Managerial Financial Resources and Decisions - Research Paper Example

Managerial Financial Resources and Decisions Question One a) Sources of Finance The selected company is Wal- Mart Stores Inc. and as per its financial statements for the fiscal year ending January 31, 2008, the sources of finance available as at January 31, 2008 are as under: Amount in million of dollars Equities or ownership funds 64608 Long Term Funds: Long term debts 29799 Capital Lease obligations 3603 Other long term obligations 7050 40452 Short Term Funding Accounts payable 30370 Other short term obligations 28084 58454 Total 163514 b) Implication of sources of funds Equities Equity capital as a source of long term financing offers the following advantages: There is no compulsion to pay dividends. If the firm has insufficiency of funds, it can skip paying dividend to equity holders without any consequences. As equity capital has no maturity date and hence firm has no obligation to redeem. As the equity capital provides a cushion to lenders and thereby it increases the creditworthiness of the company. There are following disadvantages as well of raising funds through equities: Further issuance of equity capital dilutes the control of existing equity holders. Cost of issuance of equities is the highest as compared to other sources. Dividends to equity holders are considered profit distribution and thus are not considered expenditure for profit calculations. Long Term debts Advantages: Interest on debt is a tax deductible expense. Debt financing does not result in dilution of control because debt holders are not entitled to vote. Debt holders do not partake in the value created by the company as paymnts to them are limited to interest and principal. Issue costs of debts are significantly lower than those on equities and preference capital. The burden of servicing debt is generally fixed in nominal terms. Hence, debt provides protection against high unanticipated Debt has a disciplining effect on the management of the firm. Disadvantages: Debt financing entails fixed interest and principal repayment obligations. Failure to meet these obligations can cause great deal of financial embarrassment and even lead to bankruptcy. Debt financing increases leverage which, according to CAPM, raises the cost of equity to the firm. Certain debt agreements impose business restrictions. These restrictions may impair the firm's borrowing abilities C) Appropriate sources Though Wal- Mart Stroes Inc. is properly appropriately financed at present financed with as most of its finance has come through equity contributions. It is low geared company as its debt equity ratio is 0.60. That company may not be playing on gearing but the equity holders are in control with the affairs of the company. Further financing can be raised though debts in case the company intend to take advantage of the gearing. However, at present the company is appropriately financed. Question No. 2 a) Cost of different sources of funds; Costs of Public Issue Costs of Public issue depend upon the size of issue and the level of marketing adopted. The important expenses normally incurred for a public issue are as under: Underwriting expense, Brokerage, Fee to the mangers to the issues, Fee to the Registrars to the issue, Printing Expenses, Courier and Postage expenses, Advertising and Publicity Expenses, Listing fee, and Stamp duty. Public offer of debt The mechanisms for a public offer of a debt security are much the same as that of a public offer of equity. But a debt issue cannot be made unless credit rating from a credit rating agency is obtained and disclosed in the offer document. So rating agency's cost is in addition to cost of public issue Obtaining term loan This is perhaps the cheapest source o obtaining long term finance, as generally the dealings between company and the financial institution providing the loan do not invite costs of the type involved in public issues. However, the company has to pay for professional for obtaining feasibility and other reports. b) Importance of financial planning Financial planning is part of a larger planning system in the firm. The planning process begins with a statement of the firm's goal or mission, which is usually stated in qualitative terms. From the mission of the firm, the strategy is derived which defines the products or services the firm will produce and markets it will serve. To support the strategy, policies and budgets are developed in various areas such as research and development, production, marketing, personnel, and finance. A financial planning represents a blue print of what a firm purposes to do in future. Financial planning have generally the following elements: 1. Economic assumptions: The financial plan is based on certain assumptions about the economic environments like interest rates, inflation rates, growth rates, exchange rate and others 2. Sales forecast is normally the starting point of the financial forecasts 3. Investments: The financial plans spell out the funds required for fixed assets and working capital requirements. In other words total investment or fund requirements are detailed in the financial plans. 4. Suitable sources of financing the assets are also provided in the financial plans. That is to say financial plans state how to meet the capital expenditure and working capital needs of the company. 5. Cash Budget: The cash budget shows the cash inflows and outflows expected in the budget period. 6. Planning about repayment of loan funds along with interest and dividend payouts on equity investments are also reflected. c) Information needs of different decision makers Decision makers always need some background information about the subject matter in order to devise a methodology to achieve objectives. In case of financial decision making normally the under noted information become pertinent for the decision makers: Basic financial planning of the entity. Financial statements of few earlier years Observations under internal as well as external auditing reports. Availability of funds with the entity. Information about earlier successes of raising funds, and Short and long term objectivity. d) Impact of finance on financial Statements- debt and equity Financial statements are meant for users to serve variety of purposes. Finance impact the presentation of financial statements in following ways: Equity Equity is no hassle business. Equity generates freedom to the entity and colors the financial statements with a sense of confidence. Equity strengthens the cushion on the basis of which the entity can procure debt funds. Equity leverages the capital gearing to a no risk situation, as there are no contractual agreements for dividend payments. Debts financing Debt financing stated in the financial statements provide encouragements to entity to work harder, because contractual obligations of debts if not met, may lead to insolvency proceedings. Short term debts bring improvement in current assets and thereby the accounts payable and other current obligations provider get assurances about repayments. Once current ratio get improved, the better liquidity image of the company presented through financial statements does rest of work in maintaining the working capital requirements Question No. 3 a) Analysis of the budget: For preparation of budget of 6 months of Mary Ltd. the following figures are missing: i) Information about months during which the payments of Interest Tax and Equipment purchase have been made is not available. ii) The remittances from Accounts Receivable have not been provide. In order to prepare six monthly cash budget, these information have been computed as under: 1. Cash received from Accounts receivable is calculated as under: 2. Computing details of months during which the payments Interest, Tax, and equipment purchase have been made: Based on available information and information as computed above the cash budget and budgeted profit and loss account are as under: Mary Ltd. Cash Flow forecast from January to June 2007 Marry Ltd Budgeted Profit and Loss account for six months ending 30th June 2007 2 (i) As per available information the presented figures of Budgeted Profit & Loss are of 1000 units. 4200 Accordingly, the variables for 1000000 units would be $ -------- * 1000000 or $4,200,000 1000 (ii) Though by reducing 12% of unit sales price, sales would go up by 20% but the contribution of meet fixed overheads and profits get reduced to $6048 as compared to earlier contribution of $ 5800 as is clear from following calculations: Keeping in view the reduction in the contribution the proposal of 12% reduction in unit sales price should not be undertaken. iii) Calculations of profit or loss on sale of 700,000 units during the period: Note: In absence of information, the administration and other overheads have been kept as in the sale of only 1000 units, though this looks illogical. iv) Variable Costs: It is the cost that changes in the same proportion in which volume or output increases or decreases. For example material cost of producing one unit is $10. When the 1000 units will be produced the material cost will go up proportionately to $ 10000. Variable cost is also called direct cost. Fixed Costs: Fixed cost does not change with change in output or volume of production or sale. For example depreciation, rent, salaries of administrative staff, and like that. Fixed is also sometime called 'Period costs.' Semi- variable cost Semi variable costs are those costs that remain fixed for a period of time or upto certain degree of activity. For example a supervisor is hired at monthly salary $3000 but he is capable of supervising up to 6000 units, and if the activity goes beyond that, the management will have to keep another supervisor. This is example semi- variable costs. Question Four a) i) Balance Sheet Balance Sheet is a statement of assets and liabilities of an entity showing the position as on a particular date. The balance sheet is prepared to show position of entity as on a date and such position may get changed with each date. Balance sheet depicts and describes the following: Current and Non- current assets Current and non current liabilities, debts including borrowings by issuance of bonds. The contribution of equities and the retained earning belonging to equity holders. Preference capital. Generally balance sheets of corporate entities are prepared as per the provisions and guidance issued under various statutes and regulations. ii) Income Statement or Profit and Loss account Profit and Loss account is a financial statement that is prepared to show earnings or losses of an entity over a period of time, normally an accounting or fiscal period. A profit and loss account reflects the activities of the entity over the period, particularly relating to operations of the business. But the results of non- professional activities like financial earnings and expenses, extraordinary and miscellaneous activities are also included in the statement. Results of discontinues activities are shown after the extraordinary activities in the statement. Profit and Loss account is also called Income statement. Only revenue expenses and income are taken into account while preparing profit and loss account. Capital expenditure are not considered under profit and loss account except for depreciation and amortization of such expenditure. iii) Cash Flow statement is another financial statement that is included in the statements those are required to be compulsorily prepared as per corporate laws binding companies. However, now-a-days cash flow statement is traditionally included in the statements prepared at the end of the years of an entity. Cash flow statement reflects cash flowed in and out during a period, normally a financial or accounting year, under the heads of operational activities, financial activities, and investing activities. The difference of cash inflow and cash outflow under these activities is added or deducted from beginning cash balance in order to reach closing cash balance. b) Formats of financial statements Balance Sheet "Most financial statements reflect a balance sheet format consistent with following formula: Equity = (Current assets- Current liabilities) + (Non- Current assets- Non- current liabilities)" (Balance Sheet walk) The weakness in this traditional format is that debt funding are included in non- current and current liabilities. However in order to reflect funding or sources separately than the operating components, the following format is normally liked by the analysts of the financial statements: Equity + Debt = Working capital (current assets - current liabilities) + Non- current assets. There is another way of presentation whereby also the funding or sources of finance are kept separately and that is as under: Total Capital employed = Total Net Operating assets. Traditionally the balance sheet used to be presented in T format, but that is out of fashion and horizontal presentation is in these days because of easy readability for analysis purposes. Income Statement Traditionally the title to income statement is 'Profit and Loss Account' but these days 'Statement of Earnings', 'Statement of operations', or 'Statement of operating results' are commonly used. There are two formats of income statement, one is single step and the other is multi- step' " (Richard Loh)" Cash Flow Statement The format of Cash flow statement is divided into following three sections, namely Cash Flow from Operating activities Cash Flow from Financing activities, and Cash flow of Investing activities The method used to analyze the cash flows is as under: Cash in flows outflows from the above mentioned activities are totaled up and a figure of surplus or deficit is added together to arrive at net cash in flow or cash out flow of the period. The surplus cash in flow or outflow is added to beginning cash balance to check the ending balance of cash. c) Ratio Analysis of KLM Ltd. The relevant ratios for making an analysis on profitability, liquidity, and efficiency of KLM Ltd. are calculated as under: 'Gross margin measures the percentage of each sales dollar remaining after the firm has paid for its goods sold. The higher the gross profit margin, the better." (Lawrence J.Gitman) This also indicates the operational efficiency of the entity. The Gross margin ratio of KLM has come down fro 58% in 2006 to 56%. The performance of KLM is remarkable better than that of industry. The industrial ratio was 40% and 52% in 2007 and 2006 respectively. Net margin ratio reveals the amount of generated profit on sales remaining after all overheads. KLM has handled its overheads quite efficiently and its ratio in 2007 was 32% as compared to 38% in 2007. However, it is better than the industrial ratio of 12% and 15% in 2007 and 2006 respectively Overall the KLM has performed better than industry but its own performance in 2007 is lower than the performance in 2006. Liquidity of any entity is best measured by its current ratio. It is in fact a barometer of solvency of the company. Generally the ratio of 2:1 is considered the best in any industry. KLM has this ratio of 2:1 in 2007 and 2.83:1 in 2006. The ratios are really fantastic and the KLM is ready all the time to meet its current liabilities as and when those become due. The current ratios for the industry for 2007 and 2006 are 1.6:1 and 2.2:1. So on account of liquidity even the KLM has better position when compared with KLM. Inventory Turnover and Asset Turnover reflect the efficiency of the working of the company. The inventory has turned into sales 5.5 times in 2007 as compared to 3.5 times in 2006. This is better position when internal comparisons are made as regard inventory turnover. KLM has really performed better in 2007 on account of inventory turnover. Assets turnover ratio reflects the efficiency with which assets of the entity are being used for the operations of the company. The KLM has this ratio of 1.25 times in 2007, which almost similar to 1.28 in 2006. That means KLM is efficiently exploiting its assets. It appears that none of assets is ideal. Overall profitability performance is remarkable. Liquidity wise KLM is performing very will and it will meet all its short term obligations as those become due. Inventory turnover and Assets turnover indicate that KLM is performing exceedingly well. d) Working capital cycle Working capital cycle is also called cash cycle is the time that elapses between the purchase of raw material and the collection of cash from accounts receivables. "Typically, investment in raw material, work in progress and finished goods is followed by sales on cash or credit. Credit sales funds are usually collected at a later date. The cycle may be expressed in terms of length of time between the acquisition of raw material and other inputs and flow of cash from the sales of goods." (L.S.E.) Accordingly working capital cycle is calculated as under: Inventory Period + Accounts Receivable period - Accounts Payable In case of KLM Ltd. working capital cycle is calculated as under: It will be observed that working capital cycle has tremendously come down from 51.1 days in 2006 to only 5.31 days in 2007. the reason for such a fall is tremendous reduction in inventory period held . References: Balance Sheet Walk, viewed on May 13, 2008, http://www.balancesheetwalk.com/traditional_balance_sheet.htm Lawrence J. Gitman, Principles of Managerial Finance, eleventh edition, Part one chapter 2, page 67. L.S.E. co.uk, Working Capital Definition, viewed on May 13, 2008, http://www.lse.co.uk/financeglossary.asp'searchTerm=&iArticleID=842&definition=working_capital_cycle Richard Loh, Understanding the Income Statement, Investopedia, viewed on May 13, 2008, http://www.investopedia.com/articles/04/022504.asp Wal- Mart Annual Report 2008, http://walmartstores.com/Investors/7666.aspx Read More