Expediency to Use of Retained Profit rather than an External Loan - Example

ABC Financial Business Research Introduction An effective business is vital in a company’s long term strategy to success. Having a business such as ABC Company which is a manufacturing firm that specializes in making cedar roofing and siding shingles there may be the difference between successfully raising it, and taking it to the ground. Business planning to expand its sales with a 25% increase requires the management and its shareholders to set their targets and goals through a forecast budget. An effective business will lays out the perfect strategy in realizing the companies’ goal of profit maximization. By having the capability to read the agency’s future, it is practical to form feasible strategies that work in favor of the additional products that can leverage the current ABC employee skill-set as well as the manufacturing facilities. In this case, it is critical to form a financial plan to assist the agency’s long term objectives. This is especially if it is the first time trying to make it in this entrepreneurial venture. Some of the aspects that surround this business need addressing so as to make it simpler to deal with the hurdles that these project faces. This paper will examine such a plan in bide of setting aggressive growth target of reaching $3 million annual sales within the next 3 years and how it may impact the growth and development of the business, in the long run. The paper also analyses the overall risk profile of the company based on current economic and industrial issues that it may be facing based on the track records of its financial statements. Discussion It is fundamental for one to be apprehensive about the issues the market may be facing. One of these issues may be an economic downturn. The economic activities that surround this manufacturing industry are a vital aspect in the continuation of the new proposed project (Chandra, 2011). An expansion of the activities occurring in the manufacturing environment means that, there is a chance of having restructuring other interdepartmental that do facilitate the production of final product. As a growing business, the board of management needs to be sensitive to such customer needs and requirements. Overall customer satisfaction is another sensitive area to look into in the business. Customers prefer to have access to information. The ability to provide this access at a rapid pace means that, they will be inclined to get more involved with the business (Brigham, & Ehrhardt, 2011). This works in boosting the annual revenue acquisition. This is where technology comes into play in the business. Offering customers information leads to more interaction, which is the primary focus of the product. Government regulations are also a sensitive area to look into while trying to grow the business in order not to derail the quality of their product (Chandra, 2011). The government policies could also improved access to financial services which on the other hand is help-full in raising the funds for such proposed expansion. All these sensitive areas might determine if the business will grow after expansion, or if it will remain stagnant as at the commencement of the pursuit of new venture. It is very pertinent to acknowledge the presence of all factors present in the industry that might enable it to grow, decline, or remain stagnant (Brigham, & Ehrhardt, 2011). In order to attract a wide variety of customers, it is vital to have an image of the build cedar dollhouses that are to be offered in the market. The price would depends on alternative product which the competitors also do offer in market, that reflect the loyalty of the client, and how much they are invested in the business as a cost of production. Loyalty in any business is fundamental in its growth as cabalist. However, diverting customers from the competition is instrumental in covering the business and some of its costs. In order to provide capital to enable the business to grow and give the shareholders their share, funds need to be managed appropriately. This propels management to hire the services of a financial strategist to assist in assessing the use of capital in the business. Current company cash flow ABC CASH FLOW STATSMENT FOR THE YEAR ENDED Dec. 31,19X2 Operation Activities Amount($) Net profit 50,000 Add depreciation expenses 70,000 Income tax 30,000 150,000 Working capital items Account Receivable -60,000 Merchandise inventory -70,000 Accounts payable 40,000 Income taxes payable 30,000 -60,000 Investing Activities Dividends paid -100,000 Financing Activities Purchases of equipments -100,000 Cash B/F 30,000 Cash and Cash equivalents 70,000 Monitoring the amount of capital spent in the business is fundamental in understanding how it is fairing. Production costs and other expenses can be regulated to prevent excessive consumption of capital that may be hard to come by at expansion period (Khan, & Jain, 2007). Risks and warning signs may be seen in case of poor cash flow management. In such a case, management needs to work out a strategy to monitor the receivables in the business to prevent the overreliance of one product. Since most cash flows are addressed at the end of the month, the difference in retaining some of the capital the business gains should be expanding and increasing the productivity. This is to maintain the manufacturing longevity (Khan, & Jain, 2007).. Accordingly, leverage refers to the Company reliance on debt capital obtained from external sources e.g. overdraft, borrowing loan debenture. Horizontal Analysis of Income Statement and Balance Sheet ABC Companys current financial information (before/without expansion) Dec. 31,19X2 ($) Dec. 31,19X1($) Cash 50,000 70,000 A/receivable(net) 120,000 180,000 Merchandise inventory 350,000 280,000 P.P.E. 400,000 300,000 Less: Acc/depreciation (170,000) (100,000) Total assets 750,000 730,000 Accounts payable 250,000 210,000 Income taxes payable 40,000 10,000 Common stock 240,000 240,000 Retained earnings 220,000 270,000 Total liabilities & stock, equity 750,000 730,000 ABC FINANCIAL STATEMENT FOR THE YEAR ENDED 31,19X2 /31,19X1 Sales 1,200,000 960,000 Cost of goods sold 800,000 640,000 Gross profit 400,000 320,000 less operating expenses Depreciation expense 70,000 70,000 Income taxes 30,000 30,000 Net profit 300,000 220,000 Retained earnings b/d 270,000 216,000 570,000 436,000 Dividends declared and paid during 19X2 100,000 80,000 Reserves 250,000 2,000,000 Retained earnings c/d 220,000 176,000 Growth and development must be financed through working capital, therefore, as the level of operation increases e.g. Turn-over, the fixed cost and the fixed assets as well as current assets must also increase proportionately to support the growth (Chandra, 2011). This additional capital may also be raised internally through retained earnings with increase in sales profit (Brigham, & Ehrhardt, 2011). On the other hand operating gearing a rises when the company relies on short term debts or sources of capital, for example, overdraft or creditors ABCs Product information Current Product($) Expansion Product (estimate$) Selling Price 14.5 22.3 Direct Materials per unit 1.3 5.6 Direct labor dollars needed per product per unit 2.8 4 Variable Factory Overhead 1 1 Variable Selling Expense 0.2 0.2 Contribution 9.2 11.5 Total Fixed Costs: ($) ($) ($) Units produced and expected to be sold 80000Units 85000Units Machine Hours 40000 45000 Fixed Factory Overhead 198000 4.95 4.4 Fixed Selling expenses 191250 2.390625 2.25 Break -even point = fixed cost/Contribution margin 389250/9.2=42309Units 389250/11.5=33848Units Ratio Analysis Name Formulae Dec. 31,19X2 Dec. 31,19X1 current ratio Current assets/Current liabilities 520,000/290,000=1.793 530,000/220,000=2.409 quick ratio (Current assets-inventories)/Current liabilities 170,000/290,000=0.5862 250,000/220,000=1.1364 cash to current liabilities ratio Cash/Current Liabilities 50,000/290,000=0.1724 70,000/220,000=0.3182 In ratio analysis the firm is able to assess or know the extent to which they are holding working capital by comparing the current assets and liabilities with the previous year or horizontally across the board in the same industry. IV. Potential investments to accelerate profit: ABC Company has the option to purchase additional equipment that will cost about $42,000, and this new equipment will produce the savings in factory overhead costs over the next five years: Amount($) PVIF Amount($) Initial outlay 42000 0 -42000 Year 1, 15000 0.8928 13392 Year 2, 13000 0.7971 10362.3 Year 3, 10000 0.7118 7118 Year 4, 10000 0.6355 6355 Year 5, 6000 0.5674 3404.4 40631.7 NPV -1368.3 The NPV is negative therefore reject the project because factory overhead costs savings are not enough to recoup the initial cost of the equipment and again there will be no scrap value at the end of economic life of the equipment which can be discounted as a lamp sum after five years of production. Consideration of depreciation Annual cash flows are affected by depreciation in two major ways: Depreciation should be charged as expenses and therefore reduces the profits. In financial management we are more concerned with inflows and not profits thus the depreciation should be added back since it is not an out flow. However in absence of taxation depreciation will not have an effect but a tax shield exhibited by reducing the taxable profit and therefore tax liability. Conclusion: Expected return is the most criterion of evaluating projects, the higher the expected return of a project the better the project. The expected return criterion is therefore an optimistic view that target at maximizing wealth of shareholders. Profit maximization seeks to increase the rewards to the owner and therefore it may at the expense of other stakeholders. I thus recommend the use of retained profit rather than external loan which may obligate the company due risk of its cost in financing. References Khan, M. Y., & Jain, P. K. (2007). Financial management. New Delhi: Tata McGraw-Hill. Chandra, P. (2011). Financial management: Theory and practice. New Delhi: Tata McGraw-Hill Education. Brigham, E. F., & Ehrhardt, M. C. (2011). Financial management: Theory and practice. Mason, OH: South-Western Cengage Learning. Read More