Managing Financial Resources and Decisions - Report Example

Managing Financial Resources and Decisions Sources of Finance The main sources of short term financing are trade credit, bank credit, factoring and commercial papers. Trade Credit refers to the credit extended by the supplier of goods and services in the normal course of business transactions. According to trace practices cash is not paid immediately for purchases but after an extended period of time. This deferral of payment represents a source of finance for credit purchases. This is the largest source in short term financing ad appears in the records of buyers as sundry creditors/ accounts payable. It is an informal arrangement between buyer and the seller. A variant of accounts payable is bills/ notes payable. Unlike the open account nature of accounts payable, bills / notes payable represent documentary evidence of credit purchases and a formal acknowledgement of obligation to pay for credit purchases on a specified (maturity) date failing which legal/penal action for recovery follow. Bank Credit is primary institutional source of short term /working capital. These finances are provided in the shape of cash credits/ overdrafts/ line of credit, loans, purchasing/ discounting of bills, letter of credit, and working capital term loans. Under cash credits/ overdrafts/ line of credit, the bank specifies a predetermined borrowing/ credit limit. Interest is determined on the basis of running balance/ amount actually utilized by the borrower. Loans are the arrangements where the entire amount of borrowings is credited to the current/ business account of the borrower and released in cash. The borrower pays interest on the total amount. Bills purchasing/ discounting is intended to link credit with sale and purchase of goods as a bill arises out of trade sale- purchase transaction on credit. The seller draws the bill on purchaser of goods, payable on demand or after a usance period. The seller offers the bill to bank for purchasing/ discounting. The bank releases funds to seller. The bill is presented by the bank on due date to purchaser/ acceptor for payment. Term loan for working capital are for shorter period say under three years and repayable in yearly, half yearly, or quarterly installments. Letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the supplier of goods. The bank undertakes the responsibility to make payment to supplier in case buyer fails to meet the obligation of payment. The modus operendi is supplier sells goods on credit to purchaser, bank extends guarantee and bears risk only in case of default by purchasers As per Lawrence J. Gitman (2006, page 692)1 “Commercial paper is an unsecured IOU issued by firms with high credit standings.” It is a short term unsecured negotiable instrument consisting of usance promissory notes with fixed maturity. It is a simple instrument and hardly involves any documentation and companies issuing them normally pay higher return to investors than bank interest. .Factoring provides resources to finance receivables as well as facilities for collection of receivable. As per Lawrence J. Gitman (2006, page 686)2 factoring accounts receivable involves selling them outright, at a discount, to a financial institution Receivables are sold by a firm to the factor (a financial intermediary) and factor becomes responsible for all credit control. If any of the debtors fails to make payment, the factor has to absorb losses. Sources of Long Term Financing may be internal or external. Internal resources comprise of retained earnings and depreciation charges. External sources consist of equities, preference capital, term loan and debentures/ bonds/notes. The deprecation charges are normally used to replace the concerned assets. In a way, therefore, the real internal long term source is the retained earnings. Retained earnings are described by Gallagher and Andrew (2007, page 138)3 as the sum of all net income not paid out in the form of dividends to stockholders. Retained earnings are readily available to the firm. But if the project is unprofitable retained earnings will hurt the interests of shareholders. Equity capital represents ownership capital and its owners share the reward and risk associated with ownership of corporate enterprises. Equities are permanent source of funds and also it does not require obligatory payment of dividends. Though equity holders share the ownership risks but their liability is limited to the extent of their investment in share capital of the company. Preference Capital combines some feature of equity as well as of debentures. It carries a fixed rate of dividend. It does not have share in residual profits/ assets. Payment of preference dividend is not obligatory and non- payment does not enforce insolvency. When preference capital is cumulative, all unpaid dividend are carried forward and are payable before any ordinary dividend is paid. Debentures/ Bonds represent creditorship securities and it is a promise to pay interest and repay principal at stipulated times. A.D.F. Price (1995, page 13)4 refers debenture as a written acknowledgement of long term debt. In case of debentures as long term source of finance, there is no dilution of control as debentures do not carry voting rights. It has limitations of contractual obligations of interest payments and repayments. The writer’s involvement is with an Electricity distribution company, and such a project requires large infrastructure facilities are largely financed by long term sources like equities, preference capital, and long term debentures/ bond debt capital. Treatment in financial statements: Short Term finances are normally shown as current liabilities in the balance sheet of an entity. On the other hand long term finances are treated as per the nature of owned funds or indebted capital. Equity capital, preference capital, and retained earnings are treated as part of capital investments, whereas debentures/ bonds are treated as long term liabilities in financial statements. 2. Finance as resource Short term financing Costs: Trade credit does not involve any explicit interest charge. However there I an implicit cost in the shape of credit terms offered to suppliers of goods. Long term payment for accounts payable involve low implicit cost and vice versa. Bank credits are available at prime rate plus risk bearing premium charged by the bank, and that depends upon the type of facility being attained from the bank. Bank also charge fixed or floating rates of interest and in the case of Lines of credit the borrower is required to maintain some compensating balance and also pay a commitment fee. Commercial papers are generally having cost that if few points lower that prime rate of interest. On the other hand factoring of accounts receivables costs few point extra than prime rate because of risks of recovery undertaken by the factor. Long Term Financing Costs: The easy availability of retained earnings is associated with notion of low cost; but when the entity’s project is low profits yielding the marginal costs of reinvestments of retained earnings are high. Equity capital has definitely high costs than other long term sources in terms of underwriting, brokerage, and other issue expenses. Similarly raising preference capital also involves high costs. Debentures/ bonds have the advantage of lower costs due to lower risk and tax deductibility in many countries on interest payments. Decision makers seek the information about objectives to be served by financing in order to choose between short term and long term financing. Richard G.P.MacMahon ( 1994, page 11)5 suggests that consideration which are likely to influence the type of financing include return, risk, liquidity, diversification, and control. These factors are considered besides the objectives to be served by the financing. Long Term financing are appropriate for capital expenditure for expansion, replacement, renewal, and certain other purposes of a project. Expansion usually require acquisition of fixed assets; replacement of assets are needed to avoid recurring losses due to worn out assets; renewals involve rebuilding or overhauling; and other purposes may include merger, modernization of production facilities and like that. All these purpose seek long tem finances. Short term financing is sought to meet the needs of working capital. Although long term funds provide margin money for working capital, but working capital requirements are virtually exclusively supported by short term sources. 3. Financial Decisions Main purposes of budgets Budgeting develops the communication process among different departments in order to coordinate between their plans and efforts. Budgeting seeks the development of coordination between different tasks in order to achieve targets as per budgeted time schedule. Budget provides management the authority to spend and responsibility to achieve revenue laid down in the budget. Budget is a method to evaluate actual performances with targets set in budget and fixed responsibility on variances between actually achieved and budgeted targets. Calculation of unit cost $ Variable cost per unit 3 Fixed Cost per unit 2 ($400000/ 200000) Unit cost at maximum output 5 Investment Appraisal Investment appraisal or capital budgeting decisions pertain to fixed/ long term assets which by definition refer to assets which are in operation, and yield a return, over a period of time, usually exceeding one year. In other words the system of investment appraisal is employed expenditure decisions which involve current outlays but likely to produce benefits over a period of time longer than one year. Payback method: The payback method of capital budgeting measures the number of years required for cash flow after taxes to pay back the original outlay required in an investment proposal. The payback period can be used as a decision criterion to accept or reject investment proposals. Present Value (PV)/Discounted cash flow (DCF): The present value or the discounted cash flow procedure recognizes that cash flow streams at different period differ in value and can be compared when they are expressed in terms of their present values. In this all cash in flows are expressed in their present values and the PV so determined is compared with the PV of cash outflows in order to take a decision about the investment or for comparing tow or more investment options. 4. Financial Decisions Cash flow Statement: The cash flow statement provides information about an entity’s liquidity and thereby its solvency. Cash inflows and outflows are calculated over the financial period are reflected in three parts as operational activities, investment activities, and financial activities; and net surplus or usage of cash from these activities are adjusted to beginning cash balance in order to compute the ending cash balance. Balance Sheet: Balance sheet is a financial statement of an entity that reflects position with regard to its assets, liabilities and capital on a particular date. Balance sheet is prepared on the basis of trial balance computed from the ledger balances and the profits/ loss calculated from the income statement. Accounting rate of Return Sensitivity analysis in investment decisions: Simply sensitivity analysis is risk assessment in investment decision making. Such analysis provides a range of probabilities of success. Sensitivity analysis provides a range of high level of probable success and a low level of probable success or a failure. Decision making is the consideration of this range of success and failure and that will entirely depend upon the decision maker’s capabilities or understandings of the investment results. References Read More