Unit 2 MFRD Sample Assignment

Task 1

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

Any new business capital is required for starting up. Capital here means funds which can be denoted in terms of money. This funds or capitals can come in many forms such as working capital, third party investments, hire purchase, leasing or through retained earning etc. Now the question arises for how much period does the company needs the capital i.e. for long term or short term. Short term capital is required when the business is in a need of working capital, whereas Long Term Capital is required when the business wants to expand. For a start of small scale business advertising and promotion Agencies may have a reliable and good source of funds. With the help of the available list of funds one can easily set up their business. For financing its funding requirements, the business can opt for sources like:

• Capital market.
• Loan stock.
• Retained earnings.
• Loans from bank.
• It can tap into government resources.
• It can make use of business expansion schemes.
• It can make use of venture capital.
• It can use the concept of franchising.

P1.2 Assess the implications of the different sources

Cost of Equity:  Equity share is considered as one of the costly source of finance since the dividend is paid to the shareholders after the payment of all the external liabilities. The equity shareholders are only paid if the company attains sufficient profits. In other words, if there is no profit left over after paying the preference shareholders. The retained earnings generally do not have a cost, however according to some scholars the cost of retained earnings is the same as cost of equity.  In a different way, cost of retained earnings can be set to be the opportunity cost forgone on the money of the interest that the organization could have earned by employing those retained funds somewhere else. (Small Business Chron, 2014)
Cost of Debt: the debt capital is considered as the cheapest source of finance since the interest paid to the debt holders are tax deductible. The interest is required to be disbursed to the debt holders before any dividend are declared to the shareholders. As taking more loans, have an adverse effect on the liquidity ratios of the organization.  Debt includes long term loans, short term loans.  It also includes debentures and trade credit.
Working Capital: Working capital is termed as the amount required by the company to for running its day to day activity. The working capital helps the company in ascertaining the liquidity position of the company. Advertising Agencies can become the most popular business and have a capability of growing from a small scale business to large scale business. The working capital is also use to pay off the short term liabilities of a company.
Retained Earnings: The companies are intended to raise funds by way to retaining the profits for funding its various capital needs that were supposed to be distributed to the equity shareholders in exchange for the contributions made by them in the company. Retained earnings are the cheapest source of finance. The cost of retained earnings is the amount forgone by the equity shareholders by reinvesting the profits into the company. As our advertising agencies are new in this case it is unable to create such earnings. (Small Business Chron, 2014)
Third party investment: Third party is an individual or an entity that are directly involved in a transaction or an agreement. This is another source of finance in a business. This particularly has suggestions on how to utilize the funds provided by him or the entity. The party has lots implication or suggestion in small scale advertising and promotion Agencies business. Here the business owners have a lot of business risk by losing a large stake. The use of these sources of finance in advertising agencies business also helps to restore the company’s capital base and provides a better expansion of business in upcoming years.
Current Scenario: In this given scenario the organization should go for debt funds as whatever interest the organization has to pay on the debt funds is tax deductible. (Zager and Zager, 2006)             

P1.3 evaluate appropriate sources of finance for a business project

To choose an appropriate source of finance it is very much important to choose the right funding option. It provides an appropriate suggestion and identification about the choice of finance. The sources of finance available to a business can be divided into mainly 2 types,

• Internal sources.
• External sources.

Internal Source:  The funds, which come from the owner’s equity or personal savings or selling of business assets or from business activities are known as internal sources.  Advantages of internal sources of finance are as follows:
Flexibility:  The internal sources of finance can be used for the financing of a long-term asset or can be used for the short-term business requirements of the organization.
External Source:  External sources generally take the form of loan from banks or society’s overdraft, issue of new shares or issue of new debentures.  The advantages of employing external sources are as follows:

• Larger Amount of Funds: An organization can tap the limitless amount of funds if the business is financing its operation through internal funds there would always be a limitation of the funds available, however this limitation is removed by the use of external funds as the business can tap into a huge full of the sources.  However, the external sources of finance are costlier than the internal runs as the business has to pay interest on it.  While considering the sources of finance, the business has to look into various requirements. (Zager and Zager, 2006)
• Amount of money required.  If the amount of money required is less, the business can generally make use of internal sources.  However, where the required funds are more, the business has to make use of external sources.
• How quickly are the funds required?  If the business can wait for an amount of time for the funds, generally it comes at a lower cost.  However if the business is in an urgent need of funds, the cost will go out, or in other word, it would be more costly.

In the given scenario the organization should opt for a mix of debt and owned funds. It should use the 50000 pounds of owner’s funds and should opt for a bank loan of $50000

Task 2

P2.1 Analyse the costs of different sources of finance

The sources of finance can be primarily broken up into:

1. Owned Funds
2. Loaned Funds

Owned Funds: Owned Funds generally refer to the equity and retained earnings. The cost of owned funds is the dividends that has to be paid to the shareholders of the organization. The owned funds also has an opportunity cost the interest foregone had the amount of money paid as dividends been invested somewhere else. The retained earnings are the part of the owned funds. (Small Business Chron, 2014)
Loaned Funds: Loaned funds refer to the debentures issued by the organization, loans taken from bank and other financial institutions and other forms of credit available. The interest paid on these funds are the cost, however as these expenses are tax deductible the real cost is;

Kd= I (1-T)
Where,
Kd= Cost of Debt
I= Interest Paid
T= Prevalent Rate of Tax

P2.2 Explain the importance of financial planning

Financial organization assists an organization by providing the direction and develops a base for meeting the desired objectives of a company. Financial planning assists the company to plan for an efficient utilization of various resources of an organization for achieving the desired level of success. The funds procured from these sources are generally used for expansion or start up. If the business requires funds for its working capital requirements it might want to take loans from bank which is generally repaid within a year. The main work of a financial manager is to assess the areas from where the wealth maximization of the shareholders can be achieved

P2.3 Assess the information needs of different decision makers

The information needs of the decision makers vary from time to time.
Various companies have varied information needs for their decision makers. For making decisions like procurement of new machinery, sale of an obsolete machine, expansion of the business etc. the finance manager or the decision makes needs to consider the following information:

1. The Liquidity position of the organization: For this the decision maker needs to have access to the various ratios.
2. Financial health of the organization:  The decision maker should be aware of the financial health of the concern. Hence, it is very important that he has access to the financial statements of the organization.
3. Cash Flow Statements: The decision maker should be aware of the funding needs to understand the cash flow position of the organization. He needs to understand which is cash generated from and where is it consumed.

The decision makers have to decide on the dividend policy and other important policies and for this purpose they various pieces of information should be at their disposal. As mentioned above the main of the finance manager is to maximize the wealth of the organization as a whole.

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

The sources of finance have an impact on the financial statements of an organization. If the funds have been obtained by way of issue of stock it only impacts the balance sheet and the cash flow statements. The dividends paid against such shares/stock are not charged to the profit and loss account as these are considered as appropriations and not charge. On the other hand when funds are procured by way of debt they have impact on all there components of the financial statements. The cost of debt or in other words interest is a charge against the current year’s profit. When the interest accrued is paid to the lending institution it affects the cash flow statement and the balance sheet. These sources of finance also have an impact on the ratios of the organization for e.g., Return on equity, Liquidity Ratio, Debt to Equity Ratio etc.

Task 3

P3.1 Analyse budgets and make appropriate decisions from the case study given.

While a company’s statement of accounts reveal the financial activities over the last accounting period and as well as the static picture of health as on balance sheet date, budgeting exercise acts as the forward looking forecast of the company’s potential business figures in the coming months/year, from the point of view of liquidity, mismatches and resource planning in general.
In a nutshell, a cash flow budget gives an insight about the income of the company, as to whether it would be adequate to cover the forecast expenses which are lined up. In the absence of internal accruals, any shortfall would predict the need to bring in external finance by way of capital, loans or any other source of funding.
The below statement will provide an idea about the interested parties who requires information about the cash forecasts, for quite different reasons of their own:
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 budgeting P&L figures show certain overstatements by way of inflated profits. The cash flow forecast indicates that depreciation amounts for the 6 month period add up to £ 625 k, the break up being:

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 an outflow in Oct (presumably for quarter Jul to Sep). 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 given below.

The definition of Unit cost is sum of Total Fixed cost (FC) + Total Variables cost (VC) per unit of production. In effect, it is a measure of total cost of producing and selling one unit of an item or good. Unit costs vary as the number of goods produced changes, mainly because, while the variable cost increases with higher production, fixed costs remain the same, thus bringing down the effect of creeping variable cost. (Accounting Tools Website, 2014)
The management team of Easy Electronics Limited is considering reducing the unit selling price of the product by 10%. This would increase the sales volume by 20% and also increase the cost of sales by 20%. The analysis is given as under:

When Selling Price per unit is reduced by 10%
Particulars	£'000	£'000
Sales	38,698.00
Less: Cost of Sales	22,654.00
Gross Profit	16,044.00
Profit from disposal of equipment	100.00
		16,144.00
Less: Expenses
Administration cost (£2400 + £675)	3,075.00
Distribution cost	3,481.00
		-6,556.00
Profit before interest and tax		9,588.00
Loan interest		-500.00
Profit before tax		10,088.00
Less: Corporation tax @ 23%		-2,299.00
Profit after tax		7,789.00

P3.3 Assess the viability of a project using at least two investment appraisal techniques using the case study provided below

Easy Electronics ltd is considering diversifying into manufacturing Aluminium computer cases or housing from October 2014.  The company’s cost of capital is 10%.
Net Present Value:

Project A: Aluminum Housing
Year	0	1	2	3	4	5	6
£’000	-8,000.00	2,000.00	2,800.00	3,200.00	1,200.00	800.00	500.00
Discount factor @10%	1.00	0.91	0.83	0.75	0.68	0.62	0.56
Present Value	-8,000.00	1,818.00	2,313.00	2,403.00	820.00	497.00	508.00
Discount factor @15%	1.00	0.87	0.76	0.66	0.57	0.50	0.43
Present value	-8,000.00	1,740.00	2,116.80	2,105.60	686.40	397.60	216.00
Net Present Value(NPV)@ 10% = £ 359.00
Net Present Value(NPV)@ 15% = £ -737.60

From the above it is clear that the net present value is positive when the company uses a 10% cost of capital. Therefore, in order to undertake the project the company must use 10% cost of capital.  (Wharton School Website, 2014)
IRR Method

Project A: Aluminum Housing
Year	0	1	2	3	4	5	6
£’000	-8,000.00	2,000.00	2,800.00	3,200.00	1,200.00	800.00	500.00
Discount factor @10%	1.00	0.91	0.83	0.75	0.68	0.62	0.56
Present Value	-8,000.00	1,818.00	2,313.00	2,403.00	820.00	497.00	508.00
Discount factor @15%	1.00	0.87	0.76	0.66	0.57	0.50	0.43
Present value	-8,000.00	1,740.00	2,116.80	2,105.60	686.40	397.60	216.00
Net Present Value(NPV)@ 10% = £ 359.00
Net Present Value(NPV)@ 15% = £ -737.60

Iteratively, we can arrive as follows:-
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. (Wharton School Website, 2014)
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.

The activities of an organization can be classified into profit and non-profit operations. The financial statement of organization gives a view of the financial strength of the organization and helps to compare the position with the other competitors. The financial statements include:

Task 4

P4.1 Discuss the main financial statements

1: Statement of Financial Position or Balance Sheet: the balance sheet depicts the financial position of the company in terms of liquidity and solvency particularly at the end of the accounting period. This statement is prepared to depict the assets that a company possess and the obligations that are incurred up to date.
Profit and Loss Account: this ratio indicates the performance of the company in terms of profitability. This statement takes into account all the incomes and expenses of the company during a particular period of time.
It has the following two basic elements

• Income; that may include both credit and cash sales, non-operating income such as from sale of fixed assets; interest on investment and savings account with banks. (Accounting Tools Website, 2014)
• Expense exhibits all expenses incurred for carrying out the business for the relevant financial year that may include; whether paid in cash or accrued but not paid such as salary & wages, rentals, repair and maintenance, travelling expenses, advertisement and publicity, postage and telephone, rent, taxes and insurance.
• Expenditure should be of revenue nature which means that the utility derived on expending the amount is exhausted during the financial year. Amount paid for a purpose that has utility for more than a year is ‘Capital Expenditure’ and is not exhibited in P&L account. It is added to the cost of the relevant asset and exhibited in the Balance sheet

The balance left after meeting all expenses represents profit or loss of the business.

3: Cash Flow Statement: this statement measures the cash inflow and outflow from various activities of an organization. This statement is prepared to measure the changes in the cash position during a particular accounting period.

• Cash from Operating Activities: this measures the cash flow from the main activities of a business. This helps the company to ascertain whether the company is able to generate enough cash from its direct operations.
• Cash from Investing Activities: this indicates the ability of the company to generate cash by investing into the assets of the company.
• Cash from Financing Activities: this activity indicates that the ability of the company to meet its cash from financing activities such as issue or redemption of debenture or share capital in cash.
•  4: Statement of Change in Equity, also known as the statement of Retained Earnings exhibits 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

P4.2 Formats of Financial Statements

The financial statements of a company are prepared as per the guidelines laid in International Accounting Standards (IAS). The following formats are used by different organization.
In a sole trading business the sole trader is required to prepare the trading profit and loss account and balance sheet. In a profit and loss account of a sole trading business all the incomes are depicted in the credit side of the p/l account and expenses are recorded in the debit side of the profit and loss account.
In the case of a company the financial statements are prepared following the guidelines laid in the International Accounting Standard (IAS). The financial statements of a company mainly includes statement of changes in financial position, statement of profit and loss account, statement of cash flow and statement of changes in owner’s equity. (Zager and Zager, 2006)

In the financial statement of a partnership firm the partner’s of the firm mainly required to prepare a profit and loss statement, statement of appropriation of profits, partner’s capital account and balance sheet.

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

Current Ratio: Current Assets/Current Liabilities.  The current ratio shows 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%

Interpretation: The rule is 2:1. Though the position has improved over the years the organizations are not close to the market standards.

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. The organizations are not close to the market standards and should pay attention to this. This indicates the ability of the company to meet sales by utilizing its total assets.

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 the case of WM Morrison the performance is better than J Sainsbury’s. The ratio indicates that the ability of the company to generate desired profits by utilizing the capital employed.  

Conclusion

As mentioned earlier the primary aim of the finance manager or Chief Financial Officer is to maximize the wealth of an organization. The various pieces of financial information help them to make an informed decision aimed at the development of the entire organization as a whole.

References

AccountingTools website, 2014, How to calculate cost per unit, [Online], Available at: http://www.accountingtools.com/questions-and-answers/how-to-calculate-cost-per-unit.html , Accessed on 24th March 2014
Small Business Chron.com website, 2014, What is the difference between balance sheet and cash flow statement,[Online}, Available at: http://smallbusiness.chron.com/difference-between-balance-sheet-cash-flow-statements-24327.htmlAccessed on 24^th March 2014.