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Unit 2 Managing Financial Resources and Decisions Sample Assignment
This paper will help us in understanding the different sources and application of finances in an organization. It will also give an inner view of the financial statements which will provide information to the user to enable them to make necessary decisions and form judgment.
An entrepreneur might face a lot of hurdles of acquiring finance to set up a business. Depending on the nature and size of the business an entrepreneur may require thousands of dollars to start a business. There are various sources of finance available to an entrepreneur. For different purposes financing is made in two different forms:
In Internal source of financing the funds are acquired from within the organization or from within the business. In case of external source of financing the funds are acquired from outsiders i.e. a third party involvement. Usually the internal sources of finance have no cost to the business, but as external sources involve a third party involvement it carries a cost to the company. (Ladley and Wilford, 1980)
The internal sources of financing in summaries:
- Profits after tax
There are three types of financing available in External Sources:
- Short term
- Medium term
- Long term
Short term finances provide the initial working capital to the company. It is referred as short term because the repayment has to be made within one year. Medium or long term sources are the finances which have a repayment of more than one year.
Long term sources of finance are those that are needed over a longer period of time such as funds needed for the expansion of business, purchase of fixed assets etc. long term source of funds basically comes from two sources:
- Equity share Capital
- Debenture Capital
Equity Share Capital:
Equity Share Capital is a part of ownership of the company. The equity shareholders will have powers of making decision via their votes. The characteristics of equity share capital are in direct consequence to the position in the company’s administration, control, income and assets. It is considered as the basic source of finance. It works as a base for providing the debt and loan capacity of the firm.
Advantages of Equity Financing:
- It is considered as a permanent source of finance as it does not have any maturity period. A company has the powers to retain their share through buy back.
- The issue of new equity share increases the corporate flexibility from the point of view of the capital structure planning.
Limitation of Equity Share Capital:
- It has the highest specific cost of capital as compared to other sources of finance.
- As the equity dividends are paid from the after tax profits of the company there is an extra burden on the company of Corporate Dividend Tax.
Debenture capital is the source of financing long term funds. It is issued by a borrowing company at a price which may be less than, equal to or more than the face value. A debenture holder is a creditor of a company and is entitled to receive interest on debentures of specified amount, at a specified time and also to repay the principal amount at the end of the specified time period. There are a variety of debt instruments issued by the company in practice. (Campello, 2006)
Advantages of Debenture Capital:
- As the debenture holders do not have any voting rights in the company the control is not surrendered to them.
- The tax burden on the company decreases as interest on debentures is allowable expenditure under the income tax act.
Disadvantages of Debenture Capital:
- The cost of raising capital through debentures is high because of high stamp duty.
- Common people cannot buy debentures as they are of very high denominations.
Small Business Start-up: For a small business start up the organization should resort to own funds and debt funds. A new business would not be able to obtain funds with the help of equity. Hence, the owner would have to infuse cash from their own pockets. A new business can also resort to other means such as venture capital and seed capital.
Large Business Expansion: For a large business expansion one should generally resort to the use of equity and debt financing. However the mix should be a proper one. Too much of equity would mean dilution of control and too much of debt would mean adverse ratios.
Medium Sized Organization; A group of people looking to acquire a medium sized business should resort to own funds and debts. However they can also acquire the same and go public afterwards.
1.1 The above information contains information from both the Income Statement of the company and the statement of the financial position. Discuss the purpose of these financial statements.
Financial statements are statements, which contain summarized information of the firm’s financial affairs, organized systematically. They are the end products of the system. They are intended to reveal the financial position of the enterprise, the result of its recent activities, and an analysis of what has been done with earnings.
Financial statements are also called as financial reports. Thus according to Anthony, Financial statements, essentially are interim reports, presented annually and reflect division of the life of an enterprise into more or less arbitrary accounting period- more or less frequently a year. (Fraser and Ormiston, 2001)
Balance sheet of a company gives a listing of its resources and of its sources of capital on a particular day. From balance sheet, financial statement user can have a picture of the company. They can see a composition of resources under the firm’s command. On the other hand, by examining the sources of capital, they can know how the sources have been financed. The resources of the firm are described as assets. The sources of capital used to finance the assets are known as equities. Equities consist of external equities, such as interest of banks and supplier of goods and services and owners equities. External equities are usually described as liabilities.
An income statement or profit or loss account shows the financial performance of an enterprise over a period of time. More especially, it provides for a particular period summary of revenue generated from sale, the cost incurred to generate the revenue and the different between revenue and cost is known as profit or loss.net profit indicating profitability of the firm is the excess of revenue over expenses of the period. When firm’s operation becomes unprofitable, total expenses exceeds the total revenue and the difference is referred to as loss. (White, Sondhi and Fried, 1994)
1.2 Analysis of the above information reveals that the company is financed by both debt capital and equity capital. You have been asked by the directors to prepare a short report on the costs of these different sources of finance. You are expected to discuss what factors should be considered by directors when taking decisions regarding the mode of financing.
Cost of Equity share capital:-
For the new issue the cost of equity share capital can be computed by the use of dividend valuation model. In this model it is assumed that the market value of the shares is directly related to the expected future dividends on shares. The formula is given as:
Ke = D/PO
Where Ke= Cost of Equity share capital
D= Dividend at the end of year 1
PO= Ex- dividend share price.
The shareholders will always expect dividend value to rise every year. It states that the market price of the share is the present value of discounted cash flow. So the market value is expected to give a constant growth in dividend every year. The formula is given as:
Where Ke= Cost of Equity Capital
D0= Dividend at the beginning of the year
g =growth rate in dividend
PO= market price at the beginning of the year.
Cost of Debt:-
The cost of debt is termed as the amount of return an organization must pay to its lenders. It is the cost which the company continues to use rather than to redeem to debts at a market price (Modigliani and Miller, 1958). Cost of debts has two forms one is the Cost of redeemable debt and the other is the cost of irredeemable debt. The cost of irredeemable debt can be calculated as:-
Kd = i/P0
Where= Kd= Cost of Debt
I= the interest rate
P0= market price of debt at the beginning of the year.
1.3 Selecting suitable sources of finance as 1.1 is an example of financial planning. Discuss other instances of financial planning and analyse the importance of financial planning to the company.
The essence of financial planning is to ensure that the right amount of fund is available at the right time and at the right cost for the level of risk involved to enable the firm’s objectives to be achieved. Budgeting will be a key financial planning tool. The efficiency and effectiveness of the financial planning process will be great, aided by the application of computerized financial modelling. Financial Planning is an important tool which helps an organization to manage the long term and short term sources of finance to meet their desired goals.
Financial planning helps an organization to manage its income and helps to understand how much money is needed for payment of taxes, expenditures and how much to save. Effective financial planning helps to increase the cash flow by continuous monitoring the expenses. Capital can also be increased by an increase in the cash flow. A proper financial plan helps an organization to make proper investment plans. An organization can achieve its goal when a proper financial accounting is implemented. (Carino and Ziemba, 1998)
1.4 The above information contains extracts from both the Income Statement and Statement of Financial position. Discuss how these statements meet the information needs of various stakeholders of the company.
The extracts of the financial statements given above does not give a clear picture of the performance of the organization, as it is only an extract of the financial statement and not the proper financial statements. No information about the equity or debt capital has been given above in order to determine the performance of the financial statements. All the information are in a summarized form and it is very difficult to judge the performance of the financial statements. From the given information it is only possible to judge the turnover and the expenses of the organization. From there information’s an investor can only judge few things such as return on capital employed, gross profit margin, stock turnover, debtor turnover and few other things. This information can help the investors to know whether the company is profitable or not and does not give a clear picture about the cost of debt and cost of equity.
1.5 Discuss how different forms of financing affects the format of the financial statements
There is a great impact of finance on the financial statements of an organization. When the financial impacts are released it has a great impact on the business and the investors of the company. Financial statements put a great impact on the stock price of the company. While making investment decisions an investor may look at the financial statement. If the information presented in the statements is good enough then it can send the stock price to rise. Financing through loan can also have a great impact on the financial statements. The lender will want to see the financial statement of the company. If the information in the financial statements is negative the company may fail to obtain loan from the lender.
1.6 Calculate the following ratios and comment on the performance of the business over the two years.
- Calculation of Return on Capital Employed (ROCE):
Return on Capital Employed = Net operating Profit
Net Operating Profit = Total Turnover – Cost of goods Sold- Expenses – Interest Payable
For 2003 = 2,05,157 - 1,72,065 – 27,342 – 1,925
= £ 3,825
For 2002 = 1,82,530 – 1,53,730 – 22,285 – 1,220
= £ 5,295
Return on Capital Employed = Net Operating profit
For 2003 = 3,825 = 8.05% (approx.)
For 2002 = 5,925= 16.97% (approx.)
- Calculation of Gross Profit Ratio:-
G/P Ratio = G/P *100
Gross Profit= Total Turnover – Cost of Goods Sold
For 2003 = 2, 05,157 – 1, 72,065
= £ 33,092
For 2002 = 1, 82,530 -1, 53,730
= £ 28,800
G/P Ratio = GP/Sales *100
For 2003 = 33,092*100 = 16.13%
For 2002 = 28,800*100 = 15.78%
Calculation of Stock Turnover Ratio (STR):-
STR = Net Sales – G/P
For 2003 = 1,72,065=14 times (approx.)
For 2002 = 1,53,730= 13 times (approx.)
Debtors Collection Period ( Debtors Days):-
Average Collection Period =Debtors
For 2003 =32,287*360 = 57 days (approx.)
For 2002 =28,410 *360 =56 Days (approx.)
Creditors Payment Period= Net Credit purchases/ Total Creditors
Total Purchases = Sales + Closing Stock – Gross Profit
For 2003 = 2, 05,157+12,482-33,092
For 2002 = 1, 82,530+11,862-28,800
= £1, 65,592
Average Payment Period =Total Creditor* 360
For 2003 = 17048 + 13388 *360
= 30436 *360
= 59 Days (approx.)
For 2003 = 13585 + 6870 *360
44 Days (approx.)
From the profit and loss account for the year ended
Cost of goods sold
From the balance sheet as at 31 March 2003 31 March 2002
Total Asset less current liabilities
Creditors Due after more than one year
Share Capital ( 25p share)
The sales from the last year have increased by 12% and the expenses of the company also rose by 23% as a result there is a huge loss of the company as the conversion cost is very high. The company is highly dependable on the external funds resulting in an increase in the interest expense of 58% from the last year. The company has to put a lot of effort to work on the financial performance of the company.
Cash flow statement is a statement that reveals the effect of all business transactions on the cash position of the firm over a period of time and assesses the ability of an enterprise to generate cash and cash equivalents and the need of enterprise to utilize those cash flows. It summarizes the causes of changes of cash position between dates of two balance sheets.
Over the year there is a huge fluctuation in the sales volume of the organization and the cost of conversion is also very high resulting in a gross loss of £985(£3325-£2340) which is very high. The cash flow statement does not provide a clear picture of the financial performance of the organization as a result of which it is very difficult for the user to assess the financial performance. (Jury, 2012)
The organization should take initiative to reduce the cost of conversion in order to maximize profitability. The management should also try to cut down the sundry expenses, wages and the motor expenses drastically. The organization should plan its activities more carefully in order to minimize the cash outflows and maximize the inflows.
Project A involves introduction of high tech machinery into the company’s main processing unit. This would result in a significant increase in the company’s output and a substantial saving in the company’s production and maintenance cost.
Project Binvolves increase in the company’s marketing activities. The management feels that by introducing the marketing activities the business can be increased without necessarily updating the production process.
Discounting factor @6%
Discounted Cash Flow
Discounting factor @6%
Discounted Cash Flow
Both the projects have an initial investment of ? 450,000. However the net cash flow different for every year. The cost of capital is given as 6%. Based on the above calculation the Net present Value (NPV) of project A comes down to £ 2, 54,170 and Project B is £1, 21,010. Based on the above analysis it is clear that Project A is more preferable than project B as it has a highest Net Present value of £ 2, 54,170 as compared to that of Project B (i.e. £1, 21,010).
Calculation of Total Cost of Producing 40000 puppets
Cost per Puppet=285000= £14.25
Calculation of Selling Price of each puppet:
Cost of each Puppet = £ 14.25
Add: 15% Mark-up Profit = £ 2.15
Selling Price of each Puppet: £ 16.40
An organization needs to have a proper understanding of the financial statements which includes the cash flow. A proper understanding of the same helps the organization to make informed decisions and manage the affairs in a better way.
Campello, M. (2006). Debt financing: Does it boost or hurt firm performance in product markets? Journal of Financial Economics, 82(1), pp.135--172.
Carino, D. and Ziemba, W. (1998). Formulation of the Russell-Yasuda Kasai financial planning model. Operations Research, 46(4), pp.433--449.
Fraser, L. and Ormiston, A. (2001). Understanding financial statements. 1st ed. Upper Saddle River, N.J.: Prentice Hall.
Jury, T. (2012). Cash flow analysis and forecasting. 1st ed. West Sussex [England]: John Wiley & Sons.\