINCIPLES OF FINANCE NOTES
GARISSA UNIVERSITY COLLEGE

SCHOOL OF BUSINESS & ECONOMICS
ACCOUNTING & FINANCE DEPARTMENT
BBM 206: PRINCIPLES OF FINANCE
LECTURER: MR. MWENGEI K.O. (0737348935)
COURSE OUTLINE
1.0 INTRODUCTION TO FINANCE;
Definition of Finance,
Related Disciplines,
Scope and Objectives,
Roles of Financial Manager,
2.0 FORMS OF BUSINESS ORGANIZATIONS;
Sole Proprietorship,
Partnership,
Companies Public, Private,
3.0 FINANCIAL INSTITUTIONS;
Classification and Types of Financial Institutions,
Roles of Financial Institutions,
Structure and Functions of Central Bank of Kenya,
Specialized Financial Institutions
4.0 SOURCES OF FINANCE;
Internal and External Sources
Long-Term and Short-Term Sources,
Choice of Source of Finance,
5.0 ISSUE OF SHARES AND BONDS;
Introduction,
Methods of Issuing Shares and Debentures,
Choice of Method of Issuing Shares and Bonds
Issue and valuation of bonuses and rights
6.0 FINANCIAL PERFORMANCE MEASUREMENT (RATIO ANALYSIS)
Profitability ratios
Gearing ratios
Liquidity ratios
Shareholders' investment ratios ('stock market ratios').
EVALUATION
CAT
Assignment
End of Semester Exam
TOTAL
20%
10%
70%
100%
REFERENCES
1. Brigham And Houston , Fundamentals Of Financial Management
2. Pandey I.M. Financial Management
3. Cowdell, Hyde And Alastair, Finance For International Trade
5. Brealey Myers, Principles Of Corporate Finance
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PRINCIPLES OF FINANCE LECTURE NOTES: MWENGEI OMBABA LECTURER GARISSA UNIVERSITY
INTRODUCTION
1. Introduction
Whether the business concerns are big or small, they need finance to fulfill their business
activities. Finance may be defined as the art and science of managing money. According to
Oxford dictionary, the word finance connotes management of money. Websters Ninth New
Collegiate Dictionary defines finance as the Science on study of the management of funds and
the management of funds as the system that includes the circulation of money, the granting of
credit, the making of investments, and the provision of banking facilities. Therefore, Finance is
defined as the procurement of funds and their effective utilization in business concerns. The
concept of finance includes capital, funds, money, and amount. But each word is having unique
meaning. Studying and understanding the concept of finance become an important part of the
business concern.
2. Scope of Finance
a. Financial Management (Corporate Finance)
Financial Management or corporate finance, deals with procurement of funds and their effective
utilization in the business entities. Financial management is the broadest of the three areas and is
important in all types of businesses including banks, financial institutions, industrial concerns,
and retail firms, governmental institutions such as schools, hospitals and even local
governmental departments. Corporate finance is concerned with budgeting, financial forecasting,
cash management, credit administration, and investment analysis and fund procurement of the
business concern. However, regardless of the area a finance specialist enters, he or she will need
a knowledge and understanding of all the three areas.
b. Investments
This area focuses on behaviour of financial markets and the pricing of securities. Finance
graduates who go into investment often work for a brokerage house either in sales or as security
analyst. Others work for banks, mutual funds, or insurance companies in management of their
portfolios; for financial consulting firms advising individual investors or pension funds on how
to invest their capital; for investment banks whose primary function is to help businesses raise
new capital; or as financial planners whose job is to help individuals develop long-term financial
goals and portfolios.
c. Financial Institutions
They deal with banks and other firms that specialize in bringing the suppliers of funds together
with the users of funds. One needs knowledge of valuation techniques, the factors that cause
interest rates to rise and fall, the regulations to which financial institutions are subject, and the
various types of financial instruments (mortgages, auto loans, fixed deposits, letters of credit
etc). General business administration knowledge of financial institutions is also important such
as marketing, accounting, computer systems and human resources management is also important.
3. Financial Management Decisions

The financial manager makes decisions relating to financial objectives. These decisions include
the following:
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a. Investment Decision
Every business has to decide where to allocate scarce resources. Put more simply, every business
has to look at its available investment opportunities and decide whether to make the investment
or not. In making this decision, firms have to grapple with two basic issues.
The first is the rate of return that they need to make on an investment, given its risk, for it
to be a good investment.
The second is how to measure returns on investments, especially when the cash flows on
these investments are different from accounting earnings and vary over time.
b. Financing Decisions
This function is mainly concerned with determination of optimum capital structure of the
company keeping in mind cost, control and risk. Generally this is a Procurement of Funds
function since investments in assets must be financed somehow. Financial management is also
concerned with the management of short-term funds and with how funds can be raised over the
long term.
There are two ways in which any business can raise financing. It can use the owners funds
(equity) or it can borrow money (debt). Every business has to consider whether the mix of debt
and equity that it uses to fund investments is in fact the right one. The financing decision
examines whether the firms existing mix of debt and equity is the right one.
Firms also have to pick from a variety of different financing choices short term versus long
term debt, fixed rate versus floating rate debt- and determine what type of financing is best suited
for them. Owners equity is less risky source but it leads to dilution of ownership of current
shareholders but debt finance though cheap, exposes the company to risk of liquidation or
takeover in case it fails to pay interest on such loans.
c. Dividend Decisions
After firms make investments with their chosen financing mix, the investments generate cash
flows. When the cash flows come inform of profits, firms will have to make decisions on how
much of these profits will be invested back into the business and how much returned to the
owners of the business. In a publicly traded firm, cash flows can be returned either as dividends
or by buying back stock.
Johnson (2001) pointed out that strategic decisions involving dividend policy all have long term
economic implications to the value a company creates for its shareholders. When people buy
common stock (shares) they give up current consumption but expect to collect dividends and
eventually sell the stocks at a profit.
Therefore, return on common stock includes the cash dividend paid during the year together with
an appreciation in the market price or capital gain realized at the end of the year. Therefore,
shareholders of a business firm receive benefits in only two ways: appreciation of share prices
and dividends received otherwise, they would rather withdraw their capital and invest
somewhere else.
Johnson (2001) also argued that dividends provide a signal to the public equity market as to
managements expectations of the companys prospective cash flow generating ability hence
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leads to appreciation of market share price. It can be seen that a good company would rather pay
all its earnings as dividends after all it will increase share price and shareholders wealth as well
as signal that the company has a bright future. However, this will be disastrous as part of the
profits should be retained and be invested back to ensure and assure shareholders of future
dividends. Therefore, the finance manager must strike a balance and decide the amount of
dividend to be paid
d. Risk Management Decisions
The generally argued that business entities faces risks in various forms and that the higher the
risk, the higher the return a business will receive. A finance manager is charged with the duty of
identifying the risk, measuring the risk using various techniques and methods of risk
measurement. A consultant or external experts may be used at this stage but the ultimate
responsibility still lies with the finance manager. Further, a choice of strategy of managing the
risk must be chosen e.g. transfer the risk to an insurance company, retain the risk or simply avoid
the risk.
4. Financial Objectives
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management
a. Shareholder wealth maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. Horne (2001) asserted that the objective of a
company must be to create value for its shareholders. Other writers such as Brigham et al (1994)
and Mauboussin (1998) added that the primary goal of a firm is stockholder wealth
maximization. The use of the objective of shareholder value maximization has been advocated as
an appropriate and operationally feasible goal since it provides an unambiguous measure of what
the firm should seek to maximize in making any decision. Shareholder wealth maximization is
also known as shareholder value maximization or net present worth maximization.
b. Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. However, Profit
maximization objective consists of certain drawback also:
i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
ii) It ignores the time value of money: Profit maximization does not consider the time value
of money or the net present value of the cash inflow. It leads certain differences between
the actual cash inflow and net present cash flow during a particular period.
iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business
concern.
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c. Non-Financial Objectives
A company may have important non-financial objectives, which will limit the achievement of
financial objectives. Examples of non-financial objectives are as follows.
i.
The welfare of employees
A company might try to provide good wages and salaries, comfortable and safe working
conditions, good training and career development, and good pensions. If redundancies are
necessary, many companies will provide generous redundancy payments, or spend money
trying to find alternative employment for redundant staff. Effective achievement of this
goal will imply diversion of finances from investment opportunities to employee welfare
hence forfeiting shareholders wealth creation.
ii.
The welfare of management
Managers will often take decisions to improve their own circumstances, even though their
decisions will incur expenditure and so reduce profits. High salaries, company cars and
other perks are all examples of managers promoting their own interests. The dilemma is
always the answer to the question: who TRULY owns the company? Is it the
Management or shareholders?
iii.
The provision of a service
The major objectives of some companies will include fulfillment of a responsibility to
provide a service to the public. Examples are the Nairobi City Water and Sewerage
Company. Providing a service is of course a key responsibility of government
departments and local authorities.
iv.
The fulfillment of responsibilities towards customers
Responsibilities towards customers include providing in good time a product or service of
a quality that customers expect, and dealing honestly and fairly with customers. Reliable
and quality supply arrangements, also after-sales service arrangements, are important.
v.
The fulfillment of responsibilities towards suppliers
Responsibilities towards suppliers are expressed mainly in terms of trading relationships.
A company's size could give it considerable power as a buyer. The company should not
use its power unscrupulously. Suppliers might rely on getting prompt payment, in
accordance with the agreed terms of trade.
vi.
The welfare of society as a whole
The management of some companies is aware of the role that their company has to play
in exercising corporate social responsibility. This includes compliance with applicable
laws and regulations but is wider than that. Companies may be aware of their
responsibility to minimize pollution and other harmful 'externalities' (such as excessive
traffic) which their activities generate. In delivering 'green' environmental policies, a
company may improve its corporate image as well as reducing harmful externality
effects. Companies also may consider their 'positive' responsibilities, for example to make
a contribution to the community by local sponsorship.
Other non-financial objectives are growth, diversification and leadership in research and
development. Non-financial objectives do not negate financial objectives, but they do suggest
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that the simple theory of company finance, that the objective of a firm is to maximize the wealth
of ordinary shareholders, is too simplistic. Financial objectives may have to be compromised in
order to satisfy non-financial objectives
5. Functions and Roles of a Finance Manager

Financial management can be defined as the management of the finances of an organisation in
order to achieve the financial objectives of the organisation. The usual assumption in financial
management for the private sector is that the objective of the company is to maximize
shareholders' wealth.
Generally speaking, the functions of a finance manager are mainly two: Financial planning and
financial control functions.
Under planning, the financial manager will need to plan to ensure that enough funding is
available (financing decisions) at the right time to meet the needs of the organisation for short,
medium and long-term capital.
a. In the short term, funds may be needed to pay for purchases of inventory, or to
smooth out changes in receivables, payables and cash: the financial manager is here
ensuring that working capital requirements are met. He will need to identify sources
of such short term funds such as overdrafts, short term loans, or from operating
activities. This planning function may include projection of the source, amount and
timing of such funds and perhaps prepare a cash budget.
b. In the medium or long term, the organisation may have planned purchases of noncurrent assets (formerly called Fixed Assets) such as plant and equipment, for which
the financial manager must ensure that funding, is available. In most cases funding of
non-current assets is distinguished from short-term funding and may include issue of
loan term debt such as a corporate bond, issue ordinary share capital or divesting a
business unit to get finance (financing decisions). Furthermore, a financial manager
will decide the projects and non-current assets to invest in (investment decisions),
prioritize to know the timing and amount needed and also analyse the risk inherent in
such investments (risk management decisions).
The control function of the financial manager becomes relevant for funding which has been
raised. Are the various activities of the organisation meeting its objectives? Are assets being used
efficiently? To answer these questions, the financial manager may compare data on actual
performance with forecast performance. Forecast data will have been prepared in the light of past
performance (historical data) modified to reflect expected future changes. Future changes may
include the effects of economic development, for example an economic recovery leading to a
forecast upturn in revenues.
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The two functions of planning and control are executed by finance manager by carrying out the
following roles among others:
a. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
non-current assets and forecast the amount needed to meet the working capital requirements in
future. This means that he/she must interact with people from other departments as they look
ahead and lay the plans that will shape the firms future. This role is mostly achieved through
budgeting.
b. Financing Capital requirements
After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.
Nevertheless, for an on-going concern, growth in sales requires investments in plant, equipment
and inventory among other assets. Financial manager must help determine the optimal sales
growth, discount rate to be allowed, appraisal of suppliers and creditors, optimal credit period
necessary to attract customer, specific source of finance to be utilised.
c. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital. He
should be able to consider multiple investment opportunities, some mutually exclusive and
allocate available finances able to maximize owners value. He/she must decide whether to lease
or buy, invest or divest with an aim of attaining higher than the desired rate of return or cost of
capital utilised.
d. Working Capital and Cash Management
Present days cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern. The finance manager have to ensure he avoid
overtrading and being over capitalised by choosing an appropriate approach between an
aggressive, moderate or conservative working capital approach
e. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization to be able to
participate in their budgeting processes, investment project appraisal and in managing other
activities that affects finances of the organisation such as sales and purchases.
f. Dealing with financial markets
Finance manager works as the link between money markets (banks and other short-term lenders)
and capital markets (stock and bond market) and the organisation. Each firm affects and is
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affected by the general financial markets where funds are raised, firms securities are traded and
where investors either make or lose money.
g. Risk Management
All businesses face risks, including natural disasters such as fires and floods, uncertainties in the
commodity and security markets, volatile interest rates, and fluctuating foreign exchange rates.
However, many of these risks can be reduced by purchasing insurance or by hedging in the
derivative markets. Finance manager is responsible for the firms overall risk management
program, including identifying the risks that should be managed and then managing them in the
most efficient manner.
6. Related Disciplines
Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches. The following are the
important scope of financial management.
i. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the
economic equations like money value discount factor, economic order quantity etc. Financial
economics is one of the emerging area, which provides immense opportunities to finance, and
economical areas.
ii. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But nowadays financial management and accounting
discipline are separate and interrelated.
iii. Financial Management and Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
iv. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiply
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
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department. The financial manager must be aware of the operational process and finance
required for each process of production activities.
v. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
vi. Financial Management and Human Resource
Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each department and allocate the finance to the human
resource department as wages, salary, remuneration, commission, bonus, pension and other
monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.
QUESTIONS
i) 'The financial manager should identify surplus assets and dispose of them'. Why?
ii) Can you give three examples of how accounting profits might be manipulated?
iii) Differentiate between profit and shareholder wealth maximization goal
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FINANCE AND FORMS OF BUSINESS ORGANISATION

1. Introduction
The financial decisions of a business enterprise must be made with some objective in mind. This
applies whether the decision is an investment decision (e.g., buying equipment), or a financing
decision (e.g., issuing bonds). However, different business forms will limit the financial
decisions to be made by a finance manager because of inherent limitations of each form. There
are three legal forms of business organizations: sole proprietorship, partnership and limited
companies. Sole proprietorship is argued to be the most common form of business followed by
partnership and corporation but in terms of revenue, corporation have the highest share followed
by sole proprietorship and then partnership.
2. The Sole Proprietorship

A sole proprietorship is a business enterprise owned by one person. It is the simplest and most
common form of business enterprise because it is a business owned and controlled by one person
-- the proprietor. The proprietor receives all income from the business and alone decides whether
to reinvest the profits back into the business or use them for personal expenses. If more funds are
needed to operate or expand the business than are generated by business operations, the owner
either contributes his or her personal assets to the business or borrows. For most sole
proprietorships, local banks represent the primary source of borrowed funds. However, there is a
limit to how much banks will lend proprietorships, most of which are relatively small businesses.
A proprietor is liable for all the debts of the business; in fact, it is the proprietor who incurs the
debts of the business. If there are insufficient business assets to pay a business debt, the
proprietor must pay the debt out of personal assets. The basic distinguishing features of a sole
proprietorship are:
i) Financing of the business enterprise is from proprietor's own funds and from bank
borrowings.
ii) The proprietor is liable for debts of the business.
iii) Income of business is taxed as income of the proprietor.
iv) Life of the business ends with the life of the proprietor.
There are a number of advantages and disadvantages of a sole proprietorship as a form of doing
business. Advantages include the following:
a) Decision-making is simple (because the proprietor controls decisions).
b) The owner receives all income from business.
c) Income is taxed at only one level (that of the owner).
But the sole proprietorship form of business is not without is its disadvantages. Disadvantages
include:
a) Unlimited liability -- the owner is liable for all debts of the business.
b) Limited life of the proprietorship -- the life is limited by the life of the owner.
c) The business has limited access to additional funds. Most of the funds are from the
proprietor's own assets or from lending arrangement with local banks.
3. Partnership
A partnership is a business enterprise owned by two or more persons who share the income and
liability of the business. Partnership is a partnership in which each partner is liable for the debts
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of the business. The owners (i.e., the partners) share in the management of the business and share
in the profits and losses of the business according to the terms of the partnership agreement.
The life of the partnership may be limited by agreement or by life of partners, requiring a
reformulation of the partnership as partners exit and enter the partnership. Further, ownership of
a partnership interest cannot be freely transferred; this causes some problems in cases of a
partner wanting to leave or in the event of the death of a partner (because the partnership share
cannot be inherited).
The partnership can raise funds from either partner contributions or from borrowing from local
banks, though these sources may be quite limiting for a growing partnership. Because the
partners own 100 percent of the ownership, additional ownership interests cannot be sold. The
importance of this limitation is that a large, growing partnership may be constrained by its
limited sources of financing. The income of partnership is taxed as income of partner (in portions
agreed upon in partnership agreement), flowing directly to the taxable income of the partner.
Like the sole proprietorship, the business income of a partnership is taxed only once -- as the
individual owners' income.
4. Corporations
A company is a separate legal entity. As such, it is able to hold property in its own name, sue and
be sued, and function separately from its owners. Individuals contribute capital to a company and
are known as shareholders. It is the shareholders in the company who elect company directors
who in turn will appoint managers for the day to day running of the business. An important
difference between a company and a sole trader or partnership is that of limited liability. The
liability of a shareholder for the debts of the company is limited to the amount which they have
agreed to contribute by way of capital and also includes funds they have not yet been asked to
contribute. This latter amount is referred to as uncalled capital.
Characteristics of a Company
On being incorporated, a company enjoys certain advantages over other associations. Such
advantages are termed as characteristics of a company and are as follows:a. Separate Legal Entity
A company formed and registered under the companies Act is a distinct legal entity. It is
regarded by law as a person, just as a human being is a person. It is a creation of law also called
artificial person being invisible and intangible without physical existence.
Though devoid of natural existence, it can own land and other property, enter into contracts, sue
and be sued, have a bank account in its own name, owe money to others and be a creditor to
other people and employ people to work for it.
The company is at law a different person altogether from the subscribers to the memorandum of
association. The companys money and property belong to the company and not to the members
or shareholders, similarly, the companys debts are the debts of the company and the
shareholders cannot be compelled to pay them. A company may contract with its members.
This principle of legal separate entity is clearly illustrated in the leading case of Saloman v.
Saloman & Co. Ltd.
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Case Law: Saloman vs. Saloman & Co. Ltd.

Saloman had a boot business. He sold the business to a company named Saloman & Co. Ltd
which he formed. There were seven members his wife, daughter and four sons who took 1
share each and Saloman himself took 20,000 shares. The price paid by the company to Saloman
was 30,000, but instead of paying him cash, the company gave him 20,000 fully paid shares of
1 each and 10,000 debentures. Owing to strike to the boot business the company could not
service the interest on loans and an action was instituted to enforce his security against the assets
of the company. Thereafter, at the instance of unsecured creditors of the company, a liquidation
order was made and a liquidator appointed. The assets of the company amounted to 6,000 only.
Debts amounted to 10,000 due to Saloman and secured by debentures and a further 7,000 due
to unsecured creditors. The unsecured creditors claimed that as Saloman & Co. Ltd was really
the same person as Saloman, he could not owe money to himself and that they should be paid
their 7,000 first.
It was held by the House of Lords that Saloman was entitled to 6,000 as the company was an
entirely separate person from Saloman. The unsecured creditors got nothing.
Lord Macnaghten observed in this case that;
When the memorandum is duly signed and registered, the subscribers are a body
corporate. The company is at law a different person altogether from the subscribers to
the memorandum and though it may be that after incorporation the business is precisely
the same as it was before and the same persons are managers and the same hands
receive the profits, the company is not in law the agent of the subscribers or trustee for
them.
Salomans case established beyond doubt, that in law a registered company is an entity distinct
from its members, even if one person holds all the shares in the company. There is no difference
in principle between a company consisting of only two shareholders and a company consisting of
two hundred members. In each case, a company is a separate legal entity.
Case Law: Lee vs. Lees Air Farming Co. Ltd (1960)
Of the 3000 shares in a company, L held 2,999. He voted himself as the managing director. L
was killed in an air crash while working for the company. His widow claimed compensation for
personal injuries to her husband while in the course of this employment. It was argued that no
compensation was due because L and Lees Air Farming Ltd were the same person.
The Privy Council applied Salomans case and said that L was a separate person from the
company he formed and compensation was payable.
Case Law: Peoples Pleasure Park vs. Rohleder 6 Southeast
The articles contained prohibition that title to land should never pass to a colored person. The
land was sold to a corporation all the members of which were Negroes. It was held that the
corporation was distinct from its members and that the transfer was valid.
Case Law: A. L Underwood Ltd vs. Bank of Liverpool
Mr. Underwood had carried on business as an engineering and machinery merchant.
converted the business into a limited company and allotted one share to his wife.
He
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Underwood as the sole director received 45 cheques of the aggregated value of 8,502 drawn in
favor of the company. He endorsed them ALU Ltd. ALU sole director and paid them into his
personal account with the bank of Liverpool instead of paying them into the companys account
with another bank. The Bank of Liverpool, the defendants, without inquiring whether the
company had a separate banking account collected the cheques and credited Underwood with the
proceeds and honoured cheques drawn by him against them to pay his private debts.
The court was of the opinion that when doing what they had done, the Bank of Liverpool had
treated Mr. Underwood as being identical with the company by virtue of his peculiar position as
the beneficial owner of all the companys shares and its sole director.
Consequently, the bank had overlooked the materiality of the cheques being drawn in the
companys favor and not Underwoods favor.
In an action for conversion brought by the company on behalf of a creditor to whom debentures
had been issued by the company it was held that the Bank of Liverpool was liable and that it was
precluded upon the following grounds from arguing that Underwood, when paying the cheques
into his own account, was acting within the scope of his apparent authority as agent of the
company:
(i)
The act of an agent paying his principals cheque in his own account was so unusual
as to put them on inquiry and they ought to have inquired whether the company had a
separate bank account and if it had why the cheques were not paid into that account.
The banks failure to make an inquiry amounted to negligence.
(ii)
Underwood when paying the cheques did not purport to act as the companys agent
but as being himself the company and the bank so treated him.
In the course of his judgment, Atkins L. J said:The directors, whether collectively or singly, do not have actual authority to steal the
companys goods. Although he acted in capacity of a director he is a different person from the
company.
Case Law: Macaura vs. Northern Assurance Co.
Macaura, who owned an estate, sold the whole of the timber on the estate to a company in
consideration of the allotment to him of 42,000 fully paid 1 shares. All the companys shares
were held by him and his nominees, and he was also unsecured creditor of the company for an
amount of 19,000. Subsequent to the sale, he effected insurance policies in his own name with
the Northern Assurance company covering timber against fire. Two weeks after, the policies
were effected, almost all the timer was destroyed in a fire. A claim brought by him on the
policies was dismissed by the House of Lords on the ground that he had no insurable interest in
the timber.
In the course of his judgment Lord Summer said;It is clear that the appellant had no insurable interest in the timber described. It was not his
rather it belonged to the company. He owned almost all the shares in the company and the
company owed him a good deal of money, but neither as a creditor nor as shareholder could he
insure the companys assets. The debt was not exposed to fire, nor was the shares. His relation
was to the company, not to its goods.
Page 13 of 46
In this case, it is clear that the company is very different from the subscribers and its assets
cannot be vested to the members. A member does not have interest in the property of the
company and should not be regarded as an agent or as a trustee.
Macaura owned almost all the shares of the company, but the property of the company was not
his and could not insure it in his name.
b. Perpetual Succession
According to concise Oxford Dictionary, perpetual means inter alia, applicable, valid for ever
or for indefinite time while succession means a following in order.
Unlike a natural person, a company never dies. Its existence is not affected by death, lunacy and
insolvency of its members. A company is an immortal person. Members may come and go, but
the company continues in its operation unless it is wound up. The existence of the company is
not affected by the death of all the shareholders. Thus where all the members of a company were
killed say by a bomb the company was deemed to survive.
The perpetual succession occurs because a company and its members are separate persons and so
the companys legal life is not terminated by a members death.
c. Limited liability
The fact that a registered company is a different person altogether from the subscribers to its
memorandum means that the companys debts are not the debts of its members. If a company
has borrowed money, it and it alone is under an obligation to repay the loan. The members are
under no such obligation and cannot be asked to repay the loan. In case a company is unable to
pay it debts the creditors may petition the High court for an order to wind it up. During the
winding up the members will be called upon to pay the amount, if any, which is unpaid on the
shares they hold incase of a company limited by shares or the amount prescribed by the
memorandum incase of a company limited by guarantee.
A point to note is that a companys creditor cannot institute legal proceedings against the
companys member inorder to recover from him what he owes the company. This is because the
member does not, legally, become his debtor merely because the company is his debtor.
d. Common Seal
As an artificial person it cannot sign its name on a contract. So it functions with the help of a
seal. Common seal is used as a substitute for its signature. Every company must have a seal
with its name engraved on it. Anything done under an agreement between the company and the
third party requires recognition of the company in the form of an official seal.
e. Capacity to sue and be sued
Because a company is at law a different person altogether from its members it follows that a
wrong to, or by, the company does not legally constitute a wrong to, or by, the companys
members. Consequently;Page 14 of 46
a. A member cannot institute legal proceedings to redress a wrong to the company.

The company as the injured party is generally speaking, the proper plaintiff.
b. A member cannot be sued to redress a wrong by the company. This is illustrated
by Saloman v Saloman Co. Ltd in which it was held that Saloman was not liable
for the companys failure to repay the loans as agreed with its creditors and
should not therefore have been sued to recover them.
f. Transferability of shares
The shares of a company are freely transferable and can be sold or purchased in the stock market.
The shares or other interest of any member shall be movable property transferable in the manner
provided for in the articles of the company.
Advantages include:
i) Limited liability - the most an owner can lose is the original investment in the company.
ii) The business enterprise has a life in perpetuity -- out living its owners.
iii) The corporation has access to additional funds through the sale of new share of stock.
iv) Income is distributed according to proportionate ownership.
v) Easy transferability of ownership interest
Disadvantages include:
i) The separation of ownership and decision-making.
ii) The company Act and article of Association may affect the dividend decision especially
when the company had made a loss, amount of capital to be raised unless such clauses
are changed by the AGM a process that may be too expensive and time consuming unlike
in sole proprietorship
Page 15 of 46
FINANCIAL INSTITUTIONS
An organization, which may be either for-profit or non-profit, that takes money from clients and
places it in any of a variety of investment vehicles for the benefit of both the client and the
organization. Common examples of financial institutions are retail banks, which take deposits
into safekeeping and use them to make loans to other customers, and insurance companies,
which do not take deposits, but provide guarantees of payment if a certain situation occurs in
exchange for a premium.
According to Saunders and Cornett (2001) financial institutions perform the essential function of
channeling funds from those with a surplus also called suppliers of funds to those with shortages
of funds also called users of funds.
Classification of Financial Institutions
Financial institutions include:
a) Depositories
Deposit-taking institutions take the form of commercial banks, which accept deposits and make
commercial and other loans; savings and loan associations and mutual savings banks, which
accept deposits and make mortgage and other types of loans; and credit unions, which are
cooperative organizations that issue share certificates and make member (consumer) and other
loans. The primary operations of banks include:
Keeping money safe while also allowing withdrawals when needed
Issuance of cheque books so that bills can be paid and other kinds of payments can be
delivered by post
Provide personal loans, commercial loans, and mortgage loans (typically loans to
purchase a home, property or business)
Issuance of credit cards and processing of credit card transactions and billing
Issuance of debit cards for use as a substitute for cheques
Allow financial transactions at branches or by using Automatic Teller Machines (ATMs)
Provide wire transfers of funds and Electronic fund transfers between banks
Facilitation of standing orders and direct debits, so payments for bills can be made
automatically
Provide overdraft agreements for the temporary advancement of the Bank's own money
to meet monthly spending commitments of a customer in their current account.
Notary service (legal services) for financial and other documents
Providing safe custody of valuable items
Providing services like Letters of Credit (LC) which facilitates trade.
b) Insurance companies
The primary function of insurance companies is to protect individuals and corporations
(policyholders) from adverse events. By accepting premiums insurance companies promise to
compensate policy holders if certain prespecified event occurs. However, insurance companies
provide the dual services of insurance protection and investment i.e. they protect the
policyholder but uses the premiums in investment activities so as to grow the amount. There are
two types of insurance companies: life insurance companies and casualty and property insurance
companies. Life insurance provides protection in the event of untimely death, illnesses and
Page 16 of 46
retirement while casualty and property insurance protects against personal injury, and liabilities
due to accidents, theft, fire, and other catastrophes. Insurance companies' sources of funds are
primarily policy premiums. Their uses of funds range from loans (thus competing with finance
companies, commercial banks, and savings and loan associations) to creation of investment
products (thus competing with investment companies). The functions of insurance companies
are:
Protection of individuals and corporations against losses such as life, casualty and
property losses
Investment of funds in different investment vehicle to ensure growth of the funds to be
sufficient on meeting policy holders demands
Insurance brokerage - Insurance brokers shop for insurance (generally corporate property
and casualty insurance) on behalf of customers.
Insurance underwriting - Personal lines insurance underwriters actually underwrite
insurance for individuals, a service still offered primarily through agents, insurance
brokers, and stock brokers. Underwriters may also offer similar commercial lines of
coverage for businesses. Activities include insurance and annuities, life insurance,
retirement insurance, health insurance, and property & casualty insurance.
Reinsurance - Reinsurance is insurance sold to insurers themselves, to protect them from
catastrophic losses.
c) Investment companies
Investment companies pool together funds and invest in the market to achieve goals set by
members. These are simply companies that pool money together from various investors and
invest it collectively into different types of financial assets as portfolios with an aim of
generating a return to the members. Investment companies are organized as open-end or closedend mutual funds. Open-end funds accept new investments and redeem old ones. In other word
an investor is free to join by purchasing shareholding in form of units and exiting at any point by
redeeming the units. On other hand, closed-end funds accept funds at one time and then do not
take in new funds. This is because shareholding is in form of shares purchased only at one point.
Though shares are transferable, this will be limited unless the investment company is listed on a
stock exchange like any public company. Investment companies have become very popular with
investors in recent decades, and thus they have mobilized trillions of shillings.
d) Pension funds
Pension funds in the private and the government sectors collect pension contributions and invest
them according to goals of the employees for their funds. Pension funds offer savings plans
through which participants accumulate tax-deferred savings during their working years before
withdrawing them during their retirement years. Funds so accumulated are expected to have
grown by the time of retirement of the member hence need of the pension funds to invest the
funds in different types of investment assets such as shares, bonds, properties and even overseas.
The pension industry comprises two distinct sectors: private pension funds which are fund
administered by private corporations such as insurance companies and mutual funds and public
pension funds which are funds administered by the government e.g. National Social Security
Fund
A pension fund can also be defined benefit pension fund where the employer agrees to provide
the employee a specific cash benefit upon retirement, based on a formula that considers such
Page 17 of 46
factors as years of employment and salary during employment or a defined contribution

pension fund where the employer does not commit to provide a specified retirement income but
commits to contribute a specific amount to the pension fund during employees years of
employment.
e) Investment Banks
Another investment type of company is investment banks, which provide investment and fundraising advice to potential users of funds, such as commercial, industrial, and financial
companies. They also create venture capital funds or companies. Some of them also have
brokerage and dealerships in securities. Many of them underwrite securities and then place them
in the market or sell them to investors.
f) Exchanges
Exchange markets includes stock markets, bond markets and derivatives markets that provide an
avenue for investors to exchange financial instruments such as shares, bonds and derivatives like
futures and options. In most cases stock exchange markets also acts as bond exchange markets
but derivatives markets are very few in the world. Stock exchanges play the following roles:
i) Raising capital for businesses- They provide companies with the facility to raise
capital for expansion through selling shares to the public.
ii) Mobilizing savings for investment- When people draw their savings and invest in
shares, it leads to a more rational allocation of resources because funds, which could
have been consumed, or kept in idle deposits with banks, are mobilized and
redirected to promote business activity with benefits for several economic sectors
such as agriculture, commerce and industry, resulting in stronger economic growth
and higher productivity levels of firms.
iii) Facilitating company growth- they facilitate corporate acquisition which gives
opportunity to the acquiring firm to expand product lines and profitability. A
takeover bid or a merger agreement through the stock market is one of the simplest
and most common ways for a company to grow by acquisition
iv) Profit sharing gives investors an opportunity to share in profitable companies
through dividends and stock price increases that may result in capital gains, share in
the wealth of profitable businesses.
v) Improves Corporate governance - Companies generally tend to improve
management standards and efficiency to satisfy the demands of increased number of
shareholders, and the more stringent rules for Capital Market Authority
vi) Creating investment opportunities for small investors as shares are divided into small
affordable units
vii) Facilitates the Government capital-raising for development projects by issuing and
selling treasury bills and bonds
viii) Barometer of the economy Bond and share prices rise and fall depending,
largely, on market forces of demand and supply. Share prices tend to rise or remain
stable when companies and the economy in general show signs of stability and
growth. An economic recession, depression, or financial crisis could eventually lead
to a stock market crash. Therefore the movement of share prices and in general of
the stock indexes can be an indicator of the general trend in the economy.
Page 18 of 46
g) Finance companies
These are financial institutions that make loans to both individuals and businesses. Unlike
depositories, finance companies do not accept deposits but instead rely on short and long term
debt for funding. They offer services such as
Lease financing
Personal loans
Corporate or business loans
Mortgage financing
Auto loans
Most financing companies offer lending to relatively specialized areas such as loans to civil
servant, teacher, Jua-Kali artisans, and micro enterprises
Financial markets
As a group, financial institutions form financial markets. Financial markets are defined as
structures through which funds flow. Financial markets can be distinguished into to two along
two dimensions:
a) Primary markets and secondary markets
b) Money markets and capital markets
a) Primary markets Vs Secondary markets
Primary markets are markets in which users of funds e.g. corporations raise funds through new
issues of financial instruments such as stocks (shares) and bonds. A market is primary if the
proceeds of sales go to the issuer of the securities sold. This is part of the financial market
where enterprises issue their new shares and bonds. It is characterized by being the only moment
when the enterprise receives money in exchange for selling its financial assets. Primary market
financial instruments include issues of equity by those firms initially going public called Initial
Public Offers where funds generated goes to the firm issuing the security. An IPO can be for
bonds or shares (stock). For example the government of Kenya sells treasury bonds and bills in
the primary market by mainly using commercial banks while Safaricom issued its shares through
an IPO organised through investment banks. Another security in this market is rights issue
where a firm will source additional share capital from the market. The institutions that play a key
role in primary markets are:
i) Investment banks for underwriting the offer
ii) Commercial banks acting as bankers ( where proceeds are collected)
On the other hand, Secondary markets are where once issue of the financial instruments in the
primary market is over, they are then traded. This is the market where securities are traded after
they are initially offered in the primary market. i.e. re-buying and reselling. It can also be defined
as a market where investors purchase securities or financial instruments from other investors,
rather than from issuing companies themselves. This includes stock exchange markets and bond
exchange markets such as Nairobi Stock Exchange, Bourse Rgionale des Valeurs Mobilires in
Abidjan as a bourse (exchange) for small west african countries such as Benin, Burkina Faso,
Guinea Bissau, Cte d'Ivoire, Mali, Niger, Senegal and Togo, Egypt's Stock Exchange, now
renamed Egyptian Exchange (EGX) and formerly known as the Cairo and Alexandria Stock
Exchange (CASE), the Casablanca Stock Exchange of Morocco, founded in 1929 is the oldest in
Africa, the Nigerian Stock Exchange , Johannesburg Stock Exchange Limited are examples in
Africa. Others in the world are by ranking as New York Stock Exchange (NYSE), National
Association of Securities, Dealers Automated Quotation (NASDAQ) both in USA, Tokyo Stock
Page 19 of 46
Exchange, London Stock Exchange, Shanghai Stock Exchange, Hong Kong Stock Exchange,
Toronto Stock Exchange, Bombay Stock Exchange, National Stock Exchange of India (NSE)
b) Money markets Vs Capital markets
Financial markets can also be viewed as being money markets or capital markets. Money
markets are markets that trade debt securities or instruments with maturities of one year or less
i.e short- term securities. In most countries, money markets do not operate in a specific location
but transactions occur via telephones, wire transfers, inter accounts transfers and computer
trading. The instruments in this market include:
Time deposits, commonly offered to consumers by banks and credit unions.
Repurchase agreements - Short-term loansnormally for less than two weeks and
frequently for one dayarranged by selling securities to an investor with an agreement to
repurchase them at a fixed price on a fixed future date.
Foreign Currency Deposit
Interbank loans offered overnight of for few days by one bank to another
Corporate short term bonds
Treasury bills - Short-term debt obligations of a national government that are issued to
mature in three to twelve months.
Money funds - Pooled short maturity, high quality investments which buy money market
securities on behalf of retail or institutional investors. For example, African Alliance
Kenya Shilling Fund, Old Mutual Money Market Fund, British-American Money Market
Fund
Short-lived mortgage- and asset-backed securities
Business and corporate loans for short period
Personal loan
On the other hand capital markets are markets that trade equity (stocks) and debt (bonds)
instruments with maturities of more than one year. Major capital market instruments are shares,
bonds, treasury bonds, long term loans, motgages
Functions of Financial Markets/Institutions in the Economy
a) Distribution of financial resources to the most productive units. Savings are transferred
to economic units that have channels of alternative investments. (Link between buyers
and sellers).
b) Allocation of savings to real investment.
c) Achieving real output in the economy by mobilizing capital for investment.
d) Enable companies to make short term and long term investments and increase liquidity of
shares.
e) Provision of investment advice to individuals through financial experts.
f) Enables companies to raise short term and long term capital/funds
g) Means of pricing of securities e.g. N.S.E. index shares indicate changes in share prices.
h) Provide investment opportunities. Savers can hold financial instrument for investment
made.
Basic Financial Services
The services provided by the set of institutions above can be separated into six distinct activities.
These are origination, distribution, packaging, servicing, intermediating, and market making.
Page 20 of 46
a) Origination
Financial institutions originates financial instruments such as loans, and bonds which they sell to
their clients. Depositories generate loans of all types including mortgages and personal loans. As
they collect deposits from savers, the same money can be used to issue out loan to borrowers.
Insurance companies generate policies which are sold to the public while investment companies
sell units.
b) Distribution
This is the act of availing the newly originated financial instruments to customers that have the
resources available to purchase them. This activity can be conducted through an agent as a
brokered transaction e.g. insurance brokerage companies, stock brokerage companies,
commercial banks agents or by the principal institution e.g. commercial banks and insurance
companies opening branches in various parts of the country to sell their products. In the former,
newly originated assets are placed with investors who directly remit to the issuing firm. The
financial institution (agents) never takes ownership of the asset in question, but merely facilitates
its placement into a third party's portfolio.
c) Servicing
This is the act of collecting or making payments to the clients. For a commercial bank this is
basically accepting deposits, loan repayments and other monies from clients and paying them
when they make withdrawals. In some countries, servicing is seen as a distinct business activity
in the financial markets.
d) Packaging
This is a relatively recent activity. It involves the collection of individual financial instruments
into pools e.g. mortgage loans, and originating another financial asset from such a pool. This
process is called securitization. The term securitization is often used to means a debt obligation
that is derived from some other debt obligation. This is a financial transaction in which assets are
pooled and securities representing interests (a share) in the pool are issued also called AssetBacked Securities. An example would be a financing company that has issued a large number of
auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its
existing loans, but there isn't a liquid secondary market for individual auto loans so the company
will repackage the auto loans and sell them to the public as a commercial bond effectively raising
the cash.
e) Financial Intermediation
This is when an institution acts as the middleman between investors and firms raising funds. This
is the most important function of financial institutions. In most contexts, financial institutions
can be considered synonymous with financial intermediaries in the financial markets. In a
nutshell, financial intermediaries are the financial institutions that pool resources and channel
funds from savers/lenders to spenders/borrowers. A large number of financial institutions serve
as financial intermediaries. The essential economic function of the financial markets is to
channel surplus funds from individuals who have saved from their incomes to individuals who
want to finance consumption or businesses that need funds to finance capital investments. There
are two ways in which funds are channeled from savers/lenders to spenders/borrowers. The first
is called direct finance. In direct finance, lenders lend to borrowers directly. A saver, for
example, has Kshs.10, 000 saved and buys a Kshs.10, 000 Kengen bond maturing in ten years,
paying an interest rate of 9.5 percent per annumin this transaction, the saver has essentially
Page 21 of 46
directly lent Kshs.10, 000 to Kengen for ten years. The second way in which funds are channeled
is called indirect finance. It is in indirect finance that financial institutions called financial
intermediaries are involved. In this case, a financial intermediary stands between savers/lenders
and spenders/borrowersit obtains surplus funds from savers and lends them to borrowers of its
choice. A commercial bank is a common example of a financial intermediarya commercial
bank receives savings and checking deposits from individuals, and uses them, for instance, to
make mortgage loans.
An insurance company is an intermediary between policy holders and borrowers who sell
investment securities such as bonds to the insurance company. This same function is also done
by investment companies, pension funds and stock exchange. Financial intermediation helps to
mobilize savings.
The Central Bank of Kenya

The Central Bank of Kenya was established in 1966 through an Act of Parliament - the Central
Bank of Kenya Act of 1966. The Central Bank of Kenya Act of 1966 also referred to as CAP 491
set out objectives and functions and gave the Central Bank limited autonomy. This Act has been
amended over the years to take into concern the dynamics of the banking environment. The latest
amendments were done in 2010. The Act clearly states that though CBK is a corporate body, it
will not be subjected to the Companies Act of Banking Act.
Structure of CBK
Under the Central Bank of Kenya Act, the responsibility for determining the policy of the Bank,
other than the formulation of monetary policy, is given to the Board of Directors. The Monetary
Policy Committee of the Bank is responsible for formulating monetary policy. The Board of
Directors of the Bank consists of eight members: The Governor, who is also its chairman
The Deputy Governor, who is the deputy chairman
The Permanent Secretary to the Treasury who is a non-voting member
Five other non- executive directors
All members are appointed by the President to hold office for a term of four years and are
eligible for reappointment once, provided that a Board member shall hold office for not more
than two terms. The executive management team comprises the Governor, the Deputy Governor
and fifteen heads of department who report to the Governor. The Bank operates from its head
office in Nairobi and has branch offices in Mombasa, Kisumu and Eldoret.
Section 4 of the Central Bank of Kenya Act states the core mandate of the Bank as follows:
i) The principal object of the Bank shall be to formulate and implement monetary policy
directed to achieving and maintaining stability in the general level of prices;
ii) The Bank shall foster the liquidity, solvency and proper functioning of a stable marketbased financial system; and
iii) Shall support the economic policy of the Government, including its objectives for growth
and employment
iv) Formulate and implement foreign exchange policy
v) Hold and manage its foreign exchange reserves;
vi) License and supervise authorized dealers;
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vii) Formulate and implement such policies as best promote the establishment regulation and
supervision of efficient and effective payment, clearing and settlement systems;
viii)
act as banker and adviser to, and as fiscal agent of the Government; and
ix) Issue currency notes and coins.
Page 23 of 46
SOURCES OF FINANCE
Sourcing money may be done for a variety of reasons. Traditional areas of need may be for
capital asset acquirement - new machinery or the construction of a new building or depot. The
development of new products can be enormously costly and here again capital may be required.
Normally, such developments are financed internally, whereas capital for the acquisition of
machinery may come from external sources. Nevertheless, a business will also need to finance its
day to day activities from outside sources when internal sources are not adequate. Sources of
finance can be distinguished into two distinctions according to two dimensions
a)
Internal sources Vs External sources
Traditionally, the major sources of finance for a business were internal sources such as Personal
savings for sole proprietorship and partnerships, Retained profit, working capital and Sale of
assets. This is the cheapest source of finance as the business will not pay any interest on this
capital apart from the opportunity cost. On the other hand, finance sourced outside the business
is called external finance which may be either owners capital or non-owners capital hence the
following are examples of external sources of finance: Ordinary shares, Preference shares,
bonds, Other loans, Overdraft facilities, Hire purchase, trade credit, Grants, Venture capital,
Factoring, Invoice discounting, Leasing
b)
Short term Vs Long term finance
Sources of finance can be classifies as long term or short term. The classification usually relates
to duration (term), or how long it takes before the money is received or must be repaid.
Businesses and individuals use long- and short-term sources of financing to raise capital for
improvements and meet financial obligations. Short term finance have a duration of less than one
year while long term finace is available for more than one year and some can even last for 30 or
50 years. Short-term finance is usually needed for businesses to run their day-to-day operations
including payment of wages to employees, inventory ordering and supplies. Businesses with
seasonal peaks and troughs and those engaged in international trade are likely to be heavy users
of short-term finance.Examples of short term finance are bank overdraft, trade credit, short term
lease, and short loan while examples of long term finances are Long term bank loans, Share
capital, bonds, Venture capital, preference shares, sale and leasebacks, hire purchase, long term
lease
Let us have a look at some specific sources of finance
Overdrafts
Where payments from a current account exceed income to the account for a temporary period,
the bank finances the deficit by means of an overdraft. Overdrafts are the most important source
of short-term finance available to businesses. They can be arranged relatively quickly, and offer
a level of flexibility with regard to the amount borrowed at any time, whilst interest is only paid
when the account is overdrawn.
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Amount
Margin
Purpose
Repayment
Security
Benefits
Should not exceed limit, usually based on known income

Interest charged at base rate plus margin on daily amount overdrawn
and charged quarterly. Fee may be charged for large facility
Generally to cover short-term deficits
Technically repayable on demand
Depends on size of facility
Customer has flexible means of short-term borrowing; bank has to
accept
fluctuation
By providing an overdraft facility to a customer, the bank is committing itself to provide an

overdraft to the customer whenever the customer wants it, up to the agreed limit. The bank will
earn interest on the lending, but only to the extent that the customer uses the facility and goes
into overdraft. If the customer does not go into overdraft, the bank cannot charge interest. The
bank will generally charge a commitment fee when a customer is granted an overdraft facility or
an increase in his overdraft facility. This is a fee for granting an overdraft facility and agreeing to
provide the customer with funds if and whenever he needs them.
Many businesses require their bank to provide financial assistance for normal trading over the
operating cycle. For example, suppose that a business has the following operating cycle.
Inventories and trade receivables

Bank overdraft
Trade payables
Kshs
10,000,000
1,000,000
3,000,000
4,000,000
Working capital
6,000,000
It now buys inventory costing kshs.2, 500,000 for cash, using its overdraft. Working capital
remains the same, Kshs.6, 000,000 although the bank's financial stake has risen from Kshs.1,
000, 000 to Kshs. 3,500,000.
Kshs
Inventories and trade receivables
12,500,000
Bank overdraft
3,500,000
Trade payables
3,000,000
6,500,000
Working capital
6,000,000
A bank overdraft provides support for normal trading finance. In this example, finance for
normal trading rises from Kshs.(10,000,000 - 3,000, 000) = Kshs.7,000,000 to Kshs.
(12,500,000 - 3,000,000) = Kshs.9,500,000
and the bank's contribution rises from
Kshs.1,000,000 out of Kshs.7,000,000 to Kshs.3,500,000 out of Kshs.9,500,000. A feature of
bank lending to support normal trading finance is that the amount of the overdraft required at any
time will depend on the cash flows of the business the timing of receipts and payments,
seasonal variations in trade patterns and so on. The purpose of the overdraft is to bridge the gap
between cash payments and cash receipts.
Page 25 of 46
Solid core overdrafts

When a business customer has an overdraft facility, and the account is always in overdraft, then
it has a solid core (or hard core) overdraft. For example, suppose that the account of a company
has the following record for the previous year
If the hard core element of the overdraft appears to be becoming a long-term feature of the
business, the bank might wish, after discussions with the customer, to convert the hard core of
the overdraft into a loan, thus giving formal recognition to its more permanent nature. Otherwise
annual reductions in the hard core of an overdraft would typically be a requirement of the bank.
Short-term loans
A term loan is a loan for a fixed amount for a specified period. It is drawn in full at the beginning
of the loan period and repaid at a specified time or in defined instalments. Term loans are offered
with a variety of repayment schedules. Often, the interest and capital repayments are
predetermined. The main advantage of lending on a loan account for the bank is that it makes
monitoring and control of the advance much easier. The bank can see immediately when the
customer is falling behind with his repayments, or struggling to make the payments. With
overdraft lending, a customer's difficulties might be obscured for some time by the variety of
transactions on his current account.
a) The customer knows what he will be expected to pay back at regular intervals and the
bank can also predict its future income with more certainty (depending on whether the
interest rate is fixed or floating).
b) Once the loan is agreed, the term of the loan must be adhered to, provided that the
customer does not fall behind with his repayments. It is not repayable on demand by the
bank.
c) Because the bank will be committing its funds to a customer for a number of years, it may
wish to insist on building certain written safeguards into the loan agreement, to prevent
the customer from becoming over-extended with his borrowing during the course of the
loan. A loan covenant is a condition that the borrower must comply with. If the borrower
does not act in accordance with the covenants, the loan can be considered in default and
the bank can demand payment.
Trade credit
Trade credit is one of the main sources of short-term finance for a business. Current assets such
as raw materials may be purchased on credit with payment terms normally varying from between
30 to 90 days. Trade credit therefore represents an interest free short-term loan. In a period of
high inflation, purchasing via trade credit will be very helpful in keeping costs down. However,
it is important to take into account the loss of discounts suppliers offer for early payment.
Unacceptable delays in payment will worsen a company's credit rating and additional credit may
become difficult to obtain.
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Factoring
Factoring is a financial transaction whereby a business sells its accounts receivable (i.e. invoices)
to a third party (called a factor) at a discount in exchange for immediate money with which to
finance continued business. Factoring is provided by financial institutions, for example banks
and individual factoring brokers. It is a form of asset-based financing, where the factor provides
funding based upon the values of a borrowers accounts receivable, i.e. corporate debtors.
Factoring generally includes more than just financing, and it also includes funding and
collection. The main aspects of factoring include the following.
a) Administration of the client's invoicing, sales accounting and debt collection service
b) Credit protection for the client's debts, whereby the factor takes over the risk of loss from
bad debts and so 'insures' the client against such losses. This is known as a non-recourse
service. However, if a non-recourse service is provided the factor, not the firm, will
decide what action to take against non-payers.
c) Making payments to the client in advance of collecting the debts. This is sometimes
referred to as 'factor finance' because the factor is providing cash to the client against
outstanding debts.)
The benefits of factoring for a business customer include the following.
i) The business can pay its suppliers promptly, and so be able to take advantage of any early
payment discounts that are available.
ii) Optimum inventory levels can be maintained, because the business will have enough cash
to pay for the inventories it needs.
iii) Growth can be financed through sales rather than by injecting fresh external capital.
iv) The business gets finance linked to its volume of sales. In contrast, overdraft limits tend
to be determined by historical statements of financial position.
v) The managers of the business do not have to spend their time on the problems of slow
paying accounts receivable.
vi) The business does not incur the costs of running its own sales ledger department, and can
use the expertise of debtor management that the factor has.
An important disadvantage is that accounts receivable will be making payments direct to the
factor, which is likely to present a negative picture of the firm's attitude to customer relations. It
may also indicate that the firm is in need of rapid cash, raising questions about its financial
stability.
Example
A company makes annual credit sales of Kshs.1,500,000. Credit terms are 30 days, but its debt
administration has been poor and the average collection period has been 45 days with 0.5% of
sales resulting in bad debts which are written off. A factor would take on the task of debt
administration and credit checking, at an annual fee of 2.5% of credit sales. The company would
save Kshs.30,000 a year in administration costs. The payment period would be 30 days. The
factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3%
over the current base rate). The company can obtain an overdraft facility to finance its accounts
receivable at a rate of 2.5% over base rate. Should the factor's services be accepted? Assume a
constant monthly turnover.
Invoice Discounting
Invoice discounting is the purchase (by the provider of the discounting service) of trade debts at
a discount. Invoice discounting enables the company from which the debts are purchased to raise
Page 27 of 46
working capital. Invoice discounting is related to factoring and many factors will provide an
invoice discounting service. It is the purchase of a selection of invoices, at a discount. The
invoice discounter does not take over the administration of the client's sales ledger.
A client should only want to have some invoices discounted when he has a temporary cash
shortage, and so invoice discounting tends to consist of one-off deals. Confidential invoice
discounting is an arrangement whereby a debt is confidentially assigned to the factor, and the
client's customer will only
become aware of the arrangement if he does not pay his debt to the client. If a client needs to
generate cash, he can approach a factor or invoice discounter, who will offer to purchase selected
invoices and advance up to 75% of their value. At the end of each month, the factor will pay over
the balance of the purchase price, less charges, on the invoices that have been settled in the
month.
Leasing
Rather than buying an asset outright, using either available cash resources or borrowed funds, a
business may lease an asset. Leasing has become a popular source of finance. Leasing can be
defined as a contract between lessor and lessee for hire of a specific asset selected from a
manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the asset.
The lessee has possession and use of the asset on payment of specified rentals over a period.
Many lessors are financial intermediaries such as banks and insurance companies. The range of
assets leased is wide, including office equipment and computers, cars and commercial vehicles,
aircraft, ships and buildings.
Sale and leaseback
A company which owns its own premises can obtain finance by selling the property to an
insurance company or pension fund for immediate cash and renting it back, usually for at least
50 years with rent reviews every few years. A company would raise more cash from sale and
leaseback arrangements than from a mortgage, but there are significant disadvantages.
i) The company loses ownership of a valuable asset which is almost certain to appreciate
over time.
ii) The future borrowing capacity of the firm will be reduced, as there will be less assets to
provide security for a loan.
iii) The company is contractually committed to occupying the property for many years ahead
which can be restricting.
iv) The real cost is likely to be high, particularly as there will be frequent rent reviews.
Debt (Bonds)
Bonds are long-term debt capital raised by a company for which interest is paid, usually half
yearly and at a fixed rate. Holders of bonds are therefore long-term payables for the company.
The term bonds describe various forms of long-term debt a company may issue, such as loan
notes or debentures, which may be redeemable and Irredeemable. Bonds or loans come in
various forms, including:
i) Floating rate debentures
ii) Zero coupon bonds
iii) Convertible bonds
Bonds have a nominal value, which is the debt owed by the company, and interest is paid at a
stated 'Coupon' on this amount. For example, if a company issues 10% bonds, the coupon will be
Page 28 of 46
10% of the nominal value of the bonds, so that Kshs.10, 000 of bonds will receive Kshs.1000
interest each year. The rate quoted is the gross rate, before tax. Where the coupon rate is fixed at
the time of issue, it will be set according to prevailing market conditions given the credit rating
of the company issuing the debt. Subsequent changes in market (and company) conditions will
cause the market value of the bond to fluctuate, although the coupon will stay at the fixed
percentage of the nominal value.
Venture capital
Venture capital is risk capital, normally provided in return for an equity stake.Venture capital
organisations have been operating for many years. Venture capital is also called private equity
which is medium to long-term risk capital provided in return for an equity stake in potentially
high growth unquoted companies. Some other organisations are engaged in the creation of
venture capital funds. In these the organisation raises venture capital funds from investors and
invests in management buyouts or expanding companies. There are now quite a large number of
such organisations in kenya.
Acacia Venture Capital Fund,
Africa Agriculture Capital Fund
Africa Health Care Fund (Aureos)
AfricInvest
Agri-Vie Fund (Sanlam Private Equity)
Aureos Capital East Africa Fund
Centum Investment
East Africa Venture Capital Partners (SME Ventures)
Enablis
Fanisi Fund
Fechim Investment LTD
Fusion Capital Kenya Venture Fund
GroFin Africa Fund (GAF) and GroFIN East Africa Fund
ICEA Asset Management
Imara Africa Opportunities Fund
Industrial Promotion Services (Aga Khan Fund for Economic Development)
Inreturn Capital
Investeq Africa Frontier Fund
Investment Fund for Health in Africa (IFHA)
Kenya Gatsby Trust
Kibo Fund (CIEL)
Leapfrog Investments
Loita Capital Partners
Industrial and Commercial Development Corporation
Miliki Ventures
Origins Investment Group
Trans-Century Limited
Advantages of PE Funding
i) Provision of Capital- PE investors provide medium to long term capital to facilitate
growth and/ or enabling Management participation through buy outs/ buy ins.
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ii) Improved corporate governance PE investors help their investee companies transition
from informally run businesses to professionally managed organisations with the
commensurate benefits of better management control and focus.
iii) Access to third party capital PE investors have extensive contacts with financiers to
mobilise external sources of capital for their Investees. Companies with PE investors
attain the appropriate credibility to access the financial markets (debt or equity).
iv) Access to third party business solution providers As a result of partnering with a diverse
range of companies, PE investors have accumulated knowledge on implementation of
business solutions that enhance the companies ability to embrace a culture of
measurement and accountability to various stakeholders.
Ordinary shares
Ordinary shares are issued to the owners of a company. Ordinary shares have a nominal or 'face'
value, typically Kshs.1 or Kshs. 5. You should understand that the market value of a quoted
company's shares bears no relationship to their nominal value, except that when ordinary shares
are issued for cash, the issue price must be equal to or (more usually) more than the nominal
value of the shares. Ordinary shareholders have rights as a result of their ownership of the shares.
i) Shareholders can attend company general meetings.
ii) They can vote on important company matters such as the appointment of directors, using
shares in a takeover bid, changes to authorised share capital or the appointment of
auditors.
iii) They are entitled to receive a share of any agreed dividend.
iv) They will receive the annual report and accounts.
v) They will receive a share of any assets remaining after liquidation.
vi) They can participate in any new issue of shares.
Ordinary shareholders are the ultimate bearers of risk as they are at the bottom of the creditor
hierarchy in a liquidation. This means there is a significant risk they will receive nothing after all
of the other trade payables have been paid. This greatest risk means that shareholders expect the
highest return of long-term providers of finance. The cost of equity finance is therefore always
higher than the cost of debt.
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ISSUE OF SHARE CAPITAL AND RIGHTS

There are three main types of business organisation: (1) sole proprietorship (2) partnership (3)
company. Each form of business organisation is required capital to carry on its business
smoothly. On sole proprietorship the whole capital is contributed by sole proprietor in
partnership the capital is invested by the partners and in case of company capital is invested by
the public. A share is one unit into which the total share capital is divided. Share capital of the
company can be explained as a fund or sum with which a company is formed to carry on the
business and which is raised by the issue of shares. The amount collected by the company from
the public towards its capital, collectively is known as share capital and individually is known as
share. A share is not a sum of money but is an interest measured by a sum of money and this
interest also contains bundle of rights and obligations contained in the contract i.e. Article of
Association. Investment in the shares of any company is a basis of ownership in the company
and the person who invest in the shares of any company, is known as the shareholder, member
and the owner of that company.
Most companies are started as private companies, but over the years, when the firm expands its
operation, it may change from private company (whose shares are held by few people in the
public) to a public company (whose shares are held by unlimited members of the public).
Conversion from private to public is done by issuing ordinary shares to the public. Once shares
are issued, the companys shares starts to be traded on the stock exchange, a process called stock
listing. Going public is not an easy task. In deciding whether to seek a listing, a company should
consider the alternative financing needs available and the benefits versus the drawbacks of
listings.
Benefits of stock listing
i) Creating a market for the company's shares
ii) Enhancing the status and financial standing of the company
iii) Increasing public awareness and public interest in the company and its products
iv) Providing the company with an opportunity to implement share option schemes for their
employees
v) Accessing to additional fund raising in the future by means of new issues of shares or
other securities
vi) Facilitating acquisition opportunities by use of the company's shares
vii) Offering existing shareholders a ready means of realising their investments
Drawbacks
Increasing accountability to public shareholders
i) Need to maintain dividend and profit growth trends
ii) Becoming more vulnerable to an unwelcome takeover
iii) Need to observe and adhere strictly to the rules and regulations by governing bodies
iv) Increasing costs in complying with higher level of reporting requirements
v) Relinquishing some control of the company following the public offering
vi) Suffering a loss of privacy as a result of media interest
Methods of obtaining a listing
Initial public offer (IPO)
Stock Placing
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Stock Introduction
Initial public offer
An initial public offer (IPO) is a means of selling the shares of a company to the public at large.
When companies 'go public' for the first time, a large issue will probably take the form of an
IPO. This is known as flotation. Subsequent issues are likely to be placings or rights issues. An
IPO entails the acquisition by an issuing house of a large block of shares of a company, with a
view to offering them for sale to the public and investing institutions.
An issuing house is usually an investment bank (or sometimes a firm of stockbrokers). It may
acquire the shares either as a direct allotment from the company or by purchase from existing
members. In either case, the issuing house publishes an invitation to the public to apply for
shares, either at a fixed price or on a tender basis. The issuing house accepts responsibility to the
public, and gives to the issue the support of its own standing.
A placing
A placing is an arrangement whereby the shares are not all offered to the public, but instead, the
sponsoring market maker arranges for most of the issue to be bought by a small number of
investors, usually institutional investors such as pension funds and insurance companies.
The choice between an IPO and a placing
a) Placings are much cheaper. Approaching institutional investors privately is a much
cheaper way of obtaining finance, and thus placings are often used for smaller issues.
b) Placings are likely to be quicker.
c) Placings are likely to involve less disclosure of information.
d) However, most of the shares will be placed with a relatively small number of
(institutional) shareholders, which means that most of the shares are unlikely to be
available for trading after the flotation, and that institutional shareholders will have
control of the company.
A Stock Exchange introduction
By this method of obtaining a quotation, no shares are made available to the market, neither
existing nor newly created shares; nevertheless, the stock market grants a quotation. This will
only happen where shares in a large company are already widely held, so that a market can be
seen to exist. A company might want an introduction to obtain greater marketability for the
shares, a known share valuation for inheritance tax purposes and easier access in the future to
additional capital.
Costs of share issues on the stock market
Companies may incur the following costs when issuing shares.
i) Underwriting costs (see below)
ii) Stock market listing fee (the initial charge) for the new securities
iii) Fees of the issuing house, solicitors, auditors and public relations consultant
iv) Charges for printing and distributing the prospectus
v) Advertising in national newspapers
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Underwriting
A company about to issue new securities in order to raise finance might decide to have the issue
underwritten. Underwriters are financial institutions which agree (in exchange for a fixed fee,
perhaps 2.25% of the finance to be raised) to buy at the issue price any securities which are not
subscribed for by the investing public. Underwriters remove the risk of a share issue's being
under-subscribed, but at a cost to the company issuing the shares. It is not compulsory to have an
issue underwritten. Ordinary offers for sale are most likely to be underwritten although rights
issues may be as well.
Rights issues
A rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a
price lower than the current market price. A rights issue provides a way of raising new share
capital by means of an offer to existing shareholders, inviting them to subscribe cash for new
shares in proportion to their existing holdings. For example a right to buy 1 share for every 5
shares held. The major advantages of a rights issue are as follows.
a) Rights issues are cheaper than IPOs to the general public. This is partly because no
prospectus is not normally required, partly because the administration is simpler and
partly because the cost of underwriting will be less.
b) Rights issues are more beneficial to existing shareholders than issues to the general
public. New shares are issued at a discount to the current market price, to make them
attractive to investors. A rights issue secures the discount on the market price for existing
shareholders, who may either keep the shares or sell them if they wish.
c) Relative voting rights are unaffected if shareholders all take up their rights.
d) The finance raised may be used to reduce gearing in book value terms by increasing share
capital and/or to pay off long-term debt which will reduce gearing in market value terms.
The offer price in a rights issue will be lower than the current market price of existing shares.
The size of the discount will vary, and will be larger for difficult issues. The offer price must
however be at or above the nominal value of the shares, so as not to contravene company law. A
company making a rights issue must set a price which is low enough to secure the acceptance of
shareholders, who are being asked to provide extra funds, but not too low, so as to avoid
excessive dilution of the earnings per share.
The market price of shares after a rights issue: the theoretical ex rights price
When a rights issue is announced, all existing shareholders have the right to subscribe for new
shares, and so there are rights attached to the existing shares. The shares are therefore described
as being 'cum rights' (with rights attached) and are traded cum rights. On the first day of
dealings in the newly issued shares, the rights no longer exist and the old shares are now 'ex
rights' (without rights ttached).
After the announcement of a rights issue, share prices normally fall. The extent and duration of
the fall may depend on the number of shareholders and the size of their holdings. This temporary
fall is due to uncertainty in the market about the consequences of the issue, with respect to future
profits, earnings and dividends. After the issue has actually been made, the market price per
share will normally fall, because there are more shares in issue and the new shares were issued at
a discount price.
In theory, the new market price will be the consequence of an adjustment to allow for the
discount price of the new issue, and a theoretical ex rights price can be calculated.
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Example
Mose Ltd has 1,000,000 ordinary shares of Kshs.10 in issue, which have a market price on 1
September of Kshs.21 per share. The company decides to make a rights issue, and offers its
shareholders the right to subscribe for one new share at Kshs.15 each for every four shares
already held. After the announcement of the issue, the share price fell to Kshs.19.5, but by the
time just prior to the issue being made, it had recovered to Kshs.20 per share. This market value
just before the issue is known as the cum rights price. What is the theoretical ex rights price?
The theoretical gain or loss to shareholders
The possible courses of action open to shareholders are:
a) To 'take up' or 'exercise' the rights, that is, to buy the new shares at the rights price.
Shareholders who do this will maintain their percentage holdings in the company by
subscribing for the new shares.
b) To 'renounce' the rights and sell them on the market. Shareholders who do this will
have lower percentage holdings of the company's equity after the issue than before
the issue, and the total value of their shares will be less.
c) To renounce part of the rights and take up the remainder. For example, a shareholder
may sell enough of his rights to enable him to buy the remaining rights shares he is
entitled to with the sale proceeds, and so keep the total market value of his
shareholding in the company unchanged.
d) To do nothing. Shareholders may be protected from the consequences of their
inaction because rights not taken up are sold on a shareholder's behalf by the
company. The Stock Exchange rules state that if new securities are not taken up, they
should be sold by the company to new subscribers for the benefit of the shareholders
who were entitled to the rights.
Example
Gopher Ltd has issued 3,000,000 ordinary shares of Kshs.10 each, which are at present selling
for Kshs.40 per share. The company plans to issue rights to purchase one new equity share at a
price of Kshs.32 per share for every three shares held. A shareholder who owns 9000 shares
thinks that he will suffer a loss in his personal wealth because the new shares are being offered at
a price lower than market value. On the assumption that the actual market value of shares will be
equal to the theoretical ex rights price, what would be the effect on the shareholder's wealth if:
(a) He sells all the rights
(b) He exercises half of the rights and sells the other half
(c) He does nothing at all?
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MEASURING FINANCIAL PERFORMANCE

As part of the system of financial control in an organisation, it will be necessary to have ways of
measuring the progress of the enterprise, so that managers know how well the company is doing.
A common means of doing this is through financial ratio analysis, which is concerned with
comparing and quantifying relationships between financial variables, such as those variables
found in the statement of financial position and income statement of the enterprise. The analyst
draws the financial data needed in financial analysis from many sources. The primary source is
the data provided by the company itself in its annual report and required disclosures. Other
information such as the market prices of securities of publicly-traded corporations can be found
in the financial press. Another source of information is economic data, such as the Gross
Domestic Product and Consumer Price Index, which may be useful in assessing the recent
performance or future prospects of a company or industry. Ratios can be grouped into the
following four categories:
Profitability ratios
Gearing ratios
Liquidity ratios
Shareholders' investment ratios ('stock market ratios').
The key to obtaining meaningful information from ratio analysis is comparison: comparing ratios
over a number of periods within the same business to establish whether the business is improving
or declining, and comparing ratios between similar businesses to see whether the company you
are analyzing is better or worse than average within its own business sector.
1.0 Profitability
A company ought of course to be profitable if it is to maximise shareholder wealth, and obvious
checks on profitability are:
(a) Whether the company has made a profit or a loss on its ordinary activities
(b) By how much this year's profit or loss is bigger or smaller than last year's profit or
loss
Profit before taxation is generally thought to be a better figure to use than profit after taxation,
because there might be unusual variations in the tax charge from year to year which would not
affect the underlying profitability of the company's operations. Another profit figure that should
be considered is profit before interest and tax (PBIT). This is the amount of profit which the
company earned before having to pay interest to the providers of loan capital. By providers of
loan capital, we usually mean longer term loan capital, such as debentures and medium-term
bank loans.
1.1 Gross Profit Margin
Gross profit margin Gross Profit
=
Sales
The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio indicates
how much of every shilling of sales is left after costs of goods sold. It also indicates how well a
company controls the cost of its inventory and the manufacturing of its products and
subsequently passing on the costs to its customers. The larger the gross profit margin, the better
for the company.
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1.2 Operating Profit Margin

PBIT
Operating Profit margin
=
Sales
Operating profit is also known as EBIT or PBIT and is found on the company's income
statement. The operating profit margin looks at PBIT as a percentage of sales. The operating
profit margin ratio is a measure of overall operating efficiency, incorporating all of the expenses
of ordinary, daily business activity. It indicates how the business is managing expenses
1.3 Net Profit Margin OR Net income margin
Net income margin Net Income (PAT)
=
Sales
When doing a simple profitability ratio analysis, net profit margin is the most often margin ratio
used. The net profit margin shows how much of each sales shilling shows up as net income after
all expenses are paid. For example, if the net profit margin is 5%, which means that 5 cents of
every shilling is profit. The net profit margin measures profitability after consideration of all
expenses including taxes, interest, and depreciation.
1.4 Asset Turnover
Sales
Net income margin
Capital Employed or Total
=
Asset
The total asset turnover ratio measures the ability of a company to use its assets to generate sales.
The total asset turnover ratio considers all assets including fixed assets, like plant and equipment,
as well as inventory and accounts receivable. However, the easiest way is to look at total assets
from financing point of view and use Capital employed (debt + Equity) which gives the same
figure. The lower the total asset turnover ratio, as compared to historical data for the firm and
industry data, the more sluggish the firm's sales. This may indicate a problem with one or more
of the asset categories composing total assets - inventory, receivables, or fixed assets. You
should analyze the various asset classes to determine where the problem lies.
There could be a problem with inventory. The firm could be holding obsolete inventory and not
selling inventory fast enough. With regard to accounts receivable, the firm's collection period
could be too long and credit accounts may be on the books too long. Fixed assets, such as plant
and equipment, could be sitting idle instead of being used to their full capacity. All of these
issues could lower the total asset turnover ratio.
1.5 Return On Capital Employed (ROCE)
You cannot assess profits or profit growth properly without relating them to the amount of funds
(the capital) employed in making the profits. The most important profitability ratio is therefore
return on capital employed (ROCE), also called return on investment (ROI).
PBIT
Return on Capital Employed =
Capital
employed
Capital employed = Shareholders' funds (share capital plus reserves and undistributed profits)=
total assets less current liabilities.
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ROCE give the rate of return on capital employed by the business. Generally, this rate should be
compared with cost capital employed to determine whether the business is making enough
profits or not. There are three comparisons that can be made:
i) The change in ROCE from one year to the next will indicate a change in profitability of
the business
ii) The ROCE being earned by other companies in the industry, if this information is
available will indicate whether the company is managed poorly or better than other
companies
iii) A comparison of the ROCE with current market borrowing rates will indicate
1. Cost of extra borrowing to the company if it needed more loans, and is it earning a
ROCE that suggests it could make high enough profits to make such borrowing
worthwhile?
2. If the company making a ROCE which suggests that it is making profitable use of
its current borrowing?
1.6 Secondary ratios
Net Profit margin and asset turnover together explain the ROCE, and if the ROCE is the primary
profitability ratio, these other two are the secondary ratios. The relationship between the three
ratios is as follows.
Operating Profit margin X Asset Turnover = ROCE
It is also worth commenting on the change in turnover from one year to the next. Strong sales
growth will usually indicate volume growth as well as turnover increases due to price rises, and
volume growth is one sign of a prosperous company.
1.7 Return on Equity (ROE)
Another measure of the firms overall performance is return on equity. This compares net profit
after tax with the equity that shareholders have invested in the firm.
Profit attributable to ordinary
Return on Equity = shareholders
Shareholders, Equity
This ratio shows the earning power of the shareholders book investment and can be used to
compare two firms in the same industry. A high return on equity could reflect the firms good
management of expenses and ability to invest in profitable projects.
2.0 Liquidity Ratios
Assets that may be converted into cash in a short period of time are referred to as liquid assets;
they are listed in financial statements as current assets. Current assets are often referred to as
working capital because these assets represent the resources needed for the day-to-day operations
of the company's long-term, capital investments. Current assets are used to satisfy short-term
obligations, or current liabilities. The amount by which current assets exceed current liabilities is
referred to as the net working capital. Liquidity capital ratios may help to indicate whether a
company is over-capitalised, with excessive working capital, or if a business is likely to fail. A
Page 37 of 46
business which is trying to do too much too quickly with too little long-term capital is
overtrading.
2.1 The current ratio
Current Asset
Current ratio =
Current
Liabilities
One of the most universally known ratios, which reflect the Working Capital situation, indicates
the ability of a company to pay its short-term creditors from the realization of its current assets
and without having to resort to selling its fixed assets to do so. Ideally the figure should always
be greater than 1, which would indicate that there are sufficient assets available to pay liabilities,
should the need arise. The higher the figure the better. In practice, a ratio of 2:1 is recommended,
but this can vary between different types of businesses. For those industries such as transport
where the majority of assets are tangible fixed assets, then a figure of 0.6:1 would be acceptable.
In retail and manufacturing we would expect figures between 1.1:1 to 2:1. Generally where
credit terms and large stocks are normal to the business, the current ratio will be higher than, for
example, a retail business where cash sales are the norm.
2.2 The Quick Ratio
Current assets less
Quick ratio or acid test ratio
inventories
=
Current liabilities
This ratio indicates the ability of a company to pay its debts as they fall due. It is generally
considered to be a more accurate assessment of a company's financial health than the current
ratio as it excludes stock, thus reducing the risk of relying on a ratio that may include slow
moving or redundant stock. Companies are not able to convert all their current assets into cash
very quickly. In some businesses, where inventory turnover is slow, most inventories are not
very liquid assets, because the cash cycle is so long. For these reasons, we calculate an additional
liquidity ratio, known as the quick ratio or acid test ratio. This ratio should ideally be 1.5:1 for
companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick
ratio can be less than 1 without suggesting that the company is in cash flow difficulties.
Supermarkets can, for example, easily survive on ratios as low as 0.4 with cash being received
for goods sold, before the goods are actually paid for.
2.3 The accounts receivable payment period
Accounts receivable payment period =
Current Trade receivables X

days
Credit sales turnover
365
Also called accounts receivable days. This is a rough measure of the average length of time it
takes for a company's accounts receivable to pay what they owe. The trade accounts receivable
are not the total figure for accounts receivable in the statement of financial position, which
includes prepayments and non-trade accounts receivable. The trade accounts receivable figure or
commonly called debtors should be used. The estimate of accounts receivable days is only an
approximate.
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2.4 The inventory turnover period

Inventory turnover =
Cost of sales
Average inventory
X 365 days
The inventory turnover period can also be calculated by:

Average inventory
Inventory turnover period (Finished goods) =
X 365 days
Cost of sales
Raw materials inventory holding period = Average raw materials inventory X 365 days
Annual purchases
Average production (work-in-progress) period = Average WIP
Cost of sales
X 365 days
These indicate the average number of days that items of inventory are held for. As with the
average accounts receivable collection period, these are only approximate figures, but ones
which should be reliable enough for finding changes over time. A lengthening inventory turnover
period indicates:
a) A slowdown in trading, or
b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is
becoming excessive
If we add together the inventory days and the accounts receivable days, this should give us an
indication of how soon inventory is convertible into cash, thereby giving a further indication of
the company's liquidity.
2.5 The accounts payable payment period
Accounts payable payment period= Average trade payables
Purchases or Cost of sales
X 365 days
The accounts payable payment period often helps to assess a company's liquidity; an increase in
accounts payable days is often a sign of lack of long-term finance or poor management of current
assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on.
All the ratios calculated above will vary by industry; hence comparisons of ratios calculated with
other similar companies in the same industry are important.
2.6 The sales revenue/net working capital ratio
sales revenue/net working capital ratio = Sales revenue
X 365 days
Current assets Current Liabilities
Shows the level of working capital supporting sales. Working capital must increase in line with
sales to avoid liquidity problems and this ratio can be used to forecast the level of working
capital needed for a projected level of sales.
These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company
suddenly finds that it is unable to renew its short-term liabilities (for example, if the bank
suspends its overdraft facilities, there will be a danger of insolvency unless the company is able
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to turn enough of its current assets into cash quickly. Current liabilities are often a cheap method
of finance (trade accounts payable do not usually carry an interest cost). Companies may
therefore consider that, in the interest of higher profits, it is worth accepting some risk of
insolvency by increasing current liabilities, taking the maximum credit possible from suppliers.
If there are excessive inventories, accounts receivable and cash, and very few accounts payable,
there will be an over-investment by the company in current assets. Working capital will be
excessive and the company will be in this respect over-capitalised. Indicators of overcapitalisation includes sales/working capital especially when compared with previous years or
similar companies, Liquidity ratios when compared with previous years or similar companies
and Turnover periods especially long turnover periods for inventory and accounts receivable or
short credit period from suppliers may be unnecessary
In contrast with over-capitalisation, overtrading happens when a business tries to do too much
too quickly with too little long-term capital, so that it is trying to support too large a volume of
trade with the capital resources at its disposal. Even if an overtrading business operates at a
profit, it could easily run into serious trouble because it is short of money. Such liquidity troubles
stem from the fact that it does not have enough capital to provide the cash to pay its debts as they
fall due. Symptoms of overtrading are as follows.
i) There is a rapid increase in turnover.
ii) There is a rapid increase in the volume of current assets and possibly also non-current
assets. Inventory turnover and accounts receivable turnover might slow down, in which
case the rate of increase in inventories and accounts receivable would be even greater
than the rate of increase in sales.
iii) There is only a small increase in proprietors' capital (perhaps through retained profits).
Most of the increase in assets is financed by credit, especially:
a) Trade accounts payable - the payment period to accounts payable is likely to
lengthen
b) A bank overdraft, which often reaches or even exceeds the limit of the facilities
agreed by the bank
iv) Some debt ratios and liquidity ratios alter dramatically.
a) The proportion of total assets financed by proprietors' capital falls, and the
proportion financed by credit rises.
b) The current ratio and the quick ratio fall.
c) The business might have a liquid deficit, that is, an excess of current liabilities
over current assets.
3.0 Gearing ratios
Measuring of financial gearing is an attempt to quantify the degree of risk involved in holding
debt in a company, both in terms of the company's ability to remain in business and in terms of
expected ordinary dividends from the company. The more geared the company is, the greater the
risk that little (if anything) will be available to distribute by way of dividend to the ordinary
shareholders. Gearing ultimately measures the company's ability to remain in business. A highly
geared company has a large amount of interest to pay annually. If those borrowings are 'secured'
in any way (and bonds in particular are secured), then the holders of the debt are perfectly
entitled to force the company to realise assets to pay their interest if funds are not available from
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other sources. Clearly, the more highly geared a company, the more likely this is to occur when
and if profits fall.
3.1 Debt Ratio
Total Debt
Capital Employed
Debt does not include long-term provisions and liabilities such as deferred taxation. There is no
firm rule on the maximum safe debt ratio, but as a general guide, you might regard 50% as a safe
limit to debt.
Debt ratio =
3.2 Debt Equity ratio

Debt-equity ratio =
Total Debt
Shareholders
Equity
Debt in the formulas above refers to prior charge capital is capital which has a right to the receipt
of interest or of preferred dividends in precedence to any claim on distributable earnings on the
part of the ordinary shareholders. On winding up, the claims of holders of prior charge also rank
before those of ordinary shareholders. a company is low geared if the gearing ratio is less than
100%, highly geared if the ratio is over 100% and neutrally geared if it is exactly 100%.
3.3 Interest coverage ratio
Interest coverage ratio =
PBIT
Interest
The reciprocal of this, the interest to profit ratio, is also sometimes used. As a general guide, an
interest coverage ratio of more than two times is considered low, indicating that profitability is
too low given the gearing of the company. An interest coverage ratio of more than seven is
usually seen as safe.
4.0 Shareholders' Investment Ratios

Returns to shareholders are obtained in the form of dividends received and/or capital gains from
increases in market value of their shares. A company will only be able to raise finance if
investors think that the returns they can expect are satisfactory in view of the risks they are
taking. We must therefore consider how investors appraise companies. The price of shares on the
stock exchange can be described as cum dividend or cum div meaning that the purchaser of
shares is entitled to receive the next dividend payment or ex dividend or ex div meaning that the
purchaser of shares is not entitled to receive the next dividend payment. The relationship
between the cum div price and the ex div price is:
Market price per share (ex div) = Market price per share (cum div) forthcoming dividend per
share
4.1 Dividend Per Share (DPS)
Total dividends
Dividend per Share
=
No. of ordinary shares
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Dividend per share is the entitlement given to shareholders for investing in a company. it is
usually in cent and therefore needs no further interpretation. But this should however be
compared with what other company of similar size are paying.
4.2 The Dividend Yield
Dividend yield =
Dividend Per Share

Market Price per Share
Dividend yield simply means what you expect from your investment in the form of dividend.
Investment yields is made up of DY plus capital appreciation
QUESTION
1) A company declares a dividend of 16 cents for the year ended July 31, its ex div share
price is 315 cents, what is the dividend yield?
2) A company pays a dividend of 15c (net) per share. The market price is 240c. What is the
dividend yield if the rate of tax credit is 10%?
4.3 Earnings Per Share (EPS)
shareholders
EPS =
Number of ordinary shares
EPS in common language is the amount of money that a unit of share is able to earn in a
particular period. This tells us how a company is doing in relation to the number of shares it has.
It is however worthy to note that there are other circumstances that affect the EPS (EPS dilution)
figure like issue of new shares, rights issue, conversion of convertible loans, etc. These factors
are taken care of by calculating different EPSs for a single period.
Earnings per share (EPS) is widely used as a measure of a company's performance and is of
particular importance in comparing results over a period of several years. A company must be
able to sustain its earnings in order to pay dividends and re-invest in the business so as to achieve
future growth. Investors also look for growth in the EPS from one year to the next.
4.4 Dividends Cover (DC)
Dividend cover
shareholders
=
Total Dividends
Dividend cover EPS
=
DPS
It is shows proportion of profit on ordinary activities for the year that is available for distribution
to shareholders has been paid (or proposed) and what proportion will be retained in the business
to finance future growth. A dividend cover of 2 times would indicate that the company had paid
50% of its distributable profits as dividends, and retained 50% in the business to help to finance
future operations. Retained profits are an important source of funds for most companies, and so
the dividend cover can in some cases be quite high. A sharp fall in Dividend Cover could mean
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that a company did not make good profit this year but, the management went ahead to pay the
normal dividend, this shouldnt be a cause of worry if there is prospect for growth in the
company.
4.5 Price-Earnings Ratio (P/E Ratio)
Price Earnings
ratio =
This is same as
Price Earnings
ratio =
Market price of share

EPS
Total market value of equity
Total earnings
In general, a high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story
by itself. It's usually more useful to compare the P/E ratios of one company to other companies
in the same industry, to the market in general or against the company's own historical P/E. It
would not be useful for investors using the P/E ratio as a basis for their investment to compare
the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has
much different growth prospects. The P/E is sometimes referred to as the "multiple", because it
shows how much investors are willing to pay per shilling of earnings. If a company were
currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay
Kshs.20 for Kshs.1 of current earnings. In other words, P/E ratio shows current investor demand
for a company share. The reciprocal of the P/E ratio is known as the earnings yield. The earnings
yield is an estimate of expected return to be earned from holding the stock
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BBM 206: PRINCIPLES OF FINANCE NOTES

GARISSA UNIVERSITY COLLEGE