This is a Managing Financial Resources Assignmentin which we discuss Managing financial resources in business management.
The case is about a furniture manufacturer by the name of Success Ltd.Success Ltd is a medium-sized private limited liability company producing furniture for the retail sector and private homes. Currently it employs 50 staff and has been in business in the last 5 years, mainly in a domestic market.The business was set up by 3 young carpenters, Billi kid, Bengazy and Lee Jones. Whilst their ability and enthusiasm to design the furniture is largely undiminished, other business functions such as marketing, administration and sourcing materials at the best prices are not well integrated as neither are particularly interested in the business process. This assignment will analyze the financial resources of Success Ltd. And give necessary recommendations to manage their business effectively.
The sources of Finance that have been used by Success Ltd. Are: -
- Share Capital – For success Ltd. Total value of money that they have picked up from the market is close to £ 420000.This is basically the share market where the company offers some of its stake to the general public in the form of shares in exchange for a price. The total price from the sales of all the shares of the required stake is referred to as the market capitalization of the company. The shares can be issued in the market via public issue at the face value of 10.
- Secured Loans from Banks – For Success Ltd., they have taken a secured loan from a bank at 9% rate of Interest amounting to more than £ 1 Million. The Loan amount is close to £ 50 Million.The loans are pegged at a rate of Interest that is to be borne by the company taking the loan. These are secured loans that can be taken from the bank for a period of 5-10 years. Apart from this there are unsecured loans also that can be taken from NBFC’s which don’t require the loan party to submit any security in lieu of the loan (Hung, 2000).
- Profits Retained – For success ltd. The retained earnings component is close to £ 500000. This is the source of finance that the company reserves for future use from the profits of the previous years. Whatever profits the company earns, it keeps aside a small amount for future investments as ready cash. These retained earnings are profits but for future use.
- Bank Overdraft– This is the fourth source of finance taken by Success Ltd. This is an overdraft facility taken by the bank so that this can be used in emergency situations. For overdraft the interest component is charged on a daily basis and for the time it is deficient in the bank. The amount of this overdraft for Success Ltd. Is close to £ 110000. This overdraft facility offered by banks is for a short duration only and interest is charged on the amount withdrawn by the company from the overdraft account according to the time duration for which it is not replenished.
For purchasing production machines which are part of the expansion plans of Success Ltd., the various sources of finance that can be used by the company are: -
Loans –The loans are pegged at a rate of Interest that is to be borne by Success Ltd. This would be a secured loan that will be taken from the bank for a period of 5 years. Apart from this there are unsecured loans also that can be taken from NBFC’s which don’t require the loan party to submit any security in lieu of the loan. Once the loan is disbursed, Success Ltd. can procure the production machines with the money.
Leasing – Leasing is also a source of finance that can be used by the companies. It is basically a type of borrowed loan at some rate of interest that the Success Ltd. and the lessee decide. This aid would be at a lower rate of interest but will also be of smaller amount.
Venture Capital Borrowing – This is another source of finance that can be employed by Success Ltd to procure production machines. Success Ltd. management team needs to convince the venture capital firm about the investment in the production machines for future growth. If the firm sees growth in their investment then they will definitely be willing to lend some cash to Success Ltd.
Overdraft Facility– Success Ltd. can also go for an overdraft facility from the bank. This is possible if only a small amount of cash is required for a small period of time and Success Ltd. would be able to arrange the borrowed cash within a short period of time (Garrison, 2010). This is because, the interest in this case is charged on a daily basis.
The cost of capital is basically the cost of using the funds that are given to the company for investing for future growth. One can also say that it is basically the return that the people expect out of their investments in a particular organization or company. It is the minimum return the investors demand so as to achieve break even on their investments . Cost of capital=Risk free rate of return + premium for business risk + premium for financial risk.
Risk free rate of return is the minimum return on the investment that can be earned without taking any risk. The premium for business risk is the increase in the estimated rate of return keeping in mind the risk of future uncertainties in the business. Neither the company nor the business environment is certain (Keasey, 1990). The environment in which Success Ltd. operates is pretty uncertain and at the same time it is uncertain for the investors as well. Thus whatever investors are willing to invest in Success Ltd. will demand a high rate of return which is termed as a premium in lieu to accommodate the business risk. The premium for higher financial risk is due to high debt levels of the company. In this case if Success Ltd. has high debt levels then in that case the investors would demand further high premium for their lending as in case of untoward situations their danger of losing money is also more.
The costs associated with the different sources of finance for Success ltd. are: -
- Cost of Equity –It’s a systematic risk for the investments that the shareholders make in Success Ltd. It is basically the rate of return that is being given to the shareholders in lieu of their investments in Success Ltd. Success Ltd. has raised close to £ 420000 from the shareholders at a particular price. The same is the cost of equity for Success Ltd.
- Cost of Debt –It is basically the cost that Success Ltd. will have to pay the bank lenders for the loan that has been sourced from them. One can also say that it is the cost that Success Ltd. will have to bear to continue using the finances being lent to them by the bank and avoid them being sourced back by the bank.
Economy these days has become very uncertain.There are multiple options of financing and financial planning that are available. This makes financial planning a very difficult task. However it is one task that helps you to manage your finances well in advance so as to avoid last minute delays and hassles.The importance of managing Financial Planning to Success Ltd. is: -
- Assessing the Business Requirement – Financial planning will help Success Ltd. to assess the financial situation of the company and ultimately taking the decisions according to the situation which can yield potential gains.
- Identification of Resources – Financial planning at Success Ltd. will ensure the financial goals that are set be prioritized. It will also ensure that whatever resources are needed to achieve the organizational goals and objectives shall be identified and the preparation shall start accordingly (Penman, 2007).
- Protecting the income and assets of Success Ltd.–Proper financial planning safeguards the organization against any misappropriation and efficiently manages the resources.
- Growing the Investments –If Success Ltd. manages its financial resources effectively then the investments can be monitored from time to time and also they can grow over time. The financial planning will ensure the surplus cash is invested in a way that maximizes returns in the future.
- Quantification of Results as well as resources – Financial planning at Success Ltd. will ensure the results and resource availability can be analyzed on the basis of quantity rather than quality. It will ensure the results that would be compared, to be achieved and measured in terms of quantity.
- Identification of Risks – Proper financial planning at Success Ltd. will also ensure the finances are planned and the risks associated with same can also be identified. In order to ensure smooth execution of business processes, it is important the risks are identified by Success Ltd. before hand and preparation to counter those starts well in advance.
Success Ltd. needs good information for decision making purposes as the decisions that Success Ltd. makes in the short term and long term will ultimately be aligned to the long term objectives of the company. Especially the decisions that are short term and need to be implemented they need to be based on some data. For these decisions to count and come good, the data needs to be accurate. Data analysis is an accurate tool that helps in filtering and validating the correctness of the data. If Success Ltd. is provided with faulty data, it will be calculating the results accordingly and it might lead to erroneous decisions that can affect the company in the wrong run. Analysis of faulty data can also lead to the incorrect picture being communicated to the higher management which might lead to devastating consequences. Faulty information can also lead to some loss making decisions which might be difficult to correct later like the procurement of expensive equipment’s and machines.
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Financial Statements of a company can be referred to as the basis for understanding the financial position of the company at any given point in time. They also help to assess the financial position with respect to the previous years of operation. The typical financial statements for any company similar to Success Ltd. are Balance Sheets, Cash Flow statement, Profit and loss account, Annual report etc. The sources of Finance form the basis of all these statements as they help in evaluating the finances over a period of time as it is more of a quantitative analysis than qualitative. The asset and liability picture helps to know the financial position for the firm and also to know if the company has more capacity to take debt and accordingly invest money into future prospects (Stickney, 1993). The cash flow statement of the Success Ltd. generated after studying the revenues and costs of Success Ltd. shall determine the ability for the firm to meet the cash requirements and the ability to pay the creditors who will sanction further loans upon previous backlog being cleared.
The cash Budget for Success Ltd. gives us an estimate of the cash inputs and outflows over a period of time. The preparation of cash budget helps the company to assess the position of its cash flows whether they would be sufficient to assist the operations of the company and also if the company can prevent the cash from being used in unproductive activities. The cash budget for Success Ltd. is as follows: -
Retained Earnings 497800
Trade Receivables 190000
Share Capital 420000
Bank Loan 1146280
Cost of Goods 1201000
Equipment Depreciation 210000
Trade Payables 320860
The inflow and outflow statement of cash flow of Success Ltd. determines the financial and operational activities involved in achieving the organizational goal. This statement segregates these activities and helps the accounting personnel in the company to calculate accordingly the salary and other expenses. This statement will also help the investors analyze the financial position of the company so that they can take their funding decisions accordingly. This statement of Success Ltd. has captured the operating expenses of the company as well (Saunders, 2006).3.2 A
According to the information given in section- B1
The total variable cost per chair is = £22
Total Fixed cost incurred over a year - £5400
Total Chairs Produced over a Year – 1800
Fixed cost per chair per year - £5400 / 1800 = £ 3.
Thus fixed cost per chair per year = £3.
Total Cost of Chair = Fixed Cost per chair + Variable cost per chair
= £ 3 + £ 22
= £ 25.
Thus,Total Cost of Producing a single chair = £ 25.
The fixed cost component of the chair is the same throughout which is £ 3.
The fixed cost component depends on the equipment cost and the facility cost of Success Ltd. The main cost which is the influencing factor of the cost of chair is the variable cost which will change according to the intricacies of the design. In order to achieve maximum profitability, Success Ltd. should decrease the variable cost by standardizing the process of chair production. The processes can be standardized by eliminating the redundant processes and increasing the efficiency of the process by reducing material wastage.
On the basis of information given in section - B2
Total Fixed cost for Producing the chairs = Total Cost of Administrative overheads + Other Fixed Costs = £2000 + £2500 = £ 4500.
This fixed cost is to be covered over a year for producing 1500 chairs even though the company can produce 50000 chairs.
Therefore fixed cost incurred per chair = £ 4500 / 1500 = £ 5.
Therefore each chair’s fixed cost = £ 5.
Variable costs per mini chair = Direct Labor + Direct Materials + Production overheads
= £ 4 + £ 3 + £ 5 = £ 12.
Therefore each Mini chair’s total cost = Fixed Cost per mini chair + Variable cost per mini chair = £ 5 + £ 12
Therefore total cost of production per mini chair = £ 17.
Considering section– C, the cost of capital for borrowing money to finance these machines is 10 %. Net additional cash flows after procuring those machines and the sales proceeds will not be able to beat the cost of capital as the interest component of the loan will increase drastically. By IRR method and NPV method the cost comes out to be 8.5 5 and 9 % respectively which is not sufficient to beat the cost of capital. This will also lead to the increase in variable cost. Thus the procurement of these 2 machines is not advised.
For any business there are 4 main financial statements that determine the financial position and the accounting details of a company. For Success Ltd., the four main financial statements are Income Statement or the Profit and Loss Statement, Balance Sheet, Statement of Owner’s equity and Cash flow statement.
- Income Statement –The components of an income statement are revenues or Sales proceeds, Expenses or cost of goods and profits. Moreover the element and attributes of a profit and loss account also depends on the complexity of the business. Success Ltd. is a small company and with not so complex processes. Thus income statement of Success ltd. will contain simple headings.
- Balance Sheet - The balance sheet of the company gives the financial position of the company at a particular point in time. For Success Ltd. the balance sheet gives the position of its assets and liabilities. The balancing equation for Success Ltd. states that Total assets are equal to the Total Liabilities and Owners equity.
- Statement of Owner’s Equity –This type of financial statement basically tells us the net change in the equity of the owners over a time period (Mills, 1998).
- Cash Flow statement - The inflow and outflow statement of cash flow of Success Ltd. determines the financial and operational activities involved in achieving the organizational goal. This statement segregates these activities and helps the accounting personnel in the company to calculate accordingly the salary and other expenses.
Similar to the financial statements of the company, sole traders can also have their set of financial statements to analyze the performance of their business. The companies also can have different formats of financial statements as they would be according to the reporting standards that they follow.The financial statements collect the financial transactions and details from the sales proceeds and costs of goods which are further used to calculate net profit and loss for the month. The companies or corporations have 4 main elements to their financial statements which are the P & L account, Balance Sheet, Cash Flow Statement and Statement of Shareholder’s Equity.
For a sole trader’s since he / she is the owner of the company, for his analysis he doesn’t need all financial statements to be made. Moreover the transactions of the sole trader are far less in number than company transactions. The financial statement for sole traders is simple because the report has to be analyzed only by the owner of the company. The financial statement may not consist of a balance sheet and a statement of owner’s equity. It might in some cases have a cash flow statement. Thus the financial statement is not complex. The report just needs to show the profit and loss account compared to a company as they will have to prepare by considering the international financial reporting standard (IFRS) and generally accepted accounting principle (GAAP). Moreover for the sole trader the statements are not reported out anywhere and the annual report also doesn’t mandate the same (Barnes, 1987). It is just used for comparison and benchmarking the sole trader’s company performance.
Financial ratios help to analyze the financial position of the company in consideration (Bernstein, 1994).
- Net profit margin – This is basically the percentage profit of the revenue earned after all interest and taxes have been deducted from the net profit.
Net Profit Margin = (Net Profit after Tax / Revenue) x 100
= (£110000 / £2217000) x 100
= 5 %.
Therefore net profit margin = 5 %. This basically means that the company is not that good at converting revenue into profits. This means that the variable cost is too high for the goods which needs to be reduced.
- Gross profit margin – This basically is the gross profit margin percentage of revenue. Gross Profit Margin = (Revenue – Cost of Goods) / Revenue x 100
= (Gross Profit) / Revenue x 100
= £1016000 / £2217000 x 100
= 45.82 %
Therefore gross profit margin is 46 % which means that the company can pay for additional expenses and mostly company is paying lot of interest on loans and taxes.
- Current ratio–It is the ratio of current assets to current liabilities.
Current Ratio = Current Assets / Current Liabilities
= £966240 / £427270
The ratio being above 2 means that company has the finances to pay of its debts in the next 12 months.
- Quick ratio–This is indicator of company’s short term liquidity.
Quick Ratio = Current Assets – Inventories / Current Liabilities
= £966240 - £496240 / £427270
The quick ratio is > 1 which means that company has sufficient short term liquidity to address its operating expenses.
- ROCE–Return on Capital Employed is basically the measure of company’s profitability and the efficiency of the application of its capital.
ROCE = Earnings before interest and Tax / Total Assets – Current Liability
= £ 284500 / (£2601350 - £ 427270)
This means that Success Ltd. is not able to use its capital properly and efficiently (Keasey, 1990).
- Assets turnover ratio–It is basically the indicator of how efficiently the company is been able to deploy its assets.
ATR = Revenues / Total Assets
= £ 2217000 / £2601350
This means that Success Ltd. has not been able to deploy its assets that efficiently.
- Debt/equity ratio–This ratio indicates the ratio of shareholder’s wealth and debt are used to finance the company’s assets.
Debt Equity Ratio = Total Liabilities / Shareholder’s Equity
= £ 2601350 / £ 420000
This means that Success Ltd. has been really aggressive towards using debt to finance its growth. That’s the reason the company is paying so much of interest on Loans (Mills, 1998).
Success Ltd. is a small company with business mainly in furniture products. The company finances its operations majorly through Debt and rest through shareholder’s capital. The company’s gross profit is huge but in the end the net profit is not that huge as Success Ltd. pays a lot of interest due to its loaned capital. In order to efficiently manage its resources, Success Ltd. should standardize its processes, reduce the variable cost and decrease the loan interest by writing off the loan as soon as possible.
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