Business Finance: a Value-Based Approach - Example

SUBWAY By of the of the School This report aims at providing David with an understanding of where and how to access sources of finance for his business, the implication faced from these different sources of business and then selecting the most appropriate one for the business. It then goes ahead to assess and compare the different costs of these sources of finance, explains the importance of financial planning and the designs a financial plan. Further, the information needs of different decision makers and impact of finance on the financial statements projected is described. In addition, it outlines preparation of a budget, calculation of unit cost for the products and assessment of the viability of the project to be undertaken. Finally, the report explains the purpose of main financial statement, before preparing balance sheet and profit and loss account and carrying out appropriate analysis of these projected financial statements using appropriate ratios. Introduction There are a variety of methods of raising finance for the business. The type of finance a business selects or choses basically depend on the nature of the business. Small businesses are able to borrow from families and friends. Savings provides the most obvious way of putting the money into the business. Large organizations are able to use a wider variety of finance sources than are smaller ones. In contrast, companies can also raise finance by issuing shares to the members of the public. Large companies often have thousands of different shareholders. Sources of finance available to David The following sources of finance are available for David to choose from (Dlabay, 2007): Bank borrowing Loan stock Credit cards Government sources Bank overdraft Venture capital Business angels Share capital – outside investors Financial institutions i) Bank loans The most important source of finance to David is the borrowings from banks. This is because it is mainly short term and hence most important for start-up financing. This can be in a form of a short term loan, for maybe up to three years. However, medium term loans are also being offered by banks nowadays. Medium term loans are basically offered for a period of three to ten years. The rate of interest charged on these loans may be fixed or variable and may also depend on the riskiness and credit standing of the borrower. The financial institutions normally consider the purpose of the loan, the amount, repayment pattern, term or duration of the loan, and the security before the loan is advanced (Neale, 2004). ii) Bank overdraft Banks on the other hand, advance overdraft facilities to the borrowers. This is basically a more short term kind of finance which small businesses and start-ups have widely used as a source of finance. This source is very flexible as it is only used when need arises. It allows businesses to withdraw more than what they have in deposits and in return the banks charge relatively high rate of interest. This interest is usually charged at a variable rate day to day on the amount by which the particular bank is overdrawn from (Dlabay, 2007). Business angels This is basically another external source of finance for a start-up company. Angel investors are professional individuals and businesses that are basically interested in helping small businesses to survive and grow hence have other main objectives other than just economic returns. These professional investors typically invest £10000 to £750000 particularly in businesses that have high growth prospects. They prove to be important to the business they finance because they have proven entrepreneurial expertise needed to make it grow by making their contacts, skills and experience available to the business (Dlabay, 2007). Venture capitalists Generally, Venture capitalists are large corporations that usually invest large sums of money in the start-up businesses that have high potential for large profits and growth. A venture capital is typically a financing that comes from individuals or companies to invest in young and privately held businesses. They basically provide capital to these young businesses in exchange for an ownership share of the business. Even though they do not take part in the initial financing, they can participate in companies with management that has a proven track record. In addition to capital contributed, venture capitalists also provide business advice and guidance. However, they are usually concerned with the short term gain hence look for substantial returns on the investments they provide and this may make their objectives to be at cross purpose with the founders (Neale, 2004). Credit cards Credits cards have proved to be a most popular means of funding a start-up business. It has become the most common source of financing for small businesses. It allows the business owner to pay for a number of businesses related expenses each month using the credit card. The credit card statement is then posted to the business 15 days later upon which the balance is repaid within the provided credit-free period. It provides the business with 30-45 days free credit period (Dlabay, 2007).  Government sources As part of policy to help develop national economy, the federal and state governments usually offer financial assistance to start-up businesses in the form of cash grants and/or other forms of direct assistance such as tax credits. Loan stock David can also use loan stock to raise the balance. A loan stock is a long-term debt capital that the business raises and which interest is paid at a fixed rate usually half yearly. A good example of a loan stock is debenture. Share capital- outside investors The main source of external (outside) investors for a start-up business is family and friends. David is therefore able to borrow from his friends and families to finance the deficit. Implications if these sources of finance Financial institutions Obtaining bank loans is quite difficult as banks require a substantial track record and/or valuable collateral security such as real estate. Banks also charge interest rates that are quite high and in case the business defaults in repayment it faces a risk of liquidation. Business angels They usually contribute to the business finance in return for a share in the profits and equity of the business. Just like venture capitalists, business angels demand for a high rate of return and this lowers the return to the owner. They also demand a share in the equity which results to loss of control of the business (Neale, 2004). Venture capitalist They typically require a large share of control of the business. This implies that David is going to lose a large management control to them. Further, they demand for a high rate of return and this lowers the return to the owner. Credit cards Credit cards are not a good source of financing because it provides limited funds. It also presents tough actions in case the payment is not made within the credit free period particularly in the form of fines. This will result to extra charges. Government sources This source of finance is basically not assured as it is provided at will. And in case it is advanced, the government will be interested in the progress of the business and this will put much strain on David. This is because he will be forced to work extra hard to ensure that he meets the government’s demands. This implies that some degree of control will be lost. Loan stock Debenture holders are basically creditors of the business and in case the business fails to repay them, they may file a suit demanding the liquidation of the business. Further, the interest charge on the loan may be too high for David to meet (Dlabay, 2007). Share capital- outside investors This kind of borrowing may affect the relationship in case of default in repayment particularly in case the business gets into difficulties. In addition using this source may result to loss of some degree of business control to the family members as some would want their decisions to be implemented (Neale, 2004). Appropriate sources of finance Loan stock- it results to a substantial amount necessary to meet the deficit. Financial institutions- just like loan stock, financial institutions provide substantial amount necessary to meet the deficit Business angels Venture capitalists Bank overdrafts These sources of finance are deemed appropriate for the business to be started by David because they are capable of providing the needed funds at a relatively affordable rate. In addition, some of the methods such as business angels and venture capitalists provide other benefits such as proven entrepreneurial expertise needed to make the business grow by making their contacts, skills and experience available to the business. Further, they provide guidance and business advice necessary to take the business to great heights. Task 2 Costs of finance sources selected Different sources of finance have different costs associated with them. Loan stock If the business issues a 15 percent loan, the coupon yield would be 15% of the nominal value of the stock (£230000). However, this rare may be high because of the escalating interest rate in the United Kingdom. He will pay a finance cost of 15%*230000= £34500. Bank overdrafts According to the Telegraph, the current average lending rate on overdrafts is 19.5 per cent. So suppose David borrows the deficit amount in overdrafts he will be required to pay an interest (finance cost) of 19.5%*230000= £44850 Bank loan According to the telegraph, the UK prime lending rate stands at 7.50 percent. This means that as far as bank loan is concerned, David will pay an interest (finance cost) of 7.50%*230000= £17250. Venture capitalists and business angels Because they are usually high risk business investors, they typically look for annual returns of 25-30 percent of the overall or gross investment portfolio they advance. Taking the average of 27.5 percent, David will be required to pay a finance cost of 27.5% *230000= £63250. Comparison Source of finance Costs (£) Loan stock 34500 Bank overdrafts 44850 Bank loan 17250 Venture capitalists and business angels 63250 Because of their high demands, venture capitalist and business angels are the most expensive methods of financing, followed by bank overdrafts, then loans stock and finally bank loan. Davis should therefore use bank loan as it is relatively less expensive compared to the remaining ones. Importance of financial planning Carrying out financial planning is basically important to a small business. The following are some of the importance of financial planning: Measuring progress Financial planning provides a measure of the success of the business. Cash management A financial plan provides a good cash management which provides a cash cushion to the business which can be used to take advantage of opportunities that may arise (Llp et al, 2004).. Long range view Financial plan provide a forward looking focus which assist the business to identify necessary expenditures to keep the business on a growth track and be ahead of the competitors. A financial plan acts as a blueprint for the business continual improvement in performance (Llp et al, 2004). Spotting trends A good financial plan outlines the trends in the business operations, for instance sales. Prioritizing expenditures A financial plan assist a business owner in identifying the most important expenditures particularly those that bring about immediate increase or improvement in market penetration, productivity and efficiency (Llp et al, 2004). Income Financial planning enables one to manage the income more efficiently. The best way possible to manage income is through income expenditure budgeting and cash and need analysis. Proper income management leads to increase in cash flow (Llp et al, 2004). Cash flow Financial planning helps determine what is to be done to generate cash flow so that investing can be made possible. Capital Financial planning helps one to build a long term capital base and even shape their financial future. An increase in cash flow brings about an increase in capital base. Investment Good financial planning enables one to evaluate the best investment opportunities. It also helps in allocating money among various investment types hence a greater investment success. Assets A good financial plan provides on with the opportunity to monitors the assets owned. A financial plan outlines earned, spent, and remaining assets hence keeps updated records of the resources of the business. In addition, it helps in evaluating the current assets, fixed assets and intangible assets thus outline the best way to gin or spend resources (Llp et al, 2004). Financial security and mastery Financial planning provides financial decisions to be made in order to achieve the objective of financial security and mastery. Financial plan Information needs of different decision makers The following groups of people need to make certain decisions at one point in time regarding the project and hence need the following information: Lenders, suppliers and other trade creditors Solvency of the project (ZüLch & Hendler, 2011, pg. 7-8). Governments and their agencies Compliance with rules and regulations. The profitability and liquidity (financial position) of the project (ZüLch & Hendler, 2011, pg. 7-8). Present and potential investors Firm’s risk and return The financial performance, financial position and its ability to generate cash by the project. Employees The project’s ability to provide employment opportunities, remuneration, retirement and other benefits. The stability and profitability of the project The financial position and financial performance of the project Customers Assurance of the firm’s continued existence Firm’s financial position (Weygandt et al 2010, pg. 6). Impact of finance on balance sheet and income statement Borrowing finance from external sources leads to bank loans which are liabilities. This therefore results to an increase of the liabilities in the balance sheet. This therefore will affect the balance of the assets and liabilities. This in turn affects the financial position of the firm. As for the income statement it results to the introduction of finance cost which usually reduces the net income of the firm. This will further worsen the net loss already realize as per the income statement. This therefore affects the financial performance of the firm. Task 3 Projected budget Year 1 Year 2 Year3 Total sales 2244000 2688000 3360000 Less disbursements Inventory purchases 988000 1008000 1120000 Sales commission 528000 702000 504000 Salaries and wages 264000 264000 264000 Utilities 168000 168000 168000 Miscellaneous 36000 36000 36000 Excess of receipts 260000 510000 1268000 Financing: Repayments 34000 34000 Interest 17250 17250 17250 Ending cash balance 242750 458750 1216750 Unit cost calculation In the calculation of the unit cost, one needs to arrive at a value that covers both the operating expenses and the desired margin. Using the provided data on single and double oven, the unit cost is computed as follows: Double oven Total costs= £600+400+150+100= £1450 Using a mark-up of 200 percent, the unit price will be set at 200%*1450= £2900 for 500 sandwiches. Therefore the unit cost will be £2900/500=£5.8 per sandwich. Single oven unit cost Total costs 325+300+75+50= £750 Using a mark-up of 200 percent, the unit price will be set at 200%*750= £1500 for 500 sandwiches. Therefore the unit cost will be £1500/500=£3.0 per sandwich The price will therefore be set at £5.8 for a sandwich made from double oven and £3.00 for a sandwich made from a single oven. Assessment of the viability of the oven project Cash flows are got by adding back depreciation to the net income. Depreciation= (cost-residual value)/number of years Depreciation per year (double oven) = (100000-7000)/6= £15500 Depreciation per year (single oven) = (60000-6000)/6=£9000 Cash flows year Double oven Single oven 0 100,000 60,000 1 10000+15500= £25500 4000+9000= £13000 2 20000+15500= £35500 12000+9000= £21000 3 £35500 14000+9000=£23000 4 £35500 14000+9000= £23000 5 £35500 12000+9000=£21000 6 £35500 12000+9000=£21000 a) payback period Double oven 3+3500/35500= 3.10years Single oven 3+ (3000/23000) =3.13yeas From the payback period, double oven project is more viable that the single oven because it takes few years to realize the initial purchase cost. b) Discounted payback period Present values using a discount rate of 12% year Double oven Single oven 0 (100000) (60000) 1 22767.86 10714.29 2 28300.38 16741.07 3 25268.20 16370.95 4 22560.89 14616.92 5 20143.65 11915.96 6 17985.40 10639.25 Total PVs 137026.38 81891.29 Double oven =4+1102.67/20143.65= 4.055years Single oven= 4+1556.77/11915.96= 4.131years Double oven has a few years to realize its initial cost from discounted cash flows hence more viable. However, both the ovens are viable because they have almost the same discounted payback period. c) Net present value (NPV) Using a 12 percent discount rate, the ovens have the following NPVs Double oven =£37,026.39 Single oven= £21,891.29 From the calculated NPVs, the double oven ids more viable that the single oven because it has more NPV than the single one. However, the two ovens are viable because they both have a relatively high NPV. d) Internal rate of return (IRR) From the IRR calculator, the two ovens have the following IRR, Double oven =23.66% Single oven=23.25% Double oven is more viable because it has higher IRR. However, both of them are viable because their values are higher than the discount rate of 12 percent. e) Profitability index (PI) Double oven= 137026.38/100000= 1.370 Single oven= 81891.29/60000=1.365 Double oven is more viable because it has higher PI than single oven. However, both of them are basically viable because the variation in the values is minimal. Task 4 Basically there are three main financial statements that a business should prepare namely, Income statements(profit and loss account) Statement of financial position (balance sheet) Cash flow statement Purposes Income statement shows the profitability of a business. By reported income and expenses, an income statement assists in determining the financial performance of the business, predicting future performance, and assesses the capacity of the business to generate future revenue streams (Berrington & BHANDARI, 2011). Balance sheet shows the company’s financial position because it reports what a business owns and what it owes. Ti highlights the company’s assets and liabilities. Cash flow statements show the amount of cash that flows into and out of the business over a given period of time. It also reconciles the other financial statements. Methods of preparing financial statements Basically there are two methods of preparing both income statement and balance sheet, horizontal method and vertical method. Vertical method is whereby related items are listed on one side4 while the remaining items are listed on the other side. In the case of balance sheet asset items are found in one side while liabilities items are found in the other side. And in the case of income statements, revenue items are found in one side while expenses items are found on the other side (Berrington & BHANDARI, 2011). Horizontal methods are where related items are listed and then summed up. The following items are also listed and summed up and then the difference is found. For instance one first lists revenue items, gets the total then lists expense items, gets the difference and then finally getting the difference of the totals (Berrington & BHANDARI, 2011). In this case the horizontal method has been used because it provides a good outlook for the financial statements. Further, it is the most current method being used. profit and loss account sales 420000 deduct: returns inwards 60000 net sales 360000 cost of sales opening stock 70000 plus purchases 280000 less returns outwards -4500 cost of goods sold 345500 gross profit 14500 less expenses discount allowed 500 post and packaging 1400 salaries 35600 heat and light 13750 51250 net loss 36750 balance sheet assets premises 120000 fixture and fittings 45000 bank 5000 debtors 55000 total assets 225000 capital and liabilities capital 195000 less drawings 35000 less net loss 36750 123250 creditors 47000 bank overdraft 54750 total capital and liabilities 225000 Financial analysis Liquidity ratios Liquidity ratios indicate the ability of an entity to meet its short term obligations as they fall due (Graham & Smart, 2012). Current ratio=current asset/current liabilities =60000/101750= 0.59 From the current ratio which is less than 1, it is evident that the firm is less liquid and cannot meet its short term obligations effectively. Activity ratios Activity ratio indicates how well the entity is managing its liabilities and/or how effectively it is utilizing its assets. These ratios basically indicate how efficiently the assets of the firm are working to generate sales revenue (Graham & Smart, 2012). Fixed asset turnover=net sales/fixed assets =360000/165000= 2.18 Total asset turnover= net sales/total assets =360000/225000= 1.6 Accounts receivable ratio=net sales/ accounts receivable =360000/55000= 6.55 From the above ratios it is evident that the firm is efficient it its operations. It uses well the few assets to generate high returns. Profitability ratios Profitability ratios determine the bottom line and the returns an entity gives to its investors. These ratios basically show the company’s overall performance and efficiency. These ratios highlight the firm’s ability to generate its earnings relative to assets, sales, and equity (Mukherjee & Mohammed Hanif, 2006). Net profit margin=net income/net sales =36750/360000=-10.21% Gross profit margin=gross profit/net sales =14500./360000=4.03% Return on assets=net income/total assets =-36750/225000= -16.33% In terms of profitability, the firm is less profitable as evidenced by negative values of net profit margin and return on assets. Further, its gross profit margin is quite small and cannot cover other operating expenses apart from cost 9of sales. Debt ratios These ratios basically show how leveraged a company is. They assist an entity to make comparison between their equity to the borrowed funds. It shows the proportion of the firm’s activities that is funded by the borrowed funds in comparison to those that are funded by the equity. It therefore, measures the company’s long term solvency (Khan & Jain, 2007). Debt to equity ratio=total liabilities/total assets =101720/225000= 45.22% From the ratio above, it is evident that the entity is using enough leverage in its operations. This means that the company is solvent. References BERRINGTON, M., & BHANDARI, V. (2011). Pinnacle financial statements. [Sydney, N.S.W.], IFRS System. Pg. 742. DLABAY, L. R., & BURROW, J. (2007). Business finance. Mason, Ohio, South Western. Pg 125-129 LLP, E. &. Y., NISSENBAUM, M., & RAASCH, B. J. (2004). Ernst & Youngs Personal Financial Planning Guide. Hoboken, John Wiley & Sons. Pg. 9-15 NEALE, B., & MCELROY, T. (2004). Business finance: a value-based approach. Harlow [u.a.], Prentice Hall. Pg. 214-220. Warren, C. S., Reeve, J. M., & Duchac, J. (2012). Financial accounting. Mason, OH, South-Western Cengage Learning. Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Financial accounting: IFRS. Hoboken, N.J., Wiley. ZüLch, H., & Hendler, M. (2011). International financial reporting standards (IFRS) 2011: Deutsch-Englische Textausgabe der von der EU gebilligten Standards und Interpretationen = English & German edition of the official standards and interpretations approved by the EU. Weinheim, Wiley-VCH Verlag GmbH & Co. KGaA. Read More