Financial Management and Analysis - Finance Guru Ltd - Case Study Example

and Finance Guru Ltd is an online business that sells educational material on learning Finance at University level. It was founded in 2010 by an internet entrepreneur, John Karin. The business is based in Liverpool, Britain. John wants to expand his business to cover the Britain and Europe. This report seeks to advise John on the expansion of his business, to trade internationally, and to assess the financial viability of various revenue streams for his business. Finance Guru does not have adequate finances to fund its expansion. This report seeks ways of financing operations, choosing between projects to undertake, liquidity decision, dividend decision, capital structure decision, and risk management. The report covers the efficient and effective management of the finances. It involves planning and controlling of financial resources, their allocation, and determining whether the resources are used effectively. John must ensure an optimal allocation of the financial resources because they are scarce. Therefore, they must be used prudently to ensure growth, expansion, and an increase in the value of the business. The study is important to ensure that John makes the right decisions and understand the implications of the decisions. The study analyzes the decisions that John will make to enhance the growth and expansion of Finance Guru Ltd. He will make investment decisions that involve allocating of funds in terms of total amount of assets, the composition of fixed and current assets, and the consequent risk profile of the decisions. He will also make financing decisions that involve finding ways or sources of finances as regard to availability, cost, maturity, and risk. He will also make dividend decisions that involve deciding between the amount of earning to retain and the amount to pay to shareholders as dividends. These decisions are interdependent such that a decision in one area affects another. Therefore, it is essential to recognize the impacts of a decision to the other two areas. These decisions are important to ensure an increase in the business value and maximize returns to John. He will receive maximum wealth from the business when the value of the business and dividends increases. It achieves through determining the size of cash flows to the business, timing of the cash flows, and risks associated with the cash flows (Damodaran, 2010). The decisions that John will have to undertake to ensure the growth of the business include efficient management of working capital by striking a balance between the need to maintain liquidity and the opportunity cost of holding liquid assets. He also has to make the decision of raising finance using the most appropriate mixture of debt and equity to minimize the cost of capital of the business. He also has to adopt a dividend policy that reflects the amount of dividend that the business can afford to pay, considering its level of profit and amount of retained earnings for reinvestments. He also has to consider the risk associated with financial decisions and guarding the business against such risks. FINANCING DECISION Introduction One of the key decisions that he will make is to determine how the business will finance its operations. As the business expands, he requires finances to purchase more books, acquire offices, and furniture. Finances are essential for a business to undertake its projects, ensure its survival, and profitability. Financing decisions will help the business to raise the suitable level of funds, when they are needed, and at the lowest possible cost. It is crucial to ensure the maximization of the value of business and wealth to John. The business could raise funds internally or externally. Financing Internally Finance Guru Ltd may finance its operations through cash generated and is not needed to cover its operating costs, liabilities, or dividends. It is usually surplus cash and is referred to as retained earnings. It also includes savings from the business through proper management of working capital. Proper management of trade receivables, inventories, cash, and trade receivables reduce investment in working capital thus decreasing interest charges. Internal financing has several advantages that include being a ready source of cash, has no issue costs, no dilution of control, and no restriction on business operations. However, the amount of internal finances is limited by the cash flows of the business. Therefore, the business requires considering external financing to raise funds for investment projects and expanding. Financing Externally The business may finance its operations through external sources. The external sources may be debt or equity financing. Equity finance Finance Guru Ltd may need to raise long-term finance. It can achieve this by issuing ordinary shares. Shares may be sold to new owners through the stock market when the business lists or selling its shares through a right issue. People buy and sell ordinary shares on stock exchanges and ordinary shareholders want a return on their investments. The ordinary shares are an issue at par value. Subsequent shares are sold at a premium. The ordinary shareholders obtain rights when they purchase the shares. These rights include attending general meetings, voting on appointment of directors, vote on the appointment, remuneration and removal of auditors, and receiving a share of dividends agreed (Graham & Smart, 2011). Finance Guru Ltd may list on the London Stock Exchange. It has to pay an annual fee to have its price quoted and undergo a financial assessment before being allowed to list. The Financial Services Authority regulates trading on the LSE (King & Carey, 2013). The business has to appoint a sponsor or nominated adviser to help it meet all required regulations. A sponsor is an adviser who handles putting out its prospectus, managing listing process, and liaising with the regulator and LSE. Finance Guru Ltd also requires a broker to advise on an appropriate issue price for the new shares and to market the issue to institutions and other investors. John may consider several methods to list his business at the LSE. Listing for the first time is called an Initial Public Offer (IPO) and involves issuing new shares. It may use a placing or a public offer. A placing involves issuing shares at a fixed price to several institutional investors who are approached by a broker before the issue takes place. The issue is underwritten by the issuing business’s sponsor. A placing has very little risk, and low cost because it involves distributing shares to institutional investors. It may also use a public offer whereby share prices are fixed. It is used for a large issue when a company is seeking a listing for the first time. The shares are offered to the public with the help of a sponsor and the broker in deciding on an issue price. The issue price should be low enough to attract potential investors but high enough to raise enough finances. The issue is underwritten by institutional investors so that the issuing business is guaranteed to receive the finances it requires. The underwriters buy shares that are not bought at the offer at an agreed price. The business could also list through an introduction whereby the existing shareholders grant a listing. An introduction is mainly done to increase the marketability of its shares, obtain access to capital markets, or to determine the value of the business shares. Placing is mainly used in small markets where the amounts raised cannot justify the added costs such as marketing, advertising, and underwriting incurred by a public offer. There are advantages of raising finances through a stock exchange quotation. The business raises finances by coming to the market. When the business lists at the stock exchange, it can sell some of its shares and realize some of the investment made by the owner of the business. It also has an advantage of providing access to finances that may be used to fund the expansion of the business. When the business lists on the stock market, it gets easier access to external sources of equity capital because it becomes attractive to institutional investors. It can easily obtain long-term equity finances it requires for expansion. Finance Guru Ltd is currently unlisted, limiting its growth because of difficulties in raising the finances required. The business may also obtain more financing from lenders because they perceive quoted firms with high credibility and reputation leading to low perceived risk and lower cost of debt. It also has an advantage of financing a takeover (Guerard & Schwartz, 2007). The business may need to acquire other firms to achieve its growth. The shares of a listed firm are more likely to be accepted by the target company shareholders in exchange for their existing shares than shares of a private company. It is because they are easy to sell because they have a ready market. There are also disadvantages of seeking a stock exchange quotation. It is costly to obtain and maintain a stock exchange quotation. These costs reduce the amount of finances raised by the new issue. The costs also include the admission fee, sponsor fees, legal fee, and reporting accountant fee. There are also annual costs of satisfying listing requirements and cost of increased financial disclosure requirements. There is also a disadvantage of satisfying the expectations of new shareholders. The expectations of different shareholders present a problem because dissatisfied shareholders may sell their shares to a bidding company. There is also a disadvantage of increased regulation and control because the business faces increased scrutiny from the public. London’s financial markets have scrutiny from Financial Service Authority (FSA), media, legislations, and other government regulators such as Competition Commission and Office of Fair Trading, European Union regulations, and accountants. The business may also consider raising new finances through a right issue. A business is required to offer new shares to existing shareholders for the first time. The business may offer shares to existing shareholders through a right issue. Shares are sold at a discount of the existing market price of the shares. A right issue has advantages of low issuing costs, no dilution of ownership, and no loss of control of the business. However, they are not appropriate for a business that requires a large amount of capital. The business may also fund its operations from preferential shares. Preferential shares receive a share of the annual profits. They have a preferential right to receive dividends when the business is wound up. They are irredeemable but do not carry voting rights. The business may also list in Stock Exchange of other countries to broaden the shareholder base, reward employees in the local subsidiaries, raise understanding of investors in that market, and raise awareness of the business. It could also join to understand better the economic, social, and industrial changes occurring in major product markets. Debt Finance The business may also opt for long-term financing by borrowing. The difference between debt and equity finance is that the interest paid on long-term debt finance is an allowable deduction from chargeable profit tax whereas it is not allowed in equity finance. Debt can be engineered to meet the requirement of the business and investors, for instance, new issue of bonds may be attached to warrants, and bonds may be converted into ordinary shares at a future date. Debt finances include loan stock, debentures, and bonds. Debentures are a written acknowledgment of indebtedness and signify a bond that is secured by a trust deed against assets. A loan stock refers to an unsecured bond. The debentures may be secured against assets of the business by either a fixed or a floating charge. A fixed charge is on specified assets that cannot be disposed of while the debt is outstanding. A floating charge is on a class of assets such as current assets and disposal of some assets is allowed. Debt finance may be obtained from banks and other financial institutions. They must satisfy that the purpose of the debt is good. They charge a floating charge above bank base rate depending on the perceived risk of the borrowing business. The banks also prepare a repayment schedule, which is an agreement between the bank and borrowing business on payment of both interest and capital. The business may also acquire financing through international debt finance. When the business expands to the international market, its financial needs may change. It may finance its operations in the foreign country by borrowing in the local currency to hedge against exchange rate losses. It may also borrow in a foreign currency because of lower interest rate and enable it to reduce effects of restrictions on the current exchange. One of the international debt finance debt is the use of Eurobonds. These are bonds that are outside the control of the country in whose currency they are denominated, and they are sold in different countries at the same time by large companies and governments. An example of a Eurobond is a Eurodollar bond, which is a bond outside the USA. Eurobonds are not strictly regulated, have maturities of 5 to 15 years, and have rates lower than those of domestic bonds. Long-term debt finance also includes convertible bonds. They are fixed interest debt securities that can be converted into ordinary shares of the business at the option of the holder, or a predetermined date, and at a predetermined rate. When they are not converted, they are redeemed at a date years after the conversion date. Warranties are also a long-term debt source of finance. A warrant is a right to purchase new ordinary shares in a business at a future debt, at a fixed predetermined price known as the exercise price. Leasing is also a source of financing that refers to hiring an asset under an agreed contract. A business is allowed to use an asset for a period while legal ownership of the leased asset does not change. The decision concerning the mixture of internal and external sources of finances is dependent on some factors. The level of finances required is important to determine the right proportional because the business can finance small investments from retained earnings and large investments from external financing. The cash flows from existing operations also determine the mixture such that if it is strong, a higher proportion of the finance required for investment can be generated internally. The cost also determines the proportion such that the business may use retained earnings to avoid issuing costs. The dividend policy of the business also has an impact on the proportion of debt and equity finance because it affects the amount of retained earnings. LIQUIDITY DECISION Net working capital refers to the difference between current assets and current liabilities. Current assets include inventories of raw materials, work-in-progress, and finished goods, trade receivables, short-term investments, and cash while current liabilities include trade payables, overdrafts, overdrafts, and short-term loans. The liquidity of the business is determined by the level of working capital. The business must have enough current assets to generate cash to meet short-term needs to ensure its survival (Pandey, 2009). A high level of current assets exceeding current liabilities ensures the business is more solvent and liquid. The objectives of working capital management are to ensure that it has sufficient liquidity to meet short-term obligations as they fall due. The business may choose to hold more cash than it requires for its operations. Liquid assets give the lowest return, for instance, cash kept in a safe does not generate a return while a four-month deposit bank deposit earns interest in exchange for the loss of access for the four months. The business requires formulating policies concerning the components of working capital. The business should have working capital policies on the management of inventory, trade receivables, cash, and short-term investments to minimize the likelihood of managers making imprudent decisions. Prudent working capital policies will reflect corporate decisions on the total investment needed in current assets. These include the overall level of investment, the amount of investment needed for each type of current asset, and the way in which current assets are to be financed. Working capital policies also need to reflect the credit policies of the close business competitors because it would be imprudent to lose business because of unfavorable comparisons of terms of trade. It is also important to consider any unexpected fluctuations in the supply or demand for goods and services, for instance, because of seasonal variations. Finance Guru Ltd may adopt different levels of working capital. It could adopt an aggressive policy in the level of investment in the working capital such that it operates with lower levels of inventory, trade receivables, and cash for a given level of activity. The policy will increase profitability because less cash will be in current assets. However, it also increases risk because the possibility of cash shortages or running out of inventory is increased. The business could also adopt a conservative and more flexible working capital for a given level of turnover. The policy maintains a larger cash balances. The policy will give rise to a lower risk of financial problems or inventory problems and obtain lower profits. The business may also adopt a moderate policy that is between the aggressive and conservative policies. There are several sources of short-term finances for the business. They include overdrafts, short-term bank loans, and trade credit. The business can borrow as much or as little as it needs up to the overdraft limit, and the bank charges daily interest at a variable rate on the debt outstanding. An overdraft may require to be secured with collateral by the business to protect against the risk of default. It is a flexible source of finance that the business may use when the need arises. A short-term loan is a fixed amount of debt finance borrowed by a business from a bank with a repayment to be made shortly. The business pays interest on the loan at either a fix or floating rate at regular intervals. It is less flexible than an overdraft because the full amount of the loan must be borrowed over the loan period, and the business must commit to paying interest on the borrowed amount. Short-term sources of finances are cheap and flexible than long-term sources. They also have lower interest rates. However, they are riskier than long-term sources to the business because interest rates are more volatile in the short term than in the long term. The business must balance between profitability and risk in deciding how the funding of current and non-current assets is divided between long-term and short-term debt. The financing of working capital involves a trade-off between risk and return. There has to be a decision on the choice between short-term and long-term funds to finance working capital. Matching funding finances are fluctuating assets with short-term funds and permanent current assets and non-current assets with long-term funds. The maturity of the funds hardly matches the maturity of the different types of assets. A conservative funding policy uses long-term funds to finance non-current assets, permanent current assets, and some fluctuating current assets. The risk of a conservative funding policy is lower because there is less dependence on short-term financing. However, it leads to lower profitability because there is a high cost of long-term finance. An aggressive funding policy uses short-term funds to finance fluctuating current assets and some permanent current assets. It has the highest risk to solvency, highest profitability and increases shareholders value. Liquidity decision also involves management of cash of the business. A business holds cash for transaction, precautionary, and speculative purposes. Cash management is concerning with optimizing the amount of cash available, maximizing the interest earned by spare funds, and reducing losses caused by delays in the transmission of funds. When cash is held to meet short-term needs, it incurs an opportunity cost equal to the return that could have been obtained if the cash had been invested. However, reducing the opportunity cost by operating with small cash balances increases the risk of being repaying debts as they fall due. Therefore, an optimum cash balance must be decided. The optimal cash balance may vary over time. It will be dependent on a number of factors that include forecasts of the future cash inflows and outflows, the efficiency of managing cash flows, and the availability of liquid assets. It will also depend on the borrowing capacity of the business and the business’s tolerance of risk. The business also needs to invest surplus cash to earn a return by investing on a short-term basis. The business should set limits on the amount that it deposits to individual banks because banks may fail. The factors to consider in choosing an appropriate investment method for short-term cash surplus include the size of the surplus, ease of realizing the investment, and time of maturity of investment. Other factors include the risk and yield of the investment and any penalties in case of early liquidation. Short-term methods used in managing the liquidity of the business include money market deposits, sterling certificates of deposit, Treasury bills, sterling commercial paper, and gilt-edged government securities. CAPITAL STRUCTURE DECISION John must decide on the proper proportion of debt and equity to use in financing the operations of the business. As the business expands to the international market, a number of factors are important to determine its mix of debt and equity. They include gearing, taxation, political risk, and currency risk. Gearing of the parent business and subsidiaries will be considered. If the parent business guarantees the debts of its subsidiaries, the decision on the gearing of subsidiaries can be made independently. Taxation is different in different markets. It is easy to use debt financing because interest payments on debts are tax deductibles whereas dividends are charged taxes. There is also a political risk in different countries. However, it is highly unlikely for the expropriation of assets if it is financed through local debts. There is also a currency risk such that use of local debt finances reduces translation exposure. Gearing refers to the amount of debt finance a firm uses relative to its equity finance. A business with a high level of debt finance relative to equity finance is highly geared. The implications of high gearing include increased volatility of equity returns, increased possibility of bankruptcy, reduced credibility on the stock exchange, and encouragement of short-termism. A sensible capital structure integrates sensible levels of debt into its capital structure so that it can enjoy tax advantages of debt finance and reduce its weighted average cost of capital. It must also not raise its gearing to levels that raise concern among investors about possible bankruptcy. DIVIDEND DECISION The dividend decision considers the amount of earnings to be retained by the business and amount to be distributed to shareholders. If a business has few suitable projects, it should return the unused earnings to shareholders in the form of dividends (Eckbo, 2008). The manager has to take the views and expectations of shareholders to decide on the level of dividends paid. It must also be balanced with the cost and ability of the business to access internal and external sources of finance. Paying dividend requires approval by shareholders at the business’s annual general meeting. The Articles of Association of the business determines the mechanisms of paying dividends. There are a number of limitations on paying off dividends. They include legal constraints that require a company to pay dividends only out of accumulated net realized profits. A business whose net assets fall below the total of its called up share capital reserves is prevented from paying dividends. The government has also imposed direct restrictions on the amount of dividends that a firm can pay. Firms must also follow any restrictions imposed on the dividend policy by loan agreements that seek to protect the interest of the creditors. It may also be limited by the liquidity of the business because dividends are cash transactions that have an effect on the liquidity position of the business. The dividend policy may also be restricted by interest payment obligations such that a business with a high level of gearing and interest commitments may not pay dividends. Another limitation is the investment opportunities because retained earnings are the main sources of finances of businesses. There are a number of dividend policies that the business may adopt. It could use a fixed percentage payout ratio policy such that the business pays out a fixed percentage of annual profits as dividends. It maintains a constant payout ratio. Its advantages include that it is easy to operate and send a clear message to investors about the level of the performance of the business. The disadvantages include it imposes a constraint on the amount of funds it can retain for reinvestment. It is inappropriate for the business if it has volatile profits. The business could also adopt a zero dividend policy such that it pays no dividends at all. It is beneficial to a small minority, and the business does not incur the administration costs associated with paying dividends. The business reinvests all its profits and is attractive to investors who prefer capital gains to dividends. It is appropriate for Finance Guru Ltd because it is a new business that requires large amounts of reinvestments in the first few years of their existence. The business may also adopt a constant or steadily increasing dividend such that it pays a constant or steadily increasing the dividend in either money terms or real terms. Dividends increases are kept in line with long-term sustainable earnings. The disadvantage of the policy is investors may expect that dividend payments will continue the trend indefinitely. INVESTMENT DECISION Businesses need to invest in wealth-creating assets to renew, extend, or replace the means by which they carry on their business. It allows business to generate cash flows in the future or to maintain the profitability of existing business activities. They require significant cash outflows at the beginning and will produce cash inflows over several years. There has to be careful evaluation because they need a large investment of cash and ensure sustainability of the business. John should consider the best profitable investment projects so that they can maximize the returns on the shareholders and avoid negative consequences from poor investment decisions. These decisions affect the business over a long period. There are several techniques to appraise investment decisions. They include payback period, return on capital employed, pet present value, internal rate of return, and profitability index. Payback period method refers to the number of years that a project is expected to recover the initial investment from the net cash flows resulting from a capital investing project. The decision rule in using payback period is to consider projects that have the shortest time. The advantages of using payback period include being a simple method, easy to apply, and straight forward. Its disadvantages include not recognizing the time value of money and ignoring cash flows outside the payback period. Net present value (NPV) is also an investment technique method that uses discounted cash flows to evaluate capital investment projects. It uses a cost of capital or rate of return to discount all cash inflows and outflows to the present values. It then compares the present values of all cash inflows with the present values of all cash outflows. A positive NPV indicates that an investment project will give a return in excess of the cost of capital and lead to an increase in shareholders’ wealth. Therefore, projects with a positive NPV are accepted. The advantage of NPV is that it utilizes the time value of money and uses cash flows instead of accounting profits. As the business expands, it may consider acquiring other businesses. The decision to take over or acquire other businesses must also be guided by capital investment techniques. The business may decide to acquire other firms because of economic justification for takeovers, synergy, entering to a new market, provide critical mass, providing growth, and increase market share. RISK MANAGEMENT As the business expands internationally and uses debt financing, it faces new risks. The risks include exchange rate and internet rate risks. Currencies float freely against each other and exchange rates may become volatile. The business must hedge interest rate risk because of the need and complexity of the company borrowing. The business must also hedge because of interest and exchange rate risk exposures. Interest rate risk is faced by a business that is associated with having a high proportion of floating interest rate debt. An increase in interest rate volatility leads to difficulty in forecasting and planning of future cash flows. It may even lead to bankruptcy (Homaifar, 2004). Exchange rate risks include transaction risk, translation risk, and economic risk (Jain & Khan, 2005). Transaction risk refers to risk that the amount of domestic currency either paid or received in foreign currency transactions may change because of movements in the exchange rate. Economic risk refers to the risk of long-term movements in exchange rates undermining the international competitiveness of a firm or reducing the net present value of the business operations. A business may use internal risk management to hedge interest risk or exchange rate risk through the structuring its assets and liabilities. It is cheaper than external hedging methods that incur costs and arrangement fees. Internal hedging method can manage interest rate exposure within a company’s financial position statement through smoothing and matching. Internal hedging methods can also manage transaction and translation risks through matching, netting, leading and lagging, and invoicing in the local currency. A business may also use external risk management methods to hedge interest rate and exchange rate risks. The methods include forward contracts and money market hedges. They also include derivatives instruments such as futures contracts, swaps, and options. The advantages of risk management include maintaining competitiveness, reduction of bankruptcy risk, restructuring of capital obligations, reduction in the volatility of corporate cash flows, tax benefits, and enhancement of companies’ debt capacity. The disadvantages include the complicated nature of hedging instruments, costs associated with derivatives, and risks associated with using external hedging instruments. A business in another market also faces political risks. These are risks associated with political events in a host country or a change in the political relationships between a host country and one or more other countries. Political risks may be favorable or unfavorable. Political risk management involves assessing the political risk and its possible consequences, and the development and implementation of policies to minimize political risk. The policies to manage political risks include insurance against political risk, negotiation of agreements with host governments, financing and appropriate structuring of a business’s operations. References Damodaran, A. (2010). Applied corporate finance. John Wiley & Sons Eckbo, B. E. (Ed.). (2008). Handbook of Empirical Corporate Finance SET (Vol. 1). Elsevier. Graham, J., & Smart, S. (2011). Introduction to Corporate Finance: What Companies Do. Cengage Learning. Guerard, J., & Schwartz, E. (2007). Quantitative corporate finance. Springer Science & Business Media. Homaifar, G. (2004). Managing global financial and foreign exchange rate risk(Vol. 159). John Wiley & Sons. Jain, P. K., & Khan, M. Y. (2005). Basic financial management. Tata McGraw-Hill. King, J., & Carey, M. (2013). Personal Finance: A Practical Approach. Oxford University Press. Pandey, I. M. (2009). Essentials Of Financial Management, 1E. Vikas publishing house PVT ltd. . Read More