Debt Management Techniques in Business Organizations in Nigeria
Debt Management - This chapter shall examine the related literature of debt management analysis. Within the scope of this project topic, we hereby bring to light every material that will make for easy understanding of the topic: ANALYSIS OF DEBT MANAGEMENT. Every effort is made to reach every latent problem inherent to the analysis of debt management in area of the “organizational working capital”. This is achieved through reference to the works of some learned people in this area of study as well as consolidated personnel researcher. Furthermore, analyzing debt management is studied under these two major headings such that it will be of the future scholars and an aid to contemporary business concern.
However, for clarity reason, we wish to be deductive in our approach even if it may involve going a little beyond the scope.
MEANING OF DEBT MANAAGEMENT.
Debt results from imbalance in fiscal operations of the company or firm when total expenditure exceeds the current revenue for a given fiscal year. Therefore, “debt management is defined as the process where the debt obligation is being managed in all ramifications whether from the domestic or external sources” C. A. EZIGBO (2001 p. 251). Debt management is the ability of financial manager or management make good uses of the money borrowed by the company in order to achieve the set objectives or meet the purpose of its borrowing of the company.
CLASSIFICATION OF DEBT-MANAGEMENT
Debt management can be classified into two broad classes:
a) Government debt.
b) Other debts.
a) Government debt: – Government debt may be said to the deferred obligation of government. This includes the obligation of the local government, state and federal government.
b) Other debts: – This kind of debt consists of obligation of individual’s business firm and governmental organizations.
However, in R. Charles Mayor et al (1995) p.492 the amount of debt contained in a firm’s debt capacity- since this project topic is especially an analyzing debt management in a business organization. Therefore our emphasis is more on the later than on the former.
Debt can be treated in relation to the:
- i. Organizational working capital.
- ii. Organizational capital structure.
ANALYZING DEBT MANAGEMENT IN RELATION TO ORGANIZATION WORKING CAPITAL.
Working capital is different between current assets and current liabilities. It is sometimes called circulating capital. The gross working capital is simply current assets. Debt is one of the major components of current assets.
An ideal debt is almost as liquid as cash and a bad debt is almost as bad as cash cost. This actually brings to light the necessity of good management or trade. Working capital in management may be defined as managerial decision on the amount of capital to be invested in various current assets and how this investment is to be financed.
As a matter of consistency, this project is particularized to a business organization “as such, it is deemed appropriate to look into the management of trade debt”.
COST OF CAPITAL IN RELATION TO DEBT MANAGEMENT TECHNIQUE.
A very important element in decision about the use of any resource is the cost of that resource. This is true of finance just as it is of any thing else. Therefore, these costs of finance are generally termed the cost of capital.
However, very many authors have discussed cost of capital EMEKEKWUE (1997), p.138 says that: a lot of ambiguity surrounds the concept of cost of capital. Much of this is caused by inadequacies regarded what actually is viewed as the cost of capital. “Cost of capital can be regarded as that amount of earning which must be sustained in order to ensure that the market value of equity stock does not drop”. It can also be regarded as the cost of returns, which must be earned so that the value of the firm and the market value of its common stock does not decline. It can also be regarded as the minimum rate of return, which will maintain the market value per share on its current level.
Furthermore, Ray A. Aurrisin and Erick W, (1994) p. 686 says that : cost of capital in broad concept involved a lending of the cost of all resources of investment firms, both debt and equity. In as much as business organizations usually strive to achieve a number of objectives, these corporate objectives provide a set of criteria upon which financial decision can be based. This is why business organizations seek to achieve their objectives by obtaining funds from various sources and investing some reasonably. It is relevant to recognize that the various types of funds raised has its own cost and each carries certain risks.
With the above, we can finely say that cost of capital of a firm is an aggregation of the whole components of cost with each component being matched against its relevant weight.
The organizational capital structure refers to the mix of long-term sources of fund such as a debenture, long term, preference share capital and equity share capital including reserves and surpluses (i.e. retained earnings). Individual components of option may have quite different cost, when they are obtained different markets. We consider these individual components and also the way in which they are combined to give an overall cost of capital.
The cost of capital is normally expressed like a rate of interest that is as a percentage per annum:
a) AVERAGE AND MARGINAL COST: -
For better understanding of cost of capital, one need to know of the lutive distinct concepts of the cost of capital so as to be in a better position to distinguish one from the other. The average cost of capital is the cost of capital currently employed being the weighted average of the cost for the individual components.
The marginal cost of capital is the net increment of capital to be employed. The firms is important for its measure of performance and for a current evaluation of the business, the later is also used to determine whether of not purposed development are likely to be profitable.
It is likely that as business grow in its marginal cost. This presents its improving to less expensive forms of finance as it is perceived by the market to be a better investment. At the same point, marginal cost will be equal to average cost and then to rise above it. A good knowledge of this distinction, it is a great hell to economists.
However, In B.C. Charles Mayor et al (1995) p.456 “says that, it is topical that the capital whose cost is measure and compared with the expected benefit for the proposed projects should be next or marginal capital that firm raises.
As stated in the Italia, all the sources of funds available to the business organization, cash its own cost. And to convert the mistakes in choice of the method of sourcing fund, it is good to take them in turn.
b) COST OF ORDINARY SHARE CAPITAL (EQUITY)
Since the dividend paid on ordinary share depends on the availability of profits and is in any case, paid only at the option or discretion of the directors, it might seen logical to argue that the director not under obligation to pay anything to the existing shareholding but no business can maintain the present market value of the equity. The special cost of equity is that paid of the payment (dividend), which may be in cash and put in an accretion to the reserves attributable to equity. This leads to capital appreciation.
Nevertheless Charles Mayor et al (1995) p.438 “ state that the cost of equity capital to the firm is like equilibrium rate of return required by the firms common stock investor”
c) COST OF RETAINED EARNINGS:
It would once again be a fallacy to assume that the cost of retained earnings is mill. For a company to return some of it’s earning rather than distributing there is equivalent to the issue of fresh equity to existing shareholders.
Furthermore, Stanley B. Block and Geoffrey A. Hiry 1992, p.305 state in their book that “accumulated retained earning represent the past and present earnings of the firm minus previously distributed dividends. Retained earning, by law, belong to the current stock holders in the form of dividend nor reinvested in the firm.
However, collectively, they are required to make a further investment in their company. The cost of existing retained earning is therefore, the same as the cost of the existing equity. The cost of the new retained earnings is the same as that of a new equity issue. So the formular remain the same but “k” the investment cost disappears. Some even argue that “k” the investment negative because not only that the issuing cost is eliminated by the equity holder are saved in cost of reinvesting by the equity holder are saved the cost reinvesting their dividends.
d) COST OF PREPARED CAPITAL / STOCK:
The determination of the cost of preference capital is exactly like the determination of the cost of equity.
In the book of Charles Mayor et al (1995) p.458 it is stated that “the cost of preferred stock to the firm is the rate of return required by investors on preference stock issue by the company. Therefore, present cost in the yield currently received by preference shareholders and the marginal cost in the yield, which has to be offered in order to attract fresh preference funds. The formula used in the same as that for equity, but is made simple because the term(g) – growth does not apply preference share have a fixed maximum rate of dividend and a fixed maximum capital payment in a winding up. No growth is therefore possible for them.
e) COST OF LONG TERM DEBT
The cost of long term debt is the yield received by its holder at holder current market prices. The marginal cost is the yield, which must be given to attract new investment, after allowing for issue cost or investment cost.
f) WEIGHTED AVERAGE COST OF CAPITAL:
It is often rear to see a firm that uses only on sources of fund to finance its projects. What is really obtained is that firms raise funds by issuing carious types of stocks.
Note: A combination of equity and debt second-ties in financial plan of a firm is called GEARING. If the gear is high, it means that the proportion of debt to total capital is very high. Similarly, if the reverse is the case it mean that the proportion of debt to capital is low.
Weighted average cost of capital is another method through which an average comes into the calculation of the marginal cost of capital. This is a little complicated.
g) GEARING (LEVERAGE)
In order to simplify the analysis, we shall consider only two kinds of finance, debt and equity.
However, Lawrence J. Gitman (1978) p.118 says that “leverage results from the used of fixed cost assets or fund to magnify returns to the firm’s owners.
This is also discussed in Ray H. Garrison and Eric W. Noveen (1994) p.841 say that “leverage involves that financing of assets in a company with fund that have been acquired from creditors or firm preferred stockholder at a fixed rate of return. Preference capital has so much of the nature of debt, that is not worth putting into a separate category. The use of debt along with equity is known as gearing as pointed before. Its effect is to always add financial risk to the existing level of commercial risk.
The percentage changes in the amount available to equity holder are much large because of the presence of a fixed annual interest payment. To the commercial risk has been added a factor, which amplifies it. Since this is due to the different method of financing the operation. This is described as a financial risk. This has shown the effect of financial risk to the equity holders. Since the equity holders cannot withdraw their funds, this risk represents no threat to the survival of the company. This however, is true only where the proportion of debt to equity is relatively small. If it becomes high, so that profit fluctuation threaten not only the dividend but also interest, then fore lo sure by the debenture holder would be a real possibility and financial risk would effect the company as a whole.
DIFFERENT SCHOOL OF THOUGHT IN DEBT MANAGEMENT
In a further attempt to find out whether or not an optimal capital structure does exist at all, we are brought exist with regard to the areas of capital structure.
There are two different school of thought of debt management. The different between the two school of thought are mainly attributable of different views being taken on the area known as the financial risk. This is concerned with the increase in risk borne by shareholders as the proportion of dept in the capital structures increase. As this proportion rises, the financial risk increases, and the cost of both debts …… and equity if likely to rise. However, the exact nature of these increases in cost is for from clear and different assumptions about this can lead to rather different views on capital structure. The two schools are:
(a) The traditional view and
(b) The modigliant and miller view.
(a) TRADITIONAL VIEW:
The traditionalist argue that firm’s debt ratio affect the firm’s cost of capital, thereby affecting the market value. They also argue that financing can affect the value firm. If two firm are similar except for their capital structure then the value of the leveled firm is likely to be more than of the unleveled firm.
The traditional view of capital structure is that financial risk is not perceived as significant in increasing, until a certain level of debt is reached. Beyond this point, increase returns are expected by under to rise as soon as debt is introduced, but will only do so after a certain level of debt is reached. “If debt reaches a very high proportions, the cost of both equity and desk are accepted to rise sharply, such that any advantage of debt are likely to be cancelled out. The cost of debt and equity must be brought to a minimum total for the firm to attain the optimal level.”
(b) MODIGLIANT AND MILLER VIEW (MM VIEW)
In the year 1958, Modigliant and Miller came up with a different view. They argue that: “ The value of the levered firm and that of the unleveled firm, once they belong to the same risk class must be the same in equilibrium. They also maintained that: “The market capitalization rate of both firms must be the same, once they belong to the same risk class”. This means that the value of an organization should be independent of its capital structure.
The Moligliant and Miller view theory opens that the total value of a firm depends on its commercial risk and it independent of the way in which it happens to be financed. Any other position is one of disequilibrium, which will be eradicated by investors playing the market through the process known as artbitrage (changing from one firm to the other) so as to maximize devisable from the firm. For short of time we shall not go further into the discussion of either schools, but it is as such as the need for compromise arises. These compromised level should avoid either extreme for a fair attainment of an equilibrium state.
DIFFERENT TYPES OF DEBT – MANAGEMENT
(a) TRADE DEBT (ACCOUNT RECEIVABLE):
Debt from trade, in the other words – trade debtors cannot be treated analytically like stock, which is another component of working capital.
Management of trade debtor cannot be handled without relating it to the organization credit policy. Credit has been defined by Beckman and Foster are: “The power or ability to obtain goods and service in exchange for an promise to pay for them later”.
Furthermore, David R. Andersonant et al (19991) p. 745 says that “Another area in which markov processes have produced useful result involves the estimation of the allowance for doubtful accounts. This allowance is an estimate of the amount of account receivable that will ultimately prove to be uncollectible”. These actually relates to trading credit. In practice, every business wants to be paid for the goods and or services it supplies as soon as possible. Once a sale has made this resource employed in the process cannot be set working on another cycle until they are released by payment. The convention of the trade is a very powerful factor in determining how long it takes for a customer to pay in the retail trade, a very high proportion of all business is done on cash basis.
The use of credit has certain costs attached to it, and these costs shall be taken in turns. They are:
- Cost of allowing credit
- Cost of refusing credit
(i) COST OF ALLOWING CREDIT: Certain cost will increase as the amount of credit (and thus the level of debtors increases). Such costs include the following;
(a) Financing costs: These comprise the average amount due from customer multiplied by the organization’s cost of capital.
(b) Cost of maintaining the necessary accounting record: It is necessary to keep a record for each customers, showing how much is own and for how long it has been owned.
(c) Cost of collecting the debt: Frequent debtor need to be remained that cash is due to be paid. Even if only one letter is written or a telephone call is made, such costs some money.
(d) Bad debt: If a debtor cannot be made to pay, then the supplier not only losses his profit on the sale but has to bear the cost of goods or services provided.
(e) Insurance cost: Bad debt may be insured against at a cost.
(f) Cost of obtaining a credit reference: It is usually when first granting credit to a new customer, to take up reference usually from an agency, which specializes in credit reference.
(g) Discounts: As an inducement for debtors to pay promptly, organizations often offer their debtor the right to deduct a small percentage (e.g. 25%) if they pay within a specified time from the date of sale.
(h) Inflation costs: Debt which are outstanding during a period of inflation will lose value in terms of purchasing power since the amount subsequently paid will be worthless than it was when the debt was incurred.
(ii) COST OF REFUSING CREDIT: Where however a company wishes to refuse credit entirely, certain cost are attached to it. These costs are relatively more difficult to qualify. They include the following:
(a) Lost of customer goodwill: Since most organizations do allow their customer credit, a firm which refuses to allow credit would be at a considerable disadvantage when compared with it competitors, which allow credits, causing a probable lose of trade. Such an organization can only compensate by offering some other inducement to its customers, eg lower price than the competitors.
(b) Inconveniences: An insistence on payment at the time of the security risks, since cash will be collected by a larger number of individual employees, rather than being received centrally.
THE OPTIMAL LEVEL OF DEBTORS
As with the management of stocks, management should balance the two types of cost given above (cost of allowing and refusing credit) against each other in order to achieve a position of minimum total cost. This is not an easy task and there are no mathematical models to offer guide in this matter. The management however needs to establish a policy on its trade debtors and there are certain factors to be considered. These are no mathematical models to offer guide in this matter.
The management however needs to establish a policy on its trade debtors and there are certain factors to be considered. These are:
(a) Cash discount to be offered to enhance prompt or early payment.
(b) Official period of normal credit offered.
(c) Assessing credit worthiness of customers
(d) Action to be taken regarding late payment.
These factors are to be discussed separately. It is to be noted that each will have an effect both on the general level of investment in debtors and on the firm’s competitive position. A balance between them will have to be achieved:
(a) Some firms offer a cash discount for the prompt settlement of accounts. For example FRANK and IFEOMA might state in his invoice 21/2 each discount within 7days, otherwise 30days net (stated “2.5/7 net 30”) This means that the debtor is allowed to 30days to pay his bill at the stated amount. If it is paid within the first 7days of this period, he may deduct 2.5% from the total. Since the effect, where the debtors up the offer is discount, it to reduce the average level of trade debtors, one would expect short the amount of the cash discount would be related to the firm cost of capital. In face, it is usually on a more generions scale than this (as in the above 2.5% per 3 weeks represents over 40% per annum).
This is because early payment not only reduced capital requirements but also saves administrative cost in pursuing outstanding debtors, as may reside the overall risk of bad debt as well. Cash discount are relatively expensive way of improving the inflow of cash and most companies could prefer to avoid then by concealed, way of offering however price to a sector of the market, which might otherwise to competitors.
(b) The period of credit in most cases is set by the convention of the strade and very little flexibility is afforded to the individual business. It is usual to offer various credit terms of 30days, 60days or 90days.
This implies that the payment is to be made within that interval of the invoice. Where he has a choice in the credit terms which he may increase the risk of bad debts. This does not arise so much because an individual debtor becomes more likely to default after lapse of time. It comes from the fact that firms in financial difficulties are likely to be attracted to suppliers, offering the longest credit. Thus to offer these terms will certainly draw customer away competitors but this customer group is likely to have an above average risk of default.
(c) Before allowing any customer credit, the good debt manager should assess his credit worthiness. This may be done directly by an examination of his accounts (which if the customer is a limited company, are publicly available) or indirectly through trade sources or by means of a banker’s reference. Credit worthiness is rarely assessable in term of absolutes or it will be as a matter of judging the risk in each case and categorizing the customer accordingly. Some risk is inevitable where business is done on credit. Although some potential customers in a very high risk category may not be acceptable at all, others where the risk exists but is not so great may be offered credit restricted to an overall maximum. This keeps the debt within the debtors adjusted capacity to pay and also should worst happen, limits the maximum loss which can occure, it should be borne in mind that although a great deal of business can be gained by offering credit to those with whom other will not trade the cost of legal action in pursuit of debtor can be very high and the cost of bad debt will even wipe out the profit earned on a very volume of sales.
This final point to be considered in the management of trade debtors is the following action to be taken regarding late payments. Obviously, a system must be maintained which signals outstanding debts, which has pass the due day of payment. Some direction are then possible, however, over the amount of pressure, which is then possible, however, over the amount of pressure, which is then applied.
There are many sanction ranging from polite reminders, through solicitor letter and the with holding of supplies to action through a court and the speed with, which this process is followed needs careful analysis. A service which is sometime used by a business to reduce its investment in debt without restricting the amount of credit offered to customer is that of debt factoring. This involves selling books of the organization set up of for the purpose of acquiring them. since this organization earns its income by acquiring the debt at lest than their face value, this amount to the same thing as giving a cash discount.
A practice, which has recently grown up relatively, is far a business to sell goods on contract, which include a blames reserving little in the debts until payment has been made. This is a device to minimize the risk of bad debts. Under a normal contract of sale title to the goods passes to the buyer when we obtains possession. From that point on, the seller may sue for payment but not for the return of the goods.
DEBT – MANAGEMENT IN FINANCING ORGANIZATION CAPITAL STRUCTURE
In any business organization, the balancing of the organizational capital structure is one of the initial decisions of the financial manager. This is the financing decision of the financial manage.
Finance can be seen as a resource, which Can be bought in a market in very much the same way as the vain materials of a manufacturing process. The analogy can be continued further, just as there are different types and qualities of material, which may be bought at different markets, there are several different sources of financing each with its individual characteristic.
Just as the manufacturer of a product will require a particular blend of materials of different types, so different financial manager will require an appropriate combination of capital from the available resources. He will need an expect knowledge of these, if he is to use then to the best advantage.
COST OF DEBT CAPITAL IN BUSINESS ORGANIZATION
The cost of debt instrument can be measured on a pre-tax and after-tax basis. The pre-tax cost of debt at par is the rate of return (or rate of that is required or earned by investors (Lenders). It is also equal to the contractual or the conpon rate on the face of the debt instrument. A organization or firm contemplating to raise fund through the issue of debt instrument most strive to ensure that the earnings to be generated from the investment of the fund raised is at least equal to the cost of the debt.
If the earning grated is below the cost of such funds, it will reduce the earning due to shareholders equity and preference stock holders and not the debt instrument holder because debt holders have prior claims to income before the equity holders. As a result of the reduction in the earning of the shareholders, the market value of the equity stock will drop.
Cost of capital is very importance because it involves evaluate investment, designing dept policy, performance appraisal, opportunity cost, creditor claim, share holders opportunity cost etc. for the investors.
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This article was extracted from a Project Research Work Topic “ANALYSING DEBT MANAGEMENT TECHNIQUES IN BUSINESS ORGANISATIONS IN NIGERIA”