Sources of Finance - Assignment Example

Managing Financial Resources SOURCES OF FINANCE 1. What sources of finance are available for different businesses? Discuss the following: - Advantages and disadvantages. - Implication of choice – legal, financial, dilution of control of business and what happens with bankruptcy. There are many reasons why a business needs capital to finance its operation. Some of them are capital asset acquirement to buy new equipment or to construct a new building, the development of new products, etc. There could be internal or external sources of financing. The Food and Agriculture Organization of the United Nations (FAO, 1997) explains in some detail the following sources for financing a business: “Ordinary (equity) shares “Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares. “Deferred ordinary shares are a form of ordinary shares, which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares. “Rights issues “A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings. “Preference shares “Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders. “Loan stock “Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company. “Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax. “Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. “Security “Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge. “Retained earnings “For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows: “Bank lending “Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days. “Leasing “A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. “Hire purchase “Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit instalment, whereas a lessee never becomes the owner of the goods. “Government assistance “The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment. For example, the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country. “Venture capital “Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term 'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme. “Franchising “Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.” (FAO, 1997). The Encyclopedia of Small Business (2007) defines equity financing as follows: “Equity financing is a strategy for obtaining capital that involves selling a partial interest in the company to investors. The equity, or ownership position, that investors receive in exchange for their funds usually takes the form of stock in the company. In contrast to debt financing, which includes loans and other forms of credit, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run.” The advantages and disadvantages of equity financing are stated as follows by th Encyclopedia of Small Business (2007): “The main advantage of equity financing for small businesses,which are likely to struggle with cash flow initially, is that there is no obligation to repay the money. In contrast, bank loans and other forms of debt financing provide severe penalties for businesses that fail to make monthly principal and interest payments. Equity financing is also more likely to be available to concept and early stage businesses than debt financing. Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers primarily seek security, so they usually require the business to have some sort of track record before they will consider making a loan. Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners. “The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations. For many small businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants.” (Encyclopedia of Small Business, 2007). FINANCIAL PERFORMANCE 1. Explain the purpose of and show examples of the main financial statements (profit and loss account, balance sheet and cash flow statement). Briefly mention why notes within the Annual Report are needed. The financial statements provide useful information about the financial status of a business that can help its owners to understand how the business is doing financially, and to predict and plan for the future. Understanding financial statements can help in the following areas: “Identify unfavorable trends and tendencies in your business's operations (for example, the unhealthy buildup of inventory or accounts receivable) before the situation becomes critical. “Monitor your cash flow requirements on a timely basis, and identify financing needs early. “Monitor important indicators of financial health (for example, liquidity ratios, efficiency ratios, profitability ratios, and solvency ratios). “Monitor periodic increases and decreases in wealth (specifically, owners' or stockholders' equity). “Monitor your performance against your financial plan, if you have developed one.” (Business Owner’s Toolkit, 1995-2008). Business Owner’s Toolkit (1995-2008) gives the followin description of the main financial statements: “The income statement, also referred to as a "profit and loss statement," "statement of incomes and losses," or "report of earnings," tells you or your investors: “the income the business has earned during the accounting period “the costs or expenses that were incurred by the business during the period “the difference between the costs and incomes for the period, or net profit (or loss) “The balance sheet is a statement of a company's relative wealth or financial position at a given point in time. It shows assets, liabilities, and owners' equity. “The position statement, also known as the "statement of changes in financial position" or "sources and uses of cash," helps to explain how a company acquired its money and how it was spent. “The statement of changes in owners' equity is used to bridge the gap between the amount of owners' equity at the beginning of the period and the amount of their equity at the end of the period.” (Business Owner’s Toolkit, 1995-2008). This is an example of a Profit and Loss Account by the University of Glamorgan (no date): Figure 1. Profit & Loss Account year ended 30 May 1997 David Jones   SALES     Hardware & Software 164,000   Consultancy 4,000   Total Sales   168,000       DIRECT COSTS     Materials 135,000   Stock at start of year 6,000   Total 141,000   less stock at end of year 9,000   Total Direct Costs   132,000       GROSS PROFIT   36,000       EXPENSES     Wages 7,000   Rent & Rates 4,800   Telephone 400   Professional Fees 200   Advertising 500   Transport 700   Stationery etc. 200   Insurance 400   Heating & Lighting 400   Bank charges 300   Depreciation 2000   Total Expenses   16,900       NET PROFIT   19,100       less salary   15,000 Retained in business   4,100 This is an example of a Balance Sheet by AccountingStudy.Com (1999-2007): An Example of Detailed Balance Sheet Sample Technology Corporation Balance Sheet December 31, 2006   Assets       Current Assets          Cash          Marketable Securities          Accounts and Notes Receivable          Less:  Allowance for Doubtful Accounts          Inventories          Other Current Assets             Total Current Assets       Investments          Long-Term Investments in Bonds       Property, Plant, and Equipment          Land          Buildings          Less:  Accumulated Depreciation          Equipment          Less:  Accumulated Depreciation             Total Property, Plant, and Equipment       Intangible Assets       Other Noncurrent Assets       Total Assets               Liabilities and Stockholders' Equity       Current Liabilities          Notes Payable          Accounts Payable          Income Taxes Payable          Accrued Expenses          Current Portion of Long-Term Debt             Total Current Liabilities       Long-Term Liabilities          Long-Term Notes Payable          Long-Term Borrowings          Bonds Payable          Deferred Income Tax Liabilities             Total Long-Term Liabilities       Total Liabilities               Contributed Capital          Preferred Stock, $5 par value (authorized 10,000 shares,        issued and outstanding 7,000 shares)          Common Stock, $2 par value (authorized 2,000,000 shares,        issued 1,200,000 shares, outstanding 1,150,000 shares)          Additional Paid-in Capital             Total Contributed Capital       Retained Earnings             Total Contributed Capital and Retained Earnings       Less:  Treasury Stock, at cost (50,000 shares)       Total Stockholders' Equity               Total Liabilities and Stockholders' Equity       This is an example of a Cash Flow Statement by Business Resource Software (1994-2008): 2007 2008 2009 2010 2011 Source of Funds Beginning cash 0 -11,767 143,765 416,274 924,480 Sales/Svcs Income 1,366,986 2,662,548 3,416,123 4,565,616 5,981,959 Sale of Assets 0 0 0 0 0 Customer deposits 0 0 0 0 0 Loans 0 0 0 0 0 Contributed Capital 400,000 0 0 0 0 Available Cash $1,766,986 $2,650,781 $3,559,888 $4,981,890 $6,906,439 Use of Funds Salaries 1,355,000 1,676,000 2,044,000 2,557,000 3,355,000 Other operating expenses 423,753 759,933 900,245 1,187,340 1,533,432 Loan payments 0 24,910 99,640 99,640 99,640 Capital Expenditures 0 0 0 0 0 Tax Payments 0 46173 99729 213430 277791 Total Cash Out $1,778,753 $2,507,016 $3,143,614 $4,057,410 $5,265,863 Net Cash Flow ($11,767) $143,765 $416,274 $924,480 $1,640,576 Regarding the notes in the financial statements, IBM (2008e) states the following: “The notes are required reading to understand the financial statements. Companies use notes to explain how they arrived at the numbers in the financial statements and to describe any significant events or changes in procedures that may affect the numbers. Notes also explain items in the statements and report details of the company's financial performance not shown in the statements.” (IBM, 2008e). 2. What are the differences between the different types of businesses i.e. limited company, partnership and sole trader? FastLinkSolutions.CO.UK (2000-2004) explains the different types of company structure as follows: “Sole Trader (Self-Employed) “This is a business owned by one person. Legally, the person and the business are one and the same. All financial risks are taken by that person and all that person's assets are included in that risk. “Pros “If you are operating as a sole trader you have almost complete control over how the business is run. You can make decisions (as long as they are legal!) without interference. “The administrative costs of running a sole business are small. “You will need to keep records for Inland Revenue (and also for VAT if you are VAT registered), but there are no other legal requirements. “Cons “All your personal assets are at risk if the business fails. Personal bankruptcy can occur. “Partnership (Self-Employed) “A partnership is a business run by two or more people together. There should be a written agreement detailing this arrangement. Profits are usually shared between partners according to the agreement. Although profits may be shared unequally, liabilities which may arise are shared jointly. This is something that everyone involved should be very clear about. Even if you only own 1% of the business you will still be responsible for 100% of the liability. “A partnership is a very risky type of business to get involved in, just because of all the potential for conflict, and the financial effect conflict between partners would be likely to have on the business. However, now the Limited Liability Partnerships Act has received Royal Approval and will become Law by the end of the year. There are a number of advantages to LLP including limiting liability (as with a Limited Company) and the tax advantages of a Partnership. See information below “Pros “Often more money can be raised to start the business if more than one person is involved. “You will need to keep records for Inland Revenue (and also for VAT if you are VAT registered), but there are no other legal requirements. Each partner should submit a P/SE/1 and you are taxed as an individual. If you leave the partenership your tax liability will follow you (unlike in the past when the remaining partner had to pay it) “The workload can be shared. “Cons “All personal assets of each partner are at risk if the business fails. Personal bankruptcy can occur. “Decisions are taken jointly. The agreement may specify different levels of decision making for each partner. Either way a stalemate could easily arise, or the decision making process could be hampered, if a decision cannot be reached without the major shareholder present. “Limited Liability Partnership “A LLP gives the benefits of Limited Liability in that it can protect your existing personal assets, while giving many of the Tax advantages of a sole trader partnership “You have to register with Companies House, the method is similar to registering a company. “Limited Company “Unlike a Sole Trader or a Partnership, the Limited company is legally a separate entity in its own right. The directors and shareholders have limited liability. When a limited company is created it will have an Authorised Shareholding which specifies the limit of a shareholders liability. If all shares have been issued then shareholders are not liable for any more debts that the company may accrue. This is definitely the most sensible option if capital is being put into the business by anyone who is not involved in running it. (i.e. shareholders) For information about setting up a Limited Company, have a look at our Company Formation page or follow this link “Pros “Limited liability can usually protect directors, who act in good faith, from legal actions brought against them. “Cons “There is considerably more administration involved in running a Limited Company than there is for a Partnership or Sole Trader. “As mentioned above, even with no other staff, the "owner" or director of the company is considered to be an employee of the company, therefore the more expensive Class 1 National Insurance Contributions must be paid. “You cannot keep your business affairs private. You have to hold an Annual General Meeting (AGM) for all the share holders. You must also submit an Annual Reports to the Companies Registration Office, along with a fee (currently £15.00)” (FastLinkSolutions.CO.UK, 2000-2004). 3. Find a recent Annual Report for a chosen company.( from the internet ). a) Analyse the financial statements using key accounting ratios for liquidity, profitability, efficiency and investment. Calculate at least 6 ratios. b) Make comparisons and comments against previous year’s results and mention how ratio analysis can be used for budgeting. c) Make comparisons and comments against other companies and / or industry standards. IBM (2008a) defines an annual report in the following terms: “An annual report is exactly what it sounds like - a formal report on a company's performance in the preceding year. A public company produces an annual report for its stockholders, the people and institutions who own the company. (…) “An annual report is one of the most important documents a company produces and is often the first document someone consults when researching a company. It reports how the company did financially and often explains the scope of its business mission and management philosophy.” (IBM, 2008a). The Encyclopedia of Credit (2008) provides the following definition of ratio and financial ratios and deals with their importance in any business: “Ratio: A mathematical relationship between two elements, derived by dividing one into the other (e.g., the current ratio results from dividing current assets by current liabilities). analysis is an excellent method for determining the overall financial condition of a customer's business. Ratios are useful for making comparisons between a customer and other businesses in an industry. A financial ratio is a simple mathematical comparison of two or more entries from a company's financial statements.” (Encyclopedia of Credit, 2008). According to Focal Point Consulting (no date) financial planning and budgeting are essential to keep the focus of any business. The financial ratios are useful indicators in order to forecast the financial perfomance, so they are a basic tool for the budgeting purposes of any organisation. Focal Point Consulting (no date) deals with this topic as follows: “The purpose of financial planning is to monitor how the company is using its financial resources from year to year. “Developing a plan helps business differentiate itself from its competitors by requiring management to examine its mission. “Planning is a detailed quantitative budget that specifies both how the goals for the coming year will be attained and the procedures for managing daily operations.” (Focal Point Consulting, no date). On the other hand, the 2005 IBM Annual Report and the 2006 IBM Annual Report (IBM, 2008b; 2008c; 2008d) were taken as reference in order to calculate some financial ratios according to the formulas given in BizWiz Consulting (no date). The results are the following: Financial Ratios Formulas: Acid-Test Ratio Age of Inventory  = 365 days / inventory turnover ratio 1) ACID-TEST RATIO: IBM Annual Reports: YEAR 2005 YEAR 2006 12,568+7216+267 1.97 8,022+8,902+224 1.69 35,152 40,091 2) SOLVENCY RATIO: IBM Annual Reports: YEAR 2005 YEAR 2006 1,600,591,264+20505 32,669 1,530,806,987+22,082 36,131 48,993 42,368 3) CURRENT RATIO: IBM Annual Reports: YEAR 2005 YEAR 2006 45,661 0.628 44,660 0.597 72,650 74,728 4) AGE OF INVENTORY RATIO: IBM Annual Reports: YEAR 2005 YEAR 2006 365 0.128 365 0.129 2,841 2,810 Comments: 1) ACID-TEST RATIO It can be seen that the acid-test ratio increased in 2006 from 1.69 to 1.97 even though the liabilities were higher. This ratio is along the normal range, so the company can meet its financial obligations. 2) SOLVENCY RATIO This ratio increased slightly in 2006 even though we see that the utilities decreased slightly as they are lower than in 2005. 3) CURRENT RATIO Regarding liquidity we could see that the liabilities increased in 2006, which caused a slight increase in the ratio from 0.628 to 0.597. This means that the liabilities are high in relation to the assets of the company. 4) AGE OF INVENTORY RATIO When we calculate the age of inventory ratio, we want to know its rotation. We see that these ratios for 2005 and 2006 kept almost equal with a slight increase. We can conclude that the inventory flows on a reasonable way. References AccountingStudy.Com. (1999-2007). “Balance Sheet”. (online). Available from: http://www.accountinginfo.com/study/fs/fs-bs-101.htm (Accessed January 26, 2008). BizWiz Consulting. (No date). “Financial Ratios Formulas, Definitions and Explanations”. (online). Available from: http://www.bizwiz.ca/financial_ratios_formulas_and_explanations.html (Accessed January 27, 2008). Business Owner’s Toolkit. (1995-2008). “Financial Statements”. (online). Available from: http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P06_7001 (Accessed January 26, 2008). Business Resource Software. (1994-2008). “Cash Flor Staement”. (online). Available from: http://www.businessplans.org/cashflow.html (Accessed January 26, 2008). Encyclopedia of Credit. (2008). “Financial Ratios”. (online). Available from: http://www.encyclopediaofcredit.com/WebHelp/financial_analysis/financial_ratios.htm (Accessed January 27, 2008). Encyclopedia of Small Business. (2007). (online). “Equity Financing”. Available from: http://www.referenceforbusiness.com/small/Eq-Inc/Equity-Financing.html (Accessed January 28, 2008). FAO. (1997). “Chapter 7 – Sources of Finance”. (online). FAO Corporate Document Repository. Food and Agriculture Organization of the United Nations (FAO). Available from: http://www.fao.org/docrep/W4343E/w4343e08.htm (Accessed January 25, 2008). FastLinkSolutions.CO.UK. (2000-2004). “Company Structure”. (online). Available from: http://www.fastlinksolutions.co.uk/limitedc.htm (Accessed January 26, 2008). Focal Point Consulting. (No date). “Financial Planning and Budgeting”. (online). Available from: http://www.focalpointconsult.com/Financial_Planning_Budgeting.htm (Accessed January 28, 2008). IBM. (2008a). “Guide to Annual Reports”. (online). Available from: http://www.ibm.com/investor/tools/annualreports.phtml (Accessed January 27, 2008). IBM. (2008b). “2005 IBM Annual Report”. (online). Available from: ftp://ftp.software.ibm.com/annualreport/2005/2005_ibm_annual.pdf (Accessed January 27, 2008). IBM. (2008c). “2006 IBM Annual Report”. (online) Available from: http://www.ibm.com/annualreport/2006/ (Accessed January 27, 2008). IBM. (2008d). “2006 IBM Annual Report. Financial Highlights”. (online). Available from: http://www.ibm.com/annualreport/2006/highlights.shtml (Accessed January 27, 2008). IBM. (2008e). “The Notes”. (online). Available from: http://www.ibm.com/investor/tools/financialsBasics.phtml#notes (Accessed January 26, 2008). University of Glamorgan. (No date). “Profit and Loss”. (online). Available from: http://www.comp.glam.ac.uk/pages/staff/efurse/Teaching/PSB/Accounts2.html (Accessed January 26, 2008). Read More