Understanding Financial Statements - Term Paper Example

Heading: Managing Financial Resources and Decisions Managing Financial Resources and Decisions Introduction Financial resources are the means by which a business organization is financed. There are a number of sources from which a business can get its financial resources. Some of them include; Bank loan, over lease among others. The money can be in form of cash, credit or liquid securities. An organization offers several services and products to the public which need to be financed. The management is obliged to keep track of the money used to finance these services. It is also supposed to find ways and means in which to provide additional financial resources to the organization. This is one of the major decisions that a manager is faced with. He has to decide how the available resources will be utilized efficiently. Financial resources are always scares and limited. Therefore, they have to be put into the best possible use that will give optimum benefit to the organization. The manager has to spend them in the order of priority and urgency (Baker and Powell, 2007). The best way to ensure good services is to ensure proper planning of the way financial resources will be utilized. The manager has to point out the financial shortages and surpluses. Financial statements are important in this since they help managers to control the resources and make the right decisions. Through them, the manager is able to predict the costs and expenditure. He will in turn make the right decision on how to use the resources available to meet the costs. This essay focuses on the issue of financial resource management and decision making in an organization. It discusses the various sources of finance, their advantages and disadvantages as well as how budgets can be used to help in decision making. The essay is based on Mr T. Jones Fast Foods Restaurant. Sources of Finance for Businesses The source of finance for a business depends on the type of business and the stage at which the business is (i.e.) a start -up business or a continuing business. The larger the organization, the wider the variety of finance sources available to them. In case of a start- up business, the initial investment is referred to as capital. The sources of this capital could range from savings, inheritance, loans as well as investments. This is the most difficult part of starting a business. The entrepreneurs need to get enough capital to start the business and get it going. When the business is on -going or becomes established, it has ways in which it increases its capital. The capital can be increased through internal means or external means. Internal sources of finance are the funds that are generated from within the organization. External sources on the other hand are funds generated from outside the organization. This section is going to discuss two internal sources of finance and two external sources (Baker and Powell, 2007). The first internal source of finance for a business is from retained earnings. These are the profits which are generated from business operations. Retained earnings can be used as a measure of the business success. They are a proportion of the business total earnings that are not paid out either to shareholders or to business owners in case of a small business. The other source of internal finance is the sale of business assets. The business organization may decide to dispose some of its current or fixed assets. Current assets can easily be converted into money. For instance, a company may be holding stock in another company. The management can sell that stock and use the proceedings for financing purposes. Other current assets include cash at hand and cash at hand which can also be used to finance the business. Fixed assets are not easily convertible into cash as compared to current assets. They take time to convert and therefore cannot be used for emergency financing purposes. In most cases, the sale of fixed assets is used in financing the purchase of newer assets (Bullard, 2007). External source of finance is whereby the business organizations sources funds from outside. There are a number of external sources which may differ depending on the size of the business or its nature. It turns out that in most cases, the external sources are used for long term financing of the business. The external sources could be bank loans, sale of shares, mortgages and debentures among others (ODonovan, 2005). Let us focus on loans and share capital. A business organization can acquired a long term loan from a bank to finance capital projects or to make capital investments such as purchase of plants and equipment. Loan can also be in form of a mortgage. This is the money that is lent for purchase of house, premises or land. In paying back the loan, usually the business is charged interest. A loan can also be short term. In most cases, short term loan is in form of an overdraft. This is where the owner of the business withdraws more money than he actually has in his account. Overdrafts are meant to meet urgent and short term financial requirements. The other external source of finance is through sale of shares. This is the main source of finance for companies. The company sells its shares to the public so as to raise money to fund its investments. The shareholders gets dividend in return as a share of the company’s yearly profits. The source of finance is used to finance long term projects. Implications of the finance sources for the businesses If the business organization gets its finance from retained earnings, this will have a number of implications most of which are positive. First, the amount of retained earnings indicates the performance of the business. When the amount of retained earnings is high, it indicates that the business is performing well. This is an incentive to investors as well as customers. People like being associated with success. Financing a business with the retained earnings will also save the organization from incurring debts in the future (Baker and Powell, 2007). It is important to note that debts are expensive since they are paid back inclusive of interest. Retained earnings will therefore save cost and hence increase profitability. Financing the business through sale of assets will also save the borrowing cost for the organization. External sources of finance on the other hand are expensive. Loans have an interest rate with which the business has to pay. Interest is usually an expense and therefore it reduces the profits. Similarly, issuing of shares is associated with some costs. This increases the cost of expenses incurred. However, these sources of finance are used to finance long term investments which will be profitable in the future. Advantages and disadvantages of the financial options Financing a business from retained earnings is cheap. No cost is incurred. It also indicates the performance of the organization. This acts as a wake- up call for the employees and the management to take the necessary action. In case of negative retained earnings, they will improve the performance. In case of positive retained earnings they will devise ways of maintaining and improving. Retained earnings can be a long term source of finance where no repayment is required. There is no obligation to pay interest. The sale of assets is also cheap. The fixed assets are usually sold in order to finance purchase of better assets. This helps the business to keep up with the changing technology for competitive advantage. The major disadvantage of the two sources is that, they may not generate enough funds to finance capital projects. In addition, they can only be used by a continuing business (Bullard, 2007). Loans are important to a business organization in that they provide it with the funds they require for long term investments. Enough money can be got from loans as long as the firm’s creditworthiness is not compromised. In addition, a loan can be given to any organization including the one that is planning to start operations. However, loans are expensive. They increase the organizational expenses, hence decrease the total profits. Failure to repay the loan within the specified time will call for serious consequences. Share capital on the other hand is advantageous to companies since they can get large sums of money from an issue. It is relatively cheap in the long run. However, it takes relatively longer time as compared to loans before the required amount is raised (O’Donovan 2005). Task 2 Costs As Ralph Waldo Emerson once said, “Money often costs too much”, financing a business is a costly venture. The different sources of finance are associated with costs. It is therefore the responsibility of the business managers to find ways in which they can combine the different sources of finance so as to create a financial stability that will maximize shareholders returns. In the case of internal sources of finance, the costs are not high. The retained profits are the cheapest source of finance. There is no obligation to pay any interest. It is also effective in that there is no issue cost associated with it. In case of a sale of asset as a source of finance, the most expensive is the lease back option. It will help finance the business but in the long run it is costly (Bullard 2007). The most expensive source of finance for a business is the external sources. The cost of a loan or debt is equal to the rate of return that is required by the issuer of debt. Therefore, in determining the cost of a loan, one usually focuses on the rate of interest for loans prevailing in the financial markets at the moment of acquiring the loan (Baker and Powell, 2005). It is likely in a successful business that the most expensive source of finance is equity (share capital). It is said to create value to the investor and deprive the same from the founder. Among the costs associated with the cost of equity are initial prospectus costs and other initial costs (Causholli and Knechel 2012). Importance of financial planning Financial planning is an important function that every organizational manager should embrace. The manager should know how much money the organizational needs, how it will be spent and how to get the required money. Financial planning means budgeting in advance how the available financial resources are going to be spent and how the deficit finances are going to be achieved. The plan needs to be reviewed often as financial needs keeps on changing. Financial planning is important since it helps the manager to device was of achieving organizational goals (Taparia, 2003). It is only through effective financial planning that the organization can achieve its short term and long term goals (ODonovan, 2005). The second importance of financial planning is that it helps the manager know how much money is needed and when it is needed. The manager will then determine whether the organization has enough money for the needs. If the money is not enough, they will find ways of getting the deficit. If excess, they can decide on how to spend the surplus amount. This helps in the long term development of the organization. It is important to finance Mr T business since that is the only way that it can achieve its short term and long term objectives. If the business is sufficiently financed, it can invest in the various ventures and hence maximize its earnings. Failure to finance Mr T business will lead to failure of the business. It will not be able to achieve its objectives. People involved in the Mr T business include managers, directors and employees. The business financiers are also important personnel for the business. These include mainly banks. The business gets loans from banks to finance its operations. The managers make the major business decisions including how to finance the business and how the available finances are to be spent. Financial documents are documents where financial matters of the business are recorded. The business expenses and revenues are recorded in these documents. They are important since they help the managers to prepare budgets and predict the future financial needs of the business. The finances of the business and their costs have to be recorded in the financial documents. Finances such as loans, equity and other forms of capital are recorded on the credit side of the balance sheet as liabilities. The various costs of the finances are recorded on the credit side of the profit and loss account as expenses. The liabilities and the assets on the balance sheet should be equal. The business should have enough assets to cover its liabilities (Taparia, 2003). Budgets and Decisions A budget is a financial plan that is prepared to project the financial needs of the business in the coming financial year/period. The management accountant evaluates the business needs for the coming period and how they will be financed. He then records them in the budget. It is the prepared budget that will guide the financial decisions of managers over the next financial year (Hofmann, 2008). For production purposes, the managers need to know the number of units required for next year’s production. He then enquires the prices per unit. The major aim is to spend less and earn more. Therefore, the manager will assess the various costs and settle on the one that maximizes the business incomes (Hofmann, 2008). Investment Appraisal Techniques These are techniques which help the manager screen the most viable projects from a long list of projects. The projects are put under tests such as the payback period and the Average Rate of Return (ARR). Under the first, the manager calculates the time that a project will take to generate income that equals its laid capital. The best project is the one that has the shortest payback period. ARR on the other hand is a test that calculates the average earnings and the rate of earnings from a project. Other complex tests include the Net Present Value (NPV) and the Discounted Cash Flow (DCF). The viability of a project under these techniques is relatively high. A project that is subjected to these tests is likely to be successful (Götze, Northcott and Schuster, 2008). Financial statements The main financial statements of a business include the balance sheet, the profit and loss account and the budget. The balance sheet records the assets, the liabilities and the business laid down capital. The total assets should be equal to the sum of capital and liabilities. The profit and loss account on the other hand records the business operations, the revenues and expenses. The balancing figure of this account is the profit if it is on the debit side and loss if on the credit side. Finally the budget is meant to project the future financial lay out of the business. It predicts the financing and the spending of the business for the next financial year. Different businesses have different formats for the financial statements. However, the general formats are similar for most businesses. They should have the credit side and the debit side. The format could either be the T format whereby the debit side is on the right and the credit side on the left for both the balance sheet and the income statement. The format can also be vertical whereby you subtract the totals of the debit side from the totals of the credit side. Financial ratios are used in the interpretation of the financial statements. They help the managers understand the statements in a more detailed manner. The manager can therefore make better decisions. The ratios analyse the statements into details (Bull, 2008). Conclusion Financial resources are the life blood of a business organization. The manager should be able to make the correct financial decisions so as to ensure the future development of the business organization. It is important to know the financial surpluses and the deficit of the business so as to plan on how the goals will be achieved. To know these, the financial budgets for the next financial period have to be prepared. Financial statements assist in assessing the performance of the business and hence decision making on how to improve its performance. A project should be put under the relevant tests to asses it viability. References List Baker, H. K., and Powell, G. E. 2005, Understanding Financial Management: A Practical Guide. Oxford: Blackwell Pub. Bull, R. 2008, Financial ratios: How to use financial ratios to maximise value and success for your business, Elsevier/CIMA Pub, Amsterdam. Bullard, R, K, 2007, Sale-and-leaseback as a British real estate model, Journal of Corporate Real Estate, Vol. 9 Iss: 4, pp.205 - 217 Causholli, M, and Knechel, W, R, 2012, Lending relationships, auditor quality and debt costs, Managerial Auditing Journal, Vol. 27 Iss: 6, pp.550 - 572 Götze, U., Northcott, D., and Schuster, P. 2008, Investment appraisal: Methods and models, Springer, Berlin. Hofmann, S. 2008, Determinants and consequences of the use of budgets: An exploratory empirical study in Germany. Münster: Lit. ODonovan, J. 2005, Lender liability, Sweet & Maxwell, London. Taparia, J. (2003). Understanding financial statements: A journalists guide. Oak Park, IL: Marion Street Press. Read More