FINANCIAL MANAGEMENT

THE IMPACT OF PUBLIC PROCUREMENT ON THE IMPLEMENTATION OF PUBLIC-PRIVATE PARTNERSHIPS ............................. 688
Nevenka arkid Joksimovid, Slaana Benkovid, Predrag Jovanovid
POSSIBILITIES OF REAL OPTIONS APPLICATIONS TO MERGERS AND ACQUISITIONS ............................................................... 694
Vesna Bogojevic Arsic
EFFECTS OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY IN SERBIA ...................................................................... 702
Slaana Barjaktarovid Rakoevid, Milica Latinovid, Milo Milosavljevid
INTELLECTUAL CAPITAL - A CHALLENGE FOR ADEQUATE FINANCIAL REPORTING ................................................................... 708
Veljko Dmitrovid, Sneana Kneevid, Tijana Obradovid
COLLAPSE OF THE AMERICAN MORTGAGE MARKET .............................................................................................................. 713
Andrijana Lakidevid, Veljko Dmitrovid, Sneana Kneevid
BOT PROJECT FINANCING MODEL OF PPP: THE EXAMPLE OF THE ZAGREB PUBLIC UTILITY WASTEWATER COMPANY ........... 718
Dragan Miloevid
FORMS OF FINANCING MERGERS AND ACQUISITIONS ........................................................................................................... 726
Jovan Krivokapid, Stefan Komazec, Ivan Todorovid
MINORITY SHAREHOLDERS RIGHTS IN THE REPUBLIC OF SERBIA ........................................................................................... 731
Vladimir Djakovic, Goran Andjelic
ANALYSIS OF THE GLOBAL ECONOMIC CRISIS ........................................................................................................................ 736
Vojin Vuidevid
ACCOUNTING INFORMATION SYSTEM AND DECISION SUPPORT SYSTEMS (DSS) IN INCREASING THE QUALITY OF CORPORATE
MANAGEMENTS DECISION MAKING PROCESS ...................................................................................................................... 741
Ljiljana Dmitrovid aponja, Saa Gravorac, Sunica Milutinovid
COST ACCOUNTING AS A KEY INFORMATION SUPPORT FOR MODERN MECHANISMS OF COMPANY MANAGEMENT ............ 750
Radmila Jablan Stefanovid
EXPERTNESS IN BUSINESS PLAN DEFINING IN CRISIS CONDITIONS ......................................................................................... 759
Dragutin Dragojevid, Sneana Leki,d Nada Vignjevid-orevid
INNOVATIVE BUDGETING EXPENSES OF DEFENSE .................................................................................................................. 768
Milena Knezevic, Sasa Trandafilovic, Branko Tesanovic
MEASURING FINANCIAL DISTRESS OF VELEFARM AD BELGRADE, USING ALTMAN Z-SCORE MODEL ................................... 774
Bojan Rupid, Milan Pasula, Branislav Nerandid
686

FINANCIAL SUPPLY CHAIN MANAGEMENT - NEW SOLUTIONS FOR CASH FLOW PROBLEMS .................................................. 780
Duan Sakovid, Milo Ilid, Ana Bojovid
THE LIQUIDITY ANALYSIS OF COMPANIES IN MANUFACTURING INDUSTRY IN SERBIA ........................................................... 788
Sanja Vlaovid Begovid, Dajana Ercegovac, Mirela Momilovid
CANDLESTICK MODELLING USING INTERPOLATIVE BOOLEAN ALGEBRA FOR FINANCIAL FORECASTING ................................. 793
Ivan Nesic, Pavle Milosevic, Bratislav Petrovic
FORECASTING STOCK PERFORMANCE USING MULTI-LAYER FEED-FORWARD NEURAL NETWORK: BELGRADE STOCK EXCHANGE
CASE...................................................................................................................................................................................... 802
Aleksandar Rakidevid, Ivan Neid, Ana Poledica
THE CHAOTIC REAL EXCHANGE RATE GROWTH MODEL ......................................................................................................... 809
Vesna Jablanovid
THE INFLUENCE OF THE EMISSION OF GREENHOUSE GAS ON MANAGEMENT DECISIONS ...................................................... 814
Milena Antid

687

THE IMPACT OF PUBLIC PROCUREMENT ON THE IMPLEMENTATION

OF PUBLIC-PRIVATE PARTNERSHIPS
Nevenka arki Joksimovi1, Slaana Benkovi1, Predrag Jovanovi2
1
Faculty of Organizational Sciences, University of Belgrade
2
Public Procurement Office, Republic of Serbia
Abstract: Increasingly evident is the public sectors interest in introducing new financial instruments intended
for the financing of infrastructure projects and facilities. This conditions the need for the creation and
improvement of the political, economic and legal framework that makes this possible. At the same time,
private investors are becoming increasingly interested in the creation of conditions that allow for efficient and
more regulated implementation of the public-private partnership concept. The paper aims to point out
potential opportunities brought about by the new Law on Public-Private Partnerships in Serbia, relying on the
guidelines established in the Law on Public Procurement. In essence, our wish was to point to the need for
establishing institutions that would make the implementation process of a public-private partnership
transparent and reliable for all of those interested in private sector investment. Improvements in
communication between the local and central government authorities are also necessary, in terms of
opportunities and potentials of the implementation of the public-private partnership concept, as a modality of
financing infrastructure projects.
Keywords: Public-private partnership, public procurement, infrastructure financing, projects, Serbia

1. INTRODUCTION
The public-private partnership concept has a great number of interpretations and ways in which it is defined.
Perhaps Winer (2012) gave the most precise definition when he said that a public-private partnership
represents a relationship between the public and private sectors, in which the risk is shared based on joint
efforts to achieve a desirable result of the public policies. It is a form of cooperation that allows for the
financing, construction, renovation, operation and maintenance of infrastructure works and/or provision of
services (Commission of the European Communities, 2008). Therefore, a public-private partnership
represents a contractual relationship signed between government authorities and private enterprises, whose
subject is the realization of a project of public interest in which both parties contribute with certain resources,
according to their abilities, and participate in the planning and decision making. The goal of a public-private
partnership is the achievement of greater efficiency, easier access to capital in order to share the financial
risks and risks related to deadlines, while at the same time respecting high standards of environmental
protection and employee safety.
Private partners find public-private partnerships attractive from the commercial aspect (profits and
investment opportunities on new markets), while the public sector finds them attractive because they create
a better end product/service (for the same level of investment, the same level of quality is created at a lower
cost). Financing, tasks, as well as the responsibilities and risks of the project, are allocated between the
parties in various ways, but the contribution of each contracting party is for every project accurately
determined. The basis of the public-private partnership concept is the idea that both the public and private
sector need to gain potential benefits.
As an infrastructure development concept, public-private partnerships are at a different level of development
and implementation within the EU countries, but as an infrastructure financing concept they have especially
found their place in the sectors of transport infrastructure, public construction works, the construction and
equipping of schools, hospitals, prisons, as well as conservation of the environment. In Serbia, for now, there
is significant participation of the private sector in the financing of infrastructure development in the sectors of
energy and telecommunications, where commercial interests provide sufficient incentives for the private
sector. However, the full contribution of this concept of financing infrastructure projects and facilities is yet
expected in the years to come.

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2. THE SELECTION OF PRIVATE PARTNERS THROUGH PUBLIC PROCUREMENT

Public procurement within a public-private partnership implies a process in which a public authority enters
into a contractual relationship with a private partner. Yescombe (2007) states that the public procurement
phase is the period during which:
Offers are requested and received, and a supplier is selected,
A special-purpose project company is established in whose name the public-private contract is
negotiated, as well as the various sub-contractors that are to be used during the construction, delivery of
services, management, etc., i.e. all that is together known as the project agreement,
due-diligence is completed (review and evaluation of the project company and its related risks, by the
public authority and the creditor, independently of each other) by the public authority,
equity is invested by the investor, and funds are borrowed from financiers.
It is important for public authorities that they are able to generate an efficient procedure for public
procurement based on real competition in an open and transparent process. The public procurement process
is governed by the law, and its respect and implementation are practically unavoidable when the financing or
guarantees are provided by multinational banks, such as the European Investment Bank.
The World Trade Organization (WTO), whose members include most of the developed countries, has
provided a framework for public procurement procedures in the Agreement on Government Procurement.
The WTO allows three types of public procurement (Yescombe, 2007):
Open procedure. This procedure allows anyone to submit an offer,
Selective procedure. This procedure allows public authorities to reduce the number of prospective
bidders through prequalification,
Restricted procedure. In this procedure, the public authorities directly approach prospective bidders,
without issuing a tender (with or without prequalification).
On the other hand, the Law on Public Procurement of the Republic of Serbia (Public Procurement Law,
2008) recognizes the following procedures: 1) open procedure, 2) restricted procedure, 3) negotiated
procedure with publication of a public notice, 4) negotiated procedure without publication of a public notice;
5) design contest, and 6) public procurement procedure of low value. The most widely applied, however, are
the restricted procedure and the negotiated procedure with prior publication of a public notice. Regardless of
the type of public procurement procedure, all bidders must be provided with the same information, i.e. the
principle of transparency and equality of bidders must be satisfied. The Law on Public Procurement of the
Republic of Serbia stipulates that the contracting authority is obligated to provide an equal position to all of
the bidders during all phases of the public procurement procedure.
Prior to making a decision on the best bidder, the public authority performs a comparison of the offers by:
comparing the prices, contract terms, the level of support by the public authorities in the event that it is
known that the service fees would not generate enough income to cover the costs of the project; by selecting
the economically best offer by scoring various aspects of the offer (points for design, speed or project
completion deadlines, reliability, service quality, prices, etc.). The completion of the public procurement
phase is known as financial closure, which represents the moment in which the conditions are met to allow
for the construction of the object to begin.

3. THE ROLE OF PUBLIC PROCUREMENT IN THE IMPLEMENTATION OF THE PUBLICPRIVATE PARTNERSHIP CONCEPT
The main reasons for the development of public-private partnerships are discontent with the traditional
methods of public procurement as a result of the development of the financial market and project financing,
as well as the introduction of the private partnership concept as a new form of management.
Under the existing Law on public-private partnerships and concessions (2011), these partnerships represent
a long-term cooperation between a public and private partner that serves to provide for the financing,
construction, reconstruction, management or maintenance of infrastructure and other objects of public
importance, as well as the provision of services of public interest. Public-private partnerships can be
contractual (i.e. a partnership in which the relationship between the public and private sectors is based solely

689

on contractual relationships) or institutional (a partnership that involves cooperation between the public and
private sectors within special institutional bodies) (Priji, Risti & tekovi, 2011).
Contractual and institutional partnerships are different in their structure. In an institutional public-private
partnership, the private partner enters into a partnership with mixed capital (local government and the private
partner) in order to carry out the tasks assigned to him by the public partner through a public contract or
concession. In a contractual public-private partnership the mutual relations, rights and obligations of the local
authorities and the private partner are defined by a public contract, which is concluded for a definite period of
time. Contractual public-private partnerships are most often seen in the construction of infrastructure and
public facilities, because they (Priji, Risti & tekovi, 2011):
can be contracted for a period of up to 50 years,
define the responsibilities of the partners during all phases of realization of the project: planning,
financing, construction, maintenance, use and closure of the project,
define the output performance of the project and services, and
transfer most of the project risk onto the private partner, except risks that the private partner cannot
manage appropriately and which are taken on by the public sector.
Although these two approaches differ, their common characteristic is that the public-private partnership
concept contains a segment of short term political attractiveness, which is sometimes so significant that it
represents the main motive in the decision process of establishing a partnership with the private sector.
Furthermore, the common attitude is that the provision of infrastructure goods and services would be more
effective if handed over to the private sector rather than the public, where the public sector would have a role
in monitoring and evaluating the development of the project, as well as the role of the only guarantee for the
quality and availability of the infrastructure. The benefits of public-private partnerships are reflected in the
better management of resources, and not in an increase of funds intended for the financing of infrastructure.
Projects that are implemented through public-private partnerships can play an important role in enhancing
the efficiency of procurement of goods and services that had formerly been primarily under the jurisdiction of
the public sector.
A public-private partnership represents a more complex form of public procurement (The European PPP
Expertise Centre, 2011), i.e. the key difference between the concepts of public procurement and publicprivate partnerships is the fact that the construction and management of business operations after
construction are assigned to a contractor from the private sector. In the traditional methods of financing the
construction of infrastructure through the public procurement concept, these used to be separate activities.
The argument that stems from the above, which goes in favour of a public-private partnership as a concept
of financing infrastructure, derives from the fact that, when a single legal entity is responsible for both the
construction of a facility as well as its operation and maintenance after its construction, then the legal entity is
likely to be more interested in investing in the project during its construction, seeing as how, in this way, it
reduces the cost of conducting business in the exploitation phase (Grimsey & Lewis, 2004).
However, we should also acknowledge the argument that goes in favor of understanding and respecting all
that the Law on public procurement implies, in order to implement a transparent and equal treatment that
will contribute to the legitimacy and legal validity of the public-private partnership procedure, as well as its
acceptance of by all of the stakeholders (The European PPP Expertise Centre, 2011). Well established and
legally validly implemented principles of public procurement must be implemented from the moment that a
tender is issued on the participation of private investors. All informal contacts and negotiations with potential
private participants in a public-private partnership must be performed prior to the announcement of a tender.
This ensures equal treatment for all of the participants that are involved in the bidding.

4. CONTRACTS ON PUBLIC-PRIVATE PARTNERSHIP IN INFRASTRUCTURE FINANCING

The development of public-private partnerships has accompanied a renewal of the public sector by the
adoption of a new management culture (Pavlova, V , 2009). Public-private partnerships include numerous
participants, and therefore an appropriate number of contractual arrangements that regulate the relationships
among the participants in the project financing, distribution of rights and obligations, as well as risk allocation.
Finance contracts follow the planning, construction and management of the infrastructure project, as well as
its financial aspects.

690

Public-private partnership contracts belong to the category of incomplete contracts, since it is impossible for
the contract to predict all the possible events in the future. The more complex the contract is, and the longer
its duration, the less complete the Contract itself is (Petrovi & Stankovi, 2009). That means that only the
projects which are expected to be long-term and stable, such as the construction of roads and road
infrastructure, are suitable for the implementation of a public-private partnership as a concept of financing. In
accordance with that, analysis of the legislation that monitors public-private partnership contracts is based on
the analysis and study of individual contracts with the immanent project finance concept, as well as the
elements that are essential for closing the contract.
The most important is the Project Contract, which defines the framework of the project. According to
Yescombe (2002) there are two main models of this contract:
contracts with predetermined buying conditions for project products/services, and
concession contracts.
Contracts in which the buying conditions for project products/services are predetermined are contracts
signed between a project company and the buyer of the projects final product, and they define the
conditions of buying a product/service. According to this contract, the private partner designs, constructs,
finances and manages the investment project, and, after that, sells the product/service (e. g. electric energy)
to the buyer (e. g. the company that distributes electric energy) under the conditions in the contract. With this
contract, the buyer ensures the supply of the needed product, and the private investor in the public sector
ensures the sale of his products in advance, which enables him to plan his income more easily and, in that
way, it significantly decreases possible risks in the sale of his products.
A concession, in the sense of this law, is the right to use natural resources and goods in general use or
conduct business of general concern which the grantor cedes to a domestic or foreign person
(concessionaire) for a period of time, under the conditions defined by law, for a concession fee. A concession
contract is signed by the Government in the name and on behalf of the state, and the concessionaire. If the
concession was granted to multiple persons, the concession contract is signed by each of the
concessionaires or the person authorized by the concessionaires, with special proxy. When the subject of
the concession is the construction of municipal facilities for municipal activities, the contract is signed by the
concessionaire and the authorized government body in the name and benefit of the local government, with
previous written consent by the Government (2011). The contract identifies project risks that are allocated
between the grantor and concessionaire, and specifies the role of the state, as well as the supervision and
procedure in the case of unforeseen circumstances.
Concessions are used more in the service sector than the product sector. A concession contract can be
signed between a project company and the Government of the host country, local government, government
agencies, public companies or special companies founded for the needs of the concession.

5. THE IMPLEMENTATION AND EXPECTATIONS OF THE LAW ON PUBLIC-PRIVATE

PARTNERSHIPS IN SERBIA
In the countries of the Western Balkans, the capacities for successful implementation of public-private
partnerships are still in the phase of establishment. Bearing in mind the current concept of financing
infrastructure in many countries of Southeast Europe, which includes Serbia, the best approach to
implementation of projects of public-private partnerships would be through the implementation of small-scale
projects at the level of local government, rather than large-scale projects at the national level. In addition,
experience has shown that the application of this form of financing must be organized, and not left to the
market and the conditions that dominate it.
A public-private partnership enables local authorities, the business sector and civil society, to take
responsibility for the development of their environment, and undertake joint action for its improvement. The
need for the private sector to assume greater responsibility in the fight against poverty, and improve the
quality of life of local communities, is widely recognized (United Nations Development Program, 2012). The
Law on public-private partnerships and concessions, passed in November of 2011, is meant to encourage
partnerships between the private and public sectors, attract domestic and foreign investors, and encourage
financial institutions to participate in the financing of projects of common interest. Involvement of the private
sector, however, can only be expected if the public tender is issued by the highest levels of public authority,
and if it has a clearly defined legal framework that ensures transparency and equality for all of the
691

participants in the bidding, which is supported by the Law on public procurement. This is particularly suitable
when it comes to smaller projects, which are of importance for the development of local government.
The Law in Serbia that regulates the question of public-private partnerships has to this date not yet fully
provided the expected results in its practical application, thus it is necessary to do much more in the field of
institutional improvements. This primarily relates to the securing of criteria for transparency and equality for
all participants in the bidding process, which represents the basis of the Law on public procurement.
However, the implementation of the law governing public-private partnerships itself is not the only condition
that would make the development of infrastructure projects and facilities better. It also requires other
preconditions such as the provision of: developed and modern corporate governance in the country, a more
developed securities market and insurance market, regulated property right relationships within the public
sector, a clearly defined division of institutional responsibilities, etc.
It can be concluded that, although the benefits of a partnership with the private sector are undoubted, the
concept of public-private partnerships should not be taken lightly, bearing in mind the complexity of the
procedure itself, its design, realization and management. This type of partnership must therefore be carefully
evaluated in the context of the project, public benefits, as well as the relative gains that could be achieved by
using different approaches. Showing to be the most serious in implementation of the concept of publicprivate partnerships in Serbia, at the local level, is the City Administration of Belgrade, which has with the
support of international institutions and consultants decided to establish a public-private partnership model in
public transportation, solid waste management, and the citys water-sewage system. Other local authorities
have most often made investment decisions by applying the public-private partnership concept based on the
expected value of the investment of the private partner, without additional analyses of the existing conditions
of utility services, i.e. the financial and economic effects of the public-private partnership on municipal
property.
It is expected, in the period ahead, that this financing concept has yet to gain on importance in the field of
development of services and reconstruction of infrastructure. However, it should be noted that this will also
imply solving an array of administrative and practical problems, as well as solving problems related to
structural economic transformation, the volatility of market conditions, and growing competition.

6. CONCLUSION
The term public-private partnership covers various contractual forms of transactions, where the private sector
is given the right to conduct operations over an extended period of time, and at the same time bear the
responsibility that had traditionally fallen on the public sector. A partnership between the public and private
sectors is based on best practices defined by the Law on Public Procurement, which implies transparency
and equality of the participants in the bidding. Nevertheless, the evaluation of bids for a project through
implementation of the public-private partnership concept is different from the evaluation of tenders in a
conventional procurement. Here we evaluate the solution offered by the private partner in order to achieve
ultimate performance of the facility and/or services, which are contained in the output specification of the
project of a public-private partnership within the tender documentation.
This is why the phenomenon of public-private partnerships represents one of the most important modalities
of funding and improving public services, infrastructure, as well as an array of other project activities related
to the realization and improvement of transport, health, education, safety, and waste and water management
in the countries of the EU. It is expected that its full contribution is yet to be provided to Serbia. However, this
implies that, in Serbia, it will be necessary to establish institutions that will make the process of
implementation of a public-private partnership transparent and reliable for all the interested investors from
the private sector. At the same time, it will be necessary to improve communication between regional (local)
and central government, in terms of the opportunities and potentials of implementation of the public-private
partnership concept as a modality of financing infrastructure projects.

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LITERATURE
Commission of the European communities, (2008), Community law on Public Procurement and Concessions
to Institutionalized Public-Private Partnerships, European Commission, COM (2007), 6661, p. 2.
Grimsey D, Lewis M. K, (2004), Public Private Partnership, Edward Elgor, Cheltenham, p. 92.
Pavlova V, (2009), Statistical analysis of premises, factors, and barriers of development public-private
partnership in the Republic of Bulgaria, Economic Themes, Vol 17 (4), p. 99-111.
Petrovi E, Stankovi J, (2009), Country risk and effects of foreign direct investments, Facta Universitatis:
Economics and organization, Vol. 6(1), p. 9-22.
Priji M, Risti K, tekovi M, (2011), Javno-privatno partnerstvo i koncesije, Biblioteka narodne skuptine,
Beograd, p. 13.
Program Ujedinjenih nacija za razvoj (2012), Javno-privatno partnerstvo u ruralnom turizmu, MaxNova
Creative, Beograd, p. 14.
The European PPP Expertise Centre, (2011), The Guide to Guidance: How to Prepare, Procure and Deliver
PPP Projects, European Investment Bank, Luxembourg, p. 5.
Wiener M, (2012), Engaging with Religious Communities, Ox. J. Law and Religion, Oxford University Press,
January 11, p. 1-20, doi: 10.1093/ojlr/rwr003
Yescombe E. R, (2007), Javno-privatna partnerstva - naela politike i financiranje, Mate, Zagreb, p.74
Yescombe E R, (2002), Principles of project finance, Academic Press, London, p. 69.
Zakon o javnim nabavkama, Slubeni glasnik Republike Srbije, br. 11/2008.
Zakon o javno-privatnom partnerstvu i koncesijama, Slubeni glasnik Republike Srbije, br. 88 / 2011.

693

POSSIBILITIES OF REAL OPTIONS APPLICATIONS TO MERGERS AND

ACQUISITIONS
Vesna Bogojevic Arsic
University of Belgrade, Faculty of Organizational Sciences, bogojevic@fon.bg.ac.rs
Abstract: The increasing volume, as well as the complexity of domestic and international mergers and
acquisitions, has influenced the real option valuation method application. Traditional valuation methods of
merger and acquisition analysis (such as the discounted cash flow method) these days are not enough
because of uncertainties related to the time period determination, cash flow estimation and adequate riskadjusted discount rate determination.
The aim of the paper is to point out different real options applications to mergers and acquisitions. Real
option analysis allows for explicit consideration of value-enhancing factors. In this way, decision makers can
value the opportunity to alter their decisions further into the future and to actively search such opportunities.
Keywords: mergers and acquisitions, real option, valuation, embedded option, acquisition, models.

1. INTRODUCTION
An option is the derivative instrument which gives (provides) its holder the right, but not the obligation to buy
or sell underlying asset at predefined price (i.e. exercise price) during the predefined future period of time or
at the specified date (i.e. expiration date). In this way defined option is financial option. Besides this, there
are (or may exist) options on real assets, or so-called real options. The real assets can be valued as call
options if their current value exceeds the assets current value and some predetermined level. On the other
hand, real asset can be valued valued as a put option if its value increases as the value of the underlying
asset falls below a predetermined level. In either instance, the option holder can choose to exercise (or not
exercise) the option now or at some time in the future.
The term real option refers to managements ability to adopt and later revise corporate investment decisions.
Since managements ability to adopt and subsequently change investment decisions can greatly alter the
value of a project, it should be considered in capital budgeting methodology. If we view a merger or
acquisition as a single project, real options should be considered as an integral part of merger and
acquisition (M&A) valuation.
Traditional discounted cash flow techniques fail to account for managements ability to react to new
information and make decisions that affect the outcome of a project. However, real options can be costly to
obtain, complex to value, and dependent on highly problematic assumptions. They should not be considered
unless they are clearly identifiable, management has the time and resources to exploit them, and they would
add significantly to the value of the underlying investment decision.
Investment decisions, including M&As, often contain certain so-called embedded options, such as the
ability to accelerate growth by adding to the initial investment (i.e., expand), delay the timing of the initial
investment (i.e., delay), or walk away from the project (i.e., abandon). Frequently, the existence of the real
option increases the value of the expected net present value (NPV) of an investment. For example, the NPV
of an acquisition of a manufacturer may have a lower value than if the NPV is adjusted for a decision made
at a later date to expand capacity. If the additional capacity is fully utilized, the resulting higher level of future
cash flows may increase the acquisitions NPV. In this instance, the value of the real option to expand is the
difference between the NPV with and without expansion. An option to abandon an investment (i.e., divest or
liquidate) often increases the NPV because of its effect on reducing risk. By exiting the business, the
acquirer may be able to recover a portion of its original investment and truncate projected negative cash
flows associated with the acquisition. Similarly, an acquirer may be able to increase the expected NPV by
delaying the decision to acquire 100% of the target firm until the acquirer can be more certain about
projected cash flows.
All these options exist in period prior to closing an acquisition, as well as in period post closing an
acquisition.

694

In recent years the volume of M&A and the complexity of M&A activity have increased as financial systems
have become more open with firms expanding not only domestically but also globally. Cross border mergers
in particular tend to be much more complex, and the valuation of such M&As is more involved with additional
elements of risk exposure. The analysis of any M&A goes far beyond the simple stand-alone value of the
target firm, given that the acquirer now has many decisions that can be modelled using real options.
Traditionally, M&A valuation closely followed capital budgeting methodology, predominantly the discounted
cash flow method with the focus on free cash flow. The cash flows are developed for a forecast period for the
target firm, and then a terminal value is calculated at whatever is considered a reasonable time period.
The valuation process involves parameters which are uncertain (the appropriate time horizon determination,
free cash flow estimation, growth opportunities consideration and an appropriate risk-adjusted rate
specification). Furthermore, many other factors influence the parameters (i.e. the timing of the M&A,
competitor action, the flexibility of exploiting a target firms resources, the leverage factor etc.).

Traditional capital budgeting techniques, such as NPV, fail to adequately consider uncertainties in future time
periods with regard to decisions that management may undertake (Trigeorgis (1996)). In other words, firms
typically have many opportunities to make other decisions based on the original M&A such as expanding into
(or abandoning) new product or geographic markets. Also, the embedded options in an acquisition can have
different risk levels. Theory suggests that the greater the number of adjustment opportunities in terms of
management decisions, the more value can be added (Dixit and Pindyck (1994)). Through real option
analysis, managers can more explicitly consider any added value a result of these future decision
opportunities. Such knowledge can enable both the bidder and the target firm management to negotiate and
capture more value in the transaction.
In this regard, real option analysis allows for the explicit consideration of a number of value-enhancing
factors. Clearly, the ability to identify and evaluate options associated with M&As can be of great value to
corporate decision makers. Decision makers have many options including timing of the acquisition, entry and
exit options, growth options, options on managerial flexibility, and options involving the merger terms.
Managers value the opportunity to alter decisions further into the future and actively seek such opportunities.
2. REAL OPTION ANALYSIS FOR M&As
Since the end of 1970s, there has been extensive growth in real options research in the standard financial
option framework, as well as in Bayesian and game theoretic (competitive and cooperative) valuation
frameworks. The earliest models include direct applications of standard financial options, such as the BlackScholes model, but since then, models have evolved into more complex options, such as compound real
options and other complex exotic options. These also include Bayesian learning models and game theoretic
models with incentives and agency features. Real options applications are seen in various industries and
business circumstances including forestry, oil and gas, M&As, pharmaceutical research and development
valuation, information technology, and manufacturing, among others. More recent articles have investigated
the deviation from all equity-financed firms and projects to those that have both debt and equity (Lambrecht
and Myers (2007), (2008)).
Theoretically, real options have proven to be a powerful technique for analyzing investments under
uncertainty. Researchers find the expected net present value criterion is inadequate in capturing the
managerial flexibility to delay, grow, scale down, or abandon projects, exchange resource inputs, and
incorporate learning or uncertainty resolution (when underlying asset values are uncertain). Thus, real
options that combine strategy with valuation have increasingly attracted attention in the corporate finance
literature.
Financial economists use various real option modeling techniques depending upon the problem structure.
These techniques include continuous time models, multinomial (lattice) and finite difference techniques, and
simulation.

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3. M&A PROCESS AND REAL OPTION VALUATION

Typical M&A investments are embedded real options, which may include additional investment or growth
(expansion) options, abandonment options, and wait-and-see (timing) options. Real option models can be
classified as:
(1) Standard M&A real option models,
(2) Game theoretic M&A real option models and
(3) Collaborative models.
3.1. Standard M&A real option models
Standard M&A real option models are used when the exercise decision does not directly depend on the
actions of competitors or collaborators. These models have different focus. There are models which are
focused on stock-for-stock M&A transactions, exchange ratios in M&A transactions, model oriented to
strategic option valuation, model focuses on entry and exit possibilities etc.
In one of the earliest studies, Kogut (1991) presented the perspective that joint ventures are created as real
options to expand in response to future technological and market developments. The exercise of the real
option to expand accompanies the acquisition of the venture. The author provides counter evidence to the
prevailing assumption in organizational theories that firms engage in cooperative ventures as buffers against
uncertainty. He provides a real option perspective that joint ventures are designed to exploit the upside and
not simply to buffer uncertainty.
Several researchers have developed models that investigate real option features in stock-for-stock
exchanges. Stock-for-stock M&A transactions generally take more time to complete than transactions that
are cash based (Gaughan (1999)). If a buying firms and a selling firms stock volatilities are high, the value
of respective shares may fluctuate widely between the time a fixed exchange ratio is determined and the
actual acquisition date. When a fixed exchange ratio is applied to determine a targets compensation, an
acquiring firm would overpay when its stock price is higher on the merger date than on the agreement date
or when a targets stock price is lower on the merger date than on the agreement date. Alternatively, a target
would lose if an acquiring firms stock price is lower on the merger date than on the agreement date or when
a targets stock price has risen on the merger date.
Models focused M&A transactions have investigated how to exploit the fluctuations in the exchange ratios to
increase the M&A deal value. These real option models provide more elaborate methods for structuring an
M&A deal.
Herath and Jahera (2001) argued that explicit valuation of managerial flexibility in setting the final terms of an
acquisition may enhance the M&A deal value in the process. Accordingly, the deal may be optimally
structured to benefit an acquiring firm if the stock prices are highly volatile between the announcement date
and the closing date. In a deal where the stock exchange ratio is fixed, the shareholders of an acquiring firm
may have to pay a premium for the net assets of the target firm. This will happen if the acquirers stock
appreciates in value over this period because the deal value would increase. As a result, authors model the
right of an acquiring firm to optimally switch between alternate purchase considerations: either swap stock or
pay the targets fair market value (of the net assets) as a switching option. The premium is a hidden loss to
the shareholders of the acquiring firm. They show that the value of managerial flexibility in deal optimization,
which is traditionally ignored, can be significant and could increase the deal value to both parties.
The same authors (Herath and Jahera (2002)) developed an extension of their originally model and
demonstrate how an M&A deal may be optimally structured as a real options swap. They argue that
consideration of both buyer and seller expectations often results in fairer deals. Authors use real option
analysis to model a stock-for-stock transaction as an exchange ratio swap when both the buyers and the
sellers stock prices are volatile. Hence, they show how to structure an acquisition to minimize the purchase
price paid by a bidding firm and to maximize the deal value to a target. The theoretical value of an acquisition
is defined as the deal value based on a fixed exchange ratio but dependent on the acquiring firms stock
price at consummation. Accordingly, in order to minimize the value of a deal, the authors suggest that an
acquiring firm buy a call option or hold a cap, which guarantees a minimum deal value. On the other hand, a
target should consider a put option or a floor, which ensures that the holder will receive the maximum deal
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value. Consequently, when stock prices are volatile, the flexibility available to management of both parties
can be valued as an exchange ratio swapholding a cap and selling a floor with an identical strike price.
Two years later the same authors (Herath and Jahera (2004)) investigated how to provide price protection to
both acquiring and target firm shareholders by setting conditions for active risk management by managers.
The authors investigate the contingency effects of managerial flexibility to renegotiate the deal and hedge
the market price risk by specifying a range within which the deal is allowed to fluctuate as in a collar-type
arrangement. To minimize the value of a deal, an acquiring firm could buy a call option or a cap, which
guarantees a minimum deal value. On the other hand, a target could consider a put option or a floor, which
ensures that the holder would receive the maximum deal value. Since the cap and the floor have different
strike prices, the managerial flexibility to both parties can be structured as a collar arrangement, in essence
going long on a cap and shorting a floor. Herath and Jahera argue that in addition to the valuation effects,
the contingency effects also enforce favorable managerial behaviors.
More recently, Giacomello (2008) analyzed how M&A exchange ratios can be assessed when a firms
economic capital valuation is carried out within a stochastic framework. He develops a quantitative model for
exchange ratio accounting. Assets and liabilities with stochastic cash flows represent embedded real options
such as minimum guarantees that have incremental value over traditional deterministic balance sheet
values. Hence, Giacomello introduced important differences in exchange ratios. When stochastic cash flows
are assumed to be contingent claims on underlying traded securities, the author shows that the no-arbitrage
conditions hold. In the absence of liabilities, stochastic capital reserves are shown to be equivalent to a
portfolio of European call options with a guaranteed and call component. In multi-period settings, the options
embedded in the merger contracts have multiple options such as ratchet or cliquet options. A ratchet or
cliquet option includes a series of consecutive forward start options. The first option is active immediately
and then the second becomes active after the expiration of the first option. The above stream of literature
primarily focuses on the exchange ratios in M&A transactions.
Model oriented to strategic option valuation (Smith and Triantis (1995)) considered three types of real options
that arise in strategic acquisitions and influence overall value. The first refers to growth options. Through
acquisitions, firms can exploit strategic synergies, which, in the long term, may affect the combined growth
options of the acquiring and target firms by lowering exercise prices, thus increasing upside potential and
improving exercise timing. More specifically, a firm, through a series of strategic acquisitions over time, can
change the acquirers competitive position through development of growth options, which traditional DCF
cash flow analysis tends to overlook in restructuring deals. Second type of real option refers to firms that
have substantial flexibility in organization, marketing, manufacturing, and financing can benefit from
acquisitions. The third type of real options is the divestiture (abandonment) option, which conventional
acquisition analysis ignores. These divesture options limit the downside losses to the acquiring firm.
Although there may be an opportunity to divest assets soon after an acquisition, firms may decide to hold
these divesture options in hopes of a more optimal time.
Model focuses on entry and exit possibilities (Arzac (2008)) considered the application of real options to the
entry and exit issue as well as to the foothold issue. That is, the timing of when to undertake a venture can
be modeled in the context of real options. Delaying entry until a more favorable time can at first appear to be
valuable, but this may increase risk exposure by allowing competitors time to enter the market. Likewise, the
optimal time to exit a venture or project can be modeled as a real option. The foothold issue refers to the
entry with subsequent opportunities to expand, including both geographically and in terms of production.
Besides these models, researchers considered the possibilities of real option application to accounting
aspect of goodwill impairment as well as to explanation why information and communication technology firms
might acquire early, as well as which of those firms are likely to do so (Baldi and Trigeorgis (2009), Warner
and Fairbank (2008))
3.2. Game theoretic M&A real option models
Game theoretic M&A real option models or the models of strategic M&A interactions in a real option setting
consider competition between parties. These models investigate how combining real options analysis and
game theory can help resolve valuation problems that involve strategic interaction among firms. In this
regard, various authors investigate the strategic interaction in research and development, the competitive
interaction in real option valuation of M&As and, the early preemptive investment by giving up the option
premium to wait (of a wait-and-see approach).

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Smit and Trigeorgis (2001) modeled strategic real option interactions in research and development as a twoperson game in which the growth option value depends on exogenous competitive reactions. That is, the
firms invest in research and development to develop a more cost-efficient production process and then
commercialize the product. This idea can be used in M&A valuation if the target and acquiring firms can
combine resources to mitigate exogenous competitive reactions.
Toxvaerd (2008) developed a theory to explain the merger waves based on interaction between competitive
pressure, irreversibility of mergers, and uncertainty when targets are scarce. Its real options game model is
based on three elements: there is a relative scarcity of desirable targets; mergers can be viewed as
irreversible investments containing considerable uncertainty (there is an embedded delay option or an option
value of waiting to acquire a target); and imperfect competition for the target exists. Author derived a
complete information model which has showed that waiting versus the preemption trade-off leads to a
continuum of sub game perfect equilibrium. Furthermore, the author introduced noisy private information
about merger profitability leading to a dynamic global model in a Bayesian setting.
Morellec and Zhdanov (2005) developed a dynamic real option model that jointly determines the timing and
terms of takeovers by solving option exercise games between bidding and target firm shareholders. They
examined the role of multiple bidders in the presence of competition and imperfect information on takeover
activity. The authors based their model on the analogy between exchange options and takeover
opportunities (takeover can be compared to an option to exchange one asset) and on the imperfect
information. Firms have complete information but outside investors have incomplete information. Starting
form this, the authors made certain predictions: returns to target shareholders are higher than bidding
shareholders; returns to bidding shareholders are negative if competition exists for the acquisition; and
competition affects returns on takeover deals and speeds up the acquisition process. These predictions are
consistent with the empirical evidence.
Because of formal models inability to deal with takeover incentives, Lambrecht and Myers (2007) considered
takeovers in declining markets. They develop a real optionbased theory of takeovers and divestment for
M&As and conclude that a firm can abandon a business voluntarily or be forced to do so by a takeover when
product demand falls to a low threshold level. The same authors extended their research by developing a
dynamic infinite horizon model that incorporates the option to abandon the firm and release the assets to
investors. In this model, the managers decide when to exercise the real abandonment options either
voluntarily or when forced by a takeover. The authors provide new theoretical results and testable predictions
on the optimal payout policy, the role of golden parachutes, and the link between debt and takeovers. They
show that debt service can reduce managerial rents and force managers to close the firm early. Thus, they
claimed that debt financing plays an important role in hostile takeovers.
Almost immediately, another group of authors (Magsiri, Mello, and Rukes (2008)) has developed a model in
which the acquisition price is endogenously determined as the outcome of a bargaining game between the
acquirer and the seller. The authors analyzed the fundamental trade-off between internal growth and growth
via acquisition. The opportunity to grow internally affects the price of an acquisition because it is a fallback
option in the event negotiations fail due to lower price and other factors. If the negotiations fail, the acquirer
has the opportunity to grow internally through investments, which is a real option to expand (which assumes
that the acquirer has the flexibility to decide if and when to undertake the investment). Assuming that an
acquisition investment and an internal investment represent mutually exclusive strategies, the options value
to grow internally at the time of negotiations becomes a bargaining game option. This model complements
the findings of Morellec and Zhdanov (2005) and shows that competition is unnecessary to generate
negative earnings announcements. Inclusion of the internal growth opportunity is shown to force early
acquisitions (rather than at a socially optimal time), which contrasts the finding in Morellec and Zhdanov.
3.3. Collaborative M&A real option models
Collaborative or joint action M&A real option models deals with cooperative options. Unlike Smit and
Trigeorgis, group of authors (Savva and Scholtes (2005)) distinguish between cooperative and competitive
options. Cooperative options are exercised jointly to maximize the total deal value, while competitive options
are exercised unilaterally to increase the payoff for individual parties. These collaborative real options fall
within the boundaries of risk-sharing contracts. The authors considered cooperative options, which are
partnership deals such as joint ventures with future flexibility. Cooperative options allow better understanding
of real options in partnership deals with regard to fair splits of risks and return of a partnership. In partnership
deals, the idea is to develop synergies by combining core competencies to form unique offerings that neither
698

party alone can provide. Thus, the exercise decisions are taken jointly with a view to maximizing the total
value of the deal.
On the other hand, Thijssen (2008) examined a situation in which both parties in a transaction can make bids
for each other. Assuming some agreement is reached, the firms then merge. Author considered a takeover
to be different from a merger, with the role of both parties being endogenous in a merger. He concluded that
any value associated with options in the merger is eliminated if the actions of each party are endogenous.
Beside this, the author further developed a theoretical model to support its finding.
The presence of specific antitakeover defenses can create new options, many antitakeover measures are
triggered by certain events with the intent of deterring a hostile takeover. In reality, defensive measures may
not actually prevent a takeover, but they do have the effect of increasing the cost of a takeover. Hence, an
acquirer could use the real option framework to incorporate the activation of various antitakeover measures a
target would invoke if the attempt is hostile, that is, without board approval. A target could also apply real
options to the valuation from its point of view in the context of activation of antitakeover provisions. Such an
analysis may facilitate negotiations and result in a friendly rather than hostile takeover. The reality is that
most takeovers are the result of negotiation between the boards of the acquirer and the target firm, even if
the initial offer was a hostile offer.
4. REAL OPTIONS IN PRACTICE
The actual implementation of real option analysis into the corporate decision-making framework has been
somewhat difficult. Triantis and Borison (2001) took a survey approach to gauge the actual use of real option
methodology. They categorize the use of real options into three broad groups. The first is the qualitative use
of options methodology as a thought process. Managers have long recognized that options or future
decisions exist in almost any long-term investment opportunity. The second category is the analytical use of
real options, while the third one is the use of real options in the context of much broader company planning.
Based on their survey, they noted that some respondents had viewed the use of real options primarily as an
endeavor of academic researchers while the other responses had indicated that the use of real options
evolved as managers seek to make better decisions. The authors concluded that the acceptance of real
option analysis in corporate decision making in general would depend upon its perceived value in terms of
better financial outcomes.
Beside this, Damodaran (2005) provided an overview of the actual implementation of real option analysis in
corporate decision making. According to Damodaran, many managers believe that accurately placing a value
on the many potential embedded options involved in a corporation is impossible. He noted that others
perceive that it is indeed possible to determine a quantitative value. The author attempted to examine
various options that arise in business decisions and then to develop a methodology to use the appropriate
inputs and develop a true value. With regards to investment considerations (including M&A), he focused on
the timing option, expansion option, and termination option. The parameters for determining the option value
include the cost, the variance, the exercise price, and the expiration period. While these seem
straightforward, Damodaran pointed out that, in practice, developing these parameters is more difficult. In
this regard, he argued that the investment may or may not be traded, meaning that obtaining a true variance
may be difficult. The same issues he applied to expansion decision. Regarding the abandonment, the author
argued that applying option models is complicated because abandonment value can change over time.
Regardless of the difficulties, the inclusion of option values may transform a negative NPV acquisition into a
value additive acquisition.
Barnett and Dunbar (2007) went one step further. They offered a different perspective by examining what
they call real options reasoning. They discuss how this reasoning can lead firms to undertake many
investments because each has some option involved for future decisions. Accordingly, firms may be
motivated to assume many investments, given multiple options associated with each. They discussed how
real option reasoning can lead firms to undertake many investments because each has some option involved
for future decision. The authors concluded that this would result in abandoning many such investments.
5. CONCLUSION
Real option analysis can enhance the value of M&A because it takes into account the managerial flexibility.
It enables managers to include the value of different options such as expansion, abandonment, optimal
timing and resource flexibility. Furthermore, managers may use real option analysis in preparing the terms of
699

an offer. That means than the bidding firms managerial flexibility should enhance value for the firm.
Similarly, the managers of the target firm can consider managerial flexibility in order to increase a targets
value. In this way, all parties in a transaction can potentially benefit from the identification and valuation of
any embedded options, which may differ between the acquirer and the target firm. The present literature in
this field shows that the number of papers and researches has increased in recent ten years, but they are
still largely theoretical. Practical real options use in M&A process are partly limited because of their valuation
complexity, which is related to option identification difficulties and the resources and time they require. This
does not mean that the real options are not used. On the contrary, real options had been applicated in
different industries (pharmaceuticals, IT, oil, banking etc.).
The literature suggests that real option use in M&A valuation can raise the value of M&A. The main issue
that still has not been resolved is the gap between the research and actual practice. Another issue that waits
for solution is how to encourage managers to use real options. According to recent researches, we can
expect the further use of real options in M&As, especially in decisions related to M&As timing, spin-off,
divestiture etc. Practice has shown that although many managers realize the importance of applying real
options in M&A, many of them are not capable to quantify the real option value in acquisition valuation
process as a whole.
Further research is needed, so it could be expected the researches related to better option identification as
well as real option valuation methodology creation.
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Inc.
Baldi, F. & Trigeorgis, L. (2009). Assessing the value of growth option synergies from business combinations
and testing for goodwill impairment: A real options perspective. Journal of Applied Corporate Finance,
21(4), 115124.
Barnett, M. L. & Dunbar R. L. M. (2007). Making Sense of Real Options Reasoning: An Engine of Choice
That Backfires. In Hodgkinson, G. P. & Starbuck, W. H. (eds.). Oxford Handbook of Organizational
Decision Makin. Oxford, United Kingdom: Oxford University Press.
Dixit, A. K. & Pindyck. R. S. (1994). Investment under Uncertainty. Princeton, NJ: Princeton University Press.
Damodaran, A. (2005). The Promise and Peril of Real Options. New York University Working Paper No. SDRP-05-02, Available at http://ssrn.com/abstract=1295849.
Gaughan, P. (1999). Mergers, Acquisitions and Corporate Restructuring. Hoboken, NJ: John Wiley & Sons.
Giacomello, B. (2008). Exchange ratios in a merger with stochastic capital reserves: Fair valuation and
embedded options. Managerial Finance, 34 (4), 239251.
Herath, H. S. B., & Jahera J.S. Jr. (2001). Operational risk in bank acquisitions: A real options approach to
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Herath, H. S. B., & Jahera J.S. Jr.. (2002). Real options: valuing flexibility in strategic mergers and
acquisitions as an exchange ratio swap. Managerial Finance, 28(12), 4462.
Herath, H. S. B., & Jahera J.S. Jr.. (2004). Measuring and accounting for market price risk as real options in
stock for stock exchanges. Advances in Management Accounting, 12, 191218.
Kogut, B. (1991). Joint ventures and the option to expand and acquire. Management Science, 37(1), 1933.
Lambrecht, B. M. & Myers, S. C. (2007). A theory of takeovers and disinvestment. Journal of Finance, 62(2),
809-845.
Lambrecht, B. M. & Myers, S. C. (2008). Debt and managerial rents in a real-options model of the firm.
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Margsiri, W., Mello, A. S. & Ruckes, M. E. (2008). A dynamic analysis of growth via acquisitions. Review of
Finance, 12(4), 635671.
Morellec, E. & Zhdanov, A. (2005). The dynamics of mergers and acquisitions. Journal of Financial
Economics, 77(3), 649672.
Savva, N. D. & Scholtes, S. (2005). Real options in partnership deals: The perspective of cooperative game
theory. 9th Annual Real Option Conference, Paris, France, June 2225.
Smit, H.T. J., & Trigeorgis, L. (2001). R&D option strategies. 5th Annual Real Options Conference. Los
Angeles, July 1316.
Smith, K. W. & Triantis, A. J. (1995). The value of options in strategic acquisitions. In Trigeorgis, L. ed. Real
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Thijssen, J. J. J. (2008). Optimal and strategic timing of mergers and acquisitions motivated by synergies
and risk diversification. Journal of Economic Dynamics and Control, 32(5), 17011720.
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Warner, A. G. & F. Fairbank, J.F. (2008). Integrating real option and dynamic capability theories of firm
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Standardization Research, 6(1), 3954.

701

EFFECTS OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY

IN SERBIA
Slaana Barjaktarovi Rakoevi1, Milica Latinovi2, Milo Milosavljevi3
University of Belgrade, Faculty of Organizational Sciences, sladjana@fon.bg.ac.rs
2
University of Belgrade, Faculty of Organizational Sciences, latinovicm @fon.bg.ac.rs
3
University of Belgrade, Faculty of Organizational Sciences, milosavljevic@fon.bg.ac.rs
1

Abstract: In the last decade, financial turmoil has triggered a need for more effective and efficient working
capital management (WCM) in companies. A popular measure of WCM is the cash conversion cycle (CCC),
i.e. the time lag between the expenditure for the purchases of raw materials and the collection of sales of
finished goods. The longer this time lag, the larger the investment in working capital. That implies that
companies with efficient working capital management have a relatively short CCC. This study aims to
explore the relation between liquidity measures and profitability of Serbian companies. In particular, the
survey addresses relation between CCC and return on assets, assuming these performance indicators as
the most representative for liquidity and profitability. The survey of this kind has never been conducted
among Serbian companies. Empirical data analysis is based on 51 Serbian publicly traded companies. Our
findings show some inconsistencies with the WCM theory. Specifically, number of days accounts receivable
is negatively correlated with return on assets, which may be of particular interest for both corporate
managers and academics.
Keywords: working capital, cash conversion cycle, account receivables, accounts payables, inventory,
profitability

1. INTRODUCTION
In the last decade special attention is given to the issue of working capital management. Evidently, many
authors suggest that the optimum level of working capital depends on the industry and the nature of its
transactions (Walker, 1964; Outram, 1997, Ozbayrak, 2006). According to Johnson and Soenen (2003), in
order for company to be able to achieve its aim of shareholder value creation, effective working capital
management should be integral part of its corporate strategy. Net working capital is defined as the difference
between firms current assets (including accounts receivable, inventories, and cash) and current liabilities
(including accounts payable and short term debt). These elements significantly influence companys liquidity
and that is the reason why working capital is often used to evaluate liquidity of a company.
According to Deloof (2003) working capital management will have a significant impact on the profitability of
companies and consequently WCM is a very important element of financial management. In order for
working capital management to enhance value of a company, adequate balance between liquidity and
profitability must be maintained. Same author also states that a popular measure of WCM is the cash
conversion cycle (CCC), i.e. the time lag between the expenditure for the purchases of raw materials and the
collection of sales of finished goods. The longer this time lag, the larger the investment in working capital.
That implies that companies with efficient working capital management have relative short cash conversion
cycles.
Taking all this into consideration, determining the optimum level of working capital in a company is not an
easy task. It raises questions regarding appropriate amount of currents assets as well as questions regarding
financing these assets. Garcia-Teruel and Martinez-Solano (2007) point out that working capital investment
involves a trade-off between profitability and risk i.e. decisions that tend to increase profitability tend to
increase risk, and, on the other hand, decisions that concentrate on risk reduction will tend to decrease
potential profitability.
This study aims to explore the correlation between liquidity measures and profitability of Serbian companies.
In particular, the survey addresses correlation between various liquidity measures and return on assets. The
relation between liquidity and profitability measures has widely been explored in the extant literature. This
relates to corporations in both developed (Wang, 2002; Deloof, 2003; Lyroudi and Lazaridis, 2000; GarciaTeruel and Martinez-Solano, 2007), and emerging markets (Luo, et al., 2006; Zariyawati, et al., 2006; Afza
702

and Nazir, 2007; Raheman and Nasr, 2007; Samiloglu and Demirgunes, 2007; Afza and Nazir, 2008;
Sharma and Kumar, 2011).
However, to the best of authors knowledge, the survey of this kind has never been conducted among
Serbian companies. Serbian corporations have evolved in a different economic and political setting
compared to other, both developed and emerging economies. The most important differences can be found
in general economic conditions, the development of Serbian financial markets, managerial style of Serbian
corporate leaders, corporate culture and leadership, managerial attitudes towards the risk, expectations from
shareholders etc. Thereafter, the relationship between liquidity and profitability may prove to be interesting
for management, shareholders, and other various stakeholders in Serbian corporate sector.

2. THEORETICAL BACKGROUND
The theoretical foundation for this paper derives from numerous research papers and surveys performed
both in developed and emerging markets. Deloof (2003) conducted a survey among 2.000 Belgian
corporations in order to determine what kind of effects working capital management has on firms profitability.
Deloof (2003) found that there is a significant negative relation between profitability of the firms, measured by
gross operating income, and the number of days accounts receivable, inventories and accounts payable. He
concluded that profitability could be enhanced by reducing the number of days accounts receivable and
inventories to some acceptable minimum level.
Wang (2002) studied relationship that liquidity management has with both operating performance and
corporate value. This study is based on data for Japanese and Taiwanese firms. His results suggest that
aggressive liquidity management will increase both operating performance and corporate value.
Lyrodi and Lazaridis (2000) examined liquidity of food and beverage industry in Greece and connected it to
profitability, indebtness and company size. They found that there is a significant positive relationship
between the cash conversion cycle and quick and current ratios. Furthermore, there is a positive relationship
between cash conversion cycle and both ROA and net profit margin. Hence, there was no linear relationship
between cash conversion cycle and leverage ratios. According to Lyrodi and Lazaridis (2000), current and
quick ratio had negative relationship with debt to equity ratio. Yet there is a positive relation of these ratios to
times interest earned ratio. They found no statistical evidence of difference between liquidity ratios of
different sized companies.
The study of Afza and Nazir (2007) examines the relationship between the aggressive/conservative working
capital policies with profitability and risk. Sample consists of 208 public limited companies listed on Karachi
Stock Exchange for the period of 1998-2005. Their results show that there is a negative relationship between
working capital policies and profitability, and they also found no significant relationship between the level of
current assets and liabilities with risk of the firms.
Garcia-Teruel and Martinez-Solano (2007) provide empirical evidence of the effects of working capital
management on the profitability based on a sample of small and medium-sized enterprises (SMEs) in Spain.
The research has been performed on a panel data of 8,872 SMEs covering the six year period. Their study
showed that profitability can be achieved by reducing inventories and the number of days for which their
accounts are outstanding. Also, their study proved that shortening the cash conversion cycle also increases
firms profitability.
Consistent findings can be found in research of Samiloglu and Demirgunes (2008) performed on
manufacturing firms listed on Istanbul Stock Exchange for the period of 1998-2007. The results showed that
accounts receivables period, inventory period and leverage influence profitability negatively, while growth in
sales has reverse affect.
By examining different manufacturing, retail and wholesale companies from 1980 to 2006, Luo, et al. (2006)
found that the efficiency of a firms working capital management has lasting impact on firm performance. The
future earnings increase follow improvements in working capital management. The same authors reveal that
the firm value tends to increase when cash conversion cycle decreases. The consistent results can be found
in Zariyawati et al. (2006). Covering similar period and using panel data of 1,628 Malaysian firms, these
scholars found high negative correlation between cash conversion cycle and profitability.

703

Nevertheless, Sharma and Kumar (2011) reported inconsistent results obtained from similar study conducted
in India. By examining 263 non-financial firms listed at the Bombay Stock Exchange, they find that working
capital management and profitability is positively correlated. In particular, inventory and number of days
accounts payable are negatively correlated with profitability, whereas number of days accounts receivables
and cash conversion cycle exhibit a positive relation with companies profitability.

3. METHODOLOGY
3.1. Sampling procedure and data
Aim of this study is to test whether there is a correlation between liquidity and profitability of companies in
Serbia. In order to properly determine significance of such a relationship, we have selected Serbian
corporations that list on Belgrade Stock Exchange and that are included in Belexline broad market index.
This index is chosen because it represents capital market movements. Our sample consists of 51
corporations. Index is based on price movements of 70 Serbian corporations. However, because of specific
nature of their activities we have excluded banks and financial corporations from our sample. Also,
corporations that have not yet submitted last years financial reports have not been taken into consideration.
Likewise, one corporation that has missing data for the year 2010, due to the fact that is founded in 2011,
has been removed from the sample.
Our findings are based on liquidity and profitability measures, obtained from last years financial statements
that are publically available. Sample is described with descriptive statistics, more specifically: means,
minimums, maximums and standard deviations. Interdependence of variables was examined using
correlation analysis (Spearmans rho two-tailed correlation), conducted in SPSS 17.0.
3.2. Research variables
The basic objective of the study was to examine and explore the relationship between indicators of
profitability and liquidity. Therefore, as a profitability measure the study used return on assets (ROA), defined
as the ratio of earnings before interest and tax to total operating assets. This ratio was used in numerous
studies (Afza and Nazir, 2007; Garcia-Teruel and Martinez-Solano, 2007; Uyar, 2009; Sharma and Kumar,
2011) as it provides the best insight into corporate profitability.
Liquidity and other performance measures employed in this study are number of days accounting payables
(AP), number of days inventory turnover (INV), number of days accounting receivables turnover (AR), cash
conversion cycle (CCC), size of the company (SIZE), and the sales growth of the company (GROWTH).
Similar set of variables was used to examine the relation to profitability in numerous studies (see: Lyroudi
and Lazaridis, 2000; Deelof, 2003; Garcia-Teruel and Martinez-Solano, 2005; Nazir and Afza, 2009).
The effectiveness of working capital management was measured by number of days accounts receivable
(AR), number of days of inventory (INV) and number of days accounts payable (AP). Number of days
accounts receivables, inventory and accounts payable was calculated as 365 times accounts receivables,
inventory and payables, respectively. Number of days accounts receivables indicates number of days that
passes from selling the products and services to collecting the cash from debtors. Number of days inventory
shows the period of time that passes from receiving raw materials and services from suppliers to the sales of
goods. Number of days accounts payables denotes the duration from receiving raw materials and goods
from suppliers to the payment time. Finally, the cash conversion cycle (CCC) is an additive measure of the
number of days funds are committed to inventories and receivables less the number of days payments are
deferred to suppliers (Johnson and Soenen, 2003). The size of the company (SIZE) was measured as the
natural logarithm of the actual book value of assets. The logarithm approach was used as the original large
value of companies might have disturbed the analysis (Nazir and Afza, 2009). The sales growth (GROWTH)
was measured as the relative growth in sales [
].
3.3. Descriptive statistics
The descriptive statistics for both profitability and controlling variables is displayed in Table 1. The mean for
return on assets was 6.7%, whilst minimum and maximum values for ROA are 7.8% and 62.6%,
respectively. Hence, profitability is very volatile [standard deviation is approximately .1162]. The average
cash conversion cycle of sampled companies was approximately 318 days. This means that in average it
takes 318 days from paying suppliers to collecting the cash from buyers. This was affected by accounts
704

receivables of 364 days, inventory of 130 days and accounts payables of 175 days in average. This indicates
that the average observed company in this study face myriad of problems with liquidity.
The mean growth of examined companies was nearly 10,3%, but the standard deviation indicates large
differences between the sales growth among observed companies. Average leverage is 39,52%. It is
noteworthy to notice that the maximum leverage is 123,9%, which means that some of the observed
companies have losses in excess of equity. Finally, current ratio was in average 2,45, with minimum and
maximum values ranging from 0,168 to 11,894.
Table 1: Descriptive statistics for profitability and liquidity measures

4. RESULTS AND DISCUSSION

As the objective of the study was to analyse the correlation between liquidity and profitability indicators, the
results displayed in Table 2 represent the correlation matrix. Results show that there is a statistically
significant correlation between return on assets and number of days in accounts receivable, number of days
in accounts payable, growth, size and current ratio.
The weak negative correlation exists between ROA and number of days accounts receivable and ROA and
number of days accounts payable. These findings suggest that if number of days accounts receivable and
number of days accounts payable is reduced profitability of a company will increase. Therefore, the
companies which more frequently collect cash from costumers tend to be more profitable. The working
capital management theory suggests the same. However, negative correlation of number of days accounting
payables and profitability is highly inconsistent with a working capital management theory. The theory
suggests that delays the payments increases the profitability of the company. However, similar
inconsistencies could be found in other empirical studies (Deloof, 2003; Garcia-Teruel and Martinez-Solano,
2007). These findings emphasise the fact that more profitable companies in Serbia more frequently respond
to their commercial liabilities. Nevertheless, the shortcoming of Spearmans rho, or any other correlation test,
does not allow identifying causes and consequences.
Study results also reveal a positive correlation between current ratio and return on assets (.389). With regard
to other performance measures, relatively high values for correlation could be found between return on
assets and both growth (.428) and size (.310) of corporation. Profitability is positively associated with growth
in sales, as well as with size. Hence, larger companies tend to have higher profitability, which could also be
found in Garcia-Teruel and Martinez-Solano (2007).

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Table 2: Correlation matrix

706

5. CONCLUSIONS
Extant literature provides a profound insight into effects of working capital management on corporate
profitability in both developed and emerging economies. Different authors present contrasting findings of the
relationship that exists between liquidity measures and ROA. This study analyzed profitability-liquidity
relationship within Serbian companies listed at the Belgrade Stock Exchange. Our findings suggest that
Serbian corporations suffer from severe illiquidity. Cash conversion cycle, as the most frequently used
dynamic liquidity measure, tends to be too lengthy, and it does not have statistically significant relationship
with ROA.
Our study reveals a negative correlation between ROA, and both number of days accounts receivable and
number of days accounts payable. There is a positive correlation between return on assets and current ratio,
and ROA and sales growth. Based on these results management can increase profitability by reducing
number of days accounts receivable. On the other hand, delays in payments to suppliers are not necessarily
a driver of profitability. However, it cannot be stated as a fact that liquidity affects profitability and not the
other way around.
This survey did not explore all profitability drivers and also did not determine real nature of the relationship
that exists between liquidity performance measures and various indicators of profitability, which could be
suggested for further research.

REFERENCES
Afza, T., & Nazir, M.S. (2007). Is it better to be aggressive or conservative in managing working capital?
Journal of Quality and Technology Management 3(2): 11-21.
Afza, T., & Nazir, M.S. (2008). Working capital approaches and firms profitability in Pakistan. Pakistan
Journal of Commerce and Social Sciences 1: 25-36.
Deloof, M. (2003). Does working capital management affect profitability of Belgian firms? Journal of Business
Finance and Accounting 30(3): 573-587.
Garcia-Teruel, P.J., & Martinez-Solano, P. (2007). Effects of working capital management on SME
profitability. International Journal of Managerial Finance, 3(2): 164-177.
Johnson, R., & Soenen, L. (2003). Indicators of successful companies. European Management Journal
21(3): 364-369. doe: 10.1016/S0263-2373(03)00050-1
Luo, M.M., Lee, J.J., & Hwang, Y. (2009). Cash conversion cycle, firm performance and stock value.
Retrieved from: http://www90.homepage.villanova.edu/michael.pagano/ML_CCC_20090420.pdf, Last
accessed May 3rd, 2012
Lyroudi, K. & Lazaridis, J. (2000). The cash conversion cycle and liquidity analysis of the food industry in
Greece. Retrieved from: http://papers.ssrn.com/paper.taf?abstract_id=236175. Last accessed: April
26th, 2012.
Nazir, M.S., & Afza, T. (2009). Impact of aggressive working management policy on firms profitability. The
IUP Journal of Applied Finance 15(8): 19-30.
Outram, R., 1997. Turndown that order. Management Today, October, pp. 112113.
Ozbayrak M., Akgun M., (2006), The effects of manufacturing control strategies on the cash conversion
cycle in manufacturing systems, International Journal of Production Economics 103, pp. 535550.
Raheman, A., & Nasr, M. (2007). Working capital management and profitability-case of Pakistani firms.
International Review of Business Research Papers 3(1), 279300.
Samiloglu, F., & Demirgunes, K. (2008). The effect of working capital management on firm profitability:
Evidence from Turkey. The International Journal of Applied Economics and Finance 2(1): 4450.
Sharma, A.K., & Kumar, S. (2011). Effect of working capital management on firm profitability: empirical
evidence from India. Global Business Review 12(1): 159-173. doi: 10.1177/097215091001200110
Uyar, A. (2009). The relationship of cash conversion cycle with firm size and profitability: an empirical
investigation in Turkey. International Research Journal of Finance and Economics 24: 186-193.
Walker, E.W., 1964. Towards a theory of working capital. Engineering Economist 9, 2135
Wang, Y.J. (2002). Liquidity management, operating performance, and corporate value: Evidence from
Japan and Taiwan. Journal of Multinational Financial Management 12(2): 15969.
Zariyawati, M.A, Annuar, M.N., & Abdul Rahim A.S. (2009). Effect of working capital management on
profitability of firms in Malaysia. International Symposium on Finance and Accounting (ISFA), 68 July,
Malaysia. Retrieved from: bai-conference.org/BAI2009/Pages/.../isfa2009_submission_13.doc, Last
th
accessed: April 25 , 2012.
707

INTELLECTUAL CAPITAL - A CHALLENGE FOR ADEQUATE FINANCIAL

REPORTING
Veljko Dmitrovi, Sneana Kneevi, Tijana Obradovi
Faculty of Organizational Sciences, University in Belgrade, dmitrovicv@fon.bg.ac.rs,
Faculty of Organizational Sciences, University in Belgrade, knezevics@fon.bg.ac.rs
Faculty of Organizational Sciences, University in Belgrade, tijana@fon.bg.ac.rs
Abstract: Modern enterprises of XXI century should be characterized by the ability to adequately use their
intangible resources that have become much more significant in relation to material resources. With the
spread of market uncertainty is greater, technologies are more sophisticated, competition is stronger, the
lifetime of products is shorter. Therefore, successful companies need to be able to distinguish the continual
creation of new knowledge and its dissemination to all parts of the company, building them into all
processes, new technologies, new effects. Adequate knowledge management leads to improved
performance of employees and becomes an important factor to parry competition. Knowledge is an
indispensable strategic resource for companies, because it contributes to the achievement of its basic
objectives. Use of adequate knowledge creates intellectual capital of a company that provides objective
reports with additional financial reporting and is an important factor in parrying the fierce competition.
Keywords: intellectual capital, knowledge, financial statements, measurement, enterprise, International
Accounting Standard 38

1. INTRODUCTION
The present time is characterized by global competition, political turmoil, turbulent environment, uncertainty,
marked fluctuation of qualified personnel, development of technology and others. Being surrounded with this
kind of environment a company can hardly survive in the market without professional management and staff
who possess modern knowledge, intelligence and ability to knowledge sharing in teams to improve company
performance and to parry competition. Rapid technological and market changes that would require the
company more flexible operations in order to adapt to this environment. Competitive advantage can only be
held if the company has adequate experts from various fields whose knowledge is transformed into a
intellectual capital as a pillar of defence against competitors. Therefore, the advantage can be maintained by
adequate investment and motivating employees, because they are headquarter that is key factor of
intellectual capital as a resource base for survival, growth and enterprise development, and increasing value
of it. Company's ability to properly activate their intangible resources has become more important in relation
to the management of material resources. The official financial statements present only part of the intangible
assets, and only tangible part of it (research, patents, trademarks, licenses - governed by the International
Accounting Standard 38 - Intangible assets), intangible and impalpably (i.e. intellectual capital) is not in the
official financial statements but is in the additional company financial statements in some developed
countries.

2. KNOWLEDGE AS A BASE OF INTELLECTUAL CAPITAL IN FUNCTION OF COMPETITIVE

ADVANTAGES OF COMPANY
In the new economy based on the information technology knowledge gets a great importance in relation to
the past. It became a crucial strategic factor for the development of enterprises, and thus society. The
modern corporation operates in a knowledge society - it Peter Drucker recognized in his researches.
Therefore, in the XXI century - century of knowledge, real information is not invested in the material factors,
but in the knowledge of employees. Companies in the new economy have realized that their advantage
toward competition is reflected through what it knows, how it to uses, what it knows and how fast it can learn
something new.
Adaptation and learning skills is associated with enterprise intellectual capital. Intellectual capital can be
defined as a combination of three integral segments, namely: human capital (skills, knowledge, skills, staff
and management experience, the dynamic action of an intelligent enterprise in competitive conditions),
structural capital (infrastructure support human capital including information technology, the company's
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image, proprietary databases, organizational concepts, documents, patents and licenses) and customer
capital (the ratio of companies and their clients) (Pulo & Sunda, 2008.).
The combination of qualitative and quantitative human, structural and customer capital merge into intellectual
capital that is a source of competitive advantage. In fact, the intellectual capital comprises the knowledge
involved in a dynamic process and transformed into added value for the company.
In order to gain insight into the intellectual capital and its various structural components one of the first was a
Swedish insurance company "Skandia" in 1995. get down measuring the performance of intellectual capital.
They added the intellectual capital report to traditional (official) financial statement. They made a pioneering
step in terms of more comprehensive financial reporting. An additional report called new reporting model is
made to provide a balanced picture of the intellectual and financial capital. This model is a step beyond
traditional accounting presentation of value added.
One should not misunderstand their model. Skandias intellectual capital measurement model is not a
replacement of traditional accounting, nor it is complete. Regardless the above, it represents an important
step forward compared to the traditional way of displacing of accounting the value added. It is in fact
incentive, the driving force for the development of other methods, techniques and models of monitoring
measurement and management of intellectual capital.
Numerous studies and analyzes show that knowledge and its externalization in many companies are not
shown in the financial statements, and also is present insufficient attention in the management of these
resources. It also means that the intellectual capital is under-utilized in these companies because they own
success, or failure, calculated using the old principles and methods.
For modern enterprises sources of competitive advantage are related to information, the process of
organization and relations with external stakeholders. Infrastructure of companies, relationships with
customers and business partners, innovation efforts initially incorporate intellectual capital.
The sum of knowledge of all individuals in the company, as well as the practical translation of this knowledge
in a competitive process, trademarks, masks of products, actually makes intellectual capital. More detailed
studies relating to intellectual capital are tied for second half of the nineties of last century and the beginning
of the XXI century.
The intellectual capital of the company is really focused an increase in competitiveness in the future, a
development of options, opportunities to make use of the environment and the future operations of the
company. Therefore, the real value of the company is estimated over its potential for future opportunities and
the ability to increase profitability, and therefore competitiveness. Intellectual capital is knowledge that can be
transformed into profit. From this point of view in the focus are investment, approaches, processes, ideas
and know-how.
Intellectual capital marks a new knowledge-based economy and become the most important factor of
production, which drives all other production factors. The synergy of the components of intellectual capital is
the basis of creating value-added company, positioning the company in the market creating competitive
advantage.
The role of knowledge in achieving competitive advantage is a challenge to management. It is a fluid mix of
experience, information, intuition of experts. Sveiby believes that knowledge has four characteristics (Sveiby,
1998).

Knowledge is tacit
Knowledge is directed to action
Knowledge is supported by the rules
Knowledge is constantly changing

To create innovative enterprise by transformation processes immanent is prominent place of the knowledge
without which is impossible involvement in the contemporary development trends. Therefore, the knowledge,
709

skill, creativity and innovation are becoming the main generators of human intellectual capital of employees,
which increasingly require new types of production.
Intellectual capital is intended to explain the origin of the differences between book and market values of
companies. This way value of the companies is more precisely determined and is of great importance not
only for the company, but also for investors. Intellectual capital is the knowledge included in the dynamic
process transformed into a value-added of enterprises.
International Accounting Standards 38 - Intangible Assets prescribes the accounting treatment of intangible
assets that are not dealt with other accounting standards. This standard defines the criteria for recognition of
intangible assets, as well as way of the measuring of the book value of these and requires certain
disclosures about intangible assets. Some intangible assets may have a physical form (for example a
prototype, CD-ROM, documentation of patents or licenses, or film) and is considered to be tangible
intangible assets of its definition, recognition, initial measurement, the measurement after recognition is
regulated by this standard. Intangible immaterial assets are not regulated by acts of professional regulations
and also are not integral components of the official financial statements on, but are integral components of
the additional financial reports from some companies of countries with developed market economies. The
company chooses its accounting policy that it will use the cost model or revaluation model.
Intangible immaterial property i.e. investments are not regulated by the International Accounting Standards /
International Financial Reporting Standards to the financial statements show a true picture of the property,
financial and profitability position. We should as soon as possible incorporate as the official position of the
financial statements, which implies the adoption of new standard that will govern the quantification of the socalled intangible immaterial property so called intellectual capital. Or will complement the existing
International Accounting Standard 38 with the necessary elements related to the intangible asset that is
intangible immaterial property i.e. investment. The pointed will require a change of the Accounting and
Auditing Law and Company Law and accompanying documents.

3. MEASUREMENT OF INTELLECTUAL CAPITAL

Company after setting up knowledge management strategy of its employees faced a new challenge i.e. the
question is how to measure the effects of complex activities. Some companies (Skandia, Dowchemical,
Buckman Laboratories, Canon, etc.) twenty years ago made a pioneering step and began measuring
intellectual capital, and were deeply convinced that the growth of intellectual capital leads to a positive
financial result of the company, and contrary - his fall is a sign for the future problems.
Present are the following methods for measuring intellectual capital, namely: (ijan, 2007).
1. Market to Book ratio
2. Tobin's Q
3. Calculated Intangible value
1. Relation of the market and book value is based on calculating the difference between the market
capitalization of the company and its book value. This method is simple to use, but it is difficult to embrace
complexity. Of the multitude of economic indicators and speculation in the markets in which the company
cannot influence with the results of its operations depends the market value of companies. Therefore, in
order to implementation of this method provided adequate results it is very important to anticipatory define
the criteria of determining and quantifying the market value of the company, which is not an easy task.
2. Tobin's Q was initially developed for the analysis of financial markets by James Tobin. This method uses
the value of the reproduction costs of corporate assets in order to predict investment decisions independent
of interest rates. Tobin's Q is the ratio of enterprise value and reproduction cost of its assets. Market value is
the most probable price that would be provided a means to achieve a competitive and open market under
conditions necessary for a fair sale.
If the Q ratio is greater than 1 (if the reproduction costs of corporate assets is lower than its market value),
then the company earns monopoly profits and, conversely, if the coefficient of Q is less than 1 (if the
reproduction costs of corporate assets is higher than its market value) then achieved a normal return on their
investment.
This method provides insight into the current market and financial situation of enterprises. Important is
dynamic approach to management of skills (knowledge) performances of employees who will point out the

710

positive activities to highlight and the negative to be avoided or minimized. It is an important indicator that the
company should focus on creating new value and achievement of competitive advantages continuously.
3. Method Accrued intangible value developed by NCI Research Illinois, to calculate the fair value of
intangible assets of companies. This method calculates the excess return on fixed assets and use this figure
as a base for a certain proportion of return attributable to intangible assets.
A prerequisite for calculating intellectual capital makes the availability of data of the profit of entire capital
within their own business. Intellectual capital is calculated in relation to the achievements of the average
competitor, compared with an average that type of industry to which it belongs. For a period of time is
necessary to average company revenues divided by the average of its material resources. Then this result
(which is repayable funds) compared with the average in the industry.
There is a need for linking intellectual capital with the objectives of the company that will be manifested
through competitive advantage, which is why many companies are experimenting with the management of
intellectual capital in order to achieve this. Because of it appeared many methods of measuring and
managing intellectual capital. One of the models of intellectual capital developed together Leif Edvinsson,
Hubert St. Onge, Charles Armstrong and Gordon Petrash and called it a platform of values. Platform values
(see Picture 1) describes the intellectual capital through three main components that are interconnected to
form a value that is created in the cross section of these three components, i.e. human, structural and
relational capital. In the framework of human capital considered to be people's ability and capacity to learn.
Structural capital is the infrastructure, intellectual structures and cultures. The relational capital are among
customers, brands, and contracts.

Picture 1: Platform of values

1.

INTELLECTUAL CAPITAL MANAGEMENT USING THE MAGIC PROJECT

QPR software developed by the European MAGIC Consortium (measurement reporting on intellectual
capital) has created a technology that supports the methodology and model for measuring intellectual
capital. This project is funded by the European Commission.
Many companies have realized the importance of creating a measurement system to monitor the most
important resource of the company so called intellectual capital. Seen from this aspect intellectual capital can
be defined as:

Proportional value added to all intangible resources of company and

Dominant knowledge necessary to provide the competitive advantage

711

If we measure the intellectual capital by methodology MAGIC project, its structure consists of human capital
(which includes all the skills, competencies, expertise, so that he can react to market demand and customer
needs, including leadership and management decisions and skills), organizational capital (including ability of
the company, its infrastructure and organizational processes related to creating products and services for the
market), market equity (the company's ability to communicate with the external environment, customers,
suppliers and other stakeholders), and innovation capital (referring to the company power to innovate,
improve and develop the untapped potential and create wealth in the long run).
Development of methodology of measurement system for determining the intellectual capital was actually the
goal of this project. QPR Software from Finland, Institute for Human Factors Technology, Management IAT
from Germany were partners MAGIC project.

5. CONCLUSION
Continuous adjustment of the market, technological and organizational changes in the century based on
knowledge and intellectual capital the focus is adequate management skills of employees, i.e. intellectual
capital. Only satisfied and adequately motivated employees are essential and primary resource of companies
to innovate and achieve competitive advantage. Presented methods focus on measuring intellectual capital
as a whole or its parts. The classical financial indicators are not able to cover all the results of knowledge
management and intellectual capital. It is necessary to strive to develop new, more adequate methods for
monitoring the economic effects in order to achieve competitive advantages. The invention enough precise
methods will allow quantification of intellectual capital not only in the supplementary financial statements, but
also in official statements, which represents a major challenge for theorists and for practitioners, and policy
makers for acts of professional accounting regulations.

REFERENCES
Dmitrovi, V; Kneevi, S; Milosavljevi, M. (2011). Znaaj upravljanja intelektualnim kapitalom u
savremenom preduzeu, Raunovodstvo i menadment, 12. meunarodna znanstvena i struna
konferencija, Zagreb
Split.
Kangas, L. M. (2009). Assesing the Value of the Relationship Between Organizational Culture Types and
Knowledge Management Initiatives, Journal of Leadership Studies 3.
Praktina primena Meunarodnih standarda finansijskog izvetavanja u Republici Srbiji osnovni principi
(2008, septembar). Savez raunovoa i revizora Srbije, Raunovodstvena praksa, Srbija, Beograd.
Pulo, A; Sunda, D. (1998). Intelektualni kapital, IBCC, Rijeka.
Sveiby, K, E. (1998). The New Organizational Wealth: Managing and Measuring Knowledge Based Assets,
Berrett Koehler.
ijan, G. (2007). Magistarski rad Intelektualni resursi i njihova kvantifikacija u intelektualni kapital izazov
za raunovodstveno izvetavanje, Ekonomski fakultet Subotica, Univerzitet u Novom Sadu, Subotica.

712

COLLAPSE OF THE AMERICAN MORTGAGE MARKET

Andrijana Lakievi, Veljko Dmitrovi, Sneana Kneevi
Faculty of Organizational Sciences, University of Belgrade, lakicevica@fon.bg.ac.rs,
Faculty of Organizational Sciences, University of Belgrade, dmitrovicv@fon.bg.ac.rs,
Faculty of Organizational Sciences, University of Belgrade, knezevics@fon.bg.ac.rs
Abstract: The first wave of the global economic and financial crisis in the U.S. spread to the European Union
and worldwide. Very quickly, the crisis from the mortgage market spread to stock markets, government
bonds, the labor force. The crisis has brought with it the decline of economic activity, insolvency and losses,
primarily in the financial sector and then in the real sectors of economy. Problems in credit and savings that
were accumulated in the past have reached the peak with the collapse of over a thousand banks. Those
were the first signs of emergence of the current crisis, but they were ignored. A few years later, company
corporate scandals followed (for example Enron, WorldCom, Adelphia, Global Crossing), which realized the
suspect accounting procedures, participated in accounting and financial fraud schemes for deceiving the
public and illegal acquisition of large gains by individuals.
Keywords: prime mortgage loans, sub-prime mortgage loans, U.S. housing bubble, crisis, loss

1.

INTRODUCTION

Until the mortgage market crisis, the U.S. is considered to be one of the safest and most developed markets,
which almost certainly guaranteed profits with little risk. In the frantic race for profits in the U.S. mortgage
market, global financial markets lost ground.
Globalization has contributed to the spread of the crisis of global proportions, but its occurrence did not
signalled. The cause of the crisis was irrational consumption without taking into account the traditional
business models. The cause of the boom in the mortgage market, which is the cause of occurrence of the
current financial crisis, was a seemingly easy access to affordable mortgages. Boom was not based on
fraud, as the overvaluation of stocks and excessive speculation.
This paper will tell about sub-prime mortgage loans, compensation of lenders risk, U.S. housing bubble and
its burst, possible culprits and collapse of the financial system, the help from outside, crisis spreading, and
protecting the financial system.

2.

SUB-PRIME MORTGAGE LOANS

At the beginning of the millennium two types of mortgage loans appeared in the market. Prime mortgage
loans were offered by lenders to their best customers who are creditworthy to make a repayment of a
mortgage loan and sub-prime mortgage loans were offered by lenders to customers who did not meet the
requirements for obtaining this type of loans. Believing in the idea that the value of homes in America never
fall, the U.S bankers developed this system of high-risk loans, known as "sub-prime" mortgages which
characteristics are that the housing loan is offered and approved without much checking of property of the
borrower. Many of these instruments let families purchase homes without documenting their income, putting
little down, and with potentially high loan-payment-to-income ratios if interest rates rose. Banks have been
easily approving these types of loans because the growth of housing prices in the U.S. was constantly rising
every year extending the value of collateral so after a few years the value of mortgage loans exceeded the
amount taken. Many of the borrowers could now easily get mortgage loans from banks and that led to an
increase in demand for housing due to a limited supply and an increase in property prices in the U.S. The
financial institutions that where lenders of this loans where know working in a field of low liquidity and high
leverage.

3.

COMPENSATION OF LENDERS RISK

Being attracted by the low initial interest rates on "sub-prime" loans lower-paying Americans did not pay lot of attention to
the clauses in loan agreements. There should be no doubt that lenders were at least somewhat aware of the risks they
were taking. Therefore, in order to ensure against loss, the U.S. mortgage banks have put a clauses that in the case of
irregular borrowers payments their interest exponentially increase. Although it seems that the lenders did not take into
account the riskiness of their given loans, they have already made this step with interest increase in order to compensate
713

the taken risk (Spiegel, 2011). On the other hand, U.S. lenders have started to repack mortgage loans into complex
financial arrangements and resell them to investors around the world. Many central banks around the world had
difficulties to monitor this whole process and they long had almost no insight into the rules of buying and selling these
loans (Vuji, 2008)

4.

U.S. HOUSING BUBBLE AND ITS BURST

This type of loan has directly influenced the increase in demand, and indirectly on the growth of housing
prices, so many started to buy the property from the speculative purpose - to sell for higher prices, giving
further speed to price rising. This phenomenon is called as a U.S. housing bubble, which is characterized by
rapid growth in the value of real assets such as property until it reaches an almost unbearable level,
compared with earnings and other economic factors. This was followed by bank securitization of subprime
loans where they sold their debts on the market. Thus, unwittingly endanger the entire financial system. Of
course, the price of a balloon at one point had to burst that happened in July-August 2007. Home prices had
increased by an average of 124% from 1997 to 2006 (Kjelleren, 2008.). Real estate prices have started to
fall rapidly so that the debtors faced with the situation that they owe more than their property really worth.
Many who bought the property were not able to repay taken loans, and their number was growing rapidly
and the entire financial system was potentially insolvent. When the U.S. housing bubble fully burst in 2007
and home prices dropped, 1.25 million subprime mortgages foreclosed, up 80% from 2006. In Phoenix,
Miami, greater Los Angeles and Las Vegas, home prices declined by over 25% in 2008. and the national
average declined 17%, with around 10 million families having negative equity in their homes (Kjelleren,
2008.).
Borrowers were not able to carry out their obligation and they were announcing bankruptcy. Banks
unwillingly became owners of great amount of mortgages. Banks have tried to sell mortgages in the amount
of debt but prices were constantly falling, so even if the property was sold it was not enough to service the
debt.

5.

POSSIBLE CULPRITS AND COLLAPSE OF THE FINANCIAL SYSTEM

Some authors suggest that the blame modern practice of securitizing loans, but some disagree with this
opinion mentioning 1930s and the fact that there were no securitized mortgages then. It is also very hard to
say that modern institutions are solely responsible for currently observed modification rates (Spiegel, 2011).
Going back to 1977 and Community Reinvestment Act it can be seen that the Government as one of its wellintentioned policies intentionally encouraged home ownership by low-income families and intentionally
contributed to weakening of the whole financial system. In order to meet this Act, banks began to give loans
in low- and moderate-income areas, softening credit policy with not so rigid requirements what automatically
led to higher rates for those borrowers as assuring themselves from the taken credit risk. Lower and lower
credit standards followed (Spiegel, 2011).

Consequences arisen

Unrecorded wave seizure overpriced houses owned by the impoverished Americans

drop in U.S. consumer confidence in their purchasing power,
increase the local unemployment and inflation,
Slowdown of economic growth,
Balance of costs of too expensive war in Iraq

Running away of investors

bad assets in banks' balance sheets

withdrawal due to rising investor risk

due to the low liquidity, financial institutions were forced to sell their property

due to the crisis there is a lack of investors willing to buy property

due to low demand prices decreased, and banks are forced to sell assets at a price that is lower than
the purchase price which leads to the realization of loss

Crises leads to deterioration of the balance sheets of banks, which represents an additional incentive
for investors to withdraw funds
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The disappearance of capital

bad assets on the balance sheet of banks

due to large creditor investments and the absence of regulation the banks have little capital ratio and
a high leverage

due to the crisis, banks are forced to sell assets (decrease leverage)

due to the crises there is lack of investors wishing to buy property

a decline in property prices influenced banks to sell real estate below price

As the property was sold below price that led to deteriorated of capital ratio, which is an additional
incentive to sell the property (Petkovi, 2009).
The collapse of the U.S. mortgage market has caused a great financial crisis and all the big companies that played a
key role in the process of securitization (the five investment banks - "Goldman Sachs", "Morgan Stanley", "Lehman
Brothers", "Merrill Lynch", "Bear Stearns "; two financial conglomerates -" City Group, "JP Morgan Chase"; three
companies dealing with insurance - AIG, MBIA, AMBAC, three rating agencies for risk assessment - "Moody's",
"Standard & Poor's" "Fitch" and two big mortgage corporations - "Fannie Mae", "Fredie Mac") found themselves facing
bankruptcy. But not only them, because the vast mass of "toxic" securities spread throughout the world. Banks in many
countries around the world in their portfolios had higher or lower mass "toxic" securities, and was threatened with
bankruptcy. Therefore, the crisis in the United States quickly passed on to the whole world. It should be noted that the
crisis in the housing market was just a catalyst, not the underlying cause of current global crisis (Duani, 2012).

6.

THE HELP FROM OUTSIDE

In 2008 the financial markets froze. While the financial crisis created problems for firms reducing their profits,
it also attached banking system. Banks stopped lending to each other in fear they would never be paid back.
The help from outside was indispensable so the Government officials asked Congress for funds to fill in for to
save credit markets. In response to this crisis Troubled Asset Relief Program (TARP) was founded, as
facility created by the US Government to buy distressed assets from financial institutions. The main purpose
of TARP was to create liquidity in the credit markets by buying (and freeing up) assets tied to mortgages
from banks. That way banks with the help of TARP could continue lending. Of course, those institutions
participating in this program were under Government monitoring (Duani, 2008).
European Central Bank (ECB) as one of the worlds most important central banks and someone who
implements monetary policy can provide liquidity via open-market operations. As crises was spreading ECB
had to intervene, but even though ECB s gave its best effort, the market still kept high rates for interbank
loans. Every time ECB tried to do something it was reflected in totally different way. Conducting an
aggressive politics to provide liquidity made lenders pull back from the market even more, as they were more
suspicious of borrowers. Bad situation on the market made a condition in which every ECB liquidity injection
required a new one (Spiegel, 2011).
When housing prices began their slide they even fell to about a third of their initial value what to a wave of
foreclosures. Banks were also on the loss as properties were worth far less than the underlying mortgages
were seized. Having a wish to solve this issues the Government intervene my providing funding to Home
Owners' Loan Corporation (HOLC) as its main purpose is to refinance home mortgages currently in default to
prevent foreclosure. With these funds HOLC could purchase delinquent loans, refinance them, and thus give
homeowners a chance to remain in their dwellings.

7.

CRISIS SPREADING

There is a spill over of the crisis from the U.S. to Europe and on to other developing countries. Governments
of most developed countries had to intervene. Their main goal was to restore confidence in the financial
system which was at an alarmingly low level, ensure the liquidity of many institutions and to stop the sale of
property at low prices. All of this was a reason that they approved a large amount of money. This funding
was much easier done with the investitures and countries that could borrow money from investitures than
those who could not. The other short-term measure was recapitalization of banks.
Capital increase led to a reduction in leverage. Reducing supply and recovering demand, and also getting

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prices of real estate to more realistic level was possible with states purchase of mortgages at risk from
banks.
In order to prevent the deepening of the crisis, all countries are obliged to do everything in their power to
stop the significant decrease in demand. There are some projections of IMF experts to expansionary fiscal
policy should be conducted by all countries with low indebtedness and where in the earlier period disciplined
policies was conducted. IMF experts estimate that the fiscal expansion should provide about 2% of global
GDP to avoid a significant reduction in global demand.
The Federal Reserve at the last minute halts global "domino effect". U.S. central bank has decided to make a
radical at the domestic financial market. Due to the fact that Federal Reserve authorities have the
responsibility of state regulators, it had an obligation to try to stop a possible domino effect. The Central Bank
of the United States and its move to persuade rival investment bank, "Jay Morgan" to take part of the
business of "Bear Stearns's" which was in great debt on the U.S. mortgage market, and to try to save it
bankruptcy was a great surprise for those who strongly believed in free market. Such intervene of the Central
Bank of the United States in the arena of U.S. financial markets has not been recorded since the thirties of
last century (Vuji, 2008).

8.

PROTECTING THE FINANCIAL SYSTEM

To date, no one really knows how much money is imported into a failed scheme of risk mortgage loans in the
U.S. Experts are mentioning trillion of U.S. dollars. Also, no one knows for certain how many commercial
banks and speculative funds around the world invested in maintaining the collapsed U.S. financial system.
It is curtain that after the crisis, the redraw of financial system and the monitoring and supervision in the
world has to come. Harmonization of the regulations and national policies is necessary, and to provide
common rules in the recapitalization of banks as national approaches. The role of the IMF must be redrawn.
It takes redraw in order to ensure timely multilateral temporary liquidity.
In order to protect the financial system a policy of fiscal expansion should be maintained but as a
consequence a growth of a countrys debt will occur. If the US mortgage market stabilize after the crises,
what is firmly believed, an increase in the value of property taken over by the state in times of crisis can
exceed the value of net debt in times of crisis. Being in the position of a recapitalization need, banks gave a
significant share of the property to the state, so should gradually withdraw from ownership and return the
banking sector to private hands (Petkovi, 2009).

Figure 1: Real House Prices for United States and European countries: 1997 to present
(The Mortgage Meltdown and House Prices, The B.E. Journal of Economic Analysis and Policy, 2009)

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Figure 1 shows real mortgage rates over the same time period. As real mortgage rates dropped more quickly
in 2002, house prices demonstrated a commensurate rise.
Ted Forstman renowned billionaire who runs one of the worlds biggest private equity firms said (July, New
York Times), We are in a credit crisis the likes of which Ive never seen in my lifetime. The credit problem is
considerably worse than people have said or know. I didnt even know subprime mortgages existed.
(Kjelleren, 2008)

CONCLUSION
Mortgage market crisis had first attack on real estate market in the U.S. and then spread into the financial
system and economy, and all of this did not occur by chance. The causes of the crisis can be found in
irresponsible business policy of relevant state institutions which were supposed to control the financial
markets and lack of professionalism in the work of rating agencies. Furthermore, weaknesses that existed for
years in the field of financial control and regulation in the United States also made a great contribution.
New situation created few very bad movements. Foreign capital started to melt; stock market indexes had a
dramatic drop and there was also a lack of fresh capital.
The idea of liberalization of finance markets, giving sub-prime mortgage loans to those who had questionable
credit power and who did not fulfil all credit requests with almost no regulation, caused disastrous
consequences. Initial optimistic forecasts proved wrong and unjustified, and what is worst, it reflected to the
whole world as the crises stared to spread beyond US borders what is pretty much logical due to the fact that
all parts of the world are connected and inseparable. The spreading of the crisis even hurt the economy of
countries that had no direct involvement in creating this crisis.
Although the Governments of all countries persistently struggle to develop a perfect program to neutralize or
mitigate the effects of the global economic crisis, it seems that the right solution has still not been found. All
programs already adopted or future once are concentrated on harmonization and synchronization actions of
the competent institutions, wanting to achieve harmony between monetary and fiscal policy. It is necessary
to provide the required level of liquidity, economic growth and protect the most vulnerable sections of
population from the impact of the crisis.

REFERENCES
Arner, D. W. (2009). The Global Credit Crisis of 2008: Causes Consequences, International Lawyer, Wall 43,
No. 1.
Duani, J.B. (2012, March). Neoliberalizam i kriza. Nova srpska politika misao. Retrieved from
http://www.nspm.rs/ekonomska-politika/neoliberalizam-i-kriza.html?alphabet=l
http://www.wikinvest.com/wiki/Troubled_Assets_Relief_Program_%28TARP%29
Friedman, H. H; Friedman, L. W. (2009). The Global Financial Crisis of 2008: What Went Wrong?,
available at ssrn:http://ssrn.com/apstract=1356193.
Hellwig, M. (2008). Systemic Risk in the Financial Sector: an Analysis of the Subprime Mortgage Financial
Crisis, Max Planck Institute for Research on Collective Goods, Bonn.
Hubbard, R. G. & Mayer, C.J. (2009). The Mortgage Market Meltdown and House Prices. The B.E. Journal of
Economic Analysis & Policy Symposium.
Kjelleren, L. (2008). The Housing Market Meltdown and the Credit Crisis: Basic Risk Management Ignored.
Financial History.
Petkovi, V. (2009, March). Economic crisis - causes, consequences and policies to overcome. SEF
(Serbian Economic Forum) Retrieved from http://www.sef.rs/makroekonomija/svetska-ekonomskakriza-uzroci-posledice-i-politike-za-prevazilazenje.html
Pobri, N. (2010). Globalna finansijska kriza: iskustva i smernice, asopis Finansije, br. 1-6, Srbija, Beograd.
Spiegel, M. (2011). The Academic Analysis of the 2008 Financial Crisis: Round 1. Published by Oxford
University Press on behalf of the Society for Financial Studies. Retrieved from
rfs.oxfordjournals.org/content/24/6/1773. full Home Owners' Loan Corporation (HOLC)
Troubled Assets Relief Program (TARP). Retrieved from Vujic, T. (2008). America on the threshold of a new
era. Published by Politika Online. Retrieved from http://www.politika.rs/rubrike/Tema-nedelje/Svetskafinansijska-kriza/Amerika-na-pragu-novog-doba.lt.html
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BOT PROJECT FINANCING MODEL OF PPP:

THE EXAMPLE OF THE ZAGREB PUBLIC UTILITY WASTEWATER
COMPANY
Dragan Miloevi
College for Business Economics and Entrepreneurship, info@vspep.edu.rs
Abstract: Through creating a public-private partnership (PPP), the supplying of goods and services
traditionally provided by the public sector should be provided in the most economical way. The aim of this
article is to examine ways of the BOT financing of infrastructure investment projects and to present the
example of a project financial construction of the Zagreb PUC Wastewater. Research methods are content
analysis and case studies. Users of this research may be more interested in the infrastructure projects that
consider the application of the BOT model for financing infrastructure projects. The BOT model of PPP is a
model in which the private sector finances partially (or completely) the construction and equipping of a
facility, which through the use of the goods carries out the return on investment with a reasonable profit. In
this model the role of the public sector is very significant, although it does not necessarily entail financial
investment. It consists of providing an environment for the implementation of the project and investment, as
well as monitoring and controlling services which have traditionally been the responsibility of the public
sector. The private sector interest in such partnership is a commercial nature of the equity capital and
services intended to make a profit. The structure of financing the BOT model consists of three sources of
capital: First, the initial capital invested by the concessionaire of the project at the beginning of the
establishment of a concession company, which is collected by issuing ordinary shares or payment of equity.
Second, long-term debt capital, which may consist of a senior (superior) and junior (subordinate) debt,
depending on the risk taken. A senior debt is covered by some sort of collateral, and is similar to ordinary
bank loans with long maturities. Although it does not necessarily occur, a junior debt as it does not fully
secure is often contracted through the sale of convertible securities with a possibility of converting into
equity securities, in order to attract investors. Third, a reserve loan used as needed in case of breaking the
project budget. The BOT model of PPP gives the best results in projects which are totally new investment, in
cases where there is high certainty of collection services from the BOT project. Shortcomings of this model
could be complex and expensive tendering procedures, the cost of private capital and a problem concerning
the replacement of the concessionaire in cases of contract termination.
Keywords: Public Private Partnership (PPP), project financing, BOT model
1. INTRODUCTION
In Republic of Serbia, there is a large gap between the needs and possibilities for financing infrastructure
projects. This is way one of the real option is the use of a model public-private partnership. BOT model of
financing infrastructure projects is one of the frequently applied model of public-private partnership in the
world, with different effects application. BOT models of financing of such partnership is in the group of project
financing, which is a relatively new way of financing intensively developed in recent years. The aim of this
paper is to explore the basic elements of the BOT method of financing investment projects and that the
example PUC Zagreb Waste Water show his method of financing in practice. Research methods are the
methods: content analysis, case study.
Application of public-private partnership brings both significant advantages as well as disadvantages, having
a major impact on infrastructure development, because those projects are of great value and importance to
the national economy.
Data on problems in the implementation and effects that carry the largest BOT projects are mostly outside of
experts. The main sources of information are the data obtained from international development organizations
that support the implementation of this partnership. Lack of public information and technical serious research
can dramatically affect the errors in the application of public-private partnership. Users of this research could
be all interested party in the infrastructure projects that consider the application of BOT model of
management and financing of public-private partnership on its infrastructure projects.
Under the Law on Public-Private Partnership and concessions (2011): "Public-Private Partnership
(hereinafter referred to as PPP), is a long-term cooperation between the public and private partners with the

718

aim to provide financing, construction, reconstruction, operation or maintenance infrastructure and buildings
of public importance and services of public interest Cooperation may be contractual or institutional. "
Partnership between public and private sector-PPP (Public Private Partnership - PPP) is created in order to
obtain a project or service that are traditionally provided by the public sector. The partnership allows each
sector doing what usually working best, in order that public services and infrastructure are provided in the
most economical way (European Commission, 2003).
Partnership of public and private sector based on the idea that the private sector meets the needs of services
and goods for the public sector, with similar (or nearly similar) competitive conditions, guiding on commercial
markets. The role of the public sector remains dominant, but is more focused on the development of public
services, market control and monitoring tasks. PPP is implemented by selecting the model of cooperation
and private partners, which will under the conditions of competition in the markets bidders, compete with
each other through transparent public bidding.
The way of cooperation between public and private sectors should change the traditional way of creating,
acquiring and distributing public goods from the point of service quality and efficiency of the use of social
resources, which are located within the public sector management.
This is about a systematic approach to transform ways of meeting the primary needs of society and the
common use of national resources with a view to optimal ratio of the obtained use and consumption of
resources. The aim is to take full advantage of the private sector can offer in terms of efficiency and
economy of resource use, with the opportunity to participate or even fully finance such projects
The partnership is based on the careful building of relationships that includes a win-win strategy where both
of the parties must meet their own economic interests. If it is not respected, for any reason, the realization of
cooperation will not be successful. So there must be a partnership, which reflects in the existence of the
efforts of both sides to find for long term economic interests, even in situations that could not be previously
predicted. Maximizing the interests of only one side, almost always leads to a deadlock, and then to the
termination of cooperation.
One of the basic economic needs that must be met, is the formation of the economic cost of services,
covering all costs. This precondition, allows smooth cycle of reproduction of public goods and services.
By forming the economic cost of services, raises the question of existence of the population that they cannot
pay for (The World Bank & Inter-American Development Bank, 2000), (The International Bank for
Reconstruction and Development and The World Bank, 2005). This leads to lack of use of their services or
search for ways to make this part of the population involved in a range of users. Since it is a basic existential
needs of the people, it is necessary to think about the way of subsidizing the costs for this population, taking
care that it is not used for the continuation of inefficient operations, which is characteristic for the previous
period.
The intention of the developed world is to increase the coverage and quality of public services, as a visible
indicators of increased well-being of society (The International Bank for Reconstruction and Development
and The World Bank, 2005). If, in addition to intention to increase the quality of existing services, there are
plans to invest more in infrastructure and development phase of their expansion, the need to finance the
implementation of such projects by the public sector are becoming financially unsustainable even for
developed countries. At a time when almost all countries (for various reasons) have problems with balancing
the budget of the country, it is difficult allocate funds for the dynamic development of infrastructure, certainly
not to the extent that we want to achieve the planned level of development.
Due to the centralized structure of government, the public utilities in countries in transition are almost
exclusively performed on the basis of obtaining goods and services from state-owned enterprises. Through
the development of the private sector, performs the transformation of public sector services from centralized
towards market direction. This can be seen as a new emerging market for private sector in countries in
transition

719

2. INTERESTS OF THE PUBLIC AND THE PRIVATE SECTOR FROM THE PPP PARTNERSHIP
Under the Law on public-private partnership and concessions (2011), "a project of public-private-partnership
is a project that is developed, proposed, approved and implemented by some of the public-private
partnerships model, and makes a series of interrelated activities, take place in a specific order, in order to
achieve defined objectives within a certain period of time and financial resources, and is in accordance with
this law, is approved as a project of public-private partnership, with or without elements of the concession.
What is characteristic of all models is a combination of transfers of financial and nonfinancial assets in the
models. While some time ago was the dominant consideration of financing, now are increasingly analyzed
and entered into non-financial elements of the character. An illustrative example of non-financial elements is
the question of transfer of intellectual property on PPP projects. This transfer from private to public sector
should provide greater effects on investment, which will be mostly reflected in future efficiency of investments
exploitation, than the public sector has traditionally provided.
According to Guy-and-a Crauser (Director General DG Regional Policy), "The European Commission has
identified four principally role of the private sector in PPP schemes:
1.
To provide additional capital funding.
2.
To provide an alternative to existing management and implementation skills.
3.
To provide significant added value for consumers and the public.
4.
To provide better identification of needs and optimal use of resources. "(European Commission, 2003).
Private sector interests are primarily related to the profit and reduction of risk in capital intensive projects.

3. BENEFITS AND COSTS OF APPLICATIONS BOT MODEL

BOT system is an abbreviation of English term build-operate-transfer - BOT), including all sub-types of this
system, based on the construction or reconstruction and financing of the entire building (equipment or
facilities), its use and transfer of the title to the concession grantor within the agreed timeframe.
BOT allows the private sector: construction investment, manage the work (operations) and on the basis of
that generate revenues from services they charge. From the private sector is expected to bring
modernization and improvements of the concept, structure and way of satisfying needs, while funding and
cost-effective usage of financial resources.
The key relationships in the PPP project are determined by defining the roles of the two key groups (the
grantor and the concessionaire), according to who bears responsibility for the following activities:
Ownership of property (land, buildings, equipment, installations, etc.).
Financing of investments.
Method of forming tariffs
Commercial risk.
Provision of services through operational work and maintenance of the investment made objects,
plants, etc..
The time in which a partnership agreement is concluded.
Evaluation of the sustainability of the PPP model (Milosevic, 2009) is based on the analysis and projection of
cash flows that affect the following key elements:
Size of consumer surplus.
Method of forming tariffs for consumers (tariff system) and certainty of collection
Projected capacity.
The level of exclusivity of service (there is no alternative means of satisfying the demand for services).
The level of financial support that is derived from government and other grants.
possibility of applying the project (land acquisition, satisfaction, environmental conditions, etc..).
Prices of capital engaged.
BOT project can offer a lot of economic benefits (Milosevic, 2009) such as:
Sources of financing investments in infrastructure. Special benefits can be when it comes to external
sources of funding, which guarantees the inflow of foreign currency into the country.
The government of the host country maintains strategic control over the development of infrastructure.
Increasing the efficiency of investment and reduction of operational expenses, due to well-conceived
and executed design of the system.
720

Transfer of new technologies and skills, especially for the local labour force.
Development of relations between the private and public sectors, and certain sectors of the local
economy, which appear as sub contractors on the project
Development of local capital markets, by increasing the volume and financial instruments which may
occur in the domestic market

Also there are costs related to the implementation of BOT model (Milosevic, 2009):
Costs of the tender procedure.
Consulting services costs for the host government, without sufficient knowledge and experience in
negotiating and implementing the model.
Cost of capital commitment, due to the risk premium, the issuing of collateral and the like.
Approved an increase of costs of public service, becoming the costs of end-users.
The increase in material prices due to rising demand initiated by the investment company.

4. FINANCIAL STRUCTURE OF BOT MODEL

BOT projects are mainly financed by foreign sources of funding accessed by the concessionaire, according
to their solvency and the situation on international financial markets. At the time of concluding the contract on
financing of the project, the concession company usually does not have sufficient assets that could be
pledged. Everything is based on an assessment of yield capability of the project and the conditions of
placement sources of capital that is partially or not at all covered by assets, which are only created through
the investment cycle of the project. Also, PPP projects are not commercial, in the practical mining, and
cannot easily find new customers for the concession company, if the existing funders plan to withdraw from
the project.
This certainly implies a significant risk, which bears any capital which is involved in financing the project.
Attitude to risk is essential for the initiation of investment and thus for development. United States, for
example, various tax measures are taken in order to stimulate investments in capital investment projects.
For the determination of financial structure there are the three key elements that must be considered by
financiers:
Financial sustainability of the project. The level of (security) of profits generated by the project.
The reallocation of profits between the stakeholders.
Assessment and Allocation of risk among participants in the financing.
Structure of sources of capital used to finance BOT project (Milosevic, 2009), depending on the amount of
risk taken, consists of three sources:
Equity.
Debt capital (Long-term borrowed capital).
Stand by capital (Capital reserve).
Equity is usually provided by a sponsor or group of owners of the project, bearing all the risk on the project.
It is engaged at the beginning of the project during the establishment of the concession company, which
carries the concession. And upon expiration of the concession contract is drawn. Besides the sponsors who
are dominant in this form of financing, the opportunity to invest in this type of capital is being given to other
significant participants in the project (the main contractor, provider, supplier, etc.), in order to gain security
that they will not lose business interest to be engaged in the project. Initial capital is being paid to the
founders, with the realized gain or loss only after the payment of all obligations of the concession company
at the end of the concession. If the project is well established residual value of the project is significantly
larger than the funds invested in the capital. If the project realizes losses, then they have to be offset from
the capital. So this kind of capital carries the greatest risk and so the losses or gains from investments in this
type of capital, are the largest on the project. The interest of the sponsors of the project is that this part of the
funding of the project is as little as possible represented in the funding structure. Initial capital may be well
below the 20 to 30% depending largely on how creditors estimate that the project is defined, what the
guarantees are given and what is quality management project.
Debt capital (Long-term borrowed capital) that may occur as:
Parent Debt (senior debt). It represents medium-invested debt capital that is covered by some
provision of the instrument collection. This type of capital requirements raises the largest net inflows from
721

future exploitation of the project. If the future net inflows of the project are not sufficient or have a significant
risk, according to the Lender (creditor) estimation, then additional guarantees from the founders and
sponsors of the project are required. Instalment loan payments must be made regardless of whether the
project produces results or not. The deadline in which this type of debt is placed is (mostly) the medium, with
(usually) agreed fixed interest rate. This is the kind of debt that is returned after the first operation. From the
perspective of the founders of the concession company, this is the cheapest kind of capital, in terms of price,
if it is contracted with a fixed interest rate and predefined instalments. The founders will tend to increase it to
level that creditors accept. From the standpoint of lenders, rational relation with respect to the risk and ways
to ensure payment will be required.
Subordinated debt (junior debt or Mezzanine capital). Long-term invested capital, which has a
significant collection risk, partly because there is no security or it, is partially secured from payment risk.
Because it is located between debt and investment (basic) capital, it is called Mezzanine Capital. It is paid
only if there are funds for payment. Here we paid the debt for a longer period than is superior long. Because
of the significant risk taken, the interest is higher than the superior debt. The motive of the project sponsors
to acquire equity in this way is the distribution of risk to a number of interested parties (stakeholders) on the
project. This means that if the project generates sufficient amount of cash, a portion of profits will go to the
payment of subordinated debt financiers. Failure to realize expected profits will cause that interest will not be
paid, or in worse situations, even the main part of the subordinated debt. To attract investors, however, this
type of capital is raised with an additional possibility for investors to convert subordinated to initial capital
("equity kicker"), whether the conversion is more favourable to investors, or because there is no possibility
for payment, and are forced to awaiting completion of the project and the calculation of net value of the
project. In some cases vendors are included in the project financing, through mezzanine finance, converting
their claims into Mezzanine finances. This type of financing provides greater elasticity of the project
company. The essence of the idea is sharing the risks of the project and giving up part of the profits, in order
to cover risks through the price of the capital.
Capital Reserve (stand by capital). The role of this type of funding is to provide funds to start the project for
possible funding overruns (perforation) of the budget or cash flow mismatches. At the time of contracting it is
not known the moment or whether it will be in general use. It is reported separately in the balance of the
project (depending on whether or not used). It is engaged as debt capital and is usually part of a contractual
relationship with a superior debt. If is not provided at the time of contracting senior debt funding, it will be
difficult later to find the source of funding when the project budget has already broken. In this case, the
project sponsor must either finance the budget penetration or seek financing source under considerably
worse conditions than they were at the beginning of the project.
In practice, financial structure has not necessarily have subordinated debt in their financing. Due to the
significant amount of resources required and risk allocation agreements on joint funding of more investors
are common. In making such a joint agreement among investors, consortium of financiers of the project is
formed.
International development organizations such as the World Bank, EBRD, etc. can occur as co-investors, or
initiate the formation of a consortium of large investment projects. Especially in projects which have
significant effects on the development of the country and generate an adequate profit, which may cover the
cost of financing.
The role of international development organizations is double. Besides participating in the financing of the
project, they reduce the risk of lending through its rigorous control and thus motivate other investors to join
the consortium and the project co-financing. Their role is not to appear as competitors to private capital, but
rather create conditions, stimulating the private sector to be engaged in investment projects

5. FINANCIAL INSTRUMENTS USED IN BOT PROJECT

The most commonly way to obtain the initial equity capital is emission of ordinary shares or the equity
provided by sponsors.
For superior debt, are used bonds or contract of superior credit with some kind of collateral, such as a
mortgage or bank guarantee provided by the founders of the concession company.

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For subordinated debt, it is used the equity that has no security. This is source of capital that carries a
significant part of the risk, thus the profit carries risk as well. The instruments are:
securities convertible into ordinary shares (common shares),
preferences shares,
bonds
subordinated loans
high-risk bonds (junk bonds)
slightly less options and warrants (options, warrants).
Financial policy must take into account the circumstances in which the project takes place, the lack of
property that is truly a commercially marketable thus reducing the possibility of market sales and the
provision of investment.
Assessing the financial sustainability of the project is based on an assessment of the net discounted cash
flows and risks of their realization. For this reason it is necessary in the financial policy to consider the
following questions:
Minimization of own funds in the form of capital.
Maximize the long-term funding.
Arranging fixed interest rate for the capital employed.
Risk assessment and means of refinancing.
Assessment of ways of motivating means of refinancing
In the BOT project financing not only additional guarantees (from the host government or sponsors) are
required, but the solvency of the project sponsor (the founder of the concession company) is an essential
element of the whole structure. Project sponsor should by its own creditworthiness and by transfer of the risk
offer limited possibility of recourse, to the level of investment (its) assets. The very capital value of
constructed facilities is secondary, because it actually has an extremely limited ability to be resold to third
parties. For its part, limited recourse in the form of investment project sponsor provides some assurance and
confidence to lenders that the project sponsor seriously approached the analysis of the project.
Government may finance the project from their independent sources. In cases where there is a shortage of
financial resources to requirements, many projects have to wait for the time for implementation. In doing so,
it can make a significant opportunity cost of not using additional sources of funding. BOT project does not
require an implicit obligation of the host government to participate in co-financing the project. This may be
important in certain cases when you need to improve the country's credit rating and sustain political stability
in the country. Although it is not usual for the host country government to issue guarantees for equity, it may
occur as a guarantor for certain aspects of risk. On the other hand, governments may seek performance
counter guaranty. Return on equity, which lenders are expecting, is higher than the host governments are
usually able to pay for funding. On the other hand, transfer of technology, the concept of cost-effective,
efficient operations can add the benefits of private sector participation in financing, which in a way; create
balance with the increased cost of capital commitment. As for creditors, they carry a significant risk to their
investment, due to the length of implementation.

6. SOURCES OF FUNDING ON BOT PROJECT PUBLIC UTILITY WASTEWATER ZAGREB

Project wastewater treatment plant in Zagreb city is the first project for water utilities and waste water
treatment plants in Croatia (Zagreb wastewater PUC, 2009) and one of the few in Balkan. The project allows
the city of Zagreb wastewater treatment according to EU standards. The project envisages the construction
of approximately 10 miles of main sewer, with approximately 5.5 km modification of the main drainage
channel and construction of the pipeline bridge across the Sava River.
The value of the project is 288 million EUR which is invested in municipal water supply and sewerage
services, for the population of the region Zagreb. The drive has a capacity of approximately 1.5 million users,
it is estimated that this is projected needs of the city for the next 28 years.
The borrower (the first instance debtor) is a specialized Waste Water Public Utility Company Zagreb (PUC).
PUC occur on the project in the role of main contractor and project manager during the construction phase.
According to the contract, PUC took over the commercial (operational) and administrative tasks during the
operational phase and the maintenance of buildings and equipment.
723

After completion of the entire tendering process, consortium of RWE, Aqua and SHW were selected as the
best providers in 1999. The concession contract was signed with the consortium as the concessionaire in
December of the year 2000. As Grantor appeared the city of Zagreb. Here we use the net retained profit
realized on the project, as one of the key sources of funding.
Table 1: Sources of funding in the use of BOT Project Water Zagreb (Ruhe, 2007).
Use
million EUR
Sources
Capital and other costs
209 Equity
Working capital
19 Internally generated cash
Financial costs
54 KFW main tranche
Taxes
6 EBRD main tranche
Total use of cash
288 Total sources of cash

million EUR
38
99
101
50
288

Table 2: Structure of sources of funding in a PUC-BOT project (Ruhe, 2007).

Description
Conditions
The value of superior EBRD loan
55,2 million
Grace period
Six year
Interest
The average six-month EURIBOR plus a margin.
Security: Includes security over ZOVs assets, bank
accounts, insurance policies, receivables, pledge of
the Sponsors shares in the Company, Direct
Guarantees
Agreement with City, Construction guarantee, Sponsor
funds guarantee.
Co-financing: Kreditandstalt fr Wiederaufbau
110 million
(KFW)
Contracted amounts of credit EBRD (55.2 million , and KfW 110 million) were higher than was predicted
in the financial structure of the project (the main tranche of the EBRD and KfW E 50 and 101 million) for
the amount of capital reserve which was covering the potential amount of breaking the project budget.
Reserve capital is financed under the terms of senior debt and at the moment when contracted the entire
financial structure of the project. Subsequent contracting conditions of breaking the budget of the project,
when project spend significant resources, is incomparably more difficult and demanding task, which is
certainly reflected on the cost of capital engaged.

7. CONCLUSION
BOT as an investment project must be profitable in order to be acceptable to both parties. BOT model of
PPP projects that private capital is fully or partially funded by, does not debit the public expenditure. The role
of government is crucial in ensuring the necessary conditions for the project.
The costs of public procurement and the cost of private capital engaged, represent a significant position in
the cost structure. Greater efficiency in use of private capital needs to compensate these costs. Its ability to
finance infrastructure projects can have a multiplying effect on national development, provided that the state
ensures conditions for competitive bidding.
This model shows the best results when it is completely new (green field) investment, and bad results in
cases of applications in systems with low efficiency of collection of receivables from utilities, because the
public sector has a better system of enforced collection than it can provide private sector.

REFERENCES
Republika Srbija (2011), Zakon o javno-privatnom partnerstvu i koncesijama, Slubeni glasnik RS 88-11
European Commision (2003). Guidelines for Successful Public-Private Partenrships". Brussels, EU:
European Commission Directorate General Regional Policy,.
Miloevi D. (2009), Komparativna analiza konvencionalnog i BOT modela upravljanja i finansiranja
koncesija, (neobjavljena doktorska disertacija), Beograd, RS Srbija, Univerzitet Braa Kari
724

The World Bank and Inter-American Development Bank (1998). Concessions for infrastructure. Washington.
The World Bank (2000). Maintaining Utility Services for the Poor-Policies and Practices in Central and
Eastern Europe. Washington,USA.
The International Bank for Reconstruction and Development and The World Bank (2005). Sanitation and
hygiene at the World Bank. Washington, USA.
The International Bank for Reconstruction and Development / The World Bank (2006). Approaches to Private
Participation in Water Services. Washington, USA.
United Nations Industrial Development Organization (1996) Guidelines for Infrastructure Development
through Build-Operate-Transfer (BOT) Projects. Vienna, EU .
European Bank for Reconstruction and Development (2004) Municipal and environmental infrastructure
operations policy. EU.
The World Bank (1997). Selecting an Option for Private Sector Participation. Washington, USA 1997.
Transparency International (2007). Why study PPP (public private partnership) with caution?: PPP Projects
in the Czech Republic: Implementation and Risks. Prague, Czech Republic.
Brouwer, Roy / Pearce, David (2005). Cost Benefit Analysis and Water Resources Management.
Northampton, USA : Edward Elgar Publisher,.
Herzberg, Benjamin / Wright, Andrew (2006). The Public-Private Dialogue Handbook: A Toolkits for Business
Environment Reformers. Washington, USA.
Silvije, Orsag (2002). Budetiranje kapitala-Procjena investicionih projekata, Zagreb, Republika Hrvatska,
Masmedija.
Trifunovi, Radmila / Krnjeta, Lazar (2004). Optimalni modeli transformacije i privatizacije komunalnih
preduzea u Sbiji. Beograd : PU KOMDEL.
JKP Zagrebake otpadne vode (2009), Projektiranje, izgradnja, financiranje i upravljanje Centralnim
ureajem za proiavanje otpadnih voda grada Zagreba i pripadajuim infrastrukturnim objektima po
BOT modelu, Zagreb. Republika Hrvatska, sa sajta 2009, http://www.zovzagreb.hr/hrv/default.asp?cID=projekti&eID=projekti_13),
Ruhe, Charlotte (2007), Bankarstvo u razvoju, EBRD, Zagreb, Republika Hrvatska sa sajta 2007,
http://www.export.gov/advocacy/BoD_EBRD_Presentation_03-16-07.ppt .

725

FORMS OF FINANCING MERGERS AND ACQUISITIONS

Jovan Krivokapi1, Stefan Komazec2, Ivan Todorovi3
Faculty of Organizational Sciences, Belgrade, krivokapicj@fon.bg.ac.rs
2
Faculty of Organizational Sciences, Belgrade, komazec@fon.bg.ac.rs
3
Faculty of Organizational Sciences, Belgrade, todorovic.ivan@fon.bg.ac.rs
1

Abstract: This paper describes the problems of choosing proper form to finance mergers and acquisitions.
Companies that consider integrations must perform serious analysis of the potential partner, but also
examine their own performance, in order to find the best mode of financing. They should consider
results achieved in the past, current value of the company or its shares, but they should also estimate
potential future effects of integration and its synergy. A decision will be determined by these factors,
and here are presented the main characteristics of these forms and their risks. The chosen form of
financing can greatly influence the post-integration effects, both in the buyer company and in the target
company and therefore this problem should be considered seriously before signing a contract.
Keywords: mergers, acquisitions, financing, cash, shares, bonds

1. INTRODUCTION
An increasing number of mergers and acquisitions imply that integrations have become very popular form of
restructuring. Integrations should enable participants to appear in new markets and thus lead to increased
production and better competitive position. Merger represents a combination of two companies where the
integrated company ceases to exist. In this case, the company that carried out the integration takes over the
assets and liabilities of the acquired company. On the other hand, the acquisition means taking control of
another company, its subsidiary or its specific assets. (Gaughan, 2004) It can be achieved by purchasing
shares or assets of the target company, and the buyer becomes major shareholder, while integrated
company that is merged may cease to exist. Important issue includes determining either the deal is a merger
or an acquisition. If it is an acquisition, buyer must provide an acquisition premium because of control loss of
target companys shareholders. On the other hand, if the deal is structured as a merger, these companies
remain equal, so no premium is required since neither one loses control, or because both sides equally do.
(Moeller & Brady, 2007) It should be pointed out that mergers or acquisition are not easy to accept as a
solution, because they usually require a large sum of money that should be paid in a short period. The
problem may arise in obtaining the money, and, unlike the internal development, in this case there is no
possibility of sharing risk into several stages.
The main reasons for carrying out all forms of integration are diverse. The company can expand its area of
operations by combining with a company that is engaged in another activity, and in the same way it can
ensure its appearance on some new markets, where it had not operated earlier. It is often faster and more
efficient way of growth but carries greater risk and uncertainty. However, many different forms of payment
can be used in order to complete the acquisition process, and each of them brings a different view on
integration process. (Krivokapi, Dulanovi, & Jevti, 2008)

2. FINANCING MODALITIES
The most commonly used forms of payment include exchange of shares or payment through money. The
payment is often completed through the combination of these two forms, which means partial payment in
shares, and the rest in cash. Also, the transaction can be paid by the bonds of the overtaking company,
which brings benefits to the shareholders of the target company. In practice, large acquisitions and mergers
are usually completed through the share exchange.

Financing through stock exchange

As noted, large integrations are usually financed by an exchange of shares between companies involved in
the agreement. In that case, the buyer (The Company A) makes an additional issue of shares in the capital
market, and transmits them to shareholders of the target (The Company B). (irovi, 2004) The target
company has two alternatives it can keep the acquired shares, and thus become shareholder of company
726

A, but it may also sell those shares on the financial market, and thus obtain the money which can be further
invested.
A question of compensation can be very delicate. This analysis is based on the current stock price of
company shares. It is logical that The Company A should pay for the shares of The Company B more than
they really are worth on the market.
If we assume that the price of The Company As share is 20 , and The Company Bs shares are worth 6 ,
then, respecting the relations of market prices, shareholders of The Company B should receive 6 shares of A
for its 20 shares. However, as already noted, the agreement is achieved as The Company B receives a fee
for the transfer of its shares, so the relation between these shares can be defined as 2:1, for example. It
means that the shareholders of The Company B should receive 10 shares of The Company A in exchange of
its 20 shares. Thus the agreed course brings benefits to The Company B.
But defining this course is not a simple act. In fact, if it is estimated that acquisitions will not make (or will
make very little) added value, then the relation will be the same as the relation of the current market prices.
(irovi, 2004) However, companies usually enter such transaction in order to achieve significant added
value, so the calculation is mainly based on that assumption. Redistribution of this added value depends on
several factors, but it is mostly affected by the perception of future synergies achieved through the
integration process, and negotiating power of those companies that should sign the agreement. It is not rare
situation that The Company A insists on the implementation of such integration, even though its aware that it
overpays company Bs value. This can lead to the situation that even more than the additional value is
transferred to the shareholders of The Company B. Of course, this can cause large consequences for The
Company A. However, if the share capital of The Company A is much larger than the share capital of The
Company B, then the transaction will have no impact on the market price of its shares. On the other hand, a
series of similar acquisitions will lead to the same effect as if one large is made. This can lead to the rate
decrease of The Company A.

Financing through cash

The Company A may use cash in order to finance the acquisition. This money can be obtained in several
ways: (irovi, 2004)

Most often it comes from retained profits from previous periods. These funds can be used to finance
ventures in the company, or to carry out acquisitions.

Further, the inflows of money can be generated through the sale of the companys parts. The
Company A provides money that can use to pay its obligations to the shareholders of The Company B. This
is useful because The Company A thus divests segments it doesnt need any more, or those that have
inadequate rate of return on capital.

Finally, a company can come up with the cash by selling its bonds in the financial market, or by
borrowing the money from banks. In this case the structure of liabilities should be concerned, because it
increases the debt in comparison to equity.

Payment by bonds
Payment by bonds is quite rarely used, especially in comparison to the previous described types of financing.
In this case the shareholders of The Company B do not receive any money or shares, but bonds of The
Company A, in exchange for their shares. This is not the same as if The Company A broadcasts its bonds
and sells them on the securities market, and then uses that money to pay for the acquisition of B. The
Company B will accept payments through bonds only if The Company A has a high rating, and if the interest
rate is appropriate.
It happens that The Company A issues convertible bonds and then passes them to the shareholders of The
Company B. These bonds can be converted into ordinary shares at a predetermined conversion rate, but
only if this option is used by a certain deadline. This conversion will occur if the market price of The
Company As shares is greater than the established rate. Otherwise, the conversion will not occur, but
shareholders will retain the bonds, and earn from interest rates.

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Earnout model
This model is usually applied on medium-sized acquisitions, those that include companies which are not
registered on the stock exchange. The evaluation of such companies is difficult, because they do not have
formed stock price. According to this method, the financing is done with deferred payment, where the value
of acquisitions depends on the performance of the acquired company. Income generation has specific and
important role in this model. (Galpin & Herndon, 2007)
Lets assume that The Company A wants to make earn-out acquisition of The Company B. At the moment of
reaching an agreement, this company will pay, for example, 10 million. Also, it is estimated that during the
next 4 years The Company B will gain profits before tax, respectively, 2.5 million, 3 million, 3 million
and 3.5 million. The participating companies shall conclude an agreement that The Company A will pay to
The Company B at the end of the fourth year, for example, triple the amount of profit surplus above 2.5
million.
Therefore, the maximum earn-out payment for the period would be:
3 * (0 + 500,000 + 500,000 + 1,000,000) = 6,000,000
this means that the total payment was 16,000,000.
However, if The Company B does not achieve the projected profits, the residual part of the acquisition cost
will be revised downward. This model is quite used in many developed countries, and it is reported that about
20% of medium-sized acquisitions in Germany include some earn-out elements.

3. THE CHOICE OF FINANCING MODE

The choice of financing method is determined primarily by economical motives and effects. In fact, if you look
at the two major forms of payment, then you might conclude that the paying with shares brings the risk of
value change at the moment of acquisition, in comparison to the moment of concluding the agreement, while
the payment through money does not include that kind of risk. This interval is typically a few months, so the
change of stock price is possible or even expected. If the payment in cash is agreed, there is no such a
doubt. However, given the fact that nowadays the acquisitions are mainly carried out through exchange of
shares, the problem becomes more and more complex.
Of course, there are different interpretations of the reasons why the company decides to choose one form of
financing, instead of another one. Thus, if The Company A offers to pay in cash, then it bears all the risk, in
case its shares drop on the market. This is interpreted as a sign that the company has a very great
confidence on its business and acquisition, and expects the growth of shares. On the other hand, if the offer
involves a payment in shares, the market accepts it as an indication that the leech does not have enough
confidence in the sustainability of its shares price, and therefore wants to share the risk.
However, payments through shares may imply two completely different alternatives. Thus, the buyer can
offer fixed amount of stocks for stocks of the target company, and in this case the target company takes the
risk of share prices fall. The second option implies that the bidder offers a fixed value of stocks, so in case of
prices fall, the target company cannot be harmed. This case looks like a cash payment, but differences occur
after the arrangement is completed.
The risk of price change is related to the fact that The Company A almost always pays for The Company B
more than what it is really worth. The premium is usually between 30 and 50%, and often higher. Its
justification is in expectation that the acquisition will create a synergy that will affect the profitability of the
participating companies. However, it could be doubtful whether the premium will be sufficiently covered by
these synergetic effects. In fact, in all cases of overtaking The Company A must offer some benefit through a
good price, so that the shareholders of The Company B are motivated to take part in the acquisition. This
can result in attracting some other interested competitors, so The Company A might be forced to improve the
offer. If it is really keen to make acquisitions, they it will pay even a price that is higher than the objective one,
making a loss and hoping that the effects of integration will quickly make amends.

728

Besides, the market price of the company generally does not reflect only its current but also future business
performance. (Weston, Siu, & Johnson, 2001) Since the premium includes improved operations, it is
expected that the effects reflect also the current share price.

4. MAKING AND EVALUATING OFFERS

The company that wants to acquire the other must consider several criteria in order to choose the form of
financing. First of all, it observes the price of own stocks and estimates whether they are undervalued,
realistic or overvalued. (irovi, 2004) If they are undervalued, then it would be better to implement the
acquisition through cash, which can be obtained in various ways (by selling parts, borrowing, selling bonds,
etc.). In any case, it would not be a good decision to continue with the issue of shares, because they would
be offered at a price that is lower than their actual value. Otherwise, if the shares are overvalued, then its
advised to perform a new issue, and conclude the transaction on the basis of newly issued shares.
The other aspect that should be considered is the evaluation of the expected synergies effects. If the
company finds that the risk is significant, the integration should be completed through the acquisition of
shares, as this reduces the risk. The market assesses this as a signal that the company is not sure of the
effects, or that its shares are overrated. If the buyer, however, finds that the projected synergies will be
achieved, then the transaction should be financed through the money.
Finally, the buyer should assess the market risk of its shares, for the period until the completion of the
transaction. If it is low, then the acquisition should be completed by paying in cash or by exchange of shares
with a fixed value. Otherwise, companies will seek to finance the acquisition with a fixed amount of shares,
thereby shifting the risk to the target company. However, the question is whether the target company will
agree on it, because it is aware that this kind of deal involves the transfer of risk to its side. Usually, it will
agree only if the bidder is a company with a high credit rating and reputation, especially if the premium is
high enough. Also, the target company can accept payment through a fixed amount of shares, but can also
require establishing a lower limit price, which should prevent a large decline. In such situations the upper
limit is often determined, because there is a possible increase of price, so the buyer wants to protect itself
from potential losses that could be made in this case.

5. CONCLUSION
Depending on various factors, companies prefer a particular form of financing integration. Each of the
described models provides some benefits, but also different levels of risk, and therefore every company
involved in the agreement must provide very detailed analysis of the process. Many data from different
periods of time are considered, in order to find some trend of these companies value, and to predict effects
of integration so that the appropriate funding can be arranged. (Dulanovi & Jako, 2007) Assessments are
carried out both by the buyer and target companies, and these results could define the conditions of the
contract. The target company should assess whether the offer is acceptable to potential acquires.
Assessment begins with a consideration of the premium that the bidder provides, as well as through the
evaluation of expected return on investment. Company management should assess whether such a return
can be achieved if the integration is being refused.
Besides, it is necessary to consider the effects of partnerships in post-acquired company, given the fact that
the target company's shareholders will become shareholders of the bidder in fact, if the payment is made
through the stock. It is common interest to really achieve the projected synergies, because everyone loses
otherwise. Therefore, the target company must also carry out the assessment of potential synergies,
because it is normal that its shareholders share the effects of future business, both positive and negative.

729

REFERENCES
irovi, M. (2004). Fuzije i akvizicije. Novi Sad: Prometej.
Dulanovi, ., & Jako, O. (2007). Organizaciona struktura i promene. Beograd: Fakultet organizacionih
nauka.
Galpin, T. J., & Herndon, M. (2007). Mergers & Acquisitions - Process Tools to Support M&A Integration at
Every Level. San Francisco: Jossey-Bass.
Gaughan, P. A. (2004). Mergers, Acquisitions, and Corporate Restructurings. New York: John Wiley & Sons
Inc.
Krivokapi, J., Dulanovi, ., & Jevti, M. (2008). Modaliteti integracija preduzea kao odgovori na uticaj
savremenog poslovnog okruenja. The 11th international symposium Symorg, Management and social
responsibility. Beograd: Fakultet organizacionih nauka.
Moeller, S., & Brady, C. (2007). Intelligent M&A - Navigating the Mergers and Acquisitions Minefield.
Chichester: John Wiley & Sons Ltd.
Weston, J. F., Siu, J. A., & Johnson, B. A. (2001). Takeovers, Restructuring, and Corporate Governance.
New Jersey: Prentice-Hall.

730

MINORITY SHAREHOLDERS RIGHTS IN THE REPUBLIC OF SERBIA

Vladimir Djakovic1, Goran Andjelic2
Faculty of Technical Sciences, University of Novi Sad, v_djakovic@uns.ac.rs
2
Faculty of Business in Services, Educons University, andjelic1975@gmail.com
1

Abstract: Minority shareholders have a significant role in the growth and development of the market, and
represent the basis of marketability and market relations, especially in the countries in transition. The place,
role and importance of minority shareholders are particularly evident if corporate governance is taken into
consideration, and consequently, the efficiency of markets. A clear definition of the position and the rights of
minority shareholders in the institutional regulation is a particular challenge in the process of analysing the
mechanisms for protecting the shareholders. The subject matter of the research presented in this paper is
the analysis of the position and degree of protection of minority shareholders in the Republic of Serbia. The
research methodology involves the use of methods of analysis and synthesis with a special emphasis on
comparative analysis, and methods of induction and deduction. The aim of the research is to gain specific
knowledge about the position and possibilities of the protection of minority shareholders` rights in the
Republic of Serbia with a special focus on corporate governance and institutional regulations. The research
is important for both academic and professional audience, and even more for the policy makers in the
Republic of Serbia in the field of minority shareholders protection. The results indicate that it is important to
have an adequate regulatory protection of minority shareholders, and also point towards the necessity of
employing specific measures and instruments in order to improve the position of the same.
Keywords: shareholders rights, minority shareholders protection, shareholders disputes, corporate
governance, transitional countries

1. INTRODUCTION
The issue of minority shareholder protection is an ever present question, both for the developed and for the
transitional economies. A legitimate dilemma arises; namely, how to define and who to consider a minority
shareholder? Is a minority shareholder any shareholder of a company who owns a package of shares by
which majority control and decision making is not acquired, or the term refers to a group of shareholders
who, when joining their shares, do not have the majority to manage a company? Therefore, it is obvious that,
when defining the concept of minority shareholders, it is possible to talk about the concept in a broad and a
narrow sense.
For developed economies it is typical that minority shareholders are better informed, as well as better
organized; and consequently, the impact of minority shareholders on the companys business processes is
felt more significantly. Transition economies, on the other hand, are characterised by a relatively low level of
market awareness of the minority shareholders and their weak self organization, and consequently it is
possible to manipulate with the minority shareholders rights. In that sense, it is always an issue of who
should be concerned with the minority shareholders rights: the state in a systemic way, by acts and
regulations; or is it necessary to enable a greater level of awareness and education of minority shareholders
themselves, with the expectation that the consequences of their actions be a more efficient organization?
This issue is particularly important for the transitional economies and markets; these being institutionally
incomplete and sub-capitalized markets in which ownership transformation processes have not yet been fully
completed, and where there is a significant degree of market inefficiency. All this often results in a
subordinate, inferior position of minority shareholders in the companies, which is mostly manifested through
an insufficient level of awareness about their company's operations, insufficient involvement in the
management of companies and in the decision making related to the number of shares held, and the like.
The subject matter of the research presented in this paper is to define, analyse and research the position
and rights of minority shareholders on the market, with special emphasis on the Republic of Serbia, with an
aim to reach concrete conclusions about the state of affairs in the studied area, and to propose a series of
concrete measures and instruments in order to overcome these operational challenges.
If the current state of affairs is analysed in the transition markets, it can be seen that there is a considerable
volume of information and news about the minority shareholders rights; also, the desire to enhance these
731

rights is continuously proclaimed. However, the facts and the real state of affairs point to a different situation.
Namely, as changes on the transition markets become more intense, more manoeuvring space opens for
endangering the status and rights of minority shareholders. This paper intends to draw attention of the
professional and a much broader audience on the importance of minority shareholders protection in
transition economies, because it is in this segment that the level of democratization of a society can be
indirectly observed.
In this sense, one of the currently most endeavouring market challenges is the issue of minority shareholders
protection, more precisely the issue of clearly defining the shareholders` rights and obligations in the system
of market corporate governance. The Republic of Serbia, as a typical transition economy, does not
significantly differ from other transition markets. That is the main reason why the following research
emphasizes the status and rights of minority shareholders in the Republic of Serbia.
The paper is structured as follows. The introduction defines the basic elements of the study and reviews the
studied problem. The second part focuses on theoretical assumptions and provides a review of previous
relevant research in the area, as well as provides a review of the institutional regulatory arrangement position
of minority shareholders, with a special focus on the Republic of Serbia. In the third part, the paper analyses
the current situation, presents the concrete measures and instruments aimed at improving and promoting the
position and rights of minority shareholders in the Republic of Serbia. In the summary, concrete conclusions
and directions for further research are given.

2. THEORETICAL REVIEW
Defining, planning and a clear commitment to minority shareholder position in the market system of
corporate governance are vital for the successful functioning of any economy. One cannot imagine an
efficient market and an efficient economy, without a clearly arranged, well-defined position of minority
shareholders. The essence of corporate governance, i.e. one of its main pillars, is exactly a clearly defined
position of minority shareholders on the market. That is why in all market economies, the status, rights and
responsibilities of minority shareholders are regulated systematically, with a relevant set of laws and
regulations. A contemporary view of corporate governance cannot be implemented without considering the
important phenomena and relationships that are suggested by the practice of developed countries. These
are the rule of law, institutional development, and definition of corporative relationships by contracts,
protection of property rights, managers' discretion, and the like (Vignjevic-Dordevic, 2010).
In this sense, one can notice certain differences in the approach of defining the position of minority
shareholders on the markets of developed countries and the markets of countries in transition.
The term minority shareholders means the minority in equity and voting power; minority also implies that
some shareholders for various reasons, did not vote for a particular decision accepted by the majority of
the board, which triggers some specific rights provided by the law. Minority in capital, in the case of
dispersed shareholders (as is often the case in the Republic of Serbia), is often majority in number
(Paunovic, 2005). The status of minority shareholder is acquired by shareholders who own at least 10% of
any shareholding company which was privatized in the last decade. In companies, where shareholders are
not joined voluntarily, especially during the privatization process, an individual shareholder feels unprotected
from the administration, the majority shareholders and institutions. To protect themselves, shareholders often
join, hire consultants or rush to sell their shares on the first trading day on the stock exchange (Grubin,
2006).
In developed countries, the position of minority shareholders is clearly systematically arranged with a set of
system laws, legal acts and regulations. The institutional framework governing the position of minority
shareholders is all-inclusive and rather complex due to the fact that the issues of minority shareholders
protection have an impact on all aspects of business activity. The legislation regulating the position of
minority shareholders in developed economies has a long history, a natural evolution and a set legal way.
This primarily includes a set of laws regulating the financial markets, financial instruments, the participants
and technologies; it also includes the laws governing the economic and legal status of companies, corporate
decision-making and responsibilities, as well as a set of legal acts governing the rights, obligations and
responsibilities of both the minority and the majority shareholders.
The analysis and research of the issue of minority shareholders protection in transition economies is
particularly interesting. These economies are characterized by highly dynamic, propulsive business
732

conditions, by less efficient (often in particular aspects even inefficient), and an emerging market, lack of
market transparency, lack of corporate responsibility, unharmonised regulations and the like. All these facts
have resulted in an often unequal, inferior position of minority shareholders on these markets. In this sense,
many authors deal with issues of minority shareholders protection on these markets, attempting to suggest
concrete measures in the form of different solutions in order to improve the position of minority shareholders
on these markets.
Bearing in mind the investment processes under modern market conditions, it is necessary to consider how
the degree of shareholder protection affects these processes. At the macro level, shareholder returns are
higher in countries that, comparatively speaking, have less protection of minority shareholders, i.e. their
rights and interests. At the micro level, companies with dispersed ownership (on average) have higher rates
of return in accordance with organizational changes and by creating additional value in these companies
(Christian, Betzer & Weir, 2007).
The role of shareholder activism is especially important when shareholders decide to retain ownership of the
shares, and when they initiate changes within the company (without any changes in control). These investors
can initiate reforms in the company by negotiating with the senior management (or board of directors) or by
making proposals at the annual shareholders` meetings. Also, it can be concluded that the "shareholder
democracy" is in correlation with the activities of minority shareholders, i.e. it represents the framework for
the design and further development of regulations in the function of minority shareholders protection (Mallin
& Melis, 2010).
The key obstacle to further growth and development of many emerging markets is the lack of regulatory
protection of minority shareholders, especially in the case of company takeovers. Studies point to a lack of
regulation in the given area, i.e. to a correlation between the lack of regulation and the high concentration of
ownership, market illiquidity and the low level of the development of the capital market in transition
economies (Parisi, Mathur & Nail, 2009). For the development of financial markets it is necessary to raise the
level of corporate governance and minority shareholders protection (Pavlovic & Muminovic, 2010).
By providing protection to minority shareholders, the interest in founding capital societies increases, and so
does the level of investments, i.e. the undisturbed acquisition of shares. Investors are attracted by providing
adequate protection for minority shareholders, the abuse of majority rights is prevented and the principle of
shareholder equality is established which is proclaimed and accepted in all legal systems (Knezevic, 2008).
The above-mentioned points to the actuality of the investigated area apply particularly in the case of
transition economies and with a special emphasis on the Republic of Serbia.

3. MINORITY SHAREHOLDERS RIGHTS IN THE REPUBLIC OF SERBIA

The issue of minority shareholders protection on the territory of the Republic of Serbia and the enforcement
of their rights is particularly interesting, considering the fact that the Republic of Serbia is in the so-called
`second phase` of transition, when the completion of the property-ownership transformation is expected,
accompanied by the completion of the institutional frameworks; and thus the transformation of the Serbian
market into an efficient market is expected. It seems that many challenges await the Republic of Serbia on
this path, and this work is an actual attempt to provide quality information and propose concrete measures to
accelerate the successful completion of transition reforms for market policy makers in the Republic of Serbia;
and the effects will be largely felt in the field of improving the position and the rights of minority shareholders
in the Republic of Serbia.
A characteristic of all transition economies is the relativization of the concept of the market and marketability
in general, a presence of an insufficient level of ethics and morality on them; furthermore, a pronounced
"thirst" for profit no matter from which sources and regardless the costs, an often incompatible and
inharmonious regulations, low levels of market efficiency, etc. The results of all these circumstances are felt
in significant market turbulences that contribute to an undefined position of minority shareholders on these
markets.
A particular problem in the field of minority shareholders rights protection is the lack of knowledge about the
area, the manipulation with market information and the ever-present desire of major capital holders for
controlling minority shareholders. This situation has been a constant and significant source of conflicts on the
733

relation between major capital - minority shareholders - the state; and meanwhile little has been done to
create real prerequisites for overcoming these conflicts.
The regulations in the Republic of Serbia which either directly or indirectly affects the minority shareholders
rights are:

Company Law,
Law on the Capital Market,
Law on Takeover of Joint-Stock Companies,
Set of laws regulating privatization and the distribution of `free shares` to the citizens.

Analysing and researching the norms and standards contained in these regulations, it can be realized that
they are often contradictory, insufficiently clear and reasoned, all of which having an effect of creating a large
enough market space for possible abuses in the protection of the minority shareholders rights.
According to the norms governing the takeovers of shareholding companies and forced sales the buying of
shares in fact are not directed in the same direction. In the Law on Takeover of Joint-Stock Companies the
emphasis is placed in particular on protecting the minority shareholders rights during the takeover; while
according to the new Company Law, the scale of acquiring the possibility of forced buying/selling of shares
has been reduced from 95% to the newly adopted 90% . This solution is quite uncommon and creates space
for doubts, because there is a possibility that should an individual shareholder acquire 90% plus one share of
a company, may buy the remaining approximately 10% of the shares of that company without further
objections. This sends a very clear signal to the market about the glorification of the major capital in relation
to minority shareholders, i.e. the small capital.
The question is still open how the activities considering the distribution of `free shares` to the citizens of the
Republic of Serbia will be realized, and in what manner the citizens will be able to practice the rights given to
them on these grounds.
All these circumstances directly contribute to an unstable corporate climate in the Republic of Serbia, and
also strengthen the conflict between minor - major shareholders, with no clear commitment of the state to the
how-to and the future directions considering the realization and protection of the minority shareholders rights
in the Republic of Serbia.
Considering all the above mentioned, it is reasonable to propose measures, mechanisms and instruments
whose implementation could improve the position of minority shareholders in the Serbian market and
increase their rights. These mechanisms should be systematically targeted and coordinated towards several
key directions.
The first group of measures should be related to the creation, modification and compliance of laws and
regulations, particularly in the areas regulating the functioning of companies, the financial system and the
market in general. By research it has also been found that the current institutional framework to some extent
is adequate (but not significantly), and that in most cases, there is a need to further work on its change and
modification. The greatest absurdity stems from the knowledge that often a good idea cannot be realized in
practice because of inconsistencies between the regulations themselves. This is a job that can be performed
relatively fast, and by the implementation of these modified measures, healthy conditions for the protection of
the rights of all shareholders (especially the minority shareholders`) could be established.
The second group of measures should be aimed at strengthening the monitoring of market participants. In
this regard the supervisory organs and institutions should be given a great importance, in order to prevent
any possible abuse immediately.
The third group of measures should relate to a wide range of educational activities of the widest population,
in order to let each individual become acquainted with all the existing opportunities one has as a
shareholder. This is very important, especially due to the fact that all adult citizens of the Republic of Serbia
are entitled to obtain the so-called `free shares` from the state, and it is important to let them know what is in
their possession in fact.
The fourth group of measures should be aimed at harmonizing the system of market and media information,
in order to avoid failures that might occur in the sphere of public information on important elements of
734

corporate governance, on the state of affairs in market opportunities, and therefore on the position of minority
shareholders.
All of these measures must be implemented together, mutually be adjusted and synchronized, because that
is the only way to accomplish the desired goal, which is achieving a considerable level of protection of
minority shareholders` rights in the Republic of Serbia.

4. CONCLUSION
Bearing in mind all the above elaborated, a logical question arises of what to further do, in which directions to
develop corporate governance and corporate responsibility in the Republic of Serbia, how to further guide
the development of market relations and market trends through the prism of minority shareholders. The
proposal is to do several activities simultaneously. Further development of laws and regulations
strengthening the position of minority shareholders must be carried out, especially in the sphere of
information and protection of the rights and obligations. It is necessary to strive towards the improvement of
the investment climate in the Republic of Serbia and attracting foreign capital, because it is the only way to
present the spirit of modern corporate governance in the Republic of Serbia. A continuous and systematic
education of the population on shareholding, markets and corporate governance is also essential and must
be significantly strengthened. The monopoly of certain state institutions is necessary to be reduced by
systemic measures. Also, the question of the flow, exchange and protection of privileged information must be
further regulated.
Taking everything into consideration, it can be openly concluded that the Republic of Serbia considering
the field of minority shareholders protection is not high on the list of countries, and that this fact suppresses
the inflow of capital from abroad. It is a common fact, that the so-called `small investors` are the most
attractive subjects of trading on financial markets of developed countries, and that it is them who really
contribute to a healthy, mature and affirmative investment climate. In this regard, in front of the Republic of
Serbia is a long way, where there are to arise many more challenges and ambushes.
Further research should be directed to reviewing and analysing the status, position and opportunities in the
field of minority shareholders rights protection in the Republic Serbia, and to the study of the effects of
implemented measures in this field.

ACKNOWLEDGEMENT
This work was supported by the Ministry of Education and Science of the Republic of Serbia, within the
Project No. 47028.

REFERENCES
Christian, A., Betzer, A., & Weir, C. (2007). Shareholder wealth gains through better corporate governance
The case of European LBO-transactions. Financial Markets and Portfolio Management, 21(4), 403-424.
doi:10.1007/s11408-007-0061-7
Company Law (Official Gazette of the Republic of Serbia, No. 36/11).
Grubin, P. (2006). Mali akcionari - zatita i poloaj u akcionarstva u Srbiji. Ekonomski vidici, 11(1), 109-114.
Kneevi, M. (2008). Naelo jednakosti akcionara. Pravo - teorija i praksa, 25(3-4), 55-60.
Law on Takeover of Joint-Stock Companies (Official Gazette of the Republic of Serbia, No. 46/06).
Law on the Capital Market (Official Gazette of the Republic of Serbia, No. 31/11).
Mallin, C., & Melis, A. (2010). Shareholder rights, shareholder voting, and corporate performance. Journal of
Management and Governance, Online First, 1-6. doi:10.1007/s10997-010-9138-1
Parisi, F., Mathur, I., & Nail, L. (2009). Minority Stockholders Protection in a New Corporate Control Law:
Market Implications in an Emerging Economy. Emerging Markets Finance and Trade, 45(6), 419.
doi:10.2753/REE1540-496X450601
Paunovi, M. (2005). Zatita manjinskih akcionara u funkciji stabilnosti pravnog reima direktnih investicija.
Pravo i privreda, 42(1-4), 77-83.
Pavlovi, V., & Muminovi, S. (2010). Znaaj razvoja finansijskih trita za srpsku privredu. Industrija, 38(4),
41-67.
Vignjevi-orevi, N. (2010). Korporativno upravljanje i regulativa u funkciji razvoja konkurentnosti i
transparentnosti trita, Revizor, 13(51), 99-110.

735

ANALYSIS OF THE GLOBAL ECONOMIC CRISIS

1

Vojin Vuievi1
Ministry of Labour and Social Policy IMG International Management Group, Belgrade, Serbia

Abstract: Direct instigators of the crisis are regulatory bodies of the USA (FED, SEC) and rating agencies
that have made conditions for the appearance and escalation of the crisis up to unimagined proportions by
their unscrupulous work. Regulatory and structural shortcomings of the global financial crisis have provided
the transformation of a crisis of one country into a global crisis that spread onto industrially most developed
countries of the world in the first wave, whereas less developed countries were included in the second wave.
Once an advantage of financial markets, their global character, now in conditions of the crisis represents the
greatest disadvantage. In terms of globalization, space for finding solutions and exit strategies is narrowed
down, as the level of market heterogeneity is drastically reduced [1].
Keywords: globalism, economic crisis, analysis, loans, seasoned and deseasoned price.

1. INTRODUCTION
Current financial and economic crisis has affected all countries of the world with the same intensity,
regardless of the development level and structure of economy, all economic sectors and all social layers and
individuals. Crisis has caused the fall of all macroeconomic aggregates and indicators of all world countries.
Key consequences are illiquidity, drop in production and exports, decline in employment and increase in
unemployment, drop in living standard and growth of poverty.
Republic of Serbia in the period of economic crisis has, like other countries, recorded an increase of illiquidity
of economy, drop in gross domestic product, industrial production, export and import, drop in employment
and growth of unemployment, drop in earnings and purchasing power of population and growth in poverty. In
Serbia as transitional country, delayed and pilled transitional problems had primary impact on breaking of
macroeconomic trends, and additionally the drop in aggregate demand, reduction of foreign capital inflow
and increase of illiquidity in conditions of global economic crisis and recession [2].
2. ANALYSIS OF CRISIS IN USA, EU AND SERBIA
The reason for the appearance of sub-primary market lies in constant growth of real estate prices and desire
for acquisition of an increasing profit. Constant growth of real estate prices in caused by overheated demand,
which is financed precisely through mortgage loans. As the prices of real estate have constantly been
growing, the number of granted mortgage loans by commercial banks and other smaller deposit-credit
institutions such as nonbank banks and Thrifts has been growing. Nonbank banks have been dealing with
jobs of granting loans or receiving deposits, but they have never joined two functions. Thrifts are financial
institutions that are smaller than banks by size and primarily deal with granting loans to individual users and
they do not deal with corporative jobs. One of the main actors that have contributed to the escalation of crisis
in real estate market are precisely these smaller deposit-credit institutions.
Significant number of USA citizens due to unstable jobs they have dealt with and smaller earnings were not
able to borrow in primary market from commercial banks, since they couldn't meet the required criteria for
obtaining mortgage loan. Banks and other deposit institutions, wishing to use the trend of real estate prices
growth and to acquire higher profit from its primary activity (loan placing) have initiated the establishment of a
new submarket, sub-primary market of mortgage loans. In newly-formed market, clients with bad credit rating
could obtain wanted mortgage loan [1].

736

Figure 1: Base monthly index of the movement of deseasoned and seasoned real estate prices in USA
market in the period from 01.01.1991. 01.11.2008. [1, 3]
As base month, we have taken January 1991, while prices growth in other months of the period observed is
compared to the base month. Differences between seasoned and deseasoned prices are insignificant (figure
1). When we look at the graph, we can see constant growth of seasoned and deseasoned prices of real
estate until June 2007 when growth trends was abruptly stopped. In period from 01.01.1991. to 01.06.2007.,
deseasoned prices of real estate have grown by 126% on average [3], while seasoned prices have grown by
124% [3].
Favourable loans that the banks granted to their clients have led to the creation of great demand for real
estate, which was a pressure to the growth in real estate prices. Growth in real estate prices was also
contributed by American Federal Reserve System (FED), which have led expansive monetary policy. Policy
of low interest rates that was led in the period from 2001 to the half of 2005 has led to the situation in which
cheap capital was placed in long-term and capitally intensive projects such as real estate (figure 2) [4].

Figure 2: Review of the movements of reference interest rate of FED in the period from January 2000 to
March 2009 [4]
From the second half of 2005 until the end of 2007, FED has led restrictive monetary policy which was
reflected through raising the level of reference interest rate. Since the end of 2007, face with a growing crisis,
FED was forced to relax monetary policy by lowering the reference interest rate in order to mitigate the
effects of the crisis occurred. During 2007, defence interest rate of FED was lowered three times: on 18th
737

September from 5,25 % to 4,75 %, 31st October to 4,5 % and 11th December to 4,25 % [4]. Since the
beginning of 2008, there was an abrupt trend of lowering basic interest rate, when FED lowered refence
interest rate eight times. First lowering was performed on 22nd January 2008, when interest rate was
reduced from 4,25 % to 3,5 % [4]. The second reduction happened on 30th January when reference interest
are was reduced to 3 % [4]. The next reductions of basic interest rate happened on 18th March (to 2,25 %),
30th April (to 2 %), 8th October (to 1,5%), 29th October (to 1 %) and 16th December 2008 (to 0,25 %).
Measures of FED were aimed towards the reduction of costs of borrowing and improvement of the liquidity of
USA economy.
Commercial and investment banks have suffered the greatest losses. Assets write-off in 2007 for Citigroup
was 46,4 billion USD, Merrill Lynch 36,8 billion USD, and for Swiss UBS 36,7 billion USD. From mortgage
market, crisis was transferred to the market of shares and bonds in the beginning of 2008. In September
2008, it comes to the escalation of financial crisis and real decline of American giants. The first to declare
bankruptcy were Lehman
Brothers and Wachowia. State has nationalized Fannie Mae and Freddie Mac, which have controlled about
50 % of overall mortgage loans in USA. Merrill Lynch is saved by a takeover by Bank of America for
approximately the half of real value and JPMorgan has taken over Washington Mutual. Morgan Stanley and
Goldman Sachs were forced to change their status from investment banks into commercial banks. This
decision resulted from the need of investment banks for financial aid of the state that only commercial banks
could obtain. The biggest American insurance company American International Group (AIG) was saved from
bankruptcy by debt redemption from the part of FED [5, 6].
The situation occurred has forced European countries on common measures in order to prevent crisis
expansion. Leaders of fifteen European countries and Government of Great Britain have met on 12th
October 2008, in order to agree on common strategy which they will undertake in order to exit the financial
crisis. However, unlike the USA that is a single country, EU consists of 27 countries, which additionally
complicated and makes finding of a common solution more difficult. EU has important financial institutions
such as European Central Bank, but its great shortcoming is non-existence of European Government which
would make rapid decisions and decisions that would be mandatory for all member countries. The existing
legal solution provides each state to separately devise measures to overcome the crisis, without the need of
the members to mutually harmonize the measures planned [7].

Figure 3: Movement of reference interest rate of ECB in the period from 01.01.2000. to 01.02.2009. [7, 8]
On October 13th, Germany has set aside 70 billion Euros in order to raise liquidity of banks and 400 billion
Euros in order to prove interbank loans. France has set aside 40 billion Euros of financial injection for the
banks and 300 billion Euros to provide interbank loans. Great Britain has given the aid of 20 billion pounds to
Royal Bank of Scotland, and Lloyds and HBOS have obtained the aid of 17 billion pounds. British
Government has assumed the control over mortgage bank Bradford and Bingley. Spain has prepared a
package of measures of 30 billion Euros in order to pay for bad assets from banks and simultaneously
increase their liquidity.

738

From Table 1 we can see that Slovakia, Czech Republic and Croatia are the most endangered, in case of
which foreign capital has a share of more than 90% in ownership structure of financial institutions. In addition
to Hungary and Macedonia, Serbia is among three least endangered countries with 60 and less percentage
(table 1).
Direct effects of global economic crisis will leave deep consequences on countries that expect the most in
international flows of capital and international trade. Unlike these countries, developing countries and
countries that go through the process of transition will feel indirect effects of crisis for financial sector, which
will be manifested through the drop in liquidity, lot of difficulties related to the construction and reform of
financial institutions, as well as real sector through slowing down the economic activity. Serbia is a part of
this group of countries, as a country in a transition well underway.
Table 1: Share of foreign capital in ownership structure of bank sectors of the countries mentioned [12]
Foreign ownership over financial institutions
Percentage in relation to the entire
banking sector
Slovakia

97,4

Czech Republic

96,2

Croatia

90,4

Bosnia and Herzegovina

83,3

Bulgaria

80,0

Poland

79,6

Montenegro

78,1

Romania

70,0

Latvia

67,5

Serbia

60,0

Hungary

58,9

Macedonia

54,0

5. CONCLUSION
Crisis that initially appeared in real estate market of the USA, and then spread on financial system and
economy of USA does not appear by accident. The crisis appeared as a consequence of leading
irresponsible business policy of competent state institutions for the control of financial market (FED and
SEC) and incompetence in work of rating agencies, as well as fundamental weaknesses that exist in the field
of financial control and regulations in USA for years. Source of weaknesses mentioned comes from the idea
of unlimited liberalization of financial markets, with minimal regulations and weak control of the business of
investment banks and funds. Initial assumption is that big institutional investors who have enjoyed
preferential treatment of regulatory bodies, will responsibly and in accordance with good practice of
corporative management protect the interests of their owners, it basically appeared to be wrong and harmful.
In addition to the fact that FED hasn't controlled banking system in a way in which it should have, by
implementation of expansive monetary policy, through lowering the reference interest rate, FED has made
loans even more cheaper and available to bigger number of users.
In August 2008, interest rate was increased to 4,25 % for a short period, then after the September of the
same year there was an abrupt trend of drop which lasted until March 2009. From October 2008 until March
2009, ECB has lowered reference interest rate five times. During 2008, interest rate was lowered in October
from 4,25 % to 3,75 %, in November to 3,25 % and in December to 2,5 %. In January 2009, reference
interest rate was lowered to 2 % and then in March of the same year to 1,5 % [8-12].

739

Serbia has felt the first blows of crisis on its most sensitive part of financial market stock exchange. Having
in mind the characteristics and insufficient development of capital market in Serbia, it is believed that the
impact of global economic crisis on that sector will be limited. Unstable political situation at the beginning of
2008 has additionally increased the uncertainty of investors and caused greater withdrawal of foreign capital,
which has influenced the reduction of capital market liquidity and which had an unfavourable impact on
future events on Belgrade Stock Exchange [13-15].
Decisions of the Governments of all countries to take more active and synchronized participation in solving
the crisis were influenced by experiences from the period of great depression, in the 1930s. In that period,
creators of economic policy have led laissez-faire policy, because they have considered that the market will
independently establish the balance. It was attempted to lead the policy of a balanced budget and higher
taxes in order to reduce budgetary deficit. [16-18] Central Banks have accepted the closure of banks and
havent taken any significant measures to neutralize the drop in monetary mass. In order to reduce the
import and stimulate domestic production, protectionist external policy was carried out. Result of these
measures was catastrophic, so the countries taught by events during the first global economic crisis have
concluded that costs of not taking any measures was much greater than costs of interventionist policy.
However, the question remains whether it is alright for the loss, generated by speculates bad business
decisions, to be socialized and for all burden of crisis to be taken by ordinary people.

REFERENCES
Fariborz Moshirian (2011), The global financial crisis and the evolution of markets, institution and regulation,
Journal of Banking & Finance, vol. 35, issue 3, pp. 502-511
Filipovi, S. (2009), Srpska privreda na udaru globalne ekonomske krize, Kopaonik bizinis forum 2009,
Savez ekonomista Srbije i UKDS, Beograd.
Izvetaj o stanju u fianasijskom sistemu, septembar 2008, NBS, Beograd.
Majstorovi M. (2008), Island, ledeni bankrot, www.vesti.rs: http://www.vesti.rs/exit/ISLAND-LEDENIBANKROT.html; 25.01.2009.
Makroekonomske Analize i Trendovi & Konjunkturni Barometar, br. 171, januar 2009, Ekonomski institut,
Beograd.
Makroekonomske Analize i Trendovi & Konjunkturni Barometar, br. 172, februar 2009, Ekonomski institut,
Beograd.
Manuchehr Shahrokhi (2011), The Global Financial Crises of 2007-2010 and the future of capitalism, Global
Finance Journal, vol 22, issue 3, pp. 193-210
Milienkovi, F. (2008), Evropski konsenzus, zajednika strategija, Ekonomist magazin br: 439, Emportal,
Beograd
Office of federal housing enterprise oversight: http://www.ofheo.gov/hpi_download.aspx; 28.01.2008.
Richard A. Iley, Mervyn K. Lweis (2011), Has the global crisis produced a New World Order?, Accounting
Forum, vol 35, issue 2, pp. 90-103
Stepanovi B. i ulibrk M, Globalna finansijska kriza, Ko je sledei?, Ekonomist magazin br: 437, Em
portal, Beograd.
Stratfor
(2008),
The
Financial
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in
Europe,
StockAnalyst:
http://www.istockanalyst.com/article/viewarticlepaged/articleid/2702034/pageid/2 25.01.2009
Swint, B. (2009), Bank of England cuts main rate a half point to 1%, Bloomberg.com:
http://www.bloomberg.com/apps/news?pid=20601102&sid=ak38At3528Zc&refer=uk 25.01.2009.
The Financial Crisis in Europe, Stratfor, iStockAnalyst.
http://www.fefa.edu.rs/files/pdf/razno/Svetska_ekonomska_kriza_i_posledice_po_privredu_Srbije.pdf
http://www.mfin.gov.rs/UserFiles/File/dokumenti/GLOBALNA%20FIN_i%20ek_kriza%20i%20njen%20uticaj
%20na%20priv_Srbije_17_2_2011_.pdf
http://www.e-novine.com/sr/ekonomija/clanak.php?id =17175 01.02.2009.
www.tradingeconomics.com.

740

ACCOUNTING INFORMATION SYSTEM AND DECISION SUPPORT

SYSTEMS (DSS) IN INCREASING THE QUALITY OF CORPORATE
MANAGEMENTS DECISION MAKING PROCESS
Ljiljana Dmitrovi aponja1, Saa Gravorac2, Sunica Milutinovi3
University of Novi Sad, Faculty of Economics Subotica, ljiljanad@ef.uns.ac.rs
2
University of Novi Sad, Faculty of Economics Subotica, sasa.gravorac@ef.uns.ac.rs
3
University of Novi Sad, Faculty of Economics Subotica, suncica@ef.uns.ac.rs
1

Abstract: Accounting information features as the basis for business decision making in modern-day
business environment. This information is produced by business entities accounting information systems. To
meet all the qualitative and quantitative characteristics of accounting information, the demand for the
application of modern information technologies is set before the accounting information system. These
modern information technologies significantly improve the operation of the entire accounting function. One of
the modern information systems that have found significant extent of application in business practices is the
Decision Support System (DSS). This article will attempt to shed light on the interdependence of business
decision making quality and the appropriate accounting information system, laid on solid foundations. The
effects of including decision support systems in raising the quality of accounting information systems will be
examined, as well as the implications of including DSS in improving the quality of decisions made by
corporate entity management. The aim of this study is to prove the indispensability of DSS in the
implementation of strategic business decision making, as a decision making process typical of corporate top
management.
Keywords: accounting information, accounting information system, decision support systems, business
decisions, strategic business decision making
INTRODUCTION
The modern-day business setting is characterised by a high degree of turbulence, which is primarily reflected
in incessant market change, accelerated technological advance and increased demands set before modern
business entities, and appropriate response to such market trends necessitates their rapid response. This
response, first of all, entails making appropriate business decisions providing the right response to such
market trends. These business decisions should, first of all, enable eliminating growing market risk, and
appropriate adaptation to modern-day market setting. Such response implies, first of all, availability of
adequate information, which, first of all, stem from the accounting information system. Appropriately set up
accounting information system is a good springboard for providing relevant information, necessary for
making appropriate business decisions and eliminating threats entailed by increasingly intensive market
change.
The expansion of modern information technologies has given rise to the development of numerous systems
facilitating the process of making an increasing number of business decisions. The key role of these systems
is to enable managers to see all the benefits or shortcomings of given business alternatives by means of
strategic business decision making, and based on this information, select the one that will yield highest
benefits. One of these systems include decision support systems (DSS), elaborated in this article.
-

THE IMPORTANCE OF ACCOUNTING INFORMATION SYSTEMS

Functioning of any business entity will be successful only as much as its organisation structure is based in
interdependence and mutual feedback between its segments and the whole. Thus set, the system will enable
performing business activities with maximised achieved results, and minimised costs. This is achieved by
implementing information systems in business entities.
Various information systems exist in each business entity. According to some authors, each business entity
must contain the following information systems (www.crnarupa.singidunum.ac.rs, accessed March 10, 2012):
production information system;
marketing information system;
accounting information system; and
HR management information system.

741

Depending on each individual business entitys organisational structure, each of these information systems
may exist either as an independent information system, or as a segment of the integral information system.
As the pivotal point of this article is the accounting information system, our attention will be focussed on it.
There are numerous definitions of accounting information system, depending on authors and criteria they
took in their defining. For the purpose of this article, we have opted for the following definition of the
accounting information system: An accounting information system is a set of all techniques, technologies
and methods for gathering, processing, distributing and archiving data (www.ef.uns.ac.rs, accessed March
10, 2012). It is a constituent part of the business information system providing substantial support in all
stages of system management. The very fact that it is an information system suggests the use of computers
not only in its functioning but also all across the organisation. A given system can be broken down into the
following constituent elements (www.ef.uns.ac.rs, accessed March 10, 2012.)
Financial bookkeeping with pertaining analytic bookkeeping systems;
Cost and performance accounting;
Accounting supervision; and
Accounting-based planning and analysis.
This division can be presented graphically as follows:
Accounting
management
Accounting
management

Cost and performance

accounting

Fixed assets
analytics

Cost bookkeeping

Materials analytics

Accounting based
planning and
analysis

Accounting
supervision

Cost price calculations

... analytics...
Figure 1. Constituent parts of accounting information systems (www.crnarupa.singidunum.ac.rs, accessed
March 10, 2012)
Seamless functioning of accounting information systems implies prerequisite existence of the following
constituent elements: human resources, equipment, procedures and data. This mean that employees use
appropriate equipment and follow set procedures to produce accounting information based on given data.
The accounting information system is the oldest information system in an enterprise, containing and
providing information required for conducting business transactions, decision-making, evaluating resources
and performance, and reporting. To perform its role, it must cooperate with all other information systems in
the enterprise. This cooperation must be a two-way-one; on the one hand, the accounting information system
provides other information systems with relevant information, while on the other, these information systems
provide relevant information to the accounting information system required for its seamless functioning. HR
management information system provides the accounting information system with data required for payroll
calculations; production subsystem provides data required for accounting coverage of production, etc.
The purpose of the accounting information system is to provide information of set quality and quantity
tailored to the needs of various users. On the one hand, this system produces information of synthetic
character, intended primarily for preparing and compiling annual financial reports, which is a part of financial
accounting as a constituent element of the accounting information system. On the other hand, managerial
accounting produces information tailored predominantly for manager to enable them to make business
decisions, and it is always future-oriented.
Accounting information produced by the accounting information system are tailored for making appropriate
business decisions, both by the management and all other users, both internal and external. The most
important external users of accounting information include: capital owners, investors, creditors, national
agencies, buyers and suppliers, whereas the dominant positions among internal users are taken up by
742

employees, trade unions, corporate auxiliary and expert services, etc. How the accounting information
system meets the information needs of numerous users is illustrated by the following diagram:

Investors, banks, suppliers,

government agencies, trade
unions, employees,
management

User identification

Users' information
requirements

Economic data
and
activities

Accounting
information
system

Reports

Users decisions

Financial reports, tax

returns,
management,
supervision reports

Investment, tax
assessment,
employment
contracts, loan
approvals, budget
Diagram 1. Accounting information system for providing users with relevant information (Source: Teachingallocations
materials for
th
the course in Financial Reporting and International Accounting Regulations from the 5 year of studies at the
Faculty of Economics Subotica)

The diagram No. 1 shows that accounting information systems produce information tailored to the users
requirements. If the information is intended for top management, it must be synthesised, whereas if it is
intended for lower management levels, it must be more analytical by nature. The figure above also shows
that accounting information system produces numerous reports, such as financial reports, tax returns etc.
2. DECISION SUPPORT SYSTEMS
The increasingly intensive technological advances have resulted in numerous technological solutions whose
action facilitates management processes in business entities. One group in the range of such systems are
the Decision Support Systems (DSS).
Decision support systems are, in fact, model-based sets of procedures for processing and interpreting
information supporting managers in their decision-making. They are, actually, an interactive computer
information system intended for supporting structured, semi-structured and unstructured decision-making.
They are a product of extensive theoretical research conducted in the 1960s aimed at facilitating an
extremely complex process like decision-making and simplifying it as much as possible.
The above mentioned definition of decision support systems leads to the conclusion that their purpose is to
resolve three groups of problems: structured, semi-structured and unstructured. Structured problems have all
their resolving phases defined. This means that their resolving procedures, phases etc. are known.
Structured problems do not have all their resolving phases defined and resolving them is based on intuition,
whereas semi-structured problem have some of the phases or procedures defined. Resolving semistructured and structured problems requires the use of individual decision support systems whereas
resolving unstructured problems, encompassing a major number of alternatives, requires group decision
support systems (GDDS).
Decision support systems have the following basic features (www.dss.com, accessed March 11, 2012):
They:
are intended for resolving unstructured and semi-structured problems;
support to decision-making of various levels of managers;
743

support group-based and individual decision-making;

are easy to use and construct;
are adaptable and flexible; and
significantly improve the effectives and efficiency of decision-making.

To clarify and enable better understanding of decision support systems, we shall use the following scheme,
showing the structure of decision support systems:
Users dilemma
Describing the
situation

Expert
reasonin
g and
logic

Problem definition and

formulation

Processing by DSS

Presenting the
alternatives

Describing
the
domai
n
Knowledge
Information

Izvori
podata
ka

Users choice

Social factors

Projection of consequences

Economic factors

Information for future use

Diagram 2. Structure of decision support systems (www.dss.com, accessed March 11, 2012)
The diagram No 2 above shows that decision support systems require the user to provide precise definitions
of problems or situation to be solved. After this, the system processes the presented data, and offers a
certain number of alternatives to the user, with the consequences of each of the chosen alternatives. This
enables users to make business decisions for which they can foresee the consequences (benefits or harms).
This system cannot replace the decision-maker, i.e. the human; it can only facilitate the number between
several alternatives and enable making the right business decision.
Depending on the level, there are several types of decision support systems: (www.ef.uns.ac.rs, accessed
March 12, 2012):
decision support systems for strategic decision making intended for supporting decisions made by
top managers, predominantly in semi-structured decision-making about problems related to setting
goals, choosing business strategies, defining business corporate mission and vision, making plans
etc.;
decision support systems for management control predominantly intended for middle managers,
responsible for effective and efficient use of resources and managing individual functional areas;
decision support systems for operative planning and supervision are predominantly intended for
lowest-level management, responsible for executing decisions delegated by higher management
levels.
The use of computer technologies provides insight into numerous advantages that they provide in corporate
decision making (www.ef.uns.ac.rs, accessed March 12, 2012):
speed, i.e. a large number of fast calculations at low prices;
overcoming limitations in data processing and storage, as the latter may reduce the problem-solving
ability (i.e. bad memory);
744

cost-cutting in decision making

technical support in storing, searching and transferring data, at higher speed and lower prices;
high-quality decision making through better decisions, processing more alternatives, risk analysis,
expert support; and
agility of support.

As pointed out earlier, different management levels require information of different character. Higher-level
managers are interested in information required for making decisions of strategic character, whereas this
information, like market oscillations, price fluctuations, foreign currency exchange levels etc., is less
interesting for managers of lower levels.
This is one of the shortcomings of decision support systems, which is resolved by introducing Executive
Information Systems (EIS). These systems support differentiation in managements information needs. To
facilitate insight into advantages and disadvantages of these two systems, i.e. make a comparison, we shall
use the tabular presentation below:
Table 1. A comparative presentation of logistic DSS and EIS (Teaching materials for the course in Financial
th
Reporting and International Accounting Regulations from the 5 year of studies at the Faculty of
Economics Subotica)
Logistic DSS
Expectative Information Systems
supplies data for decision making
supplies
data
for
performance
management
aimed at semi-structured and unstructured uses performance directions in relation to
problems
the plan
secures instrument, not solutions
secures information, rather then ad hoc
analysis tools
used by senior and middle management
used by top management
usable when developing alternatives usable in reporting phase in decision
and/or decision-making variants
making
functions
in
interaction
with
the expressly usable when integrated in
environment
corporate culture & style
The table 1 above points to the fact that the executive information system is primarily tailored to support
decision-making by top management, secures information, and is usable in the reporting phase of decision
making. Unlike EIS, the logistic DSS is tailored for information requirements of both top and middle
management, enables decision making in the case of multiple alternatives and provides decision-making
tools, but the system itself makes no decision. Unlike EIS, which exists when integrated in the business
entitys corporate structure, the logistic DSS functions in interaction with the environment.
3. MANAGERIAL DECISION MAKING AND QUALITY OF BUSINESS DECISIONS
Corporate decision-making process is a highly complex and demanding activity. The complexity of this
process is notably manifest in the conditions of increasing uncertainty and a large number of alternatives that
managers must take into account when making business decisions. This is primarily caused by the
increasingly dynamic character of the business setting and the growing turbulence of business events.
Corporate decision making is primarily in the hands of administrators and managers of all levels. The
administrative level determines the significance of business decisions made, and the importance of the made
business decision also results in responsibility for future business and corporate survival. Thus, top
management makes decisions of strategic character, whereas the lower management levels are mostly
focussed on operative decisions.
There are numerous definitions of the decision making process, depending on the criteria and factors taken
into consideration in classification. In this article, we opted for the definition of two prominent authors in the
management area, Koontz and Weihrick, who view the decision-making process as choosing the direction,
i.e. manner of action, where it features as choice between two alternatives. Decision making is the central
activity of a corporate entitys management. The relationship between the corporate management and
decision-making is best illustrated by the following diagram:

745

PLANNING

ORGANISING

DECISION

CONTROL

LEADING

Figure 2. The relationship between management function and decision making (Bahtijarevi iber,
Sikavica & Poloki Voki, 2008)
The figure 2 above shows that decision making is not a separate management function, but, we can freely
say, function used by management to fulfil their role in the corporate subjects. It is a superfunction, featuring
as a constituent part of all classical management functions, i.e. planning organising leading and control.
The outcome of the decision-making process is a decision. A decision is a choice between multiple different
alternatives. For the decision to be relevant, one needs to have certain information serving as the foundation
for the decision made. The decision-making process can best be represented by the following figure:

Recognising
the
existing
problem

Finding
alternativ
e
solutions
to the
problem

Choosing
the
most
benefici
al
alternat
ive

Implementin
g the
chosen
alternat
ive

Gathering
feedback
related to
Figure 3. The decision making the
process
model (Certo C.S. & Certo T. S, 2008)
problem
The figure 3 above shows that decision making begins with appropriate diagnose of the problem, followed by
considering all available alternatives for its resolution. After this, managers consider which of the activities
are the most beneficial, choose one of them and implement the chosen alternative. This is not the end of the
managers activity, as they follow and gather all information related to implementing the given alternative,
which is in the function of resolving the observed problem.
The managerial decision making process itself consists of several typical steps, as follows (Certo C.S. &
Certo T. S, 2008):
1.
recognising the existing problem
2.
listing the possible alternatives for problem solving
3.
choosing the most useful alternative;
4.
implementing the selected alternative; and
5.
gathering feedback to establish whether the chosen alternative contributes to resolving the problem.
Viewing the given decision-making phases, we come to a conclusion that they were made based on the
diagram above. When managers view which alternatives can be taken into consideration when solving the
problem, they must bear in mind that there are certain limitations acting outside the corporate entity itself, but
also those. Actually, we can highlight that there are limitations existing not only within the corporate entity,
but also limitations of external nature, such as social norms, legal provisions and other types of limitations.
The given limitations are illustrated by the figure below:

746

LEGAL CONJUNCTIONS

MORAL AND
ETHICAL
NORMS

DISCRETION
AREA

UNOFFICIAL SOCIAL
NORMS

OFFICIAL POLICIES
AND RULES

Figure 4. External factors limiting the managements number of alternatives for resolving problems (Certo
C.S. & Certo T. S, 2008)
Given that each corporate entity is also a market player, in view of the fact that they conduct their business
operations and earn their income, the decision making process is also influenced by the environment factors,
best illustrated by the table below:

Table 2. Business environment factors exerting pressure on organisations (www.crnarupa.singidunm.ac.rs,

accessed March 13, 2012)
Factor
Description

Market

Customer demands

Technology

Society

strong competition
growth of global market
development of e-market on the Web
new marketing methods
benefits of outsourcing with IT support
need for real-time online transactions
demands for customisation
demands for quality, product range, assortment, and speed of
delivery
increased role of customers and decreased loyalty
more innovation, new products and services
faster outdating
greater information overload
more state regulation/deregulation
more staff turnover, increasing age, more women
concern about defence and terrorist attacks
compulsory reporting
more corporate social responsibility

As mentioned above, to function successfully management decision process requires all necessary
information. This information is provided by accounting information system, so it can be freely regarded
as a constituent element of the management information system, and its most vital element at the
same time. The accounting information system encompasses four subsystems (ogi, 2009):
1.
subsystem dealing with the coverage of daily business events and making daily business decisions
based on the former;
2.
ledger and finance reporting subsystem, producing sets of financial reports, and other financial reports
required by legal provisions;
3.
fixed assets and capital investments subsystem; and
4.
managerial reporting subsystem, providing information for corporate decision making.
747

The development of decision support systems has resulted in facilitated business decision making process.
These systems are a symbiosis of a whole range of functional knowledge and information systems, whose
fundamental function is to support corporate decision making processes. Actually, it can be concluded that
decision support systems support all decision making process phases, starting from problem formulation
through design, choice, down to implementing the chosen alternative.
Managerial decision support systems are best illustrated by the figure below:
ANN, EIS, MIS, data mining, OLAP
- problem identification
- problem classification

Implementation phase

OLAP, GDSS, MS, ANN, data mining

- model generation
- alternative generation
- sensitive analzsis
- Decision making

Formulation phase

Design phase

GDSS, MIS, ES
- communication
- feedback

Selection phase

Figure 5. Computer support to decision making phases (Vasiljevi, 2007)

The fundamental feature of decision support systems in corporate decision making is reflected in the
following:
1.
Decision support systems are used for loosely and inadequately specified decision.
2.
The fundamental role of decision support systems is to assist the corporate decision maker.
3.
Decision support systems contain trends in management science and traditional data processing
function.

CONCLUSION
The decision making process in the modern-day market setting is gaining complexity, which is predominantly
caused by powerful and constant change in the business setting. When making business decisions,
managers face a large number of business alternatives, which must be taken into account so that the real
business decision is made. This is where development and advancement of decision support systems gains
prominence.
Decision support systems are to assist the corporate decision-making process in terms of encompassing a
large number of available alternatives, analysing each of them, and point to the possible consequences of
their implementation. Modern-day managerial decision-making is characterised by a large number of
possible alternatives, but successful business operation forces corporate entities to choose the one that will
yield maximum benefit against at minimum cost. This is what is enabled by decision support systems.
An oft-cited opinion is that high-quality business decisions only require IT support, and many people regard it
as sufficient. Such a position is unacceptable, for decisions can only be made by humans, whereas the
systems role is only to support business decision making. The decision cannot be made by the system itself;
this is the prerogative of the manager. Responsibility for decisions made cannot be taken over by the
system; it is the decision maker that is responsible.

748

REFERENCES
Bahtijarevi, iber, F., Sikavica, P., Poloki, Voki, N. (2008). Suvremeni menadment vjetine, sustavi i
izazovi, Zagreb: kolska knjiga.
Certo, Samuel, C., Certo, Trevis, S. (2008). Moderni menadment 10 izdanje, Zagreb: Zagrebaka kola
ekonomije i menadmenta.
Dmitrovi, aponja, Lj., Petkovi, ., Jaki, D. (2011). Raunovodstvo, Subotica: Ekonomski fakultet.
ogi, R. (2009). Efikasan raunovodstveni informacioni system pretpostavka uspjenog upravljanja
preduzeem. Ekonomski horizonti, 11 (1), 55 84.
OBrien, James A., Marakas, M., G. (2008). Management Information Systems: a Managerial end User
Perspective, Richard D Irwin, INC.
Teaching materials for the course in Financial Reporting and International Accounting Regulations from the
5th year of studies at the Faculty of Economics Subotica
Vasiljevi, A. (2007). Menadment informacioni sistemi, Beograd.
www.crnarupa.singidunum.ac.rs
www.ef.uns.ac.rs
www.dss.com

749

COST ACCOUNTING AS A KEY INFORMATION SUPPORT FOR MODERN

MECHANISMS OF COMPANY MANAGEMENT
Radmila Jablan Stefanovi
University of Belgrade, Faculty of Economics, rasty@ekof.bg.ac.rs
Abstract: In contemporary conditions of great external and internal complexity companies operate in an
extremely dynamic world of interdependent and nonlinear events. The companys existence on the turbulent
and uncertain market directly depends on the degree of fulfillment of customer expectations but also on the
intensification and strengthening of cooperation with other organizations from the environment customers,
suppliers, and distributors. The modern company achieves its success as a result of the interaction with the
environment, resources and management, i.e. its ability to employ the resources adequately, bearing in mind
the companys position its strenths and weaknesses. This requires, along with acceptable risk, a maximum
exploitation of challenges brought by the environment, in order to realize the interests of various
stakeholders. Managers face complex and numerous problems and challenges of successful company
management. Achieving sustainable competitive advantages, as a condition sine qua non of modern
business, in a dynamic and thoroughly uncertain environment necessarily requires sophisticated professional
knowledge and skills, as well as designing an adequate information system as a quality support to larger and
more complex information requirements of managers at all levels of management. This paper puts an
emphasis on the importance of flexible designed cost accounting information system a key information
core of companys accounting information system in generating quality information as a support to modern
company management mechanisms. Only as flexibly designed it can qualitatively respond to numerous and
various information requirements it will be able to adapt to changes occurring in business environment as
well as in the company itself. It also discusses some of the new and, in turn, enhanced existing tools,
techniques, concepts and approaches to costing and cost management, which are fundamentally important
in order to implement and support the competitive strategies of companies.
Keywords: management, strategy, competitive advantages, cost accounting, cost management

750

1. INTRODUCTION
Last decades business environment has changed and will changing more than ever in the years that have to
come. The trends of globalization inevitably result in sharp intensification of international competition and
require systemic perception and coordination of business processes of all involved organizations. Quality
decision-making requires having at ones disposal information relevant for solving a particular problem.
Within business and financial decision-making cost accounting (CA), as the essential part of a companys
accounting information system (AIS) as a whole, represents a reliable information support for the
management. Therefore, it is necessary to continuously review its information offer, as well as to find new
ways of generating quality information as a support for modern mechanisms of company management. Only
flexibly designed CA information system can qualitatively respond to numerous and various information
requirements it will be able to adapt to changes occurring in business environment as well as in the
company itself. Integrating the internal and external aspects it is possible to provide quality information for
strategic management of a modern company. Strategic cost management (SCM) implies the use the cost
data to develop and identify superior strategies that will produce sustainable competitive advantages. The
purpose of the paper is to highlight the role CA has in offering support to managers at all managerial levels.
Some of the new tools, techniques, approaches and concepts to costing and cost management (CM) have
been emphasized (ABC/ABM, TQC/TQM, TC/TCM, LCPC/LCPCM, VCA, VSA/VSM).

2. KEY IMPORTANCE OF FLEXIBLY DESIGNED COST ACCOUNTING INFORMATION

SYSTEM
Constant and dramatic changes in contemporary competitive environment, as well as the need of integrating
into European and world market flows, require the knowledge of a wide focus cost and performance
management. The management is expected to lead the company towards the achievement of set objectives,
which in the contemporary settings of marked external and internal complexity requires sophisticated
professional knowledge and skills, as well as quality information support. CA which measures and reports
financial and non-financial information related to the organisation`s acquisition or consumption of resources
(Horngren, et al., 2005), has an exceptionally important position within the entire AIS of an organization
because it provides information to both management accounting (MA) and financial accounting (FA) as
subsystems of the AIS. When its information is intended for the FA it measures product costs in compliance
with the strict legal and professional regulations; however, when its information is used for internal purposes
it provides the basis for planning, control, and decision-making.
The importance of CA as information basis for external financial reporting (which is its traditional task) is
particularly reflected in providing relevant data for the purpose of inventory balance and determining the cost
of products sold. In compliance with the widely accepted regulations, it includes into the inventory value only
the necessary costs of functional production fields but not the costs of uneconomical spending, inefficient
work and unused capacity, which represent period costs. Accounting data used for external reporting very
often do not completely satisfy managers needs for decision-making purposes. Attempts at slight
modifications of financial accounting systems for managerial purposes rarely end happily like eating soup
with a fork: it is possible, but it is far from effective (Maher,1997). Cost data for the purpose of internal
reporting are meanwhile relatively free from the constraints of legal and professional regulations. When
internal reporting is in question, analytical and short-term aspect notably the success accomplished is
emphasized. Apart from presenting the overall business results of the company as a whole, it is possible to
segment it from various aspects it is an extremely important management instrument for planning and
control. When activities of planning and control of the performance of the company and its narrower
segments for various time intervals are in question, CA provides the management with relevant information,
i.e. it represents the basis of the accounting planning and control. This is so because it assumes short-term
and analytical aspect of costing, and compiling relevant reports as well, regarding the ever increasing need
for planning and control of managers performance. Therefore, internal reports created by CA are primarily
used by MA for offering adequate information support to management for the purposes of planning and
control of business activities, i.e. for the purposes of more qualitative and efficient operations and making
various business decisions. Meeting various information needs of the management related to making
individual business and financial decisions has been emphasized over the last few decades as the
fundamental CA task it assumes calculating costs and benefits of individual business alternatives. By using
non routine cost-benefit analyses, CA creates reports based on the concept of relevant information. The
concept of relevant costs (relevant revenues as well), in choosing among alternatives, assumes considering
751

the expected future costs which differ in alternative actions. Relevant cost analysis generally emphasizes
quantitative financial information, but in decision-making, managers must pay due attention to quantitative
non-financial and qualitative information and must, occasionally, give greater significance to qualitative or
non-financial quantitative information. Non-financial information concerns legal and ethical considerations
and long-term effects of decisions on the company image, employees morale and the environment, and is
relevant to particular business decisions.
While designing CA information systems one must not lose sight of the following (Maher, 1997): decisionmakers needs must be met; different cost information is used for different purposes what works for one
purpose will not necessarily work for other purposes; cost information must meet the cost-benefit test
namely, cost information can always be improved, but before establishing a new system, one basic question
should be asked: will the benefits outweigh the costs? It is of vital importance that CA information systems
should be flexibly designed. Due to the fact that they are relatively free from legal and professional
constraints and are in function of the company management, they are, in accordance with the needs of
internal users, able to generate a broad range of information. Organizational and methodological settings
and functions are adapted to management requirements. Being flexible, it will be able to adapt to changes
occurring in the business environment as well as in the company itself and, accordingly, respond in a
qualitative manner to numerous and various information requirements of the company management. Today,
there are new requirements for changes and continuous improvement so that the management could have
adequate information support in managing the company particularly key strategic variables.
The extent to which CA is capable of helping the management in serving the abovementioned purposes
fundamentally determines its significance, i.e. the usefulness of its information. It is of great importance that
the accountants should know their job well and seek the ways to add value to their organizations. In many
successful companies in the world the accountant is a member of multifunctional teams as a reliable
associate.

3. CONTEMPORARY CHALLENGES TO COST ACCOUNTING

In the last couple of decades numerous and dramatic changes in business environment have contributed to
a high level of complexity, turbulence and uncertainty in the environment in which contemporary companies
accomplish their economic mission. The trends of globalization followed by the removal of national barriers
inevitably result in sharp intensification of international competition. What is more, the consumers demands
are changing more and more frequently and becoming more sophisticated, which, along with intense
introduction of new information and communication technologies, drastically shorten product life cycle. As a
response to numerous contemporary challenges, a broad range of new management approaches and
philosophies is developing, such as: value chain analysis, setting up long-term relationships of close
cooperation with key customers and suppliers, continuous improvement, broad empowerment of employees,
new production management systems and many others. Despite the underlying notional differences, they all
have the same universal motif to master key factors for business success (cost, quality, time, innovations)
and supply customers with superior value on the market. Powerful integration relations require systemic
perception and coordination of business processes of all involved organizations. Therefore, managers in
contemporary companies face complex and numerous challenges of successful company management.
Achieving sustainable competitive advantage, as a condition sine qua non of modern business, in a dynamic
and thoroughly uncertain environment necessarily requires sophisticated professional knowledge and skills,
as well as designing an adequate information system quality support to larger and more complex
information requirements of managers at all levels of management.
In recent years, companies worldwide have considerably changed their strategies - from internally focused
strategies to externally focused ones, whose top priority is customer satisfaction. There is a widely accepted
saying that customers are company's most valuable assets. Profit is generated by customers, and products
are only the ways of turning customer demands into profits. The quality of customer service is a sole criterion
for distinguishing a successful company from unsuccessful one. The company's power is based on its
superiority to create values for customers. The company manages to satisfy customer demands and
enhance their loyalty if it succeeds to provide: a superior quality of their products to those of their
competitors; products which are tailored to customer wishes and demands; reliable and timely delivery of
752

products; after-sales services; product quality guarantees; an effective communication system with
customers, etc. Regardless of the concrete orientation regarding business strategy, the contemporary
company inevitably faces the requirements of cost competition. Numerous and skilled competitors with new
sophisticated approaches to CM and cutting edge technological achievements force it to manage costs
carefully and skillfully. It is constantly being emphasized that CA should provide information useful for the
decision-making process and particularly the information support for CM analyses and projects. Numerous
studies point at the weaknesses of traditional formal CA systems, particularly emphasizing the problems of
distortion, i.e. distorted information and limitations in presenting cost drivers, amounts and cost profiles in an
extended business operations system. Thus, modern business environment inevitably requires CA
restructuring and new approaches to costing and CM in order to improve cost information quality. It is
necessary to provide adequate information support concerning the process of business strategy formulation
and implementation, i.e. finding adequate directions leading to the strengthening of the competitive position
on the increasingly turbulent market. In general, improved CA can reach more management objectives than
traditional.
One of the new key themes in CA is turning our attention to the customer. Customer in focus is the key point
of the organizations success. To be customer-driven lies at the heart of CM; among all aspects of business
operations which the management must take care of, the customer is the most important because without
him the organization loses its purpose. There is a permanent question in the way business operations are
performed which puts the emphasis on customer satisfaction: how can value be added for the customer?
The focus is on the most profitable customers and the ways to first attract them and then retain them. Today,
companies first identify customer needs and demands, and then proceed with the product design and
production. Value chain and supply chain analysis is also a key theme. Value chain (VC) facilitates
consideration of the possibilities of achieving and retaining competitive advantage through strategically
relevant activities. By using VC and activity cost information companies can identify strategic advantages on
the market. Supply chain (SC) assumes the idea of an extended company - the focus expands from
company production VC to purchase VC on the one hand to distribution VC as the final part of the whole
industrial VC on the other. CM emphasizes integration and coordination of these activities through all links
i.e. companies in the SC, as well as through each business function in the VC of individual companies.
Costs, quality, time and innovations are key factors of business success. The management must
continuously focus on these key strategic variables in relation to competition, which surpasses the frames of
their company and draws their attention to changes in the external environment observed and assessed by
their customers as well. It is of vital importance to manage them carefully and thus affect the level of
customer satisfaction. Low costs are a significant business goal but cost improvement does not necessarily
have to be sufficient. Customers want more than just lower prices and costs they want quality,
responsibility, punctuality. The combination of benchmarking and continuous improvement is an ever-present
theme in the new approach to management. By comparing with the best examples, the management finds
ways of continuously improving their proper practice. Benchmarking and continuous improvement are often
described as a the race with no finish because management and employees displeased with a particular
performance level seek continuous improvement. When they adopt this philosophy, the organizations
perceive that they are able to achieve performance levels which they previously considered unattainable.
Thus, new environment brings new challenges and problems which inevitably impose the need for serious
reconsideration of past business philosophy established in stable and predictable business settings. It is of
great importance to adopt a wider external orientation with the constant focus on changeable and
sophisticated customer demands. The companys existence on the market directly depends on the degree of
fulfillment of customer expectations but also on the intensification and strengthening of cooperation with
other organizations from the environment (customers, suppliers, distributors). Quality exchange of ideas and
information, better inter-organizational coordination and integration of vital business activities are necessary
assumptions for more successful competitive positioning of the company on the market.

4. IMPRUVED COST ACCOUNTING INFORMATION SYSTEM

There has been an increasing number of discussions about CM and extending various limits in the past
decades. It is a dynamic process which assumes intensive efforts directed towards continuous improvement,
i.e. improving the existing and inventing new tools and techniques, starting with early activity-based costing
models and pursuing lately in the direction of strategic cost management (SCM) which implies the use of
cost data to develop and identify superior strategies that will produce a sustainable competitive advantages.
In that period, the most prominent trend has been shift the focus from determining product costs by using
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standard traditional cost models, towards providing support for strategic and operational decisions by using
certain forms of activity analysis. While considering the development of CM, it is very important to link it to
modern challenges to organizations. Therefore, suggestions go in the direction of separating it from
traditional accounting and abandoning the long-standing linearity of measuring historical costs and static
standards. Managers should anticipate rather than simply react to changes in cost structure and financial
performances.
The turning point in the development of CA was the advent of Activity Based Costing (ABC) which emerged
primarily as an expression of the need to provide much more accurate data about the output cost price
compared to traditional methods. It focuses on activities as parts of the entire process in a company and their
cause and effect relations with the resources used as well as with cost objects (products and services,
market segments, customers) i.e. activity drivers. However, management can use it not only for the purpose
of calculation, i.e. more accurate product costing and, therefore, more successful price and product and
service range management, but also for providing financial and non-financial information on activities, and
effective CM as assistance to activity based management. When considering the use of ABC for the
strategic purposes, many experts think that it offers strategic opportunities to companies. Many companies
have gained competitive advantage due to ABC information, i.e. cost reduction by lowering prices in order to
increase their market share. Activity Based Management (ABM) focuses on managing activities with the aim
of increasing the value which the customer receives and profit obtained by providing this value, which
assumes driver analysis, activity analysis and performance evaluation. ABM assumes a set of decisions and
actions based on ABC concept information. The goal is to increase the value delivered to customers and to
boost company profitability to a higher level. Strategic and operational ABM are singled out. Strategic ABM
assumes directing the organization towards the most profitable use of resources. Due to ABC information we
can point out non-profit activities as well as the most profitable ones, and make decisions affecting product
development and design, fixing sales prices, specifying the production and sales mix, and establishing and
developing relations with key customers and suppliers. All this can be achieved due to skillful combining of
the knowledge about cost behavior (i.e. their drivers) with the knowledge about customer behavior.
Operational ABM assumes decisions and actions with the goal of continuous improvement of business
processes; and for designing ABC systems, as its information support, several hundred activities may be
necessary in order to obtain better insight into processes underlying production and customer service.
Operational ABM is directed towards the improvement of efficiency and reduction of resources necessary for
performing respective activities (Cooper&Kaplan, 1999). The advantages of activity analysis come primarily
from the activity cost classification according to the possibilities of cost improvements. This classification
enables managers to get an insight into how many current operating costs occur during inefficient processes
or processes of low efficiency. ABC model determines where the greatest possibilities of cost reduction lie;
but ABC information is not a current operating tool for the activities of improvement. This model offers the
key direction for decision-making where to launch initiatives such as kaizen costing, pseudo-profit centers,
TQM and reengineering. Activity Based Budgeting (ABB) extends the ABM idea to the planning cycle by
using it to establish cost limits and control systems in organizations. Supported by activity analysis ABB uses
benchmarking information to help the company to control costs and eliminate the increasing trend of
exceeding the budget without improving the companys ability to create value for customers (McNair, 2007).
ABB is directed towards future resources, activities and outputs and is a valuable information support to the
process of strategic decision-making.
A philosophy of Total Quality Management (TQM), in which managers strive to create an environment that
will enable workers to manufacture perfect (zero-defects) products, is replacing the acceptable quality
attitudes of the past. Reducing defects, in turn, reduces the total costs spent on quality activities. Four
categories of quality costs are emphasized: prevention costs are incurred to prevent poor quality in the
products/services being produced; appraisal costs are incurred to determine whether products/services are
conforming to their requirements or customer needs; internal failure costs are incurred because
products/services do not conform to specifications or customer needs; external failure costs are incurred
because products/services fail to conform to requirements/satisfy customer needs after being delivered to
customers. Quality costs can also be classified as observable (available from an organizations accounting
records) or hidden (opportunity costs resulting from poor quality not usually recognized in accounting
records). A quality cost report is prepared to improve managerial planning, control and decision making
(strategic pricing and cost-volume-profit analysis). Quality is one of the major competitive dimensions for
world-class competitors (Hansen&Mowen, 1997). Organizations operating under the TQM philosophy have
introduced a broad array of non-financial measures to monitor and improve the quality of their
products/processes. For example, Motorola, a leading company in applying the TQM philosophy, adopted an

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aggressive approach to quality, setting a quality target of a level representing fewer than 12 defects per 1
million parts (Cooper & Kaplan, 1999).
Target Costing (TC) is a tool (McNair, 2007) which emphasizes the relation between the price and market
share as a basis for disciplining an organizations spending during product and process design, development
and engineering. Basically, it assumes cost reduction per product unit. It is a completely new approach: how
much a product is allowed to cost (Seidenschwarc, 2005). The implementation of new methods of identifying,
measuring and providing information about critical factors of business success ensures the development of
products to suit customer demands, regarding the features and quality, as well as the price. As a concept of
a much more comprehensive and aggressive CM information support, TC is built in the decision-making
(planning) process concerning introduction of new and making radical changes to the existing products and
processes. Target Cost Management (TCM), as a tool for a comprehensive cost and profit management and
as a concept of long-term strategic CM, focuses on the design stage. It initiates CM in the earliest stages of
product development and is aimed at intensifying the cooperation with the suppliers and other organizations
on the market. TC operates after a general model: target costs = target sales price target profit. If the target
cost (as the difference between the sales price needed to ensure a previously determined market share and
the desired profit per unit) is below the presently feasible cost, the management budgets cost reductions
which direct real costs to target costs (Hansen&Mowen, 1997). Bearing in mind the organizational aspect, a
successful implementation of TC concept assumes the creation of an organizational team structure that
should include experts from different functional areas of the company as well as from the organizations it
cooperates with on the market.
Life Cycle Product Costing (LCPC) is an extension (McNair,2007) to TC tools, which links all costs driven by
a new product, from the conception of the idea for the product through to its removal from the production
program and withdrawal from the market, i.e. from the cradle to the grave. The products are analyzed in
order to determine whether they will bring profit during their entire life cycle. Life Cycle Product Cost
Management (LCPCM), according to the integrated approach, consists of activities leading to product
design, development, manufacturing, marketing, distribution, use, maintenance, service and removal, with
the aim of maximizing life cycle profits. As a result, product costs are tracked and analyzed through all
stages of its life cycle, which is radically shortened due to changeable customer demands and the
increasingly ambitious competition regarding the technological product innovations. In contemporary settings
it is of vital importance to launch a new product on the market and replace the existing product with the
innovated one as soon as possible (regarding quality and functionality). LCPCM stresses cost reduction, not
cost control. Since 90% of the life cycle product costs are determined in its design process, i.e. in the stages
of a new product development and construction, activity management during this stage of product existence
is stressed. This should, by all means, affect the managerial decisions regarding investments and directing
more resources towards activities in the early stages of product life cycle. However, the overall success
depends on how well the managers in manufacturing companies understand the activities, cost drivers and
interaction among activities. Although LCPCM is important for all manufacturing companies, it is particularly
significant in short life cycle circumstances, when good planning is critical and the prices must be accurately
determined in order to cover all life cycle costs and ensure a good profit (Hansen&Mowen, 1997).
Value Chain Analysis (VCA), i.e. costing and CM through the value chain, is a concept representing the
broadest approach to management. It assumes monitoring the relations among activities that create value
with the aim of cost reduction, where the problems of tracking, measuring, analyzing and managing costs are
extended outside the borders of a company. Beside internal value chains (VC), it extends to the area of
supply chain, i.e. suppliers, on the input side, and distribution chain, i.e. customers distributors and end
users, on the output side, because the internal VC of a company is built in the broader value system which
includes both supply VC and customer VC. That is to say that the leadership strategy in low costs and/or the
differentiation strategy can lead to sustainable competitive advantage, but successful application of these
strategies requires the managers to understand all the activities that contribute to their achievement. It is
necessary to understand the industrial value chain as a whole, not only the part in which the company
participates. Without an external focus there is no effective strategic CM. With the aim of successful
implementation of the relevant strategies it is necessary to break the VC into strategically relevant activities
of a company. VC is a necessary approach to understand these activities; understanding both the complex
links and interrelations between activities performed inside the internal VC of a company (internal linkages),
and those describing the linking of activities of a company with the activities of suppliers VC and customers
VC (external linkages). Therefore, in order to describe and exploit these relations, it is necessary to identify
company activities and choose the ones that can be used for creating and sustaining competitive advantage.

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The optimal choice assumes the knowledge of costs and value created by each of the activities, as well as
relevant cost drivers.
Also, it is very important to point out that one of the critical factors of the success of pursuing competitive
strategies on the market is to provide a rounded up performance measuring system. One of the solutions is
the so-called Balanced Scorecard (BSC) which provides a comprehensive framework linking strategic
objectives of the company with a coherent set of performance measures (Zimmerman, 2000). BSC attempts
to unite and balance traditional financial perspective (concerning the measuring of current and designing
future financial results) with three more perspectives of vital importance for a successful pursuit of
competitive strategies on the market the perspectives of customers, business processes and innovations
and learning. In the BSC approach to performance improvement the most critical processes for the success
of a strategy are identified. They are stressed not only for their potential for cost reduction, but also for their
ability to fulfill end users expectations. When using BSC, managers usually realize that for the
implementation of a new strategy it may be much more important to stand out in completely new processes
than to create gradual cost improvements in the existing processes (Cooper&Kaplan, 1999).
Value Stream Accounting (VSA) is characteristic of lean manufacturing (LM) which developed from Toyota
production system based on the JIT model and is the complete opposite of traditional production. Many
companies, aspiring to the world class position, follow LM whose objective is to improve efficiency and
effectiveness in every area including product design, interaction with the suppliers, factory operations,
managing employees and customer relations. In order to keep this position, they must persist in endless
journey which requires continuous innovations and improvement. Lean includes making the right product
at the right place at the right time in the right quantity with minimum waste and sustaining flexibility. Thus, the
key for successful LM lies in the achievement of production flexibility which includes physical organization of
production plants and the application of automated technologies including CNC machines, CIM, robotics,
CAD, CAM. Companies inclining to LM often use the tool value stream map (VSM) to present their business
process graphically in order to identify the wasteful aspects which should be eliminated. VSM identifies all
actions needed to complete product processing (batches or individual products) together with the key
information about each individual action (it can include total labor hours, overtime, cycle time for the task
completion, error rate). Some commercial VSM tools produce, beside the current state map, a future state
map, describing the process which is lean where waste is removed to the fullest extent. Since it is possible
to identify, from the latter, the steps of the action of eliminating nonvalue-added activities within the process,
it is also the basis for the lean implementations (Hall, 2008). Information needs of a lean company cannot be
adequately supported by traditional information provided through conventional accounting techniques,
because of inaccurate cost allocation, promotion of non-lean behavior, inaccessibility in real time, financial
orientation. Therefore, many lean companies have adopted an alternative accounting model. Some of them
see the solution in ABC method, but many replace it with a simpler accounting model, the so-called VSA.
VSA tracks costs by the value stream instead of department or activity; the value streams cut across function
lines and departments, i.e. horizontally, and thus links with traditional vertical reporting on structure and cost
flows are broken (McNair, 2007). It is of fundamental importance for its implementation to define product
families (Hall, 2008). As for the information support to lean manufacturing and world class companies, three
information systems are being considered, from MRP (Materials Requirements Planning), and MRP II
(Manufacturing Resource Planning), to ERP (Enterprise Resource Planning). In the past few years a range
of software of the so-called ERP systems has been developed. ERP integrates departments and functions
throughout the company into one system of integrated applications with a unique common database. A lean
manufacturing company will thus have ERP system capable of external communication with customers and
suppliers through electronic data interchange (EDI).
Considering that companies operate in an extremely dynamic world of interdependent and nonlinear events,
we should finally emphasize that CM cannot stay focused on independent activities and simple linear cost
models and their drivers. In order that CM could secure an important position in the 21st century and reject
the label old wine in new bottles, it is said that it is necessary to withdraw completely from simple
assumptions and traditional limitations and that the key of the CM future lies in understanding the dynamic
relationships between various resources and the amount of value they can create for the company
stakeholders. In that sense, key instructions are listed for the most recent research and practice regarding
new techniques for the 21st century, such as: resource consumption accounting; the relative cost of
intellectual capital and the value it creates; waste measurement and analysis; non-linear cost functions;
dynamic cost modeling and prediction. Each of these techniques adopts a broader view of costs, focusing
more on the way resources affect one another in creating or destroying the company value than on

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measuring the status quo. CM follows the need to define measure and help the organization to maximize its
potential to create value.

6. CONCLUSION
In the past decades there has been an increasing number of discussions about CM and extending various
limits. It is a dynamic process which assumes intensive efforts directed towards continuous improvement, i.e.
improving the existing and inventing new tools and techniques, starting with early activity-based costing
models and pursuing lately in the direction of strategic cost management (SCM)- the use of cost data to
develop and identify superior strategies that will produce a sustainable competitive advantage. In that period,
the most prominent trend has been shift the focus from determining product costs by using standard
traditional cost models, towards providing support for strategic and operational decisions by using certain
forms of activity analysis.
New environment brings new challenges and problems which inevitably impose the need for serious
reconsideration of past business philosophies of companies based on stable and foreseeable business
conditions. Therefore, suggestions are heading towards the separation of cost accounting from traditional
accounting, together with abandoning of the long sustained linearity of measuring historical costs and static
standards. Only by integrating the internal and external aspects it is possible to provide quality information
for strategic management of a modern company. The key point is flexibility - the cost accounting information
system should be able to supply different data for different purposes. Practical application of some new
solutions faces difficulties in developed countries as well, because of high investment and operational costs.
It is particularly emphasized that, from the aspect of modern cost management, there is much left to be done
in order to raise cost management to the highest level of the modern practices.
Our conditions are characterized, unfortunately, by underdevelopment and weak application in practice of
the conventional as well as the new solutions for cost accounting. It is necessary to widen and deepen more
intensively the existing theoretical and practical knowledge which will enable us to examine the wide focus of
company cost and performance management and to recognize the right conditions for gradual development
and implementation of new solutions along with the development of our economy. It also seems logical to
ask the following question: How much do cultural features and mentality affect the implementation and
efficient functioning of a particular solution? In any case, the new solution must be closely examined by the
cost-benefit analysis which should clearly show whether the benefit of using particular information outweighs
the costs of providing it.

REFERENCES
Cooper, R. and Kaplan, R.S. (1999), The Design of Cost Management Systems, Text and Cases, (2nd ed.)
Prentice Hall.
Drury, C. (2004), Management and Cost Accounting, (6th ed.), International Thomson Business Press,
London.
th
Hall, J.A. (2008), Accounting Information Systems, (6 ed.), South-Western, USA,
Hansen, D.R.&Mowen, M.M. (1997), Cost Management,Accounting and Control,South-Western College
Publising, Cincinnati, Ohio.
Horngren,C.T. et al. (2003),Cost Accounting,A Managerial Emphasis, (11th ed.), PrenticeHall.
Horngren, C.T. et al. (2005), Management and Cost Accounting, (3rd ed.), FT Prentice Hall, Pearson
Education Ltd.
Kaplan, R.S. and Cooper, R. (1997), Cost&Effect: Using Integrated Cost Systems to Drive Profitability and
Performance, Harvard Business School Press, Boston.
Maher, M. (1997), Cost Accounting, Creating Value for Management, (5th ed.), Irwin, McGraw- Hill Co, Inc.
McNair, C.J. (2007), Beyond the Boundaries: Future Trends in Cost Management, Cost Management,
January/February pp10-21.
Silvi, R. et al. (2008), SCM and Lean Thinking: A Framework for Management Accounting, Cost
Management, January/February pp 11-20.

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Seidenschwarc,W., (1993), Target Costing - Marktorientiertes Zielkostenmanagement, Mnchen: Verlag

Franz Vahlen (engl. Target Costing - Market-oriented Target Cost Management,Munich:Publicher
Franz Vahlen)
Seidenschwarc,W.,(2005),Target Costing-Auf dem Weg zum marktorientierten Unternehmen,
Seidenschwarc & Co. (engl. Target Costing on the Way to Market-oriented Organization,
Seidenschwarc & Co.) Seidenschwarc & Co.
Zimmerman, J.L. (2000), Accounting for Decision Making and Control, (3rd ed.), Irwin, McGraw-Hill
International Edditions.

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EXPERTNESS IN BUSINESS PLAN DEFINING IN CRISIS CONDITIONS

Dragutin Dragojevi1 Sneana Leki2 Nada Vignjevi-orevi3
Abstract: The global financial crisis is caused by a structural disturbance, sudden lack of capital and a huge
mass of liquid funds for the regular maintenance of economic trends in the world. Highly developed countries are
threatened with the risk of long-term recession. In less developed countries, like ours, the global crisis has posed
a much greater risk than a general financial collapse, due to limited resources to quickly overcome financial
insolvency. For Serbia, the way out of financial crisis lies in a faster start-up of available unused national
resources, where a relatively small investment project with new fresh capital can create new job positions in very
short time, GDP growth and the fastest routing of new products and export services. The New Economic
Development Strategy of Serbia depends on the skill and speed of running the huge resources available in the
agricultural sector and industries that rely on the agricultural sector. The existence of more than 400,000
registered farms, along with several thousand small and medium-sized companies for the processing of primary
agricultural products and logistical support, offers a real opportunity for a faster exit from the crisis. However, the
available resources in the agricultural sector are still very limited with a range of products and services involving
a higher degree of processing, which could be offered to our traditional foreign buyers. Even though there are
conditions for the development of new export-oriented business ventures in Serbia, there is a lack of business
ideas, knowledge and skills necessary to start such a business. In order to start new business ventures,
hundreds of good business plans must be provided in a very short period. A business plan is an important
document for providing necessary financial resources from the public funds or from commercial banks. In crisis
conditions, it is difficult to choose an appropriate subject of a new business plan. Thus, the authors paid special
attention to defining the optimal choice of subjects and a business plan in a crisis atmosphere. The expected
effects of reducing unemployment and creating new jobs were not achieved with the activities of government
institututions in underdeveloped areas in the agricultural sector with the financing from foreign grants. This is a
limiting factor for a faster way out of the crisis and the promotion of rapid economic growth. It emphasizes the
importance of the implementation of previous positive solutions to check market mobility of new programs,
selection of the best technology and equipment with the lowest cost per unit, in order to achieve competitiveness
in the market in a crisis situation. A good business plan is based on credible budgeting for the necessary
financial resources, without which there will be no successful business. Proper analysis of the investment and
business risk should provide security to entrepreneurs and owners of capital for investment given in the business
plan. This research is primarily intended for current needs and implementation in practice, as a contribution to
more rapid initiation of new economic activities in the agricultural sector meant to encourage the country's rapid
exit from the current crisis.
Keywords: business plan, agricultural organizations, agricultural markets, financial incentives and new jobs.

1. HOW TO GET GOOD BUSINESS IDEAS FOR CREATING AN EFFECTIVE BUSINESS PLAN
In the currently difficult economic conditions and tough competition in other businesses it is important, both
for individual entrepreneur and a company, to possess the right knowledge and skills for organizing a
successful business enterprise, if they want to survive in the market and make a profit. The main goal of any
undertaken business is to gain profit.
Profit is realized when an entrepreneur or a company successfully operates, which means the best use of its
available resources, contained both in mental and business acumen, their employees, all the material and
financial resources engaged, in order to successfully place its products or services on the market at the
lowest possible operating costs and by achievement of the highest possible income.
This includes well-designed and defined subject of a business plan as a starting point for achieving defined
business objectives, particularly in the current crisis conditions. In the business plan, the limit point of return
in a crisis atmosphere is best measured by establishing the relationship of fixed and variable costs in a
1
2
3

EARN European Auditing Research Network, President of ICAA,

Belgrade Business School - College of Professional Studies, Belgrade
Professor at State University of Novi Pazar.

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planned and realized business. When defining the subject of a business plan, at the current difficult business
conditions, this relationship is first to be checked. A company, whose total business organization is weaker,
especially with inadequate market research, marketing and distribution, has higher fixed costs. Organization
with higher fixed costs of its products and services per unit, will therefore increase its selling prices, become
uncompetitive, lose its business arrangements, realize less revenue, operate with losses and quickly go into
bankruptcy.
In crisis conditions, the definition of objects of a business plan is usually expressed as follows:
Selection of an optimal subject of the business plan is correlated with the degree of successfully organized
and achieved management of available resources, to become competitive on the market in order to achieve
maximum sales impact and security of the long-term income and profit.
In practice this premise means that finding the product (s) or service (s) in the optimum extent based on
previous market tests of demand volume and levels of sales price trends (sales) that could be placed under
the best conditions, with the structure of the available resources (fixed and current assets), applied
technology, expertise of employees and successful management.

2. THE KEY CHARACTERISTICS OF EFFECTIVE BUSINESS PLAN

Business plan is a key document for determining effective business and financial skills of legally organized
company or its management in order to:
start a new business undertaking or establish a new company,
introduce the alternative business programme which is more competitive on the market and enables
successful opposition to competition,
enable business and financial consolidation of the existing company that sunk into financial difficulties due
to the obsolescence of products or services, loss of markets, lack of funds and other weaknesses in the
previous period, and
Conduct planned expansion of existing operations, increase the capacities in order to meet increased
demand of their products or services in the market and increase exports of goods and services.
An effective business plan, as an important starting business document of well-organized business
enterprise is both a "tool" and a guide for the on-going management of successful entrepreneurial venture or
business organization and is intended for:
the entrepreneur who intends to initiate and conduct a new entrepreneurial venture,
entrepreneur or legal entity that intends to develop new products and services, according to a prior
assessment of market demand and the perceived intentions and actions by competitors,
a legal entity that has decided to extend or change a registered business,
Investors who intend to make investments in the purchase of new enterprises, plants, joint ventures, etc.).
An effective business plan is primarily intended for owners and management of the companies for reliable
and secure planning of business activities and designing optimal business results. The aim of every business
plan is to check the profitability of investment (financial) in business ventures, especially if they are subject to
tough competition and difficult economic conditions.

3. THE STARTING POINT FOR EFFECTIVE BUSINESS PLAN IN CRISIS CONDITIONS

An effective business plan is usually prepared prior to the business and/or investment decisions. If this is
done in critical conditions it is necessary to establish the main focus of activity of the crisis on the business
entity (general illiquidity, an unfavourable investment climate, reduced purchasing power of population,
significantly exceeding of the approved budget deficit, etc.). In such circumstances, an effective business
plan seeks to use the best subject of future business activities, which will resolve the identified limiting
factors for the successful continuation of business. Timely and proper selection of appropriate items of
business plan provides the timely adoption of optimal business and/or investment decisions. This means that
the business plan perceived correct directions of the projected business enterprise, and identified potential
business and investment risks on time. Therefore it is possible to neutralize or minimize detected risks and
set up adequate and safe business solutions.
In principle, an effective business plan is usually drawn in preparing loan applications submitted to banks or
other lending institutions for timely provision of necessary short-term or long-term funding for the successful
conduct of business. In the crisis situation other business purposes can be expressed, and primarily for
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financial and business faster consolidation of the business entity, and define the appropriate exit strategy
from the created of financial and economic crisis.

4. METHODOLOGICAL DIFFERENCES IN THE PREPARATION OF A BUSINESS PLAN

Tests conducted in 2011 and 2012 of actions on the training of unemployed people in undeveloped areas,
which, with the help of foreign donations, should start own entrepreneurial ventures in agro-sector, based on
the self-employment, showed that there had been many failures, why the goal - to reduce unemployment,
has not been achieved. The main reason for not achieving the goal is that the official factors, foreign donors
and consultants engaged to train unemployed people, do not perceive significant differences in the
methodology for training persons in the development and use of effective business plans for new
entrepreneurial ship and the establishment of new businesses, in relation to the methodology used to
prepare business plans for existing businesses that have financial difficulties or need of expanding existing
facilities.
In practice, there are important conceptual and methodological differences of preparation and drawing up
effective business plans, for:
a) New business ventures and the establishment of new companies,
b) The purchase of the partial or complete facilities and enterprises,
c) The change of the business venture orientation during downturns,
d) For the business and financial consolidation of existing businesses, entrepreneurs or companies, which
have come to financial difficulty, insolvency and continuing blockade of the current account of erroneous
conduct of its work in the past?

4.1. Business plan for new business ventures,

Business plan for new business ventures, establishment of new entities and so, while preparing and drawing
up an effective business plan focus the attention on the market research and finding the proper object of the
intended venture. For the preparation of this type of business plan it is logical that a beginner first examines
the market to which it intends to focus its attention, particularly in finding the right somersault of business and
checks the market demand. This is the basis for determining its capabilities and ability for achieving planned
sales and production of defined products or services. In doing so, it especially checks whether this increase
in market demand represents current or permanent condition. It is also necessary to further determine the
level of development of existing capacity and level of sales prices of other similar market players
(competitors) in the local and global environment from the intended operation of the new program.

4.2. Business plan for the existing business ventures and existing companies
Business plan for the existing business ventures and existing companies is methodologically quite different
from the initial entrepreneurial venture. The focus in this case is placed on analysis of current status,
weaknesses and shortcomings of the existing organization. First, it is necessary to identify and analyse
mistakes and perceived shortcomings in the use of available resources, then analyse the objective difficulties
in placement of existing products or services, that occur due to technological obsolescence of products,
tougher competition from other market players, adverse effects of economic measures that emphasize the
import of products and restricting sales of national products, and the like. During preparation and assembly
of this type of effective business plan attention is focused on research for alternative solutions to overcome
arising difficulties, better use of existing resources, and quick improvement of the existing production
technologies, improved business efficiency, in order to end the crisis and ensure profitable operations in the
future. After examining the causes of such a situation and finding alternative solutions for the rehabilitation of
future business, the following procedure is to conduction of detailed market research, assessment of market
demand in order to redefine the business case, which will be then processed in the new business plan.

5. PARTICULAR ASPECTS OF DEFINING A BUSINESS PLAN IN CASE OF CRISIS CONDITIONS

An important feature for effective drafting of a business plan is to select the appropriate items of business
enterprise, then determination of the appropriate scope of business activities and selection of the right
methodological approach. Some banks and other financial institutions (Development Fund and similar
institutions) determine for their loan claimants specific methodology for the preparation and presentation of
effective business plans as a basis for reviewing and approving loans. Before preparation of the Business

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plan, entrepreneur, business consultant, company management and others must first choose the institution
to which they will address for securing the necessary funds.
In crisis conditions, providers of financial support require from the holder of an effective business plan to
accurately describe the selected product or service, in order to test the comparative advantages of the
offered items in relation to other market operators, subject to similar businesses. When describing the
chosen item, the business plan should include, in particular:
the main characteristics of products or services,
the needs of customers for the selected product or service,
the willingness of consumers to pay the projected cost of the product or service,
Preparation technology on which the selected product is based and others.
In order to determine the possibility or chance of the selected product or service, there should be included
the analysis of the situation in the industry or sector in which it operates, in order to resolve potential risks
with appropriate modifications and other marketing measures.

6. THE IMPORTANCE OF TESTING MARKETING OPPORTUNITIES IN CRISIS CONDITIONS

Market research is very important and responsible task in preparing and drafting a business plan in a crisis
conditions. Narrowed market demand due to reduced purchase options imposes more detailed examination
and description of any significant market events that are related to the selected item of business plan. From
the experience of good practice in critical operating conditions, careful market research should include:
1) Detailed assessment of characteristics of the selected product (service),
2) In particular, a detailed examination of the potential scale of market demand,
3) The verification of the formation of the selling prices of selected products or services,
4) Check the behaviour of competition:

Identify main competitors and their strength?

Identify their business strategy?

Consider the advantages and disadvantages relative to competitors in their own business?

Consider the production and sales capacity of competitors,

5) Check the selected sales methods and distribution channels that they intend to include in effective
business plan,
6) Selecting the best advertising techniques to promote selected products or services provided in an
effective business plan is one of the key elements for successful implementation of business ventures.

7. THE NECESSITY OF PRIOR ANALYSIS OF COMPETITION IN THE BUSINESS PLAN

Competition is a rivalry between alternative market entities that address the same group of customers, where
each is trying in its own way to increase sales, marketing share and gaining higher profits. Competition is a
latent (hidden) risk to a particular manufacturer and market subjects. Elements through which competition
operates in the market are: volume, structure and size of bids, price and product quality, technology, capacity
management, and financial and marketing power of the subject. The subject of research and proper analysis
of competition in a crisis atmosphere directed primarily to offer their system (range, sale price, payment
terms, the system of distribution and post sales service, display and use of marketing mix, market position).
Based on the survey formed database includes: name of the entrepreneur or business entity, name of a
competitor, location, program supply for market area in which it operates, technological capability and the
like. The collected information relating to market share achieved in meeting the needs of customers needs to
be fatherly analysed for the different market segments and key products, which are the subject of an
effective business plan. It is also necessary to analyse the sales channels of competition, and how they
cooperate with the customers, especially if they use discounts and the like.

8. SELECTION AND PRICE DEFINITION IN THE BUSINESS PLAN

The selection and definition of price is not a simple economic category. The economic entity, as the market
participant trough defined by price can develop two types of strategies:
a) A market strategy of price competition and
b) A market strategy of non-price competition.

762

If the total costs of products or services (variable and fixed) represent a lower bound or "floor" price, then the
level of market demand determines the upper limit or "ceiling" prices. Application of pricing strategy
assumes that an entrepreneur or a company has mass production and low production costs. Sellers who
implement this sales strategy are forced to have a policy of flexible sales price. Prices change due to
changes in the structure of operating costs (increase of variable or fixed costs) or because of increased
demand for particular products or services. Price changes are possible when the competition does so. The
essence of pricing implies a good knowledge of market changes and the ways in which changes in market
demand may influence the formation of different prices.
Strategy of non-price competition in the market applies to improving the quality of products or services over
the competition, better and more attractive packaging, providing favourable conditions of sale, deferred
payment or other services (free transport of goods or similar free installation and free services). In non-price
marketing strategy vendors keep prices stable. Non-price market strategy is applied by entrepreneurs that
previously positioned their products or services highly on market, using permanent maintenance of the high
quality, better marketing promotions, additional services and other market activities...

9. THE FINANCIAL SEGMENT OF AN EFFECTIVE BUSINESS PLAN IN CRISIS CONDITIONS

The main objective of the establishment, commencement and conduction of any business ventures or the
company is profit. Previously reviewed key financial parameters in the process of preparing an effective
business plan (determined by structure of fixed and variable costs, marginal rate of income, the coefficient of
possible sales charges, maintenance of the required coefficient of raw and finished products, materials, the
coefficient of discharge of obligations to creditors, the expected rate of gross profit before taxation, financial
liquidity and leverage, participation interest on the borrowed funds in the total income, etc..) determine the
feasibility of a business venture, as to whether one could expect average earnings and return on total assets
invested in a new businesses or financial consolidation of the existing business entity.
At the beginning of the preparation of the financial segment of an effective business plan it is necessary to
make a realistic pre-estimation of the total funds required for the realization of the projected business
enterprise. This amount usually includes: the amount of the excess, and the amount of missing funds (these
funds are most often provided through banks loans, borrowed). Planning is done from the total amount of
required financial resources - for which purpose it will be used. In this regard, it is necessary to:

calculate the required fixed assets,

calculate the necessary working capital,

calculate the expected costs of all operations,

estimate expected sales revenues,

Make cash flow projections for the next 3 years.

To forecast the necessary financial resources it is very important to determine: the days for setting the time
of sale, time of keeping the supplies and raw materials, reconciliation of accounts payable. In the following
text we will present an example of model with integrated calculations of necessary financial resources,
proven in practice for many years and accepted by many financial institutions that provide financial support
to individually entrepreneurs and small companies.

10. THE EFFECTIVE PROCESSING MODEL OF FINANCIAL SEGMENT OF THE BUSINESS

PLAN FOR THE PRODUCTION OF PACKAGING USED IN AGRICULTURAL PRODUCTS
It is assumed that the founders and co-owners of small company made the decision to prepare a business
plan, to ensure the necessary resources for financing production of contemporary plastic packaging which
will be used in the food industry. Previous market tests have shown that planned products are highly in
demand due to the increased needs of industry for processing agricultural products intended for export.
After completing market research, major customers are defined, as well as their annual needs. Based on
this, project of technology used for new plastic packaging is completed, and appropriate equipment was
selected, and in connection with that, the technical, material and labour standards were established. An
overview of the annual fixed cost for the company business is also determined. Based on the technical
standards, the amount of material needed for productions are defined and preliminary contracts for the
delivery concluded. According to the adopted technical, technological and labour standards, budget for
necessary funds is being calculated (financial segment of the business plan), for the planned production
volume. To calculate the necessary financial funds, for this example, we used defined parameters as follows:
a) Projected annual sales volume of finished products is RSD 15.000.000.
b) According to defined technical standards, direct costs are 40% of revenue from total planned sales
c) Fixed costs amount to 20.40% against planned sales.
763

d) Planned Amortization of permanent funds on average should be 10% per year

e) Depreciation for the first year is covered by the planned fixed costs, and the rest is covered by the
planned funds for the purchase of fixed assets.
f) Sales financing are planned to be 30 days on average
g) Funding of material, in accordance with the production technology and the on the dynamics from the
contracts with suppliers, should be 85 days.
h) Planed supplies of material for the beginning of the production are in amount of RSD 1.000.200.
i) Planned purchases for the period in amount of RSD 6.300.000
j) Provided supplies to the end of the period amounted to RSD 1.5 million, and are slightly increased due
to the planned increase in production for the period
k) The suppliers agreed to deferred payment terms for 20 days without interest
l) The value of the acquisition of fixed assets in accordance to the business plan is RSD 2.5 million.
m) The planned interest rate on the requested amount of the loan is 12% per annum.
Based on the previous parameters, the financial segment of an effective business plan includes:
1) Preparation of the projected income statement (check of business profitability),
2) The preparation of the budget for total funds required in business plan,
3) Checking the profitability and feasibility of an effective business plan
4) Preparation of the planned balance sheet in order to review the financial position and the certainty of
return on invested funds
5) The preparation of the cash flow forecast to determine the ability of management to manage cash and
generate invested money.
Here is the example for the preparation of financial segment of the effective business plan:
T HE MO DEL O F CAL CUL AT I O N O F NECESSARY F I NAN CI AL RESO URCES
I) PLANNED INCOME STATEMENT
1. Projected sales revenue
Less direct costs:
- materials (40% of No.1)
6.000.000
- gross wages (20% of No.1)
3.000.000
Total direct costs
9.000.000
2. Marginal profit
Less:
- Fixed costs (20,40% of No. 1)
3. The planned operating profit (margin)
Less:
- Borrowing costs (12% per annum, 60% of No. 9)
4. Net profit before taxation
II) PROJECTION OF NECESSARY ASSETS
5.
Financing
the
purchase
of
fixed
assets
(2.500.000 250.000)
2.250.000
6. Financing sales
(15.000.000 x 30 days / 365)
1.232.877
7. Funding maintenance of supplies (stocks)
- initial stocks
1.200.000
- supply in the period
6.300.000
total
7.500.000
- final stocks
1.500.000
6.000.000
Net consumption of materials
(7.500.000 x 85 days / 365)
1.746.575
5.229.452
8. Use of the funds from suppliers
(6.300.000 x 20 days / 365)
- (345.205)
9. The total planned engagement of the funds
4.884.247
10. NET FUNDS NEEDED
Turnover ratio for engaged funds
The planned rate of net profit

3,07
Equity
17,26% Loan
764

15.000.000

9.000.000
6.000.000
3.060.000
2.940.000
351.666
2.588.344

4.884.247
2.295.913
918.365
40%
1.377.548 60%

The rate of return on total funds invested

52,99%

III) PROJECTED BALANCE SHEET

A) ASSETS
I. FIXED ASSETS
- Purchase value
- Depreciation
- Current value
II CURRENT ASSETS
1. Stocks
2. Receivables from debtors
3. Cash
Total current assets

2.500.000
250.000
2.250.000

2.250.000 (1)

1.500.000 (2)
1.232.877 (3)
246.575 (9)
2.975.452 (8)

Less:
III CURRENT LIABILITIES
4. SUPPLIES CREDITORS
NET CURRENT ASSETS (NCA)
TOTAL FIXED ASSETS + NCA
Less:
IV LONG-TERMS LOAN FOR BUSINESS PLAN
NET ASSETS OF THE OWNER
B) LIABILITIES + EQUITY
1. Initial capital
2. Net profit after taxation
(2.588.334 x 14/100)
TOTAL OWNERS EQUITY

- (345.205) (4)
2.634.247 (7)

2.634.247 (6)
4.884.247 (5)
1.377.548 (10)
3.506.699 (11)
1.280.731 (14)
2.225.968 (12)
3.506.699 (13)

IV) PLANNED BALANCE OF CASH FLOW

A) CASH FLOW FROM OPERATING ACTIVITIES
1. Gross profit from the planned operation
2. Non-monetary activities
included in gross income
2.1. Receivables from debtors
2.2. Stocks
2.3. Liabilities to creditors
Total
3. Net cash flow operating activities
B) CASH FLOW FROM INVESTING ACTIVITIES
4. Investment in buildings
5. Investment in equipment
Net cash flow of investing activities
C) CASH FLOW FROM FINANCING ACTIVITIES
6. Loan for business plan
7. Equity
8. withdrawal of funds
Net cash flow from financing activities
D) INCREASE - DECREASE IN CASH
9. Opening balance
10. Cash at the end of period

2.588.334
- (1.232.877)
- (1.500.000)
+ 345.205
- (2.387.672)

- (2.500.000)
- (2.500.000)
1.377.548
+ 1.280.731
- (112.366)
2.545.913

- (2.387.672)
+ 200.662

- (2.500.000)

+ 2.545.913
+ 246.575
0
246.575

10.1. The rating for financial segment of the business plan

The presented methodological approach for processing the financial segment of the business plan makes it
possible to establish the first anticipated profitability of the business enterprise. In this example, the planned
income statement states that the marginal profit rate is 40%, which corresponds to a highly profitable
business. The production of contemporary plastic packaging for food products is therefore profitable venture.
765

After determining the profitability of the planned business venture, the next step is to make the projection of
the required financial resources, as a key segment of the business plan.
From the above stated parameters, a relatively small number of sales financing days is determined, which
requires verification of the actual situation regarding the degree of collection of revenue from product sales.
Preparation of the budget shows the existence of critical points of the items for required funds in the part
relating to the financing of the volume of material production, due to the greater the number of days for
keeping the stocks, prior to use in the manufacturing of the plastic packaging.
Number of inventory turnover days for the production of materials is determined by the structure of sources
of supply of key materials. The total volume of stocks at highly automated production, such as the production
of plastic packaging for the food industry, depends on the length of time for delivery of the last of
components, especially those purchased abroad, with the prolonged delivery.

10.2. Reading and understanding of financial statements of the business plan

Checks and controls when developing and implementing an effective business plan include reading and
mastering the skills of financial information. Introduction of accounting categories and logic, allows efficient
evaluation of business projections made in the business plan, comparing the obtained results with those of
other businesses, particularly in the following financial categories:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)

Relation of fixed and current assets (to avoid excessive immobilization of funds)?
Relation of long-term and short-term liabilities (to achieve greater financial liquidity)?
The structure of equity (in order to strengthen the equity and financial position)?
The structure of debt (principal and interest payments)?
Relations of fixed and variable costs (for maintenance of rational organization of entities)?
Relations of direct and indirect costs (for monitoring the efficiency of business)?
Analysis of the calculated costs of products or services (in order to maintain competitiveness)?
Analysis of the balance sheet for maintenance operations or financial position of the company,
Analysis of the income statement - revenues, expenses, profit or loss (to maintain profitability)?
The analysis of cash and cash management (to improve financial liquidity)?

11. WHAT IS NOT INCLUDED IN FIGURES IN THE BUSINESS PLAN

In financial calculations and financial information we cannot see, but, between the lines of a business plan,
we can read following:

the business skills of owners, entrepreneurs and management of a business entity,

quality of organization and certainty of business success in the future,

future demand for specific products and services company,

The certainty or uncertainty of future operations (expected bankruptcy and bankruptcy).

As a rule, if the company's business - the business entity is simple or a smaller scale, the accounting data
are less complicated, more efficient, more accurate and reliable for use. Financial accounts are usually
prepared in a manner that would be adapted and prepared for a tax audit, which has been recently very
present and represents a limiting factor for the proper and accurate preparation of financial budgets,
business plans and preparation of new strategies that should ensure faster emerging from the crisis and
boost future business development, increase revenue, net income and dividends.

12. REFERENCES
Companies Act, Official Gazette of RS No. 36/2011,
The Law on Accounting and Auditing, Official Gazette of RS No. 46/2006 and 111/2009,
Act on the registration of the Business Registers Agency, Official Gazette of RS No. 99/2011,
IAS International Accounting Standards and IFRS international reporting standards FINANCIAL - official
translation, Official Gazette of RS No. 77/2010 and no correction in 95/2010,
Regulation on the registration of agricultural Farms, Official Gazette of RS BR 45/2004
arki-Joksimovic, N., Filipovi, V., Dragojevi, D. (1995). ACCOUNTING FOR MANAGEMENT by the
Phare program, FON - Faculty of Organizational Sciences, Centre for Management Development.
766

arki-Joksimovic, N. (1995). MANAGEMENT ACCOUNTING, (Upravljako raunovodstvo) Editor FON

Faculty of Organizational Sciences, Institute for Management Development Belgrade.
Kaplan, R., Anthony, A. (1998). ADVANCED ACCOUNTING MANAGEMENT, Third edition, Prentice Hall
Inc. Internationals. New Jersey.
Dragojevic, D. (2002). Manually BUSINESS PLAN - Methodology and application, Editor of the "Savremena
praksa", Beograd.
Ggic.P. (2005). COST THEORY WITH calculations, edition Faculty of Agriculture, Beograd.
arki-Joksimovic, N., Jasko, O., & Dragojevi, D. (2005). BUSINESS PLAN of "ZIDAR" doo Negotin,
rounding the technological capacity and the expansion of production of joinery in the privatized
company "Naa kola", Obrenovac, approved document, the Faculty of Organizational Sciences.
Institute of Management, Beograd, and the project realized.
Rani, D., Radovi-Markovi, M., Leki, S. (2008). "Quality of managerial, entrepreneurial and Leader
Behaviour - similarities and differences", the issue of Belgrade Business School, College of
Professional Studies, Beograd.
Dragojevi, D., Diki, S. (2011). INSTRUCTIONS FOR REMOTE BUSINESS PLANNING, Computerauthorized solution for writing a business plan, ICAA International Comparative Accounting
Association, for contract customers, Beograd, 2011,
Shi Huai Zhang, L. (2011). ON ALTERNATIVE MEASURES OF ACCRUALS, Accounting Horizons, Vol. 25,
No.4. 2011, page 811-836, Publications of the AAA American Accounting Association.
McGuigan,N.,Weil,S.,Kern,T.,& Hu, B.(2012). PROGRAM WORKSHOP INDUSTRY PERSPECTIVE: An
Instructional Case Used to Integrate transferable Skills in Introductory Accounting, Education, Vol. 27,
No.1, February 2012, page 157-187, Publication of AAA American Accounting Association.
uriin, D., Janoevi, S. (2011). MANAGEMENT AND STRATEGY, Belgrade Faculty of Economics.

767

INNOVATIVE BUDGETING EXPENSES OF DEFENSE

Milena Knezevic1, Sasa Trandafilovic 2 i Branko Tesanovic 3
1
Univerzitet odbrane, milena.knezevic@mod.gov.rs
2
Uprava za budzet, sasa.trandafilovic@mod.gov.rs
3
Vojna akademija, brate@verat.net
Abstract: This document presents a system of programming budgeting, that is a model management with a
goal to establish relations between engaged and proposed resources, in fact achieved results. Special
attention is dedicated to the needs as well as to the achieved results of the applied model in order to dispose
rationally and finally to efficiently conduct determined tasks.
Keywords: programming budgeting, development, resources, management, defense system.

1. INTRODUCTION
Changes in society and therefore in state, that occurred in the last decade of the 20th century and in the first
decade of the 19th century, have influenced by the fact that the rooted attitudes and opinions have changed
within the society which are a reptil of old times when it was thought that the education and defense are too
important from a political, sociological and human aspect to be able to undergo some kind of economic
calculations. On the contrary, in the todays situation, management structure of the system of defense must
act immediately and make concrete decisions according that and, also, being faced with the problem of
limited resources.
The additional problem for the defense system of the early 21st century, is that the previous system of
financial resources, particularly budgeting, was not sufficiently effective and did not corespond to the
complex requirements that were demanded of the management structure of the defense system of Serbia.
The planning area of the defense system of Serbia was largely undeveloped and the need to regulate this in
a qualitatively new basis was reported as an imperative. There were no mechanisms to provide sufficient
information if the planned goals and objectives of the defense system would successfully implemented, and
whether if an appropriate allocation of the resources for the realisation of the planned objectives would
carried out.
Managing of financial resources was reduced to an allocation of available financial resources, without
interconnections between the tasks of defense and financial plans. Also, there is problem of converting
strategic objectives into financial plans that can be linked to budget resources. The fact is, of course, that
many aspects of pre-defined objectives are implemented within the regular activities in the defense, but
without feedback.
Financial planning, mechanisms for the preparation of financial plans and regulations for their enforcement
havent, until recently, provided sufficient information on whether the defined objectives have implemented
successfully in practice. Because of this it was very important to improve the links between financial plans
and strategies, to provide appropriate mechanisms for monitoring the effectiveness of their implementation
and consideration of future needs. The introduction of functional programmatic dimension into the existing
budget classification was one of those mechanisms.
The modern view and the view of overcoming problems of increasingly limited incomes also in the public
4
sector of the Serbian government, found the solution in the budget directed to results or program budget .
The role and place of the state in financing defense system is characterized by compromise in conflict
resolution: to achieve the defined goal with minimal financial investment. The cause of this discrepancy is
primarily the needs of the various growth opportunities that defense functions of the state require and its
limited material and financial resources. However, the government of every state is obliged to, on the one
hand, consider the economic situation of the country, and on the other hand, to give stable defense system,
racionally using limited resources.
4 Program budgeting is based on the concept, methodology and practice of cycle management in project oriented organizations and recommendations of possible solutions of that
model in the organizations of functional type in which belong the institutions of state administration.

768

Management structures of the defense system, as an integral part of society and its problems were faced,
already in the 20th century and in the first half of 21th century, on the one hand, with the problem of
transmission of liabilities from year to year, rising debts to suppliers, costs of court udgements for the delay
in payments, penalty and interests for late payments of accrued liabilities, and on the other hand, with limited
and insufficiently available financial resources. What necessarily required news and changes in management
of financial and other resources of defense.
The significant changes have been implemented in the system of defense of The Republic of Serbia in
recent years. The overall objective of the changes is the transformation of the system in line with modern
security challenges and threats, that is needs and opportunities of The Republic of Serbia.
In order to ensure continuous growth in the quality of defense capabilities, increase efficiency of execution of
the defense tasks, rational use of available resources, ensuring adaptability and flexibility of the process
executing the defense tasks and coordination of development components of the defense system with the
overall development of the State in the Ministry of Defense and the Army of Serbia in 2008. the system of
planning, programming, budgeting and execution (PPBE) was introduced as a new management system of
defense resources and in the final funding of developing programs and projects of defense system.

2. BUDGETING ANALYSIS OF DEFENSE SPENDING BEFORE AND NOW

Planning of the development of the defense system in the period before the introduction of program
budgeting model was disintegrated and there was no continuity in the planning process. The development
plans were made by the the office holders of the defense system each of them for themselves individually.
Disintegration of planning functions, that existed before the introduction of a new defense resources
management process, was a reflection of the existence of a large number of office hlders dealing with
problems of planning. A particular problem was reflected in the lack of legislative and normative framework
that would regulate this area.
Integration of the functions of development planning of the defense system, as it introduced a model known
as program budgeting system PPBE, contributed to increase the overall performance of the Ministry of
Defense and the Army of Serbia, because the defense system is viewed as a whole, fortified with all the
tasks and resources required for their completion. Of course, the global financial crisis further complicates
the problem, because the fundings for the tasks laid down by the Ministry of Defense and the Army of
Serbia is getting more and more restrictive.
Decision makers in the defense system chose to introduce an integrated system of defense resource
management, in order to bridge the created situation and to coordinate the requirements of the defense
system and the possibilities of our society. Due to adoption and implementations of the PPBE system,
integration of planning function as a first stage in the process of defense resource management comes into
play.
Long-term defense planning

National
Assembly

Government

Minister of
Defense

Program
managers
and function
holders

National
Defense
Strategy

Mid-term defense planning

Long-term
Def. System
Devel. Plan

Strategic
Defense
Review

Short-term defense planning

Law on Budget

Memorandum
on budget

Guidelines for
mid-term Devel.
Plan and Prog.

Main Programs

Bill on Budget

Mid-term Def. Sys.

Devel. Plan and
Program

Function Holders
Mid-term Devel.
Plans

MOD Financial
Plan Proposal

Ministerial
Guidance

Annual Plans

Picture 1: Model of Serbian Defense Planning-now

769

MOD Financial
Plan

Continuity in the programming phase is ensured with the development and adoption of long-term
development plans of the defense system on which the medium term plans and development programs are
made, which later serve for the development and implementation of short-term plans. Planning model which
is represented in the defense system of the Republic of Serbia in 2011.is presented in picture 1.
Long-term planning is the process of setting objectives of the defense system for a longer period of time, as
well as methods for their implementation. The long-term defense planning is an interdisciplinary process that
involves many different activities. Activities are mutually dependent and precise coordination is needed. An
interdisciplinary approach to planning requires close cooperation between the planners and military
commanders, various specialists, political authority, etc.
The purpose of long-term defense planning is to consider the mission and tasks of the defense system and
to establish realistic long-term objectives adjusted to the missions and tasks, as well as to determine the
strategy of its realization. Long-term planning is oriented toward the relatively distant future and that
represents a problem for planners as they face many difficulties that are the consequences of uncertainty in
the future. Also, long-term defense planning should enable the appropriate development of defense system
and avoidance of unwanteded effects.
Medium-term planning is the process of determining the objectives of the defense system for medium-term
planning period and the ways of their implementation. The objectives and priorities are determined by factors
of development capabilities of the defense system that need to be realistic, purposive, implementable,
measurable, time limited and classified according chronological and logical sequence.
Short-term planning is part of an integrated planning process that operationalized the medium term
planning. In the defense system of the Republic of Serbia it includes a one-year planning period. Successful
implementation requires the preparation of annual plans of a number of different plans that are differents in
content, level of detailing, the time interval covered etc.

3. PROGRAMME BUDGETING EXPENDITURE OF THE DEFENSE SYSTEM

In the public sector reform and within it performance-based budget or PPBE system, expenditures are
classified according to programs and projects, operational objectives of each program are determined , and
performance indicators are established for each program and activity. PPBE system is one of the important
components of a wider process of reform of public finances. Specifically, it means the introduction of an
effective mechanism for monitoring the achievement of defined objectives.
In the current environment of public finances, it is difficult to translate strategic objectives into operational plans and
projects of development of the defense system, which can be linked to the budget means (picture. 2). The fact is, of
course, that many aspects of already defined objectives are being implemented within the ordinary activities of direct
budget funding.
S
T
R
A
T
E
G
I
E
S

PLANNING
PROGRAMMING
BUDGETING
EXECUTION

F
I
N
A
N
C
E
S

Picture 2: Converting strategic objectives into financial plans

However, operational planning, mechanisms for the preparation of financial plans and rules for the
enforcement of them, within the line budgeting, which was represented by 2008. in the defense system, did
not provide enough information about whether the defined objectives are being successfully implemented in
practice. It was therefore important to improve the links between financial plans and strategies in order to
provide appropriate mechanisms for monitoring the success of their implementation and consideration of
future needs.
Therefore, the program budget is a comprehensive system of defense resource management - a system of
monitoring results (performance management system). Key feature of the program budget is in a change of
770

budget focus from budgetary commitments on short-and long-term results and reached objectives of the
defense system.
However, limited resources imposes, in fact, wanted it or not, accepting different, basically an economic
standpoint, which is characterized by:
1.
the need for the best utilization of resources available for the specific purpose
2.
the influence by the consequences of decisions in the present to a quality of development in the
future
3.
the necessity to be efficient, which correspond to a care that the set objectives achieve with
adequate real available resources and
4.
the obligation to legally dispose and permanently control the expenditure of resources for
implementation of planned needs.
To increase the efficiency of the management structures of the defense system, changes in the sphere of
budget expenditures were necessary, just because of limitation and scarcity of available funding. Otherwise
the time and attention of management structures would be focused on securing funding for a reconciliation of
the regular needs of defense and would be lost to the efficiency of doing the basic tasks.

4. SECTOR PROGRAMS AS AN INOVATIVE WAY TO BUDGETS EXPENDITURES OF

DONATIONS OF DEFENSE
Defense expenses are financed by funds from the budget and donations from the European Union through
Sector Approaches (also known as Sector Wide Approaches SWAps). Sector Approaches are usually seen
as programme-based approaches (PBA) operating at the level of a sector. PBA is defined as follows:5
A programme-based approach (PBA) is a way of engaging funds EU in development sectors programme,
such as a National defence strategy, a sector programme, a thematic programme or a programme of a
specific organisation (defence).PBAs have the following features:

leadership by the host country;

a single comprehensive programme and budget framework;

a formalised process of donor coordination and harmonisation of donor procedures for reporting,
budgeting, financial management and procurement end

efforts to increase the use of this systems for programme design and implementation, financial
management, monitoring and evaluation.
The European Commission (EC) is committed to delivering "more and better aid" for "legitimate strategies".
One of the legitimate strategies is National defence strategy.
Sector approaches or sector-wide approaches (SWAps) are processes aimed at the development of
coherent sector policies and strategies. They involve governments, donors and other sector stakeholders in
a unified process and framework.
As mentioned above, EC decisions about whether and how to support a sector programme are based on
6
assessments in seven key areas:

5 European Commission, (July 2007).Guidelines for ec support to sector programmes short version, p.23-30
6
European Commission, (July 2007).Guidelines for ec support to sector programmes short version, p.27-35

771

The five elements of a sector programme

1.
2.
3.
4.
5.

The sector policy and overall strategic framework

The budget and it medium-term perspectives
Sector and donor coordination systems
The institutional setting and existing capacities
Performance monitoring

And the two additional elements influencing the sector

programme's performance
6. The macroeconomic framework
7. Public financial management (PFM) systems

Limitations EC provide an insight into the basic concepts that are relevant to each assessment, identify key
issues to be addressed and point to additional sources for more detailed guidance. The aim is to assist
programme managers throughout the cycle of operations of EC support in reviewing the quality of sector
programmes and deciding on appropriate support modalities.
Assessment of these areas would start during the programming and identification phases of the sector
politics cycle, with the analysis then being completed during formulation. During implementation, these
assessments would also need to be updated regularly in order to keep abreast of developments in the sector
politics and each of the areas.
There are many overlaps between these assessments (for example, there are obvious connections between
sector expenditure strategy, the macroeconomic assessment and the review of public finance management;
all the other assessments may feed into the institutional and capacity assessment, and so forth).
Also, many of the assessments are also required for other aspects of EC work (e.g. a macroeconomic
assessment will have been undertaken as part of limits preparation and to support any sector politics and so
on. Those working on analyses should first of all draw on given limits, and if necessary update, existing
assessments. Wherever there are relevant preexisting studies and materials, these should be drawn upon.
When it is possible, the EC works jointly with other donors, as well as with the partner government, on such
assessments, and does so in ways that support the development of partner country capacity. The
assessment required at the design stage of an politics sector is part of a continual process of monitoring and
review of key issues. There are few, if any, absolute criteria involved in the assessments. Balanced
judgements are required, which identify opportunities as well as risks, and which assess the direction of
change as well as current levels of performance.

5. CONCLUSION
The introduction of the new model of program budgeting, situation in the field of management of defense
resource is changing drastically. Namely, there is a process that takes place continuously. All plans and
programs are integrated into one unit. The financial plan of the defense, as a function of plan holders, serve
to establish a connection between the proposed appropriation of resources and results achieved.
Mechanisms for monitoring the implementation of goals achieved are being introduced, which is advantage
compared to the state so far.
The system of financial management of defense resources is becoming a complex, dynamic, interoperable,
and integrated process. The main purpose of this process is management of maintenance and capacity
building of the Ministry of Defense and the Serbian Army to achieve the defense objectives of Serbia. Finally,
the purpose of defense resource management process is the provision of conditions for achieving the
mission and tasks of the defense system.
772

However, the process of resource management is not just a technical procedure, but also an important
political process. In the event that there is no political will and consistency in terms of sustainability of the
planned and predicted values, there is a risk that the budgeting process could turn back into the allocation of
available financial resources, as it has been the case until the year of 2010.

REFERENCES

Dess, G., Lumpkin, G. & Eisner, A. (2007). Strategijski menadment. Data status, Beograd.
European Commission, (July 2007).Guidelines for ec support to sector programmes short version
orevi, R. (1999). Planiranje, budetiranje i potronja sredstava za finansiranje odbrane u realnim
uslovima, doktorska disertacija, Beograd,
Zrnic B. (2007). The New Trends In Defence Planning And Their Impact On The Defence Planning Systems
In Transitional Countries. Royal College Of Defence Studies, London.
Joksimovi, S. & Kneevi, M. (2008). Model kratkoronog odbrambenog planiranja. XXXV Simpozijum o
operacionim istraivanjima SYM-OP-IS 2008.
Kova, M. & Stojkovi, D. (2009). Strategijsko planiranje odbrane. Vojnoizdavaki zavod Beograd,
Kneevi, M. (2008). Budetiranje kao faza procesa PPBI. Vojno delo br.04, Beograd.
Robbins,S. & Coulter, M. (2007). Management. 9th edition, Pearson Prentice Hall, New Jersay,
Nordhaus, S. (2007). Ekonomija. MATE, Zagreb.
Ministarstvo odbrane Republike Srbije. (2010). Pravilnik o planiranju, programiranju, budetiranju i izvrenju
u Ministarstva odbrane i Vojsci Srbije. Beograd.
Vlada Republike Srbije, (2007). Smernice za izradu godinjeg operativnog plana (GOP), Beograd
Grupa autora., (2008).Razvoj i uvoenje sistema PPBI,(Studija), Ministarstvo odbrane.

773

MEASURING FINANCIAL DISTRESS OF VELEFARM AD BELGRADE,

USING ALTMAN Z-SCORE MODEL
1

Bojan Rupi , Milan Pasula , Branislav Nerandi

DIJ-AUDIT doo Belgrade, e-mail: bojanspurs@gmail.com
2
University in Novi Sad, Faculty of Tehnical Sciences, e-mail: milan.pasula@gmail.com
3
University in Novi Sad, Faculty of Tehnical Sciences, e-mail: branen@uns.ac.rs
1

Abstract: The study of bankruptcy is becoming more relevant regarding the fact that even large companies
are failing and therefore causing economic and social problems to the society. Using financial distress
models to predict failure in advance is for most businesses absolutely essential in their decision making
process. Hence, this study involves a critical investigation in the process of applying the Altman Z-score
model in predicting financial distress in Serbia. The Altman model was developed in a different economic
environment, time horizon, industry and country. Testing this model in the Serbia context is important for
determining practical applicability and relevance of the model. The main objective of the study is to test the
Altman model in determining practical predictive ability of failure in selected company - Velefarm AD,
Belgrade, listed on the Belgrade Stock Exchange and to comment on the model applicability according to the
empirical results. The data in the research consist of financial statements of Velefarm AD for the period of
2008-2010. The study is designed into three sections. The first section will discuss the theoretical aspects of
the study. The second part will be the discussion of the research results, and finally the conclusion and
recommendations of the study will be presented. Based on the conducted empirical research over financial
statements of Velefarm AD, Z-Score model predicts bankuptcy for this company. The empirical results are
interesting since they can be used by company management for making financial decisions, by regulatory
authorities and by portfolio managers in stock selection.
Keywords: financial ratios, bankruptcy, Z-Score model, Altman, financial statements

1. INTRODUCTION
Disclosure of the fact that the company is about to collapse represents fundamentally important knowledge
which allows following the development of finance - threatening phenomena which might become a threat to
the company's existence. It is important to have general financial outlook, methodology for monitoring the
phenomenon and the people responsible for such monitoring and reporting the findings, along with the
opinion about the implications and recommendations for dealing with the problem. Instruments for monitoring
the emergence of financial distress represent the set of analytical tools that can be used alone or in
combination. Financial distress is the situation when a company does not have capacity to fulfill its liabilities
to the third parties (Andrade & Kaplan, 1998).
In making an investment, investors need to know how much risk they are taking. This paper attempts to
answer how can we predict which businesses are likely to go bankrupt? About 40 years ago, Edward I.
Altman set out to answer this question. Altman, then a financial economist at New York University's
Graduate School of Business, developed a model for predicting the expectancy that a firm would go
bankrupt. His model uses five financial ratios that combine in a specific way to produce a single number
(Milojevi, 2012). This number, called the Z-Score, is a general measure of corporate financial health. Later,
Altman developed a modified version for private manufacturing firms and a second version for use by all
businesses (Muller, 2008). This article describes the first original version, which is easy to use in Excel or
similar application.
For this study, Altman Z-Score model is applied to Velefarm AD, Belgrade, one of the the biggest wholesaler
of medications and medical products in Serbia, which is listed on Belgrade Stock Exchange since 2003. The
data in the research consist of financial statements of Velefarm AD for the period of 2008-2010 (BELEX
Belgrade, 2012). The study is focus on the potential bankruptcy of Velefarm AD.

2. ALTMAN Z-SCORE MODEL

774

The Z-score model of Edward I. Altman which was created at the end of the 60's of the last century. It
attracted the attention of experts and was greeted with hope that it can be a very important tool for early
detection of financial distress.
The intention of the model authors was to give investors an opportunity to evaluate (with one expression)
status of financial distress, which might be better described as the probability that the company will enter into
insolvency and threat to its existence (Gruszczynski, 2004). It is known that in evaluating the financial
condition of a firm we can use many indicators based on the correlation between the two categories (ratios).
Over time, these ratios drastically increased and those numbers alone have led to confusion. In a variety of
ratios user does not have a clear idea on which to rely. In other words, an important issue emerged: Which
ratio of gives reliable information on the status of the debtor? In response to this question Altman made the
interesting structure which he called Z-score. Z-score model is based on a number of other terms, and all
these expressions are in circulation in the financial professional community. Z-score model is an expression
by which investors can make reliable investment decisions or judgments about whether their investment is
safe or compromised.
Based on the above results, it is suggested that the Z-Score model is an accurate forecaster of failure up to
two years prior to distress and that accuracy diminishes substantially as the lead time increases.
Z score bankruptcy model:

Z 1,2 X 1 1,4 X 2 3,3 X 3 0,6 X 4 X 5

(1)

Original z-score component definitions variable definition weighting factor:

where

X 1 = Working Capital / Total Assets

X 2 = Retained Earnings / Total Assets

X 3 = Earnings Before Interest and Taxes / Total Assets

X 4 = Market Value of Equity / Total Liabilities

X 5 = Sales / Total Assets
Z = overall index.

X 1 , Working Capital/Total Assets.

The working capital/total assets ratio, is a measure of the net liquid assets of the firm relative to the total
capitalization. This ratio measures liquid assets in relation to the size of the firm. Working capital is defined
as the difference between current assets and current liabilities. In general, a firm experiencing consistent
operating losses will have shrinking current assets in relation to total assets. This ratio proved to be the most
valuable liquidity ratio ever evaluated (Altman, 2000). Company which doesn't have sufficient working capital
is handicapped and vulnerable to financial stress. Lack of working capital inevitably lead to insolvency.
X 2 , Retained Earnings/Total Assets
Retained earnings is the account which reports the total amount of reinvested earnings and/or losses of a
firm over its entire life. It measures profitability that reflects the firm's age and earning power. The account is
also referred to as earned surplus. It should be noted that the retained earnings account is subject to
"manipulation" via corporate quasi-reorganizations and stock dividend declarations. The age of a firm is
implicitly considered in this ratio. For example, a relatively young firm will probably show a low Retained
Earnings/Total Assets ratio because it has not had time to build up its cumulative profits. Therefore, it may be
argued that the young firm is somewhat discriminated against in this analysis, and its chance of being
classified as bankrupt is relatively higher than that of another older firm, ceteris paribus. The incidence of
failure is much higher in a firms earlier years. In addition, this ratio measures the leverage of a firm. Those
firms with high Retained Earnings, relative to Total Assets, have financed their assets through retention of
profits and have not utilized as much debt.
If the balance sheet shows both retained earnings and a loss, we will take the difference between retained
earnings and a loss. This difference can be negative, which will happen when the retained earnings are less

775

than the loss. In this case, the ratio beween loss and total assets is negative as well. When the company
shows only the loss in the balance sheet, then the Retained Earnings/Total Assets ratio is negative, too.

X 3 , Earnings Before Interest and Taxes (EBIT)/Total Assets.

This ratio is a measure of the true productivity of the firms assets. It recognizes operating earnings as being
important to long-term viability. Since a firms ultimate existence is based on the earning power of its assets,
this ratio appears to be particularly appropriate for studies dealing with corporate failure. Furthermore,
insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of the firms assets
with value determined by the earning power of the assets. Altman (2000) point out that this ratio continually
outperforms other profitability measures, including cash flow (p. 11).
Although financial reports in Serbia are in compliance with IAS/IFRS, Earnings before interest and taxes
need to be adjusted, with respect to the fact that distribution of positions within the income statement in
Serbia differs from its equivalents in the USA. Earnings Before Interest and Taxes represents gross profit
increased by interest expenses. However, if instead of a gross profit they achieved a loss, then the loss is
subtracted from interest expenses, and that means that this result could be negative, which happens when
the loss is greater than interest expenses In that case, Earnings Before Interest and Taxes/Total Assets ratio
is, also, negative.

X 4 , Market Value of Equity/Book Value of Total Liabilities

Equity is measured by the combined market value of all shares of stock, preferred and common, while
liabilities include both current and long term. The measure shows how much the firms assets can decline in
value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm
becomes insolvent. This ratio adds a market value dimension. It also appears to be a more effective
predictor of bankruptcy than a similar, more commonly used ratio; net worth/total debt (book values). There
is added Dimension of Market so, even if the market capitalization is higher and more sustained, confidence
in the soundness of the financial position of the company is greater.
X 5 , Sales/Total Assets
The capital-turnover ratio is a standard financial ratio illustrating the sales generating ability of the firms
assets. This is a standard measure for total asset turnover which varies greatly from industry to industry. It is
one measure of managements capacity in dealing with competitive conditions. This final ratio is quite
important because it is the least significant ratio on an individual basis. However, because of its unique
relationship to other variables in the model, the sales/total assets ratio ranks second in its contribution to the
overall discriminating ability of the model.
Table 3: Relative contribution of the variables
Variable
Coefficients

In total:

Percent (%)

X1
X2

1,2

16,00

1,4

18,67

X3

3,3

44,00

X4

0,6

8,00

X5

1,0

13,33

X 1 to X 5

7,5

100,00

The above formula clearly shows that the author does not give equal importance to all factors. According to
the above mentioned the top priority goes to X 3 - Earnings Before Interest and Taxes/Total Assets.,

X 2 - Retained Earnings/Total Assets, then X 1 - Working Capital/Total Assets, then X 5 Sales/Total Assets and finally X 4 - Market Value of Equity/Book Value of Total Liabilities with the lowest
followed by
coefficient.
According to this model, zones of Discrimination are:
776

Z > 2.99 -Safe Zones, this means bankruptcy risk is low. The higher the score, the better the
company's chances of avoiding bankruptcy.
1.81 < Z < 2.99 -Grey Zones, bankruptcy risk is possible, but not likely in the near-future
Z < 1.81 -Distress Zones, bankruptcy risk is high.

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior
to the event, with a Type II error (false positives) of 6% (Altman, 1968). In a series of subsequent tests
covering three different time periods over the next 31 years (up until 1999), the model was found to be
approximately 8090% accurate in predicting bankruptcy one year prior to the event, with a Type II error
(classifying the firm as bankrupt when it does not go bankrupt) of approximately 1520% (Altman, 2000).
Over the time, the Z-scores gained wide acceptance by auditors, management accountants, courts, and
database systems used for loan evaluation (Eidleman, 1995).
The Z-Score is not intended to predict when a firm will file a formal declaration of bankruptcy. It is instead a
measure of how closely a firm resembles other firms that have filed for bankruptcy. It is a measure of
corporate financial distress, a measure of economic bankruptcy.
Z-Score model weaknesses are:
A prerequisite for any serious analysis of financial statements and therefore the prediction of bankruptcy,
is that the financial statements are examined by an independent auditor. In the case of poor quality and
unreliable financial information, Z-score test is useless and this model can't be compensated for deficiencies
in the quality of financial information.
Companies that have a low EBIT level have no chance of success when it comes to this test. Hence so
much emphasis on state EBIT ratio by 3.3 (Kidane, 2004).
This model does not take into account the issue of cash flow despite the fact that a cash flow represents
a basis for payment and maintaining liquidity and safety. We should bear in mind the fact that cash flow is
given significant attention only recently, and at the moment when the model was created, was not largely
popular.
Although this model is directed towards the future since it is designed as a tool for assessing companies
bankruptcy, it takes into account only the historical data while any predictions of the future have no place in
the model.
And yet, despite these concerns, the original Z-Score model is the best-known and most widely used
measure of its kind (Pranovo, Achsani, Manurung, Nuryartono, & Nunung, 2010). This measure is not
perfect, but it's easy to calculate in Excel and many practitioners continue to find it useful.

3. APPLYING THE ALTMAN Z-SCORE TO VELEFARM AD

Joint-stock Holding Company Velefarm Belgrade (hereinafter also referred to as Velefarm AD, the Company)
is one of the the biggest wholesaler of medications and medical products in Serbia. Velefarm AD is the
partner of biggest domestic and international producers of medications, medical equipment, medical devices,
parapharmaceuticals, and specialized medical programs products. Velefarm AD has region-wide distribution
network in Serbia, Bosnia and Herzegovina (Republika Srpska) and Montenegro. In the year 1999 Velefarm
AD was the first Serbian company in the industry to implement a certified quality management system. The
Company owns the largest, cutting edge storage facilities equipped with specialized chambers (VELEFARM
AD, 2012). At the end of 2010., the Company had 142 employees.
Velefarm AD is listed on Belgrade Stock Exchange since 2003.
Velefarm AD seems like a good candidate for applying the Z-score given the size and reputation of the
company, and the fact that there are evident signs of poor performance in the previous three years. Namely,
the company has for years benefited and then in 2009 it began to suffer a great loss. The net loss for 2009.
was RSD 2,108,178 thousand (approximately EUR 21,986 thousand), and net loss for 2010. was RSD
2,716,458 thousand (approximately EUR 25,749 thousand). At the time of writing this paper, data on
financial results for 2011 were not yet known.
Auditor of the company is in Independent Auditors Report on Financial Statements of Velefarm AD as of and
for the year ended 31 December 2010, draw attention to the following matters: the Company operates with a
shortage of permanent capital and working capital, The Company incurred a net loss of RSD 2,716,458
777

thousand during the year ended 31 December 2010, the Companys operations are burdened with the
cosequences of the global financial and economic crisis, which has a negative impact on the activities of a
significant number of companies in Serbia and Europe. These conditions indicate the existence of a material
uncertainty which may cast significant doubt about the Companys ability to continue as a going concern.
The company is in the process of negotiations over the restructuring of contractual obligations to creditors
and suppliers and in the process of finding new sources of long-term finance.
Stock market price of the company also indicates a bad situation and which amounted to RSD 1,000 on
December 31, 2010 and on the same date in 2009 same stock was worth RSD 2,444, and only a year earlier
(in 2008, last year when the company had positive financial result) market price of shares was RSD 3,280.
The latest data from the Stock Exchange from December 31, 2011. which amounts only RSD 300 per share,
indicate a deepening distrust of the company and pessimistic forecasts about the recovery of the company in
2012.
In this situation, it is interesting to see the results of Z-Score model for the observed firm based on data from
financial statements available for the last three years (2008-2010). The results are shown in Table 2.
Table 2: Z-score test of Velefarm AD
Variable
2008

2009

2010

X1

13,175,917/26,549.931 = 0.4963

3,555,457/16,614,687 = 0.2140

1,564,220/13,879,356 = 0.1127

X2

160,724/26,549,931 = 0.0061

(4,656,102)/16,614,687 =
(0.2802)

X3

1,534,900/26,549,931 = 0.0578

(137,185)/16,614,687 = (0.0083)

X4

5,113,831,600/20,401,092,000 =
0.2507

1,559,095.000/13,690,321,000 =
0.2783

(7,013,266)/13,879,356 =
(0.5053)
(1,527,868)/13,879,356 =
(0.1101)
1,559,095,000/13,684,357,000 =
0.1139

X5

9,845,659/26,549,931 = 0.3708

5,402,261/16,614,687 = 0.3251

2,009,966/13,879,356 = 0.1448

Z score:

1.316

0.3292

(0.7224)

Negative Z-Score shown in the obtained results can also be displayed graphically:

Figure 1: Z-score of Velefarm AD, Belgrade (2008.-2010.)

Based on the above results shown in Figure 1, all of the observed ratios show a deteriorating trend. In the
observed period, calculated Z-score was in Distress Zones (Z < 1.81). The Z-Score model forecasts that
Velefarm AD is approaching bankruptcy. Negative trend indicates this scenario of Z - overall index, which fell
from 1.316 in 2008 to the negative 0.7224 in 2010. Time will tell if the forecast is correct.
778

4. CONCLUSION
This model, when it was created, caused a great deal of attention and was received with high credibility, and
it appears that its actuality its not an issue even today. However, because of the limitations that are inherent
to this model it should be used with other tools and financial indicators.
Although this test provides an excellent insight and synthetic view of the financial condition of companies
observed, this model should not be only prediction tool. In the present test of Velefarm AD, model only
indicates a problem, but for a reliable diagnosis it is necessary to perform a series of additional tests. This
research points to the possible application of the Altman Z-Score test in Serbia, in which case minor
adjustments are needed (Earnings Before Interest and Taxes adjustments).
In the past three years Velefarm AD has constantly been in Distress Zones, which means that bankruptcy
risk is very high. The Z-score of the Company is constantly decreasing during this period, and in 2010 was
even negative (-0.7224). The results indicate the imminent bankruptcy of Velefarm AD, Belgrade.
The empirical results are interesting since they can be used by company management for financing
decisions, by regulatory authorities and by portfolio managers in stock selection.

REFERENCES
Altman, E.I. (1968, September). Financial Ratios, Discriminant Analysis and the Prediction of Corporate
Bankruptcy. Journal of Finance. 589-609.
Altman, E.I., (2000, July). Predicting financial distress of companies: Revisiting the Z-score and Zeta models.
Altman, E.I., Haldeman, R., & Narayanan, P. (1977). Zeta Analysis: A New Model to Identify Bankruptcy Risk
of Corporations. Journal of Banking & Finance, 1.
Andrade & Kaplan. (1998). How Costly is Financial (Not Economic) Distress? Evidence from Highly
Leveraged Transactions that Became Distressed. Journal of Finance 53, 1443-1493.
Eidleman, Gregory J. (1995, February). Z-Scores A Guide to Failure Prediction. The CPA Journal Online.
Gruszczynski, M. (2004, November). Financial Distress of Companies in Poland. IAER Vol. 10, No. 4.
Milojevi, M.M. (2012, March). Altmanovim testom na finansijsku krizu. Revizor 57/2012.
Muller, G.H. (2008, March). Development of a model to predict financiall distress of a companies listed on
the JSE. Paper presented at the in partial fulfilment of the requirements for the degree of Master of
Business Administration at the University of Stellenbosch.
Kidane, H.W. (2004, November). Predicting financial distress in IT and services companies in South Africa.
Paper presented in accordance with the requirements for the degree Magister comercii in the Faculty of
Economic and Management Sciences Department of Business Management University of the Free
State, Bloemfontein, Republic of South Africa
Pranovo, K., Achsani, N.A., Manurung, A.H., Nuryartono, & Nunung, N. (2010). Determinant of Corporate
Financial Distress in an Emerging Market Economy: Empirical Evidence from the Indonesian Stock
Exchange 2004-2008. International Research of Finance and Economics.
BELEX Belgrade. (2012). Belgrade Stock Exchange. Retrieved from http://www.belex.rs
VELEFARM AD Belgrade (2012). Official site of VELEFARM AD Belgrade. Retrieved from www.velefarm.rs

779

FINANCIAL SUPPLY CHAIN MANAGEMENT - NEW SOLUTIONS FOR

CASH FLOW PROBLEMS
Duan Sakovi1 Milo Ili2 Ana Bojovi3
Hidrozavod DTD, ad Novi Sad, dusansakovic@yahoo.com
2
Erste bank, ad Novi sad, milosilic.ns@gmail.com
3
Eurobank EFG, ana.bojovic@eurobankefg.rs

Abstract: The aim of this paper is to present new trends and practices in cash flow management of an
enterprise, and to show how the concept of financial supply chain management, as a modern solution of
cash management but also as a new strategic approach, can help the company raise the efficiency of
financial operations, reduce costs and increase profitability. In the analysis were used the achievements of
financial theory and practical experience of large companies in cash flow management. Adoption of ideas,
techniques and FSCM tools contribute to improving key performance indicators of financial flows, thus they
increase the efficiency of operations along the supply chain and enable successful implementation of
strategies of creating maximum value for consumers. Maintaining liquidity, faster circulation of funds and less
engagement of working capital are particularly important goals in times of crisis when the financial and real
sectors encounter lack of fresh money. Therefore the FSCM is a very relevant issue of concern to financial
managers of companies of all sizes and industries, especially those who deal with a large number of invoices
relating to customers and suppliers on a daily basis.
Keywords: financial supply chain management, cash flow, liquidity.

INTORODUCTION
Modern business conditions, often characterized as dynamic and complex in front of companies and their
managers put great challenges. The expansion of business across national borders, mass communication, a
large number of suppliers and customers, the growing importance of accurate and timely information, have
created conditions for the existence of global markets and global competition in all industries. In these
conditions of New economy in order to operate successfully companies must optimize their operations in
the way that will make maximum savings in all aspects of business, starting at procurement, production all
the way to the distribution of products and services and collection of receivables. The dominant strategy
becomes the strategy of activity management in all phases of supply chain, and as a primary goal the
creation of the maximum value for customers with minimum costs for all participants in the chain.
In dynamic business conditions there is a growing corporate demand for financially efficient supply chains,
with companies and their suppliers under conflicting pressures to improve payment terms, reduce prices and
improve cash flow efficiencies. In order to achieve true efficiency within the financial supply chain,
organizations must take a holistic approach and consider how to improve communication and integration
between different parts of the business, as well as continuously improve the efficiencies of their working
capital processes.
Within any corporate's organizational structure, there are numerous departments that all have an impact on
the financial supply chain in some way. For example, procurement department manages procurement terms
and sourcing, the treasury department manages working capital while the sales department generates
revenues. There is also the finance department that manages all commercial payments, accounts receivable
and payable. The problems that many organizations face, however, are the lack of coordination and
integration between departments in handling the supply chain. Each department often has its own agenda
and its on set of key performance indicators (KPIs), so the efficiency of the supply chain may not be
foremost in their mind when it comes to their everyday activities.
Financial supply chain management (FSCM) has the task to integrate all financial processes within the
supply chain, to influence on growth of the financial KPI's, because only an efficient, on information
technologies based FSC, can provide an adequate platform for the implementation of strategies of creating
maximum value for the consumer with minimal costs for all participants in the chain.

780

1. RELATIONSHIP BETWEEN FINANCIAL SCM AND PHYSICAL SCM

Optimization of business processes from suppliers to the final customers with maximizing the total value
generated for consumers is a basic principle on which to base strategies that recognize the SCM. Managing
the physical supply chain is a long-standing practice of many companies, especially those who have chosen
as a strategic option to create maximum value for consumers. According to Scott, Lundgren, Thompson
(2011) physical or manufacturing SCM refers to the savings that are realized in relation to service areas:

Transportation;
Warehousing;
Finance;
Market research;
New product design;
Information, communication and technology (p.6).

The focus to date for many organizations has been the physical supply chain. Supply chain managers have
worked hard to build cross-functional teams bringing together managers from sales and marketing,
operations, procurement and logistics. Internal and external collaboration with suppliers and supply chain
partners, particularly around logistics, has been the business priority.
In today's world of global trade, supply chain management is considered normal and often the necessary
strategic approach, which requires a much greater capacity and expertise of professional managers who
participate in the organization of the supply chain. Today, supply chain measure thousands of kilometers,
tons and minutes and therefore anyone who works on the principles of activities management within the
supply chain has the possibility to achieve large savings that he can bring a competitive advantage in the
market and increase profitability in the long run.
Historically FSC is regarded as an independent process from manufacturing supply chain. Creating and
transmitting value from vendor to the final customers is separately seen from the material aspect and the
aspect of finance or cash flows. The functioning of a modern supply chain involves the necessity of closer
links with all key business functions that are included to information, goods and money flows within and
between different enterprises. Supply chain according to Braun (2008) encompasses three parallel flows:

Physical supply chain: The flow of services or products, such as raw materials, that moves between
the buyer and seller within the supply chain.

Financial supply chain: The flow of financial transactions that pays for the physical goods or
services.

Information flows: Information associated with the payment for products and services also flows
through the supply chain. This includes purchase orders, inventory documents, confirmations and invoices.
The information initiates the physical flow of products and services as well as the financial transactions. It is
a supportive flow and part of both the financial and physical supply chains (p.1).

DOWNSTEREAM: Material, Information & Financial

Supplier

Manufacturer

Distributor

UPSTREAM: Material, Information & Financial

Figure 1. Flows in the Supply Chains (Hausman, 2005. p.3)

781

Customer

The FSC can be defined simply as the flow of cash between businesses along the supply chain, which can
be in the form of a payment between buyer, broker, carrier, third party logistics agent (3PL) and suppliers, or
in the form of finance, either from a bank, financial institution or a supply chain partner willing to lend in the
form of an early or extended payment. This definition needs to be extended to embrace the exchange of
assets and liabilities within the working capital management cycle, again across the entire supply chain.
Therefore, besides cash and bank debt, this also includes account payables, account receivables and the
movement of inventory or stock.
According to the Robinson (2007) at the heart of FSCM is the management of working capital and financial
flows, but equally important is the management of information across the chain and the documents and data
that support these flows, such as purchase orders, advanced shipping notices, invoices and payment
approval processes. Much of the data contained in these documents is the same information that is used to
efficiently manage ever more complicated physical flows (p.1).
Managers agree that sharing critical information, in real time, has been shown to reduce costs dramatically
and improves the performance at all SC levels. Collaboration by sharing information has joined the ranks of
integration and automation as a hallmark of competitive advantage in the supply chains (Marquez, 2010).
The convergence of physical and financial supply chains around increasingly electronic information flows has
been a key feature of recent years.
Opportunities for greater savings related to the physical supply chain are mostly exhausted. Days required
for processing the orders were reduced from 5-7 days to 1 day, the time required for delivery of goods to
customers decreased from 2-3 weeks to 2 days. In recent decades there has been little progress in the areas
of billing, receivables management and collection, assessment of client's credit ratings in general money
management, so that today these areas are becoming the primary place for business improvement and
generation of savings. FSCM as a set of knowledge, activities, tools for managing financial activities need to
integrate, support and monitor physical activities of supply chain.

Figure 2. Connection between FSCM and production SCM (Philips, 2003. slide 9).
Global environmental challenges and the emergence of the global economic and financial crisis put modern
financial management in even more difficult situation. Cash management and provision of liquidity represent
a great challenge for financial managers today. Optimization of financial operations while maintaining the
practice adopted, in relation to physical SCM, is becoming a trend for all companies who adopted a proactive
approach and who are prepared to meet the emerging changes in the business. Proper management of
financial flows and using modern tools, supported by information technology products, provide great
opportunities to increase efficiency through automation and speeding up financial processes and eliminating
the most significant vulnerabilities of financial operations, such as slow processing vendor invoices and
reconciliation, a large amount captured working capital, the slow collection of receivables from customers,
complicated and slow credit rating scoring, the more difficult possibilities of raising funds from banks.
2. CASH FLOW CHALENGES
The financial crisis of 2008 showed that corporate finance volume depends not only on the market position
nor structure of physical products, but also on the general health of the financial markets. Corporate's have
felt the impact on trade credit, bank loans and cash flow in general, experiencing a shortage of liquidity. This
is critical as sufficient liquidity is a fundamental condition when entering into a new business ventures or
keeping existing alive. Without adequate liquidity support from banks or from business partners, some
corporates could become insolvent because they would not have sufficient liquidity to pay their obligation.
782

The challenges facing companies today in the cash flows management come from the mass business
activity, the more complicated financial relations and transactions between trading partners and between
groups within large companies. Financial flow in the supply chain of a typical global enterprise includes
thousands of invoices for which related payments and charges have to be addressed and processed.
Problems such as slow processing of data, unreliable and unpredictable cash flows, expensive processes,
high days sales outstanding (DSO) ratio, inappropriate decisions regarding the assessment of credit risk are
caused partly by the effects of economic crisis and partly by using non holistic and non integrated method of
money management, which is not based on the ideas of FSCM and the ideas of cooperation of all functions
across the supply chain. Some of the internal causes of these miss functionalities and the reason for the
emergence of a growing interest CFO's for better management of cash flows according to Hausman (2005)
are:

Manual and stand-alone processes. Manual processes tend to be slow, unreliable, unpredictable,
and in the final analysis, often more costly than automated solutions.

Lack of timely information. In many situations, financial flows do not contain sufficient detailed
information for either manual or automated systems to accomplish their jobs. As a result, additional time and
effort is required to obtain missing information (e.g., invoice-level detailed information such as item quantities
and purchase order numbers).

Lack of employee empowerment and compliance. If purchasing by individuals isnt carefully

monitored and controlled, inappropriate spending may occur, undermining the companys initiatives to control
expenses and improve strategic sourcing.

Delays in invoice reconciliation. Delays in invoice reconciliation are a particular cause of additional
working capital. They delay receipt of payments and increase days sales outstanding. When there is a threeway mismatch of invoice, P.O., and shipping receipt, there is an inevitable delay while the mismatch is
investigated. These investigations typically take time, as well as add cost.

Manual processes for setting optimal credit limits. Companies often maintain their own departments
to set customer credit limits. However, the ability to set optimal credit limits may require sophisticated
algorithms that are often inaccessible to non financial companies (p.6).
Modern business conditions, followed by world economic crisis contributed to creating new streams in
financial practice. Now the most significant source of short-term financing for companies becomes trade
finance. Relationship with vendors and customers and adequate managing of receivables and liabilities
today are the most important instrument for companies looking to optimize short-term bank loans and is a
strong determinant of corporates financing costs. FSCM requires particular care to preserve the balance
among established financing partners (Cavenaghi, 2012). Previously companies sought to extend their
payments terms as long as possible, but now it is widely recognized that pushing cost and risk down the
chain is no longer an effective proposition. Companies must work together to overcome raising challenges,
so improving efficiencies across the whole chain, and therefore improving efficiencies for all parties, is now
the ultimate goal.
3. FSCM-MODERN APPROACH
Adopting a strategic approach of creating maximum value for the consumers at minimal costs for all
participants in the supply chain from companies requires cooperation and integration processes at all levels
not only in relation to the physical-logistic aspect of business but also in the field of finance and information
exchange. In practice, according to Cohen and Roussel (2005) this means achieving:

Enterprise connectivitybusiness and transactional systems that are linked, allowing data to be
seen and transported to different entities within the supply chain

Distributed decision makingbidirectional information flow and defined business rules used to
manage ongoing changes in demand and supply

Real-time performance managementreal-time, accurate information available to enable rapid and

informed decision making (p.232).
783

Financial management in accordance with the principles FSCM can enable more efficient and effective way
of managing cash flows which are every day more and more complex. In recent years much attention is paid
to information technology, channels of mass communication and the opportunities they provide for improving
the financial operations of the company. Current trends in the management of cash flows increases the
efficiency of FSC through the application of new solutions in dealing with customers, suppliers, creditors, etc.
Some of these solutions according to Hausman (2005) are:

Purchasing cards and distribution cards. More and more companies are installing purchasing cards
(P-Cards) as a way of making purchasing more efficient and cost-effective. P-Card systems also enable
companies to aggregate spend data quickly and frequently, and to maintain compliance with company spend
policies. They also increase financial transparency and help companies adhere to regulations. The
distribution card is designed to re-engineer distributors and wholesalers accounts receivable (A/R) process
through the replacement of cash, customer credit and promissory notes. By shifting the manual-driven
process and burden of invoicing and collections from the distributor to the bank, the distribution card
transforms the collection process into a quick paperless electronic payment, reducing accounts receivable
(A/R) costs substantially. Sales proceeds can be immediately transferred into working capital for faster
turnover.

Electronic invoice presentment and payment (EIPP). Gradually, companies are moving toward
electronic invoice presentment (EIP) and electronic invoice presentment and payment (EIPP). Todays new
EIPP tools provide an excellent opportunity to perform financial flow and information flow tasks at the same
time. The ability to send detailed invoice-level information (quantities, P.O. numbers, etc.) along with
remittances enables the supply chain to transfer this information quickly and without errors often found in
manual procedures.

Invoice imaging. Some companies are creating soft copy images of paper invoices so that all
payments can proceed along an electronic, paperless pathway. Others are creating data warehouses to
maintain line item detail, with information from a P-Card solution or other sources.

Supplier web portals for invoice inquiries. Another significant trend is to develop web-based
automated inquiry systems for suppliers. Instead of accessing a call center to make a simple inquiry,
suppliers can access a web portal for their company and perform self-service inquiry regarding the status of
their invoices (received, in payables queue, in reconciliation queue, scheduled to be paid as of a certain
date, etc.).

Web-based financial reporting. To reduce costs, significantly improve spend management, and make
more informed business decisions, many companies are finding that its critical to electronically capture
financial transaction and invoice-level data and then review it through a web-based reporting tool. This
transaction and invoice-level data may be easily integrated with existing back office financial systems (p.7).

784

Best practice: Financial supply chain management with SAP ERP

SAP Financial Supply Chain Management (FSCM) supports companies
optimizing their cash flows within the whole supply chain (from vendor to
customer). That is, the financial process that accompanies the "real"
business process from a financial point of view often offers potential for
improvement in the areas of invoicing and reconciliation. The aim of the
FSCM SAP component is to improve an organizations cash flow mainly in
the Order to Cash business process. Components of FSCM are:

SAP Credit Management- provides companies with the opportunity to

monitor the total liability of their customers by using appropriate credit
lines.

Electronic Bill Presentment and Payment (SAP Biller Direct)- allows billers
to send and customers to receive invoices electronically and making
invoicing more efficient.

SAP Dispute Management-offers the system support for processing

payment deductions.

SAP Collections Management- allows you to structure, classify and

minimize the receivables owed to your organization.

SAP Cash and Liquidity Management- supports the cash manager in

efficiently managing liquidity and currency risk.

SAP Treasury and Risk Management- offers a comprehensive set of

functions for managing your financial transactions and risk.

SAP In-House Cash- application allows diversified companies to optimize

intra-group
payment
transactions
by opening
in-house
bank in the computers field, modern
All newtheir
trends
in relation
to cash
flow management
relyanon
achievements

SAP
Bank
Communication
Managementis
used
for
managing
multiple
means of communication and data exchange. In order to realize successful
implementation of strategies
bank
communication
interfaces,
enabling
you
to
connect
to
your
bank,IT infrastructure, knowledge
based on FSCM company and its business partners must have the appropriate
tracktothe
entire
payment
life cycle
of a transaction
andofimprove
straightand ability
adapt
to new
challenges.
Education
and training
employees
and all other participants in the
through
processing
rates
and
internal
compliance
(Adelsberger,
Khatami,
supply chain becomes continuous duty. A prerequisite for the successful management of financial supply
Khatami,
2011) of adequate communication channels based on the internet, allowing rapid exchange
chain is
the existence
of large amounts of data, hardware devices and software solutions as well as qualified personnel. If such
conditions are met a basic platform is created for the successful cash flow management, increasing the
efficiency of financial operations and costs reduction.
4. FSCM MAKING CASH FLOW EFFICIENT
The adoption of new strategies and the introduction of new management practices of enterprises cash flows
is caused by the growing need for raising the efficiency of overall operations. Improving the performance of
financial operations, and therefore the overall results of the company means overcoming difficulties related
primarily to the liquidity and eliminating the causes of their origin, through the implementation of latest
achievements in financial management practice along the supply chain.
Firstly, FSCM practice contributes to improving the process of reconciliation of documents related to
suppliers and customers. Matching shipping receipt, corresponding purchase order and invoice is now
electronic, which reduces errors, speeds up the process of reconciliation accounts because the matching is
done in the earlier stages of the process. Speeding up cash flow along the chain helps companies to save
working capital, use it for covering other expenses or increasing profitability.
Secondly, modern solutions for managing electronic billing operations give the analytical possibilities to
CFO's because they provide sufficient invoice detail so that many mismatches can be quickly diagnosed with
the information provided electronically. This speeds up the reconciliation process significantly and
accomplishes it at much lower cost. Cooperation between business partners in the supply chain is lifted to a
higher level; all participants are now dedicated to creating maximum value for the end customer. The flow
and exchange of information becomes significantly easier and quicker. Companies now have the ability to
use common portals, for the information support to all participants in the supply chain.

785

Lastly, FSCM delivers company and its partners new capabilities in money management through a reduction
days sales outstanding, reduce errors, transparency of business operations, better access to information,
effective planning and control of cash flows, which ultimately results in less involvement of working capital,
reduced operating costs. All this results in increased liquidity KPIs such as current liquidity ratio, future
liquidity ratio, general liquidity ratio, supplier and customer turnover ratio (Vunjak, 2005).
The adoption of new strategies and the introduction of new practices in the management of cash flow of an
enterprise imply a new way of organizing the financial function. The transition from manual processes to new
fully or partly automated carries on certain risks related to system reliability, data protection from non
authorized access, the time needed to learn new technology by staff and acceptance by the business
partners etc. Regardless of the often high costs of implementation and the difficulties that the company and
its business partners may have in the period of adjustment to new solutions, it is considered that potential
benefits for the company are much greater in the medium and especially long run and that the impacts on
liquidity, solvency and overall result of the company are primarily positive.
Modern business conditions require permanent adjustment of an enterprise, which despite some limitations,
must lead towards automation and increasing efficiency of business processes. Adopting the idea of FSCM
is not only a new way of performing daily activities, but also represents a new strategic approach aimed at
creating maximum value for consumers and increase efficiency particularly of financial operations of an
enterprise through the growth of cash flow KPI's.
CONCLUSION
Dynamic environment, a large number of suppliers and customers, their territorial distance, mass
communication, free flow of goods, services, people and capital have led many companies to become a part
of global market. Maintaining competitiveness in such harsh conditions of the company requires continuous
improvement in efficiency of operations, increased cooperation with business partners, and proactive
approach to problem solving. The emergence of global economic and financial crisis in 2008 pushed
companies further into uncertainty and forced them to devote more attention to finding a source of savings in
daily activities.
Common strategic direction that enterprises nowadays choose is management of activities at all stages of
the supply chain, in order to create maximum value for consumers while minimizing the cost of business
operations of all participants in the chain. So far, much attention enterprises dedicated to activities
management in relation to the physical supply chain, thus the possibilities for savings in logistics, production,
warehousing is almost exhausted. The problems that companies have nowadays are largely related to the
question '' How and where to find the cash''. Difficulties in the area of liquidity are partly a result of the effects
of the global economic crisis, and partly result of lack of adequate cash flows management. Financial supply
chain management can be defined as the flow of cash between businesses along the supply chain, including
payment between buyers, brokers, carriers, third party logistics agents, suppliers, banks etc. Also FSCM
deals with exchange of assets and liabilities within the working capital management cycle, again across the
entire supply chain. Very important part of FSCM is information flow, as the way companies interact and
exchange financial and other documents.
Today corporates feel the impact on trade credit as DSO rates are high, on bank loans as conditions for
external financing are more rigid and on cash flow in general, which has implications on more trapped
working capital and higher expenses. Now the most significant source of short-term financing for companies
becomes trade finance. Managing receivables and liabilities today are the most important instrument for
companies looking to optimize short-term bank loans and is a strong determinant of corporates financing
costs.
FSCM, based on the ideas of holistic approach and integrated money management of all functions across
the supply chain, can help overcoming miss functionalities within cash flows and the causes of their origin
such as: manual and stand-alone processes, lack of timely information, delays in invoice reconciliation, slow
processes for setting optimal credit limits etc.
Financial management in accordance with the principles FSCM can enable more efficient and effective way
of managing cash flows through the application of new solutions in dealing with customers, suppliers,
creditors such as: purchasing cards and distribution cards, electronic invoice presentment and payment
786

(EIPP), invoice imaging, supplier web portals for invoice inquiries, web-based financial reporting. Adoption of
the previous solutions of FSCM practice contributes to improving the process of reconciliation of documents.
give the analytical possibilities to CFO's, reduction days sales outstanding, reduce errors, transparency of
business operations, better access to information, effective planning and control of cash flows, which
ultimately results in less involvement of working capital, increased liquidity and reduced operating costs.
REFERENCES
Adelsberger H. H., Khatami P., Khatami T. (2011) Integrated Business Processes with SAP ERP Script 8:
Financial
Accounting
in
SAP
ERP.
Retrieved
from
http://sapcourses.wiwinf.unidue.de/course/view.php?id=61
Braun A. (2008).Corporate Cash Management Trends - Part 3: The Financial Supply Chain. Retrieved from
http://www.gtnews.com/feature/225_3.cfm
Cavenaghi E. (2012). Supply Chain Finance: Not Always a Game for Only One Investor. Retrieved from
http://www.gtnews.com/article/8613.cfm
Cohen S., Roussel J. (2005). Strategic supply chain management, The Five Disciplines for Top
Performance. McGraw-Hill Companies, Inc. USA
Hausman H. W. (2005). Financial Flows & Supply Chain Efficiency, Executive Summary. Stanford University,
US
California.
Retrieved
from
http://www.visaasia.com/ap/sea/commercial/corporates/includes/uploads/Supply_Chain_Management_Visa.pdf
Marquez A.C. (2010). Dynamic Modeling for Supply Chain Management, Dealing with Front-end, Back-end
and Integration Issues. Springer-Verlag London Limited
Phillips J. (2003). Optimizing the Financial Supply Chain. Presentation at the Windy City Summit. Retrieved
from http://www.slideshare.net/Bobtb/optimizing-the-financial-supply-chain
Robinson P. (2007). Financial Supply Chain Management - Part 1: Changing Dynamics. Retrieved from
http://www.gtnews.com/feature/178_1.cfm
Scott C., Lundgren H., Thompson P. (2011). Guide to Supply Chain Management. Springer-Verlag Berlin
Heidelberg
Vunjak N.(2005). Finansijski menadment-Poslovne finansije (6. izd.). Proleter ad Beej, Ekonomski fakultet
Subotica.

787

THE LIQUIDITY ANALYSIS OF COMPANIES IN MANUFACTURING INDUSTRY IN

SERBIA
1

Sanja Vlaovi Begovi , Dajana Ercegovac Mirela Momilovi

Higher School for Professional Business Studies, Novi Sad, sanjavbegovic@gmail.com
2
Higher School for Professional Business Studies, Novi Sad, dajana_vindzanovic@yahoo.com
3
Higher School for Professional Business Studies, Novi Sad, bizniscentar@gmail.com
1

Abstract: Debt payments of companies at maturity also imply regular payments received from customers.
Therefore, time between debt payments and received payments from custormers should be put to minimum.
Using liquidity analysis we determine if the copmany is capable to contracted debt payments at maturity. In
this paper authors present comparative analysis of liquidity ratio and cash conversion cycle between
companies in manufacturing industry in Serbia. Financial reports of 100 joint-stock companies in
manufacturing industry that have stocks quoted at Belgrade stock exchange were taken for this research.
Companies were divided into 8 groups in regard to the branch of manufacturing industry and analysis
includes three consecutive years. Based on conducted research it could be concluded that average liquidity
of all analyzed companies in defined time was gradually increased in order to have the ratio of rigorous
liquidity at satisfactory level in the last year. Nevertheless, it can be observed the deficit of cash funds at the
analyzed companies as well as the long period of time between debt payments and received payments from
customers. In conclusion authors present the measurements that companies should implement in order to
increase their liquidity and ensure the smooth business activities.
Keywords: Liquidity, cash conversion cycle, analysis, manufacturing industry.

1. PREFACE
Analysis of liquidity provides information about companys capability to meet their obligations at maturity.
Liquidity analysis in necessary not only for companies management because of efficient business
management but also for banks, suppliers, buyers, as well as insurance companies, that are interested in
liquidity of firm with which they do business. Also, liquidity analysis is important to all employees and
stockholders that expect regular dividend payment and constant growth of company.
Beginning liquidity analysis is based on determination of relation between working assets and short-term
obligations. In case of equality between short-term assets and short-term obligations the company has shortterm financial equilibrium. Equality between long-term assets and long-term financing sources brings to longterm financial equilibrium. On this way the conditions for keeping liquidity are ensured. Nevertheless, in
practice the case of absolute short-term and long-term financial equilibrium is scarce.
If long-term financing sources are exceeding the companys long-term assets, there is certainty in keeping
the liquidity, because the surplus of long-term sources can be used for financing the short-term assets.
However, if long-term assets are not covered with long-term sources and they are financed with short-term
sources, there is danger of illiquidity. Time period between generating the money and paying back matured
short-term obligations isnt a match at expense of short-term obligations. Described structure of assets and
financing sources isnt long-term sustainable and company must find way to increase their liquidity.
Also, it is necessarily to accent that liquidity analysis isnt determined just with volume of short-term assets
but also with it structure. Because of that for calculation of companys liquidity different indicators are used,
that are presented in continuation of the paper.

2. LIQUIDITY ANALYSIS ON BASE OF RATIO INDICATORS

In short-term asset structure supplies are at the last place at the liquidity degree, because they have the
slowest process of turning into cash. Next are short-term claims, short-term financial placements and cash
and cash equivalents. There are different coefficients in regard to the relations between total short-term
assets, liquidity assets and assets of large degree of liquidity with short-term obligations, such as:

788

Ratio of current (general) liquidity is calculated as relation between short-term assets and short-term
obligations. Traditional thinking that this relation has to be 2:1 in favor of short-term assets should be taken
extremely careful, as extenuate Krasulja, Ivanievi (2001) with regard that on adequacy of general ratio
have influence many general and specific factors, such as: category and size of company, business activity
volume, time bondage of short-term assets in specific phase of business cycle, crediting conditions of
suppliers in regards to the crediting conditions that are granted to buyers, efficiency of received claim
payments, discipline of matured debt payment etc. (p.23). However, ratio value larger than 2 indicates the
inefficient cash and short-term obligations management, while ratio value below 1 indicates the lack of
liquidity assets for financing short-term obligations. Shortage of ratio is reflected in structure of short-term
assets that includes supplies. Namely, company can have in their short-term asset structure large
participation of supplies that have for consequence the indication of liquidity. However, because supplies
have the slowest transformation process in cash, it is necessarily to reduce short-term assets in order to
accurately calculate the liquidity (ratio of reduced liquidity).
Ratio of reduced liquidity is calculated with putting in relation the short-term assets with excluded supplies
with short-term obligations. Given ratio indicates the number of dinars of liquidity short-term assets that
covers the one dinar of short-term obligations. This ratio needs to be larger than 1. In numerator of this
relation is cash, short-term placement in securities and receivables from customers. As receivables from
customers presents category that doesnt have to be fully transformed into cash (if customer goes to
bankruptcy and default in their obligations towards the given company), develops the need for even more
rigorous valuation of liquidity.
Ratio of money liquidity, which is calculated with putting into relation the cash and liquidity securities with
short-term obligations, shows if company possesses enough cash and highly liquidity securities to cover
short-term obligations.
Company thrives to keep the optimal structure of short-term assets and improve their quality (problem of
slow moving and obsolete inventories or uncollectible receivables from customers), that leads to the better
liquidity of the company.

3. CASH CONVERSION CYCLE

During the liquidity analysis it is necessary to take in consideration the period between the debt payments
and received payments from customers. Namely, company buys materials for product manufacturing that
represents cash outflows, but from the other side they expects cash inflows from sale of manufactured
products. It raises the question whether company receives payments from customers faster than debt
payments or debt payments to creditors are faster than received payments for sold goods.
Cash conversion cycle takes in consideration the time bondage of inventories, time bondage of customers
and time bondage of suppliers. As the time bondage of inventories implies time from first investment in
supplies until the day of sale, and time bondage of customers implies time from sale until the received
payments for sold products, combining the time bondage of inventories with time bondage of customers,
result is period in which the company is without funds. From this sum it should be deduced time bondage of
suppliers, in other words time that is necessary for debt payments of company. On this way time period
between debt payments and received payments is calculated, that is called cash conversion cycle or (Brili,
Majers, Markus, 2007):
Average supplies / (annual cost of sold products / 365)
+ Average value of receivable claims / (annual revenue / 365)
- Average value of debt to suppliers / (annual cost of sold products / 365)
= Cash conversion cycle
Time discrepancy between cash inflows and outflows is reason for cash conversion cycle analysis that can
be positive, neutral and negative. Positive cash conversion cycle indicates how much days company must
wait on received payments in order to payback its debts. Neutral cash conversion cycle (result is zero)
implies time discrepancy between cash inflows from buyers and cash outflows for debt payments. Negative
cash conversion cycle indicates number of days of money disposal before company must pay their
obligations. Accordingly, company receives payments for sold products faster than payments of their
obligations. Company tends to ensure low or negative cash conversion cycle.
789

4. RESEARCH OBJECTIVE
The papers objective is to comparatively analyze liquidity ratio and cash conversion cycle between
companies in manufacturing industry in Serbia. For purpose of these research financial statements of 100
joint-stock companies in manufacturing industry that have stocks quoted on Belgrade stock exchange are
taken in consideration. At the same time random sample selection is used. Companies are divided into 8
categories in regards to branch of manufacturing industry they belong (tobacco, machine, chemical,
metallurgy, wood, textile, food or construction industry). Analysis is following the consecutive three years.
With this analysis authors determine trends of liquidity indicators of all analyzed companies, every branch of
manufacturing industry, as well as their interrelationship.

5. RESEARCH RESULT
Average value of every individual liquidity ratio of all analyzed companies in manufacturing industry record
slight but constant growth since 2008 until 2010. Ratio of current liquidity ranged from 1,69 in 2008, along
1,71 in 2009 to 1,73 in 2010, that indicates the gradual improvement of liquidity. However, with analysis of
only current liquidity, wrong impression could be taken about apparent liquidity if the majority of short-term
assets are the most illiquid assets. Rigorous liquidity ratio excludes supplies from short-term assets, and on
the examined companies ranged from 0,85, along 0,92 to 1,04 in 2010. It means that on 1 dinar of short-term
obligations company owns 0,85, 0,92 and 1,04 dinars of liquid asset. In first two observed years company
cant settle occurred short-term obligations with liquid assets, while the liquidity of companies in
manufacturing industry was improved in 2010 and has acceptable level. However, with analysis is
determined that companies doesnt own enough funds - cash and liquid securities to settle short-term
obligations. On every dinar of short-term obligations, companies owns only 0,07, 0,08 and 0,10 dinars of
cash funds. Liquidity analysis by ratio indicators for 2008, 2009 and 2010 is presented on next picture.

Picture 1: Liquidity analysis for companies in manufacturing industry

Comparing the liquidity ratio in observed years at branches of manufacturing industry it can be spotted that
liquidity ratio moved also in increasing and decreasing intensity that is conditioned with industry category,
companys size and time bondage of short-term assets in specific phases of business cycle etc. The lowest
value of current liquidity ratio was recorded in construction and wood industry, and the highest value in
chemical industry. Ratio of reduced liquidity was also the highest in chemical industry, but the lowest was in
metallurgy. However, ratio of money liquidity in all branches of manufacturing industry records low value.
Average values of liquidity ratio indicators at branches of manufacturing industry are presented next in Table
1.

790

Table 4: Average values of liquidity ratio indicators at branches of manufacturing industry

Ratio of current
Ratio of reduced
Ratio of money
liquidity
liquidity
liquidity
Branch of manufacturing
(average
(average
(average
industry
values)
values)
values)
2008. 2009. 2010. 2008. 2009. 2010. 2008. 2009. 2010.
Tobacco industry
2.34
1.58
1.50
0.90
0.69
0.79
0.38
0.06
0.17
Machine industry
1.87
1.53
1.43
0.75
0.72
0.74
0.13
0.19
0.22
Chemical industry
1.94
2.67
2.32
1.03
1.50
1.48
0.06
0.14
0.08
Metallurgy
1.29
1.28
1.70
0.55
0.55
0.86
0.03
0.04
0.16
Wood industry
1.31
1.27
1.21
0.80
0.69
0.81
0.03
0.01
0.05
Textile industry
2.01
1.64
1.52
0.71
0.63
0.60
0.02
0.02
0.02
Food industry
1.73
1.74
1.81
0.96
1.03
1.19
0.06
0.07
0.07
Construction industry
1.22
1.47
1.10
0.83
1.01
0.70
0.00
0.00
0.02
Based on average values of inventory turnover ratio, claims and suppliers for every branch of manufacturing
industry, average duration of cash conversion cycle for every individual branch was determined. The longest
period from received payments to debt payments was recorded in wood and textile industry (from 200 to 400
days). Cash conversion cycle in food industry (in which there is the most companies that have stocks traded
on exchange) is ranged from 88 to 102 days. Something lower time period was recorded in chemical,
machine, construction industry and metallurgy. Since the 2008 companies in Serbia were stricken with global
economic crisis that produced decreased business activities. In addition, there were problems with servicing
matured obligations and increased borrowing that could only overpass problems of liquidity in short-term.
Liquidity analysis in individual branches of manufacturing industry points out on conclusion that companies in
chemical industry in relation to other observed companies managed to fight with consequences of crisis,
achieves high ratio of current liquidity, acceptable ratio of rigorous liquidity and time between debt payments
and received payments reduces on average 60 days.

6. CONCLUSION
Providing liquidity has great value for smooth functioning of business activities and companys survival.
Liquidity analysis starts with checking whether the total short-term assets can cover all short-term
obligations. Thereafter, is determination of how much dinars of liquid short-term assets comes on one dinar
of short-term obligations, and last ratio indicator determines how much cash company owns for coverage of
short-term obligations.
If liquidity is threatened, company has to conduct several measurements such as efficient inventory
management. Namely, with providing the optimal inventory that dont disturb constant business activities,
and dont bond unnecessarily, time desynchronized, money in material form, decreases the level of supplies
on one side, and level of short-term obligations on the other side. Next, efficient received payments from
customers can be reached with discounts for customers that regularly pay in short-term, while customers that
are late with payments can be calculated interest. On this way the value of receivable claims is faster
transforming into cash that company can use for settlement of occurred obligations and companys liquidity
increases.
With increased liquidity comes the decreased time period between debt payments to creditors and received
payments from customers. With efficient inventory management, received payments from customers and
prolonging the time for debt payments, cash conversion cycle is decreasing.
Based on liquidity analysis of selected companies that have stocks coated on exchange, potential investors
can make the difference between individual branches for investment activities. Next is analysis of individual
companies from selected branch in order to make the best investment call.

791

REFERENCES

Brili, R., Majers, S., Markus, A. (2007). Osnovi korporativnih finansija, Mate doo, Beograd.
Kneevi, G., Mizdrakovi, V. (2010). Rizik likvidnosti i njegovo prikazivanje u finansijskim izvetajima,
Raunovodstvo i revizija, SRRS, Beograd.
Krasulja, D., Ivanievi, M., (2001). Poslovne finansije, Ekonomski fakultet Beograd.
Rodi, J., Vukeli, G., Andri, M., (2011). Analiza finansijskih izvetaja, Proleter, Beej.
Saunders, A., Millon Cornet, M. (2006). Finansijska trita i institucije: moderno vienje, Masmedia, Zagreb.
Stani, P. (2006). Savremeno upravljanje finansijama preduzea, Ekonomski fakultet Univerziteta u
Kragujevcu.
Stowe, J., Robinson, T., Pinto, J. (2002). Analysis of Equity Investments: Valuation, AIMR, Charlottesville
CFA Institute, (2005). Corporate Finance and Equity, Pearson Custom Publishing, Boston.
CFA Institute, (2006). Economics and Financial Statement Analysis, Pearson Custom Publishing, Boston.
Uyar, A., (2009). The Relationship of Cash Conversion Cycle with Firm Size and Profitability: An Empirical
Investigation in Turkey, International Research Journal of Finance and Economics, Retrieved from
http://www.eurojournals.com/finance.htm
Wild J., Subramanyam K., Halsey R., (2007). Financial statement analysis ninth edition. Mcgraw- Hill/Irwin.
New York.

792

CANDLESTICK MODELLING USING INTERPOLATIVE BOOLEAN

ALGEBRA FOR FINANCIAL FORECASTING
Ivan Nesic1, Pavle Milosevic2, Bratislav Petrovic3
Faculty of Organizational Sciences, University of Belgrade, ivan.nesic@ewcom.ch
2
Faculty of Organizational Sciences, University of Belgrade, pasha.47@gmail.com
3
Faculty of Organizational Sciences, University of Belgrade, bratislav.petrovic@fon.bg.ac.rs
1

Abstract: In this paper we present a modelling approach to candlestick patterns based on interpolative
Boolean algebra (IBA) which is applied to stock market BELEX. We have decided to use IBA instead of
conventional fuzzy logic, since it simplifies the process of modelling and as a consistent fuzzy technique it
further improves the existing efforts and resolves some known issues. Results show that a candlestick
pattern modelling using IBA is indeed successful and should be adopted for further use. The proposed
method gives a degree of fulfilment for observed patterns, thus giving traders easy interpretation of how
much candlesticks fit into different patterns.
Keywords: candlestick, interpolative Boolean algebra, fuzzy, BELEX, stocks

1. INTRODUCTION
Effectiveness of candlestick patterns interpretation analysed by some papers give opposite results. They
prove to be useful on some markets and unprofitable on others. Some back-up negative results by the fact
that candlestick patterns were invented for rise markets during the 1700s and are not suitable for today
markets (Marshall, 2006). Still, vast number of traders uses this kind of technical analysis on an everyday
basis. Emotional beliefs are an important factor that affects market prices and technical analysis is supposed
to reveal these behaviours (Nison, 1991). Since this kind of behaviour is not completely rational, technical
analysis transforms thought process of investors into charts in an effort to forecast the price change.
Since models are individual for each trader, we do not try to propose an optimal solution, but rather a
methodology that can help traders to express their personal preferences. Emerging papers in scope of
candlestick patterns show an uprising interest in their fuzzy modelling. Many of these papers show respectful
results, but for traders who are not familiar with fuzzy logic, putting these concepts into action can really be
difficult. Since conventional fuzzy logic lacks the ability to consistently treat all logical relations, for instance
law of excluded middle does not hold in general case, using it for proposed models is not satisfactory. To
address this problem we introduce interpolative Boolean algebra to candlestick modelling.
Method proposed in this paper uses interpolative Boolean algebra as a consistent fuzzy technique,
introduced by Radojevic (2000), which should simplify steps in defining candlestick patterns. Conventional
fuzzy approach is hindered by the fact that it cannot consistently describe elements of Boolean algebra, such
is law of contradiction (
), and stay in a Boolean frame (Radojevic 2008b). Therefore, proposed models
cannot be implemented with traditional approach. Consistent fuzzy technique, as IBA is sometimes referred
in literature, is applied in this paper to improve upon strongly set conventional one.
For testing purposes we used data from Belgrade Stock Exchange (BELEX) market. Our results reveal that
transforming candlestick parameters into intensity of a candlestick pattern, using proposed methodology,
truly depicts human perception.
A brief description of chapters 2 to 5 is given. In chapter 2 contemporary literature is analysed. Data and
methodology are described in Chapter 3. Chapter 4 discusses results. The last section concludes the paper.

2. LITERATURE REVIEW
There are different opinions regarding the effectiveness of Japanese candlestick patterns on stock and
similar markets. Some papers suggest that usage of such patterns for forecasting on stock markets is
unjustified. For instance, studies conducted by Horton (2009) and Marshall et al. (2006) show that
candlestick technical analysis does not produce profit. Marshall et al. used thirty-five individual stock indexes
with carefully chosen sample period of ten years. Robustness of the system was tested using the bootstrap
793

methodology. One of the criticisms was addressed to the fact that candlestick patterns were originally
devised for rice markets.
In contrast, recent study conducted by Lu et al. (2012) shows that some types of candlestick technical
analysis patterns are indeed profitable when applied to Taiwan stock market. Data used for testing their
method comprised of individual stocks found in Taiwan 50. To check the robustness of results, same as
previously mentioned, bootstrap methodology was used. Although some of these results put shadow onto
candlestick patterns effectiveness, never the less, many papers have been written regarding their usage in
forecasting.
Lee & Jo (2009) created an expert system based on candlestick chart analysis. Their system looks up in a
database for signals and interprets them as candlestick patterns. They get 72% accurate results on the
Korean stock market. Model is rule-based and does not take gradation into consideration.
Tool which uses fuzzy candlestick patterns to describe investment knowledge on the Taiwan stock market
was presented by Lee et al. (2005). By using fuzzy technique, they are addressing the problem of
candlestick pattern definition vagueness which arises from different authors comprehensions of the same
pattern. In another paper, group of same authors compare their method with previously presented ones,
acquiring better results (Lee et al., 2006). Finally Lee (2009) constructs personal ontology to describe
candlestick patterns.
Approaches presented by Kamo and Dagli (2009) use candlestick method in gating network, by using rules
for describing the market and also by fuzzy logic-based weight generator, as part of their hybrid system. As
they have shown, fuzzy logic based systems deliver smoother and more accurate forecasting results.
Another fuzzy-candlestick model for reversal point prediction was presented in (Lan et al., 2011). It tries to
set a warning before a reversal of a stock price occurs. Reported results show precision far greater than
50%.

3. DATA AND METODOLOGY

Candlesticks are originating from mid-18th century, firstly introduced by a youngest child of Munehisa family
Homma (Nison, 1991). From his excellence in the field of trading, people started calling him god of the
markets. Since Nison introduced Japanese candlestick trading methods to western markets, they rapidly
gained popularity. Today, candlesticks chart analysis is one of the most widely used technical analysis
technique. Candlestick patterns should reflect psychological state of the market and then traders should
base their decisions on recognized patterns.
Candlesticks are formed out of open, high, low and close price for a predefined time period (figure 1). Body
colour of a candlestick depends on whether a close price is higher or lower than an open price. If it is higher,
body has a white, empty filling and oppositely, if it is lower, body is black. Lines called shadows above and
under body represent highest and lowest price of the time interval, respectively. Body size indicates the
market momentum and the shadows show extremes of the price movement. Body and shadows are usually
described as long or short, when defining patterns.

Figure 2: Candlesticks example

794

Example on how a candlestick reflects a market state is for instance candle with white body without
shadows, the so called White Marubozu pattern. Open price equals lowest price, and close price equals the
highest (figure 2). That means buyers are very bullish, since market opened at one price and closed at
another, never dropping below initial price, and closing well above it. The opposite rule applies for black bar,
Black Marubozu.

Figure 3: Marubozu example

However, interpretation of candlestick patterns is individual. Investors can obtain different pieces of
information from the same pattern and apply custom set of rules. This is one of the reasons why we use
interpolative Boolean algebra, a consistent fuzzy technique, to model vagueness of candlestick patterns
interpretation. This new approach simplifies pattern definition, making it easier for investors to use. Usage is
straightforward and only basic mathematical skills are required. Need for gradation is also satisfied, for
instance how intensive White Marubozu is. This gives information on certainty that the pattern rules will
reflect the future market movement.
For test and example purposes, daily stock prices of NIIS (Naftna Industrija Srbije) from BELEX (Belgrade
Stock Exchange) are used. Time period is one year, from January to December of 2011. Particular stock
from BELEX was chosen because it can oscillate around an open price between 12% upwards and 8%
downwards, as regulated by stock market rules.

Figure 4: Real data compared to normalized data

795

IBA requirement is that all values must be on [0,1] interval. Candlesticks were normalized taking those rules
into consideration (Figure 3). Since we know maximal possible price change, it is better to treat extreme
movements with higher degree. The upward movement of 12% can be considered as 1 and downward
movement of 8% as 0. One problem with this kind of normalization is that movements are sometimes too
small, because movements near extreme borders are very scarce. Another problem is that when analyzing
two or more bar patterns, one does not consider normalizing them in such a way, so that pairs maintain bar
parameter relations. Easy solution to latter problem is Min Max normalization executed on the whole data
set. However, this will not address the first problem. Another option is to normalize each group of elements
that create a pattern. This way, relevant bars will maintain their relations. If bar size on the whole data set
interval has any importance, one should consider aggregating results of two or more different normalization
techniques. For simplicity sake, we used Min Max normalization on pattern groups.
Radojevic (2000) presented [0,1]-valued logic that is in the Boolean framework. With it we have the
opportunity to use consistent fuzzy relations, also called interpolative relations (Radojevic, 2005), to measure
logical similarity and dissimilarity between individuals. Interpolative Boolean algebra provides a frame for
consistent realization of all possible elements of finite Boolean algebra. It is consistent in a sense that it
preserves all the laws on which Boolean algebra relies.
We will use classical Boolean expressions to model candlestick patterns. As an example, a few expressions
have been described. Equivalence is used when we want to state that parameters are equal. Relation of
equivalence ( ) is well-known expression of logical similarity between objects. Equivalence of two objects A
and B is noted as:
(1)
For Doji pattern open equals close price so it can be defined with ease by stating open

close.

If we do not want attributes to be the same, logical choice of an operator is exclusive disjunction ( ). Relation
of exclusive disjunction is complementary relation to the equivalence relation:
(2)
Long day pattern can be modeled as an exclusive disjunction between open and close price. It can be
expressed as close and open prices as far apart as possible. Candlesticks, whose open price is in relation of
exclusive disjunction with close price, are best rated if open and close have values 1 and 0.
Very useful expression is implication ( ). It can be viewed as a not strict inequality relation - less or equals.
(3)
For instance, this expression can be used for defining Engulfing pattern which is described as a bar with a
small body which is engulfed by a bigger body of a next bar.
These relations are based on interpolative Boolean algebra (IBA), which is real-valued [0,1]-valued
realization of finite Boolean algebra (Radojevic, 2008a). Any element from the IBA has its corresponding
generalized Boolean polynomial (GBP) (Radojevic, 2008b).
Transformation from Boolean expressions to GBP is described in (Radojevic, 2008b) and example
explanation of the process for exclusive disjunction is given by (4).

(4)

796

The GBP is, as its name says, general form of polynomial. Generalized product ( ) is any function that
satisfies conditions of commutativity, associativity, monotonicity and 1 as identity and non-negativity
condition (Radojevic, 2008a).
(5)
If both attributes are of the same type, we can use minimum t-norm as a generalized product. That would
mean they are correlated. For instance, if we compare two persons by their height, intersection of their
heights is height of a smaller person. If they are non-correlated attributes, product t-norm should be used
instead. An example for this if compare two persons by their height and their wealth. At last, if they are
negatively correlated ukasiewicz t-norm-norm should be used.
Example above (4) can now be translated to:
(6)
Next, example models for candlestick patterns are given. This should illustrate how fuzziness can help in
determining the intensity and avoid completely discarding candlestick patterns that only on small part do not
satisfy conditions.
White marubozu:
(7)
Black marubozu:
(8)
Doji:
(9)
Hammer:
(10)
Hanging man:
(11)
Inverted hammer:
(12)
Shooting star:
(13)
Bullish engulfing:
(12)
Bearish engulfing:
(12)
Tweezer tops:

(14)

797

Tweezer bottoms:

(15)

4. RESULTS
Tests conducted on various models show that IBA approach to modelling candlesticks can indeed provide
insight into pattern fitness. Traders can monitor provided indicators and decide when input attributes form
candlestick patterns. Also, these pieces of information are easily used for creating automated decision
support systems. By setting a border near value 1, traders can receive signals when a pattern occurs. IBA
can be used for automation as a logical aggregation tool. This kind of automation can induce signals of
pattern occurrences on which traders can base their decisions.
Results presented are a fragment of our research. Only one bar candlestick patterns are used in the
example.

Figure 5: IBA candlesticks modelling results

Table 1 contains data on which previous charts are made (figure 4).

798

Table 5: Original data and results sample

Open
High
Low
Close
White
Marub
ozu
515
519
510
515
0,4444
510
515
510
513
0,6000
519
534
517
522
0,2941
524
549
524
538
0,5600
550
592
550
590
0,9524
584
590
570
580
0,3000
590
638
590
621
0,6458
630
683
630
675
0,8491
743
743
720
740
0,0000
777
788
730
771
0,1897
731
735
709
722
0,1538
672
740
672
711
0,5735
722
759
722
750
0,7568
515
519
510
515
0,4444

Dodji

Marubozu
Dodji

Marubozu
Dodji

1,0000
0,4000
0,8235
0,4400
0,0476
0,8000
0,3542
0,1509
0,8696
0,8966
0,6538
0,4265
0,2432
1,0000

0,0000
0,3600
0,0519
0,3136
0,9070
0,0600
0,4171
0,7209
0,0000
0,0196
0,0533
0,3289
0,5727
0,0000

0,4444
0,8400
0,4187
0,8064
0,9977
0,4400
0,8746
0,9772
0,1304
0,2735
0,4467
0,8181
0,9408
0,4444

Some models described in chapter 3 are very rough and could use some improvement. Simplest way to
improve Marubozu model is to compare it to Doji. Since there is no ambiguity in Doji pattern definition, we
can use it to improve upon other models. For instance, Marubozu is a Marubozu, only when it is not a Doji.
Marubozu models described in chapter 3 can have high intensity even when Doji appears. By definition, it is
correct to treat them in such a way, but traders will dismiss them if they do not have larger body. That leaves
us with at least two options. One is to look for Marubozu when Doji does not occur and the other is to look for
Marubozu when Doji is described as less intensive.
The first scenario White Marubozu and not Dodji depicts traders who consider that Marubozu patterns
cannot occurre unless body has the opposite size of an ideal Doji body size. Second scenario (White
Marubozu Dodji) is less harsh and the condition is met when Dojis intensity is smaller than the one of a
Marubozu. It is interesting to note that both scenarios give very similar results, but the latter one, case with
the converse implication between indicators, is more tolerant. It also appears shifted up compared to the first
scenario.
Results depend on type of normalization chosen. For hammer, if data are for instance normalized using Min
Max for each bar, we get redundant calculations left and right from . But, if we choose some other type of
normalization, results will change accordingly.
For data presented in Table 1 and Figure 4, we used Min Max normalization on each candlestick. If Min Max
normalization on the whole interval was used, results would be different. Most notable difference is how
logical relations influence changes. Sheffer stroke between White Marubozu and Doji will almost never
produce maximal intensity. If converse implication was used, Doji will have very little influence on White
Maubozu.
Another possible normalization presented on figure 3 is the one based on 12% and -8% price change
boundaries. Since price changes are based on the above assumption, after normalization they are more
intense. This affects results to be more volatile. Still, changes are small and there is a big chance of pattern
getting recognized with high intensity as a Doji. Last normalization gives us the highest degree of change, so
no difference between candlesticks regarding their relative size is made.
From presented results, one can conclude that by looking at intensities of individual or combined patterns,
we can get more pieces of information than from two valued logic. Since there are other fuzzy approaches to
this problem, strongest argument for using this one is that it is easier to model. From relations between one
candlestick data, over relations between two or more candlestick patterns, to relations between complex
patterns, everything is modelled using logical relations. Downside is that this approach works with relations,
and as a consequence it can be less intuitive than the traditional fuzzy approach. But by using presented
techniques, any type of candlestick patterns can be modelled.

799

As generalized product in GBP for Doji and Marubozu we use minimum t-norm, since all inputs have the
same nature. But, for relations between them, we use product t-norm. If the proposed method needs more
tuning, pseudo-logical polynomial can be used to introduce weights (Radojevic, 2008c).

5. CONCLUSON
In this paper we presented a way of modelling Japanese candlestick patterns which should be easy for
traders to use. The base for creating more complex models is made. In our example we wanted to illustrate
that the proposed methodology works satisfactory. To our best knowledge this paper is the first to address
candlestick patterns modelling using IBA.
Earlier studies implemented fuzzy logic by defining candlestick elements sizes and then setting IF-THEN
rules. Once applied, these methodologies show good results, but it can be hard for traders to get to that point
without solid knowledge of fuzzy logic. Another arising issue is situation where multiple patterns should be
combined into more complex ones or should be used in creation of trading strategies. Though possible, it is
not a straightforward process. Our methodology uses basic logic expressions to model everything from
candlestick patterns to strategies and then uses IBA to translate these expressions into values. This process
is very simple for traders to comprehend.
Further studies should compare success rates of previous methods to the proposed one and test them for
robustness. Also, they should create comparison of different normalization methods and show their influence
on results. Finally, effects of using pseudo-logical polynomial on candlestick patterns modelling should be
explored.

REFERENCES
Horton, M. J. (2009). Stars, crows, and doji: The use of candlesticks in stock selection. The Quarterly Review
of Economics and Finance, 49(2), 283294. doi:10.1016/j.qref.2007.10.005
Kamo, T., & Dagli, C. (2009). Hybrid approach to the Japanese candlestick method for financial forecasting.
Expert Systems with Applications, 36(3, Part 1), 50235030. doi:10.1016/j.eswa.2008.06.050
Lan, Q., Zhang, D., & Xiong, L. (2011). Reversal Pattern Discovery in Financial Time Series Based on Fuzzy
Candlestick Lines. Systems Engineering Procedia, 2(0), 182190. doi:10.1016/j.sepro.2011.10.021
Lee, C.-H. L. (2009). Modeling Personalized Fuzzy Candlestick Patterns for Investment Decision Making, 2,
286289. Los Alamitos, CA, USA: IEEE Computer Society. doi:10.1109/APCIP.2009.207
Lee, C.-H. L., Chen, W., & Liu, A. (2005). Candlestick Tutor: An Intelligent Tool for Investment Knowledge
Learning and Sharing, 0, 238240. Los Alamitos, CA, USA: IEEE Computer Society.
doi:10.1109/ICALT.2005.82
Lee, C.-H. L., Liu, A., & Chen, W.-S. (2006). Pattern Discovery of Fuzzy Time Series for Financial Prediction.
IEEE Transactions on Knowledge and Data Engineering, 18(5), 613625. doi:10.1109/TKDE.2006.80
Lee, K. H., & Jo, G. S. (1999). Expert system for predicting stock market timing using a candlestick chart.
Expert Systems with Applications, 16(4), 357364. doi:10.1016/S0957-4174(99)00011-1
Lee, M. H., Ismail, Z., & Efendi, R. (2009). Modified weighted for enrolment forecasting based on fuzzy time
series. MATEMATIKA, 25(1), 6778. Retrieved from http://www.fs.utm.my/matematika/
Lu, T.-H., Shiu, Y.-M., & Liu, T.-C. (2012). Profitable candlestick trading strategiesThe evidence from a
new perspective. Review of Financial Economics. doi:10.1016/j.rfe.2012.02.001
Marshall, B. R., Young, M. R., & Rose, L. C. (2006). Candlestick technical trading strategies: Can they create
value
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investors?
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Operational
Research
YUJOR,
10(2),
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Radojevic, D., (2008a). Interpolative Realization of Boolean Algebra as a Consistent Frame for Gradation
and/or Fuzziness, Forging New Frontiers: Fuzzy Pioneers, (Eds.) Nikravesh, M., Kacprzyk, J., Zadeh,
L.A., Springer-Verlag Berlin, Heidelberg, 295-318. DOI: 10.1007/978-3-540-73185-6_13
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801

FORECASTING STOCK PERFORMANCE USING MULTI-LAYER FEEDFORWARD NEURAL NETWORK: BELGRADE STOCK EXCHANGE
CASE
1

Aleksandar Rakievi , Ivan Nei , Ana Poledica

Faculty of Organizational Sciences, University of Belgrade, aleksandar.rakicevic@fon.bg.ac.rs
2
Faculty of Organizational Sciences, University of Belgrade, ivan.nesic@ewcom.ch
3
Faculty of organizational sciences, University of Belgrade, ana.poledica@fon.bg.ac.rs

Abstract: This paper presents possible usage of neural networks in forecasting stock returns within the
Belgrade Stock Exchange. Forecasting is done on the example of the NIS (Serbian Oil Company) stock,
which has been chosen as the most liquid equity with the biggest market capitalization. The neural network
that has been used for this purpose is a classical multi-layer perceptron with one hidden layer. Technical
indicators and stock valuation ratios have been used as inputs. Three combinations of input sets have been
developed: the first consisting only of technical analysis indicators; the second consisting of financial ratios;
and the third as a mix of the previous two input sets. Results are compared in order to investigate the
potential of technical and fundamental analysis as a tool for predicting price changes. Stock valuation ratios
have shown excellent characteristics in forecasting future price movements and outperform other
approaches. Furthermore, the simpler model has made better results than the complex one, showing that
more is not always better.
Keywords: neural networks, multi-layer perceptron, stock price forecasting, technical analysis indicators,
stock valuation ratios.

1. INTRODUCTION
Forecasting is certainly the most exotic field of science. Second half of the 20th century has brought exciting
development to this field. With the emergence of computers, forecasting has become more and more
interesting and many complex technologies rose. Forecasting is one of the main topics in finance. For
centuries, men have sought to understand the underlying processes of financial markets in order to predict
the future or at least one day ahead. It is the constant battle between man and the market forces. The
efficient market hypothesis (EMH) asserts that in an efficient market stock prices movements are random
and unpredictable. It means that predicting price movements is impossible. Therefore, analysing history data
is useless given that no additional information can be extracted from historical data. But there is no
consensus so far on EMH validity. There are numerous papers that give empirical evidence that it is possible
to predict, to certain extent, future returns or at least direction of future price change. On the basis of those
forecasts, many researches created trading systems that are profitable.
Since 1940s and the first mathematical model of single neuron introduced by McCulloch and Pitts, artificial
neural networks (ANN) have gained their popularity in different scientific fields. Their ability to mimic structure
and learning process of the human brain made them promising and interesting for lot of researchers around
the world. But the main reason for their popularity lies in the fact that ANN requires few theoretical
assumptions for modelling. After initial success of Rosenblatts perceptron and the first criticism of Minsky
and Papert, a dramatic resurgence of interest in artificial neural networks have begun in 1980s. Since then,
ANN technology has been developing very fast with a wide variety of scientific applications and many types
of business applications. Business application areas that require pattern recognition, classification and
prediction were candidates for ANN technology. Therefore, it is not surprising that financial application of
ANN were one of the most extensively studied, forecasting especially.
In this paper, we use feed-forward neural networks as one of the oldest and most commonly used ANN
technology. We use technical and fundamental analysis tools, in order to extract additional information from
the history data that we use as input variables in the ANN model. Using these input data we trained neural
network to understand underlying process of the market in order to predict future price movements. Results
indicated best performances of fundamental analysis approach based on stock valuation ratios. It
outperformed other approaches and showed very good results in forecasting future stock movements with
high hit rate which indicates what percent of predictions are on the right side of the market.

802

The remainder of this paper is organized into four sections. Section 2 will present theoretical background and
literature review. In section 3 we describe methodology along with the data used for analysis. Section 4 will
report results of the comparative analysis. In section 5 we present our conclusions.

2. BACKGROUND
There are a lot of financial areas that are suitable for artificial neural network applications. Credit rating
evaluation, price/interest rate forecasting, bankruptcy prediction, corporate health estimation are just some of
them. Wong and Selvi (1998) made a review and analysis of different ANN applications in finance.
Forecasting has been for decades one of the most interesting areas of finance. Many researchers studied
different techniques in their efforts to discover the underlying model of the market in order to make accurate
prediction of price changes. De Gooijer and Hyndman (2006) reviewed many different techniques that were
used since 1982 and artificial neural networks have taken its important place among other forecasting
methods. Atsalakis and Valavanis (2009) surveyed many scientific articles that focus on neural and neuralfuzzy techniques indicating that soft computing techniques are widely accepted for evaluating stock market
behaviour.
Although very old, feed-forward neural networks (FFNN) are still one of the most used networks for financial
forecasting. They are simple, fast and easy to implement. In (Atsalakis and Valavanis, 2009) we see that
about one third of the surveyed articles use feed-forward neural networks as a forecasting tool. Multi-layer
networks with one or two hidden layers are most commonly used. In principle, there is no need to consider
other architectures, since the ANN with one hidden layer already has universal approximation capabilities
(Bishop, 1994). Cao et al (2005) use simple FFNN with one and three input variables and compare the
results with CAPM and 3-factor model. Their results indicate that ANNs do indeed offer an opportunity for
more accurate forecasts.
In order to predict stock prices, authors use variety of different inputs. Technical analysis indicators and
fundamental analysis ratios are very popular tools among traders and researches. For example, Armano et
al. (2005) use historical prices along with five different indicators in order to predict prices for the next three
days. Olson and Mossman (2003) used 61 accounting ratios for 2352 Canadian companies to forecast
annual returns. In many cases, researches are not trying to predict actual prices of the stock or other
financial instrument, but their daily returns. Cao et al. (2005) use univariate and multivariate FFNN to predict
stock price movements (price returns). Predicting trading signals that can be used for trading strategies is
also very popular among researchers. Tsang et al. (2007) use open, close, high and low price of the previous
day, along with volume and momentum indicator in order to predict trading signals. Chang et al. (2011) use
more than twenty technical indicators as input variables in order to predict buy and sell signals.

3. METHODOLOGY
Artificial neural network (ANN) is referred to computational model that is inspired by the structure of
biological neurons. ANN consists of a certain number of artificial neurons that are interconnected and can be
arranged in one or more layers and the information is processed through layers. The main characteristic of
ANN is their ability to mimic the knowledge acquisition.
Artificial neurons are the constitutive units of ANN. It is a simple mathematical model of biological neuron.
This model receives one or more inputs (representing the one or more dendrites) and sums them to produce
an output (representing a biological neuron's axon). Usually the values of the input nodes are weighted and
their sum is squashed or transformed by a function known as activation function. An activation function can
be linear or non-linear, and most commonly used functions are: threshold, threshold linear, sigmoid and
hyperbolic tangent function. There are no clear criteria regarding which activation function to use.
The feed-forward neural network (FFNN) is the oldest and the simplest type of ANNs. In this network, the
information moves in only one direction, forward, from the input layer, through the hidden layers (if any) and
to the output layer. There are no loops in the network. ANN that is used in this paper is simple feed-forward
neural network (FFNN) with one hidden layer. Hidden layer is consisted of 15 neurons. Log-sigmoid
functions were used as activation functions in the hidden layer neurons. There are several input variables
and only one output variables. Activation function that is used in the single output node is threshold linear
function. Figure 1 shows such FFNN with 8 input variables.
803

Figure 1: Architecture of the FFNN used in this paper

In order to train our feed-forward network we use recursive methodology. Instead of partitioning data once
and for all into training and test set, we use the type of recursive methodology called expanding window.
Within a given data set that is consisted of N daily values, we use the first M<N observations for initial
estimation to obtain initial forecast
. Then we re-estimate the model based on M+1 observation, and
obtain
forecast. The process continues until the entire sample is covered. This methodology is called
expanding window since the sample size becomes larger as we move forward in time.

3.1. INPUTS
In this paper we use three input sets for the same ANN architecture in order to make comparison of the
resulting forecasts. In the first case we use technical analysis indicators as input variables, in the second
case stock valuation ratios are used and in the third case both technical indicators and financial ratios are
used as input variables for the purpose of forecasting. The idea of these three cases is to investigate the
power of technical and fundamental analysis as tools for financial forecasting, first separately and then
jointly. Table 1 and Table 2 present the selected technical indicators and stock valuation ratios, along with
their formulas and verbal description.
Table 6: Technical analysis indicators as input variables
Indicator
Formula

Description
Moving Average Convergence/Divergence
line tracks a difference between
longer and shorter trend of the price.
Rate of Change is designed to show the
relative difference between today's
closing price and the close N days
ago
The Relative Strength Index is designed to
measure the velocity and magnitude
of directional price movements.
Chaikin Volatility determines volatility of
financial instrument using percent
change in a moving average of
subtraction of high and low prices
over some period of time.
Generally, the idea of Volume-price trend
is to show the trend of the volume
and to investigate is it moving along
with price trend.

MACD line

ROC

RSI

Chaikin
volatilit
y
Volumeprice
trend

Table 2: Stock valuation ratios used as input variables

Ratio

Formula

Description
Price-to-earnings ratio shows how much
the investors are willing to pay per
dollar/euro/dinar/etc of earnings.
Price-to-sales ratio shows how much the
investors are willing to pay per
dollar/euro/dinar/etc of sales.
Price-to-book ratio is used to compare a
stock's market value to its book
value.

P/E

P/S

P/B

804

3.2. OUTPUT
The selected input variables, presented in the previous section, are used for prediction of daily stock returns.
Therefore, the stock return is the only output variable.

3.3. DATA
The proposed feed-forward neural network is used on the example of the Belgrade Stock Exchange (BSE) in
forecasting daily returns for stock NIIS (Naftna industrija Srbije A.D.). This stock is selected as the most
liquid equity on the BSE market. Naftna industrija Srbije A.D. is also the company with the largest market
capitalization on the BSE.
This study covers the time period of May 4th, 2011 through April 30th, 2012. The data consists of 251 daily
prices accompanied with daily values of the corresponding technical indicators and stock valuation ratios.
Technical indicators were calculated on the basis of daily open, close, low and high prices and volume,
collected from official site of BSE7. In order to calculate financial ratios, a manual review of the data from the
8
annual financial report of the company was done. Table 3 presents the part of the data that are used in
order to forecast.
Table 3: The data
Chaikin
VolumeVolati
price
lity
trend
(12)

Date

Return

Close
pri
ce

04.05.2011.

NA

510

5,04

0,49

1,76

NA

NA

NA

NA

19.575,00

05.05.2011.

0,78

514

5,08

0,49

1,78

NA

NA

NA

NA

19.788,69

06.05.2011.

0,97

519

5,13

0,50

1,80

NA

NA

NA

NA

20.120,46

09.05.2011.

-0,77

515

5,09

0,50

1,78

NA

NA

NA

NA

19.957,95

10.05.2011.

-0,39

513

5,07

0,49

1,78

NA

NA

NA

NA

19.905,74

P/E

P/S

P/B

MACD line
(12,26)

ROC
(12)

RSI
(12)

01.02.2012.

0,52

579

2,61

0,51

1,27

-9,00

-3,18

32,14

116,11

70.518,95

02.02.2012.

3,80

601

2,71

0,53

1,32

-6,88

2,56

51,95

123,68

72.194,44

03.02.2012.

6,16

638

2,87

0,57

1,40

-2,19

9,62

75,49

158,51

75.071,33

06.02.2012.

5,49

673

3,03

0,60

1,48

4,30

14,85

84,21

146,97

76.826,21

07.02.2012.

-3,12

652

2,94

0,58

1,43

7,67

11,45

72,00

159,14

75.574,14

24.04.2012.

-0,61

647

2,60

0,55

1,20

-10,49

-4,15

15,56

32,91

81.229,43

25.04.2012.

0,46

650

2,61

0,55

1,21

-10,54

-2,55

22,22

39,70

81.283,43

26.04.2012.

1,54

660

2,65

0,56

1,23

-9,67

0,00

42,55

38,39

81.549,47

27.04.2012.

-0,76

655

3,18

0,59

1,11

-9,27

-1,06

44,44

29,72

81.442,19

3.4. NORMALIZATION
Values of the input variables are normalized to [0,1] interval and afterwards put through neural network in
order to forecast future stock returns. We use the following linear rescaling function:
(1)
7
8

www.belex.rs
http://www.belex.rs/trgovanje/informator/NIIS
805

3.5. FORECASTING ACCURACY MEASURE

We compute the following three error metrics to measure forecast accuracy of the network:

Mean absolute error (MAE)

(2)

Root mean square error (RMSE)

(3)

Hit rate (HR)

(4)

4. RESULTS
This paper is intended to analyze the power of technical and fundamental analysis as forecasting tools. For
that purpose, the data were separated into three datasets. In the first dataset daily returns (1 output) and
corresponding daily values of technical indicators were used (5 input variables). In the second dataset daily
returns (1 output) were used along with the corresponding values of the selected stock valuation ratios (3
inputs). Third dataset was consisted of the data from both previously described datasets (1 output and 8
input variable). Therefore, in third dataset there are eight input variables. Forecasting results from these
three datasets were compared with each other. The purpose of this analysis is to investigate usefulness of
technical analysis indicators and stock valuation ratios as a forecasting tool, first separately and then jointly.
Resulting forecasts are presented in Table 4.
Table 4: The results
Approach 1
HISTORICAL DATA

Technical
indicators

Approach 2
Stock
valuatio
n
ratios

Approach 3
Technical
indicato
rs +
valuatio
n ratios

DATE

ACTUAL
RETURNS

FORECASTS

FORECASTS

FORECASTS

07.03.2012.

-2,07

-1,10

-3,78

-0,34

08.03.2012.

0,42

-6,39

0,88

-1,62

09.03.2012.

-0,28

-0,68

-0,48

-0,75

12.03.2012.

-0,56

-0,37

0,55

-2,19

17.04.2012.

-0,15

-0,84

-0,15

-1,27

18.04.2012.

0,15

-0,53

0,31

-0,40

19.04.2012.

0,15

-3,01

-0,51

4,64

20.04.2012.

0,46

-0,59

-0,73

-0,44

23.04.2012.

-1,51

-4,75

-4,33

-1,05

24.04.2012.

-0,61

0,17

-0,73

-0,76

25.04.2012.

0,46

-0,75

2,17

-2,58

26.04.2012.

1,54

2,40

-0,61

-2,56

27.04.2012.

-0,76

-3,44

-0,25

-1,04

In order to compare these three approaches, we use mean absolute error (MAE), root mean square error
(RMSE) and hit rate (HR). The following Table 5 gives the resulting errors for all three approaches.

806

Table 5: Accuracy measures

Accuracy measure

Technical analysis

Fundamental analysis

approach

approach

Universal approach

MAE

1,4902

1,1980

1,2497

RMSE

2,4114

1,7295

1,8751

HR

58,33%

61,11%

47,22

The most accurate is the second approach that uses stock valuation ratios in order to forecast future stock
return. It has very a good hit rate of about 61%. It is very interesting that technical analysis approach had
worst performances looking at MAE and RMSE, but it had good performances looking at the prediction rate.
Surprisingly, universal approach that should use all the best characteristics of both approaches showed
disappointing results. Perhaps, this finding proves that more does not always mean better. Cao et al. (2005)
proved the same in their work when they unexpectedly got better forecasting results for univariate (with one
input variable) multi-layer perceptron (MLP) than for multivariate MLP with three input variables. First two
approaches have hit rates bigger than 50% which means they are most of the time on the right side of the
market. However, this does not mean that they could bring profit to their owners.
Since it is the most successful approach, Figure 2 will show the graphical representation of the forecasting
results achieved using stock valuation ratios. Forecasts are marked with circles in the upper graph and red
bars in the lower graph, and actual prices are marked as crosses and blue bars. The upper graph represents
normalized data while lower shows regular data.

Figure 2: Graphical representation of stock valuation ratio accuracy

2.

CONCLUSION

In this paper, feed-forward neural networks (FFNN) are used in order to predict stock price movements on
the example of NIIS (Naftna industrija Srbije A.D.) from Belgrade Stock Exchange (BSE). Even though FFNN
are among the oldest and simplest neural network architectures the results shown that they indeed offer an
opportunity for investors to improve their predictive power. Three different approaches are used in order to
create accurate forecasting system. The first approach used stock valuation ratios to predict future stock
movements, the second used technical indicators and the third was combination of the previous two.
Unexpectedly, it appears that simpler models are more successful in forecasting returns and price movement
directions than the complex one. Results have shown that fundamental analysis approach gives excellent
results. Stock valuation ratios outperformed both technical analysis and universal approach.
As for the future work, it will be interesting to investigate more carefully potential of fundamental analysis.
Also, we are willing to assess the relationship between the number of input variables and the accuracy of the
model. Furthermore, we will try to extract trading signals from the forecasting results in order to make
profitable trading system.

807

REFERENCES
Armano, G., Marchesi, M., Murru, A. (2005). A hybrid genetic-neural architecture for stock indexes
forecasting. Information Sciences 170, 3-33. DOI:10.1016/j.ins.2003.03.023.
Atsalakis, G., S., Valavanis, K., P. (2009). Surveying stock market forecasting techniques Part II: Soft
computing
methods.
Expert
Systems
with
Applications
36,
5932-5941.
DOI:10.1016/j.eswa.2008.07.006.
Bishop, C., M. (1994). Neural networks and their applications. Review of Scientific Instruments, 65(6), 18031832. DOI:10.1063/1.1144830
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artificial neural network in predicting the Chinese Stock market. Computers and Operations Research,
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Chang, P., C., Liao, T., W., Lin, J., J., Fan, C., Y. (2011). A dynamic threshold decision system for stock
trading signal detection. Applied Soft Computing, 11, 3998-4010. DOI: 10.1016/j.asoc.2011.02.029.
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Intelligent Systems in Accounting, Finance & Management, 9(2), 119-144. DOI: 10.1002/10991174(200006)9:2<119::AID-ISAF182>3.0.CO;2-Y
De Gooijer, J., G., Hyndman, R., J. (2006). 25 years of time series forecasting. International Journal of
Forecasting 22, 443-473. DOI:10.1016/j.ijforecast.2006.01.001.
Olson, D., Mossman, C. (2003). Neural network forecasts of Canadian stock returns using accounting ratios.
International Journal of Forecasting, 19 (3), 453-465. DOI: 10.1016/S0169-2070(02)00058-4.
Tsang, P., M., Kwok, P., Choy, S., O., Kwan, R., Ng, S., C., Jacky, M., Tsang, J., Koong, K., Wong, T., L.
(2007). Design and implementation of NN5 for Hong Kong stock price forecasting. Engineering
Applications of Artificial Intelligence 20, 453-461. DOI:10.1016/j.engappai.2006.10.002.
Wong, B., K., Selvi, Y. (1998). Neural network application in finance: A review and analysis of literature
(1990-1996). Information & Management 34, 129-139. DOI:10.1016/S0378-7206(98)00050-0,

808

THE CHAOTIC REAL EXCHANGE RATE GROWTH MODEL

Vesna Jablanovi
University of Belgrade, Faculty of Agriculture, Serbia, vesnajab@ptt.rs

Abstract: Chaos theory is used to prove that erratic and chaotic fluctuations can indeed arise in completely
deterministic models. Chaos theory reveals structure in periodic, dynamic systems. The number of nonlinear
business cycle models use chaos theory to explain complex motion of the economy. Chaotic systems exhibit
a sensitive dependence on initial conditions: seemingly insignificant changes in the initial conditions produce
large differences in outcomes. The basic aim of this analysis is to provide a relatively simple chaotic real
exchange rate growth model that is capable of generating stable equilibria, cycles, or chaos.
Key words: real exchange rate, growth, depreciation, chaos

1. INTRODUCTION
Chaos theory started with Lorenz's (1963) discovery of complex dynamics arising from three nonlinear
differential equations leading to turbulence in the weather system. Li and Yorke (1975) discovered that the
simple logistic curve can exibit very complex behaviour. Further, May (1976) described chaos in population
biology. Chaos theory has been applied in economics by Benhabib and Day (1981,1982), Day (1982,
1983,1997, ), Grandmont (1985), Goodwin (1990), Medio (1993,1996), Medio, A. and Lines, M ( 2004),
Lorenz (1993), Shone, R.(1999) , Jablanovic ( 2010, 2011a, 2011b, 2012). Deterministic chaos refers to
irregular or chaotic motion that is generated by nonlinear systems evolving according to dynamical laws that
uniquely determine the state of the system at all times from a knowledge of the system's previous history.
Chaos embodies three important principles: (i) extreme sensitivity to initial conditions ; (ii) cause and effect
are not proportional; and (iii) nonlinearity.
National saving is the source of the supply of loanable funds. Domestic investiment and net capital outflow
are the sources of the demand for loanable funds. At the equilibrium interest rate, the amount that people
wand to save exactly balances the amount that people want to borrow for the purpose of buying domestic
capital and foreign capital. At the equilibrium interest rate , the amount that people want to save exactly
balances the desired quantities of domestic investment and net capital outflow.
The real exchange rate is determined by the supply and demand for foreign currency exchange. The
supply of domestic currency to be exchanged into foreign currency comes from net capital outflow. The
demand for domestic currency comes from net exports. Because a lower real exchange rate stimulates net
export , the demand curve is downward sloping. At the equilibrium real exchange rate, the demand for
domestic currency to buy net export exactly balances the supply of domestic currency to be exchanged into
foreign currency to buy assets abroad.
The supply and demand for loanable funds determine the real interest rate. The interest rate determine net
capital outflow, which provides the supply of dollars in the market for foreign currency exchange. The
supply and demand for domestic currency in the market for foreign-currency exchange determine the real
exchange rate.
In an open economy, government budget deficit raises real interest rates, crowds out domestic investment,
decreases net capital outflow, causes the domestic currency to appreciate. However this appreciation
makes domestic goods and services more expensive compared to foreign goods and services. In this case,
exports fall, and imports rise. Namely, net exports fall. An appreciation of the real exchange rate expresses
that the foreign price of a bundle of goods has risen relative to the domestic price. If the real exchange rate
appreciates it means that the real value of the domestic currency has depreciated

809

Consumption

Crowding-out effect

Budget
deficit
(Ne
gati
ve
pub
lic
sav
ing
)

Saving

Real
inte
rest
rate

Aggregate
Dem
and

Investment

Net

capital
outflow

(Net export)

Real exchange
rate

Negative
multip
lier
effects

Government
expenditure

Real
o
u
t
p
Price u
le
t
v
el

Taxes

Figure 1. Relation between budget deficit, saving , investment, and real exchange rate
The basic aim of this analysis is to provide a relatively simple chaotic real exchange rate growth model that
is capable of generating stable equilibria, cycles, or chaos.

2. A SIMPLE CHAOTIC REAL EXCHANGE RATE GROWTH MODEL

The chaotic real exchange rate growth model is presented by the following equation

km
k

K
Y

(1)

K
Y

(2)

Yt = Kt1/2
NCOt = Nx

(3)
(4)

Nxt = - et

(5)

NCO t= - Bd t

(6)

Bdt = Y t

(7)

Where e real exchange rate, NCO net capital outflow, Nx- net export, Bd budget deficit; Y real output
; K capital; k- average capital coefficient, km- marginal capital coefficient, , , , , , -coefficients.

810

(1) defines marginal capital coefficient ; (2) defines average capital coefficient ; (3) determines production
function; (4) the identity between net capital outflow and net export; (5) describes the demand for dollars
which comes from net export; (6) describes net capital outflow as a function of budget deficit; and (7)
describes the relation between budget deficit and the real output.
Firstly , it is supposed that = 0 and = 0. Further, by substitution one derives:

e t 1

km
1
et
et 2
km k
k m k

(8)

Further, it is assumed that the current value of the real exchange rate is restricted by its maximal value in its
time series. This premise requires a modification of the growth law. Now, the real exchange rate growth rate
m
depends on the current size of the real exchange rate, e, relative to its maximal size in its time series e . We
m
introduce as = e/e . Thus range between 0 and 1. Again we index by t, i.e., write t to refer to the size
at time steps t = 0,1,2,3,... Now growth rate of the real exchange rate is measured as

t 1

km
1
t
t 2
km k
k m k

(9)

This model given by equation (9) is called the logistic model. For most choices of , , k and km there is no
explicit solution for (9). This is at the heart of the presence of chaos in deterministic feedback processes.
Lorenz (1963) discovered this effect - the lack of predictability in deterministic systems. Sensitive
dependence on initial conditions is one of the central ingredients of what is called deterministic chaos.

3. LOGISTIC EQUATION
The logistic map is often cited as an example of how complex, chaotic behaviour can arise from very simple
non-linear dynamical equations. The map was popularized in a seminal 1976 paper by the biologist Robert
May. The logistic model was originally introduced as a demographic model by Pierre Franois Verhulst.
Chaotic dynamics was made popular by the the logistic map. The most interesting characteristic of the
logistic map is in the simplicity of its form (quadratic) and the complexity of its dynamics. It is the simplest
model that shows chaos. It is possible to show that iteration process for the logistic equation
z t+1 = z t ( 1 - z

0 ,4 ]

) ,

z t 0 ,1 ]

(10)

is equivalent to the iteration of growth model (9) when we use the identification

zt

km

and

km
.
km k

Using (9) and (11) we obtain:

zt 1

km

t 1

k m

2
1
t
t

k m k m k
k m k
1

811

(11)

2
1
1

t 2 2

t
k m k
k m k m k
On the other hand, using (10) and (11) we obtain:

z t+1 = z t ( 1 - z

) =

km

1
1
t 1
t
km k km km

2
1
1

t 2 2

t
k m k
k m k m k
It is important because the dynamic properties of the logistic equation (10) have been widely analyzed (Li
and Yorke (1975), May (1976)).
It is obtained that :
(i) For parameter values 0 1 all solutions will converge to z = 0;
(ii) For 1 3,57 there exist fixed points the number of which depends on ;
(iii) For 1 2 all solutions monotnically increase to z = ( - 1 ) / ;
(iv) For 2 3 fluctuations will converge to z = ( - 1 ) / ;
(v) For 3 4 all solutions will continously fluctuate;
(vi) For 3,57 4 the solution become "chaotic" wihch means that there exist totally aperiodic solution or
periodic solutions with a very large, complicated period. This means that the path of zt fluctuates in an
apparently random fashion over time, not settling down into any regular pattern whatsoever.

3.

CONCLUSION

The basic aim of this analysis is to provide a relatively simple chaotic real exchange rate growth model that
is capable of generating stable equilibria, cycles, or chaos.
In an open economy, government budget deficit generates an appreciation of the real exchange rate. An
appreciation of the real exchange rate expresses that the foreign price of a bundle of goods has risen
relative to the domestic price. If the real exchange rate appreciates it means that the real value of the
domestic currency has depreciated
A key hypothesis of this work is based on the idea that the coefficient

km
km k

plays a crucial role in explaining local stability of the real exchange rate growth, where,
km the marginal capital coefficient, and k - the average capital coefficient.

812

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THE INFLUENCE OF THE EMISSION OF GREENHOUSE GAS ON

MANAGEMENT DECISIONS
Milena Anti1
Institute Mihajlo Pupin, milenaantic85@gmail.com

Abstract: The emission of greenhouse gas and global warming are one of todays greatest climate
problems. In order to reduce the emission of greenhouse gas and the slowdown of global warming, the
international agreements, such as the Kyoto Protocol and the European Union Emission Trading Scheme
(EU ETS), have been arranged. Both agreements are obligatory only for developed countries. These
agreements have imposed obligations not only for the governments of developed countries, but also for the
companies that operate in these countries. However, global warming is a problem that influences all
countries, both developed and developing. Therefore, the inclusion of developing countries in the contracts
mentioned above has been initiated. If this initiative comes to life, it will be necessary for companies
operating in developing countries to introduce some changes in their decision-making process. These
changes will entail the companies to calculate the price of the emission of greenhouse gas and include it in
the costs-benefit analysis of new investments. Furthermore, the cost of emission might influence the
profitability of products that are already produced within a company. Companies that operate in developed
countries have already included the cost of emission in their decision-making process. Companies operating
in developing countries must try to do the same, or at least include the cost of emission in their long-term
plans in order to prepare their activities for future changes that will inevitably occur. The implementation of
the Kyoto Protocol and the EU ETS, the inclusion of the price of emission in the decision making process
and some problems related to it, as well as changes in the agreements that will probably happen and
possible gains of companies have been described in this paper.
Keywords: the Kyoto Protocol, the EU ETS, cost of emission, developed countries, developing countries,

1. PREFACE
The emission of greenhouse gas is one of the major climate problems in the world. In its Third Assessment
Report (2001) the Intelligent Panel on Climate Change presented evidence showing that in the last 50 years
global warming has, by and large, been the result of human activities. Therefore, human behavior must
change in order to slow global warming down. The United Nations Framework Convention on Climate
Change (UNFCCC) is the first internationally binding instrument that addresses the issue of response to
climate change. UNFCCC has one ultimate objective to achieve stabilization of greenhouse gas in the
atmosphere at a level that would prevent dangerous anthropogenic (human inducted) interference with the
climate system. Other multinational agreements were also arranged in order to introduce the need for
reduction of greenhouse gas emission in countries throughout the world. The Kyoto Protocol and the
European Union Emission Trading Scheme are examples of these agreements. Those agreements are, for
now, binding only for developed countries. Nevertheless, the global warming is a problem that affects all
nations and all countries. Parallel with the industry growth of developing countries, the emission of
greenhouse gas in these countries will rise too. The need for the inclusion of developing countries in the
agreements mentioned above has already been discussed and it is probable that it will happen soon.
Agreements mentioned above have effect on the business activities of companies operating in developed
countries. EC survey on corporate behavior indicated that 70% of companies were pricing the value of
allowances into their daily operations and 87% into the future marginal pricing decisions. All industries stated
that it was a factor in long-term decision-making. These companies had to include the question of reduction
of emission and the valuing of emission in their decision making process. Entities that operate in developing
countries, as Serbia, have not had to face this question yet, but they will probably have to do so soon.

2. THE IMPLEMENTATION OF THE KYOTO PROTOCOL

The Kyoto Protocol is an international agreement linked to the UNFCCC. Kyoto protocol set targets for 37
industrialized countries and the European community in order to reduce the greenhouse gas emission.
Industrialized countries have agreed to achieve 20% of reduction of greenhouse gas emission by 2020, with
1990 as the base year. During the first commitment period, from 2008 to 2012, industrialized countries are
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obliged to reduce their emissions, and minimum reduction should be equal to five per cent of the greenhouse
gas emission in 1990. The difference between the UNFCCC and the Kyoto Protocol is that the former does
not oblige countries to reduce emission of greenhouse gas and the latter does. The reason why only
developed countries are obliged to reduce their emission of greenhouse gas is because developed countries
are mainly responsible for the current level of greenhouse gas emissions, which is the result of more than
150 years of industrial activity.
The Kyoto Protocol is organized in the following manner: developed countries are given certain number of
rights for emission of greenhouse gas annually. The quantity of rights every country has is called cap, and it
is being reduced over time. Rights for emission are distributed to companies that operate in these countries.
If a company does not have enough rights to cover its emission during a certain period, it can buy rights on
the market. Also, if all emission rights are not used within a company, they can be sold on the market, or
saved for future periods (when these rights will not be given free of charge). The possibility of selling rights
on the market motivates companies to reduce their emission and earn profits.
Companies are given the opportunity to earn rights for additional emission of greenhouse gas through
investing in the reduction of greenhouse gas emission in other Annex I countries (industrialized countries), or
in developing countries. If a company decides to invest in reduction of greenhouse gas emission in Annex I
country, it will earn certain number of emission reduction unit (ERU). If a company invests in reduction of
greenhouse gas emission in developing country, it will earn certified emission reduction (CER). Both one
ERU and one CER are equivalent to the emission of one tone of greenhouse gas. In both cases the result of
investment must be controllable (the reduction of emission must be measurable).

3. THE IMPLEMENTATION OF THE EUROPEAN UNION EMISSION TRADING SCHEME

The organization of the European Union Emission Trading Scheme (EU ETS) is very similar to the
organization of the Kyoto Protocol. The basic goal of 20% reduction of greenhouse gas emission by 2020,
with 1990 as the base year, is the same as in the Kyoto Protocol. European countries are given rights for the
emission of greenhouse gasses, which are distributed amongst companies. The difference between the
Kyoto Protocol and the EU ETS is the existence of trading periods that last more than one year. The
introduction of these periods was necessary in order to neutralize annual irregularities in emission of
greenhouse gas that occur due to extreme weather events. The first trading period lasted from 2005 to 2008,
while the second trading period still lasts and it will end on December 2012. Rights are also traded on the
market, and their value is depended on the relation of demand and supply. It is not allowed to transfer rights
that were not used from the first trading period to the second trading period (therefore, rights should be either
used or sold on the market until the period ends). The third trading period will start in 2013. It is planned for
more rights to be auctioned during the third trading period, which will probably have effect on entities
behavior.

4. THE POSSIBILITY OF INCLUSION OF DEVELOPING COUNTRIES

As it was previously said, the emission of greenhouse gas is a global problem. The reduction of emission in
developed countries will lead to a partial solution of this problem. In order to address the problem
adequately, developing countries must also reduce emission in their countries. Kyoto protocol encourages
industrialized countries to invest in clean technology in developing countries, but the governments and
companies operating in these countries must be motivated to do the same. The question is how to stimulate
developing countries to invest in clean technology? The governments of developing countries have other
things on their minds, and because industries in this countries are not big polluters (comparing to
industrialized countries); the need for reduction of emission is often not being considered. More urgent
problem developing countries must face with is the development of their industries. But, industrial
development will inevitably lead to higher emission of greenhouse gas. If developing countries are not
obliged to reduce emissions, all efforts from developed countries might prove to be pointless.
Some solutions to the problem have been suggested. One solution that is often being proposed is sectorial
introduction of the Kyoto Protocol. This means that only sectors that are the biggest polluters (energy sector,
for example) will be obliged to reduce the emission of greenhouse gas. Other possibility is that the Kyoto
protocol will become obligatory for all countries. After the first commitment period of the Kyoto Protocol,
some changes in the system will probably occur. One of the changes might be the introduction of
greenhouse gas emission in developing countries.

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5. THE INTRODUCTION OF COST OF EMISSION IN DECISION-MAKING PROCESS

The introduction of some of these systems for the reduction of emission in developing countries will influence
business operations of companies that do not have to deal with this problem now. Same as with the
governments of developing countries, top managements of these companies are struggling with the problem
of managing day-to-day activities and developing the business.
If the Kyoto protocol or the EU ETS is adopted in developing countries, managers of companies that operate
in these countries will have to face with the following question: Should we invest in clean technology, or
should we buy additional rights for emission of greenhouse gas? Both options will influence future business
results of the companies and their cash flows. The cost of emission of one tone of greenhouse gas will have
to be integrated in their decision making process.
If, for example, management had to decide if the money should be invested in clean technology or not, total
costs to total benefits related to this investment should be compared. If total benefits are greater than costs
of investment in clean technology, the company will decide to invest. If, on the contrary, investment in clean
technology is greater than benefits which can be earned by selling extra rights on the market, companies will
opt for status quo.
The cost of investment in clean technology is relatively easy calculated. Price of filter that company wants to
buy, for example, can be found on the market. Costs of maintenance and services will have to be included in
total costs, too. Finally, costs of disposal of the filter will have to be calculated. All these costs are available
on the market. In order to calculate present value of these costs, some of them will have to be discounted
(one example of these costs is the cost of disposal).
The calculation of total benefits is far more complex. Total benefits include revenues earned from the selling
extra rights on the market. Also, they might include some subsidies from government for the investment in
clean technology. Finally, total benefits include auction price of rights that company will not have to buy in the
following periods (comparing to the rights that would have to be bought if the investment was not made). In
order to be able to calculate total benefits, company must forecast the reduction of emission (in tones) and
price of one right for the emission of greenhouse gas. The biggest problem in this calculation is related to the
prediction of the price of rights for emission.
To illustrate the difficulty of predicting the price of rights, we will use the example of the price of rights on EU
ETS market. Variation of this price during the first trading period (from 2005 to 2008) will be depicted. As it
can be seen from the Figure 1, the price of rights increased steadily until April 2006, when it peaked at 30
Euros per right. In the following month the price of right plummeted to only 10 Euros, because of news that
some countries gave their industries such a generous emission cap that there was no need for them to
reduce emissions. In March 2007 the price fell to 1, 2 Euros per right, and in September 2007 the price was
only 0, 1 Euros per right. This big volatility and surge of price in the second half of the trading period made
the managers recalculate their costs and change their decisions.

Figure 6: Spot price of European allowance

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The biggest problem was the fact that until April 2006 no one could predict that price will fall. The change of
price might have made the current investments in clean technology non-profitable. For example, a company
has calculated that an investment in clean technology will reduce emission for 100 tons until the end of the
first trading period. If a decision had to be made in February 2006, the price that would be used to calculate
the value of saved rights would probably be equal to 30 Euros. Total value of rights that could be sold on the
market would be estimated at 3.000 Euros. If the same company would calculate the values of extra rights
one year later, the value of one right would be 10 times less (around 3 Euros, or even less than this). The
value of extra rights would be estimated at only 300 Euros. If we assume that total costs of investment have
been predicted at 1.000 Euros, the change of price of rights would have made the investment non-profitable.
The price of rights during the second trading period has also been volatile. The price of rights has also fallen,
because of the economic recession in Europe and the whole world. According to research, the quantity of
rights that countries distributed to companies during the second trading period was in line with their
economic activity planned before the recession. However, after the recession the emission of greenhouse
gases decreased drastically, leading to the increase in the supply of rights on the market and, consequently,
to the fall of prices.
Managers must also be aware of the fact that most rights will be auctioned in the third (and all following)
trading period. This means that companies will have to pay for the rights on the beginning of the trading
period, and use them during the trading period. According to this, the market price of rights might not have to
be used in the decision making process. It will be replaced with the auctioned price of rights. The quantity of
rights will be calculated based on the predicted decrease of emission during the useful life of the investment.
If we use the example mentioned above (the installation of filter), total value of emission cut during the
second trading period will have to be increased with the total value of saved rights (rights that will not have
to be bought in the future period due to the emission cut).
It is planned to use money earned from the auction of rights to subsidize new investments in clean
technology. This fact will also have to be included in cost-benefit analysis, because it will affect the value of
initial investment.
The price of carbon must not be used only for decision making for new investments. This information is very
important for the calculation of profitability of both existing and new products. In order to include the cost of
emission in the calculation of the profitability of every product, it will be necessary to distribute total
companys emission to all its products. This is a complicated process and it cannot be done easily. There are
usually more products made within a company or within one section at the same time, and the right key will
have to be found in order to distribute total emission to all products. After the quantity of emission is
calculated, it is necessary to determine the cost of emission of one tone, and difficulty of this decision is
described above. In spite of the difficulties related to the distribution of total emission to a single product, this
can be very useful information for managers, because they can see the quantity of emission that every
product makes, and decide if that product is going to be produced in the future or not. Also, if emission
related to some of the products is high, managers may try to find different method of production, or use
different fuel in order to reduce emission.

6. THE POSSIBILITY OF WINDFALL PROFITS

Although the Kyoto Protocol and the EU ETS have imposed some obligations for the companies, some of
them have used these systems to make gain. Those companies have been incorporating the price of carbon
in the price of their products. This right has been reserved for companies that have monopoly on a certain
market. If a company competes with firms that do not operate under the emission cap, it may not be able to
pass on the full costs of rights to consumers. Also, if market is regulated by the government, the company
will not be legally allowed to raise prices.
Under the EU ETS system, energy companies have had the opportunity to compute the price of rights for
carbon emission in the price of electricity. The best evidence that can back up this behavior of companies
can be found by monitoring the prices of electricity during the first commitment period. The fall of prices of
rights in May 2006 was followed by the fall of the prices of electricity by 5 to 10 Euros. This price adjustment
can be directly linked to the fall of prices of rights, because it was not connected to other energy market
movements that could also affect electricity prices. These companies have treated rights that were given
(free of charge) to them as a cost and increased the price of their products. To be precise, these companies
have treated the price of rights as opportunity costs. The reason for this is the following: all allowances that
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were given to a certain company could be either used to cover the emission of greenhouse gas, or sold on
the market. The production (and emission of greenhouse gas) eliminates the latter option. Therefore, the
companies have been giving up the profit they could earn on the market by selling those rights. Because of
this, managers have been treated the price of rights that must be saved as opportunity cost, and increased
the price of electricity.
As it was previously said, after the second trading period, most rights will probably be auctioned. Based on
this, it will be legitimate for companies to include the costs of rights in the prices of their products.

7. CONCLUSION
The Kyoto Protocol and the EU ETS have imposed certain obligations to companies that operate in
developed countries. These companies have been dealing with the problem of inclusion of the cost of the
emission of greenhouse gas in their decision making process for some time. Along with their competitors
from developed countries, the companies from developing countries will have to face with the problem of the
reduction of greenhouse gas, now or in a couple of years. The managers of companies that think ahead will
start to include the cost of emission in their long-term plans now and prepare their companies for future
actions.

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