Unit 2 MFRD Assignment Solution

Unit 2 MFRD Assignment Solution

Introduction

Financial Statements are the medium a company discloses information concerning its financial performance. In order to make investment decisions, followers use the quantitative information obtained from financial statements. Hence, the financial statements help an investor to take appropriate decisions regarding investment. In this paper we are going to discuss about the usefulness of financial statements.

Task 1A

Capital are not the only source of funds required for a business start-up or expansion of a business,  but a business also requires more funds in order to carry on its different activities. The funds raised from the capital market need to be procured at a low cost and an effective utilization needs to be ensured in order to maximize return on investment.
The sources of capital to be chosen depends upon a lot of conditions such as:-
Companies raise long term fund from the capital market. Equity share capital is the long term source of finance which enables the company to use the funds for a very long time. Equity share capital is the basic source of financing for any company. It represents the ownership interest in the company. The characteristics of equity share capital are direct consequence of position of its position in the company’s control, income and assets. Equity Share capital does not have any maturity nor there is any maturity nor there is any compulsory to pay dividends.  (Mason, 2007, pp. 259--299)
Advantages of Equity Share Financing:-

1. Since equity share do not mature, it is a permanent source of fund. However, a company, if so desires, can retain shares through buy back as per guidelines issued by the SEBI.
2.  The new Equity share capital increases the corporate flexibility from the point of view of the capital structure planning.

Limitations of Equity Share financing:-

1. The equity share capital has the highest specific cost of capital among all the sources of finance.
2. Equity dividends are paid to the shareholders out of after tax profit. These dividends are not tax deductible rather implies a burden of corporate Dividend Tax.

Debt Financing: A bond or debenture is the basic debt instrument which may be issued by a borrowing company for a price which may be less than or equal to or more than its face value. A debenture also carries a promise by the company to make interest payments to the debenture holder of specified amount, at a specified time.   The biggest advantage of using such funds is that the organization does not have to repay these during its lifetime (Though redeemable preference shares have to be redeemed at the end of the maturity period) however, the organizations behaviour cannot go on issuing such shares as that would dilute the control in the organization and also weakens the capital base.
At the start-up phase an organization can resort to venture capital and other source of finance. For a business expansion the company can resort to both debt and equity mix. At the start-up phase it is very difficult to resort to equity financing. However the company can resort to debt financing all the time as the impact on the capital structure and also the rate of interest keeps on increasing with the amount of debt. (Israel, 1991, pp. 1391--1409)

Task 1B

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 the measures of financial performance for a specified time period. It depicts the financial performance by giving a summary about how the company incurs its revenue and expenses through both operating and non-operating activities which is also known as the “Profit & Loss Statements”
Income statement is one of the major financial statement. The income statement has two portions one is the operating portion and the other is non-operating portion. The operating portion basically deals with the revenue and expenses which are directly relate to a business operation. Suppose if a business deals with manufacturing of steel then the operating items will talk about the revenue and expenses directly involved in manufacture of steel. The non-operating portion basically deals with the revenue and expenditure which are not directly related to production. For example, if the steel manufacturing unit sold some of its equipment then such transaction will be a non-operating item. (Elliott and Elliott, 2008)
A Balance sheet is the statements which show the financial performance of an organization at a specified point of time basically at the end of the year. Balance sheet sums up all the economic resources (assets), obligations (debts & long term liabilities) and owners capital at a specified point of time. This is called Balance Sheet because at a particular point of time the sum total of all the assets and liabilities will equal or balance.

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.

There are different sources of finance available to an organization. The basic two of them are the (a) Loan Funds & (b) Own Funds.

1. Loan Funds: Loan funds are a long term debt capital raised by the company from the capital market. Funds available for a period of less than one year are short term funds and the funds available for a period of more than one year is a long term fund. A bond or a debenture is the basic debt instrument which may be issued by a borrowing company for a price which may be less than or equal to or more than the face value. A debt also carries a promise by the company to make interest payments to the debenture holder of a specified amount, at a specified time and also to repay the principle amount at the end of a specified period Since the debt instruments are issued keeping in view the need of cash flow profile of the company as well as the investor there have been a variety of debt instruments being issued by the company in practice. (Crundwell, 2008, pp. 507--529)
2. Own Funds: Own funds are the funds which is generated within the organization. Equity Share capital is the basic source of finance for any company. It represents the owner-ship interest in the company. The characteristics of equity share capital are a direct consequence of its position in the company’s control, income and asset. Equity share capital does not have any maturity nor there any compulsion to pay dividend on it. The equity share capital provides funds more or less on a permanent basis. It also works as a base for creating the debt and loan capacity of the firm.

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.

Financial planning involves analysing the financial flow of the company, forecasting the consequences of various investments, financing the dividend decision and weighting the effects of various alternatives. The idea is to determine where the firm has been, where it is now and where it is heading, not only the most likely course of events, but deviations from the most likely outcomes.
The advantage of financial planning is that it forces management to take account of possible deviations from the company’s anticipated path. The aim of financial planning is to match the needs of the company with those of the investor with a sensible gearing of short term and long term fixed interest securities. Financial planning aims at eliminating the waste resulting from complexions of operations. For e.g. technological advantage, higher taxes, fluctuations of interest rates etc. Financial planning helps to waste by providing policies and procedures, which makes possible a closer coordination between various functions of the business enterprise.

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.

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1.5 Discuss how different forms of financing affects the format of the financial statements

As discussed above, there are different sources of finance available to an organization. The two important sources of finance ore the equity funds and the loan funds. An imbalanced mix of debt and equity can affect the financial statements to a great extent. The finance and funding manager has to establish an optimum capital structure to ensure the maximum rate of return on investments. The ratio between the equity and the other liabilities carrying fixed charges has to be defined. In this process he has to consider the operating and financial leverages of his firm. The operating leverage exist because of operating expenses, while financial leverage exist because of the amount of debt capital involved in the firm’s capital structure. (Bierman, 2003)

1.6 Calculate the following ratios and comment on the performance of the business over the two years

1. Calculation of Return on Capital Employed (ROCE):

              ROCE =     Net operating Profit

                                  Capital Employed

        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

             Capital Employed = Total Assets – Current Liabilities (Given)

Return on Capital Employed

                  For 2003 =      3,825 = 8.05% (approx.)

                                           47,505

                   For 2002 =      5,925 = 16.97% (approx.)

                                           34,912

Calculation of Gross Profit Ratio:-

   G/P Ratio =     G/P *100

                               Sales               

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:-

                           For 2003 = 33,092*100 = 16.13%

                                              2,05,157

                           For 2002 =  28,800*100 = 15.78%

                                              1,82,530

Calculation of Stock Turnover Ratio (STR):-

STR =    Net Sales – G/P

                     Stock

         = Cost of Goods Sold

                     Stock
  For 2003 = 1,72,065=14 times (approx.)

                                    12,482

               For 2002 =  1,53,730= 13 times (approx.)

                                      11,862

Debtors Collection Period ( Debtors Days):-

Average Collection Period =   Debtors

                                                    Sales
  For 2003 =    32,287*360 = 57 days (approx.)

                           2,05,157

       For 2002 =   28,410 *360 =56 Days (approx.)

                            1,82,530
Creditors Payment Period:

Total Purchases = Sales + Closing Stock – Gross Profit

For 2003 = 205157+12482-33092

                 = 184547

For 2002 = 182530+11862-28800

                 = 165592

Average Payment Period =   Total Creditor   * 360

                                                 Credit Purchase
                                        For 2003 = 17048 + 13388 *360

                                                       184547              

         = 30436 *360

              184547

        = 59 Days (approx.)

                                         For 2003 = 13585 + 6870 *360

                                                             165592

                                                       =    44 Days (approx.)

Inference: Since the sales have increased by 12% from the last year the expenses of the company rose up to 23% resulting in a huge gross loss. The company should take initiative to control the outflow. Company is highly dependable on the external funds resulting an increase in the interest expense of 58% from the last year as a result of which there is a huge net loss of the company. In order to maximize profitability the company should take initiative to work on the financial performance.  

Task 2A

Cash flow of an enterprise is useful in providing users of financial statements with the basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of enterprises to utilize those cash flows. This statement deals with the provision of information about the historical changes in cash flow during the period from operating, investing and financing activities. (Jury, 2012)

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. (Bode, 2010, p. 367)
Recommendations 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.

Task 2B

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 B involves 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.

Analysis: Both the projects has an initial investment of ? 450,000, however the net cash inflows are different for every year. It has been assumed the cost of capital will be 6%. Based on the above information the Net Present Value of  Project A comes down to £254170 and that of Project B is £121010. Based on the  Net Present Value Project A is more preferable than that of Project B as the NPV is higher in case of Project A i.e. by £133160.

Task 2C

Cost per Puppet = 285000 = £ 14.25
                                  40000 

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

Conclusion:-

An organization should be able to comprehend the importance of various techniques like cash flow analysis and ratio analysis. Such analysis helps the organization to understand the financial resources position and health.

References

Bierman, H. 2003. The capital structure decision. Boston: Kluwer Academic Publishers.
Bode, G. L. 2010. Cash Flow Analysis. The Business of Medical Practice: Transformational Health 2.0 Skills for Doctors, p. 367.
Crundwell, F. K. 2008. Sources of Finance. Finance for Engineers: Evaluation and Funding of Capital Projects, pp. 507--529.
Elliott, B.andElliott, J. 2008. Financial accounting and reporting. Harlow: Financial Times Prentice Hall.
Israel, R. 1991. Capital structure and the market for corporate control: The defensive role of debt financing. The Journal of Finance, 46 (4), pp. 1391--1409.
Jury, T. D. H. 2012. Cash flow analysis and forecasting. West Sussex [England]: John Wiley & Sons.
Mason, C. M. 2007. Informal sources of venture finance. Springer, pp. 259--299.