Loan as a Source of Finance for the Investment Proposal - Essay Example

?Use the information provided to make a brief analysis of the present position of the furniture business. Explain how this information could be used within the business to make improvements. Answer Jools Furniture Industries Ltd has four divisions-Quality products division, Bedrooms division, Kitchens division and Office supplies division. Each division is managed by a divisional managing director, enjoying a considerable autonomy in most of the operational and financial decisions. In order to critically evaluate the current financial position, each division is separately evaluated. In addition, the comments in the audit management letter are also taken into account as they serve the purpose of impartial analysis of the divisions’ performance. They are considerably relevant and helpful to properly and fully assess the divisional financial and economic performance. After the critical evaluation, the relevant improvements are recommended accordingly. Quality Products Division The quality products division deals in furniture items made by hand and the raw natural materials are made part of it. Due to its quality products, this division has significantly contributed into the exports, especially in the Middle East. However, to critically understand the actual financial position of this division, the financial position and the audit comments are taken into account. Financial position 2007 2008 2009 Gearing (TL/TL+SC) 100% 53.98% 52.65% 52.32% Return on investment [PBIT / (TA – L)] x100% (Loss) 16.24% 18.96% Gross profit (gross profit/turnover) 100% 38.89% 40.43% 41.36% Profit before interest (profit before interest/turnover) 100% (loss) 5.70% 6.37% Profit after interest (PAI/Turnover)100% (Loss) 1.97% 3.34% Overseas Turnover (overseas turnover/turnover) 100% 53.79% 44.51% 36.59% These are fundamental indicators of financial position of any corporate entity. According to the policy of the group, the divisions are required to maintain their gearing at or below 50%, however, this division is completely failed to fulfil this requirement and from 2008 to 2009 it has been unable to follow this requirement. Although the division is improving in its gearing, yet it has been unable to drop the gearing from the required level of 50%. However, that is not the same case with the ROI figure, which is constantly improving and fulfilling the 10% requirements of return on investment. Gross profit and profit before interest, profit after interest figures are slightly improving and on yearly basis, they provide 2 to 3% growth in these figures. With so much potential in the markets, local and foreign markets, this division’s gross profit and profit before tax are not increasing as they should be. In addition, this division has been more stable and in demand in the markets of Middle East, however, its recent decreasing overseas turnover highlights some of worrying signs for this division. This is negatively affecting the gross profit and profit before tax figures as well. Additionally, there are no positive audit comments for this division; the audit management letter clearly highlights that some quality control problems with a new range of adjustable chairs for senior citizens. As this industry considerably depends on the quality, such kind of quality control problems may reduce the number of customers. Additionally, the audit management letter points out that in every month 20 boxes of flat-packed chairs and desks are disappearing from the one of the division’s outlets. Improvements Profits can be improved by entering into the contract segment of the industry. This segment accounts for 29% of the entire furniture industry. For achieving that aim, the division is required to more concentrate on quality issues which are recently highlighted in the audit management letter. In addition, the disappearance of chairs and desks must be reduced by introducing some physical controls such as only authorized persons should be allowed to enter into the internal parts of the outlets and each incoming and outgoing shipment of desks and chairs must be signed by an outlet manager. Kitchens Division This division makes every kitchen item with its hand and has been very old part of this business. The audit management letter has not mentioned any loopholes in this division; however there are certain areas where, the divisional managers are not satisfied with the tool of performance appraisal adopted by the holding group. In the management letter, it is mentioned that some of divisional managers are of the opinion that such type of performance appraisal tool does not serve the group objectives rather has become a barrier. Financial position 2007 2008 2009 Gearing (TL/TL+SC) 100% 5.7% 7.48% 10.27% Return on investment [PBIT / (TA – L)] x100% 17.93% 12.85% 12.70% Gross profit (gross profit/turnover) 100% 39.22% 36.18% 37.61% Profit before interest (PBI/turnover) 100% 5.32% 3.60% 3.86% Profit after interest (PAI/turnover) 100% 4.96% 3.25% 3.50% The financial position is not considerable attractive. As the gearing is constantly under control and return on investment also fulfils the required criteria, however, the proposed investment proposal, if approved, by the divisional managers is going to increase the gearing of this division. But, according to the given information in the case study, the net present value of the investment project is not only positive but also financially lucrative as well, if it is approved, without any doubt, it would bring positive impact on the aggregate gross profit and profit before tax figures. Despite attractive ROI and gearing, gross profit is not sufficiently improving ; in the year of 2008, gross profit has declined up to 3.04% and in comparison with the gross profit of 2008, 2009’s figure has only 1.43% increased. Aggregately, if gross profit figure of three years is compared, net 1.61% (3.04%-1.43%) decreases is visible. This shows that aggregately, the gross profit is decreasing rather than increasing. The profit before interest is decreasing in 2008 in comparison with the profit before interest of 2007; further declined can be seen in 2009 as well; this shows that the division is not financially performing well. Constantly, profits are decreasing and aggregately, gearing is increasing which can also be seen from a considerable increase in the interest payments accounted for in 2008 and 2009. Improvements The kitchens division’ improvement considerably depends on the new investment proposal. Since the investment project looks financially lucrative and the markets especially in Asia, are economically growing; as a result, the approved investment proposal would bring a positive change on the gross profit and profit before tax figures. Bedrooms Division This division is run by Maurice Blackstock for the last 12 years. He is proud of the fact that his division is performing well due to the 12 years old machinery is still being used to make bedroom items. Financial position 2007 2008 2009 Return on investment [PBIT / (TA – L)] x100% 18.16% 16.60% 14.62% Gross profit (gross profit/turnover) 100% 26.37% 31.43% 29.78% Profit before interest (PBI /turnover) 100% 3.50% 4.06% 3.97% Profit after interest (PAI /turnover) 100% 2.47% 3.26% 3.22% No financial trend seems to be financially stable and growing rather it would be incorrect to say they are aggregately decreasing! Undoubtedly, return on investment fulfils the return requirement by the holding company. If we closely look at the trend of return on investment, it is decreasing; in the year of 2008, it is dropped from 18.16% to 16.60%, and in the next year, it has further declined to 14.62%. Obviously, just bringing the required rate of return on investment is not sufficient, rather it must be keep increasing so that the financial statements look financially healthy and stable as well. Interestingly, the pattern in the gross profit, profit before interest and profit after interest does not seem to be going up, nor is showing a stable pattern. For instance, profit before interest is increasing in 2008 to 4.06% from 3.50% of 2007. In the next year, instead of increasing, it has dropped to 3.97%. In the audit management letter, it is clearly mentioned that the salaries of retired employees are being paid and are being accounted for in the accounts in every month. Additionally, sales ledger balances have highlighted a significant proportion over 5 months old. Improvements Even this division uses 12 year old machinery, yet profits are unstable and are showing a decreasing pattern. The holding company must a professional replacement for this division. A more qualified and experienced divisional managing director must be assigned to take the charge of this division. Additionally, some controls should be placed over the salaries issue raised by the audit management letter. Since they can severely hit the profitability of the division, new appointment of managing director should be accompanied with the enforcement of new controls. Office Division Financial position 2007 2008 2009 Gearing (TL/TL+SC) 100% 9.86% 8.39% 6.99% Return on investment [PBIT / (TA – L)] x100% 15.79% 12.22% 13.45% Gross profit (gross profit/turnover) 100% 38.90% 33.62% 36.96% Profit before interest (profit before interest/turnover) 100% 6.44% 4.70% 4.88% Profit after interest (PAI/Turnover) 100% 5.51% 4.62% 4.85% Overseas Turnover (overseas turnover/turnover) 100% 4.80% 5.60% 5.30% The financial trend does not look financially stable. Like other divisions, this division also faces the problem of unstable yearly pattern in some of the major ratios. The gearing ratio is considerably reduced. It looks this division does not believe in investing more in the division. Over the given period of three years, the division is putting its best to reduce the gearing ratio by paying back much of long term liabilities. Although technically, this seems to be better, yet it cannot be a good sign for the longer stable future of the division. Gross profit figure has considerably declined in 2008 up to 5.28%. This may have caused by a significant increase in the cost of sale in the same year. However, it has improved in 2009 up to 3.34%. Almost, the same situation can be seen in the figures of profit before interest and profit after interest. Slight upward and downward movements have occurred in these years. This highlights that the division has not learned in any of these years; there is no stable and appropriate policy in the division that can ensure a smooth and stable growth in the above mentioned figures. The division is only trying to remain in the business only; it would be better to say that the division has been unable to determine its course of action over these years. This fact can be validated when its young managing director, Giles Granger, is not being tolerated by the other divisional directors and he is considering switching over to his previous employer. Due to this tussle, the division looks paying the price by underperforming and not receiving a due managerial process from the managing director. In the audit management letter, several discrepancies are bound by the audit team in the stocks of the offices division. 20 boxes of flat-packed chairs and desks have been went missing; and this theft is being done every month. Improvements The holding group must intervene as Giles Granger is not satisfied within the company. The chairman must discuss this situation with the Giles and he must try to understand the true nature of the problem. If there is any problem between Giles and others whom he is complaining about; it must immediately be resolved to avoid further underperformance of the offices division. Additionally, Chairman must ensure a congenial working environment for the staff, more professional practices and training of the divisional managers must be done in order to increase their divisional performance. Professional training is a significant part of today’s business working. In addition, some controls should be introduced reducing the chances of disappearance of stocks of the company. Stock taking must be done regularly if not on monthly basis. A regular stock taking would considerably reduce the chances of disappearance of stocks. Evaluate the current role of the Financial Director. This should include a critical evaluation of how the current system could be improved to aid planning, control and performance management in the future Accounting is described as the universal business language and management accounting system (Hussain, 2005). Accounting is an art of classifying, summarizing, interpreting and recording financial and non-financial data. An accountant is required to understand these basic terms of the definition of accounting. Without fully understanding these basic terms, the accountant would not be in a position to professionally perform the terms of job description. However, the above mentioned four words in the definition of accounting are not limited in their practical meaning and usage; budgeting, planning, costing and profitability, working capital and performance management cannot be overlooked for the significant use in today’s accounting related practices in different organisations. In the subsequent parts of this work, these terms are explained and their application in the given case study is critically analysed as well. However, before going to understand these topics, it is required to comprehend the current role of financial director in the company. Role of current financial director David Green is not playing a substantial role. As the majority of the financial decisions are determined and decided by the divisional managing directors, and a considerable authority is delegated to the divisional managers, a limited role is being played by the current financial director. However, financial director provides its services when divisional managers are required to make a request for long term debt, serving the long term needs of a division. All in all, there is no big role being played by David Green in the company despite he is an FCA. As he has sufficient knowledge in the field of accounting, it would really in the group’s financial interests to utilise his financial expertise in order to increase the aggregate financial performance of the group, which is declining in the recent years. Budgeting Budgets can be divided into short or long term (Welsch, 1988). However, a budget is defined as a quantitative statement (Performance Management, ACCA text book, 2007). Planned assets, expenses, liabilities, revenues may be included in a budget. However, mostly, cash budget, production budget, marketing budget, purchase budget, and sales budget are commonly devised by organisations to put their financial plans into actions in an effective way. Various uses are offered by budgeting. First, a budget can be used for planning. And planning is a tool that can be used to look into future and promote forward thinking. This forward thinking guides to identify potential problems. As a result, an appropriate additional planning can be put in place to manage that problem. Second, in various organisations are consisted of different sections and departments, which aggregately work to attain the strategic objectives. However, they are also given individual objectives. And most of the time, these individual objectives are linked with the objectives of other departments working in the same organisation. It is this coordination of the various departments that not only ensures achievement of the strategic objectives but also works attaining the departmental objectives. Third, if a departmental manager is given a budget in which it is mentioned that if he achieves 50% of this budget, a car will be given. As a result, the manager becomes motivated. He receives his motivation from the budget given to him. In addition, a budget can also be used to evaluate performance of a divisional manager. In the budget, daily, monthly and yearly targets are mentioned; by taking into account these targets, the divisional manager prepares his planning and tries to achieve his target. At the end of year, his evaluation with the use of budget suggests that whether the divisional manager has achieved the budgetary targets. And on the basis of that evaluation, a future course of action is determined by organisations. The drawbacks of budgeting cannot be overlooked. Most of time, budgets are planned to reduce costs. And, there is a managerial tendency to reduce costs at the cost of the value. Many divisional managers do not avoid doing that as their divisional performance is also judged on the basis of their cost reduction and cost saving policy via budgeting and other available means. Budgeting becomes aimless when value on which customer loyalty is based is compromised to gain small savings. The Jools furniture industries can greatly benefit from the use of budgeting. Currently, there is word in the given description of the case study above the use of budgeting by any divisional managing director. A production budget of desks and chairs in the offices division can help the division to speculate the appropriate demand in the domestic and foreign markets. And on the basis of outcome, the production budget must be prepared and implemented. Costing and profitability The significance of cost is paramount. Most organisations do not survive when their costs outshine their profits. They find no other way except to shutting down business operations. As a result, to control costs, most organisations incorporate cost controlling as their strategic objective. Organisations have certain objectives which require them to adopt a certain policy towards costs. Among those objectives, external reporting, planning and decision making and management control are mostly incorporated by organisations in the list of corporate objectives. Normally, organisations are owned by shareholders and controlled by directors. Shareholders always prefer to get fully informed about the current cost related and profit related organisational policies. In the same context, shareholders always want to minimum cost and maximum profit should always be the first objective of the organisations. By publishing the financial statements, shareholders are made informed about the current costs occurring in the organisations. Additionally, efficiency of management is also analysed with the cost; if an organisation is not generating more profits instead of it incurring more costs. Then, shareholders would not be doubtful about the efficiency of the current management over the running and managing the affairs of the organisation. This situation would highlight the presence of incompetent elements in the management who are failing to properly controlling costs and are failing to increase the profits as are expected of them. As the costs are incurred to generate profits, so without fully knowing the cost information, it would not be easy to make appropriate planning and decision making necessary to generate profits. The Jool furniture industries ltd has not used the cost and profitability analysis tool. As much of cost related information is available for all the divisional managing directors of the group, it can be further used to make more appropriate financial decisions. In the first part of this assignment, we saw many divisions were not financially performing well and some were looked unclear over their clear direction leading them towards more profits and less costs. there is no doubt that all sorts of financial and cost related information is available to them, but the divisional managers of the groups are required to concentrate on these points. Management of working capital The financing, control and investment of net current assets within the boundary of policy guidelines are called as management of working capital (Pike and Neale, 1999). Working capital is related with the transactions of current assets. Cash in hand, inventory, debtors- all collectively are called as current assets. Cash in hand is mostly used to fulfil the day-to-day basis cash requirements of a business. For example, to pay an electricity bill for factory or warehouse, cash in hand can be used with this purpose. This and certain other needs can be served with the use of cash in hand. Additionally, inventory can be in three forms- raw material, work in progress and finished goods. Raw material is processed via work in progress and reaches to the finished goods stage. These are the types of working capital from the assets side, current liabilities have its own elements that are also used to serve the purpose of working capital. business has operating cycle, which is mostly divided into sub cycles- inventory cycle, liquidity cycle and cash cycle. The cash cycle provides cash and deposits. Richards and Loughlin (1980) describes that the cash conversion cycle that takes into account all relevant cash flows comes from operations. With the help of cash cycle, liquidity cycle is formed. In the liquidity cycle, accounts payable is used to purchase raw material, which is an element of inventory cycle. The raw material is converted into finished goods after going through the stage of work in progress. The finished goods stage requires sale of these goods, which are sold at credit to different customers. After a certain period, the customers pay cash to clear their outstanding balances of accounts receivable. In that way, the received cash is again used to purchase raw material and so on. A number of factors are considered in a working capital policy. How much investment should be made in the current assets and what sources should be used to fund the needs of current assets? These are the fundamental questions, which are needed to be answered by the makers of working capital policy. However, there are certain other factors such as type of industry, stock and credit policies, management of working policy are directly affecting on the working capital policy. Different organisations adopt different working capital polices. Mostly, aggressive working capital policy is adopted by those organisations that want to control or minimize the risk of bad debts. In aggressive working capital policy, low levels of stock, cash and debtors are placed. With this policy, an organisation increases of chances of earning more returns as the risk of bad debt is under control and it is minimized at the tolerable or acceptable level. Working capital also requires some costs. for instance, carrying costs and storage costs are the fundamental costs. The carrying costs can be further sub-divided into storage and handling costs. On the other hand, storage costs may consist of ordering costs and costs of running out of stock or cash. Both are separately used. Carrying costs occur when an organisation implements a policy of storing raw material. Till the point of converting the raw material, the organisation is required to maintain the physical and other properties of raw material as they are required to be. This depends on the nature and type of raw material. There are certain types of raw material which are needed to placed under a certain conditions; otherwise, rotten or spoilage chances cannot be avoided. Most of the divisional managing directors are unaware of the uses of working capital and operating cycle in Jool furniture industries ltd. By implementing working capital in their respective divisions, the managing directors can considerably be able to the sources of costs. Additionally, by comprehending the working capital costs, they can become in a position to considerably reduce their divisional costs. and in that way, they can improve their financial statements with increased profitability and reduced costs. Highbury construction Using the data relating to Highbury Construction, comment upon working capital management in the construction industry. ROCE Average return on capital employed is being shown in the entire period. In 2008, the ROCE increased to 22.3 but dropped to 21.1 in 2009. The company E and B are performing better than the Highbury. Stocks From 2007 to 2009, stocks days are increasing. In the year of 2008, they have increased in 22 days, however, in 2009, they have increased in 5 days. In comparison with A, Highbury stock days are less which means Highbury holds inventory for fewer days than the company A does! Debtors Debtors days are also increasing meaning the company has relax debtor policy. This kind of policy may increase chances of bad debts. In comparison with the industry averages, the company is displaying better figures. Creditors The suppliers and lenders do not like this type of paying back trend. Constantly, the company’s creditors’ days are increasing. However, they are considerably better in comparison with the industry figures. Gearing The year of 2009 has not an attractive figure of gearing ratio. Aggregately, other industry gearing ratios are far better than the gearing ratio of Highbury. This indicates that company is looking for more long term debt in these days. Current ratio The company has produced comparatively better current ratio in the given three year’s period. In comparison with the industry, current ratios of company B and E are far better than Highbury construction. PE Average expectation is being shown by the investors and shareholders of the Highbury Company. In the industry, more optimistic expectations are being shown by the company C and E. Assess a loan as a source of finance for the investment proposal, and discuss two suitable alternatives. A company considerably depends on the sources of finance. Their entire financial structure works with the use of appropriate mix of finance. And this appropriate mix of finance is used to fulfil the short term and the long term financial needs. Working capital is one of the short term needs of companies. The basic function of working capital is to fulfil the regular and routine requirements of expenditure done to keep the company’s vehicle moving. Any shortfall in the working capital requirements can negatively impact on the operations of the company. So, in order to avoid any such negative impacts, the company puts its best efforts not to let any effect on the working capital. Working capital only fulfils the short term needs of the company not the long term requirements. To invest in a mega project, or to plan to acquire a new business, or to increase the efficiency of current business or to plan to merge with a new company; these financial objectives can push the company to raise long term finance. Undoubtedly, short term sources of finance cannot fulfil the needs of long term requirements as a considerable amount of capital is required to invest in. Each of the above mentioned long term financial objectives requires a different amount of capital. As a result, this requires different factors will be considered. However, there are certain factors which are generally put into consideration before going to embark upon investing in a long term project. For instance, a cost factor is highly significant. How much cost of capital will be paid by a company if the company obtains a long term loan? Undoubtedly, this is a strategic matter that should be very carefully considered. Most of the time, a long term borrowing is consisted of a period of 5 to 10 years and some borrowings could extend to more than that period. During that period, the company is required to pay cost of capital in the shape of interest rates. The amount of interest mostly paid monthly. It depends on the borrowed amount. A specific percentage of interest is charged and fixed by a lender. Monthly, or semi-annually, the company is required to pay the interest amount to that company. Till the final payment of the principal amount, the interest rate is needed to be according to agreed schedule by the company. Most of the time, the interest rate is fixed; however, in some cases, the lender may require the market rates to determine the interest rate. Additionally, long term borrowing requires a period of five to ten years or in some cases more than that. As a result, this factor can put some extra pressure on the financial capabilities of the companies in the long run. In addition, the company must take into account the term structure of interest rates as the possibility of some heavy conditions may be made part of an agreement. In these days, lenders are considerably careful while lending money due to the recent financial crisis, which has decreased the lenders’ trust on the borrowing companies. In order to secure the repayment of a loan, the lenders are putting as much stricter conditions as they consider safe and secure. Furthermore, the company must consider the subsequent effects of long term borrowing on its cost of capital structure. This consideration must not be limited to the short term but to the long run as well. Any inconsiderate financial decision may bring some additional pressure on the cost of capital of the company. Without any doubt, this impact cannot be limited to the cost of capital, but the shareholders of the company may view it as negative development in the financial statements of the company. Various sources of finance can be used to invest into a long term project. Equity, debt are the prime sources of finance. In equity, ordinary shares, preference shares, rights issues can be used to raise further finance. Additionally, debentures, traded securities, unsecured loans; mezzanine finance can be sources that can be used to fund the long term needs of the company. Also, venture capital, retained earnings and finance lease can be used for the similar long term needs. Each source has advantages and disadvantages as well. It depends upon some above mentioned factors and certain other industry related factors that are deeply and carefully considered before going to use any particular mode of finance. Additional ordinary shares can be issued to fund the long term needs. However, it is important to ponder over certain factors such as cost of procedures, pricing, and control and dividend policy. Ordinary shares require cost of procedures necessary to issue the ordinary shares. This cost depends on the number of shares, printing and certain other factors. Most importantly, in order to raise the required level of finance, a company must devise such issuing policy that should be capable of attracting current and potential shareholders. If the price of new shares is attractive as well as lucrative, shareholders will be willing to buy the new ordinary shares. Additionally, dividend policy is also a significant factor which is keenly seen by the existing and potential shareholders. If the dividend policy is financially lucrative and promising; the shareholders will not be hesitating to investing into the company. Multiple advantages can be brought by raising finance by issuing ordinary shares. First, more easy access to finance can be made if they are publically sold. Comparatively, this source is cheaper than the debt, where fixed and regular interest payments are required whether the company earns profits are not. If the company is financially strong and stable, there would be more chances of selling the ordinary shares. Debentures can be issued to for the same objective. Debenture is a type of loan notes, and like a document acknowledging a debt with a particular amount is owed by the company. Mostly it is traded on stock markets. Debentures can be secured or unsecured, depending on the needs and mode of the company; additionally, mostly loans are tax free, which means companies do not pay taxes on its loans rather they pay interests. This can bring a savings in the form of not paying taxes for the loans. However, shareholders may object to this kind of borrowings as they can put a negative effect on the dividend policy in the long run. Since interest payments are needed to be paid whether the company is earning or not, shareholders prefer to discourage management opting for this option. References 1. Association of Chartered Certified Accountant (2007). “Performance Management- F5”. UK: Get Through Guide Ltd 2. Welsch, G.A., Hilton, R.W., Gordon, P.N. (1988), Budgeting: Profit Planning and Control, Prentice-Hall, Englewood Cliffs, NJ, 3. Hussain, Md. Mostaque. (2005).” Management accounting performance measurement systems in Swedish banks.”European Business Review. Vol: 17. Iss: 6. [Available at: http://www.emeraldinsight.com/journals.htm?issn=0955-534X&volume=17&issue=6&articleid=1528640&show=html ] [Accessed on: 8th April, 2011]. 4. Pike, R. and Neale, B. (1996), Corporate Finance and Investment, Decisions and Strategies, 2nd ed., Prentice-Hall, London. 5. Richards, D. Laughlin, J., 1980, A Cash Conversion Cycle Approach to Liquidity Analysis, Financial Management 9, 1, 32-38. Read More