Financial Resources and Decisions Management - Essay Example

?Task 1 In order to finance any project, a company needs to raise capital in the form of revenue funds, short term finance, long term finance, running finance etc. Raising capital can be a significant and crucial task for any company as several technicalities and procedures are involved. It is generally observed in an economic scenario that the company with a good credit history and uplifted financial outlook is likely to raise funds easily as compared to the otherwise. Raising capital significantly affect the gearing of a company. Both modes of financing i.e. equity and debt, comes with their advantages and disadvantages. Several factors, such as statutory rules and requirements, terms and conditions imposed by the counter party and general economic conditions are analyzed before selecting one of the options. The downside of acquiring financing through issuance of equity is that the procedure is quite complicated as compared to acquiring funds by approaching any bank. In most cases, a loan is acquired from any bank or financial institution by filing an application for the sanctioning of the loan. The bank or any other financial institution, after evaluating the necessary details such as credit history, financial outlook for assessing the ability of the entity to repay the loans in future, and the purpose of the project for which the loan application was filed, sanctions the loan. Whereas in the case of raising finances through issuance of equity shares, the company has to fulfill several requirements such as issuing a predefined number of shares, issuing shares to the existing shareholder in proportion to their existing shares and appointing a financial advisor for conducting a due diligence of the entity’s operations. Although these statutory rules and requirements are enforced by the relevant authorities in order to safeguard the interest of the organization and general public, complying with them can be quite troublesome when the requirement of the fund is urgent. There is another drawback of raising finances through issuance of equity. There is always an uncertainty that the shares will not be completely subscribed by the public, whenever they are floated in the market, and thus the company would not be able to raise the required funds. In contrast, in equity financing, the company has to wait for a considerable longer period of time for the funds to become available for their utilization. 1.2 The two modes of finance available to the company would be raising funds through issuance of equity or acquiring loan in the form of a mixture of a long term and short term debt. Let us assume that the total requirement of funding for Quality windows Ltd is for ? 100,000. As provided in the scenario, 40% of the funding requirement can be met through internally generated funds, whereas for the remaining 60% the company has to decide about the mode of funding. Thus the amount of fund required to issue is ? 60,000. Option 1: Raising the fund through the issuance of shares The company decides to issue 6,000 shares at ? 12 (par value is ? 10 and premium is ? 2). As per the current market knowledge, the issuance cost per share is ? 1. Other administrative cost pertaining to the issuance of share is ? 5,000 in total which relates to publishing prospectus and appointing an under-writing agent. Thus the total cash inflows to the company for the first financial year would be as under: Particulars Amount in ? Shares issued 72,000 Issuance cost (6,000) Other costs (5,000) Total inflow 61,000 Option 1: Acquiring loan from a financial institution The company decides to acquire loan from a financial institution amounting to ? 70,000. The principal repayment will start two years from the end of the current financial year. In return, the financial institution will charge interest rate at the rate of 12%. Thus, following is the net cash inflow at the end of the financial year: Particulars Amount in ? Loan acquired 70,000 Interest cost (8,400) Total inflow 61,600 Thus it is apparent from the above analysis, that acquiring loan from the financial institution is the better option. 1.3 Debts are classified into current and non-current. Current debts include items such as accounts payable, accruals etc which arise in the normal course of business and pertain to company’s day to day operations. In order to understand the impact of debt in the capital structure of a company, it is imperative that the company should clearly get acquainted with the concept of debt. There is no universal agreement between the financial analysts all across the corporate sector when it comes to identifying what constitute a debt. It is considered a general notion that the long term debt as appearing in the balance sheet of the company constitutes the debt in the capital structure of the company. However, this definition of debt is way too broad and it includes the credits and short term overdraft of the company as well. The cost of raising funds in the form of loan acquired from the bank or financial institutions is substantially less as compared to the cost of raising financing through shares or bonds. The cost of raising equity comprises of printing of shares, cost of listing the equity shares on the stock market and the legal and professional charges paid to the consultants for the due diligence of floating the new shares in the market. When it comes to raising finance through debt, very little or minimal cost is involved for the sanctioning of the loan whether it is long term or short term. However, with so many disadvantages for raising fund through issuance of equity, the biggest advantage of raising funds through issuance of shares is that no subsequent cost arises in such respect. For raising funds through debt financing, the company has to pay interest charges to the financial institution based on a predetermined rate. The interest rate is usually depended upon the tenure of the loan. The longer the period the higher the interest rate is expected to be. Moreover, there can be a situation where the company is not able to discharge its liabilities, for example the case where the company is short of liquid assets. No payment of interest charge can label the company as defaulter by the bank or the financial institution and it would not be able to secure financing from the very same financial institution in future. Another factor which the investors consider, while making investment, is the imposed debt covenant that the company must comply. Banks and financial institutions, while sanctioning long term finances to companies impose certain restrictions such as maintenance of debt equity ratio, ensuring that the current ratio level does not fall below a specific level; the profitability of the company does not decrease below a specific level etc. Task 2 2.1 Following are the five main types of business organizations: Sole Proprietors: These are un-incorporated business. There are no legal requirements to start up a business and is the easiest of all the forms. The most common examples of these businesses are independent contractors, consultants and freelancers Corporations: Corporations are incorporated entities. Unlike the sole proprietorship, corporations are considered separate entities from the shareholders. The biggest advantage of a corporation type of organization is that it has a legal status and thus provides protection to its shareholders. Corporations are usually for profit organizations. The chief executive officer of corporations assumes all the responsibilities of the business. Partnership: These are also incorporated businesses, which possess the status of a separate entity from its shareholders. In partnership types of organizations, there is a general partner with who lays all the major responsibility of the business. Trusts: Trusts are generally formed upon the death of an individual and the sole purpose of it is to provide continuity to the investment and business activities of the individual. Non-profits: These are corporations established for charitable purposes. The distinguishing feature of these organizations is that they are exempt from any sort of tax. These corporations are highly regulated as they are closely monitored by the government in order to ensure that they perform their charitable activities appropriately. [Studyfinance.com (1999)] The cost of acquisition of funds, in the form of loan, is quite less if compared to the cost of raising financing through shares or bonds. Initial cost pertaining to the raising of equity financing includes printing of shares, cost of listing of shares on the stock market and professional charges paid to financial advisor for conducting the due diligence of the issuance of shares. Whereas, no or very minimal cost is expended in the acquisition of short term or long term financing. The biggest advantage of financing through shares or bonds is that no subsequent cost arises after the issuance. In case of debt financing, subsequent cost arises in the form of interest payments which is spread over the period of the term of the loan. Although, initially the cost of raising equity financing would be much higher, but the burden put on by the debt financings, in the form of interest payments, would significantly affect the net earnings of the company for a longer period. Moreover, if a company finds itself in a stringent economic condition and the repayment of interest charges and principal becomes difficult for it, the credit rating of the company would be adversely affected which in turn would affect its financial outlook. 2.2 The importance of capital investment decision cannot be ignored in today’s dynamic economy where every company is striving to earn the best return on its investments. [Abeysinghe, R. L., 2010]. Capital investment can be interpreted as an investment venture of considerable larger amount which is on long term basis and is likely to generate revenue for the company over that particular term. In today’s world, a brief analysis will present the fact that companies have separate departments equipped with experts in the fields of financial appraisal and decision making. The sole job of these financial analysts is to identify whether a particular investment is likely to bring inflow or outflow of benefit to the company. 2.3 Several factors need to be considered when it comes to the investment appraisal decisions. The board of directors of Quality windows limited needs to consider a considerable number of factors when it comes to the taking capital expenditure decisions in the company. One of the imperative factor which needs to be considered by the company while evaluating an investment is the inflation in the future cash flows. The inflation in the future expected revenue and cost (i.e. the cash inflow and outflow) can significantly impact the NPV and IRR of the project. In addition, one of the most important decision making factor is the source of funding for the capital expenditure and how it will be arranged. The board of directors of the company needs to decide whether the funding should be equity based or debt based. Both modes of financing i.e. equity and debt have their own advantages and disadvantages. There are several factors which need to be considered before taking such decisions. For example statutory rules and requirements, terms and conditions imposed by the counter party and general economic conditions are analyzed before selecting one of the options. 2.4 (a) As per the general equation of accountancy, the assets of a company are financed either through equity or debt. In the statement of financial position or balance sheet of a company, the total of assets is always equal to the total of liabilities and debt. The decision of how to finance the asset of a company is of prime importance for the management of the company. Debts are classified into current and non-current. Current debts include items such as accounts payable, accruals etc which arise in the normal course of business and pertain to company’s day to day operations. (b) For raising funds through debt financing, the company has to pay interest charges to the financial institution based on a predetermined rate. The interest rate is usually depended upon the tenure of the loan. The longer the period the higher the interest rate is expected to be. Moreover, there can be a situation where the company is not able to discharge its liabilities, for example the case where the company is short of liquid assets. No payment of interest charge can label the company as defaulter by the bank or the financial institution and it would not be able to secure financing from the very same financial institution in future. Thus the interest charge is likely to reduce the annual profit of Quality windows if they acquire the debt finance. Another factor which the investors consider, while making investment, is the imposed debt covenant that the company must comply. Banks and financial institutions, while sanctioning long term finances to companies impose certain restrictions such as maintenance of debt equity ratio, ensuring that the current ratio level does not fall below a specific level; the profitability of the company does not decrease below a specific level etc. [Investopedia, 2013] 3.1 The financial statements are prepared by the corporations in order to present their annual financial position. The primary reason for the preparation of financial statements is that they provide the users of the financial statements knowledge about the finances of the company and its financial outlook. The financial statements presents the revenue earned by the company during the current year, the costs incurred, the net and gross profit earned, the total assets acquired and disposed off, the liabilities assumed and paid off during the year etc. For the public listed companies, preparation of financial statements is a statutory requirement, as the stake of the public in such entities is higher. A complete set of financial statements comprises of a balance sheet, profit and loss account, cash flow statement, statement of changes in equity and notes to the financial statement. Quality windows limited should also prepare financial statements so that its shareholders are aware of the activities the company is undertaking year after year. In addition, since the company is planning to acquire funds, it would be a compulsory requirement imposed by a financial institution that the company should present its latest financial statements, before the loan is sanctioned. 3.2 The financial statements in both cases i.e. Partnership and Corporations serve the same purpose that it describes the flow of money. The difference between the financial statements of Partnership and Corporations is basically of presentation and the core accounting concept applies in the same fashion. In the balance sheet of a limited liability company, the assets are presented as balanced against the total liabilities and the equity. This equity is shareholders equity which is the sum of money raised through issuing shares in the market. The issued capital figure in the balance sheet of a company does not decrease unless the company decides to buy back the shares. On the other hand, in the balance sheet of a partnership, there is owners equity which is the amount contributed by the partners at the time partnership was initiated. This equity reduces every time a partner makes a drawing. In addition, corporations are required to prepare their financial statement on a financial reporting framework such as GAAP or IFRS whereas, there is no such requirement for the partnership accounting. 3.3 The ratios can be divided into various categories such as profitability, gearing and liquidity, each focusing on a different area of the financial outlook of the organization and highlighting the company’s performance. These analysis form an integral part of the financial statement analysis, especially from the investors point of view, who always strive to invest in countries having strengthen and stabilizing financial ratios and representing an upward trend. Gross profit margin is one of the key profitability ratio indicators which indicate how well a company is in the process of utilizing its working capital in earning the desired level of profit. In order to calculate the gross profit margin ratio, the gross profit (i.e., sales less the cost of sales) is divided with the revenue of the company. The next profitability indicator is the net profit margin. The net profit margin is calculated by dividing the net profit (i.e., gross profit less administrative and selling expenditure) with the total revenue. The net profit margin follows almost the same historical pattern as the gross profit margin. The return on equity is calculated by dividing the net profit attributable to shareholders by the shareholders equity. [Investopedia, 2012] The ratio is quite essential from the investor’s point of view as it represents how well a company is earning on its shareholder equity, which mainly comprises of issued capital and retained earnings. Current ratio is one of the most important measures of the liquidity of the company. The ratio is calculated by dividing the current assets with the current liabilities of the company [Investopedia, 2012]. A ratio of greater than 1 represents that the company have enough current assets to pay off its current liabilities falling shortly from the end of the financial year. Acid test ratio is calculated in the similar manner as the current ratio, except the figure of inventory is deducted from the total current assets. Since the inventory takes more time to be converted in to cash, the acid test ratio presents the true picture of the liquidity of the company. References Investopedia.com (2012) Financial Ratio Tutorial | Investopedia. [online] Available at: http://www.investopedia.com/university/ratios/ [Accessed: 8 April 2013]. Investopedia.com (2011) Understanding Financial Liquidity. [online] Available at: http://www.investopedia.com/articles/basics/07/liquidity.asp [Accessed: 8 April 2013]. Qfinance.com (2010) Gearing Ratios - Definition of Gearing Ratios - QFINANCE. [online] Available at: http://www.qfinance.com/dictionary/gearing-ratios [Accessed: 8 April 2013]. Peavler, R. (2012) Profitability Ratios - Financial Ratio Analysis - Profit Margin - Return on Equity - Return on Investment. [online] Available at: http://bizfinance.about.com/od/financialratios/a/Profitability_Ratios.htm [Accessed: 8 April 2013]. Investopedia.com (2013) Effects of Debt on the Capital Structure – CFA Level 1 | Investopedia. [online] Available at: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/debt-effects-capital-structure.asp [Accessed: 20 Mar 2013]. R.A. Brealey, S.C. Myers and F. Allen. (2011) Principles of Corporate Finance. 11th ed. McGraw-Hill/Irwin. Abeysinghe, R. L., 2010. Nature and introduction of investment decision. [Online] Available at [Accessed 10 Mar 2013]. Studyfinance.com (1999) StudyFinance: Types of Business Organization. [online] Available at: http://www.studyfinance.com/lessons/busorg/ [Accessed: 10 Apr 2013]. Read More