Financial Markets and Bank Management - Coursework Example

Financial Markets and Bank Management Introduction I am assuming the position of a loan officer at the Happy Days Bank. Currently, there are two loan applications under my review. The first application is from Rive Gauche Ltd that wishes to improve the working capital level. The second application is from Peng Shao, who is interested in taking up more loans in the form of overdraft. Shao wants to meet various needs and also top up the mortgage by £ 15,000. My task is to review the two loan applications and respond to the various applicants as done below. Question 1: the case of Rive Gauche Ltd Part a Based on the case study, Rive Gauche Ltd is a company that deals on clothing. The company sells second-hand clothes in the African markets. Rive Gauche plans to explore a new market opportunity in Asia. The company plans to meet the demand in the new market by importing more clothes from Germany. Rive Gauche Ltd seeks for working capital funding through overdraft. The facts point that the company prefers meeting the shortage in its working capital by seeking for short-term sources of funds (bank overdraft). On that note, the current overdraft of the company stands at £ 90,000. The management plans to increase the overdraft level to £ 400,000, which is an increase by £ 310,000. In other words, the company is seeking for a loan worth £ 310,000 to meet its working capital needs as it explores the new market. Working capital is arrived at by the following formula: working capital = (current assets – current liabilities). The company relies on its working capital to meet current obligations and run the day-to-day operations. Therefore, is advisable for managers to formulate and implement more efficient working capital management strategies. The primary reason behind the most effective strategy is to ensure the constant availability of sufficient levels of working capital. Rive Gauche Ltd.’s current assets are (stock + debts + cash) = (311,000 + 208,000 + 40,000) = £ 559,000. On the other hand, the current liabilities are (creditors + other liabilities) = (200,000 + 200,000) = £ 400,000. Based on the working capital formula, the company’s working capital = (559,000 – 400,000) = £ 159,000. The estimation states that Rive Gauche Ltd currently has £ 159,000 to meet its current obligations. The analysis clearly shows that working capital is not sufficient to cover the current obligations. Therefore, the company’s working capital requirement is determined as follows: working capital requirement = (current liability – working capital) = (400,000 – 159,000) = £ 241,000 (Bhattacharya 2009, pp. 406-408). The company has amendments to three accounts of the balance sheet (debtors, Equipment, and Creditors). Debtors are estimated at 20% of the projected sales, the new equipment to be purchased for £ 25,000 and creditors estimated at 15% of projected purchases. The projected sales and purchases are £ 1,550,000 and £ 900,000. On an individual basis, the debtors are (20%*1,550,000) = £ 310,000. The new debtor increases the current assets to £ 661,000. Other factors held constant, the working capital = (£ 661,000 – 400,000) = £ 261,000. Therefore, the new working capital requirement = (400,000 – 261,000) = £ 139,000, £ 102,000 down from the original amount. On the other hand, the projected creditors are (15%*900,000) = £ 135,000. The creditors, reduce the current liabilities to £ 335,000 (Bhattacharya 2009, pp. 406-408). Other factors held constant, the working capital = (559,000 – 335,000) = £ 224,000. Therefore, the new working capital requirement = (335,000 – 224,000) = £ 111,000, £ 130,000 down from the original amount. Jointly, the amendments will have the following influence: First, the projected current assets will increase to £ 661,000. On the other hand, the projected current liabilities will reduce to £ 335,000. Therefore, the projected working capital = (661,000 – 335,000) = £ 326,000. Consequently, the projected working capital requirement = (335,000 – 326,000) = £ 9,000 (Mathur 2003, pp. 4-7). Part b The current and projected working capital requirements are £ 241,000 and £ 9,000 respectively. The two figures are below the new overdraft facility sought by the company (£ 310,000). My response is that the company should consider reducing the overdraft amount for two reasons. First, the level of the overdraft is above the working estimated working capital requirements. Therefore, a portion of the overdraft will be idle. Second, the overdraft is a current liability since it falls under short-term loans. It increases the company’s obligations. That is the principal amount and interest payments (Mathur 2003, pp. 4-7). Question 2: the case of Peng Shao Peng Shao seems to be surrounded by many obligations. First, he services a mortgage loan that he applied for two years ago. The mortgage loan is worth £ 80,000. The initial price of Peng Shoa’s house is £ 120,000. Peng Shao has other debts like the £ 7,500 overdraft, which is inclusive of the mortgage loan. In addition, Shao’s took another overdraft loan to cover for delays in the receipt of his business costs. Shao’s bank overdraft shows a steady increase and is currently £ 3,600. Peng Shao is interested in increasing the overdraft amount to £ 10,000. He also wishes to top up the mortgage by £ 15,000. Other financial plans involve the payment of £ 700 per term for his younger son in the same private school as his first son. However, the rate of credit card spending is increasing and is currently at £ 3,000. Shao admits that he makes less consideration regarding the risk of credit card overspending, which is driven by impulse. Lenders conduct a background check to aid in assessing the creditworthiness of the borrower. The assessment includes determining the net worth of the borrower in terms of ownership of both real and financial assets. The mentioned criterion is used if the borrower owns the mentioned assets otherwise a different criterion is implemented. If the borrower has no ownership of any real assets (like in the case of Peng Shao), the most appropriate criteria for determining the creditworthiness of such a borrower is the total debt service (TDS) ratio. The Total debt service (TDS) ratio is a tool used by the lenders to determine the portion of a potential borrower’s annual income that is committed to settling mortgage plans, property taxes, rental expenses and the payment of other debt obligations such as a car loan. As a financial advisor, I am interested in ascertaining the ability of Shao Peng to service the loans without default and at the same time meet his other financial plans. Therefore, Peng Shao TDS = (annual mortgage repayment + Property tax + Credit card debts +other debts) /annual gross income = (10,020 +1,200 + 3,000 + 340) /480,000*100 = 3.03% (Ong 2013). The TDS determined above implies that 3.03% Peng Shao’s gross income is used to cover obligations. The current leverage situation of Shao is below the limit set by the financial institutions (60%). That means that it is possible for Shao to seek for more loans before settling the current ones. Therefore, from a professional stand, I suggest that shao proceeds with the initial plan, but reduce credit spending since it increases his debt burden (Lending max 2015). Conclusion The estimated working capital requirement of Rive Gauche Ltd is below the actual amount of loan sought. The company should consider reducing the amount of overdraft so as to reduce the current liability and avoid maintaining excess levels of working capital. Based on Peng Shao case, the total debt service ratio is below the limit (3.03%). Therefore, he should proceed with loan plan, but reduce credit card spending. List of References Bhattacharya, H. 2009, Working capital management: strategies and techniques. New Delhi, Prentice-Hall of India. Lending max 2015, Viewed 18 March 2015, http://www.lendingmax.ca/artman/gross-debt-and-total-debt-service-ratio.php Mathur, S. B. 2003, Working capital management and control: principles and practice. New Delhi [u.a.], New Age International. Ong, Ryan 2013, Total debt service ratio (TDSR) and how it affects your loans, Viewed 17 March 2015, http://blog.moneysmart.sg/home-loans/total-debt-servicing-ratio-tdsr-and-how-it-affects-your-loans/ Read More