Impact of Finance Sources, Financial Decision-Making - Coursework Example

Table of Contents Task Sources of Finance for a Business 2 1Different Sources of Finance 2 2Implications of Different Sources of Finance 4 3Evaluation of Appropriate Finance Sources 5 Task 2: Impact of Finance Sources 6 2.1 Costs of Finance Sources 6 2.2 Importance of Financial Planning 7 2.3 Information need of Decision Makers(150 words) 7 2.4 Impact of Finance on Financial Statements 8 Task 3: Financial Decision Making 8 3.1 Analyse Budgets and Make Appropriate Decisions 9 3.2 Calculation of Unit Cost and Price Decision Making 9 3.3 Assessing Project Viability Using Project Appraisal Techniques 10 Task 4: Evaluation of Financial Performance 10 4.1 Discussion of Main Financial Statements 10 4.2 Comparison of Financial Statements Formats 11 4.3 Interpretation of British Airways Financial Statements using Ratios 12 References 12 Appendices 15 Task 1: Sources of Finance for a Business 1.1 Different Sources of Finance There are several sources of finance for any type of business. Usually, the type and nature of business determines the type of financing to be used. Business finance sources can be classified into three major categories which are short term, medium term and long term sources. This type of categorisation is based on repayment time. There exists another categorisation of business finance sources which includes internal sources, external sources and personal sources. This section is going to focus on time-based categorisation of finance sources (Boundless, 2014). The purpose for the funds usually determines the category in which the source of funds falls (Deakins & Freel 1999). Short term sources of finance are sources that are those that can be used for a period of less than one year. These sources are mostly used to finance an organisations operations as well as increasing its working capital. In this regard, short term business finance sources should be readily available to the business because sometimes they are used to meet a business need that had not been foreseen such as a new opportunity. A bank overdraft is a short term finance source available to most business that have a bank account. This is a type of a short term unsecured loan whose limit is determined by the bank depending on the business’ account ratings. This facility allows the business to overdraw funds from their accounts up to a certain limit. The repayment period is usually short and is payment is at an interest rate that is determined by the bank. Bank overdrafts are usually flexible and they come in handy when a business is experiencing cash flow problems. Asset-based loans and repurchase agreements are other sources of short term business finance. The difference in these two is that asset-based loans involve borrowing loans that are secured by working capital assets such as accounts receivable. Repurchase agreements are basically loans that are secured by securities and usually involve an agreement to repurchase the securities once the borrowed money is paid back. Hire purchase and leasing are more sources of short term business finance. Hire purchase involves acquiring an asset on hire basis where the business hires an asset and the hire charges paid in instalments add up towards payment for the cost of the asset and eventual ownership. Leasing involves hiring an asset but without eventual ownership of the same asset. Leasing is mostly preferred because of its benefits. A leased item’s maintenance costs are met by the owner and managing a leased asset is much easier than managing an acquired one. A trade credit is a short term business finance source that usually has a period of one month or less. It is mostly used by business to finance acquisition of trade goods and assets. It is highly flexible and is readily available. A credit card can also be used as a short term finance source. This allows a business in possession of a corporate credit card to purchase goods on credit. The business can pay either part of the borrowed amount or the whole amount within the given repayment period. It is also highly flexible (Business Finace Guide, 2010). Medium term sources of business finance are those whose funds will be used for a period of three to five years. These sources are usually used in instances where long term finance source cannot be used or are unavailable and where short term sources will not provide adequate funds (Deakins, 1999). Leases and hire purchase also fall in this category when their repayment period is more than three years and less than five years. Medium term loans are sources of medium term finance for a business if their repayment period fall within the period specified for medium term financing. Other medium term sources of business finance include preference capital and issuance of financial bonds. Preference shares are a type of fixed share capital that is issued by a business for a specific time period. Bonds have fixed rates of return and have specific repayment period too. Long-term sources of finance are those finance sources that can used by a business to acquire funds for a period of more than five years (Borad, 2009). These sources are usually used when financing long term projects, long term working capital as well as other capital business expenditures. Some of these sources are long term loans, capital and preference shares, corporate bonds, venture capital through strategic partners, retained earnings and use of assets as security for funds (Putteraman & Krozsner, 1996). 1.2 Implications of Different Sources of Finance Every business finance option has its implications on the financial performance of a business. These implications have to be considered while choosing a finance option because one option does not have the same implications on all types of businesses. Short term finance option in most cases gives an impression that a business is struggling financially. This is because short term finance options increases the current liabilities of a business within a short time and this is considered risky by some potential investors. Short term sources are required to be paid within a short period of time. This increases the risk of defaulting or late payments which affects the credit rating for a business. Medium term sources have increased risk due to the repayment period where a borrower can default. Medium term sources involve interest and delayed payments attracts penalties. Long term finance sources involve repayments over long periods of time (over five years). Except for ordinary share capital, most of the other sources have an interest and fixed amounts of instalments for repayment. This means that the business or borrower will have to pay the agreed instalment regardless of whether the business is performing well or poorly. Strategic partners are also long term finance sources with some implications. Partners usually demand for a stake in the business which is considered as a percentage ownership in the company. This means that the business owners will have to cede some control over the business though they still partially own the business. In such an arrangement, the business owner will have to share losses as well as profits with the financing partners. Internal business sources such as accruals and retained earnings have less risk and are readily available. These are mostly used by business that pursue a risk averse strategy. Internal sources do not involve any kind of repayment thus they reduce any risks of bankruptcy and financial strain on the business (Ferson & Campbell, 1994). 1.3 Evaluation of Appropriate Finance Sources When choosing the source of funds for a business project, the management should consider several factors. These factors assist the business to determine the best type of funding for the project. Different finance sources are suitable for different types of businesses and projects. The risk involved in a source of fund is a major consideration when making decisions on source of funds. Firms with an aggressive strategy will favour risky sources while companies with risk averse strategies will favour less risky sources. Risk is categorised into business risk and financial risk. An illustration will involve a company that wants to invest in a high risk business project. In order to keep overall risk on check, the company might favour less risky finance sources that will either maintain or reduce their financial risk. Cost of getting the finance is another major consideration for a business when choosing a finance option. Cost of the debt refers to the amount of interest that is to be paid on the funds borrowed. High cost of debt means paying high interest which might strain the organisations finances. A business should also consider its cash flows when sourcing funds for its projects (Barrow, 2011). This is to ensure that it will be able to repay the borrowed funds and still be able to meet its daily financial obligations. Businesses should also match the source of funds to the intended projects. Long term projects should be matches with long term capital sources as this will ensure that there are no cash flow problems. Availability of the source of funds and the ease of issue are other considerations when choosing a finance option. This is because some sources such as equity issues take long due to the procedures involved before a business can conduct a share issue (Butler, 2012). For example, a company seeking $50 million for an expansion project has $10 million in retained earnings and an existing interest rate of 12%. The business is well geared with enough working capital. In this case, the company should consider first using the retained earnings then use a long term source of fund to finance the $40 million for the project. Task 2: Impact of Finance Sources 2.1 Costs of Finance Sources Cost of finance means the amount the business has to forego in order to acquire finance. It can also be explained as the amount paid by the business so that they can use funds. The cost of loans is he interest paid over the borrowed money. Retained earnings from a business or personal savings have the cost of increased business or personal risk. This is because in most cases retained earnings or personal savings are viewed as a form of security for the business. When a business seeks for funds from investors or strategic partners, they usually demand for some percentage of ownership of the business. The percentage of ownership ceded by the owner of the business in order to acquire funds is the cost of these finances. Equity share capital involves payment of dividends while preference shares and debentures involves fixed payments that have interest (Zikmund, Carr & Griffin , 2012). 2.2 Importance of Financial Planning Financial planning is a critical component of business finance as it assists in maintaining financial balances that are critical for efficient business operations. Financial planning basically involves determining an organisations capital mix, managing the available financial resources, determining the financial needs of a business and formulating policies on capital acquisition and utilisation (Rooij, Lusardi & Alessie, 2011). Financial planning is important as it ensures that there is a balance between the amount of cash getting into and out of the business. Deficiencies in cash flow can be corrected using short term finance sources. Financial planning ensures that there is stability in the business as a going concern. Unforeseen business opportunities and shocks in the market are countered using adequate funds. As earlier stated in this paper, the business can rely on short term finance sources to finance an unforeseen business opportunity. Proper financial planning also favours the business when it is sourcing for funds. Most investors and lending institutions usually conduct due diligence before they lend funds to businesses. Firms and businesses with proper financial planning find it easy to acquire funds for their projects. Financial planning also helps in keeping financial risk at minimum levels. Low financial risks contribute towards lowering the overall business risk (Brigham & Houston, 2012). 2.3 Information need of Decision Makers(150 words) Finance managers and entrepreneurs need to have relevant and accurate information so as to make sound financial decisions. Making wrong financial decision can have serious impacts on financial performance and liquidity of a business. Financial decision makers should have accurate information on the costs of different finance options. Cost of finance enables a business to decide whether it is sustainable for them or not. Knowledge on ease and availability of financial information is also important as it will assist finance managers to decide on what bests suits them depending on the urgency of the financial needs. Maturity period is also an important factor for consideration. 2.4 Impact of Finance on Financial Statements Injection or withdrawal of finances into the business has its impact on financial statements. The three main financial statements which are balance sheet, income and loss statement and the cash flow statement have their figures significantly determined by the capital structure. Finance affects a business’ assets in that the total equity must be equal to the total assets. This means that a change in the total equity causes an equal change in the total assets. Capital injection into a business cause an increase in the amount of cash circulating in the business. Cash flow statement is commonly affected by short term sources of finance. In most cases, funds are sought by businesses to boost their operation. This has an effect of increasing the profits in a business which reflects in the profit and loss statement (Ebaid, 2009). Task 3: Financial Decision Making Identify and discuss objectives of a budget Budgets are prepared for futuristic purposes and they act as guidelines in finance management. A budget is prepared so that finance can be controlled as planned. Another objective of budgeting is to ensure adequate allocation of financial resources by the business. Budgets provide guidance on the capital mix for a business as well as give projections into how cash flows will look like in the future. Budgets can also be created with the aim of assisting in decision making. This involves modelling financial situations so as to determine the outcomes of a certain decision (Hofstede, 2012). 3.1 Analyse Budgets and Make Appropriate Decisions In view of the previous point that budgets can be used for decision making, keen and expert analysis is required. Budgets can be modelled to simulate financial situations and from the results of the models, proper financial decisions can be made. Budgets also give a business’ financial performance and from this financial managers and entrepreneurs area able to determine the best source of finance for the business (Eckerson, 2010). 3.2 Calculation of Unit Cost and Price Decision Making Calculating the costs of a product or service involves considering several factors. The first step towards determining cost of a product is to identify factors that have an impact on the cost and the relationship they have to the cost. In this regard, fixed costs and variable costs are considered. Fixed costs do not change with the number of units produced while variable costs change depending on the number of units produced. In most cases, variable costs and the total unit cost have a positive relationship until a certain production level where they decrease due to economies of scale and factors such as discounts. Fixed costs do not change with the number pf units produced but they are affected by production capacity. Changes in capacity might require investment in more or disposal of some fixed assets (Niazi, Balabani & Seneviratne, 2006). Unit cost of a product is used to determine the product price. Several other factors are also considered. Some of these are competitor prices, use of the product, the profit levels desired by a business and market positioning. A business needs to develop a comprehensive pricing strategy that they can use to determine prices of their products or services. 3.3 Assessing Project Viability Using Project Appraisal Techniques There exists several methods of capital project appraisal which include internal rate of return (IRR), payback period method (PBP) and net present value method (NPV). Among these methods of capital project appraisal, Net Present Value method is the most widely used method. This method basically involves calculating and discounting future cash flows at a predetermined rate. The expected cash flows are then added up and the sum is compared to the present investment amount. The decision criteria is if the project has a positive net present value it should be accepted while a negative net present value should be rejected (McAllister,2010). Task 4: Evaluation of Financial Performance 4.1 Discussion of Main Financial Statements There are three main financial statements in any business or company. These are balance sheet, income statement and the statement of cash flows, also called cash flow statement. Financial statements are a mixture of words and numbers that give an insight into a company’s performance. These documents are important to business owners, shareholders and potential investors as they use them for financial decision making. The balance sheet gives a company’s worth at a particular time. It is a financial statement that gives a total of the company’s assets, liabilities and equity. The totals for a company’s assets must be equal to the sum of liabilities and equity for the business owners. Balance sheets are prepared as at a particular date and they give the company’s financial position of the company, hence the name statement of financial worth. The income statement is another financial statement, otherwise called profit and loss statement. This statement basically gives a company’s financial income, expenditure and the net amount for a certain trading period. This statement gives a company’s profitability at a glance (Codjia, 2015). The statement cash flows tracks cash getting in and out of the business over a specified period of trading. The statement is a detailed form of the cash account in the business. It this statement non-cash items are eliminated so as to deal with only cash items. Cash inflow from investments and operations are added to the net cash balance for a previous trading period and cash outflows are deducted from this total sum to arrive at the net cash balance (Codjia, 2015). 4.2 Comparison of Financial Statements Formats There are two formats for preparing a company’s income statement; the single step format and the multiple-step format. The difference between these two formats is the amount of details involved. The multiple-step format has more details than the single step format. In travel and tourism industry, the operating expenses are calculated separate from the other financial expenses. In the single-step format, these two types of expenses are combined and deducted as a total (Anthony, 2014). There are several formats for a balance sheet for a company in travel and tourism industry. These are; comparative, vertical, classified and common size formats. The comparative format has a comparative aspect as it presents figure for the past two or three periods while the common size format includes the standard figures for that are found in ordinary balance sheets. The classified format presents categorised information. Several items are grouped into subcategories for easier calculations. 4.3 Interpretation of British Airways Financial Statements using Ratios Financial ratios are important tools in finance as they give analytical information about a company’s performance. In this section, financial documents for British Airways for the year 2012-2013 will be considered. Profitability, liquidity and efficiency ratios are calculated in attached in the appendix. The current ratio of 0.4 indicates that British Airways is not adequately liquid. The current ratio indicates the extent to which short term liabilities are covered by the available short term assets. A quick ratio of 0.4 also indicates that the company does not have adequate ability to meet its short term obligations. British Airways inventory capital ratio is a negative and it indicates that the company’s working capital is highly tied to its inventory (British Airways, 2013). British Airways has a net profit margin of 0.07 and an earnings per share ratio of 1.06. The two are profitability ratios that and indicate that the company is running at a profit. The fixed assets turn-over ratio of 1.03 and total assets turn-over of 0.8139 indicate that the company’s assets are being utilized optimally. These ratios are compared against the industry’s average (British Airways, 2013). Quick ratio= (total current assets-current inventory)/ total current liabilities. References Anthony, L., 2014. Format of a Finacial Statement. [Online] Available at: http://smallbusiness.chron.com/format-financial-statement-3768.html [Accessed 24 April 2015]. Barnes, P. (1987). 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Financial ratios and the probabilistic prediction of bankruptcy. Journal of accounting research, 109-131. Parrino, R., Kidwell, D. S., & Bates, T. W. (2009). Fundamentals of corporate finance. John Wiley & Sons. Putteraman, L., 1996. The Economic Nature of a Firm: A reader. London: Cambridge University Press. Rooij, M. V., 2011. Financial literacy and stock market participation. Journal of Financial Economics, 101(2), pp. 449-472. Sangster, A. (1993). Capital investment appraisal techniques: a survey of current usage. Journal of Business Finance & Accounting, 20(3), 307-332. Slee, R. T. (2011). Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests+ Website. John Wiley & Sons. Zikmund, B., 2012. Business research methods.. Nwe York: Cengage Learning. Appendices Liquidity ratios 1. Current ratio = Current ratio = = 0.437 2. Quick Ratio = Quick ratio = 3. Inventory to net working ratio = Inventory to net working ratio = = -0.02 Profitability ratios 1. Return on assets= = 2. Net profit margin= = 3. Earnings per share= = = 1.06 Efficiency ratios 1. Fixed Assets turnover= = 2. Total assets turnover= = Read More