The most common short term sources of finance that corporations use to generate funds - Essay Example

? Module Semester In this report, we will be discussing the most common short term sources of finance that corporations use to generate funds, secondly, annual reports of two companies Premier Oil and LukOil will be compared, thirdly, the liquidity ratio and efficiency ratio of those will be compared and their financial position will be analyzed. Short term finance sources refer to sources that have to be repaid within a year. These are important tools which help in operating the business efficiently. The short term finances also help in making a long term strategy for the business. They can be used to pay for the salaries of the employees and other administrative costs. There are four most common short term sources of finance that a business uses to finance its expenses and they are; 1) Bank overdraft 2) Short term loans 3) Trade credit 4) Sale of unused assets In today’s modern era, every business maintains a bank account of its own where it deposits the money it receives from the sales generated by the business. As the businesses expand, the ratio of their cash sales ratio decreases to the credit sales ratio, because of which the businesses can face difficulties in paying their short term and immediate expenses such as paying salaries of their work and the heating bill. This is when the businesses ask ‘their’ bank for an overdraft so that they can pay for their expenses. Bank overdraft is a form of loan given by the bank to its customers and businesses, where the customers and businesses are charged interest on the money spent by them. Another option that a business can exercise to pay for its expenditures and administrative costs is by arranging a short term loan from the bank. Any loan taken from the bank that has to be repaid within a year can be defined as ‘short term loan’. Trade credit is the number of days in which a business has to pay for the good it has received from the supplier. The number of days in which the payment has to be made for the business entirely depends on the working relationship between the supplier and the buyer. If the buyer has been maintaining a good reputation and has always being paying on time, the supplier may also go a little easy on the buyer by giving him enough time to arrange for the funds. Most businesses only exercise this source of finance when all their sources of finance are have been used up. In this source of finance, funds are generated by selling unused fixed assets of a business or assets that the business is not making full use of, which may include extra machinery, buildings and vehicles. By selling the unused fixed assets, the business is able to generate enough funds to meet its requirements. In 2010, LukOil used four sources of finance to meet their requirements which were, Trade Credit, Sale of investments, Sale of property and Sale of its subsidiary companies. To generate funds to meet its short term obligations, LukOil had to sell its short term investments, which included bonds and other cash equivalents. In addition to that, LukOil also sold some of its subsidiary companies to generate enough cash for the company so that they don’t have to arrange for a bank overdraft or short term loans to pay for the expenses. The company also sold some of its property that it had bought long time back for expanding purposes, in order to generate cash to meet the short term obligations of the company. On the other hand, the primary sources of finance that were used by Premier oil to finance its expenses were Trade Credit, Sale of unused assets and Sale of investments. Premier oil asked their suppliers to extend the payment time given to them so that they meet their other short term expenses first, and then, when they have enough funds, the suppliers will be paid. This helped in solving the problem of meeting short term obligations for Premier Oil. Another source through which Premier Oil arranged for funds to meet its short term obligations was sale of its unused fixed assets, the assets that the company had in surplus. This included sale of property, offices, buildings, sites which were not profitable or were not generating enough revenue to meet the company’s demand. This source of finance helped in putting the idle money into use. Like LukOil, Premier Oil also used sale of investments as a source of finance to meet its short term needs. The company sold some of the bonds and other cash equivalents that it owned to meet the demand of its short term obligations. LukOil’s Liquidity Ratios Name of ratio Formula With figures ($ m) Final Value Current Ratio Current Assets / Current Liabilities (20617/10775) 1.91 Quick Ratio (Current Assets – Inventory)/Current Liabilities (20617-6231)/10775 1.33 Premier Oil’s Liquidity Ratios Name of ratio Formula With figures ($ m) Value Current Ratio Current Assets / Current Liabilities (311.2+299.7+18.6+67.5)/(503.2) 1.38 Quick ratio (Current Assets – Inventory)/Current Liabilities (697-18.6)/503.2 1.34 Premier Oil’s Efficiency Ratios Name of ratio Formula Figures ($ m) Value Debtor days 365/ [Turnover / Average Debtors ] 365/[(763.6/126.7)] 60.56 days Creditor days 365/ [Trade receivables / Cost of goods sold] 365/[(64.4/43.5)] 246.5450311 Stock turnover days 365/[COGS/ Average Inventory] 530.5/[(18.6+35.3)/2)] 19.68 days The ‘Current Ratio’ of LukOil is 1.91, which gives an indication that the company has enough funds and assets to pay off its liabilities easily, should the need arise for it to. Anything above 1 in the current ratio suggests that company has no liquidity problems and the funds are being well used by the management of the company. The ‘Quick Ratio’ of LukOil is also above 1, which means that even without considering the inventory, the company will still be left with more than what it owes to its suppliers and other stakeholders, thus the company is in a good financial position and can very easily pay off its liabilities. Moving on to the analysis of Premier Oil’s Liquidity Ratios, the current ratio of the company is 1.38, and anything above 1 is considered good, which means that even Premier Oil can pay off its liabilities, but not as easily as LukOil can, as LukOil has a current ratio of 1.91. The quick ratio of Premier Oil is 1.34, which is better than that of LukOil, which suggests that Premier Oil is in a good financial condition and can pay off its liabilities easily. If we look at the efficiency ratios stated above, they suggest that LukOil has been managing its working capital more efficiently compared to Premier Oil, as the ‘Debtor Days Ratio’ of LukOil is only 28.58 days, while the same ratio for Premier Oil is 60.56 days which means that LukOil receives its money from the debtors much earlier than Premiere Oil does which helps LukOil in managing their working capital more efficiently. In addition to that, the creditor day’s ratio of Premiere Oil is 246.54 days, while the creditor day’s ratio of LukOil is 184.95 days, which means that Premier Oil pays it suppliers and creditors later than LukOil Oil does. The last efficiency ratio, that is Stock turnover days, is also much higher for Premier Oil compared to LukOil, which means that LukOil is able to sell its inventory quicker than Premier Oil thus generating enough cash to manage its working capital efficiently. After analyzing the annual reports and ratios of both the companies, it can be said that LukOil is in a better financial position than Premier Oil, as it is using new and better techniques to manage its working capital effectively. In addition to that, since the Stock Turnover Ratio of LukOil is twice as much as Premier Oil, it helps them in generating more quickly. References Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced Manufacturing: The CAMI Conceptual Design. Boston: Harvard Business School Press. Asish K. Bhattacharyya, “Financial Accounting for Business Managers”, Prentice Hall of India Private Limited, Connaught Circus, New Delhi, 2007. Tom Nelson, “Management Accounting”, Macmilan, New York, 1970. Bierman Jr. H. & Drebin Allen Jr., “Financial Accounting – An Introduction”, Macmillan, New York, 1965. Read More