Managing Financial Resources and Divisions - Assignment Example

Managing Financial Resources and Divisions Section 1: The company for which you are a senior accountant has recently won a major government contract to supply equipment to the health service. While the company in naturally encouraged by this, it is the biggest contract ever won by them and will require substantial expansion and changes to operating systems. Your responsibilities will mean you will need to oversee the management of the increased working capital needed to respond to the order and to contribute to the appraisals of new projects required to achieve the necessary expansion. Section 1 requirements: 1. In the company’s current position you are acutely aware of the dangers of over trading. Discuss what those dangers are and how they might be overcome. Overtrading Overtrading refers to the phenomena where company sells too much too quickly and grows too rapidly that it essentially runs out of cash. It happens when the companies accept the projects and do not have money to pay their suppliers or any other concerned person for buying the materials essential for starting a project. There are many dangers associated with overtrading. Some of these that are applicable in this particular scenario are as under: Dangers of overtrading Using the opportunity of bank overdraft or taking a business loan from a bank happens every where and in almost every business. But when businesses indulge in overtrading without having any cash reserves then they have go for borrowing money on regular basis in order to complete the contract. This creates problem for businesses as they have to mortgage their personal assets as collateral in case of zero cash reserves. In overtrading companies sell their products even on credit basis. Collection of cash from the customers is essential for maintaining the operational efficiency of business. Thus, it is important for the businesses to collect cash timely from the customers in order to carry on smoothly with their day to day activities. So one of the dangers associated with overtrading is the occurrence of bad debts and that could lead to the lower cash reserves. Manufacturing and merchandizing concerns rely heavily on suppliers. Companies need to keep their suppliers updated with their financial position. This is important because in case of high quantity demanded and slow payment plan the supplier can get nervous and feels insecurity in terms of cash collections. This may affect company’s relations with suppliers. In case of overtrading, companies run short of working capital and enter into negative financial cycle. To tackle the problem they go for borrowing money on which they have to pay interest. This largely affects their profit margins. They earn fewer profits than forecasted. How to overcome dangers of overtrading There are many ways that companies can devise to overcome the dangers of overtrading. These solutions are accurate cash flow forecasts, stock control, debtor control and avoidance from taking one huge project (Bnz, 2010) In overtrading companies keep on selling their products and as a result their working capital reduces and they enter into negative financial cycle. To overcome this problem accountant need to forecasts the detailed cash flows forecast. This gives a fair picture of the capital that company can employ for undertaking a project. However, taking account of all the expenses that companies are likely to incur in future is also essential. Controlling investment in stocks such as piling up of inventory in advance should be avoided. Instead of tying up the working capital it is better to order to order the stock or raw materials just before you need them. This provides companies with sufficient amount of capital for carrying out their projects. Regular monitoring of debtors’ book is also essential in order to keep the sufficient amount of capital in the business. In overtrading,, as companies go for selling on credit basis so they should chase their payments because cash is the most liquid asset and it provides liquidity and businesses can carry out their projects efficiently. Most of the times companies opt for one huge project that they think will earn maximum profits for them. It is not objective. Instead of taking up one huge project it is better to take few of the small projects. This is important because under certain conditions like inability of customer to pay back the money, lower level of satisfaction from company’s services or switching to some other company can lead to huge losses that are to be only bear by the company. 2. identify two different sources of short term finance available to the company and discuss the strengths and weaknesses of each source, were it to use it to finance its proposed expansion. Two sources of short term finance: Two sources of short term finance available to the company can be trade credit and bank loan. Trade credit: Trade credit refers to the process where companies buy materials e.g. equipments, raw materials or any other thing required by them on credit from the supplier and they are given a period of about 28 days for the settlement of the account. Strength and weaknesses: One of the advantages associated with the trade credit is its availability. It is available to the company free of cost and they do not have to negotiate on terms and conditions. However, in other types of short term financing they need to negotiate with the lender and they have to go through a lengthy process for getting a loan such as giving something as collateral, signing a note etc. Businesses that opt for trade credit can focus more on other areas of their business as well because they do not have to worry much about the sales target as they do not have to make cash payments immediately. Talking abut the weaknesses associated with the trade credit are new businesses cannot avail this opportunity as huge business can. This is because of the fact that if an organization fails to give back payments within the prescribed period, that may affect their credit rating and they might not be able to get loan from any other source. This is a heavy blow to the success of any business. Bank loans If any business takes loan from a bank for a period of less than one year then it comes under short term finance. Businesses in order to cater for their needs for liquidity go for taking loans from commercial banks. Strength and weaknesses There are quite many strengths of a bank loan. It is a speedy way of taking a loan. Reliable customers or businesses having a good credit history get loan any time. The commercial banks in case of companies analyze their credit history and give them the loan. In addition to this, loans taken from banks can be used for many diverse purposes. Talking about the weaknesses associated with the bank loan is the fee that customers have to give in case they give prepayments. Thus, this increases the cost which is to be bear by the customer. However, loans taken from commercial banks greatly affect the cash flows. In most of the cases the interest payments are so huge that customers have to pay from their income which affects the profitability of any company. In this particular scenario, a company cannot use short term finance for its expansion. Expansion requires a huge amount of money and a long period of time. That is why under such conditions short term finance is not preferable. However, in case of need of funds company should go for long term debt instrument i.e. bonds. Issuing the bonds and getting the money can enable them to go for its proposed expansion. 3. Explain how the company’s gearing ratio would help measure any increase in financial risk that the company might encounter. Gearing ratio Gearing ratio depicts the proportion of the capital borrowed by the organizations. When companies go for borrowing money they have to pay interest on that borrowed amount of money. Whatever the financial condition may be companies who borrow funds from general public are bound to pay interest to them. However, gearing ratio is calculated as: Gearing ratio =Loan Capital  Capital Employed Gearing ratio helps in measuring the financial risk in a way that higher the gearing ratio, higher is the borrowed amount of money and higher is the risk. High gearing ratio is an alarming situation for the company if interest rates are increasing and corresponding sales revenue are decreasing. Under such conditions profits are most likely to suffer. Section 2: The company’s current long term capital structure consists of 2,000,000 equity shares issued with a value of £2 each and £1,000,000 of debentures issued two years ago. The company currently estimates that shareholders require an annual return on their equity investment of 6%. The debentures were issued with a fixed interest rate of 4%. Section 2 requirements: 1. Explain the concept of a weighted average cost of capital and calculate the company’s existing weighted average cost of capital. Weighted average cost of capital Most of the firms can finance their business by means of common stock. However, most of the firms employ several types of capital called capital components with common and preferred stock along with debt being the most frequently used types (Brigham and Ehrhardt, 2008). If the firm goes for financing its business through common stock then the return given to its common share holders will be the cost of capital. However, companies float different securities depending on different risk exposures and offer different rate of return which is regarded as its component cost, and the capital cost calculated for capital budgeting decisions should be the weighted average of all the costs and we call this as a weighted average cost of capital. Calculation of WACC: WACC=Equity/Total capital*cost of equity (Qfinance,2000 ) =2000, 000/3000, 000* 0.06 = 0.04*100 =4% WACC=debt/total captal*cost of debt =1000, 000/3000, 000*0.04 =0.01*100 =1% 2. Why might the UK tax system encourage the company to adopt a relatively high gearing ratio? As mentioned earlier that gearing ratio depicts the proportion of borrowed capital. As the company borrow funds from general public they have to give return on the money borrowed from them. If the company go for common stock then it is required to give returns to the common share holders. Return on shares is of two types i.e. capital appreciation and dividends. Dividends are subject to double taxation. One time the tax is deducted at the source and second time it is deducted from the income of the investor. So for a company adopting a high gearing ratio means that it is highly financed by the borrowed funds and on that they have to pay taxes and if the value of return is high, tax amount imposed on that particular return will also be high which will be in the best interest of UK government. That is why they will encourage the companies to adopt high gearing ratio. 3. In management meetings you have repeatedly said that fulfilling this order will have an opportunity cost for the company. Explain briefly what you meant by that. In this scenario company has won a huge contract from the government. Now to carry out the project company is in the need of funds. They go for collecting funds from general public either through equity or debt and on that they have to give returns either in the form of dividends or interest. This leads to the huge cost bear by the company. If the company would have enough financial resources they would have utilize that money for carrying out some other activity which now they have to pay to the investors. So while carrying out this project there is an opportunity cost that the money which company is now using for giving returns to the investors can use for some other purpose if it would have enough financial resources for carrying out a project. 4. Consider the cash flow forecast for the company Cash flow forecast for Jan – June 2011 Jan (£000) Feb (£000) Mar (£000) April (£000) May (£000) June (£000) Sales 750 1150 1380 1460 1890 2139 PAYMENTS Wages and salaries 430 430 430 640 640 640 Supplies 160 460 540 540 540 880 Rent and rates 170 170 170 340 340 340 Advertising 50 50 50 50 50 50 Miscellaneous 100 100 100 150 150 150 TOTAL 910 1210 1290 1720 1720 2060 Receipts minus payments -160 -60 90 -260 170 79 Balance brought forward 750 1150 1380 1460 1890 2139 Balance carried forward 910 1210 1290 1720 1720 2060 You are required to complete the cash flow forecast. Comment briefly on the implications of the cash flow you identify over the period. Implications of cash flow statement: Cash flow statement provides complete information to the investors, stake holders and to all the other entities whose interest is vested in the company about the company’s ability to meet its obligations, finance opportunities and to come up with cash when need arises. If the cash flow statement shows inconsistent flow of cash as depicted from the statement also then it shows the operational inefficiency and management problems. While preparing financial statements accountants can also get complete information about cash reserves whose value is reported in balance sheet under assets. Identify any other groups who would be interested in the above cash flow statement and set out briefly what information they would be interested in and why? Investors, creditors and other entities such as suppliers would be interested in company’s cash flow statement. This is because of the reason that they want to have complete information about the cash reserves that whether the company has the ability to meet its obligations. However, other groups such as financial intermediaries e.g. banks would also be interested because they want to analyze that whether the company has enough cash to pay off the loan amount or not. However, in case of insufficient cash amount companies have to pledge their personal assets as collateral. Section 3: One of your roles as senior accountant is to contribute to project evaluation. A proposal for a new manufacturing facility has recently been drawn up and passed to you. The cash flows forecast to result from this project are: Company policy is to depreciate all capital assets over their expected useful life using straight line depreciation. Anticipated capital cost (in year zero) £1,000,000 Section 3 requirements 1. Calculate the following for the above project i) Payback ii) accounting rate of return 1. Payback: Anticipated capital cost (in year zero) £1,000,000=b Year Cash inflow 000 Cash outflow 000 Cumulative cash inflow 1=a 635 449 635000=c 2 998 766=d 1633000 3 1195 952 2828000 4 1858 1407 4686000 5 1959 1517 6645000 PBP= a+b-c/d =1+1,000,000-635000/766000 =1+365000/766000 =1+0.47 =1.476 years Accounting rate of return: ARR=Average income/ initial investment (Qfinance, 2000) Average income=635000+998000+1195000+1858000+1959000/5 =1329000 =1329000/1,000,000 =1.329% Strength and weaknesses of PBP: One of the problems with PBP is that it does not take into account large number of periods and thus, works only till 2-3 periods and cannot be regarded as a measure of profitability. It also ignores the time value of money. It works only when the companies are dealing with risky projects. This technique can be used by banks to calculate that how long their capital will be at risk. Strength and weaknesses of ARR It fails to take into account the profits. If the cash flows from the projects are same then the time the occurrence of those cash flows should be taken into account. Projects giving the same ARR but are based on different tm periods are not equally attractive. Thus, ARR does not take into account the time period. It ignores the concept of time value of money (Price, 1995) Accounting rate of return does provide measure of profitability. Internal rate of return and net present value is considered as a better technique because it takes into account the time period and magnitude of expected cash flows. It also helps to calculate the difference in the timing of cash flows in each period of a project’s life. 2. Summarise the main factors that should be taken into account by any company when setting prices. Factors to be considered while setting prices There are many important factors that need to be considered while setting prices. These factors are material cost, labour cost, overhead cost, type of target customers, your market and most important your profit margin (reference for businesss, 2007) Material cost includes the cost that company has incurred for buying raw material. In addition to this labour cost is important to determine because without that production cannot take place. On similar lines, factory overhead cost constitute of all indirect cots incurred by the company. All these costs and the total cost of manufacturing are also important to determine while setting prices. In addition this, it is important to determine that who are your target customers. If they are elite class then you set high prices if it is middle class you set lower prices and so on. However, setting your mark up is also essential while setting prices. 3. In year 5 the new investment is expected to produce 800 units of production. Including depreciation in your calculation, identify the unit cost of production that year From the table the year 5 investment value is 1517000. This might be the amount that the company has invested in purchasing the raw material. Thus, in 5th year the cash outlay is 1517000 which can also b regarded as the cost incurred by the company. In order to get the cost/ unit we divide the total cost by the total no. of units produced. Cost/unit= total cost/total no of units = 1517000/800 =1896.25£ Section 4: Your professional institute has asked you to devise a series of short courses on company financial statements, which it can market to business people. You have begun to make some notes on this issue and decide to expand those into brief formal essays to help you prepare the course outlines. Section 4 requirements: Explain the contents of a balance sheet and profit and loss account Contents of balance sheet: Assets under which current assets and fixed assets are reported. Liabilities under which current liabilities and long term liabilities are reported. Owner’s equity under which retained earnings and issued shares at their par value are recorded. Contents of profit and loss account: Profit and loss account reports revenues and expense, gains and losses and net income. Gross profit before taxes is also incorporated. 2. Discuss the differences in the above financial statements across different legal forms of organisation. Form of balance sheet organization: There are several differences in the legal form of organization of these statements. Balance sheets are developed by following two methods i.e. Vertical method and horizontal method. Vertical method lists all the times in one column. It is also called as running format. Horizontal method lists the items in the form of t account. It is also called as a reporting method. Assets are recorded at debit side and liabilities and owner’s equity are reported at credit side. Form of profit and loss account organization: Profit and loss account statement which is also known as income statement or statement of earnings is organized in two ways i.e. simple step and multiple step format (Gibson, 2008). Simple step lists all then gains and then expenses are deducted and give net income. While multiple-step format first calculates the revenue from sales then subtracts the cost of goods sold and gives gross profit value. After that operating expenses are deducted this gives a value of operating income and then after the deduction of taxes net income in calculated. 3. Using appropriate examples, explain how ratio analysis can assist in the assessment of a firm’s profitability. While analyzing the financial statements companies carry out ratio analysis (Gibson, 2008). Ratio analysis consists of many ratios. However, there are several ratios that give clear picture about the profitability of the company. These ratios are net profit margin ratio that provides a look at firm’s operation. In addition to this, total asset turnover also gives clear picture of the firm’s profitability. It provides a look on the ability of the organization to generate sales revenue by the use of its assets. Return on assets and return on investments are also used to calculate the profitability of the organization. In addition to all these gross profit margin ratio also calculates the profitability of the firm. 4. Briefly explain books of prime entry, the double-entry bookkeeping system, ledgers and the trial balance. Books of prime entry: It is the book of accounting where the transaction is recorded first. Any transaction that takes places is recorded immediately in prime books. Double entry book keeping system: In double entry book keeping system each transaction is recorded with its total amount on the debit side and credit side of the T account. This scheme revolves around the accounting equation: Assets=liabilities –Owner’s Equity Ledgers: After that the amount are transferred to the journals and journal summarizes all accounts and the total value of the accounts are then transferred to the ledgers. Trial balance: Trial balance consists of three columns. In 1st column name of the account having non- zero balance is mentioned, in second column the debit balance is mentioned, in third account credit balance is mentioned. The debit balance must always be equal to credit balance. Bibliography Bnz, 2010. The dangers of Overtrading [online] (updated 11.08.2010) Available at:http://www.bnz.co.nz/business-banking/business-help-and-info/articles-and-resources/articles/ci.the-dangers-of-overtrading.BHIArticle[accessed:29th November, 2010] Brigham, E.  Ehrhardt, M. (2008). Financial Management: Theory and Practice: 12TH ed., Cengage Learning Gibson. C. (2008). Financial Reporting and Analysis; 10TH ed., Cengage Learning Price, A. (1995). International Project Accounting, 1ST ed., International Labor Organization, Geneva QFINANCE, (2000). Weighted Average Cost of Capital [Online] Available at: http://www.qfinance.com/balance-sheets-calculations/weighted-average-cost-of-capital [Accessed 30th november, 2010]. References for busineeses,(2007).Pricing[online] available at: http://www.referenceforbusiness.com/small/Op-Qu/Pricing.html [accessed 30th November, 2010] Read More