Unit 2 Managing Financial Resources Sample Assignment

Managing Financial Resources Sample Assignment

Unit 2 Managing Financial Resources Sample Assignment

Programme

 Level 5 Diploma Business

 Unit Number and Title

 Unit 2 Managing Financial Resources

 QFC Level

 Level 5

Introduction

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. 

TASK 1

P1.1- Identify the sources of finance available to a business

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.

  • Equity Financing:- Equity Financing is the process of raising funds through by issuing shares. It refers to the sale of ownership interest to raise funds for the development of organization. It is the most costly source of finance as it involves payment of dividend to the shareholders from the net profit after the payment of all government taxes, interest on debt and preference dividend. Hence there is always of risk of nonpayment of dividend. It works as a base for creating the debt and loan capacity of the organization. (Bhowmik and Saha, 2013, pp. 61--71)
  • Debt Financing:- Debt Financing is the process of borrowing funds from the outsiders. It carries a promise by the organization to pay a fixed amount of interest, at a specified time and also repay the principle amount at the end of the specified period. Debt financing may be secured or unsecured. Secured debts are those which carry a charge on valuable assets of the company in case of any default made by the borrower. While unsecured debts do not carries any charge on the assets of the company and the lender is not in a secured position in case of any default made by the company. As the debt holders are the creditors of the company, in normal situation they do not have any voting rights in the company’s affairs. (Crundwell, 2008, pp. 507--529)

P1.2- Assess the implications of the different sources

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:-

  • Trade Credit:- The credit which is allowed in connection to the raw materials used by the manufacturer in producing its product or the goods purchased for resale by the retailer is termed as Trade Credit. When the company buys goods from another, it does not immediately pay for those goods. During this period, before the payment falls due the purchaser has a debt outstanding to the supplier. Such outstanding is recorded in the liability side in the company’s balance sheet under the head ‘creditors’
  • Accrued Expenses:- Accrued expenses or outstanding expenses is the another form of short term financing. It refers to the services availed by the company, but payment for the same has not yet been made. It is shown in the Asset side in the company’s balance sheet under the head ‘Loans and Advances’
  • Commercial Papers:- Commercial Papers are the unsecured promissory notes issued by the company to raise funds for a short period which varies between 15 days or 1 month. There are generally purchased by the commercial banks and other financial institutions. (Berggren and Olofsson et al., )
  • Inter-Corporate Deposits(ICDs):- Due to the liquidity shortage in the company the company borrows fund for a short term period, say 6 months; from other companies which has a surplus liquidity. This is termed as Inter-corporate deposits. Depending upon the amount and the period for which the amount is borrowed the rate of interest varies. Long term finance enables a company in the creation of assets and infrastructure. Some of them are discussed below:-
  • Equity Share Capital:- It is the basic source of finance for any company. It refers to the sale of an ownership interest to raise funds for the enterprise. The equity shareholders enjoy the voting rights in the company’s affairs. It does not have any maturity period nor any compulsion to pay any dividend on it.
  • Preference Share Capital:- Preference share capital represents preference with respect of payment of dividend and preference for repayment in case of liquidation of the company. It is also reprents the ownership interest but has a maturity period. The preference shareholders have the right to receive dividends prior to Equity shareholders. (Pushpa Bhatt and Sumangala, 2012)
  • Debentures:- It is the basic debt instrument which is issued by the borrowing company. A debenture may be secured or unsecured. It carries a interest which is paid by the borrowing company at a specified debt and a promise to repay the principle amount after a specified period.
  • Lease & Hire Purchase:- Instead of procuring funds for purchasing its equipments the company can acquire the asset on lease from the lessor. In case of hire purchase the asset is acquired on credit and the payment is made on the terms and condition as laid in the Hire Purchase agreement.
  • Term Loans:- Term loan is also a source of long term finance. It is a loan arranged by the bank with a repayment schedule and a floating interest rate. It has a maturity period which varies between 1 to 10 years.

P1.3- Evaluate appropriate sources of finance for a business project

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
  • External Sources

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
  • Sale of Stock
  • Debt Collection
  • Retained Earnings

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)
External Sources:-

  • Bank Loan or Overdraft
  • Share Issue
  • Mortgage
  • Trade Credit

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.

TASK 2

P2.1- Analyze the costs of different sources 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.

  • 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. (Crundwell, 2008, pp. 507--529)
The formula is given as:
Ke= D0(1+g)/PO+g
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. 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.

P2.2- Explain the importance of financial planning

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)

P2.3– Assess the information needs of different decision makers

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)  

P2.4- Explain the impact of finance on the financial statements

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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Task 3

P3.1- Analyze budgets and make appropriate decisions

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:

Stakeholders

Cash flow focus

Finance Manager of Company

To judge short term finances of the company

Accounts Manager

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

Potential investors

To assess, financial ability of company for future returns

Employees

To assess if company can afford compensation

Shareholders

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:

  • The budgeted P/L shows the figure by way of inflated profits. The cash flow statement reveals that the depreciation amount for the six months period is upto £ 625 k. the break up is shown as below:

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.

  • In terms of the Cash flow forecast, corporate tax of £900 has been shown as a outflow in Oct No mention of tax for previous quarter is visible. One needs to verify if a tax amount could devolve, in which case this too may further reduce profits (PAT).

P3.2 Explain the calculation of unit costs and make pricing decisions using relevant information

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:

  • Selling price goes down from 55.12 to 49.61
  • Total number of units goes up from 650,036 to 780,043
  • COGS go up to £ 22.653 mn from £ 18.878 mn

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.

P3.3- Assess the viability of a project using investment appraisal techniques

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:

 

Year

Project A: Aluminium Housing

£’000

0

(8,000)

1

2,000

2

2,800

3

3,200

4

1,200

5

800

6

500

 

Year

Discount factor @10%

Discount factor @15%

0

1

1

1

0.909

0.870

2

0.826

0.756

3

0.751

0.658

4

0.683

0.572

5

0.621

0.497

6

0.564

0.432

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=

    (8,000)+

2,000 +

 2,800 +

 3,200+

 1,200 +

 800 +

 500+400

DF 10%

        1.000

 0.909

 0.826

        0.751

        0.683

        0.621

        0.564

DCF =

    (8,000)

 1,818

 2,313

 2,403

    820

    497

    508

NPV                                       = +358

Since the NPV is positive even when discounted at rate of cost of finance (%), this project is considered to be viable

IRR Method

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.

Task 4

P4.1 Discuss the main financial statements

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:

  • Statement of financial positions and balance sheet:

It signifies the financial health of the organization. It is divided into three categories:

  1. The land, building, stocks, cash and receivables owned by the organization are shown in the asset side of balance sheet. Assets are further divided into current and noncurrent assets.
  2. Liabilities are the amount of funds that the business owes to outsiders. It even includes the amount that the business might owe in the near future. Provisions are made for future losses that the business might incur in future.
  3. Share capital is the amount that the organization owes to its owners. This is only paid back at the time of winding up of the business. (Fraser and Ormiston, 2001)
  • Income Statement/Profit and loss Statement: This statement enables to gauge the financial performance of the organization during a given period of time.  it exhibits the financial performance of the business over a definite period of time; usually a financial year.
  • Cash Flow Statement: A cash Flow statement is a statement which shows the changes in cash for a particular period of time. It shows the change in position of cash of an organization. It is more than a legal requirement. An organization may command a very strong position as per the balance sheet but may be tied up for the want of cash. In a lot of countries there are rules that if an organization is not able to pay its debt, the creditors can apply to the court for the winding up of the organization. The cash flow shows the actual position of the organization in terms of liquidity. The cash flow is also useful in the calculation of various ratios which indicate the financial health of the organization. It shows the change in the position of cash over a period. It gives the following information:
  • Cash from Operating Activities: This enables the user of the financial statement to understand the cash generated or cash used by the main business of the entity. This would allow one to understand if the organization is generating enough cash or not. If the cash from operating activities is negative then it is sign of concern for the organization.
  • Cash from Investing Activities: This section of the cash flow shows the flow of cash from activities such as purchase and sales of assets of the organization. A negative cash flow under this head could be an indicator the fact that the organization is diversifying its business. (Fraser and Ormiston, 2001)
  • Cash from Investing Activities: This section shows the cash flow from investing activities such as issue or redemption of share capital or debentures. A negative cash flow under the head indicates that the organization is trying to buy back its shares or debentures from the market.

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

  • Net profit or loss of the year
  • Share capital issued or repaid during the period
  • Amount paid as dividend
  • Gains or losses, assignable to equity such as revaluation surpluses

P4.2 Compare appropriate formats of financial statements for different types of business

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.

P4.3 Interpret financial statements using appropriate ratios and comparisons, both internal and external

Current Ratio: Current Assets/Current Liabilities.  The current ratio indicates the liquidity position of the firm.

Current ratio (x)

2011

2010

Change

WM Morrison Supermarkets PLC

0.57

0.55

4%

J Sainsbury PLC

0.65

0.58

12%

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

2011

2010

Change

WM Morrison Supermarkets PLC

2.34

2.35

-0.43%

J Sainsbury PLC

2.42

2.5

-3.20%

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

2011

2010

Change

WM Morrison Supermarkets PLC

17.55

16.13

8.80%

J Sainsbury PLC

14.19

15.25

-6.95%

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.

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Conclusion:

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.

Reference

  • Akerson, C. B. 1988. The internal rate of return in real estate investments. Chicago, Ill.: American Society of Real Estate Counselors.
  • Berggren, B., Olofsson, C. and Silver, L. Learning to handle control aversion: The use of different sources of finance by SMEs. The International Journal of Entrepreneurship and Innovation.
  • Bhowmik, S. K. and Saha, D. 2013. Sources of Finance. Springer, pp. 61--71.
  • Crundwell, F. K. 2008. Sources of Finance. Finance for Engineers: Evaluation and Funding of Capital Projects, pp. 507--529.
  • Fraser, L. M. and Ormiston, A. 2001. Understanding financial statements. Upper Saddle River, N.J.: Prentice Hall.
  • Hallman, G. V. and Rosenbloom, J. S. 2003. Personal financial planning. New York: McGraw-Hill.
  • Harkavy, O. 1953. The relation between retained earnings and common stock prices for large, listed corporations*. The Journal of Finance, 8 (3), pp. 283--297.
  • Kane, A. R. and Cooper, T. W. 1987. A preliminary evaluation of potential sources of revenue for highway finance. Transportation Research Record, (1124).
  • Maceachen, A. J. 1980. The budget. Canada: Dept. of Finance.
  • Pushpa Bhatt, P. and Sumangala, J. 2012. Impact of Earnings per share on Market Value of an equity share: An Empirical study in Indian Capital Market. Journal of Finance, Accounting & Management, 3 (2).
  • Selling, T. I., Sondhi, A. C. and Sorter, G. H. 1989. Consolidating Captive Finance Subsidiaries: The Impact of SFAS 94 on Financial Statements. Financial Analysts Journal, pp. 72--75.