Managing Finance Questions - Assignment Example

Accounting Question 1 Table1- A monthly cash flow statement for the first year of trading for the first six months of 2010/2011.   March April May June July August Cash inflows Amount in £ Amount in £ Amount in £ Amount in £ Amount in £ Amount in £ Opening Balance 0 72,000 72,125 102,250 101,125 70,000 Owners Contribution 250,000 0 0 0 0 0 Issued 375,000 0 0 0 0 0 Loans 375,000 0 0 0 0 0 Sales 125,000 125,000 125,000 125,000 125,000 125,000   1,125,000 197,000 197,125 227,250 226,125 195,000 Cash out Flows               Business purchase 1,000,000 0 0 0 0 0 Raw Materials 0 40,000 40,000 40,000 40,000 40,000 Office rent 0 30,000 0 0 30,000 0 Loan repayment 0 0 0 31250 31250 31250 Interest on capital 0 1875 1875 1875 1875 1875 Wages 50,000 50,000 50,000 50,000 50,000 50,000 Utility Cost 3000 3,000 3,000 3,000 3,000 3,000 Total cost 1,053,000 124,875 94,875 126,125 156,125 126,125 Balance 72,000 72,125 102,250 101,125 70,000 68,875 Table-2 A monthly cash flow statement for the first year of trading for the last six months of 2010/2011 September October November December January February Amount in £ Amount in £ Amount in £ Amount in £ Amount in £ Amount in £ Opening Balance 68,875 67,750 36,625 35,500 34,375 3,250 Owners Contribution 0 0 0 0 0 0 Issued 0 0 0 0 0 0 Loans 0 0 0 0 0 0 Sales 125,000 125,000 125,000 125,000 125,000 125,000   193,875 192,750 161,625 160,500 159,375 128,250               Business purchase 0 0 0 0 0 0 Raw Materials 40,000 40,000 40,000 40,000 40,000 40,000 Office rent 0 30,000 0 0 30,000 0 Loan repayment 31250 31250 31250 31250 31250 31250 Interest on capital 1875 1875 1875 1875 1875 1875 Wages 50,000 50,000 50,000 50,000 50,000 50,000 Utility Cost 3,000 3,000 3,000 3,000 3,000 3,000 Total cost 126,125 156,125 126,125 126,125 156,125 126,125 Balance 67,750 36,625 35,500 34,375 3,250 2,125 Tony can raise the required funds by either borrowing or issuing shares or a combination of these. Explain the difference between the two and how the gearing level might be significant. The decision that Tony will make on the source of additional funding needed by his company, will significantly affect the capital structure of the company. The relationship between the amount of money borrowed as long-term loan (debt) and the owners’ contribution (equity) is refereed to as gearing. Therefore, gearing ratio is a ratio that is obtained by dividing the total amount of long term debt by the total amount of capital employed. Gearing ratio (level) = long-term liabilities debts ÷ Total capital employed Table 3- Gearing ratios if Tony chooses Scenario A, Scenario B or Scenario C Scenario A: Scenario B Scenario C Capital structure Amount Capital structure Amount Capital structure Amount Borrowing £750,000 Borrowing £0 Borrowing £375,000 Owner Contribution £250,000 Owner Contribution £1,000,000 Owner Contribution £625,000 Total £1,000,000 Total £1,000,000 Total £1,000,000 Gearing ratio 0.75 0 0.375 The table above shows the gearing ratios (capital structure) when Tony decides the three scenarios; Scenario A: Tony will contribute £250,000 and borrow £750,000. The gearing ratio is 0.75. This indicates that level of long-term debt is dangerously high and the company will experience high interest payments on capital borrowed. Scenario B Tony and other shareholder will contribute all the finance £1,000,000. The gearing ratio is 0. There is no long-term debt financing and the company does not pay any interest. The company may need to borrow some capital to raise the gearing ratio above 0. Scenario C: Tony will contribute £250,000 while the other shareholders will contribute £375,000 and borrow remaining £375,000. The gearing ratio is 0.375. The amount of long term debt financing is lower and the company will pay less interest on the capital borrowed as compared to scenario A. This could be more acceptable level of debt financing as compared to scenario A. An assessment of the key risks that Tony will face based on the information above and in your cash flow. The three scenarios above will affect the cash flow statement differently. This can be looked at individually. Scenario A: Tony will contribute £250,000 and borrow £750,000. This indicates that Tony will have to attach most of his assets to the long term debt. The implication of this is, if the company fails to pay its financial obligation as they fall due, the lenders may take away company’s assets leading to business closure and failure. Furthermore, Tony will pay out £41,667 monthly to the lender if the repayment period is eighteen months. This means that the cash of the company will reduce each month by £41,667 a figure that might drain the working capital of the company especially if the company is not making adequate profits. In addition to the monthly repayment, the company will be paying out most of its profits to the lenders in form of interest charge for the money borrowed. Scenario B: Tony and other shareholder will contribute all the finances (£1,000,000). If Tony raises the remaining capital via issue of shares, it means that the company will not have monthly debt finance repayment and all the profits will accrue to the shareholders. This means that the working capital of the company is likely to remain stable and sufficient for its operations. In addition, if the company does not pick up quickly and generate adequate profit, it can still survive and give the managers time to rethink a better strategy because the assets of the company will be safe. Scenario C: Tony will contribute £250,000 while the other shareholders will contribute £375,000 and borrow remaining £375,000. Just like in Scenario A; the company will pay out monthly interest charge and loan repayment. However, the effect of the money that will be leaving the company each month would not significantly affect the working capital of the company as compared with Scenario A because the money going out will lesser. Furthermore, most assets of the company will not be tied on debt finance. Therefore, the risk will be lesser as compared to Scenario A; According to the cash flow statement in table 1 and 2 above, the amount of balance each month is reducing because of the interest charge and loan repayment. However, once loan repayment is paid fully, the business would have an improved cash flow inflow. Question 2 Explain how the idea of limited liability might apply to a small business. (8 marks) Liability as used in business context is a financial obligation of a business entity that must be paid to the creditor when it falls due. For example, a business entity must pay the supplier what is due to him or her as per the agreement when time of payment is due. The business must also pay back the money borrowed from lender together with the agreed interest upon maturity. Therefore, limited Liability can be described as a situation where the owner of the business can meet his or her financial obligation to a certain level recognized by law. This is true when the business fails to generate enough money to meet its financial obligations as they fall due. This privilege is only extended to business owners who registered their businesses as Limited Liability Company or Partnership. Strictly speaking, people who own limited liability companies or partnership will pay for company debts to a fixed sum equivalent to the amount of capital they contributed if the business goes bankrupt. This is because a limited liability company is a different entity from the owner and when creditor sues the company for unpaid dues, he or she is not suing the shareholder or owner of the business. Even business entities with the best service or product and management can go bankrupt due to many factors. The factors that can make company unable to pay its debts as they fall due include devastating natural calamities, change in consumer preferences, fierce competition and fraud perpetuated by management or other employees. Therefore, the owners of the company are protected by the limited liability clause from paying beyond their contributions if unfortunate event befall the company. However, if the owners of the company become, negligent, malicious, and dishonest or defraud the company, the liability clause does not protect them. Limited liability companies and partnerships are safer to operate. Produce a diagram setting out a typical budget setting process. (8 marks) Figure 1 -The diagram showing typical budget setting process Give an opinion, with reasons, on the extent to which published accounts should all be in the same format irrespective of their country of origin. (8 marks) The Companies Act of the 1985 gives two ways for preparing the balance sheet and profit and loss statements. They are vertical and horizontal formats. The published financial accounts should be of the same format irrespective of where it originates. This is to enhance understanding and interpretation of the published accounts because different people use financial accounts for different purposes. For example the courts may use the accounts to determine the solvency of the company, tax administrators use to confirm the payable tax while investors use it to make an investment decision. However, any format that is chosen should be detailed enough to provide the needed information to make a given decision and draw a given conclusion. In addition, the published accounts should be made within the legislative and the legal framework. Finally, the accounts should be easy to read and interpret. This will ensure that there is better understanding and consistency in their interpretation. Distinguishing between management accounts and financial accounts (8 marks) According to Stittle (2008: 4), financial accounting involves recording, classification, processing and presenting past financial data in accordance to the accounting regulatory and legal environment. The people who use the financial accounts are from outside the company. They include investors, tax administrators, suppliers, researchers and scholars. Financial accounting generates balance sheets, profit and loss accounts, cash flow statements, directors’ reports as well as notes of accounts. All the companies registered under the companies Act in the United Kingdom must prepare set of financial accounts that are complete and accurate to present true and fair view of company’s financial performance. On the other hand, management accounting is branch of accounting comprising of identification, classification, analysis and interpretation of financial accounts for internal use. The financial reports are communicated to managers who will find it useful to plan, evaluate and control company’s performance. In addition, the financial reports generated by management accounting investigate whether resources have been used appropriately as expected. Management accounting promotes transparency and accountability in the use of company’s resources. Management accounting involves costing of business processes and outputs as well as budgeting for financial and non financial resources. Break-even points and financial ratios such as efficiency ratios, capital structure ratios, profitability ratios and liquidity ratios are product of management accounting. Management accounting is not tightly regulated by accounting legislations and legal frameworks as compared to financial accounting. Management accounts help the managers to make informed business decisions as to what products to produces and what not produce depending on the efficient and effective use of the company’s resources. Finally, management accounts are usually private and confidential and usually the preserve for the managers and supervisors in the company. They are helpful for performance management, strategic planning and management as well as risk management. Question 3 Attached to this paper are the profit and loss account and balance sheet of W S Atkins, an engineering consultancy group. A company has a number of stakeholders. Identify four of these and explain why they are classed as stakeholders. (4 marks) WS Atkins is a business entity with stakeholders just like any other business. They are shareholders (owners), employees, customers and creditors. The above shareholders are directly affected by the company’s activities. For example, if the company performs poorly, they may lose and if the company performs extremely well they gain. All stakeholders expect management to be transparent and honest when dealing with them. It is always better for the company’s management to build strong and positive relationship with their stakeholders because it will enhance company’s survival. The shareholders are considered key stakeholders in the company because they contributed money to run the business. Shareholders influence the company by influencing the appomitiment of company’s directors and auditors durring annual shareholders meeting. Their interest is profit after taxation and interest. For example, the shareholders of WS Atkins engineering consultancy group limited contributed £500,000 for purchasing assets as well as working capital. In return, they are interested in company’s share of profits.The dividends paid to the company’s shareholders were £21.5p and £17.5p in 2008 and 2007 respectively. In addition, the proposed dividends were £24.0p and £20.0p 2008 and 2007. the second shareholders of the company are the employees. According to Firestein (2009:14), employess are directly engaged in company’s transactions and are key to its survival. They provide their labour and skills to the company in return for wages and salaries. Therefore, their interests are directly linked with the company’s fortune. The salaries paid for the employees of the company is contained in the administrative expenses. Thirdly, customers are the key stakeholder of the company. the customers gain from the product and services of the company. Therefore, they purchase company’s output for their own consumption. Consequently, the company gain from their money and continue with production. The trade receivable of £8.4 in 2008 and £8.5 in 2007 is adequate prove that the company has customers and depend on them for survival. On the other hand, the customers also depend on the company for their products and services. The fourth Key stakeholder of the company is the long term debt financers (lenders). They provide the capital for purchasing capital goods for the company especially when the additional money needed could not be raised by the stakeholders alone. In return, debt financers charge interest in return of the capital advanced to the business entities. WS Atkins engineering consultancy group limited paid finance cost of £5.5 in 2008 and £5.4 in 2007. cost of finance is a prove of existence of long term debt financers. Each stakeholder will require different things from the accounts. List five ratios that might be used by each of the stakeholders to assess the company and explain why you have made the selection. (i.e. Four lists each of five ratios. You can use the same ratio in more than one list.) (16 marks) Shareholders The ordinary shareholders will need the return on ordinary share capital percentage because it indicates the amount of profit generated by every pound that is invested by them. Return on ordinary share capital = ((Net profit- tax) ÷ (shareholders fund)) × 100 The second ratio is the earning per share ratio. This is useful to shareholders because they will be able to know actual returns (dividends) they will make for every share they invest. Earning Per share = distributable profits for the year divided ÷ number of share issued. The third ratio is the dividend yield. The ratio provides comparison between the dividend received and the value of the share. Dividend yield= dividend ÷ share price The fourth ratio is the debt ratio. This will show them the amount of borrowed money used to purchase the assets of their business. This will indicate the level of risk their business is facing and the need to either reduce it or increase it depending on the circumstances. If the ratio is high, then the shareholders should look for other ways of funding their business apart from debt financing. Debt ratio= total debt ÷ total assets. The fifth ratio that is useful to the shareholders is the gearing ration. This indicates the proportion of the debt borrowed as compared to the total capital available. This indicates the level of risk the company is in. Gearing ratio= long term borrowing ÷ total capital employed. Employees also utilize the financial ratios. The most important are the profitability ratios and efficiency ratios. Gross profit ratios indicate the amount of money the company is making after covering the cost of production. It dictates the level of wages and salaries they earn as well as other benefits they receive from the company in which they work. Gross margin ratios= (gross profit ÷ sales) × 100. The second ratio is the net profit ratio. Net profit ratio determines the longevity of the company. When the net profit ratio is high, it means that the jobs of the employees are more permanent as compared to companies with very low net profit ratios. Net profits ratio = (net profit ÷ sales) × 100. The third ratio applicable to the employees is the return on asset ratio. The ratio indicates how effective and efficient the employees are using company’s resources. Lower ratios may indicate some form of asset mismanagement and when higher, it means that employees are hardworking and efficient in using company’s resources. The return on asset ratio = net profit ÷ total assets. The fourth ratio is Current asset liability ratio. This ratio indicates whether the company is able to meet short term financial obligation as they fall due. The current liability ratio 2:1 is sufficient to encourage employees that the company is stable in the short-run and therefore they should not worry about the fate of their jobs. Current asset-liability ratio = total current asset ÷ total current liabilities. The fifth ratio is the average collection period. The ratio helps the employees especially the marketers to know the average period of time under which their clients must service their debts. Customers Customers are key stakeholders of the company. The financial ratios that are important to them are the efficiency ratios and the profitability ratios. The first ratio is the receivable turnover. The ratio helps the customer to know how first they need to pay for the goods they bought on credit. Receivables Turnover = Annual Credit Sales ÷ Accounts Receivable. The second ratio is the average collection period. The ratio helps the customers to know the average period of time under which they need to pay their credit. The third ratio is the net profit ratio. Net profit ratio helps them make decision on their loyalty to the company. Higher net profits show that the company will operate for a longer time in the market. As a result, they can rely on it in the provision of goods and service. They may also use the ratio to demand price discounts from the company. The fourth ratio is the gross profit ratio. This ratio indicates the profitability of the business operations after the cost of sales. It helps the consumer to understand the price of goods or services offered especially higher price because they will know that higher prices were caused by high cost of production and not payments to the owners of the business. Finally, current asset-liability ratios are also important to the customer because it provides an idea of how long the business will serve them. If the current asset-liability is 1:2, the business may not last long because they may not be able to service their short term creditors. Consequently, customers will shop for more reliable suppliers early enough to prevent drastic cut for their supplies. Lender (long-term debt financers) Lenders are some of the most careful stakeholder. Most of them do not want to invest their money in companies that are not financially stable. As a result, they are more interested in solvency, profitability and gearing ratios. The ratio is the Current asset liability ratio. This ratio indicates whether the company is able to meet short-term financial obligation as they fall due. The current liability ratio 2:1 is sufficient to build confident of the lender. Current asset-liability ratio = total current asset ÷ total current liabilities. The second ratio is the Acid test ratio. The ratio indicates whether the business entity is able to meet the short term financial liabilities as they fall due comfortably. 1:1 ratio is sufficient to show that the business is solvency sound in the short run. Acid test ratio = cash and debtors ÷ total current liabilities. The third ratio is the debt ratio. Debt ratio helps the lender to know if the company uses more debt to finance it assets and other operations. Higher debt ratio warns the lender because a company indicating high level of debt financing may be experiencing financial difficulties and may soon be announced bankrupt. Debt ratio= total debt ÷ total assets. The fourth ratio is the gearing ratio. This also indicates the level of debt financing of the company. Higher gearing ratio means that the business is risky to invest in. Gearing ratio= long-term borrowing ÷ total capital employed. The fifth ratio is the gross profit ratio. Higher net profit ratio indicated that the business is able to repay the principle and the interest charge. Table 5- The lenders were chosen and their corresponding ratios   2008 2007 Million £ Million £ Sales 1313.6 1240.3 Gross profit 479.5 398.7 cash 154.5 187.7 Financial assets at fair value through loss or profit 29.7 49.6 debtors 299.9 284 Cash +Financial asset+ debtors 484.1 521.3 Current asset 484.2 521.7 current liability 455.2 459.4 total assets -23.4 -76.1 total debt 245.1 322.7 total capital employed -23.4 -76.1 Ratios Current asset-liability ratio 1.0637083 1.1356117 Acid test ratio 1.063489 1.134741 debt ratio -10.4744 -4.24047 gearing ratio -10.4744 -4.24047 gross profit ratio 36.50274 32.14545 From the above ratios chosen for the lender, both the current asset liability and acid test ratios are reducing implying that the business is reducing its capability of paying the short term financial obligations as they fall due. Debt and gearing ratios are also in the decline indicating that the financial structure of the group is changing from bad to worse. However, the gross profit margin is reducing is increasing. Generally, the company is not performing well and the management as well as the owners must look for innovative ways of making the company to stay afloat. It is not enough to look at single financial ratios, considering all financial ratios help the management and other users to make sound financial decisions for their business. Reference Stittle, J., Wearing, R., & Wearing, R 2008, Financial Accounting, SAGE, London. Firestein, P 2009, Crisis of Character: Building Corporate Reputation in the Age of Scepticism, Sterling Publishing Company, Inc., New York. Read More