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Level 5 Diploma Business
Unit Number and Title
Unit 2 Managing Financial Resources
This paper involves a descriptive study about the importance of financial planning, usefulness of different sources of finance and the impact of finance on the financial statements. While selecting a particular source of finance various implications have to be analyzed which helps the company in the decision making process.
Capital is not only required to set up a business but a business may require additional funds or capital to carry on their day to day activities. To start up a business financing is the basic requirement in order to ramp up its profitability. There are different sources of financing available during the startup of business strategy. But first it has to be considered how much fund is required and when it is needed. The funds required by an organization will depend upon the type and size of the organization. Short term capital is required where the organization is in a need of working capital and long term capital is required for the expansion of the business. Financing requirements comes from various sources like Capital Market, Loans from Banks, Loan stock, Retained Earnings, government grants, venture capital. The two major sources of finance are: Equity Financing and Debt Financing.
Different sources of finance are available to small business or a big company. With each sources of finance listed will assess the implications at the cost of the business. At the initial phase all companies are in a need of short term finance to cover their day to day running cost. Short term finance also provides the initial working capital to the company. Some short term sources of finance are listed below:-
The type of finance chosen depends upon the nature and the size of business. In order to choose the type of funding option an appropriate source of finance is very important. The sources of finance are basically categorized under two heads’ namely
Internal Sources of finance means the money which comes from within the organization. Some of the internal sources of finance are described below:-
Owners Investment: -It refers to the money which comes from owner’s own savings. It is referred as a long term source of finance. It is used in the form of startup capital while setting up the business. It used in the form of additional capital for expansion of any business.
Sale of Stock:-The profit made by selling the unsold stock and ploughed back into the business for its expansion. It is the quick way of raising short term finance. (Kane and Cooper, 1987)
Debt Collection: -A debtor is a person who owes business money. A business can raise funds by collecting its debts owed to them from the debtors. In normal circumstances, there is no additional cost involved in collecting this finance.
Retained Earnings: -When the profit made by the business entity is ploughed back or retained into the business for its expansion, it is known as retained earnings. This source of finance is available to a business entity after it has completed a full year operation. (Harkavy, 1953, pp. 283--297)
Bank Loan or Overdraft: - The money which is borrowed from the bank at a specified rate and a promise to repay back after the expiry of a specified period of time. It is considered to be a long term source of finance.
Share Issue: - This source of finance is available to the limited company’s only. It involves issuing of shares to the outsider to collect funds from them and invest it in the business operations. This is considered as the long term source of finance.
Mortgage:-This is a long term source of finance. The loan which is obtained by securing its property is known as mortgage. The time limit for its repayment is generally 25 years.
Trade Credit: - The credit which is allowed by the seller on purchase of materials for manufacturing any product is known as trade credit. The credit time is basically extended for a period of 30 days. This is considered as a short term source of finance.
The two main sources of finance are the Equity share capital and Debt Capital. Finding out the cost of capital of these sources of finance are relatively important.
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. (Crundwell, 2008, pp. 507--529)
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.
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 planning is implemented. (Hallman and Rosenbloom, 2003)
Information needs of different decision making vary from time to time. For a better financial planning a decision maker has to analyze various ratios, budgets, cash flow and variances. The main ratios considered by a decision maker are activity and liquidity ratios, capital gearing ratios, profitability and performance ratios.
A decision maker needs to make proper analysis of these ratios, correct forecast and a professional overview on the company’s performance. A decision maker also has to consider other tools such as:
Cash flow: -it is an important tool which looks at the likely future of cash outflow and revenues. In order to control the expenditure the organizations plans to see what it might need to borrow.
Budgetingis an important tool by which an organization makes its future plans. It helps an organization to plan where it will incur cost and from where revenue will come from.
Variancesshow the difference between what the forecast was and what actually happened. The reasons shows the difference to show from the variances occurred. (Hallman and Rosenbloom, 2003)
The sources of finance put a great impact on the financial statements of an organization. When the financial impacts are released irt 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 are negative the company may fail to obtain loan from the lender. (Selling and Sondhi et al., 1989, pp. 72--75)
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A company’s statement of accounts reveals the financial activity over the previous accounting period and the company’s performance is revealed the tough the balance sheet. A budget is the comprehensive and coordinated plan for the operation of an organization for a given period of time. The concept of budgeting focuses on the elements like plans, financial terms, operations, resources, future period etc.
A cash flow budget gives information about the income of the company. In the absence of any accruals, any shortfall will bring in the external sources of finance such as capital, loans etc.
In the same manner capital budgeting is the forecast of allocation of funds towards long term use of sources of finance such as purchase of assets, repayment of liabilities etc. (Maceachen, 1980)
The table below gives the various stakeholders who would be interested in studying the cash forecasts, for quite different reasons of their own:
Cash flow focus
Finance Manager of Company
To judge short term finances of the company
To rectify if adequate liquidity exists for day to day payments, such as, salary, overheads etc.
Potential lenders, Creditors
To maintain, potential ability of company to repay
To assess, financial ability of company for future returns
To assess if company can afford compensation
Return on investment
An analysis of the Easy Electronics’ Budgeting P&L as well as Cash flow forecast of the 6 month period provides us with the following information:
Depreciation @ £100 k per month
For months of July to Sept= £ 300 k
Depreciation @ £125 k per month
For months of Oct to Dec= £ 375 k
= £ 675 k
When this amount is adjusted PBIT reduces to £10,496 - £ 675 = £9,821
The adjusted PBT would be £9,321 and PAT = £7,177 only.
Unit cost is sum of Total Fixed cost (FC) + Total Variables cost (VC) per unit of production. It is a measure of total cost of producing and selling one unit of an item or goods. Unit cost varies as the number of units produced varies mainly because of the change in the variable costs increases with the production units.
In the case of Easy Electronics, the cost of goods sold includes components to be credit purchase wages, making up a VC and a FC
The calculation is shown below:
Based on the above information we find that the unit cost remains the same at £29.04, in spite of the decrease in selling price. As the unit cost remains the same due to decrease in the selling price. The profitability will rise to £ 907,651 proving that the changes have not worked well for the company. Hence in my opinion, the changes should not be accepted.
From October 2014 Easy Electronics ltd is considering diversifying into manufacturing Aluminum computer cases or housing. The company’s cost of capital is given as 10%. The project has a scrap value of £400,000. The net cash flow from the projects are shown below:
Project A: Aluminium Housing
Discount factor @10%
Discount factor @15%
The two suitable techniques could be the Net Present Value Method (NPV) and the Internal rate of Return(IRR) method
Cash Flow from year 0 to Year 6 would be=
NPV = +358
Since the NPV is positive even when discounted at rate of cost of finance (%), this project is considered to be viable
Alternatively, we can arrive at the following:-
When discounted at 10% (Cost of finance), the NPV stays positive
Next if discounted at 15%, NPV turns negative, implying that the IRR (Rate that discounts Cash flows to zero) must lie somewhere in between. (Akerson, 1988)
Now we can use the formula:
IRR = Base factor + [Positive NPV ÷ Difference in positive and negative NPVs] x DP
Where Base factor = Positive discount rate & DP = Difference in the 2 discount percentages
IRR = 11.939%; Since IRR is more than the financing rate of 10%, the project is considered as viable.
Financial statements provide important information concerning financial transactions and their impact on the profitability and the financial positions of business. The main financial statements are discussed as below:
It signifies the financial health of the organization. It is divided into three categories:
Statement of Change in Equity, also known as the statement of Retained Earnings which entails the detail movement of equity of the owner over a period. It is derived from the following components
Financial statements are prepared in accordance to the guidelines as laid in GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). The basic difference between profit and non-profit organization is that the profit making organization has to prepare a profit and loss statement whereas the nonprofit organization prepares receipt and expenditures account. Balance sheet is the same for both the organizations.
In case of a sole proprietorship concern the sole trader is required to prepare the sole trading account, sales revenue is shown in the credit side along with the closing stock. On the debit side opening balance of stock, purchases, freight inwards and wages are shown and the Balance is the Gross Profit which is then carried over to the credit side of the Profit and Loss account. All expenses are exhibited on the left side and deducted from gross profit to show the Net Profit.
In case of a manufacturing concern a trading account is also prepared which shows the sales, gross profit, purchases and the closing stock. All the expenses which are indirectly related to the operations are debited to the profit and loss account. These expenses are deducted from the gross profit to arrive at the net profit. (Fraser and Ormiston, 2001)
In the case of partnership firm the financial statements includes the profits or losses are added or subtracted from the partner’s capital. In case of a private limited organization the financial statements should clearly reflect the assets and liabilities while following the relevant standards.
Current Ratio: Current Assets/Current Liabilities. The current ratio indicates the liquidity position of the firm.
Current ratio (x)
WM Morrison Supermarkets PLC
J Sainsbury PLC
Inference: - The standard is 2:1. Though it is not been closer to the market standards the position has improved over the year.
Net Sales to Total Assets Ratio: This ratio illustrates the firm’s ability to generate sales from its assets.
Net Assets Turnover
WM Morrison Supermarkets PLC
J Sainsbury PLC
Interpretation:The standard is 3.4:1. It is not up to the market standards and the company should take initiative to check it.
Net Profit to Equity Ratio:The ratio is also known as Return on Shareholders’ Equity. It is also a measure of profitability. The ratio is, Net Profit/Shareholders’ Equity.
Return on Shareholders’ Funds % 1
WM Morrison Supermarkets PLC
J Sainsbury PLC
Interpretation: The industry standard is 16%. In this regard WM Morrison has done better than J Sainsbury’s. High ratio indicates better security for dividend payment & also greater managing financial strength of the firm.
As from the point of view of the organization a finance manager should always work on the Wealth maximization of the company. Various sources of finance help them to take appropriate decisions which would help the entire organization as a whole.