Managing Business and Financial Decision - Research Paper Example

Section-One – Sources of Finance a) Working capital management is one of the most important aspects of managing an organization’s finances in most optimal manner. Working capital is the difference between the current assets and current liabilities of the firm however, in its most obvious manner; working capital management often refers to the management of the current assets of a company. Current assets and current liabilities of the firm are those assets and liabilities which are consumed and settled within one year. Generally, there are four important elements of working capital which are managed by the financial managers. These four elements are: (Brigham and Ehrhardt) 1. Management of cash of the firm is probably the most critical tasks for financial managers to accomplish. Managing cash means that the firm has to manage enough liquidity to pay off for its day to day expenses as well as manage excessive cash in optimal manner. Since working capital is always non-productive for firms, it is therefore important that excessive cash is invested or managed in such a manner that it can provide reasonable return to the organization. 2. Accounts receivable is another important element of working capital management outlining the need for managing receivables of the firm. It is always a general practice in almost every industry that goods are provided on credit therefore receivables tend to arise. Since accounts receivables is a credit which firms provide to their customers, it is important that credit extension policy of the firm is within the industry norms of the firm. A good working capital management practice would require that the firm’s credit extension policy is neither strict nor lax. A strict credit extension policy may result into lost sales because every customer may not be able to afford to pay quickly. Similarly, a loose credit policy would increase the cost for the firm and might indicate that firm is finding it hard to sell its products. As such it is critical that a balance is struck in order to achieve optimal management of account receivables. 3. Inventory management is another important element of working capital management and requires that the inventories of the firm are managed in most efficient manner. The inventory management would require that the firm maintain economic quantity of inventory which not only reduce the cost of storing and managing the inventory but also ensure that firm never runs out of the stock. Further, slow moving inventory items will indicate that the firm’s product may not be saleable in the market whereas fast moving inventory might indicate that the firm may run out of the stock. 4. Last element of working capital management is the accounts payables management. A good working capital management practice will ensure that firm takes optimal use of this spontaneous financing and attempt to take full advantage of it i.e. paying late. However, the overall cost of not paying for purchases on time shall also be taken into consideration. It is generally therefore argued that firms shall pay for its accounts payables at the end of credit extension period in order to maximize the benefits of this spontaneous financing. b) Sources of Long Term Financing Long term financing is often used for the purpose of capital expenditure and expansion of the business. This may include expansion of current operating capacity of the firm, extending the reach of the firm into new markets or spending funds on research and development etc. There are different sources from which organizations can actually obtain the finances in order to complete such projects. Three of the most important sources of long term financing are: a) Issuance of Stocks: A firm can obtain permanent source of long term financing by issuing common stock through primary markets. However, the owners of common stock of the firm also become the owners of the firms with full voting rights. As such the control of the existing management or owners therefore will be diluted. It is also important to note that obtaining financing through issuance of stock can be expensive as the firms not only have to meet the requirements and regulations for listing but will also have to pay for the arrangement of the road shows etc for the subscription of the stocks. It is however, important to note that unlike other sources of finance, firm do not have to repay this type of financing and shareholders can easily sell their shares in secondary market against the current market price which can be fetched by that particular stock in given stock market. b) Another source of financing is that of the issuance of long term bonds wherein firm undertake to repay the debt over the period of time. By issuing bonds firm actually will not allow the bond holders to have the voting rights however, firm pay interest against the funds borrowed through bonds? The main strength of obtaining financing through bonds is that it is relatively cheaper to arrange with less regulatory restrictions. However, on the other side, bondholders may place positive as well as negative covenants on the firm. Further the overall cost of repaying the debt may be high as compared to stocks. c) Last source of obtaining long term financing is obtaining bank financing which can be easier to obtain. However, the overall quantum of bank financing may not be as large as the firm can otherwise raise through the issuance of stocks as well as bonds. This is because of the fact that the overall risk is shared over many investors in case of stocks and bonds whereas in case of bank financing, risk is mostly concentrated to one or few banks. Further, banks may place difficult conditions for the firms to follow and comply with and the overall interest charged against such loans may be higher. Further, Bank loans are often given against a collateral security therefore firms has to arrange the collateral security in order to satisfy the banks. In most of the cases, the assets which are financed by the banks are kept as security. C) Interest coverage and gearing ratios actually measure the overall ability of the firm to earn its interest as well as the debt as percentage of assets or equity. As such higher the interest coverage ratio, more are the chances that the firm will be able to meet its obligations. Similarly, lower gearing ratio indicates about the solvency of the firm and its ability to pay its long term as well as short term loans. However, if gearing ratios increase, it would suggest that the firm is relying on external debt to finance its expansion rather than utilizing its internally generated funds in the form of retained earnings. Using higher level of debt will therefore affect the solvency and interest coverage ratios of the firm. If the firm undertakes to obtain the long term financing, its interest coverage as well as gearing ratios will increase thus invariably increasing the overall risk profile of the firm. It is however, important to note that only by issuing bonds or getting the Bank financing that will increase the overall risk profile of the firm. It is generally believed that obtaining financing usually improves the ROE ratio due to the tax benefits which can be obtained by getting the financial support. However, getting long term financing also tend to increase the overall risk of the firm therefore if firm decides to obtain long term financing by either through issuing debt or obtaining bank financing, it must ensure that it balances its risk profile. Section-2 a) Weighted average cost of capital is actually the rate which a company is expected to offer or pay to all its stakeholders i.e. equity holders and debt holders. It indicates the weighted average of the costs that company pay to each of these stakeholders according to the overall weight of each component in the capital structure of the firm. It is also the cut off rate which firm should earn in order to satisfy all the stakeholder including its creditors as well as shareholders. It is generally believed that there is an ideal level of weight which every firm should attempt to achieve. The level of Weighted Average Cost of Capital (WACC) which is considered as ideal is achieved at a level when firm’s value is maximized. Brightheart’s WACC is: The above calculations indicate that the firm’s WACC is 6.45% ignoring the impact of taxation which might have over the rate paid to debenture holders. b) When a firm issues debt in the form of bonds or debentures, it can take the benefit of the tax concessions on the interest rate paid to the holders of the debt. Thus while calculating the weighted average cost of capital of a firm, the impact of tax is also taken into consideration in following manner: After Tax cost of debt = Interest rate x (1- Tax Rate). Thus the interest rate which is taken into the calculations of WACC is the rate which can be arrived after netting it off by the applicable tax rate of the firm. c) Opportunity cost is the cost which is foregone by not taking an alternative. d) 1) Oct (£,000) Nov (£,000) Dec (£,000) Jan (£,000) Feb (£,000) Mar (£,000) Sales 1,950 2,230 2,760 3,150 3,450 3,550 PAYMENTS Wages and salaries 1,050 1,050 1,050 1,350 1,350 1,350 Supplies 460 960 1,080 1,580 1,750 1,990 Rent and rates 170 170 170 340 340 340 Advertising 100 100 100 110 110 110 Miscellaneous 100 100 100 150 150 150 TOTAL 1880 2380 2500 3530 3700 3940 Receipts minus payments 70 -150 260 -380 -250 -390 Balance brought forward 750 820 670 930 550 300 Balance carried forward 820 670 930 550 300 -90 2) Some of the trends which may be emerging from this cash flow forecasts indicate that the overall balance of cash on hand is decreasing over the period of time. This may be due to the fact that firm is either incurring higher expenses or its sales volumes are low. These trends also indicate about the overall working capital management strategies of the firm wherein its receivables are probably paid late whereas payables are paid early. This may not be a very good working capital management strategy and as such management should give due consideration towards this fact and reconsider their credit extension policy. Further, days in payables seem to be too low thus indicating that the firm may be facing difficult condition from their suppliers i.e. suppliers may be not willing to offer relatively easier terms to the firm. It can also mean that the overall working capital management of the firm may not be entirely satisfactory and need careful consideration from the top management of the firm. 3) These cash flow trends might of the interest to the bankers and other creditors of the firm also as they indicate that the firm’s overall cash position is on the decline. Bond holders as well as the banks and financial institutions will be particularly interested in watching these trends and might change their terms and conditions. They would probably be interested in watching the sales trends as well as trends in the expenses besides actually observing the cash flow patterns. It is also important to note that the negative cash flow trends might prompt some of the financial institutions to provide further short term financing facilities so that the firm can actually overcome its liquidity constraints. Section-3 1) Payback Period = 3 + (12,555-8040/10000) = 3 + 0.45 = 3.45 Years 2) Accounting Rate of Returns* = 16,980 / 10,000 = 169.8% *in absence of income, net cash cumulate cash flow is considered as the income. B Accounting rate of returns and Net Present value Technique are two of the techniques which are used to measure the profitability of the project. Accounting rate of return is calculated by dividing the total income earned by the project with the total cost incurred on the project whereas net present value is calculated by taking the net present values of the expected cash flows of the project. Accounting rate of return is also called the average rate of return of the project also however; it does not take into the consideration the time value of money. However, it provides a one figure approximation of how much the firm will earn if it undertakes a particular project. It is also easy to calculate and provides a quick and easy estimate of how much the project will earn therefore project selection criteria is based upon higher accounting rate of return. Net present value technique however, takes into account the time value of money and discount the expected cash flow of the firm with an appropriate discount rate. It not only takes into account the time value of money but also the overall risk of the project. Since discount rate is calculated after integrating the risk premiums therefore the resulting figure of NPV also indicates that value addition to the firm once all the risks are taken care of. Though NPV is most commonly used method however, it only provides an absolute value whereas IRR provides a percentage rate of return. IRR or internal rate of return is also an alternative measure but its basic weakness is the fact that considers the re-investment rate as same as IRR therefore this assumption does not fully take into account the expected rate of return which may be offered to the shareholders against any given project. c) At the time of setting the prices, it is important that the firm must take into consideration the fact that prices are enough to recover the overall cost to the firm. Value will only be created once a firm earns profit from its products therefore it is important that the prices are set in a manner which can create value for the firm. It is also important to note that the impact of inflation shall also be included into the pricing decisions to be made by the firm. Though inflation premium is added into the discount rates however, its impact within the prices shall also be material in the sense that prices must reflect the manner in which costs are increasing. d) Total Cost = £10,000,000 Life = 5 year Cost per year = 10,000,000/5 = 200,000 Total Units Produced = 800 Total per unit cost = 200,000/800 = £250 Section-4 a) Balance sheet and profit & loss account are the two most critical and essential financial statements that every firm has to prepare in order to asses its financial strength. Balance sheet provides a clear and concise view of the financial state of the firm at one particular period of time. i.e. balance sheet indicates the overall state of firm’ liabilities, assets and equity at one particular time period. As such it reflects as to what the firm actually owns and what are the obligations of the firm which it need to fulfill either in the short term or long term time horizon. Profit and loss account is prepared to measure the firm’s profitability during a given period of time. It shows how much the firm has been able to sell and what were the expenses incurred in generating such sales. Thus profit and loss account of the firm indicates about the overall expenses incurred as well as the profit or loss incurred during the period. (Stickney, Weil and Schipper) The basic difference between balance sheet and financial statement therefore is the fact that balance sheet indicates the financial health of the firm at a particular time whereas profit and loss indicates the position for a period. b) There are various legal forms of organizations and each is classified according to the overall liability of the owners or shareholders. A business where the owner has the personal liability for the liabilities of the business is called sole proprietorship whereas where the shareholders have the liability to the extent of their shareholding, the legal form of the business is called Limited Liability Company. For a sole propertiership, the Balance Sheet and Profit& Loss account may be relatively different as compared to the limited liability company which needs to present in the information given in both these financial statements in a particular format and according to particular rules and regulations. c) Financial ratio analysis is very helpful tool in assessing the performance of the firm during a period of time. It provides a critical insight into the various trends over the period of time as well as is also helpful in making comparison across the firms in a given industry. (Britton and Waterston) There are various profitability ratios including Gross Profit margin, net profit margin, operating profit margin etc. These ratios actually indicate as to how much the firm has earned as a percentage of sales at different levels of costs i.e. net profit margin indicates the overall profitability of the after deducting all the expenses from the sales. Similarly, working capital ratios indicate how well the firm has been able to manage its working capital over the period of time. For example, days sales outstanding indicates the number of days receivables remain outstanding before they are collected. If this ratio is relatively different from the industry trends, firm need to probe into the reasons as to why this deviation is occurring. Another important ratio which the firm might look into is the current ratio which indicates the ability of the firm to pay off its current liabilities falling due within a year. Thus financial ratio analysis provides a very clear and concise picture of how the firm is performing. c) Books of primary entry are those books where a firm or business actually records the transactions for the first time. As such it is not necessary that books of prime entry shall follow the double entry accounting system. An example of book of prime entry is sales day book where a business records its every day sales before they are posted to the ledgers. Double entry bookkeeping accounting system indicates about a system where every transaction affects two accounts. Further, for every transaction there is a debit as well as a credit. Ledger is the main double entry bookkeeping record which records every transaction in its particular head by debiting and crediting two different accounts. Each ledger is normally divided into two sides i.e. debit and credit and records each entry into the respective column or side. Depending upon the nature of account, a debit and credit subsequently increase or decrease the balance in a particular account. Trial Balance shows the debit and credit balance of all the ledger accounts and presents a concise picture of the unadjusted balances of all the ledger heads. It is from the trial balance that other financial statements are drawn. Read More