Managing Financial Resources: Bruce McIntyre - Case Study Example

BTEC Higher National in Business Managing Financial Resources Assignments 2 and 4 Submitted by: ASSIGNMENT Bruce McIntyre case study There are afew options open to Bruce and David in financing their Restaurant venture. Before identifying financing sources, we examine the sources that exist from the point of view of applicability, merits and demerits. Since requirements and conditions for financing Capital expenditure and Revenue expenditure differ; we deal with these separately. Capital expenditures are those relating to large purchases that are intended for long term use and are essential for carrying out business operations. These are maintained as assets for continued use in the business throughout its life cycle. On the other hand; Revenue expenditures are those of a recurring nature, required for short term business needs. These are “used up” in the course of running the business. A. Capital expenditures A(i) Internal Funding Utilisation of internally generated funds is possible in an ongoing situation of running a business. Such internal funds may be cash surpluses generated from operations or cash obtained upon sale of non-essential assets. Obviously this is not relevant in the present case. A(ii) External Funding Options for external funding include issue of Shares and Debentures, property mortgaging, resorting to Bank loans, Hire purchase, Venture capital or Leasing. Aii(a) Issue Shares or Debentures. Shares are documents certifying apportioned ownership of a company to the extent of “face value” declared in the issue document. Only Private Limited or Public Limited Companies can issue such shares, subject to the controls of regulatory agencies. Those individuals or entities holding shares have defined rights to exercise control in the company to the extent of the number of shares held by each. Rights include voting rights in Annual meetings, receiving “dividends” declared by the company to provide returns on the investment to the shareholders etc. Debentures on the other hand are secured instruments issued by “Limited” companies with commitment to redeem the value within a specified period and to pay interest to the investor during the specified period of operation. Shares and Debentures are normally issued when large investments are planned with a minimum investment from the “Promoters”. Issue expenses are high and it entails time consuming formalities. In this case the two individuals involved are able to meet a substantial portion of the investments and therefore this option is not suggested. Aii(b) Mortgaging Mortgaging is a means to avail of loans, pledging Real property as security. A legal document is created defining the terms of the mortgage. The agreement specifies the period of the mortgage and schedule of payments including interest and other legal aspects. When repayment in full is made as per the agreement the pledge is cancelled (1). This method of raising funds enables the borrower to avail of a large proportion of the money spent on purchase of property. 1. Definitions of Mortgage [Available online] The Loan-to- Value (LTV) ratios can be as high as 85 percent (2). Mortgages are available for the following purposes. Working Capital raising New business start-ups Business turnaround solutions Short Term Finance and debt consolidation Property improvement Business expansion Mortgaging necessitates pledging the asset that is created out of the funds borrowed. Aii(c) Long Term Loans from Banks Banks provide loans based on Agreements executed between the parties defining the repayment instalments and rate of interest. Banks require securities that may be business assets or private assets. Interest rates are lower when compared to few other options. Banks normally lend money after detailed appraisal of the project to ensure that the business has the capability to repay. Therefore this takes more time than the option of raising funds through mortgages. Aii(d) Venture Capital There are many organisations that make funds as loans even when there are certain perceived risks. The Venture capitalists charge higher rate of interest, understandably to 2. “Commercial Mortgages” [Available online] set-off their risks. This possibility exists only for Limited companies, and not applicable in this case. Aii(e) Hire Purchase This facilitates purchase of a capital item without owning it, till considerations, in instalments for the deal are paid over a defined period of time. Considerations include purchase cost and interest payable through the specified period. In case of default the entity providing the facility has the right to repossess the asset. Aii(f) Leasing The financer purchases the asset and places it for use by the borrower for considerations payable at specified time intervals. The lease period is also agreed initially. Such lease payments spare the borrower from incurring capital expenditure for the leased item. (This subject is discussed under the current head of Capital expenditures since this is a substituting arrangement). Payments against lease are recognised as trading expenses that come under Revenue expenditures. B. Revenue expenditures As already explained, Revenue expenditures are those of a recurring nature, required for short term business needs. These are “used up” in the course of running the business. Applications include maintenance of stock of raw materials and finished products, payment of wages, maintenance needs of a recurring type etc. Revenue expenditures are met by application of short term finances. B(i) Short Term Bank Loan­­­ Banks normally give specified amounts of loan based on Agreements to this effect and against some form of security. Repayments are normally specified as monthly instalments. B(ii) Overdraft This is a facility negotiated with the bank to draw funds more than what are available in the borrower’s account to meet short term needs. Interest rates for overdrafts are very affordable. Overdraft provides an economical option to draw funds for short-term needs. B(iii) Factoring This is a facility to receive immediate payments from Third parties against bills raised on customers specifying an agreed credit period. The bills are presented through the Third party (for a consideration payable to them) for the risk they take in realizing payment, when due from the customer. Factoring is an option to exercise, when there is need to provide credit to customers and the seller needs immediate cash to run the business smoothly. The question of Factoring does not arise in the case of the current restaurant business, since the system is to collect payment immediately after providing the service. Finance – Assignment 1 Guidelines/Structure Plan 1. Have a look at the figures in the case study and put them into these two columns: Items that may require a large capital outlay Items that are needed as part of running and opening costs 1. Premises 2. Refixing 3. Kitchen equipment 1. Advertisement 2. Training period wages 3. Consumables during training period 2. Read the Study Pack on sources of finance and taking each item above, consider the advantages and disadvantages of each method: Item Source of Finance Advantages Disadvantages Premises Own High salvage value is beneficial to the owner Can be pledged to raise a loan Can be disposed of easily Own funds get frozen entirely Need arises to borrow funds to make the premises fit for use Refitting work Mortgage loan Readily available source of finance High proportion of the value of property is available as loan. Terms are flexible Makes premises fit for use Meets Ambience needs of customers Low salvage value Increases cost of Restaurant service due to liability to pay interest for money borrowed Kitchen equipment Utilising surplus cash from Mortgage or going for Hire purchase Cash from Mortgage loan Can be utilised to meet pre-operative and working capital needs Hire purchase Reduces Mortgage linked borrowing. Enables utilisation of profits for creating the asset Enables running the business Cash from Mortgage loan Advantage of dealing with only one financer Hire purchase Results in increased cash outflow towards hire purchase instalments Reduces cash surplus Moderate salvage value Advertisement & Training period wages Utilising surplus cash from Mortgage Improves volume of business Enables improvement of quality in food and service The impact of interest payment is not significant Commercial operations delayed by one week Contributes to cost of operations Consumables during training period Utilising surplus cash from Mortgage Meets minimum needs Contributes to cost of operations 3. Using your results from above, which source of finance seems to be the most appropriate for each item? Mortgage loan is the preferred option for meeting the major expenditures which may include or exclude kitchen equipment. Hire purchase terms for Kitchen equipment can be evaluated on considerations cost of operations involving alternative financing options of Mortgage and Hire purchase. Take into consideration how much redundancy money they had, and what the total needed was. How much of their own money should be used and for what purpose. Do your recommendations help the business in both the short and long term? As suggested above the premises have to be secured with own funds totalling £200, 000. They need another £129, 000 to be ready for operations. They will also need working capital to maintain a certain minimum stock of grocery for day to day operations, for payment of wages besides meeting any unforeseen cash expenditures. The working capital requirements have to be estimated considering cost of a minimum requirement of stock and cash needed for payment of wages and for meeting contingencies. It is understood that up to 85 percent (Ibid) of the purchase price of land can be availed of as loan through mortgage. This would mean that an amount up to ₤ 170,000 can be availed of. If this amount is borrowed they will have a surplus of ₤ 41,000 as cash in hand after meeting all other expenditures till start up, that is ₤ 129,000. The actual amount to be borrowed can be worked out after estimating the working capital requirements. The owners have the option to buy kitchen equipment on hire purchase. This option can be exercised upon study of projected profitability and cash flow from the business and finding out as to which is more advantageous. The financing arrangements suits long term operations. After repayment of loans taken, the entire assets will belong to the partners. They are bound to make the operations viable as one of the partners possesses required knowledge in food service operations. Managing Financial Resources Assignment 2 Business Funds Business funds comprise funds from three sources. The sources are: Own funds; Borrowed funds and Funds from retained profits resulting from operations. These funds are applied in the form of “Fixed assets” and as “Working capital” Long term borrowings are applied for financing “Fixed assets” and short term borrowings are applied for meeting “Working capital” needs. Borrowed funds add a charge to the cost of operations to the extent of liability to pay interest. Long term borrowings also entail repayment of the loan in specified number of instalments. Therefore payment against the long term loan includes re-payment instalments plus the interest as per agreed terms. Interest is payable against short term borrowings made for meeting working capital needs. The borrowed fund can be retained as long as required or can be “closed” by paying off the borrowed amount. Fixed assets comprise immovable properties such as land and buildings, appurtenances, etc. This also includes movable assets like machinery, vehicles etc. Fixed assets are needed to run the business and there is a minimum requirement for each business. Funds that are not “sunk” as fixed assets, are available for operations directly relating to goods and services, such as for purchase of “stocks” to be maintained or for payment of wages or for maintenance of fixed and movable assets. Funds that are not “sunk” and applied for day to day operations are termed “Working capital.” The total of funds applied that includes fixed assets and working capital is known as “Capital employed.” The quantum of working capital required to run a business, depends on the mode and scale of operations. For ensuring smooth flow of inputs, some stocks of these have to be maintained. For ensuring timely supplies, some stocks of finished products may also have to be maintained. When products are sold, the payment may be realized only after a lapse of time. So money is “blocked” till payment is received. Some money is required for payment of wages, payment for utilities or consumables, maintenance of assets or for meeting contingencies. The funds applied for meeting these requirements are known as “Working capital.” Working capital can be arrived at considering the following information: • How much is to be paid out • How much is expected to flow in • How much is available as cash and in the bank • How much money is applied for maintaining stocks? What is pending to be paid out is known as “Current liabilities” and what is expected to flow in, together with retained cash and stocks is known as Current assets. The relationship can be represented as: Working Capital = Current assets minus Current Liabilities A business can be considered healthy, so long as Current assets remain higher than Current liabilities. It requires careful controls to maintain a balance between the two. A statement containing actual or projected cash held in various forms along with what is expected to flow out and flow in is known as a cash flow statement. The flows have to represent the time periods to which these relate. The cash surpluses revealed from cash flows can be used for making useful decisions in running the business. Assignment 2 Framework In this assignment we are only interested in CASH, particularly WHEN it goes in and out of the business. Derek starts January with £8,000 in cash. During the month of January he will spend some of this on materials for use in FEBRUARY, when he will need 1,500 sets of car mats (he keeps “enough finished goods in stock to last 30 days trading”) these cost him £6 each to make. He will also receive some cash in January from his December sales (he allows his customers 30 days credit) So January looks like this: Cash balance at start of month £ 8,000 Cash received during the month £ 8,000 (from Dec. sales) Total available £16,000 Cash spent during the month £ 9,000 (to produce 1,500 sets) Every month will follow the same pattern. The cash from the PREVIOUS month’s sales will come in, and the cash for NEXT month’s production will go out. So the cash information for February is to do with January’s sales (cash coming in) and March’s production (cash going out). Jan Feb March April May Start Balance 8,000 7,000 3,000 Cash In 8,000 8,000 Total 16,000 15,000 Cash out 9,000 12,000 End Balance 7,000 3,000 Questions 1 and 2 - Complete the cash flow forecast to find the answer. The completed cash flow is given below: Item January February March April May Start Balance 8,000 7,000 3,000 0,000 (-)2, 000 Cash in 8,000 8,000 12,000 16,000 20,000 Total 16,000 15,000 15,000 16,000 18,000 Cash out 9,000 12,000 15,000 18,000 21,000 End Balance 7,000 3,000 00,000 (-)2,000 (-)3,000 1. Has Derek Gortons business generated more cash in February than January? End balance of Derek Gortons business came down from ₤ 7,000 in January to ₤ 3,000 in February. He generated the same profit as in January, but need for maintaining increased stock brought down the cash balance. 2. Is the business likely to generate increasing levels of cash in the forthcoming months? Since his sales are increasing every month @ 500 mats per month and there is no increase in overheads, he will earn more profits in the forthcoming months. However he has to apply more funds as working capital to meet increased commitments to suppliers and customers. The working capital requirements in the forthcoming months are given below: Sr.No Item January February March April May 1 Cash 8,000 7,000 3,000 0,000 0,000 2 Stock 9,000 12,000 15,000 18,000 21,000 3 Debtors 8,000 12,000 16,000 20,000 24,000 4 TOTAL Current Assets 29,000 31,000 34,000 38,000 45,000 5 Current liabilities Nil Nil Nil 2,000 3,000 6 WORKING CAPITAL (4-5) 29,000 31,000 34,000 36,000 41,000 The above reveals that working capital requirement is steadily increasing from January to May. Derek will not find funds to the extent of ₤ 2,000 in April and another ₤ 3,000 in May to pay for his stock of goods. He will have to find ways and means to meet these requirements. Question 3.1 What would happen to your cash flow forecast if another £2,000 a month cash went out of the business? If an additional cash outflow ₤ 2000 is committed, the cash flow will be as follows: Item January February March April May Start Balance 8,000 5,000 (-)1,000 (-)6,000 (-)10, 000 Cash in 8,000 8,000 12,000 16,000 20,000 Total 16,000 13,000 11,000 10,000 10,000 Cash out 9,000 12,000 15,000 18,000 21,000 Additional cash outflow 2,000 2,000 2,000 2,000 2,000 End Balance 5,000 (-)1,000 (-) 6,000 (-) 10,000 (-) 13,000 3.2 Would you advise Derek Gorton to lease the computer system on the basis that working capital can provide the cash payments? Derek was able to sustain business when his sale was 1000 mats per month. Since the margin earned per mat is ₤ 2; sale of 1000 additional mats will generate additional ₤ 2000. This will make him afford the computer system. He will achieve this level of sales in the month of March. Since Derek can generate an additional cash of ₤ 5000 per month, by increasing sales from 1000 mats in January to 3500 mats in June, he can afford to go for the computer system involving a commitment of ₤ 2000 per month. However by April, Derek will face shortage of funds. If he goes for computer system earlier than April, he will find difficulty in making additional payments from internally generated funds. He may better wait till his sales increases to 2000 mats per month. 3.3. What other courses of action might Derek take in order to finance the computer system? The options available to Derek are: (a) Negotiate with the supplier for credit arrangements for payment of bills, to match the availability of funds from sales of finished products. This will improve his cash flow considerably to purchase a computer. The supplier when offered the increased volume of business should be able to offer credit by making his own arrangements for increased working capital or may be able to resort to factoring. Derek may offer a marginally increased price for the supplier to meet increased cost of working capital or the cost of factoring. (b) Arrange over draft facilities with the Bank for meeting his short-term fund requirements of working capital. Question 4. This is partly about other sources of finance, but mainly about how he could organise his business better. Any source of finance is likely to put the business cash flow under strain. How could he improve the cash flow of the business? Derek should negotiate with the supplier for one month credit facility for payment of bills. In that case he will be able to improve his cash flows. The projected cash flow taking this into account, the outflow for computer system is given below: Item January February March April May Start Bal. 8,000 8,000 11,000 12,000 14, 000 Cash in 8,000 8,000 12,000 16,000 20,000 Total 16,000 16,000 23,000 28,000 34,000 Cash out 6,000 3,000 9,000 12,000 15,000 Additional cash outflow 2,000 2,000 2,000 2,000 2,000 End Balance 8,000 11,000 22,000 14,000 17,000 Note: Cash out flow for February relates to the additional quantity of 500 mats purchased in January, for making 1500 mats in February. (Quantity for 1000 mats was already purchased against cash in January) Managing Financial Resources – Assignment 4 Guidelines The report should have headings for the three main sections: Variance Analysis Pricing Policy Investment Appraisal They are all of equal importance. Variance Analysis Produce a detailed variance analysis of the overhead budget, using the study pack example as a guide. Which item has the largest adverse variance? What is the over spend being used for? Variance analysis of Overheads The budget provision was ₤ 50 measures to cover overheads. The over spend has been ₤ 30 measures. This represents a significant increase of 60%. The share of increase of various items is as follows: No. Item Budget Actual Difference Favourable/ Adverse % 1 Admin. 5 8 + 3 60 A 2 Personnel 10 9 (-)1 10 F 3 Production 13 18 + 5 38 A 4 Design 15 18 + 3 20 A 5 Marketing 7 27 + 20 285 A TOTAL 50 80 + 30 60 A Increases in cost for Marketing are very high, and requires detailed review to identify whether there have been omissions in budgeting and also to identify individual items that have contributed towards high costs. All other areas with the exception of Personnel, (where the variation has been favourable), have also to be investigated for drawing conclusions. Produce a variance analysis for the master budget. Which are the most important variances? What are the most likely reasons for these adverse affects? (There are similar discussions in the study pack). Variance Analysis of Master Budget No. Item Budget Actual Difference Favourable/ Adverse % Income 1 Sales 230 200 (-) 30 15 A Costs 1 Direct costs 110 112 + 2 1.8 A 2 Overheads 50 80 + 30 60 A 3 Gross profit 120 88 (-) 32 27 A 4 Net profit 70 8 (-) 62 89 A Sales declined by 15 percent. Normally the Direct costs also should have gone down proportionately. Ideally the direct costs should have come down from ₤ 110 million to about ₤ 96 million. This indicates that direct costs are not truly apportioned among the products. A review of the costing method is required to identify the defects. Similarly, when sales have gone down by 15 percent, gross profit came down by 27 percent. If profit margin was the same on all products, the gross profit would have come down to a similar extent. The above observation, when seen together with the increase in production overheads confirms the view that the costing of products is not done in a realistic manner. Deployment of more resources in production resulting in increased production overheads, did not result in increased sales realization. Pricing Policies Identify and discuss the pricing policy currently used at Slingshot. What alternative pricing policies are there? How does Slingshot’s pricing policy cause the variances identified above? Recommend an alternative pricing policy and explain how it would solve the adverse variances problem. Slingshot follows “cost plus pricing.” This method adopts an average cost for products and the selling price is arrived by adding a percentage “mark up” (In this case 15 %). This method overlooks the fact that the basic costs of some products are more than those of other products. In fact, the selling price is not directly related to the value addition done in specific products. A more reliable method for pricing is ‘Absorption Cost Pricing.” In this method, direct and indirect cost of each product is scientifically determined and allocated. The “mark up” is applied on the actual cost as determined for each product. “Cost plus pricing” as well as “Absorption cost” pricing do not take into account any “market factors” such as demand and availability. This may not be necessary for this kind of business where market demands remain steady. Variance analysis done on Slingshot’s operational result reveals that even when the sales went down by about 15%, the direct costs charged did not come down. Overheads in production have also gone up. The sales could be lower if the total quantity sold is lower or when the proportion of under-priced items becomes higher. When “cost plus” pricing is adopted the selling price of some of the products can be disproportionately lower than the value addition that has gone into it. In such a case the direct costs will indicate a higher proportion of the selling price. This is what has been revealed in the variance analysis above. Slingshot should change over to the “Absorption Cost Pricing” to effectively plan and monitor its operations. Investment Appraisal Use at least two of the appraisal techniques shown in the pack. Clearly explain how they help to make investment decisions. Justify your choice of machine with reference to your results. The investment proposal contained in the pack is analysed using two methods. One is the criterion of “Pay back period” and the other is the “NPV” method. Payback period method Any investment made is intended to fetch returns to cover costs and to earn profit. Assets created through investments, help the investor to use these for running the business throughout the life of the assets for making “returns.” The returns that accrue over a period of time are usually higher by a few times of the investments made. The concept of “Payback” period is used to compare alternative options of investments for making returns. It is as simple as finding out how much time (years) is required to generate an amount equal to the amount spent initially for acquiring the asset. Earlier the payback period, the better is the investment. Therefore two opportunities of investments or two alternatives of achieving the planned operations can be compared on the basis of the Payback criterion. The payback period is calculated by dividing the amount spent initially by the average annual earnings from the investment. The following gives the results of payback on the two alternative machines mentioned in the course pack. Here we are considering the total earnings of each machine over a period of five years. The data is tabulated below: Particulars Machine A Machine B Cost of Machine (₤) 40,000 58,000 Net yearly earnings (Income less running costs) Year 1 (₤) 18,000 20,000 Year 2 (₤) 22,000 20,000 Year 3 (₤) 15,000 18,000 Year 4 (₤) 14,000 19,000 Year 5 (₤) 12,000 19,000 TOTAL (₤) 81,000 96,000 Average Annual income = Total/5= 16,200 19,200 Payback period = Investment / Av.income 2.47 years 3.02 years It is seen that Machine A has a better Payback. NPV Method NPV method is based on the principle that money earned earlier has better value than money earned later.(3) In other words the present value of money earned later has a lower value relative to the potential of today’s money that normally grows by earning compounded interest. In the NPV method we “discount” the deferred income generated at different points of time at a normative annual discount rate (a factor) applicable to the 3. “Discounted Cash Flow- Wikipedia, the free encyclopedia” [Available online] time period, to arrive at the present value. An appropriate discounting factor to reflect the interest earning potential of money is used in the calculations. The factors used for discounting takes into account the principle of compound interest. The discounted total for the defined period is considered the earnings and the surplus of this over the initial investment is termed the NPV. In other words: NPV= Discounted total income minus Initial investment An investment yielding a higher NPV is more attractive than one that gives lower NPV and vice versa. If we use the NPV method for the above exercise using an annual discount factor of five percent, the results will be as below. Particulars Machine A Machine B Cost of Machine (₤) 40,000 58,000 Net yearly earnings (Income less running costs) and discounted values Particulars Actual cash Discounted cash Actual cash Discounted cash Year 1 (₤) Discount factor= 0.952 18,000 17,136 20,000 19,040 Year 2 (₤) Discount factor= 0. 907 22,000 19,954 20,000 18,140 Year 3 (₤) Discount factor= 0.864 15,000 12,960 18,000 15,552 Year 4 (₤) Discount factor= 0.823 14,000 11,522 19,000 15,637 Year 5 (₤) Discount factor= 0.784 12,000 09,408 19,000 14,896 DISCOUNTED TOTAL (₤) ------------- 70,980 ------------- 83,265 NPV= Discounted total minus Investment --------------- 30,980 ------------- 25,265 It is seen from the above table that the NPV is higher in the case of Machine A, and therefore Machine A is more advantageous. References 1. “Glossary of Banking Terms-Definitions of Mortgage on the Web” [cited April 18, 2007]; Available from http://www.google.co.in/search?hl=en&q=define%3A+Mortgage&btnG=Google+Search&m www.midfirst.com/library1.aspeta= 2. Commercial Mortgages [cited April 18, 2007]; Available from http://www.sterlingknight.co.uk/commercial-mortgages.asp 3. RyanC. 13 Dec 2005. “Small Biz 101: Cash Flow” [cited April 18, 2007] Available http://www.37signals.com/svn/archives2/small_biz_101_cash_flow.php Bibliography Commercial Mortgages [cited April 18, 2007]; Available from http://www.sterlingknight.co.uk/commercial-mortgages.asp C,Ryan. “Small Biz 101: Cash Flow” 13 Dec 2005. [cited April 18, 2007] Available http://www.37signals.com/svn/archives2/small_biz_101_cash_flow.php “Glossary of Banking Terms-Definitions of Mortgage on the Web” [cited April 18, 2007]; Available from http://www.google.co.in/search?hl=en&q=define%3A+Mortgage&btnG=Google+Search&m www.midfirst.com/library1.aspeta= Sue Gull, “Core Module, Managing Financial Resources” in BTEC-Higher National Business. Stranford Business School, 2003 “Wikipedia, the free encyclopedia- Discounted cash flow” [cited April 18, 2007] Available http://en.wikipedia.org/wiki/Discounted_cash_flow Read More