The Source of Finance for Motors Parts Direct Limited - Essay Example

Business Different source of finance i. Asset Based Financing: This type of financing is defined by the utilization of inventory, accounts receivable, real estate or equipment. ii. Angel Investors: Angel investors are responsible in fund raising for 30,000 small businesses approximately every year. There are around 250,000 active angels around the world, which comprise the angel investor network. iii. Bank Loans: Many large banks have the tendency to engage in conservative lending for a small business loan. iv. Business Charge Cards: This secures cash source without costly interest payments. v. Business Credit Cards: An easy and fast way for accessing cash that is available for business expenses. However, the interest for the cash is costly. vi. Crowd Funding: It is defined as a creative approach for raising capital without relying on the banks or investors. vii. Factoring: With the help of factoring, finance is sourced from through the sale and accounts receivables, which are achieved at a discount. viii. Grants: The grants are provided by the government after the validity of the project is examined. ix. Equipment Leasing: Leasing of the equipment also forms the part of financing. It allows the purchaser or borrower to purchase or borrow equipments with 100% financing. x. Letters of Credit: Letter of credit is an important tool for dealing with the payment transactions that are made overseas with the foreign customers. xi. Merchant Cash Advance: Merchant cash advance permits the borrower to use future credit card sales. xii. Line of Credit: It operates like a revolving credit card; however low interest rate and high credit limits are available. xiii. Microfinance Loans: Microcredit loans are easier to obtain and less time intensive for qualifying with loan amounts that ranges from $500 to $35 million. xiv. Merchant Line of Credit: It is based on the monthly sales volume of a company. xv. Social Loans: It provides an opportunity to the individuals for borrowing and lending money from each other. xvi. SBA backed Loans: SBA backed loans are flexible than the traditional banks loans. xvii. P2P Loans: P2P Loans have removed the traditional lending process and have changed the finance equation. It allows the lending process to take place between individuals directly. xviii. Venture Capital: Venture capital not easy to tap but it can be a feasible source of funding. xix. Vendor Lines of Credit: The vendor lines of credit, which are also known as, trade credit is used when a company wants to extends credit so as to ensure purchase of products. 1.1 Source of finance available to MPD Ltd. Motors Parts Direct Limited (MPD ltd) operates as an importer and distributor of motor parts in United Kingdom (UK). The business is basically owned by Geoff Carter and he owns about 90% of the property. However, he is approaching retirement age so he wants to pass on the management by September 2015 to his son, Daniel Carter, and daughter, Linda Carter. As a financial advisor, the business performance can be evaluated on the basis of the information that is obtained from the owner. In explaining the source of finance for Motors Parts Direct Limited, it is important to understand its meaning for the business. Financing is extremely important for starting a business and draw profit from it. There are various sources of finance when a business is looking for start-up. The need for source of finance varies according to the type of business. For processing a business huge amount of capital is needed (Iowa State University Extension, 2013). The source of finance for a business is basically equity or debt. In case of MPD Ltd only debt financing is used as source of finance. However, there are both long term and long term debt for the business. The short and long term debt instruments for the business are discussed hence forth. Amount Short term finance (Over draft) £ 4,00,000 Long term finance (Balance Loan) £ 1,000,000 Total debt £ 1,400,000 From the above table it can be stated that the business has started its operation with the help of loan and overdraft. The two types of debt instruments are noted as the liability for the company (Iowa State University Extension, 2013). This liabilities aims at decreasing the liquidity of the company, if the current asset base is not high; even the business does not have enough cash position to maintain a stable working capital. For maintaining its working capital the company requires short term finance of £ 1,200,000. He also needs the finance for paying the suppliers and make payment to its employees. He needs the amount as these cash are paid even before payments are received from customers. 1.2 Implication of source of finance Loan is a useful source of finance for business, which is provided by a single entity at an interest rate. This interest rate is specified by the lender of the loan and it is not decided on mutual basis. If the lender is a bank then the interest rate depends upon the demand of the loan and the rate that are imposed on the banks by the central banks (Steffan, 2008; Fabozzi, 1998). Thus, an interest is bound to be paid by the receiver of loan as a result it become a long term liability for it. For MPD Ltd the loan is useful in a way that it has provided a huge source of finance to start its operation. However, the payment of interest on the loan amount is also looked upon by the business. The main advantage of the business to take loan is that the payment is staggered. It is observed that MOPD Ltd has been paying the interest for the loan over the past few years and the balance company loan is about £ 1,000,000. However, for ensuring the monthly payment of interest and principle the business has also opted for a short term finance, which will help it to pay the interest amount and also make payment to the suppliers and employees even before the customers have made their final settlement. The main disadvantage of the instrument is that liability increases if the debt is not paid and more loans are needed to support the working capital. In such a position the business can get into a very risky position (Steffan, 2008; Fabozzi, 1998; Iowa State University Extension, 2013). Overdraft is also a good source of finance as it provides flexibility to a business. It is a temporary instrument that enables an entity to overdraw for a bank account even if the balance is zero. Interest is charged based on the amount and time period of the overdraft and it is charged on a regular fee basis. The debt instrument is preferred when a business wants to finance its daily purchase and sales. Thus, it helps the business entity to maintain a positive cash balance. It plays an important role in ensuring that the business pays off its bills when cash is not received from the debtors and customers (Carmichael and Ray, 2007; Steffan, 2008; Fabozzi, 1998). Similarly, the overdraft used for financing operation of MPD Ltd will helps the company to pay of its short term liability such as payment to suppliers. This enables the business to increase its liquidity and avoid solvency position. The liquidity position of MPD Ltd is assumed to increase when it will take additional short term financing of £ 1,200,000. This short term finance will provide extra security in paying off to its suppliers and wages to its employees. Thus, overdraft helps in assuring the company that even if the cash balance is nil in the bank, there is an opportunity for it to continue drawing money for any emergency purpose. However, there is disadvantage too; the liability of the company increases as a result liquidity decreases (Carmichael and Ray, 2007). 1.3 Appropriate source of finance for MPD Ltd Source of finance for MPD Ltd is very important for its operation as the working capital is depended on it. Source of finance of MPD Ltd is observed to be only debt financing. However, equity financing can also be expected from the company as it has achieved good contracts, which have increased balance. This cash balance of company will provide an opportunity to distribute shares among the interested stakeholders and there are high chances that they will buy the shares. This will add to the asset of the company, which can be used for ensuring its improved operations (Gibson, 2008; Flynn and Koornhof, 2005; Carmichael and Ray, 2007). Though equity financing can be a good source of finance for the company, but it has concentrated on debt financing. It is noteworthy to mention that the latter is less risky than the former. The operation of the former is dependent on the performance of the market and many other factors related to the economy. Nevertheless, debt financing is depends on the performance of the company (whether it is earning enough profit to pay back the loan). Apart from this type of financing, the retained profit of the company can also be a significant source of finance. MPD Ltd has acquired three large contracts from Strictly Business Limited, Alpha Motors LTD and Northern Motor LTD. The total purchase from the first contract is £ 10 million, whereas, £ 5.5 million has been earned by the other two contracts in the previous year. However, there are around 1000 customer base, which comprise small independent garages. The expense of the company to provide motor parts to these customers is about £ 20,000 per annum approximately compared to that the sales amounts to £ 7 million; thus, there is huge scope of earning profit. After deducting all the administrative expenses and payment to the suppliers, the profit can be used as source of finance for further development of the company. Hence, it can be concluded that after debt financing, which is already applicable by the company, retained profit can act as an appropriate source of finance (Carmichael and Ray, 2007). 2. Implications of finance as source within the business The above mentioned 15 source of finance are important for starting or extending a business. The sources add cost to the company in form of interest but they are significant for its operation and even start-up. In order to start a company, it is important to understand the exact requirement of the source of finance and try to achieve it as soon as possible so that the operation is not hampered. The source of finance is accompanied with additional cost but at times of restructuring a business ot start-up, the sources acts as a backbone of the project. 2.1 Assessment and comparison between costs of different source of finance The main source of finance for the company is debt financing and the alternative source of finance can be equity financing. These two types of financing are assessed and compared with respect to MPD Ltd. Debt financing enables the company to borrow money in form of loan from any bank for funding its operation or expansion. However, equity financing will involve a number of investors in the company, who will offer capital in exchange for shares of ownership in the business. In case of debt financing, MPD Ltd have the opportunity to retain ownership on the business, however, equity financing will distribute the ownership among the stakeholders, who are interested in the company. In debt financing, the company has to repay the loan without compromising its ownership. However, if the company undertakes equity financing it has to sacrifice the profit and part of the ownership to the stockholders. Thus, it can be stated that cost of equity financing will be higher than debt financing as a result the former is appropriate for MPD Ltd. The cost of these types of financing is also related to risk associated with them. In case of debt financing, loan is used as the main source of capital and as a result MPD Ltd is required to comply with repayment schedules during the low and high cash flows. The interest costs associated with the debt rises the proportion of cash and the company have to break that in even terms so they can balance the operation costs as well. However, in case of equity financing, MPD Ltd does not have to repay any amount and thus the risk of losing the investment fall on shareholders or investors. The cost of risk is higher in case of debt financing than equity financing. Thus, it can be stated that MPD Ltd can adopt equity financing when risk is examined (Carmichael and Ray, 2007). In case of debt financing, MPD Ltd get the opportunity to retain the profit earned in the business. However, if it undertakes equity financing the profit will be distributed among the shareholders as they will own a significant portion in the company. Debt financing ensures that the interest costs are listed as tax write-off; this reduces overall cost of loan amount. However, MPD Ltd can use the cash collected from equity financing to strengthen their capability to pay future debts. Thus, in this perspective it can be noted that the cost of equity debt financing debt financing is higher than that of the other (Carmichael and Ray, 2007). 2.2 Importance of financial planning for MPD Ltd Financial planning helps a company is regarded as a process of predicting capital that is required for completion of a certain project. It helps in determining the capital structure i.e. proportion of debt or equity for the company. It also determines the amount of capital that is needed for the company to finance its operation (Carmichael and Ray, 2007; Gibson, 2008; Flynn and Koornhof, 2005). This determination of amount of capital is dependent on a number of factors such as cost of fixed and current asset. However, the main reason for financial planning in MPD Ltd is discussed hence forth. The company can manage its income more tactfully through the use of plans. Management of income helps in ascertaining the amount of money that is required for tax payments and other expenses. Financial planning assists in monitoring the spending pattern of the company and also determines tax payments so that the cash flows is balanced and maintained. The increase in cash flow raises the capital simultaneously. A proper financial plan enables the company to evaluate a particular project and measure the risk associated with it. It helps in guiding and choosing right type of investment that will fetch good return in future. It ensures liability cancellation and asset accumulation, which helps in gathering greater amount of wealth for the company. For ascertaining true value of asset, liabilities need to be cancelled or settled (Carmichael and Ray, 2007; Gibson, 2008; Flynn and Koornhof, 2005). 2.3 Information needs for banks, suppliers and investors before providing finance A company prepares its financial statement not only for its internal use but also fir the external stakeholders and auditors. This statement reflects the financial condition of the company in a certain period of time. The balance sheet highlights amount of assets and liabilities possessed by the company moreover total equity investment by the investors are also given. Nevertheless, income statement and cash flow statement is crucial as it depicts the cash position, spending and income of the company. These three elements of financial statement are important for a number of users. The group of users has considerable interest in the company, which encourages them to study the statements and evaluate its financial state. The users include investors, suppliers and banks (Gibson, 2008; Flynn and Koornhof, 2005). Investing in company shares are risky if proper information are not collected beforehand. Investor’s needs information pertaining to the percentage of return company is capable of providing its stakeholders. The share price movement is also very crucial for them to examine as it highlights whether the stock has the ability to give higher dividend in future. For obtaining this information, the investors need to check the amount of assets and liabilities that are available to the company. The income statement depicts the profit earned by it and this is the most important element in the financial statement for the investors; as they will receive part of the profit as return (Fridson and Alvarez, 2011; Gibson, 2008; Flynn and Koornhof, 2005). Banks check the liquidity of every company before providing them loans. Liquidity refers to the fact whether they have enough cash to pay its current liabilities with the help of the current assets. The liquid cash is evaluated by the banking authoring to ascertain whether they can pay back the loan and interest on time and there is no scope of default. If the liquidity position is low, the bank is reluctant to permit the loan. The banking authorities also examine the profit of the company, as part of the asset comes from the retained profits (Gibson, 2008; Flynn and Koornhof, 2005). Suppliers play an important role in the success of a company. Timely delivery of raw materials and products is crucial for production team as it ascertains zero ideal time (Fridson and Alvarez, 2011). After the delivery of the products it is the responsibility of the company to make payment of the invoice. The payment pattern is dependent on the liquidity position of the company. If the current asset is lower than that of the liability the company will encounter difficulty in paying the suppliers. Thus, in order to examine the financial ability of the company, the suppliers should check its liquidity position and goodwill (Gibson, 2008; Flynn and Koornhof, 2005). 2.4 Impact of cost of finance on financial statement Source of finance in financial statement is crucial as it highlights the financial condition of a company (Quiry, et al., 2011; Mayo, 2011). The cost of source or cost of capital determines the amount if cost that is scarified by the company to raise fund for its operation. Cost of capital includes cost of borrowing, debt, equity and funds. The weighted average cost of capital (WACC) signifies the arithmetic mean of the cost of capital. The contribution of each of the capital source is being weighed with the help of proportion of total funds that is provided by the business (Mayo, 2011). Cost of borrowing is regarded as the total amount of cash paid by the debtor for securing a loan. The cost includes accounts maintenance, loan related expense and loan recognition. This affects the financial statement to a great extent; if the cost is higher, the company can encounter difficult in paying off the interest at a definite period of time. It lowers the assets base as well as increases the liability of the company, which is depicted in the balance sheet. If the ration between current asset and liability is below 1 then it can be notified that the company has weak financial condition. Thus, cost of borrowing increases the liability of the company. Cost of debt is regarded as the overall rate that the company pays for all the debt obligations, which consists of bank loans and bonds. It also increases the liability and decreases the asset. However, the cost of equity forms the parts of capital structure of the company. It measures the return that is expected from the stocks by the investors, who is ready to bear the risk of losing the investment (Quiry, et al., 2011; Mayo, 2011). The cost of equity does not add to the liability of the company instead it contributes towards the capital structure. The investors invest in the company shares on a hope to earn good return from the investment amount, which is dependent on the profit of the company. If the profit is high then the investors have the opportunity to earn higher return on their investments. This increase the cost of equity for the company as it has pay to pay back higher amount to the investors. Thus, the cost of equity is dependent on the earnings and profit of the company (Quiry, et al., 2011; Mayo, 2011). However, the cost also depends on the market condition and few economic factors like recession and inflation. In case of loss to the company, the investors do not get any return from their investment; hence their money is subject to market risk. However, if the economic factors and sales revenue of the company is considerable then the cost of equity is high for the company. The investors are satisfied with the return ((Gitman, 2007) 2.5 Evaluation of the discount offered by supplier The company has annual credit sales about £20 million and the company has encountered huge difficulties in credit control department. The average collection period for the debtors is about 55 days even if the policy of the company is ascertained to 30 days. 1% of the sales are written off as bad debt, which is the loss amount for the company. Apart from debtors, the creditors are also significant for MPD Ltd. The suppliers or creditors have offered a discount of 1% cash settlement to MPD Ltd within 20 days. The discount is acceptable in manner that it will enhance the cash position of the company. Reference List Carmichael, D. and Ray, O., 2007. Accountants handbook, financial accounting and general topic. New Jersey: John Wiley & Sons. Fabozzi, F., 1998. Bank loans: Secondary market and portfolio management. New Jersey: John Wiley & Sons. Flynn, D. and Koornhof , C., 2005. Fundamental accounting. New York: Juta and Company Ltd. Fridson, M. and Alvarez, F., 2011. Financial statement analysis: A practitioners guide. New Jersey: John Wiley & Sons. Gibson, C., 2008. Financial reporting and analysis: Using financial accounting information. Connecticut: Cengage Learning. Gitman, 2007. Principles of managerial finance. New Delhi: Pearson Education India. Iowa State University Extension, 2013. Types and Sources of Financing for Start-up Businesses. [online] Available at: < http://www.extension.iastate.edu/agdm/wholefarm/html/c5-92.html > [Accessed 25 October 2014]. Mayo, H., 2011. Basic finance: An introduction to financial institutions, investments and management. Connecticut: Cengage Learning. Quiry, P. Fur, Y., Salvi, A., Dallocchio, M. and Vernimmen, P., 2011. Corporate finance: Theory and practice. New Jersey: John Wiley & Sons. Steffan, B., 2008. Essential Management Accounting: How to Maximise Profit and Boost Financial Performance. 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