Internal and Short-Term Sources of Finance - Essay Example

Sources of Finance

There are different sources of finance for listed companies. The suitability of a given source of finance varies across companies and industries. It is important for financial managers to analyse critically the financial needs of a company when making the decision on the appropriate source of finance. The importance of analysing the available sources of finance for a company is that it helps in determining the risk involved with acquiring funds (Bennouna et al., 2010).

Internal and short-term sources of finance

A company can raise funds by re-investing profits instead of making dividend payments to shareholders. Another internal source of funds for a company is its assets. A firm can finance its activities by use of proceeds from the sale of assets that are not critical for the operation of the company (Bennouna et al., 2010). Financial institutions are also a direct source of funding for firms. A firm can obtain a loan or an over-draft from a bank to finance its activities. Most companies prefer over-drafts because of flexible payment terms and it does not tie the firm to the lender. Another advantage of an over-draft over a loan is that it does not require the provision of collateral.

It is important for financial managers to analyse the cash flow of a firm before deciding whether to go for a loan or an over-draft. Furthermore, a good debt history is significant when sourcing funds since lenders would analyse the credit worthiness of the firm before extending a loan to the firm. A poor debt history increases the risk of default and as such, reduces the chances of the firm acquiring a loan or an over-draft (Bennouna et al., 2010).

External Sources of Finance

A firm can obtain funds from external sources by issuing shares to a third party. This option of raising funds is significant in improving the balance sheet of the firm. Nonetheless, an issue of share to a third party may interfere with the original capital structure of the firm. Additionally, the issue of shares to a third party may distort the initial decision making process of the company. Third parties provide funds for a firm by buying shares and in return receive privileges such as voting rights on matters affecting the firm (Bennouna et al., 2010).

Venture capital organizations are another external source of finance for firms. Under the venture capital system, the firm can acquire funds without any interfering with its management and control, unlike in the case of issuing shares to third party. Another advantage of venture capital is that the firm not only receives funds but it also acquires expertise advice on management of projects, which is invaluable for a company’s performance (Bennouna et al., 2010). The only shortcoming of venture capital is that most venture-capital organizations prefer collaborating with established firms and as such may not be accessible to start-ups or small companies.

Efficient working capital management

Working capital is a financial metric that measures the operational liquidity of a firm (Baker et al., 2010). The working capital of a firm is given by the difference between current assets and current liabilities. A firm is efficient if it has a positive working capital, which indicates that the firm is able to take care of its operations including covering operational expenses and servicing short-term debt. However, it is important to analyse the components of current assets before concluding that a firm has an efficient working capital (Baker et al., 2010).

A high working capital may not be favourable especially if a large portion of the firm’s current assets is made up of inventory and receivables rather than cash and short-term liquidity.

There are different techniques that can ensure effective management of capital. Managers need to dwell on areas that are responsive to the company’s operations. These areas include current assets and current liabilities of the firm (Baker et al., 2010). The specific accounts for consideration when implementing capital management techniques include accounts payable, inventory, and accounts receivable.

Effective management of working capital reduces a firm’s dependency on external sources of funds as it provides extra cash to finance the firm’s operations. Three techniques can be used in managing the working capital of a firm. Firstly, management should negotiate for favourable payment terms with suppliers. Aspects to consider when negotiating the payment terms include quality, price, delivery periods, and payment terms (Baker et al., 2010). The management can consider limiting the payment runs for payables to an optimal frequency. The limits should be in line with the country and industry specific conventions and they should consider the firm’s accounting system. There should be a clear definition of the compliance standards. This may require the supplier to provide data on products, which is essential in ensuring adherence to stipulated standards (Baker et al., 2010).

The second area of consideration in management of working capital is inventory. Excess inventory is a good source of cash for a company (Baker et al., 2010). A firm should reduce its inventories to an optimal level to free up funds that lie idle in form of excess inventories. One technique of minimizing inventories involves streamlining stakeholder processes with internal processes. Accurate forecasts combined with an up to date demand schedule gives room for reliable planning, which minimizes a firm’s inventory and improves delivery. The management of the company can also ensure an optimal level of inventory by establishing advanced delivery and logistics concepts (Baker et al., 2010).

Some of the effective concepts include vendor-managed inventory and just in time (JIT). The company may also consider redesigning its production process to reduce excess inventory and do away with time lags in the production process. Redesigning the production process may entail implementing demand-driven pull systems and clearing any holdups in the production process. Service level adjustments can also help in reducing the level of inventories (Baker et al., 2010). This approach entails designing a service level that puts more emphasis on products critical to customers than products that are not critical to customers. This approach ensures that the company holds an optimal inventory that meets customer needs. Additionally, variance management may help a firm to identify the demand pattern of products, which can help in reducing excess inventory (Baker et al., 2010).

The final area of consideration in implementing effective techniques of managing working capital is the collection of receivables. Cash flow problems can arise from a mismatch in the timing of costs incurred and customer payments. A firm should manage prepayments and receivables efficiently to ensure there no cash flow problems (Baker et al., 2010). Specific areas of interest include offering early reminders, payment schedule, invoicing cycle, and payment terms. The firm should provide invoices to customers as early as possible to ensure customers honour their invoices in time. The invoicing process should be swift and free of any obstacles. Offering early reminders will also help in reducing the time taken by customer to pay (Baker et al., 2010). The company can also consider establishing direct debiting system to avoid overdue payments. For firms operating in project business, payments schemes should cover incurred costs. Furthermore, introducing a prepayment system may also increase liquidity and provide extra cash for the firm to use in its operations (Baker et al., 2010).

Capital Budgeting

Net Present Analysis

Net present value = summation of the present value of cash flow- initial investment cost.

From the above calculations, both investment proposals are viable since they have a positive net present value (Bennouna et al., 2010). However, Madison Platform proposal has a greater NPV compared to Madison Super. In case the Madison plc has capital rationing problems, then the Company should opt for Madison Super proposal since it costs less than Madison Platform proposal. Other capital budgeting techniques other than NPV include internal rate of return and the payback period.

The Internal Rate of Return

Three methods can be used to compute or estimate the internal rate of return: the trial and error method, linear interpolation, and the direct calculation (Bennouna et al., 2010). The direct calculation is only used when the cash flow are for a single year. Therefore, the case above will make use of the linear interpolation method to estimate the internal rate of return.

Linear interpolation

It is important to note that by using this method, the higher discount rate yield a negative net present value while the lower discount yields a negative net present value (Bennouna et al., 2010).

Linear interpolation

Based on the IRR method, both Madison Super proposal and Madison platform proposal are viable since the IRR>R. However, the company should select Madison Super proposal since it has a higher IRR than Madison Platform proposal.

Payback Period

Payback period is the duration that the project takes to break even. This is the period when the cumulative cash flow will be equal to the initial capital investment. Madison Super proposal has a payback period of one year while the Madison Platform has a payback period of one year and four months. Based on the above results, the Madison Super proposal is more viable since it has a shorter payback period compared to the Madison Platform proposal (Bennouna et al., 2010).

Break-even Analysis

A break-even analysis involves comparing the costs of production with the sales forecasts of a business. The break-even point is the point where the firm’s production costs are equal to the sales (Hillier et al., 2010). Having a low break-even point is advantageous because it makes it easy for a company to make profits. Below is an example of a break-even analysis of a small business.

Assume that a piece of jewellery is produced at a cost of $50 with fixed costs worth $1,000. What would be the break-even points for selling the jewels at a price of $100 per item and at $150 per item?

Break-even point = fixed costs / (selling price-variable cost)

Selling price

Fixed costs

Variable cost

Break-even point

$100

$1000

$50

1000/(100-50) = 20

$150

$1000

$50

1000/(150-50) = 10

From the above break-even chart, it is clear that the break-even point is higher when the selling price is higher. A higher selling price means that the company has a greater profit margin than that of a company with a lower selling price (Hillier et al., 2010). However, break-even analysis has some constraints. Firstly, this analysis is based on predicted values and as such, it is not reliable in case of unforeseen factors that might affect future sales (Hillier et al., 2010). Another shortcoming of break-even analysis is that the method assumes that all products will be sold. However, it is not guarantee that a business will sell all its products especially in a competitive market full of demand shocks.

On the other hand, break-even analysis may be beneficial to the company in some ways. Firstly, the analysis is simple and easily accessible (Gervais, 2010). The break-even tool is useful for many companies because it is easy to calculate and can be modified using MS Office to meet specific needs of a business. The break-even analysis is also important in making investment decisions as it helps businesses to analyse critically the viability of expanding into a new market. Finally, the break-even analysis tool can help a business source funds from potential creditors. The tool breaks down the financial overview of an investment by detailing how the funds will be used and the expected revenue streams (Gervais, 2010).

In conclusion, I would advise Madison Plc to use the break-even analysis tool to analyse the prospects of investing in either of the proposals at hand. Break-even analysis will help Madison plc to reduce the chances of diseconomies of scale because the firm will be able to forecast the outcomes of an investment project. However, the tool relies on predictions, which may not reflect the actual costs and sales revenues from an investment project. Therefore, the tool is more appropriate for making long-term investment decisions rather than near-future investment decisions (Hillier et al., 2010).

Other factors affecting investment decisions

Different factors must be considered before making a decision to invest in a project. Normally, firms invest in projects that maximize shareholders’ wealth (Gervais, 2010). Factors such as the duration of the project and cost of capital must be analysed before making capital investments. One of the factors that a firm should consider when making investment decisions is the regulatory environment of the business. Legal requirements may be an obstacle to the smooth operation of a business (Gervais, 20100. Another important factor of consideration when making investment decisions is the risk inherent in the proposed investment. Analysing associated risks may help a business to avoid some of the risks through diversification or passing liability to third parties (Hillier et al., 2010).

Additionally, a business should consider the economic outlook of a region or industry before making an investment decision. Issues such as business cycles, foreign exchange regimes, and political stability may affect the outcome of an investment (Baker et al., 2010). Furthermore, a firm should look at the opportunity cost of investing in a project and weigh the available options to ensure that the investment will yield the best results. Cost-benefit analysis is important in making such decisions. Other factors that could affect the investment decision of a firm include ethical concerns, market features, governance, and level of competition. It is important for a business to evaluate all the factors before making a final investment decision (Baker et al., 2010).

Ratio Analysis

Return on assets = (Net profit / Total assets) * 100%

Puteaux France = 16.92% in 2013, 19% in 2012, and 16.49%

Melian Spain = 9.56% in 2013, 9.49% in 2012, and 9.41% in 2011

Return on Capital employed = (Net profit / Equity) * 100%

Puteaux France = 19.22% in 2013, 21.82% in 2012, and 21.06%

Melian Spain = 123.6% in 2013, 48.11% in 2012, and 28.25% in 2011

The return on capital employed for Melian Spain was higher than that of Puteaux France for the last three years. The return on equity ratio measures the company’s performance in earning return to its shareholders. The figures above indicate that Melian Spain is more efficient in terms of increasing shareholders’ wealth compared to Puteaux France (Buffet & Clark, 2008).

The return on assets ratio measures the company’s performance in generating sufficient profits from its total assets. Puteaux France had a higher return on assets ratio compared to Melian Spain over the three-year period. This result is an indication that Puteaux France is more efficient than Melian Spain in utilising its assets (Buffet & Clark, 2008).

Other than financial ratios, the management’s report may be useful in making investment decision. The management’s report contains comprehensive information regarding the operations of a company over a given financial period (Robinson, 2009). By analysing the management’s report, an investor will be able to identify important information regarding the current market trends, challenges, and future expectations of the company. Additionally, the annual report may also contain notes that explain the financial performance of the company in a given period. Ratios indicate the financial performance of a company but they do not explain any changes in financial position (Robinson, 2009). Having additional information is significant in ensuring that ratio analysis does not overshadow underlying factors that affect a firm’s performance such as investment in new equipment or technology. Such factors may have a short-term negative impact on the financial performance of a company but they may have a positive impact in the long-run (Robinson, 2009).